Consumer Spending Habits: The Results of Unintended Inventory Changes

The Results of Unintended Inventory Changes Suppose the quantity of final products demanded fell short of aggregate quantity supplied at the existing price level during the year. Under such circumstances there would be an abundance of unsold goods. Many industries would experience slack demand for the final products produced during the year. Manufacturing firms would find that their orders were less than anticipated. As inventories built up, these firms would lay off workers and cut back on orders for materials. Similarly, service firms such as banks, insurance companies, and brokerage houses will find that their staffs were excessive for the volume of their business, and they too would lay off workers. Under such circumstances production and employment would begin to fall, and there will also be downward pressure on the price level. You can imagine a different scenario if quantity of final products demanded exceeded aggregate quantity supplied. Inventories of goods and services would be rapidly drawn down. Manufacturing firms would experience difficulty keeping up with orders. Firms would seek to hire more workers or work their plants around the clock with existing workers as goods and services were reordered. Service firms would also seek to expand their staffs or offer overtime bonuses to existing workers. There would be upward pressure on the price level and upward pressure on the output of final products as the economy moved to a macroeconomic equilibrium. In a market economy no one coordinates the production decisions of business firms with the purchase decisions of buyers. For example, businesses might anticipate a strong holiday selling season. Then an unanticipated event such as a sharp increase in real interest rates or a stock market collapse may cause buyers to buy less than sellers anticipated. As the unexpected decline in sales occurs, business firms that are stuck with lots of inventory cancel their orders for more goods. Similarly, some businesses may revise their investment purchases. As orders are canceled, aggregate production will decline and so will aggregate real income. There could also be downward pressure on the price level as sellers stuck with inventories of unsold goods lower prices. Real GNP, and possibly the price level, will adjust until an equilibrium is attained. Similarly, if sellers underestimate the aggregate quantity demanded during a period, there will be upward pressure on real GNP and the price level as reorders of goods and additional hiring of workers increase aggregate quantity supplied and aggregate real income. How a Decrease in Aggregate Demand Can Affect the Economy A decrease in aggregate demand can result in a decrease in equilibrium real GNP and a consequent decrease in earnings and employment in the economy. If the decrease in aggregate demand is severe enough, it can cause the economy to operate well below its potential and thereby result in excessive unemployment. If the decline in aggregate demand is prolonged, it pushes the economy into a recession. The graph in Box shows the impact of a decrease in aggregate demand in an economy. Suppose the economy is initially in equilibrium at point E,, at which the price level is 120 and real GNP is at the full-employment level of $5,000 billion. When aggregate demand decreases, the economy moves to an equilibrium at point E2, at which real GNP declines to $4,500 billion and the price level falls to 115. The decline in aggregate demand during the year means that a level of output corresponding to $5,000 real GNP cannot be sustained, because at the new level of aggregate demand, it is not possible to sell that much output. As inventories build up unexpectedly during the year, firms cut back orders, and both real GNP and employment decline as the economy moves to the new equilibrium at point E2. The decline in real GNP means the economy moves into a contraction as a result of the decrease in aggregate demand. A decline in aggregate demand is one possible cause of contractions or recessions and can explain increases in cyclical unemployment. We can now begin to unravel the mysteries of the causes of excessive unemployment and recessions.