Inventories

So far, our model has a lot of simplifying assumptions, and is pretty mechanistic. The next chapters will be devoted to the simplifying assumptions, and by the time we finish with them, we will have a model that is at least realistic enough for a few practical applications. For now, let's rethink some of the mechanistic aspects of the model. Just what sort of "equilibrium" is this? Are there any forces in the real economy that would move the economy toward the "equilibrium" and keep it there? What might these forces be?

Inventories will be a key to it.

Inventories: Inventories are stocks of goods held in businesses to bridge the gap between unpredictable sales and scheduled deliveries. For example, in a retail shoe store, the inventories would consist of pairs of shoes available to be sold.

Despite what you may have read about just-in-time deliveries and doing business with almost no inventories, inventories still play a big role in many kinds of businesses and will continue to play a role (I suspect) as long as human beings continue to be unpredictable.

Inventories are a kind of capital good. That means, in turn, that an increase in inventories is an investment. A decrease in inventories is a negative investment. (That shouldn't cause any confusion. Negative investment just means we have less capital goods available at the end of the period than at the beginning. It happens from time to time, especially with respect to inventories).

Investment in inventories is a small proportion of total investment, but it has a special leverage. Here is the reason. At the beginning of a period, businessmen can decide how much they think it will be profitable to invest in capital goods of all sorts: plant and equipment, structures, inventories. As the period goes on, the investments in plant and equipment and structures will be relatively under control. But the investment in inventories will not, because the increase in inventories depends on how much businessmen sell. If businessmen do not sell as much as they had expected, they will find themselves with more inventories than they had planned to have, or wanted to have. These increases in inventories are investments, but they are not investments the businessmen had intended to make. They are "unintended investment."

So we now have two concepts of investment: planned investment and realized investment. Unintended investment is the difference between them, or, to put it the other way round, realized investment is defined as the sum of planned investment and unintended inventory increases.

Thus far, we have said that investment is treated as a constant in our simple model. But we have not said whether it is planned investment or realized investment that we are treating as a constant. The answer is that it is planned investment that we treat as a constant. Realized investment is not a constant, since it is not under control, and may differ from planned investment.

And that, as we shall see, is a key to the equilibrium in the simple Keynesian model we have been studying.

Disequilibrium in the Example