Lets see what happens in our numerical example if the economy is away from equilibrium. To do that, we'll take another look at Figure 2. Remember, in Figure two, autonomous consumption is 500, intended investment is 1000, and the marginal propensity to consume is 0.7.
We know that the equilibrium income here is 5000. Suppose, instead, that income is 7000 -- corresponding to the vertical orange line to the right. What would happen then?
Remember, income is the same as production. In macroeconomics, "income" means "real income," that is, RGDP or some part of it. Real income is the production of goods and services for final use, measured in dollars of constant purchasing power. So when we say "income is 7000" we are saying "goods and services worth 7000 in dollars of constant purchasing power were produced." Expenditure is shown by the light green C+I line. Comparing it to the 45 degree line -- which translates income from the horizontal to the vertical axis -- we can see that spending is less than income, that is, less than production. Checking the Table, we see that total spending at an income of 7000 is 6400 -- spending falls short of income (production) by 600. When spending is less than the market value of production, it means that some of the goods being produced are not being sold. Goods that are produced but not sold are added to inventories. So what we see is that 600 of production is going into inventory build-ups that businessmen didn't plan on and don't want.
What happens when businessmen have more inventories than they want? The only way they can get rid of unwanted inventories is by selling more than they order. So, with sales down, they have to cut back on orders. In these circumstances, businessmen will cut back on orders, so the factories will cut back on production. Production had been 7000, but as factories cut back it will drop below 7000 -- toward the equilibrium level of 5000.
So we see that when production is above the equilibrium level, unwanted inventory buildups will lead back toward the equilibrium level of production. Let's see what happens when the economy starts out producing less than the equilibrium amount.
More Disequilibrium
