Question

What role do inventories play in the equilibrating process in the simple Keynesian model (as described in the \(T E-T P\) framework)?

Short answer

Inventories in the Keynesian model equilibrate the economy by acting as a buffer between total production and total expenditure. When total production exceeds total expenditure, the surplus goods end up in inventory, and firms subsequently cut back production, moving the economy back towards equilibrium. Conversely, when total expenditure exceeds total production, inventories are depleted and firms respond by increasing production, also moving the economy back towards equilibrium.

Step-by-step solution

Understanding the Keynesian model

The Keynesian model spots the importance of total expenditure in an economy which covers consumption, investments, and net exports. It stresses that total economics spending influences inflation and output.

Comprehending the Role of Inventories

Inventories in this context are the goods produced but weren't sold yet. When firms produce more goods than consumers want to purchase (Total Production is more than Total Expenditure), the extra goods are stored as inventories. The rise in inventories causes firms to decrease their production till inventories begin returning to normal levels.

Understanding the Equilibrating Process

Equilibrium occurs when total production equals total expenditure (\(T E = T P\)). The inventories play an important role in this equilibrating process. If \(T P > T E\), inventories increase and firms decrease production, leading to a decrease in total production towards equilibrium. If \(T E > T P\), inventories fall and firms respond by increasing production, leading to an increase in total production towards equilibrium.