Question

Consumer spending was sluggish in late 2007, and economists worried that an inventory overhang—a high level of unplanned inventory investment throughout the economy—would make it difficult for the economy to recover anytime soon. Explain why an inventory overhang might, like the existence of too much production capacity, depress current economic activity.

Short answer

Inventory overhang through sluggish consumer spending can trigger depression in the economy through decreased production and investment in the long run.

Step-by-step solution

Explaining the reason for an inventory overhang to depress current economic activity

An unplanned accumulation of inventory follows an unanticipated reduction in consumer spending.

An inventory overhang indicates an unplanned reduction in consumption expenditure in the short run. The unplanned inventory accumulation in the short run makes producers more aware of the market conditions and decreases output to match the sluggish consumption expenditure.

The producers reduce production in the long run because they anticipate the increasing inventory to meet the additional consumer demand. Further, producers also cut down on investment spending, anticipating the fall in future output and income.

If the production and investment expenditure falls, the national income will fall, leading to a consequent decline in the consumption expenditure through the marginal propensity to consume. Thus, through the multiplier effect, the national income will decline significantly.

Therefore, sluggish consumer spending can trigger depression in the economy through decreased production and investment in the long run.