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Chapter 5.5

ECON202 Chapter Notes - Chapter 5.5: Expenditure Function, Dodecahedron, Flickr

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Harvey King

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Figure 5.4 Equilibrium Expenditure
It would likely be helpful to right-click on this graph and open it in a new window to follow
Our next step is to understand how the economy gets to such an equilibrium.
What happens in our economy if spending is not equal to production?
First, we need to understand how firms find out that spending is more or less than production.
Economists focus on inventories, and specifically on unplanned changes in inventories.
Inventories are stores of the final product that firms hold in order to ensure a cushion of product
in case of a surge in sales.
Suppose that you were running a retail storefor example, selling CDs or dresses.
Based on your normal sales and the costs versus benefits of holding inventories, you would have
a target optimal planned inventory of perhaps 200 dresses.
Each week you might sell an average of 40 dresses, and also reorder 40 dresses from the
manufacturer who supplies you.
In this simple example, production of 40 dresses equals the sales (planned expenditure) of 40
dresses on average, with week to week fluctuations depending on the weather, etc.
As a parallel example, we could think about inventories of trucks at truck dealerships.
Trucks are a bigger ticket item, and linked strongly to oil prices (why??).
Let's keep both trucks and dresses in mind as we go forward.
Given this planned level of inventories, let us see how equilibrium expenditure is achieved,
based on what happens when there is an unplanned change in inventories.
We start out with a given expenditure function (AEp), based on the values of the underlying
variables (e.g. the level of business confidence, interest rates, etc.)
As Figure 5.4 illustrates, there are three possible cases, given our expenditure function.
5.5.1 Production = Expenditure
At the production level Y0, the expenditure curve crosses the 45° line.
This says that AEp = Y, or sales = production .
In our dress shop, dress sales = dress orders from the supplier.
Inventories are constant, the store is in equilibrium.
5.5.2 Production > Expenditure
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