Explain, in detail, how the adjustment to macroeconomic equilibrium occurs when spending is less than production. Be sure to discuss how inventories play a crucial role in the adjustment process

Question

State what happens to GDP and employment during the adjustment process.

Answer 1

If spending is less than production, then firms will not be selling as many goods and services as they had expected. Inventories of goods will start to build up. This sends a signal to those managing the retail firms to cut back on orders of goods from their distributors. Distributors cut back purchases from manufacturers. Manufacturers of the goods will cut back on production of the goods, and reduce purchases from their suppliers and lay off workers. The reduction in production will continue until inventories equal their desired levels, or until spending equals production. If this happens across many different industries, GDP and total employment will decline.