Correct Option
The correct option is Inventories will deplete, leading to an increase in production.
Explanation
In macroeconomics, ex ante Aggregate Demand (AD) refers to the planned expenditure on final goods and services, while ex ante Aggregate Supply (AS) refers to the planned output by producers. Equilibrium occurs when ex ante AD equals ex ante AS. When these two are not equal, the economy adjusts through changes in inventories and subsequently, output levels.
Analysis of the Adjustment Mechanism
The adjustment process in the short run (assuming price rigidity) operates as follows:
- Disequilibrium Condition: The situation specified is Ex ante AD > Ex ante AS. This means that households and firms plan to purchase more goods than producers plan to produce.
- Impact on Inventories: Since demand exceeds current production, producers must sell from their existing stock to meet the excess demand. This results in an unplanned depletion of inventories (unplanned disinvestment).
- Producer Response: Observing that inventories are falling below the desired level, producers will respond by increasing production to replenish stocks and meet the higher demand.
- Outcome: This increase in production leads to an increase in income and employment until the economy reaches a new equilibrium where AD equals AS.
Why other options are incorrect:
- Prices will rise immediately.: In the standard short-run macroeconomic framework (Keynesian), prices are often assumed to be rigid or sticky. The immediate adjustment variable is quantity (inventory and output), not price.
- Inventories will accumulate, leading to production cuts.: Inventories accumulate when Supply exceeds Demand (AS > AD), leading to production cuts. This is the reverse of the given situation.
- The government will intervene to reduce demand.: Government intervention is a discretionary policy response, not an automatic market adjustment mechanism inherent to the AD-AS model.
Key Takeaway: When Planned Demand exceeds Planned Supply, the immediate signal to producers is a fall in inventories, which incentivizes them to increase output to restore equilibrium.