Curiosity 4.1: What about Unwanted Investment in Inventories?

		increase in government spending serves eventually to increase income by 3.3 dollars. In this case the income multiplier with respect to government spending, or the increase in equilibrium income due to a dollar increase in government spending referred to casually as "the" multiplier is said to be 3.3. The iterative process whereby an increase in government spending leads to an extended increase in income is called the multiplier process.

		The heart of the multiplier process is consumption demand induced by income increases. These consumption demand increases keep the multiplier process going. A government decision to build an airplane-producing plant in a small town should have a significant multiplier effect on that town as incomes earned by those building the plant and employed in the plant are spent in town shops and restaurants. In turn, these businesses and new businesses drawn in by the prosperity will need to hire more workers who will spend part of their incomes in local shops, and so on, expanding this prosperity through the multiplier process.

		The value of the multiplier in the real world is subject to much debate, with estimates ranging from about 2.6 to about 0.6. Critics claim that a variety of factors serve to decrease the multiplier value, many of which are discussed in chapter 7. Anything that reduces the increase in domestic aggregate demand for goods and services caused by an increase in income will slow the multiplier process down and decrease the value of the multiplier. A lower MPC, a higher tax rate, and a higher marginal propensity to import are examples.

		4.4 Inventories and Forecasting

		In figure 4.1, inventory changes play an important role, mainly serving as a signaling device that alerts producers to changes in aggregate demand. They also play two other important roles in macroeconomics.

		First, desired inventory changes are a component of aggregate demand that affects the dynamics of an economy's reaction to disequilibrium, thereby playing an important role in the propagation and maintenance of business cycles. Consider a stimulating dose of fiscal policy. As the economy goes through the multiplier process, inventories are constantly falling because aggregate demand is continually a bit higher than output. If firms do nothing about these reductions, after the multiplier process has worked itself out inventories will have fallen to an undesirably low level. To prevent this result, firms must produce some extra output during the multiplier process. The time path followed by the economy during the multiplier process is affected by when and how quickly the firm decides to do so. If, for example, the firm elects to increase output to restore inventory levels at a late stage in the multiplier process, the level of national income could temporarily overshoot its final level.

		Second, inventory changes can help in forecasting the direction of the economy. Their use in this regard occurs frequently in newspaper commentary, where they play a more prominent role than complex economic models built expressly for forecasting purposes.

		When inventory levels are unusually high or are rising rapidly, firms should react by cutting back on production meeting demand out of inventory to decrease inventory levels