25 Demand-Side Equilibrium: Unemployment or Inflation? A definite ratio, to be called the...

25

Demand-Side Equilibrium: Unemployment or

Inflation?A definite ratio, to be called the Multiplier, can be

established between income and investment.JOHN MAYNARD KEYNES

● The Meaning of Equilibrium GDP● The Mechanics of Income Determination● The Aggregate Demand Curve● Demand-Side Equilibrium and Full

Employment● The Coordination of Saving and Investment● Changes on the Demand Side: Multiplier

Analysis

● The Meaning of Equilibrium GDP● The Mechanics of Income Determination● The Aggregate Demand Curve● Demand-Side Equilibrium and Full

Employment● The Coordination of Saving and Investment● Changes on the Demand Side: Multiplier

Analysis

ContentsContents

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

● The Multiplier Is a General Concept

● The Multiplier and the Aggregate Demand Curve

● Appendix A: The Simple Algebra of Income Determination and the Multiplier

● Appendix B: The Multiplier With Variable Imports

● The Multiplier Is a General Concept

● The Multiplier and the Aggregate Demand Curve

● Appendix A: The Simple Algebra of Income Determination and the Multiplier

● Appendix B: The Multiplier With Variable Imports

Contents (continued)Contents (continued)


Copyright© 2003 Southwestern/Thomson Learning All rights reserved.

● GDP cannot be at its equilibrium if total spending differs from the value of output.

● If spending exceeds output, inventories fall and firms increase production.

● If output exceeds spending, inventories rise and firms reduce production.

● GDP cannot be at its equilibrium if total spending differs from the value of output.

● If spending exceeds output, inventories fall and firms increase production.

● If output exceeds spending, inventories rise and firms reduce production.

The Meaning of Equilibrium GDPThe Meaning of Equilibrium GDP

FIGURE 25-1 The Circular Flow Diagram

FIGURE 25-1 The Circular Flow Diagram


1

3

6

5

4

2

Investors

Government

Firms(produce the

domestic product)

Consumers

Financial SystemRest of the

World

Saving (S

)

Consumption (C

)

Inve

stm

ent (

I) C + I

Gov

ernm

ent

C + I + GImports

(IM)

Exports (X

)C

+ I +

G +

Tran

sfers

Disposable

Income (DI)

Taxes

Gross

National Income (Y)

(X – IM

)

Purch

ases

(G)


● The equilibrium level of GDP on the demand side is the one at which total spending equals production.

● In such a situation, firms find their inventories remaining at desired levels, so there is no incentive to change output or prices.

● The equilibrium level of GDP on the demand side is the one at which total spending equals production.

● In such a situation, firms find their inventories remaining at desired levels, so there is no incentive to change output or prices.

The Meaning of Equilibrium GDPThe Meaning of Equilibrium GDP


The Mechanics of Income DeterminationThe Mechanics of Income Determination

● Constructing the total expenditure schedule♦ Expenditure Schedule = table showing the

relationship between GDP and total spending

♦ Induced Investment = the part of investment spending that rises when GDP rises, and falls when GDP falls.

● Constructing the total expenditure schedule♦ Expenditure Schedule = table showing the

relationship between GDP and total spending

♦ Induced Investment = the part of investment spending that rises when GDP rises, and falls when GDP falls.

TABLE 25-2 The Determination of Equilibrium Output

TABLE 25-2 The Determination of Equilibrium Output


FIGURE 25-2 Construction of the Expenditure Schedule

FIGURE 25-2 Construction of the Expenditure Schedule


G = $1,300

I = $900

C + I + G

C + I + G + (X – IM)

C + I

C

7,200 6,800 6,400 6,000 5,600

6,000 6,100

4,800

Rea

l E

xpe

nd

itu

re

Real GDP

5,200

3,900

X –IM = –$100


● Both the expenditure table and the corresponding “income-expenditure diagram” or “45 degree line diagram” show the equilibrium level of GDP.

● All other levels of GDP are disequilibrium points, at which GDP will move in the direction of the equilibrium.

● Both the expenditure table and the corresponding “income-expenditure diagram” or “45 degree line diagram” show the equilibrium level of GDP.

● All other levels of GDP are disequilibrium points, at which GDP will move in the direction of the equilibrium.

The Mechanics of Income DeterminationThe Mechanics of Income Determination

FIGURE 25-3 Income-Expenditure Diagram

FIGURE 25-3 Income-Expenditure Diagram


Spending exceeds output

Output exceeds spending

Equilibrium

6,000

Rea

l Exp

end

itu

re

45°

5,200 5,600 6,000 6,400 6,800 7,200 0

4,800

5,600

6,400

6,800

7,200

Real GDP 4,800

5,200

C + I + G + (X – IM)

E


price level consumption

● Therefore, price level total expenditures and equilibrium GDP

● Therefore, price level equilibrium level of real aggregate quantity demanded

price level consumption

● Therefore, price level total expenditures and equilibrium GDP

● Therefore, price level equilibrium level of real aggregate quantity demanded

The Aggregate Demand CurveThe Aggregate Demand Curve

FIGURE 25-4 The Effect of the Price Level on Equilibrium AD

FIGURE 25-4 The Effect of the Price Level on Equilibrium AD


(b)

Fall in Price Level

Rea

l E

xpen

dit

ure

Real GDP

C0 + I + G + (X–IM)

Y0 Y2

(a)

Rise in Price Level

Rea

l E

xpen

dit

ure

Real GDP

C0 + I + G + (X–IM)

Y0 Y1

45

45

45

45

C2 + I + G + (X–IM)

E0 E0

C1 + I + G + (X–IM) E1

E2


The Aggregate Demand CurveThe Aggregate Demand Curve

● The negatively-sloped aggregate demand curve shows all the equilibria of price levels and GDP.

● Remember that any income-expenditure diagram is drawn for a specific price level.

● The negatively-sloped aggregate demand curve shows all the equilibria of price levels and GDP.

● Remember that any income-expenditure diagram is drawn for a specific price level.

FIGURE 25-5 The Aggregate Demand Curve

FIGURE 25-5 The Aggregate Demand Curve


E2

E0

E1

Pri

ce

Le

vel

Real GDP

P1

P0

P2

Y2 Y0 Y1


● Equilibrium GDP may not = full-employment GDP.

● Recessionary gap: amount by which equilibrium GDP < potential GDP

● Inflationary gap: amount by which equilibrium GDP > potential GDP

● Equilibrium GDP may not = full-employment GDP.

● Recessionary gap: amount by which equilibrium GDP < potential GDP

● Inflationary gap: amount by which equilibrium GDP > potential GDP

Demand-Side Equilibrium and Full EmploymentDemand-Side Equilibrium and Full Employment

FIGURE 25-6 A Recessionary GapFIGURE 25-6 A Recessionary Gap


Recessionary gap

C + I + G + (X – IM)

45°

45°

Potential GDP

7,000

Rea

l Exp

end

itu

re

Real GDP

6,000

E

F

B

FIGURE 25-7 An Inflationary GapFIGURE 25-7 An Inflationary Gap


Inflationary gap

45°

45°

Potential GDP

8,000

Rea

l Exp

end

itu

re

Real GDP

7,000

C + I + G + (X – IM)

F

B E


The Coordination of Saving and InvestmentThe Coordination of Saving and Investment

● Equilibrium GDP = full employment only if saving out of full-employment incomes = investment

● Savers are not the same people as investors, so it is unlikely that this condition will hold.

● Equilibrium GDP = full employment only if saving out of full-employment incomes = investment

● Savers are not the same people as investors, so it is unlikely that this condition will hold.

FIGURE 25-8 A Simplified Circular Flow

FIGURE 25-8 A Simplified Circular Flow


1

3

Investors

Consumers

Financial System

Saving (S

)

Consumption (C

)

Inve

stm

ent (

I) C + IC

+ I

Y

Firms(produce the

domestic product)

2


Changes on the Demand Side: Multiplier AnalysisChanges on the Demand Side: Multiplier Analysis

● Multiplier = ratio of the change in equilibrium GDP (Y) divided by the original change in spending that caused the change in GDP

● Multiplier = ratio of the change in equilibrium GDP (Y) divided by the original change in spending that caused the change in GDP

TABLE 25-3 Total Expenditure after a $200 Billion Increase

TABLE 25-3 Total Expenditure after a $200 Billion Increase


FIGURE 25-9 Illustration of the Multiplier

FIGURE 25-9 Illustration of the Multiplier


Rea

l E

xpen

dit

ure

45

$200 billion

6,800 0 6,000 Real GDP

C + I1 + G + (X – IM)

C + I0 + G + (X – IM) E1

E0


Changes on the Demand Side: Multiplier Analysis Changes on the Demand Side: Multiplier Analysis

● Demystifying the Multiplier: How It Works♦ The multiplier is greater than 1 because one

person’s spending is another person’s income. spending income

♦ A portion of the increase in income is spent on consumption, creating more income, which in turn creates more consumption spending, and so on.

● Demystifying the Multiplier: How It Works♦ The multiplier is greater than 1 because one

person’s spending is another person’s income. spending income

♦ A portion of the increase in income is spent on consumption, creating more income, which in turn creates more consumption spending, and so on.

TABLE 25-4 The Multiplier Spending Chain

TABLE 25-4 The Multiplier Spending Chain


FIGURE 25-10 How the Multiplier Builds

FIGURE 25-10 How the Multiplier Builds


Spending Round

20 15 10 8 6 4 2

Cu

mu

lati

ve S

pen

din

g T

ota

l $4.0

2.0

3.0

1.0

0



● Algebraic Statement of the Multiplier♦ Multiplier = 1 (1 - MPC)

♦ The MPC has been estimated to be about 0.9, implying that the multiplier is 10.

♦ In fact, the multiplier is < 2.

● Algebraic Statement of the Multiplier♦ Multiplier = 1 (1 - MPC)

♦ The MPC has been estimated to be about 0.9, implying that the multiplier is 10.

♦ In fact, the multiplier is < 2.


● Algebraic Statement of the Multiplier♦ Factors that reduce the size of the multiplier

■International trade■Inflation■Income taxation■Financial system

● Algebraic Statement of the Multiplier♦ Factors that reduce the size of the multiplier

■International trade■Inflation■Income taxation■Financial system



The Multiplier Is a General ConceptThe Multiplier Is a General Concept

● An autonomous change in consumer spending (caused by something other than an increase in income) shifts the consumption function and has a multiplier effect, just the same as a change in I does.

● An autonomous change in consumer spending (caused by something other than an increase in income) shifts the consumption function and has a multiplier effect, just the same as a change in I does.

TABLE 25-5 Consumers Spend $200 Billion More

TABLE 25-5 Consumers Spend $200 Billion More



●Other multiplier effects:♦ A change in G has the same multiplier effect as

a change in I or a change in autonomous C.

♦ The multiplier effect of a change in (X - IM) is the same as for the other components of spending.

♦ Consequently, trade links the GDPs of the major economies.

●Other multiplier effects:♦ A change in G has the same multiplier effect as

a change in I or a change in autonomous C.

♦ The multiplier effect of a change in (X - IM) is the same as for the other components of spending.

♦ Consequently, trade links the GDPs of the major economies.



GDP in a foreign country its imports, a portion of which are exports from the U.S.

● The growth in U.S. exports has a multiplier effect, raising GDP in the U.S.

● Booms and recessions tend to be transmitted across national borders.

GDP in a foreign country its imports, a portion of which are exports from the U.S.

● The growth in U.S. exports has a multiplier effect, raising GDP in the U.S.

● Booms and recessions tend to be transmitted across national borders.



The Multiplier and the Aggregate Demand CurveThe Multiplier and the Aggregate Demand Curve

autonomous spending horizontal shift of the AD curve by an amount given by the oversimplified multiplier formula.

autonomous spending horizontal shift of the AD curve by an amount given by the oversimplified multiplier formula.

FIGURE 25-12 Two Views of the Multiplier

FIGURE 25-12 Two Views of the Multiplier


45

C + I1 + G + (X – IM )

$200 billion

C + I0 + G + (X – IM )

0 6,000

100 Pri

ce L

evel

Rea

l Exp

end

itu

re

6,800

6,800 6,000

Real GDP

(I = $1,100) D1

D1

(I = $900) D0

D0

E0

E0

E1

E1

Appendix A: The Simple Algebra of

Income Determination and the Multiplier


Simple Algebra of Income Determination & MultiplierSimple Algebra of Income Determination & Multiplier

● All of the relationships discussed can be represented in simple algebra.

● All of the relationships discussed can be represented in simple algebra.



● Consumption function: C = a + b(DI)♦ Positive linear relationship between C and DI

♦ a = autonomous consumption, determined by factors aside from DI

♦ b = marginal propensity to consume = C/ DI

♦ b(DI) = induced consumption, determined by DI

● Consumption function: C = a + b(DI)♦ Positive linear relationship between C and DI

♦ a = autonomous consumption, determined by factors aside from DI

♦ b = marginal propensity to consume = C/ DI

♦ b(DI) = induced consumption, determined by DI



● Equilibrium Y = C + I + G + (X - IM), so Equilibrium Y = a + b(DI) + I + G + (X - IM)

● Since DI = Y - T, Equilibrium Y = a + b(Y - T) + I + G + (X - IM)

● Therefore Equilibrium Y = a + bY - bT + I + G + (X - IM)

● Equilibrium Y = C + I + G + (X - IM), so Equilibrium Y = a + b(DI) + I + G + (X - IM)

● Since DI = Y - T, Equilibrium Y = a + b(Y - T) + I + G + (X - IM)

● Therefore Equilibrium Y = a + bY - bT + I + G + (X - IM)



● Then solve for Y: Equilibrium Y = [a - bT + I + G + (X - IM)] / (1 - b)

● Then solve for Y: Equilibrium Y = [a - bT + I + G + (X - IM)] / (1 - b)

Appendix B: The Multiplier With Variable

Imports


The Multiplier With Variable ImportsThe Multiplier With Variable Imports

● Exports are probably insensitive to domestic GDP, but imports are positively related.

● Therefore, net exports decline as GDP rises.

● The effect of this is to lower the value of the multiplier.

● Exports are probably insensitive to domestic GDP, but imports are positively related.

● Therefore, net exports decline as GDP rises.

● The effect of this is to lower the value of the multiplier.

TABLE 25-6 Equilibrium Income with Variable Imports

TABLE 25-6 Equilibrium Income with Variable Imports


FIGURE 25-13 The Dependence of Net Exports on GDP

FIGURE 25-13 The Dependence of Net Exports on GDP


X – IM

X

IM

Real GDP

Negative net exports

Positive net exports

Positive net exports

Negative net exports

Rea

l Net

Exp

ort

s R

eal E

xpo

rts

and

Imp

ort

s

Real GDP

200

100

0

–100

–200

–300

7,200 6,800 6,400 6,000

5,600 5,200 4,800

950

850

750

650

550

450

7,200 6,800 6,400 6,000 5,600 5,200 0 4,800

FIGURE 25-14 Equilibrium GDP with Variable Imports

FIGURE 25-14 Equilibrium GDP with Variable Imports


Positive net exports Negative net exports

X – IM

Real GDP

C + I + G + (X – IM ) (fixed imports)

45

Rea

l Ex

pen

dit

ure

6,000

C + I + G + (X – IM ) (variable imports) E

FIGURE 25-15 The Multiplier with Variable Imports

FIGURE 25-15 The Multiplier with Variable Imports


Real GDP

Rise in exports = $160

Rise in GDP = $400

C + I + G + (X0 – IM )

45C + I + G + (X1 – IM )

6,400

Rea

l E

xpen

dit

ure

6,000

E

A

TABLE 25-7 Equilibrium Income after a $160 Billion Increase

TABLE 25-7 Equilibrium Income after a $160 Billion Increase


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