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Chapter 26

Chapter 26. 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. Assumptions Constant Price level Rate of interest

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Chapter 26

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  1. Chapter 26 Demand-Side Equilibrium: Unemployment or Inflation? A definite ratio, to be called the Multiplier, can be established between income and investment. JOHN MAYNARD KEYNES

  2. The Meaning Of Equilibrium GDP • Assumptions • Constant • Price level • Rate of interest • International value of the dollar • Total production = Total income • Total expenditure = C + I + G + (X-IM)

  3. Figure 1 The circular flow diagram

  4. The Meaning Of Equilibrium GDP • Equilibrium • Consumers & firms • No incentive to change behavior • Content - continue with things as they are • If Total spending > Output • No equilibrium GDP • Firms - Depleting inventory stocks • Increase production • Meet higher demand • Raise prices

  5. The Meaning Of Equilibrium GDP • If Total spending < Output • No equilibrium GDP • Firms • Inventory increase • Decrease production • Cut prices • Stimulate demand

  6. The Meaning Of Equilibrium GDP • If Total Spending = Output • Equilibrium level of GDP - demand side • Firms • Inventories - desired levels • No incentive to change • Output • Prices

  7. Mechanics of Income Determination • Assumption • I, G, and X-IM are fixed • Total expenditure = C + I + G +(X-IM) • Induced investment • Part of investment spending • Rises - GDP rises • Falls - GDP falls

  8. Table 1 The total expenditure schedule

  9. Figure 2 Construction of the expenditure schedule X-IM=-$100 6,100 6,000 Real Expenditure C+I+G C+I C+I+G+(X-IM) C 4,800 G=$1,300 I=$900 3,900 0 5,200 5,600 6,000 6,400 6,800 7,200 Real GDP

  10. Mechanics of Income Determination • Expenditure schedule • Relationship • National income (GDP) • Total spending • Condition for equilibrium GDP (Y) Y = C + I + G + (X-IM)

  11. Table 2 The determination of equilibrium output

  12. Mechanics of Income Determination • Income-expenditure diagram • 45° line diagram • Plots • Total real expenditure - vertical axis • Real income - horizontal axis • Specific price level • 45° line • Marks off points: • Income = expenditure

  13. Figure 3 Income-expenditure diagram 45° 7,200 C+I+G+(X-IM) 6,800 E 6,400 Real Expenditure 6,000 Output exceeds spending 5,600 Spending exceeds output Equilibrium 5,200 4,800 7,200 0 4,800 5,200 5,600 6,000 6,400 6,800 Real GDP

  14. Mechanics of Income Determination • If Expenditure line – above 45° line • Total spending > Total output • Production – below equilibrium • Inventories – fall • Firms - increase production • If Expenditure line- below 45° line • Total spending < Total output • Production – above equilibrium • Inventories – rise • Firms - cut back production

  15. Aggregate Demand Curve • Higher prices • Decrease demand for goods & services • Erode purchasing power • Of consumer wealth • Lower real wealth • Less spending • Any given level of real income • Lower consumption function • Shift downward

  16. Aggregate Demand Curve • Lower prices • Increase demand for goods & services • Enhance purchasing power • Of consumer wealth • Higher real wealth • More spending • Any given level of real income • Higher consumption function • Shift upward

  17. Figure 4 Shift of the consumption function Movements along consumption function C0 C2 C1 Real Consumer Spending A Shifts of consumption function Real Disposable Income

  18. Aggregate Demand Curve • Higher prices • Lower consumption function • Total expenditure – shift downward • Equilibrium quantity of real GDP demanded • Decreases • Lower prices • Higher consumption function • Total expenditure – shift upward • Equilibrium quantity of real GDP demanded • Increases

  19. Figure 5 Effect of the price level on equilibrium aggregate quantity demanded 45° 45° E0 E0 E2 E1 C0+I+G+(X-IM) Real Expenditure Real Expenditure C2+I+G+(X-IM) C1+I+G+(X-IM) C0+I+G+(X-IM) 45° 45° Y0 Y1 Y0 Y2 Real GDP Real GDP (b) Fall in price level (a) Rise in price level

  20. Figure 6 The aggregate demand curve E1 E2 E0 Price Level P2 P0 P1 Y1 Y0 Y2 Real GDP

  21. Demand-Side Equilibrium&Full Employment • Potential GDP • Full-employment level of output • Equilibrium GDP < potential GDP • Occurs: • Low spending (consumers, investors) • Low government spending • Weak foreign demand • Price level - too high

  22. Figure 7 A recessionary gap Potential GDP 45° C+I+G+(X-IM) E F B Real Expenditure Recessionary gap 45° 0 7,000 6,000 Real GDP

  23. Demand-Side Equilibrium&Full Employment • Equilibrium GDP < potential GDP • Unemployment & Recession • Recessionary gap - amount • Equilibrium level of real GDP • Falls short of potential GDP • To reach full employment • Increase total expenditure line

  24. Demand-Side Equilibrium&Full Employment • Equilibrium GDP > potential GDP • Occurs because • High spending (consumer, investment) • Strong foreign demand • Government spends too much • Low price level

  25. Figure 8 An inflationary gap Potential GDP 45° E C+I+G+(X-IM) F B Real Expenditure Inflationary gap 45° 0 7,000 8,000 Real GDP

  26. Demand-Side Equilibrium&Full Employment • Equilibrium GDP > potential GDP • Inflation • Inflationary gap • Equilibrium real GDP • Exceeds full-employment level of GDP • To reach full employment • Decrease total expenditure line

  27. Demand-Side Equilibrium&Full Employment • Full employment • Occurs: • Spending plans – just right • Price level – just right • No recessionary gap • No inflationary gap

  28. Coordination of Saving & Investment • If S = I • Equilibrium at full employment • On demand side • If S ≠ I • Full employment – not an equilibrium

  29. Figure 9 A simplified circular flow

  30. Coordination of Saving & Investment • Unemployment • Total spending - too low • Stems from coordination failure • Savers • Investors • Coordination failure • Party A – want to change behavior, if • Party B – changes • No changes – no coordination

  31. Multiplier Analysis • Multiplier – Ratio of • Change in equilibrium GDP (Y) • By original change in spending • Caused change in GDP • Multiplier principle • GDP – rises by more than • Change in spending • Multiplier > 1

  32. Table 3 Total expenditure after a $200 billion increase in investment spending

  33. Figure 10 Illustration of the multiplier 45° C+I1+G+(X-IM) C+I0+G+(X-IM) E1 E0 Real Expenditure $200 billion 0 6,800 6,000 Real GDP

  34. Multiplier Analysis • Multiplier = = 1 + MPC + (MPC)2 + (MPC)3 +… • Oversimplified multiplier formula • Actual multiplier • Much lower

  35. Table 4 The multiplier spending chain

  36. Figure 11 How the multiplier builds

  37. Multiplier is a General Concept • Induced increase in consumption spending • From: increase in consumer incomes • Movement along consumption function • Autonomous increase in consumption • Independently of consumer incomes • Shift of consumption function • Change in C, I, G, or (X-IM) • Same multiplier effect • Equilibrium level of GDP – demand side

  38. Table 5 Total expenditure after consumers decide to spend $200 billion more

  39. Multiplier is a General Concept • GDPs of major economies • Linked by trade • Boom in one country • Raise its imports • Other countries • More exports • Increase GDP • Recession in one country • Other countries • Decrease GDP

  40. Multiplier & Aggregate Demand Curve • Income-expenditure diagrams • Given price level • Different price levels • Different total expenditure curves • Increase in spending • Given price level • Multiplier effect • Horizontal shift of aggregate demand

  41. Figure 12 Two view of the multiplier E1 E0 E1 C+I0+G+(X-IM) C+I1+G+(X-IM) E0 45° $200 billion D0 D1 Price Level Real Expenditure 100 Real GDP Real GDP 0 0 D1 (I=$1,100) D0 (I=$900) 6,800 6,000 6,000 6,800

  42. Algebra of income determination & multiplier • b = MPC

  43. Multiplier with variable imports • Our GDP – increase • Our imports – increase • Our exports • Relatively insensitive to own GDP • Sensitive – other countries GDP • International trade • Lowers – value of multiplier

  44. Table 6 Equilibrium income with variable imports

  45. Figure 13 The dependence of net exports on GDP Positive net exports Negative net exports Positive net exports IM 950 200 850 100 750 0 650 -100 Real Exports & Imports Real Net Exports 550 -200 X 450 -300 Negative net exports X-IM 7,200 7,200 Real GDP 4,800 4,800 5,200 5,200 0 5,600 6,000 6,400 6,400 6,800 6,800 5,600 6,000 Real GDP

  46. Multiplier with variable imports • Our GDP – increase • Net exports – decline • International trade • Lowers – value of multiplier • Any autonomous increase in spending • Partly dissipated • Purchases of foreign goods • Additional income – foreigners

  47. Figure 14 Equilibrium GDP with variable imports C+I+G+(X-IM) (fixed imports) 45° E Positive net exports Real Expenditure C+I+G+(X-IM) (variable imports) X-IM Negative net exports 0 Real GDP 6,000

  48. Table 7 Equilibrium income after a $160 billion increase in exports

  49. Figure 15 The multiplier with variable imports 45° A Rise in exports = $160 E C+I+G+(X1-IM) C+I+G+(X0-IM) Real Expenditure Rise in GDP = $400 0 Real GDP 6,000 6,400

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