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Chapter 9

Chapter 9. Demand-Side Equilibrium: Unemployment or Inflation?. A definite ratio, to be called the Multiplier, can be established between income and investment. JOHN MAYNARD KEYNES. Outline. Suppose AS is given, how does AD affect the equilibrium ?. The Meaning Of Equilibrium GDP.

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Chapter 9

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  1. Chapter 9 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. Outline Suppose AS is given, how does AD affect the equilibrium?

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

  4. Figure 1 The circular flow diagram

  5. 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

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

  7. 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

  8. 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

  9. Table 1 The total expenditure schedule

  10. 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

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

  12. Table 2 The determination of equilibrium output

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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

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

  22. Demand-Side Equilibrium&Full Employment • Potential GDP • Full-employment level of output • Equilibrium GDP < potential GDP • Occurs: • Low spending (consumers C↓, investors I↓) • Low government spending (G↓) • Weak foreign demand (X↓) • Price level - too high (X↓, IM↑)

  23. 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

  24. 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

  25. Demand-Side Equilibrium&Full Employment • Equilibrium GDP > potential GDP • Occurs because • High spending (consumer C↑, investment I↑) • Strong foreign demand (X↑) • Government spends too much (G↑) • Low price level (X↑, IM↓)

  26. 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

  27. 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

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

  29. Coordination of Saving & Investment • If S = I • Equilibrium at full employment • On demand side • AD=C+I=GDP=NI=C+S → S=I • If S ≠ I • Full employment is not an equilibrium • S<I → inflationary gap • S>I → recessionary gap

  30. Figure 9 A simplified circular flow

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

  32. Changes on Demand Side: Multiplier Analysis • Question: What’s the effect of changes in C, I, G, (X-IM) on Y? • Multiplier – Ratio of Change in equilibrium GDP (Y) by original change in spending • Multiplier principle • GDP – rises by more than • Change in spending • Multiplier > 1

  33. Table 3 Total expenditure after a $200 billion increase in investment spending Multiplier = ∆Y/ ∆I = 800/200 = 4

  34. 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

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

  36. Table 4 The multiplier spending chain

  37. Figure 11 How the multiplier builds

  38. 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 • Only autonomous increase brings multiplier effect • Change in C, I, G, or (X-IM) • Same multiplier effect

  39. Table 5 Total expenditure after consumers decide to spend $200 billion more (Autonomous increase)

  40. 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

  41. Multiplier is a General Concept Booms and recessions tend to be transmitted across national borders

  42. 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

  43. Multiplier & Aggregate Demand Curve An autonomous increase in spending leads to a horizontal shift of the AD curve by an amount given by the oversimplified multiplier formula.

  44. 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

  45. Summary Demand side equilibrium Y = AD = C + I +G +(X-IM) Income-expenditure diagram Derivation of AD curve Inflationary gap vs. Recessionary gap Multiplier is same for an autonomous increase in C, I, G, and (X-IM) Multiplier = 1/(1-MPC)

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

  47. 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

  48. Table 6 Equilibrium income with variable imports

  49. 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

  50. 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

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