Demand-Side Equilibrium: Unemployment or Inflation?

1. 9 Demand-Side Equilibrium: Unemployment or Inflation?

2. Contents • Meaning of Equilibrium GDP • Mechanics of Income Determination • Aggregate Demand Curve • Demand-Side Equilibrium and Full Employment • Coordination of Saving and Investment • Changes on the Demand Side: Multiplier Analysis

3. Real World Puzzle: Why does the Market Permit Unemployment? • Market economies coordinate the decisions of millions of buyers and sellers to ensure the correct amount of C goods are produced with most efficient prod means. • Yet market economies stumble with periodic episodes of mass UE and recessions. • Widespread UE is a failure to coordinate economic activity. • If UE were hired, they could buy the goods firms can’t sell; and revenues from these sales would allow firms to hire the UE.

4. The Meaning of Equilibrium GDP • Recall: total production (GDP) = total income • But total production need not = total spending • If total expenditures > value of output produced • (1) ↓inventory stocks → signals retailers ↑orders → signals manufacturers ↑ production • (2) if high levels of spending continue to deplete inventories → firms ↑prices • If total expenditures < value of output produced • (1) ↑inventory stocks → signals retailers ↓orders → signals manufacturers ↓ production • (2) if low levels of spending continue → firms ↓prices

5. The Meaning of Equilibrium GDP • Equilibrium on the Demand-side of the Economy • GDP↑ when total expenditures > GDP • GDP↓ when total expenditures < GDP • Equilibrium can only occur when there is just enough spending to absorb current level of prod. Then producers conclude their Q and P decisions were correct. • Equilibrium: total spending = total production • Firms inventories remain at desired levels → no reason to ∆Q or ∆P

6. The Mechanics of Income Determination • Expenditure Schedule = table showing the relationship between GDP and total spending • Table 1: • C is the Consumption f(x) • I, G, and X-IM are all fixed regardless of the level of GDP • C + I + G + X-IM = total expenditure

7. TABLE 1.The Total Expenditure Schedule

8. C + I + G C + I + G + ( X – I M ) X – IM = –$100 C + I G = $1,300 C I = $900 FIGURE 1.Construction of the Expenditure Schedule C is the C f(x). It is shifted up by the amount of I ($900) and G ($1,300) and shifted down by the amount of X-IM (-$100). Slope of the expenditure schedule = MPC because I, G, and X-IM are assumed to be constant and do not vary with GDP. 6,100 6,000 Real Expenditure 4,800 3,900 5,200 5,600 6,000 6,400 6,800 7,200 Real GDP

9. The Mechanics of Income Determination • Use Table 2 to understand why $6,000B must be equilibrium level of output. • Any output below $6,000B → total expenditures > GDP → ↓inventories → ↑production • Any output above $6,000B → total expenditures < GDP → ↑inventories → ↓production • Equilibrium only occurs when Y = C + I + G + X-IM or GDP = total expenditure, which happens at $6,000B.

10. TABLE 2.The Determination of Equilibrium Output

11. The Mechanics of Income Determination • Use Figure 2 to show why $6,000B must be the equilibrium level of output. • 45 degree line shows all points where output and spending are equal. • These are all points where the economy can possibly be in equilibrium. • Economy is not always on the 45 degree line but it is always on the expenditure schedule. • Equilibrium is shown where 45 degree line intersects the total expenditure schedule.

12. Output exceeds spending 45° C + I + G + ( X – I M ) E Equilibrium Spending exceeds output FIGURE 2.Income-Expenditure Diagram Left of point E: total expenditure schedule is above the 45 degree line → spending > GDP → ↓inventories and firms ↑prod. Right of point E: total expenditure schedule is below the 45 degree line → spending < GDP → ↑inventories and firms ↓prod. 7,200 6,800 6,400 6,000 Real Expenditure 5,600 5,200 4,800 0 4,800 5,200 5,600 6,000 6,400 6,800 7,200 Real GDP

13. The Aggregate Demand Curve • The expenditure schedule is drawn for a fixed P level. • Derive AD curve using the expenditure schedule. • Recall  P level  shifts C f(x) downward •  P level (at fixed levels of DI)   purchasing power of wealth by lowering the value of money-fixed assets •  P level  shifts the expenditure schedule downward • ↓ P level  shifts the expenditure schedule upward

14. The Aggregate Demand Curve • How do changes in the P level impact real GDP on the demand-side of the economy? • ↑P level → ↓expenditures → ↓Equil level of GDP • ↓P level → ↑expenditures → ↑Equil level of GDP • We can now draw an AD curve (in Fig 3) where Y0, Y1, and Y2 correspond to the GDP levels depicted in the 45 degree line diagram.

15. 45 C + I + G + ( X – I M ) 2 C + I + G + ( X – I M ) 0 E 0 C + I + G + ( X – I M ) 1 E 1 45 Y Y Y Y Y Y 1 1 0 0 2 2 FIGURE 3.The Effect of the Price Level on Equilibrium AD E2 E1 P1 Price Level Real Expenditure E0 P0 E2 P2 AD Real GDP Real GDP Change in P level Movement along AD curve

16. The Aggregate Demand Curve • AD has a (-) slope • ↑P level → ↓C via ↓wealth • ↑P level → ↓X-IM • Note: this also shifts the expenditure schedule down and lowers GDP. • Each expenditure schedule describes only one P level. At different P levels, the expenditure schedule is different so equilibrium GDP is different.

17. Demand-Side Equilibrium and Full Employment • Will economy achieve full employment without inflation? • If the economy always gravitates toward full employment, then gov should leave the economy alone. • We’ve shown that equil GDP is where 45 degree line intersects the exp schedule, but we haven’t determined if that equil level of GDP is at full employment.

18. Demand-Side Equilibrium and Full Employment • If equil GDP > full employment level of GDP → economy has inflation. • If equil GDP < full employment level of GDP → economy has unemployment.

19. Potential GDP 45° F C + I + G + ( X – I M ) E B Recessionary gap 45° FIGURE 4.A Recessionary Gap Full emp = $7,000B and equil GDP = $6,000B. Here exp is too low to have full emp. Happens if C, I, G, or X are weak or P level is “too high.” UE occurs because there isn’t enough output demanded to keep entire L force working. Full emp can be reached if exp schedule shifts up to pt F. This could happen without gov intervention if ↓P level. Real Expenditure 6,000 7,000 Real GDP

20. Potential 45° GDP Inflationary gap E B C + I + G + ( X – I M ) F 45° FIGURE 5.An Inflationary Gap Full emp = $7,000B and equil GDP = $8,000B. Happens if C, I, G, or X are very high or P level is “too low.” Full emp can be reached if exp schedule shifts down to pt F. This could happen without gov intervention if ↑P level. Real Expenditure 7,000 8,000 Real GDP

21. The Coordination of Saving and Investment • Must full employ level of GDP be an equilibrium? No! • Ignore G and X-IM then we can restate equil GDP: • Y = C + I • Y – C = I • S = I • Reach full employment equil only if S = I. • If S > I → spending is inadequate to support prod at full emp → GDP falls below potential and there is a recessionary gap. • If I > S → spending exceeds potential GDP → production is above full emp level and there is an inflationary gap.

22. The Coordination of Saving and Investment • S is decided by households and I is decided by corporate executives and home buyers. • Their decisions are not well coordinated. • Not clear the gov can solve the coordination problem of UE.

23. Changes on the Demand Side: Multiplier Analysis • Multiplier = (∆ in equil GDP)  (∆ in spending that caused the ∆ in GDP) • In Table 3, I rises by $200B (from $900B in Table 1), yet equil GDP rises by $800B (not just $200B). Why? • Multiplier > 1 because one person’s spending is another person’s income. Note: multiplier = 4 here. •  spending  income • A portion of the ↑ in income is spent on C, creating more income, which in turn creates more C, etc.

24. TABLE 3.Total Expenditure after a $200 Billion Increase in Investment

25. 45 ° E 1 C C + + I0 I1 + + G G + + ( ( X X – – I I M M ) ) $200 billion E 0 FIGURE 6.Illustration of the Multiplier Multiplier = ∆Y/∆I = $800/$200 = 4 Or multiplier = 1/(1-MPC) = 1/(1-0.75) = 4 Real Expenditure 0 6,000 6,800 Real GDP (or Y)

26. Changes on the Demand Side: Multiplier Analysis • Multiplier = 1  (1 - MPC) • MPC in U.S. has been estimated to be about 0.95, implying that the multiplier is 20. • In fact, the multiplier in U.S. is < 2. • Factors that reduce the size of the multiplier • International trade • Inflation • Income taxation • Financial system

27. The Multiplier Is a General Concept • ∆I has same multiplier effect as a ∆C, ∆G, or ∆(X - IM). • Consequently, trade links the GDPs of major economies. •  GDP in a foreign country  its IM, a portion of which are X from U.S. • Growth in U.S. X has a multiplier effect, ↑GDP in U.S. • Booms and recessions tend to be transmitted across national borders.

28. The Multiplier and the Aggregate Demand Curve •  spending  shifts AD by an amount given by the oversimplified multiplier formula (1/(1-MPC)). • In Fig 7, I has risen by $200B which shifts AD out by $800B (i.e., 4 (the multiplier) x $200B).

29. 45 ° C + I + G + (X – I M ) 1 E C + I + G + ( X – I M ) 1 0 $200 billion E 0 6,000 6,800 D D 0 1 E E 0 1 D ( I = $1,100) 1 D ( I = $900) 0 6,800 FIGURE 7.Two Views of the Multiplier Real Expenditure 0 Price Level 100 6,000 Real GDP

30. Supply-Side Equilibrium: Unemployment and Inflation?

31. Contents • Aggregate Supply Curve • Equilibrium of AD and AS • Inflation and the Multiplier • Recessionary and Inflationary Gaps Revisited • Adjusting to a Recessionary Gap or an Inflationary Gap • Stagflation from an Adverse Supply Shock

32. The Aggregate Supply Curve • Like AD, AS is a curve and not a fixed number. • Qs by firms depends on prices, wages, other input costs, and technology. • AS represents the relationship between P level and GDP supplied, holding all other determinants of Qs fixed. • AS has a (+) slope → ↑P → ↑Qs • Firms are motivated by profit. • Profit per unit = P – AC

33. S S FIGURE 1. An Aggregate Supply Curve Price Level Real GDP

34. Why does the Aggregate Supply Curve have a Positive Slope? • Many input prices are fixed for certain periods of time. • Long-term contracts for L or raw materials • Firms choose Qs by comparing selling prices with production costs which depend on input prices. • If ↑selling prices while input costs are fixed → ↑Qs • If ↓selling prices while input costs are fixed → ↓Qs

35. Shifts of the Aggregate Supply Curve • Costs of production are constant along the AS curve. •  costs of production  shifts AS curve • Money wage rate • wages account for more than 70% of all prod costs. • ↑wages → ↓profit at any given P of output → ↓Qs • ↑wages → shifts AS inward and ↓wages → shifts AS outward • Prices of other inputs • ↑P of any input → shifts AS inward and ↓P of any input → shifts AS outward

36. Shifts of the Aggregate Supply Curve • Technology and productivity • Technological breakthrough that ↑L productivity → ↑output per hour of L → ↑profit per unit → ↑Qs • Technological improvements shift AS outward • Available supplies of labor and capital • AS curve shifts out if L force↑; ↑L quality; or ↑K stock because more output can be produced at any given P level.

37. S (higher wages) 1 S (lower wages) 0 B A S 1 S 0 FIGURE 2.A Shift of the Aggregate Supply Curve 100 Price Level 5,500 6,000 Real GDP

38. Equilibrium of Aggregate Demand and Supply • Intersection of AD and AS determine the equilibrium level of real GDP and the P level. • Equilibrium (in Fig 3) occurs at a P level = 100 and GDP = $6,000B. • At higher P levels, like 120, Qs > Qd by $800B → ↑inventories → ↓prices and ↓output. • At lower P levels, like 80, Qd > Qs by $800B → ↓inventories → ↑prices and ↑output.

39. S D E D S FIGURE 3.Equilibrium Real GDP and the Price Level 130 120 Price Level 110 100 90 80 5,200 5,600 6,000 6,400 6,800 Real GDP

40. Inflation and the Multiplier • Recall: multiplier effect suggests A’s spending becomes B’s income, and B’s spending becomes C’s income, etc. • Earlier discussion focused on spending and assumed the P level was fixed. • Focused on the D-side equilibrium and ignored the reactions of firms (i.e., the S-side). • Will firms supply the additional demand without ↑P? • Not if AS slopes upward! • Inflation  size of the multiplier

41. Inflation and the Multiplier • In Fig 4, ↑I by $200B which shifts AD out by $800B ($200B x oversimplified multiplier of 4). • Shown by the movement from E0 to A. • Firms react to higher levels of spending (shift of AD at P level = 100) by ↑output and ↑prices. • Shown by the movement from E0 to E1 –along AS curve. • ↑P level → ↓purchasing power of money-fixed assets → ↓C and ↓X-IM • Shown by the movement from A to E1 –along new AD curve. • Multiplier is only 2 now = ∆Y/∆I = $400B/ $200B.

42. D1 S D0 $800 E1 billion E0 D1 S D0 FIGURE 4.Inflation and the Multiplier Assume I rises by $200B. This raises total expenditure (or Q of AD) by $800 (= $200B x multiplier of 4). If AS were horizontal → multiplier = 4 and equil GDP would rise to $6,800B. If AS were vertical → multiplier = 0 and equil GDP would remain at $6,000B. Here AS is upward sloping and ↑P level with the shift in AD. The multiplier is 2 (= $400B/$200B). 130 120 110 Price Level (Y) 100 90 80 6,000 6,400 6,800 Real GDP (Y) NOTE: Amounts are in billions of dollars per year.

43. Recessionary and Inflationary Gaps Revisited • Short run: equilibrium of AS and AD may or may not equal full employment GDP • Recessionary gap: equilibrium GDP < full employment or potential GDP • Inflationary gap: equilibrium GDP > full employment or potential GDP • Long run: wages adjust to labor market conditions to make equilibrium GDP = full employment or potential GDP • But this may take a long time!

44. Adjusting to a Recessionary Gap • In Fig. 5, equil GDP falls below the full employment level. • This might be caused by weak C or low I. • Loose L market • There is UE and jobs are hard to find. • Employees may be anxious to keep their jobs. • Workers won’t win ↑wage and wages might fall. • If ↓wages → AS shifts outward →↓P level and ↓UE • Deflation erodes the recessionary gap –but this process happens very slowly!

45. Potential GDP S 0 S 1 D E B Recessionary F gap S D 0 S 1 FIGURE 5. The Elimination of a Recessionary Gap Recessionary gap = $1,000B. Weak spending and UE at pt E. Weak labor markets put pressure on wages to fall. Falling wages shift AS outward which lowers prices. Falling prices stimulate C and net X. Price Level 100 6,000 7,000 Real GDP

46. Adjusting to a Recessionary Gap • In the real economy, however, wage reductions are slow and uncertain, particularly in the post-WWII period. • E.g., even with the severe recession of 1981-82 where UE reached 10%, prices and wages were not forced down –though their rates of increase were.

47. Adjusting to a Recessionary Gap • Why haven’t wages fallen much since WWII? • Institutional factors: like min wages, union contracts, and gov regulations that place legal floors on wages and prices. These were all developed since WWII. • Psychological resistance: firms are reluctant to cut wages for fear their employees will resent it and reduce effort. • But why wasn’t this true prior to WWII?

48. Adjusting to a Recessionary Gap • Business cycles were less severe: after WWII so firms and workers wait out the bad times rather than accept wage or price cuts. • Firms lose their best workers: if a firm cuts wages, it may lose its best employees. Individual productivity is hard to measure. The best workers have the greatest opportunities elsewhere. • Should have been true before WWII. • With sticky wages and prices, cyclical unemployment may last a long time.

49. Adjusting to a Recessionary Gap • Does the Economy Have a Self-Correcting Mechanism? • The economy will self-adjust eventually. •  wages  demand for labor •  prices   demand for goods and services • But many people believe that gov intervention should help to speed up the process. • Eg., Recovery from 1990-91 recession took almost 4 years. • UE fell from 7.7% to 5.4% • Inflation fell from 6.1% to 2.7%

50. Adjusting to a Recessionary Gap • An Example from Recent History: Disinflation in Japan in the 1990s. • Recovery from the 1990-91 recession was weak and long delayed, but it did eventually come. • Practical question: How long can we afford to wait?