Download Chapter 26 DEMAND-SIDE EQUILIBRIUM: UNEMPLOYMENT OR INFLATION?

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
Contents
● 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
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Contents (continued)
● 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
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The Meaning of Equilibrium
GDP
● 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.
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1: The Circular Flow
Diagram
FIGURE
Rest of the
World
Financial System
3
2
Investors
Consumers
4
1
Government
5
Firms
(produce the
domestic product)
6
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The Meaning of Equilibrium
GDP
● 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.
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The 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.
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2: The Determination of
Equilibrium Output
TABLE
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2: Construction of the
Expenditure Schedule
FIGURE
C +I+ G
C + I + G + (X –IM)
X –IM = –$100
6,100
6,000
Real Expenditure
C+I
G = $1,300
C
4,800
I = $900
3,900
5,200
5,600
6,000
6,400
Real GDP
6,800
7,200
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The Mechanics of Income
Determination
● 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.
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3: Income-Expenditure
Diagram
FIGURE
Output exceeds spending
7,200
45°
6,800
C +I +G +
(X – IM)
Real Expenditure
6,400
E
6,000
Equilibrium
5,600
5,200
4,800
0
Spending exceeds
output
4,800 5,200 5,600
6,000 6,400 6,800 7,200
Real GDP
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The Aggregate Demand
Curve
●  price level   consumption
♦  price level   purchasing power of wealth
(not real income)
♦ A change in real income would be illustrated as
a movement along the consumption function,
not a shift.
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The Aggregate Demand
Curve
●  price level   consumption
♦ Therefore,  price level   total
expenditures and  equilibrium GDP
♦ Therefore,  price level   equilibrium
level of real aggregate quantity demanded
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5: The Effect of the Price
Level on Equilibrium AD
FIGURE
45
45
C2 + I + G + (X–IM)
Real Expenditure
C0 + I + G + (X–IM)
E0
C1 + I + G + (X–IM)
E1
45
Real Expenditure
E2
E0
C0 + I + G + (X–IM)
45
Y1
Y0
Real GDP
(a)
Y0
Y2
Real GDP
(b)
Rise in Price Level
Fall in Price Level
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The 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.
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6: The Aggregate
Demand Curve
Price Level
FIGURE
P1
P0
P2
E1
E0
E2
Y1 Y0 Y2
Real GDP
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Demand-Side Equilibrium
and Full Employment
● Equilibrium GDP may not = fullemployment GDP.
● Recessionary gap: amount by which
equilibrium GDP < potential GDP
● Inflationary gap: amount by which
equilibrium GDP > potential GDP
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FIGURE
7: A Recessionary Gap
Potential
GDP
45°
Real Expenditure
F
C + I + G + (X – IM)
E
B
Recessionary gap
45°
6,000
7,000
Real GDP
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8: An Inflationary Gap
Potential
GDP
45°
Inflationary gap
E
B
C + I + G + (X – IM)
Real Expenditure
FIGURE
F
45°
7,000
8,000
Real GDP
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The 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.
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FIGURE
9: A Simplified Circular
Flow
Financial System
2
Investors
Consumers
1
3
Firms
(produce the
domestic product)
Y
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Changes 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
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3: Total Expenditure after
a $200 Billion Increase
TABLE
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10: Illustration of the
Multiplier
FIGURE
45
C + I1 + G + (X – IM)
C + I0 + G + (X – IM)
Real Expenditure
E1
$200 billion
E0
0
6,000
6,800
Real GDP
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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.
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4: The Multiplier
Spending Chain
TABLE
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FIGURE
11: How the Multiplier
Builds
Cumulative Spending Total
$4.0
3.0
2.0
1.0
0
2
4
6
8
10
15
20
Spending Round
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Changes on the Demand
Side: Multiplier Analysis
● 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.
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Changes on the Demand
Side: Multiplier Analysis
● Algebraic Statement of the Multiplier
♦ Factors that reduce the size of the multiplier
■International trade
■Inflation
■Income taxation
■Financial system
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The 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.
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5: Consumers Spend
$200 Billion More
TABLE
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The Multiplier Is a General
Concept
●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.
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The Multiplier Is a General
Concept
●  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.
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The Multiplier and the
Aggregate Demand Curve
●  autonomous spending  horizontal
shift of the AD curve by an amount given
by the oversimplified multiplier formula.
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12: Two Views of the
Multiplier
FIGURE
45
C + I1 + G + (X – I M )
C + I0 + G + (X – I M )
Real Expenditure
E1
$200 billion
E0
6,000
0
Price Level
D0
6,800
D1
E0
E1
100
D 1 (I = $1,100)
D 0 (I = $900)
6,000
6,800
Real GDP
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Appendix A: The
Simple Algebra of
Income Determination
and the Multiplier
Simple Algebra of Income
Determination & Multiplier
● All of the relationships discussed can be
represented in simple algebra.
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Simple Algebra of Income
Determination & Multiplier
● 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
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Simple Algebra of Income
Determination & Multiplier
● 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)
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Simple Algebra of Income
Determination & Multiplier
● Then solve for Y: Equilibrium Y = [a - bT
+ I + G + (X - IM)] / (1 - b)
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Appendix B: The
Multiplier With Variable
Imports
The 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.
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6: Equilibrium Income
with Variable Imports
TABLE
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13: The Dependence of
Net Exports on GDP
Real Exports and Imports
FIGURE
IM
950
850
Negative net
exports
750
650
550
X
Positive net
exports
450
0
4,800 5,200
5,600 6,000 6,400 6,800 7,200
Real GDP
Real Net Exports
200
100 Positive net
exports
0
4,800 5,200
–100
–200
6,000 6,400 6,800 7,200
5,600
Negative net
exports
–300
X – IM
Real GDP
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14: Equilibrium GDP with
Variable Imports
FIGURE
Real Expenditure
45
E
Positive net
exports
C + I + G + (X – IM )
(fixed imports)
C + I + G + (X – IM )
(variable imports)
Negative net exports
6,000
X – IM
Real GDP
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15: The Multiplier with
Variable Imports
FIGURE
45
Real Expenditure
A
C + I + G + (X 1 – IM )
C + I + G + (X 0 – IM )
Rise in
exports = $160
E
Rise in GDP = $400
6,000
6,400
Real GDP
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7: Equilibrium Income
after a $160 Billion Increase
TABLE
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