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Chapter 9 Demand Side Equilibrium DC=MPC*D National Income : Wages Profits Interest Rents Y = 5,000 Y = 10,000 Y = 19,000 C = 22,600 C = 17,200 C = 9,100 AE = 24,400 G= 500 G= 500 I = 1000 AE = 19,000I = 1000 I = 1000 AE = 10,900 = 1000 AE =I 6,400 G= 500 NX= 300 NX= 300 G= 500 NX= 300 AE = C + I + G + NX C = 4600 NX= 300 AE Y = 25,000 DC=MPC*D Increase in National Income National Income : Wages Profits Interest Rents 100 Y = 5,000 Y = 10,000 Y = 19,000 C = 22,600 C = 17,200 C = 9,100 G= 500 G= 500 I = 1000 I = 1000 I = 1000 I = 1000 100+1800 1900 C = 4600 G= 500 NX= 300 NX= 300 G= 500 NX= 300 NX= 300 Aggregate Expenditures AE Y = 25,000 AE = Total sales to consumers, firms, government and other countries 24,400 Sold Produced 19,000 AE5,000 = 1,900 + 0.9 Y Produced Produced 10,000 Sold19,000 Sold Sold 6,40010,900 Inventories do not change Inventories fall Inventories fall Firms do not change Production FirmsFirms increase Production increase Production 19,000 Produced 25,000 Sold 24,400 Inventories rise Firms decrease Production Produced 10,900 6,400 5,000 10,000 19,000 25,000 AE 24,400 19,000 Produced 19,000 Sold19,000 Inventories do not change Firms do not change Production: 10,900 6,400 5,000 10,000 19,000 25,000 Y 10,000 25,000 Y = 19,000 and Aggregate24,400 Expenditures AE = 24,400 Y = 10,000 19,000 Y = 5,000 and Aggregate Expenditures AE = 19,000 5,000 10,900 If total production Y 25,000 =Y 10,000 If production Y If total production = 5,000 If total total production Y == 19,000 and Aggregate Expenditures AE =10,900 6,400 and Aggregate Expenditures AE = 6,400 Change Change in in Inventories Inventories == Change in Inventories == Change Inventories 19,000 == 0 (no 25,000 ––in19,900 24,400 600 10,000 10,900 = -900 5,000 - –6,400 = -1,400 change) (increase) (decrease) (decrease) 19,000 AE Firms will decrease production Firms will not change production AE Firms will increase production Y = 25,000 The Keynesian Cross Output The line line 4545 degree Converts Horizontal Distances into Vertical Distances. D A 100 B C 1000 Income AE 450 Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000 AE 450 Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000 At Equilibrium there is NO change in Inventories Y AE AE AE AE=C+I+G+X-M AE (Sales) Y(Production) For any output level For any output level above belowTotal equilibrium Production (Y) equilibrium Y = 5,000 Y = 10,000 Real Income = Real GDP = Y Y = 19,000 AE = 24,400 G= 500 I = 1000 AE = 19,000I = 1000 C = 100 + 0.9Y C = 22,600 C = 17,200 I = 1000 AE = 10,900 G= 500 If C, I, G or NX increase C = 9,100 If C, I, G or NX drop I = 1000 AE = 6,400 G= 500 NX= 300 NX= 300 G= 500 NX= 300 The AE line shifts down C = 4600 G= 500 I = 1000 NX= 300 NX= 300 The AE line shifts up AE Y = 25,000 AE Equilibrium 450 Y* AE Equilibrium If AE line shifts down Y > AE Inventories increase Firms decrease output Lower Y* Equilibrium output decreases AE New Equilibrium Equilibrium If AE line shifts up AE>Y Equilibrium output increase Firms Increase Output Y* Inventories Decrease Higher Y* Income that does not come back to buy goods and services Leakages larger than Injections Injections I+G+X=S+T+M Larger than Leakages Spending = Output inventories do not change Not enough spending Inventories accumulate I+G+X Injections Y below equilibrium Y Equilibrium Too much spending inventories fall Y above equilibrium AE =Total Purchases of Goods and Services AE = 1,900 + 0.9 Yd AE = 100 +1,800+ 0.9Yd 22,600 +1,800 = 24,400 AE = C+ (I+G+NX) AE = C + 1,800 17,200 +1,800= 19,000 AE = 100 + 0.9Y +1,800 9,100 +1,800 = 10,900 C 4,600 +1,800= 6,400 Y 5,000 10,000 19,000 25,000 Find the value of AE=C+I+G+NX for each of these values of Y: AE = 1,900+0.9Y 24,400 C = 100+0.9Y 19,000 10,900 6,400 5,000 10,000 19,000 25,000 Find the value of consumption for each of these values of Y: C = 100+0.9Y 22,600 17,200 9,100 4,600 Y 5,000 22 10,000 19,000 25,000 I =1,000 G = 500 NX = 300 1,800 1,800 1,800 1,800 1,800 5,000 10,000 19,000 25,000 I+G+NX Find the value of I+G+NX for each of these values of Y: 23 Too much Demand for output AE Inventories increase Y < AE Inventories fall Leakages = Injections I+G+X=S+T+M Y > AE Not enough Demand for output Y Equilibrium Leakages Injections > > Injections Leakages Y below equilibrium Y Equilibrium Y above equilibrium I+G+X At equilibrium, Leakages = Injections S+T+M = I + G + X Rearrange: S = I + (G-T) + (X-M) What At Y =is 3,000 5,000 the equilibrium are inventories GDP?rising? Falling? Unchanged? For Forwhat whatvalue valueofofGDP GDPis: is: YY==AE? AE? For what value of GDP is: S = I +(G-T) +(X-M)? I + (G-T) + (X-M) Aggregate Expenditures Matches Aggregate Expenditures = C + I + G + NX with the corresponding value of output Aggregate Demand Matches the price level with the corresponding value of equilibrium output Aggregate Demand Price Level P0 AD Y0 Real GDP Demanded Two things to remember when you use the AD line: Real Value = of Wealth Wealth Price Index 1. An increase in prices, decrease the purchasing power of Wealth Two2.things to remember when An increase in prices, decrease Consumption you use the AD line: C Prices C0 C1 Consumption Decrease Y Y0 31 Two things to remember when you use the AD line: An increase in prices, 1. Decrease the purchasing power wealth 2. Decrease Consumption 32 The equilibrium value of output decrease from Y0 to Y1. When prices increase from P0 to P1, The real value of wealth decreases and consumption decreases from C0 to C1. C C0+I+G+NX C1+I+G+NX 450 Y1 Y0 Y The AE line shifts down Aggregate Demand Price Level P1 A movement ALONG AD NOT a SHIFT! Y1 Y0 When prices increase equilibrium output decreases P0 AD Y1 Y0 Equilibrium Output Real GDP Demanded The equilibrium value of output increase from Y0 to Y2. When prices decrease from P0 to P2 The real value of wealth increase and consumption increase from C0 to C2. C C2+I+G+NX C0+I+G+NX 450 Y0 Y2 Y The AE line shifts up Aggregate Demand Price Level A movement ALONG AD NOT a SHIFT! P0 P2 AD Y0 Y2 Equilibrium Output Real GDP Demanded When prices drop, equilibrium output increases Output Y Building the Lower Aggregate Demand Curve 1 When prices increase from P0 to P1, Equilibrium Output drops from Y0 to Y1. corresponds to higher prices P1 When prices decrease from P0 to P2, Equilibrium output increases from Y0 to Y2. Higher Output Y2 corresponds to lower prices P2 Inverse Relationship between Aggregate Output Demanded and Price Level The Consumption Function C = a + MPC* d Y Consumption responds to Consumption responds changes in wealth, prices to changes in after tax income and expectations Changes in income: Changes in wealth, prices Movement Along the C and expectations: Shift C line. line Shift C If G,I,C, NX increase AE line Shifts up AD shifts NOT a movement ALONG ! Aggregate Expenditures 45 Price level P0 The size of the change in equilibrium Y Y0 Y1 Equilibrium Income increase Prices are the same AD1 Is the size of the shift in AD AD0 Y0 Y1 AD Shifts If C, I, G or NX increase, When prices drop, AE shiftsup, up C shifts Equilibrium AE shifts up output increases AD shifts right (outward). Equilibrium output increases AD does NOT shift! But move along Price Level P0 Except when prices drop! P1 AD1 Y0 Y1 AD0 Real GDP Demanded If G,I,C, NX decrease AD shifts NOT a movement ALONG ! AE line Shifts down Aggregate Expenditures Price level P0 The size of the change in equilibrium Y Y1 Y0 Equilibrium Income decrease Prices are the same AD0 Is the size of the shift in AD AD1 Y1 Y0 If C, I, G or NX decrease, AE shifts down, Equilibrium output decrease, AD shifts left (inward). Price Level AD Shifts When prices increase, C shifts down, AE shifts down, Equilibrium output decrease, A movement along AD P1 Except when prices rise! P0 Y1 Y0 AD1 AD0 Interest Rates drop: Investment increase by DI AE1=C+G+I1+NX DAE=DI AE0=C+G+I0+NX AE shifts up AE1=AE1=C+G+I1+NX AE0=C+G+I0+NX Equilibrium Output Increase DY The Shift in AD is the same as the increase in Equilibrium output: DI AE1 AE0 DAE P0 AD1 AE1 AD0 AE0 DY DY The increase in GDP = Shift in AD: DY Excess Demand: AE > Y, inventories drop. If there is excess capacity and Unemployment, firms increase output but DO NOT raise prices AS0 DY P0 AD1 AD0 Y0 Real GDP Y2 The increase in GDP SMALLER than Shift in AD: DY AS1 P1 P0 ) DY = DG (1/1-MPC) DY Excess Demand: AE > Y, inventories drop. With some excess capacity and lower unemployment, firms increase both production and prices. AD1 AD0 Y0 Y1 Y2 Real GDP No Increase in GDP: DY=0 AS1 P1 P0 DY = DG (1/1-MPC) Excess Demand: AE > Y, inventories drop. With NO excess capacity and zero unemployment, firms cannot increase production, only prices rise. AD1 AD0 Y0 DY=0 Potential GDP AE 450 Where we want to be: zero cyclical unemployment, no excess capacity AE Equilibrium GDP: where the economy is stuck Equilibrium GDP Potential GDP To increase To eliminate a AE, we need recessionary gap, AE an increase in must rise. C, I, G or NX Recessionary gap: when actual GDP is than Economy is lower producing full less employment than desired GDP output E Distance E-B B Recessionary Gap 7,000-6,000 =1,000 Increase AE to Eliminate a Recessionary/Deflationary Gap To increase Consumption: Decrease taxes or increase transfers. To increase Investment Tax incentives. Lower interest rates Increase Government Spending To increase Exports and decrease Imports: Make dollar weaker (increasing supply of dollars) To eliminate To decrease an AE, we need a inflationary decrease in C, gap, AE must I, Gfall. or NX Labor shortages: Inflationary gapFirms when trying to hire workers Equilibrium GDP is who already have higher than Fulla job GDP Employment = 7,000-8,000 =-1,000 Decrease AE to o Eliminate an Inflationary Gap Decrease Consumption: increase taxes or decrease in transfers. Decrease Government Spending Increase interest rates Decrease exports and increase imports: stronger dollar. Which AE line will cause a recessionary gap? Which AE line will cause an Inflationary gap? Assume the Economy is at Equilibrium 1. 2. 3. 4. 5. 6. GDP = ? Is total spending larger than/smaller than/equal to Output? Do Inventories fall, rise or remain unchanged? Does the economy experience a recessionary/inflationary gap? What is the size of the gap? How can the gap be closed? Assume the Economy is at Equilibrium 1. 2. 3. 4. 5. 6. GDP = ? Is total spending larger than/smaller than/equal to Output? Do Inventories fall, rise or remain unchanged? Does the economy experience a recessionary/inflationary gap? What is the size of the gap? How can the gap be closed? Potential GDP C+I+G+NX 1.1. 2.2. 3.3. 4.4. 5.5. 6. 6.6. theeconomy economyat atequilibrium equilibrium?? IsIsthe TotalSpending( Spending(>>==<<)Output )Output Total Inventories(rise, (rise,fall, fall,remain remainthe thesame) same) Inventories Firmswill will(increase, (increase,decrease, decrease,not notchange)output. change)output. Firms Oncethe Does the theEconomy economy Economyreaches experience reachesequilibrium, equilibrium, a (recessionary, willthe the inflationary) economyexperience experience gap? Once will economy aa (recessionary, Is the economy inflationary) experiencing gap? unemployment or labor shortages? (recessionary, inflationary) gap? theeconomy economyexperiencing experiencingunemployment unemploymentor orlabor laborshortages? shortages? IsIsthe AE shifts up AE1 AE0 DAE= AE1 AE0 P0 AD1 AD0 DY Equilibrium Output Increase DY Aggregate Demand shifts Right = DY*MPC Using the MPC =DC DC/DY DC = DY*MPC DC = 1000*0.7 2250+700 = 2950 ? DC = 700 MPC =0.7 2250 a* DY = 1000 1000 58 2000 45 The Multiplier effect Government Output Spending has a Increase Dc = 81*0.9 effect multiplicative on by MORE Sum DC Dc = 90*0.9 81 equilibrium output than DG Newly employed buy more Dc = and 100*MPC 90services goods DAE AE1=Y1 DG=100 Inventories Drop=-100 DG AE0=Y0 DY==DG DAE DY + sum Dc DY=100 DY=90 DY=81 Y Y1 Increase Firms Increase Y0 Output: hire more workers Y We can write the total change in spending as: 100 100 * 0.9 100 100 ** 0.9 0.9 *0.9 *0.9 *0.9 100 100 * 0.9 *0.9 100 * 0.9 *0.9 *0.9 *0.9 100 and so on… For any increase in autonomous Factor out 100: This infinite sum terms equals: spending and anyofMPC: 100 100 100 * 0.9 100 * 0.9 *0.9 *0.9 100 100 * 0.9 *0.9 100 * 0.9 *0.9 *0.9 *0.9 Use the To calculate the chain of spending generated from an increase in: Government Spending Investment Autonomous Consumption Net exports 62 The Multiplier 45 DAE AE1=Y1 AE0=Y0 DY = DG (multiplier) DY Y Y0 Y1= Y0+DY G increase by DG = 700 To calculate the change in Equilibrium Y use the Multiplier formula: AE1 AE0 DAE= 700 D Y = DG x AE1 AE0 D Y = 700 x [ 1 (1- MPC) [ ] 1 (1- 0.9) ] 10 D Y = 700 (1/0.1) = 7000 DY= 7000 A 700 increase in government spending generates a 7000 increase in output. The Shift in AD is the same as the increase in Equilibrium output: AE1 AE0 DAE= 700 AE1 AE0 P0 AD0 DY= 7000 DY= 7000 AD1 Output increases by Full Multiplier Amount AD Shifts by the full multiplier amount DY = DG (1/1-MPC) Excess Demand: AE > Y, inventories drop. If there is excess capacity and Unemployment, firms AS0 increase output but DO NOT raise prices DY = DG P0 (1/1-MPC) AD1 AD0 Y0 Real GDP Y2 Inflation Reduces the Size of the Multiplier Excess Demand: AE > Y, inventories drop. With some excess capacity and lower unemployment, firms increase both production and prices. AS1 P1 DY = DG P0 (1/1-MPC) AD1 AD0 Y0 Y1 Y2 Output increase by less than the multiplier amount Real GDP At Full Employment there is NO multiplier effect AS1 Excess Demand: AE > Y, inventories drop. With NO excess capacity and zero unemployment, firms cannot increase production, only prices rise. AD P1 DY = DG P0 (1/1-MPC) 1 AD0 Y0 Real GDP What is the necessary DG = ? AE1 AE0 DAE= ? DY = DG x [ [ 1,000= DG x AE1 AE0 1 (1- 0.9) 1,000 = DG (1/0.1) DG = 1,000 /10 = 100 DY= 1,000 ] ] 1 (1- MPC) Effect of Expansionary Policy Only Prices At Full Employment As the riseeconomy gets closer toCloser Potential to Full Employment GDP, the slope of AS increase (steeper) Prices Increase Prices do Not change Below full employment Output Increases by full multiplier Output Output can Increases not increase by noless multiplier than multiplier effect 5,500 4,750 4,000 3,250 2,500 2,000 3,000 4,000 5,000 6,000 7,000 The economy must be operating in segment: a.A - B b.B – D c.D – G d.None of the above Labor costs are rising due labor shortages. After The abillion 40 main billion effect increase of an in Ghas , inflation in rose increase and output ininprices. remained AA 50 increase in resulted inGto aislargest 500 increase output 50 billion increase inGincrease G resulted in aan 400 increase in output An increase in investment the multiplier effect. the same Y C I G X M 15000 19000 23000 27000 31000 15000 18200 21400 24600 27800 900 900 900 900 900 500 500 500 500 500 700 700 700 700 700 500 500 500 500 500 1. 2. 3. 4. 5. 6. 7. 8. NX AE Change Leakag Injectio in Firms S es=S+T ns Inventori react by: +M =I+G+X es Calculate the MPC and the intercept of the consumption function. Show your work : Write the Consumption equation: Write the Savings equation: Calculate NX(fill in the values in the table) Show your work : Write the AE equation: Calculate AE (fill in the values in the table) Show your work : Calculate S (fill in the values in the table) Show your work : Calculate the Change in Inventories (fill in the values in the table) be sure to write a sign (+ or -) for increase or decrease. Show your work : 9. Write in each space in the table how do firms react to the change in inventories? Do they increase/decrease production? 10.Calculate Leakages and Injections (fill in the values in the table) Show your work : 11.What is the equilibrium value of GDP? 12.Are Leakages = Injections at equilibrium? 13.Why is the economy at equilibrium at this Output level? 14.Fill in ALL blank boxes in the graphs : 73 Y C I G X M NX AE 15000 15000 900 19000 18200 900 500 500 700 700 500 500 200 200 16600 19800 23000 21400 900 27000 24600 900 31000 27800 900 500 500 500 700 700 700 500 500 500 200 200 200 S Chang Injecti Firms Leaka e in ons react ges=S Invent =I+G+ by: +T+M ories X 0 -1600 Inc Y 800 -800 Inc Y No chang 23000 1600 0 e 26200 2400 800 Dec Y 29400 3200 1600 Dec Y 500 2100 1300 2100 2100 2100 2900 2100 3700 2100 Questions for review 1. Determine the effect on AE, AD, Equilibrium output a) Prices Increase (decrease): in red because changes in prices do not shift the AD line! b) NX Increase (decrease) c) Exports Increase (decrease) d) Imports Increase (decrease) e) Wealth Increase (decrease) f) Interest rates Increase (decrease) g) Technological Improvement h) Government spending Increase (decrease) i) Taxes Increase (decrease) j) Transfers Increase (decrease) AE component affected Shift? Movement Along? C drops due to wealth effect: consumers feel Prices Increase poor C shifts down C increases due to wealth effect: consumers Prices Decrease feel rich C shifts up AE Shifts Equilibrium Y AD down decreases Movement up along up increases Movement down along up increases shifts right NX Increase NX increase NX shifts up NX Decrease NX decrease NX shifts down down decreases shifts left Exports Increase NX increase NX shifts up shifts right Exports Decrease NX decrease NX shifts down down decreases shifts left Imports increase NX decrease Imports Decrease NX increase C increases due to Wealth Increase wealth effect C drops due to wealth Wealth Decrease effect NX shifts down down decreases shifts left NX shifts up up increases shifts right C shifts up up increases shifts right C shifts down down decreases up increases shifts left Shift? Movement AE Equilibrium AE component affected Along? Shifts Y Interest rates increase Interest rates Decrease Technological Improvement Government Spending Increase Government Spending Decrease Taxes Increase Investment drops I shifts down Investment Increases I shifts up Investment increases I shifts up down decrease up up increase shifts left shifts right increase shifts right increase shifts right G increases G shifts up G drops C drops G shifts down down decrease C shifts down down decrease Taxes Decrease C increases Transfers Increase C increases Transfers Decrease C drops up AD C shifts up up increase C shifts up up increase shifts left shifts left shifts right shifts right C shifts down down decrease shifts left Practice 1. Determine the effect on Aggregate Expenditures. Identify the component of AE which is affected (C, I, G, X or M) and explain how it is affected. a) Prices in the US Increase (decrease) relative to prices abroad. b) The U.S. dollar becomes weaker (stronger) c) Home prices collapse (increase) d) Stock prices collapse (increase) e) Interest rates Increase (decrease) f) A zero-emissions engine is developed. g) Government announces an Increase (decrease) in the number of troops deployed abroad. h) As the economy recovers (enters into a recession) incomes increase (drop). 78 AE component affected Relative US US prices higher to foreigners: X fall. Prices Foreign prices seem lower to Increase Americans: M rise Shift? Movement Along? AE Shifts NX shifts down down Relative US US prices seem cheaper to foreigners: Prices X rise. Foreign prices seem higher to Decrease Americans: M drop NX shifts up up Dollar weaker Dollar buys less foreign currency: US prices seem cheaper to foreigners: X rise. Foreign prices seem higher to Americans: M drop up Dollar Stronger Dollar buys more foreign currency: US prices seem higher to foreigners: X drop. Foreign prices seem lower to Americans: M rise NX shifts down down NX shifts up 79 AE component affected Home prices drop Home prices rise C drops (consumers are poorer) AE Shift? Movement Along? Shifts C shifts down down C shifts up up Stock prices drop C rise (consumers are richer) C drops (consumers are poorer) C shifts down down Stock prices rise C rise (consumers are richer) C shifts up up Interest rates increase Investment drops I shifts down down Interest rates Decrease Zero Emissions Engine invented Investment Increases I shifts up up Investment increases I shifts up up G increases G shifts up up Government Spending Increase (increase Troops) Government Spending Decrease (Decrease Troops) G drops G shifts down down Recession (Income Disposable Income drops C Movement down Drops) drops along C down Expansion (Incomes Disposable Income increase C Increase) increase Movement up along C up 80 Practice Label the two lines in the next slide. Use the information in the graph to find the following: A. Find the slope of the AE line. Recall the slope of the AE line is the MPC. B. Find the intercept of the AE line. C. Write down the equation of the AE line. D. Find the value of AE when income is 40,000 E. What is the equilibrium value of income/output in this case? F. Find the value of AE when income is 50,000 and when income is 25,000. G. Fill in the values for each box in the graph.