Download Equilibrium and the Multiplier

Chapter 9
Demand Side Equilibrium
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
2
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:
3
AE = C+ (I+G+NX)
AE = C + 1,800
Total Purchases of Goods and Services =
22,600 +1,800 = 24,400
AE = 100 + 0.9Y +1,800
AE = 1,900 + 0.9 Y
17,200 +1,800= 19,000
9,100 +1,800 = 10,900
4,600 +1,800= 6,400
Income
5,000
10,000
19,000
25,000
4
Find the value of AE=C+I+G+NX for each of these values of Y:
Aggregate
Expenditures
Y = 5,000
Y = 10,000
Y = 19,000
Real Income = Real GDP = Y
C = 22,600
C = 9,100
I = 1000
500
500
300
NX=
G=
300
C = 4600
1000
C = 17,200
C = 100 + 0.9Y
Y = 25,000
Y = 5,000
Y = 10,000
Y = 19,000
Real Income = Real GDP = Y
AE = 24,400
G=
500
G=
500
I = 1000
AE = 19,000I = 1000
I = 1000
AE = 10,900
I = 1000
AE = 6,400
C = 100 + 0.9Y
C = 22,600
C = 17,200
C = 9,100
C = 4600
G=
500
NX=
300
NX=
300
G=
500
NX=
300
NX=
300
Aggregate
Expenditures
AE
Y = 25,000
Aggregate
Expenditures
Y = 5,000
Real Income = Real GDP = Y
G=
500
C = 22,600
C = 17,200
Y = 19,000
I = 1000
G=
500
Y = 10,000
I = 1000
G=
500
C = 9,100
100
C = 4600
I+G+NX
I = 1000
1900
I = 1000
G=
500
100+ I+G+NX
1000+500+300
100+
NX=
300
NX=
300
NX=
300
NX=
300
AE
Y = 25,000
AE = 1,900+0.9Y
C = 100+0.9Y
24,400
19,000
10,900
6,400
5,000
10,000
19,000 25,000
AE
Sold
24,400
Produced
AE5,000
= 19,000
1,900 + 0.9 Y
Produced
Sold19,000
Sold
6,400
Inventories
dofall
not change
Inventories
Firms increase
do not change
Production
Firms
Production
19,000
Produced 10,000
Produced 25,000 Sold10,900
Sold 24,400 Inventories fall
InventoriesFirms
rise increase Production
Firms decrease
Produced
Production
10,900
6,400
5,000
10,000
19,000 25,000
Y
AE
24,400
19,000
Produced 19,000
Sold19,000
Inventories do not change
Firms do not change Production:
Equilibrium: Y = 19,000
10,900
6,400
5,000
10,000
19,000
25,000
Y
Y = 19,000
25,000
10,000
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
production
Y
25,000
If total
total
If total
production
production
Y ==Y 10,000
19,000
= 5,000
and Aggregate Expenditures AE =10,900
6,400
and Aggregate Expenditures AE = 6,400
Change
Change in
in Inventories
Inventories ==
10,000
19,000
25,000
10,900
19,900
24,400
= 600
-900
0
(no
5,000 - –6,400
= -1,400
(decrease)
change)
(increase)
(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
AE
AE
For any output level
below equilibrium
For any output level above
equilibrium
AE
G=
500
NX=
300
Y = 5,000
Y = 10,000
Real Income = Real GDP = Y
Y = 19,000
I = 1000
AE = 24,400
C = 22,600
AE = 19,000I = 1000
C = 17,200
C = 9,100
I = 1000
AE = 6,400
C = 100 + 0.9Y
C = 4600
G=
500
When C, I, G
or NX
increase
(shift up)
I = 1000
NX=
300
When C, I, G
or NX drop
(shift down)
I = 1000
AE = 10,900
G=
500
G=
500
G=
500
NX=
300
NX=
300
The AE line shifts
down
NX=
300
The AE line shifts
up
Y = 25,000
Equilibrium
AE
450
Y = 19,000
Y = 5,000
Y = 10,000
Y = 25,000
AE
Equilibrium
If AE line
shifts down
Y>AE
Inventories
increase
Firms
decrease
output
Equilibrium
output
decreases
Y = 10,000
Y = 5,000
Y = 19,000
Y = 25,000
AE
New
Equilibrium
Equilibrium
If AE line
shifts up
Y<AE
Equilibrium
output
increase
Firms
Increase
Output
Y = 19,000
Inventories
Decrease
Y = 25,000
NI
HouseholdsIncome that does not
come back to buy
goods and services
produced
GDP
Firms
NI
Households
Firms
GDP
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
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
<
Leakages
Injections
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)
Savings finance
Investment, the
government’s
deficit and the
trade deficit.
Government’s
Trade
Deficit:
Deficit: Buy
Spending > more from
Tax Revenue
other
countries
than we sell
to them
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
Real Income = Real GDP = Y
Match Expenditures (C+I+G+NX) with the corresponding
value of output/income.
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
An increase
in prices, decrease
Two2.things
to remember
when
Consumption
you use the AD line:
Wealth
Expectations
C
C0
Prices
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!
P0
AD
Y1
Y0
Equilibrium Output
Real GDP Demanded
Y1
Y0
When prices
increase from P0
to P1, the
equilibrium value
of output
decreases from Y0
to Y1.
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
P0
A movement
ALONG AD NOT
a SHIFT!
P2
AD
Y0
Y2
Equilibrium Output
Real GDP Demanded
When prices
decrease from P0 to
P2, the equilibrium
value of output
increases from Y0 to
Y2.
Building the Aggregate Demand Curve
When prices increase
from P0 to P1,
Equilibrium Output
drops from Y0 to Y1.
Output Y1
corresponds to
P1
Output Y2
corresponds to
P2
When prices decrease
from P0 to P2,
Equilibrium output
increases from Y0 to Y2.
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
A shift of the AD line 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
Shifts in the Aggregate Demand Line
Price Level
If C, I,prices
G or NX
shift up,
When
drop,
shifts
CAE
shifts
up,up
AEEquilibrium
shifts up output increases
AD shifts right
(outward).
Equilibrium
output
increases
AD does NOT shift! But move
along
P0
Except when
prices drop!
AD1
P1
Y0
Y1
AD0
Real GDP Demanded
If G,I,C, NX decrease
AE line Shifts down
Aggregate Expenditures
Price level
P0
The size of the change in
equilibrium Y
Y1
Y0
Equilibrium Income decrease
A shift of the AD line
NOT a movement
ALONG !
Prices are the same
AD0
Is the size of the shift in
AD
AD1
Y1
Y0
Shifts in the Aggregate Demand Line
When
If C, I, prices
G or NX
increase,
shift down,
C shifts
down,
AE shifts down,
AE
Equilibrium
shifts down,
output decrease,
Equilibrium
AD shifts leftoutput
(inward).
decrease,
AD does NOT shift! But move
along
Price Level
P1
P0
Except when
prices rise!
Y1
Y0
AD1
1
AD0
Interest Rates drop: Investment increase by DI
I1
I0
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:
I1
I0
DI
AE1=C+G+I1+NX
AE0=C+G+I0+NX
DAE=DI
P0
AD1=C+G+I1+NX
AE1=AE1=C+G+I1+NX
AD0=C+G+I0+NX
AE0=C+G+I0+NX
DY
DY
The increase in GDP = Shift in AD:
Excess Demand: AE > Y,
inventories drop.
If there is excess
capacity and
Unemployment, firms
AS0 increase output but DO
NOT raise prices
DY
P0
AD1
AD0
Y0
Real GDP
DY
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
Excess Demand: AE > Y,
inventories drop. With
NO excess capacity and
zero unemployment,
firms cannot increase
production, only prices
rise.
AD
P1
P0
DY = DG (1/1-MPC)
1
DY=0
Y0
Real GDP
AD0
Potential GDP
The real gross domestic product (GDP) the
economy would produce if its labor force
were fully employed with no excess
capacity
Potential GDP
AE
450
Equilibrium
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 recessionary
AE, we needgap,
AE must
an rise.
increase in
C, I, G or NX
Recessionary
when
Economy is gap:
producing
actual
GDP desired
is loweroutput
than
less than
full employment GDP
Recessionary Gap
= 7,000-6,000 =1,000
Or
Distance EB
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
At
AtAtYYY===5000
4,000
3000
1.
1.
2.
2.
3.
3.
4.
4.
5.
5.
6.
6.
Is
Is the
the economy
economy at
at equilibrium
equilibrium ??
Total
Total Spending(
Spending( >
> == <
< )Output
)Output
Inventories
Inventories (rise,
(rise, fall,
fall, remain
remain the
the same)
same)
Firms
Firms will
will (increase,
(increase, decrease,
decrease, not
not change)output.
change)output.
Once
the economy
Economyexperience
reaches equilibrium,
will the
economy experience
a
Does the
a (recessionary,
inflationary)
gap?
(recessionary,
gap?
Is the economyinflationary)
experiencing
unemployment or labor shortages?
Is the economy experiencing unemployment or labor shortages?
= 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
The Multiplier effect
45
Output
Government
Increase
Spending has a
by MORE
multiplicative effect
on
than DG
Dc = 81*0.9 output
equilibrium
Sum DC
Dc = 90*0.9
81
Newly employed buy more
Dc
= and
100*MPC
90services
goods
DAE
AE1=Y1
DG=100
DG
Inventories
Drop
AE0=Y0
DY == DAE
DG + sum Dc
DY
DY=100 DY=90
Y0
Y
DY=81
Firms Increase Y1
Increase
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 outand
100:
spending
any MPC:
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 Autonomous Spending
Multiplier:
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
G1=3,700
DG = 700
G0=3,000
To calculate the change in Equilibrium Y
use the Multiplier formula:
D Y = DG x
AE1=C+I+G1+NX
AE0=C+I+G0+NX
DAE= 700
AE1=C+I+G1+NX
AE0=C+I+G0+NX
D Y = 700 x
[
1
(1- MPC)
[
1
(1- 0.9)
]
10
D Y = 700 (1/0.1)
= 7000
A 700 increase in government spending
generates a 7000 increase in output.
DY= 7000
]
The Shift in AD is the same as the increase in
Equilibrium output:
G1=3,700
DG = 700
D
G0=3,000
Y = 700 (1/0.1) = 7000
AE1=C+I+G1+NX
AE0=C+I+G0+NX
DAE= 700
P0
AE1=C+I+G1+NX
AE0=C+I+G0+NX
DY= 7000
AD1=C+I+G1+NX
AD0=C+I+G0+NX
DY= 7000
Output increases by Full Multiplier Amount
AD Shifts by the full multiplier amount
DY = DG (1/1-MPC)
P0
Excess Demand: AE > Y,
inventories drop.
If there is excess
capacity and
Unemployment, firms
AS0 increase output but DO
NOT raise prices
DY = DG (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
P0
DY = DG (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
P0
DY = DG (1/1-MPC)
1
AD0
Y0
Real GDP
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