Download Demand Side Equilibrium and Full Employment

Vocabulary for Chapters 9 through 11
Chapter 9
Multiplier – results from the secondary expansion of consumer demand from higher disposable
incomes and from possibly more induced investment as output rises.
What is true at equilibrium – …AE equals Yd equals the expenditure schedule which shows planned
expenditures at every level of output.
Induced investment – Id equals (I + kYa ) where k equals the marginal propensity to invest (induced
investment) and causes the investment curve to slope upward. This is because as income rises,
more inventories are needed, more factories are needed to produce the extra output, and
profitability of new investment rises so that companies are willing to invest more at any given
interest rate.
The term “induced increase in consumption” is what I call “the secondary expansion of
consumption” which causes a much larger increase in the equilibrium level of income from
and upward shift of the expenditure schedule.
An autonomous increase in consumption merely refers to an upward shift in the consumption
function at every level of income. I call such changes “primary shift” and it could occur with
government spending, imports, exports, taxes transfers, and investment. Any autonomous
increase in demand results in a multiple impact on the equilibrium level.
The multiplier describes the change in the equilibrium level of income that result from an
autonomous change in investment (we could also say the change in equilibrium level of
income resulting from a shift in the primary components of aggregate demand) and is merely a
number.
Calculation of the multiplier. On page 178 the book shows you the underlying mathematics and give
you an oversimplified multiplier function: the multiplier = 1/1-MPC.
The MPC stands for the marginal propensity to consume which is the extra consumption from an
extra dollar of income. In our analysis, it is the slope of a tangent at any point on the
consumption function. If the consumption function is a straight line, the way we have draw n
it in class, it has a Y axis intercept ( C ) or in the consumption C = 400 + .75Ya. 400 is the
intercept and .75 is the marginal propensity to consume.
If we did a cross sectional analysis of a function of income at any given point in time, we would find
that consumption function rises more and more slowly as income goes up. What is happening
to the marginal propensity to consume of the rich compared to people with lower incomes?
Also, note the importance of real wealth, the price level and its impact on assets of fixed dollar
value such as bonds or cash, the real interest rate which we showed had virtually no effect on
consumption in the United States and the importance of expectations about changes in real
disposable income (remember the difference a permanent upward shift in income and a
temporary upward shift in income).
Saving is identical to disposable income minus consumption. S = Ydi-C Thus, anything that
happens to the consumption function has exactly the opposite affect on the savings function
Simplest income equilibrium model: remember our Principle of Business Behavior
1. If savings are greater than planned investment, Id, then unplanned inventory accumulation and
unsold new houses are growing, orders will go down, construction will stop and output and
incomes will go down, ...until Ydi has gone down enough so that actual saving have equal
planned investment.
2. If actual savings are less then planned investment Id, inventories in the stores, new homes
being built and new factories will be too low relative to planned levels. Orders will rise and if
we are at less than full employment, GDP output will continue to rise until planned savings
grow to be equal to planned investment. Always think of savings as “nonbuying” which
frees up resources for investment. If however, we are at full employment or above, any
attempt to produce more will cause inflation.
3. Equilibrium occurs only when the level of income generates just enough savings so that
actual savings equals planned investment. Id= Sa (when assume that household are able to
buy or save what they want so the Sd = Sa.
S=-400 + .25Ydi = -C + (1-b)Ydi
Excess Inventory
Desired Investment Id
Shortages
Ya=Ydi if there is no taxes or transfers
Ya
Ya
Ya*
Too low
Too hi.
Paradox of thrift: Be able to explain the paradox of thrift. If I want to save more, I can do it. But if
everyone in a society tries to save more, then the consumption functions shifts downward which is
the same thing as the savings function shifting upward.. If planned investment does not change,
what will have to change? Output and income have to go down so that savings drop down to the
original level of planned investment.
If you had concluded that everyway could save more, you would have fallen into the fallacy of
composition by assuming that what is true for one, is true for the whole. Others: If I get a higher
real income, then we can raise then incomes of all workers and they will enjoy higher real income.
(What happens to prices?)
Under what circumstances would an increase in the society’s desire to save lead to a actual reduction
in the amount actually saved and invested at the new level of equilibrium. If we have induced
investment, could consuming more during a depression actually leave future generations with
a larger capital stock.
Excess output at Yfe,
ΔYd=Yd at YFE-Yd >0
Demand Side Equilibrium and Full Employment
Causes recession
Ya Yd = target
Upward shift in C, I,
In the diagrams to the right, we illustrate a
G, X or –M to buy the
ΔYd Yd = original
excess output at Yfe
recessionary gap where the potential
GDP YFE is greater than the potential GDP Ya*
The recessionary gap is the change in equilibrium
output which must occur in real terms. In chapter
Recessionary gap
10 we show that you divide this recessionary gap
What I called the
(this income gap) by the multiplier to calculate the
Recessionary income gap
*
ΔYa>0 = ΔYa=YFE-Ya
Equlibrium Ya*
Yfe Potential Ya
Where Ya=Ys
Max GDP
upward shift in the AE(Yd) curve indicated by the
dotted line. At that point the demand for goods and
services would just equal the supply of goods and
services.
Downward shift in C,
I, G, X or +M to reduce
the demand for output
at Yfe and stop prices
from rising
Excess demand at Yfe,
In the graph to the right we see that the potential GDPΔYd=Yd at YFE-Yd <0
Causes inflation
Yfe is below the equilibrium GDP Ya* and they
define the inflationary gap as the reduction in the
equilibrium level Ya* required to prevent inflation.
We can do that with fiscal and monetary policy to
shift the aggregate demand curve AE(Yd) by dividing
the recessionary gap by the multiplier.
ΔYd
In the third graph, there is not inflationary gap or
recessionary gap. This is where the demand for goods
equals the supply of goods or in our simple model
where the savings equals investment.
Be sure to understand the slight differences in notation
between the book and my lectures. Be sure to read
Appendix A of Chapter 9 “The Simple Algebra of
Income Determination and the Multiplier”. In that
appendix, the “b” is the samething as the “MPC”.
Ya
Yd = original
Yd = target
Inflationary gap
What I called the
Inflation income gap =
ΔYa<0
ΔYa=YFE-Ya*
Yfe
Equlibrium Ya*
Potential Y
Max GDP
ΔYd = ΔYa
= YE
Where Ya=Ys
-Yd
M
Chapter 10
On pages 190 through 205, they analyze equilibrium in
terms of the short run aggregate demand and short run
aggregate supply and they focus on the shift the aggregate
supply curve. In essence, the aggregate supply curve Ys
was assumed constant in most of our lectures because we
assumed that wages did not fall much if there was
unemployment and that wages and prices rose at the same
rate if there was inflation so that it did not cause any shift
in the potential output (YFE).
If in fact money wages and the prices of other inputs rise
faster than the price of the output, sellers are only
willing to produce less and the aggregate supply curve
shifts inward and it will intersect the aggregate demand
curve at a lower equilibrium and a higher price level.
Stagflation If wages are “sticky” downward and other
prices such as imported oil are also sticky downward, we
find ourselves in the unlucky position of having
stagflation which means unemployment and rising prices
as long as Unions can bargain for higher wages which
causes higher prices which causes them to bargain for
higher wages, etc., etc. so we now have unemployment
with rising prices.
SRAD
New equilibrium Ya*
with high prices and
high unemployment,.
Lost output and
growth because of
stagflation
1
SRAS
o
SRAS
Yfe = Potential Y and
equilibrium Ya*
before external factors
shifts aggregate supply
inward. (oil shortage)
Prices and wages don’t fall because of many
reasons and are stuck here preventing a return
to the full employment at lower prices.
See page 201 for the example of stagflation discussed in class. It shows that the equilibrium level of
output occurred at a higher price and far below potential output of YFE. The short run solution to this
supply shock induced recessionary gap is to take steps to increase the primary or autonomous
components of aggregate demand (CITx, Tr, I, G, X, IM), which will reach full employment again
but at a higher price level.
As well explained on page 201, if we waited for the “self correcting mechanism” of falling wages
and falling prices, you might be old and gray.
The one knight in shining armor riding to our rescue over the long run is technological change to
lower costs and institutional change which prevents unions and monopolies from raising prices in the
face of unemployment and lastly international competition that drives down commodity prices as
happened between 1973 and 1998.
Chapter 11: Fiscal Policy for Managing Aggregate Demand
The simple model below sets up a situation, which we will use to illustrate how fiscal policy, can be
used to close the recessionary gaps.
Three tools of fiscal policy: 1. changes in taxes, 2. changes in government spending, and 3. changes
in transfer payments. It is important to understand that changes in taxes and changes in transfer
payments work by changing the amount of disposable income available to households at any given
level of GDP but have very different impacts on income distribution, MPC and political impacts
A upward shift (autonomous change) in investment spending or government spending leads to a
multiple impact on the equilibrium level of income because of the multiplier effect. If the multiplier
is defined as M= 1/(1-MPC) so if the MPC = .,75 the M=1((1-.75) = 1/.25 = 4
G*1/(1-MPC) = Ya*. For example, if the MPC is equal to .75 and G is $100,
then Ya*=G*M => Ya*= 4 x 100 = 400.
Is this true for a reduction in taxes? Lets work it out for a cut in taxes of 100.
Tx  Ydi. In words, a tax decreases increases disposable income by the same amount
But does the tax decrease of $100 increase consumption by $100? NO!
C = MPC*Ydi . In words, because part of the increase in disposable income is saved, the tax cut shifts
the consumption function upward be only a part of the tax cut (.75) and the rest is saved (.25).
So what is to total impact of the tax decrease on the equilibrium level of income?
Tx  Ydi = and this Ydi *MPC = C
Tx= -100  Ydi = +100 but Ya*Ydi *MPC*M = +100*.75 *4= -75 * 4 = +300
So, you see that the multiplier for an increase in government spending is greater than the multiplier
for an equal cut in taxes so we have the concept of the tax multiplier.
Tax multiplier = MPC/(1-MPC), because it simply says that savings take away part of the increase
in disposable income before it is spent.
Impact of income taxes on the multiplier: In the last two lectures we analyzed the impact of income
taxes and imports on the multiplier. This is now easy for you.
Income taxes reduce disposalble income by a percentage tx% of a 1$. So an increase in output
which pays wages of $100 only increases disposable income by (1-tx%)*$100: tx%*100 goes to the
Tresaury and has no effect on future spending by the government.
So a $100 increase in output in wages increase disposable income by (1-tx%)*100. Since disposable
income goes up by (1-Tx)*Ya , it reduces the slope of the consumption function relative to the
horizontal axis of output because it reduces the slope of disposable income relative to output.
Remember before we had assumed that taxes and transfers were fixed. So what does this do to the
multiplier. You can work it out from Appendix in Chapter 10.
Multiplier with income taxes: M = 1/(1-MPC +txMPC) or as they simplify it M=1(1-MPC(1+tx).
If the MPC = .8, the simple multiplier would be 5
If the MPC = .8, and the flat rate income tax is 25% then the M = 1/(1-..8 +.8*.25) = 1
Income taxes are very powerful automatic stabilizers so that autonomous shifts in aggregate
expenditure (Yd) have a much smaller impact on the equilibrium level of income Ya* .
Similarly, a change in transfer payments which include unemployment payments Tr which are
dependant on the level of income have a similar stabilizing effect because when output and therefore
payment of wages go down as workers are laid off, the payment of unemployment goes up.
Transfer payments basically function as negative taxes. The book unfortunately combines them in
the symbol T. I insist that you keep taxes and transfer payments separate because they immense
political and social implications and probably different marginal propensities to consume.
Some harsh realities
Estimates of multipliers are not precise, nor do they occur instantaneously and often are slowed down
in the swamp of Congress and Presidential vetoes.
Supply-side economics focuses mostly on supply-side tax cuts, which would increase producers
incentives to invest, increase the supply of savings that would free up resources for investment,
reducing the tax on corporate income and capital gains. It is not a different economic theory, just an
extension of what we have already learned.
Graphical treatment of taxes and fiscally policy: Be sure to read appendix A and B of chapter 11
Be able to solved any problems with both numbers and symbols.
I should be posting an old mid term with hand written answers. Study hard and good luck.