1. Demand-Side Equilibrium: Multiplier Analysis
A definite ratio, to be called the Multiplier, can be established between income and investment.
JOHN MAYNARD KEYNES
Asst. Prof. Dr. Serdar AYAN

2. 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.

3. FIGURE 1. The Circular Flow Diagram
Rest of the
World
Financial System
C + I
Consumption (C)
Investment (I) 3 2
C + I + G
Purchases (G)
Imports (IM)
Saving (S)
Exports (X)
Investors 4
Government
C + I + G +
Consumers 1
Government
(X – IM)
Disposable
Firms
(produce the
domestic product)
Transfers
Taxes 5 6
Income (DI)
Gross
National
Income (Y) .

4. 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.

5. 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.

6. TABLE 1. The Determination of Equilibrium Output

7. FIGURE 2. Construction of the Expenditure Schedule+ I G C + I G
+ ( X – M ) X –
IM =
–$100
6,100
G =
$1,300
6,000 C + I
Real Expenditure
4,800 C
I =
$900
3,900
5,200
5,600
6,000
6,400
6,800
7,200
Real GDP .

8. 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.

9. FIGURE 3. Income-Expenditure Diagram
Output exceeds spending
7,200
45° C + I G ( X – M )
6,800
6,400 E
6,000
Real Expenditure
Equilibrium
5,600
5,200
Spending exceeds
output
4,800
4,800
5,200
5,600
6,000
6,400
6,800
7,200
Real GDP

10. 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

11. FIGURE 4. The Effect of the Price Level on Equilibrium AD45 45 C 2 + I G
+ ( X – M ) E 2 C + I G
+ ( X – M ) C + I G
+ ( X – M ) E E
Real Expenditure C 1 + I G
+ ( X – M )
Real Expenditure E 1 Y 1 Y Y Y 2
Real GDP
Real GDP ( a)
Rise in Pric
e Level ( b)
Fall in Pric
e Level

12. 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.

13. FIGURE 5. The Aggregate Demand CurveP 1 E 1
Price Level E P E 2 P 2 Y 1 Y Y 2
Real GDP

14. Demand-Side Equilibrium and Full Employment
Equilibrium GDP may not = full-employment GDP.
Recessionary gap: amount by which equilibrium GDP < potential GDP
Inflationary gap: amount by which equilibrium GDP > potential GDP

15. FIGURE 6. A Recessionary Gap
Potential
GDP
45° F C + I G ( X – M )
Real Expenditure E B
Recessionary gap
6,000
7,000
Real GDP

16. FIGURE 7. An Inflationary Gap
45°
Potential
GDP C + I G ( X – M )
Inflationary gap B E
Real Expenditure F
7,000
8,000
Real GDP

17. 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.

18. FIGURE 8. A Simplified Circular Flow
Financial System
C + I
Consumption (C)
Investment (I) 2
Saving (S)
Investors
C + I
Consumers 1
Firms
(produce the
domestic product) 3 Y

19. 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

20. The Consumption Function and the Marginal Propensity to Consume
Marginal Propensity to Consume =  consumption   disposable income

21. TABLE 4. The Multiplier Spending Chain

22. 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.

23. 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.

24. FIGURE 10. How the Multiplier Builds
$4.0
3.0
Cumulative Spending Total
2.0
1.0 2 4 6 8 10 15 20
Spending Round

25. 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

26. 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.

27. 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.

28. The Multiplier Is a General Concept
 GDP in a foreign country   its imports, a portion of which are exports from the Turkiye.
The growth in U.S. exports has a multiplier effect, raising GDP in the Turkiye.
Booms and recessions tend to be transmitted across national borders.

29. The Multiplier and the Aggregate Demand Curve
 autonomous spending  horizontal shift of the AD curve by an amount given by the oversimplified multiplier formula.

30. TABLE 5. Consumers Spend $200 Billion More

31. TABLE 3. Total Expenditure after a $200 Billion Increase

32. FIGURE 12. Two Views of the Multiplier45 C + I 1 G (X – M ) E 1 C + I G ( X – M )
Real Expenditure
$200 billion E
6,000
6,800 ( I
= $900) D ( I
= $1,100) D 1
Price Level
100
6,000
Real GDP

33. The Simple Algebra of Income Determination and the Multiplier

34. Simple Algebra of Income Determination & Multiplier
All of the relationships discussed can be represented in simple algebra.

35. 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

36. 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)

37. Simple Algebra of Income Determination & Multiplier
Then solve for Y: Equilibrium Y = [a - bT + I + G + (X - IM)] / (1 - b)