 # 25 Demand-Side Equilibrium: Unemployment or Inflation? A definite ratio, to be called the Multiplier, can be established between income and investment.

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25 Demand-Side Equilibrium: Unemployment or Inflation? A definite ratio, to be called the Multiplier, can be established between income and investment. JOHN MAYNARD KEYNES Demand-Side Equilibrium: Unemployment or Inflation? A definite ratio, to be called the Multiplier, can be established between income and investment. JOHN MAYNARD KEYNES

●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 ●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 Contents Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

●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 ●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 Contents (continued) Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●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. ●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. The Meaning of Equilibrium GDP

FIGURE 25-1 The Circular Flow Diagram Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 1 3 6 5 4 2 Investors Government Firms (produce the domestic product) Consumers Financial System Rest of the World Saving (S) Consumption (C) Investment (I) C + I Government C + I + G Imports (IM) Exports (X) C + I + G + Transfers Disposable Income (DI) Taxes Gross National Income (Y) (X – IM) Purchases (G)

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●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. ●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. The Meaning of Equilibrium GDP

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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. ●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.

FIGURE 25-2 Construction of the Expenditure Schedule Copyright © 2003 South-Western/Thomson Learning. All rights reserved. G = \$1,300 I = \$900 C +I+G C +I +G + (X– IM) C +I C 7,2006,8006,4006,0005,600 6,000 6,100 4,800 Real Expenditure Real GDP 5,200 3,900 X–IM = –\$100

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●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. ●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. The Mechanics of Income Determination

FIGURE 25-3 Income-Expenditure Diagram Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Spending exceeds output Output exceeds spending Equilibrium 6,000 Real Expenditure 45° 5,2005,6006,0006,4006,8007,2000 4,800 5,600 6,400 6,800 7,200 Real GDP 4,800 5,200 C + I + G + (X –IM) E

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●  price level   consumption ●Therefore,  price level   total expenditures and  equilibrium GDP ●Therefore,  price level   equilibrium level of real aggregate quantity demanded ●  price level   consumption ●Therefore,  price level   total expenditures and  equilibrium GDP ●Therefore,  price level   equilibrium level of real aggregate quantity demanded The Aggregate Demand Curve

FIGURE 25-4 The Effect of the Price Level on Equilibrium AD Copyright © 2003 South-Western/Thomson Learning. All rights reserved. (b) Fall in Price Level Real Expenditure Real GDP C 0 +I +G + (X–IM) Y 0 Y 2 (a) Rise in Price Level Real Expenditure Real GDP C 0 +I +G + (X–IM) Y 0 Y 1 45 C 2 +I +G + (X–IM) E 0 E 0 C 1 +I +G X–IM) E 1 E 2

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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. ●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.

FIGURE 25-5 The Aggregate Demand Curve Copyright © 2003 South-Western/Thomson Learning. All rights reserved. E 2 E 0 E 1 Price Level Real GDP P 1 P 0 P 2 Y 2 Y 0 Y 1

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●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 ●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 Demand-Side Equilibrium and Full Employment

FIGURE 25-6 A Recessionary Gap Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Recessionary gap C + I + G + (X –IM) 45° Potential GDP 7,000 Real Expenditure Real GDP 6,000 E F B

FIGURE 25-7 An Inflationary Gap Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Inflationary gap 45° Potential GDP 8,000 Real Expenditure Real GDP 7,000 C + I + G + (X –IM) F B E

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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. ●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.

FIGURE 25-8 A Simplified Circular Flow Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 1 3 Investors Consumers Financial System Saving (S) Consumption (C) Investment (I) C + I Y Firms (produce the domestic product) 2

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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

TABLE 25-3 Total Expenditure after a \$200 Billion Increase Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 25-9 Illustration of the Multiplier Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Real Expenditure 45  \$200 billion 6,800 0 6,000 Real GDP C + I1I1 + G + (X –IM) C + I0I0 + G + (X –IM) E 1 E 0

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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. ●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.

FIGURE 25-10 How the Multiplier Builds Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Spending Round 2015108642 Cumulative Spending Total \$4.0 2.0 3.0 1.0 0

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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. ●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.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Algebraic Statement of the Multiplier ♦Factors that reduce the size of the multiplier ■International trade ■Inflation ■Income taxation ■Financial system ●Algebraic Statement of the Multiplier ♦Factors that reduce the size of the multiplier ■International trade ■Inflation ■Income taxation ■Financial system Changes on the Demand Side: Multiplier Analysis

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●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. ●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. The Multiplier Is a General Concept

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●  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. ●  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. The Multiplier Is a General Concept

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Multiplier and the Aggregate Demand Curve ●  autonomous spending  horizontal shift of the AD curve by an amount given by the oversimplified multiplier formula.

FIGURE 25-12 Two Views of the Multiplier Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 45  C+ I 1 + G+ (X– IM) \$200 billion C+ I 0 + G+ (X– IM) 0 6,000 100 Price Level Real Expenditure 6,800 6,000 Real GDP (I = \$1,100)D 1 D 1 (I = \$900) D 0 D 0 E 0 E 0 E 1 E 1

Appendix A: The Simple Algebra of Income Determination and the Multiplier

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Simple Algebra of Income Determination & Multiplier ●All of the relationships discussed can be represented in simple algebra.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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 ●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

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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) ●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)

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Simple Algebra of Income Determination & Multiplier ●Then solve for Y: Equilibrium Y = [a - bT + I + G + (X - IM)] / (1 - b)

Appendix B: The Multiplier With Variable Imports

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 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. ●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.

FIGURE 25-13 The Dependence of Net Exports on GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. X – IM X IM Real GDP Negative net exports Positive net exports Positive net exports Negative net exports Real Net Exports Real Exports and Imports Real GDP 200 100 0 –100 –200 –300 7,2006,8006,4006,000 5,600 5,200 4,800 950 850 750 650 550 450 7,2006,8006,4006,0005,6005,20004,800

FIGURE 25-14 Equilibrium GDP with Variable Imports Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Positive net exports Negative net exports X– IM Real GDP C+ I+ G+ (X– IM) (fixed imports) 45  Real Expenditure 6,000 C+ I+ G+ (X– IM) (variable imports) E

FIGURE 25-15 The Multiplier with Variable Imports Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Real GDP Rise in exports = \$160 Rise in GDP = \$400 C+ I+ G+ (X 0 – IM) 45  C+ I+ G+ (X 1 – IM) 6,400 Real Expenditure 6,000 E A

TABLE 25-7 Equilibrium Income after a \$160 Billion Increase Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

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