9 9 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

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Define Equilibrium and graph it using a Expenditure Schedule. Goal #1

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●.●.●.●.●.●. ●.●.●.●.●.●. The Meaning of Equilibrium GDP

TABLE 2: The Determination of Equilibrium Output Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

FIGURE 2: Construction of the Expenditure Schedule Copyright © 2006 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© 2006 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 3: Income-Expenditure Diagram Copyright © 2006 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© 2006 Southwestern/Thomson Learning All rights reserved. ●.♦.♦.●.♦.♦. ●.♦.♦.●.♦.♦. The Aggregate Demand Curve

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●.♦.♦.●.♦.♦. ●.♦.♦.●.♦.♦. The Aggregate Demand Curve

FIGURE 5: The Effect of the Price Level on Equilibrium AD Copyright © 2006 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© 2006 Southwestern/Thomson Learning All rights reserved. The Aggregate Demand Curve ●.●.●.●. ●.●.●.●.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Identify Recessionary and Inflationary Gap and graph them using a Expenditure Schedule. Goal #2

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●.●.●.●.●.●. ●.●.●.●.●.●. Demand-Side Equilibrium and Full Employment

FIGURE 7: A Recessionary Gap Copyright © 2006 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 8: An Inflationary Gap Copyright © 2006 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© 2006 Southwestern/Thomson Learning All rights reserved. The Coordination of Saving and Investment ●.●.●.●. ●.●.●.●.

FIGURE 9: A Simplified Circular Flow Copyright © 2006 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© 2006 Southwestern/Thomson Learning All rights reserved. Changes on the Demand Side: Multiplier Analysis ●Multiplier =.

FIGURE 10: Illustration of the Multiplier Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Real Expenditure 45  $200 billion 6, ,000 Real GDP C + I1I1 + G + (X –IM) C + I0I0 + G + (X –IM) E 1 E 0

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Changes on the Demand Side: Multiplier Analysis ●Demystifying the Multiplier: How It Works ♦. ♦  spending   income ♦. ●Demystifying the Multiplier: How It Works ♦. ♦  spending   income ♦.

TABLE 4: The Multiplier Spending Chain Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Copyright© 2006 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© 2006 Southwestern/Thomson Learning All rights reserved. ●Algebraic Statement of the Multiplier ♦Factors that reduce the size of the multiplier ■. ■\ ●Algebraic Statement of the Multiplier ♦Factors that reduce the size of the multiplier ■. ■\ Changes on the Demand Side: Multiplier Analysis

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Multiplier Is a General Concept ●.●. ●.●.

TABLE 5: Consumers Spend $200 Billion More Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Other multiplier effects: ♦. ●Other multiplier effects: ♦. The Multiplier Is a General Concept

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●.●.●.●.●.●. ●.●.●.●.●.●. The Multiplier Is a General Concept

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Multiplier and the Aggregate Demand Curve ●.●. ●.●.

FIGURE 12: Two Views of the Multiplier Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 45  C+ I 1 + G+ (X– IM) $200 billion C+ I 0 + G+ (X– IM) 0 6, 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© 2006 Southwestern/Thomson Learning All rights reserved. Simple Algebra of Income Determination & Multiplier ●All of the relationships discussed can be represented in simple algebra.

Copyright© 2006 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© 2006 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© 2006 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© 2006 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.

TABLE 6: Equilibrium Income with Variable Imports Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

FIGURE 13: The Dependence of Net Exports on GDP Copyright © 2006 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 –100 –200 –300 7,2006,8006,4006,000 5,600 5,200 4, ,2006,8006,4006,0005,6005,20004,800

FIGURE 14: Equilibrium GDP with Variable Imports Copyright © 2006 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 15: The Multiplier with Variable Imports Copyright © 2006 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 7: Equilibrium Income after a $160 Billion Increase Copyright © 2006 South-Western/Thomson Learning. All rights reserved.