Demand Side Equilibrium Chapter 9 Demand Side Equilibrium

Y C=500+0.9*Y I G X M AE DInventories Firm's Reaction 10000 9500 400 300 200 100 10,300 -300 Increase Production; hire more workers 11000 10400 11,200 -200 12000 11300 12,100 -100 13000 12200 13,000 Equilibrium 14000 13100 13,900 Decrease Production Hire less workers 15000 14,800

Consumption changes with Disposable Income Yd C = a + MPC*Yd C = a + MPC*(Y-Tx+Tr) C1 DC=MPC*DYd Y National Income : Wages Profits Interest Rents Move UP Along C C0 Yd= Y- Tx+ Tr Yd0 Yd1

Consumption changes with National Income Y C = a + MPC*(Y+ Tr – Tx) C = a + MPC* (Tr – Tx) + MPC*Y C will shift with an increase in Transfers or a drop in Taxes New Intercept: A C = A + MPC*Y C1 DC=MPC*DY Move UP Along C Y National Income : Wages Profits Interest Rents C0 Increase in National Income Y Y Y0 Y1

National Income Y(wages, Profits, Interest, Rents) Aggregate Expenditures ~Total Sales AE = C + I + G + NX AE = 6,400 NX= 300 G = 500 I = 1000 AE = 6,400 C= 4,600 C = 100 + 0.9Y C = 4600 Y = 5,000 National Income Y(wages, Profits, Interest, Rents)

National Income Y(wages, Profits, Interest, Rents) Aggregate Expenditures AE NX= 300 AE = C + I + G + NX NX= 300 G = 500 NX= 300 ~Total Sales NX= 300 G = 500 G = 500 G = 500 I = 1000 I = 1000 AE = 24,400 I = 1000 AE = 19,000 AE = 10,900 I = 1000 AE = 6,400 C = 22,600 C = 17,200 C = 100 + 0.9Y C = 9,100 C = 4600 Y = 10,000 Y = 5,000 Y = 19,000 Y = 25,000 National Income Y(wages, Profits, Interest, Rents)

Equilibrium Y = 19,000 ~Total Sales Firms decrease production No change in production ~Total Sales +600 AE AE Firms increase production Change in Inventories = 10,000 – 10,900 = -900 (decrease) Change in Inventories = 5,000 - 6,400 = -1,400 (decrease) Change in Inventories = 19,000 – 19,900 = 0 (no change) Change in Inventories = 25,000 – 24,400 = +600 (increase) -900 -1,400 Y =25,000 If total production Y = 25,000 If total production Y = 19,000 If total production Y = 5,000 If total production Y = 10,000 AE=19,000 AE=24,400 Y=19,000 AE=10,900 AE=6,400 Aggregate Expenditures AE = 19,000 Aggregate Expenditures AE = 6,400 Aggregate Expenditures AE =10,900 Y=10,000 Y=5,000 Equilibrium Y = 19,000 Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000

Distances into Vertical Distances. The 45 line Converts Horizontal Distances into Vertical Distances. Y = 19,000 Y = 10,000 Y = 5,000 450 Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000

Total Sales=Aggregate Expenditures AE Total Sales=Aggregate Expenditures Total Production 450 Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000

At Equilibrium there is NO change in Inventories Total Production AE Inventories Increase Y Aggregate Expenditures AE AE AE (Sales) Inventories Decrease Y(Production) For any output level below equilibrium For any output level above equilibrium Total Production (Y)

AE = 24,400 AE = 10,900 C, AE C If consumption, I, G or NX increase AE = C+I+G+NX G = 500 NX= 300 If consumption, I, G or NX drop G = 500 I = 1000 AE = 24,400 The AE line shifts up The AE line shifts down I = 1000 AE = 10,900 C = 100 + 0.9Y C = 22,600 C = 9,100 100 Y = 10,000 Y = 25,000 Real Income = Real GDP = Y

Total Sales or Aggregate Expenditures AE AE= C+I+G+NX Total Sales or Aggregate Expenditures Total Production or Total Income (Y) 450 GDP/Income Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000

Production > sales Inventories increase GDP/Income Equilibrium Equilibrium AE AE= C+I+G+NX If C,I,G or NX Decrease, AE line shifts down Production > sales Inventories increase Firms decrease output Equilibrium output decreases Lower Y*

Sales > Production Inventories Decrease AE New Equilibrium Equilibrium Equilibrium output increase Sales > Production Inventories Decrease If AE line shifts up Firms Increase Output 450 Higher Y1* Y0*

Equilibrium AE Potential GDP AE Where it should be: zero unemployment, no excess capacity Where the economy is stuck 450 Equilibrium GDP Potential GDP

E B Equilibrium AE Potential GDP AE AE To increase AE: increase in C, I, G or NX To eliminate a recessionary gap, AE must rise. AE Equilibrium Decrease Taxes/Increase Transfers Decrease interest Rates Increase Government Spending Make Dollar Weaker E B Distance E-B Economy is producing less than desired output Recessionary Gap Recessionary gap: GDP is lower than full employment GDP 7,000-6,000 =1,000 450 Equilibrium GDP: 6,000 Potential GDP : 7,000

E B Equilibrium AE To decrease AE: Increase Taxes/Decrease Transfers Increase interest Rates Decrease Government Spending Make Dollar Stronger Trying to produce more than possible Zero Unemployment, No excess capacity AE Working at full capacity: equipment breaks down more often: costs rise Labor shortages: hiring workers who already have a job: Labor costs rise To eliminate an Inflationary gap, AE must fall. AE Equilibrium Rising costs = rising prices E B Distance E-B Inflationary Gap 7,000-8,000 = -1,000 450 Potential GDP : 7,000 Equilibrium GDP: 8,000

Which AE line will cause a recessionary gap? Which AE line will cause an Inflationary gap?

Assume the Economy is at Equilibrium 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 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?

At Y=3000 At Y=4000 At Y=5000 Potential GDP AE=C+I+G+NX Is the economy at equilibrium ? Total Spending( > = < )Output Inventories (rise, fall, remain the same) Firms will (increase, decrease, not change)output. Does the economy experience a (recessionary, inflationary) gap? Size of the Gap = __________ Is the economy experiencing unemployment or labor shortages? Is the economy at equilibrium ? Total Spending( > = < )Output Inventories (rise, fall, remain the same) Firms will (increase, decrease, not change)output. Once the Economy reaches equilibrium, will the economy experience a (recessionary, inflationary) gap? Size of the Gap = __________ Is the economy experiencing unemployment or labor shortages? Is the economy at equilibrium ? Total Spending( > = < )Output Inventories (rise, fall, remain the same) Firms will (increase, decrease, not change)output. Once the Economy reaches equilibrium, will the economy experience a (recessionary, inflationary) gap? Size of the Gap = __________ Is the economy experiencing unemployment or labor shortages?

At Y=3000 At Y=4000 At Y=5000 Is the economy at equilibrium ? Total Spending( > = < )Output Inventories (rise, fall, remain the same) Firms will (increase, decrease, not change)output. Once the Economy reaches equilibrium, will the economy experience a (recessionary, inflationary) gap? Is the economy experiencing unemployment or labor shortages? Is the economy at equilibrium ? Total Spending( > = < )Output Inventories (rise, fall, remain the same) Firms will (increase, decrease, not change)output. Does the economy experience a (recessionary, inflationary) gap? Is the economy experiencing unemployment or labor shortages? Is the economy at equilibrium ? Total Spending( > = < )Output Inventories (rise, fall, remain the same) Firms will (increase, decrease, not change)output. Once the Economy reaches equilibrium, will the economy experience a (recessionary, inflationary) gap? Is the economy experiencing unemployment or labor shortages?

Income that does not come back to buy goods and services NI Spending Leakages Taxes Imports Income that does not come back to buy goods and services Saving GDP

NI GDP Spending Injections Imports Taxes Government spending Exports Saving Investment

Equilibrium Leakages S+T+M I+G+X Injections Not enough spending Inventories accumulate Spending = Output inventories do not change Leakages S+T+M Leakages larger than Injections I+G+X I+G+X=S+T+M Injections Larger than Leakages Injections Ybelow equilibrium Y Equilibrium Yabove equilibrium Too much spending inventories fall

Equilibrium AE S+T+M I+G+X > Inventories increase Inventories fall 45 Too much Demand for output Y > AE Inventories increase Y < AE C+I+G+NX Inventories fall AE Not enough Demand for output Equilibrium Leakages = Injections Y Equilibrium S+T+M Leakages > Injections Injections > Leakages I+G+X I+G+X=S+T+M Y below equilibrium Y Equilibrium Y above equilibrium

At equilibrium, Leakages = Injections S+T+M = I + G + X Rearrange: S = I + (G-T) + (X-M) Savings finance Government’s Deficit: Spending > Tax Revenue Trade Deficit: Buy more from other countries than we sell to them Investment http://www.mises.org/fullstory.aspx?control=1598

At Y = 3,000 are inventories rising? Falling? Unchanged? What is the equilibrium GDP? For what value of GDP is: Y = AE? For what value of GDP is: Y = AE? For what value of GDP is: S = I +(G-T) +(X-M)? I + (G-T) + (X-M)