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

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.

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) .

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.

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.

TABLE 1. The Determination of Equilibrium Output

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 .

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.

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

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

FIGURE 4. The Effect of the Price Level on Equilibrium AD 45 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

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.

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

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

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

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

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.

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

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

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

TABLE 4. The Multiplier Spending Chain

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.

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.

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

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

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.

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.

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.

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

TABLE 5. Consumers Spend $200 Billion More

TABLE 3. Total Expenditure after a $200 Billion Increase

FIGURE 12. Two Views of the Multiplier 45 ° 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

The Simple Algebra of Income Determination and the Multiplier

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

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

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)

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