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 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.

TABLE 25-2 The Determination of Equilibrium Output Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

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, ,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.

TABLE 25-4 The Multiplier Spending Chain Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE How the Multiplier Builds Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Spending Round Cumulative Spending Total $

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.

TABLE 25-5 Consumers Spend $200 Billion More Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

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 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, 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.

TABLE 25-6 Equilibrium Income with Variable Imports Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 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 –100 –200 –300 7,2006,8006,4006,000 5,600 5,200 4, ,2006,8006,4006,0005,6005,20004,800

FIGURE 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 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.