Demand-side Equilibrium (Keynesian Equilibrium)

Consumption function in the DI-C Space C DI (Disposable Income) C 0 C = constant + coefficient * DI

Consumption function in the Y-C Space C Y (GDP) C 0 C = constant + coefficient * Y

Consumption Function in the Y-C space  The equation form: C = constant + coefficient * Y  To convert from the old form C = a + b DI = a + b (Y - T) = a + b (Y - T) = a + b Y - b T = a + b Y - b T where T is a (lump-sum) tax, and DI = Y - T

Consumption function in the Y-C Space C Y (GDP) C 0 C = ( a – bT) + b Y a – bT

Consumption Function in the Y-C space  T is assumed to be a lump-sum tax, it is a constant.  DI = Y – T  If T= 0, then C = a + bY, same as before  If T increases, then the C function line will shift  Note the C function does not shift in the DI-C space

Other components in AE  AE = C + I + G + (X - IM)  In addition to C, there are components: I, G, and X-IM

Investment (I)  Investment is the business firms' purchase of new physical assets (including adding in inventories, and house construction).  It very volatile.

Shifters of I  Business confidence and expectations  Growth of demand (sales)  Interest rate  Product innovation  Tax incentive

Government expenditure G  Government expenditure is the purchases of goods and services by all government levels.  Determined by the government

Net Exports: X - IM  Gross exports minus imports  Shifters of net exports: –Other countries' income: affects X –Our income: affects IM –Relative prices of exports and imports

The Circular Flow of Expenditures and Income 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)

Flow in the circular flow diagram As the flow circulates around the circular flow system, will the volume grow larger, smaller, or keep the same level?

Keynesian answer  Depends on AE and Y  If AE > Y, Y increases, flow grows bigger.  Reasons: When AE > Y –Spending greater than output –Inventory falls –Firms find sale is strong, and increase output

Keynesian answer  If AE < Y, Y falls, flow becomes smaller. Reasons: When AE < Y –Spending less than output –Unintended inventory increases –Firms find sale is slow and cut the production

Keynesian answer  When AE = Y, remains the same level  Reasons: Firms found the current output just satisfies the demand. So keep the same output level.  Keynesian equilibrium condition: AE = Y

The Keynesian Equilibrium  Denote Y* (at Y*, AE=Y)  Also called “Demand-side equilibrium”  The output is determined by spending, or the demand.  It is stable  It does not imply full employment  So recession can be prolonged

Construct the AE schedule  The Aggregate Expenditure Schedule (AE)  The AE refers to the relationship between AE and GDP (Y)  AE = C + I + G + (X - IM)  It tells you what the total spending is at different income Y level

The AE function C Y (GDP) AE 0 C+I C+I+G AE= C+I+G+X-IM X-IM G I

The AE function Y (GDP) AE Y0Y0 AE 0

The 45 degree line  Property  Any point on the 45 degree line has the equal distance to the vertical axis and horizontal axis.

The 45 degree line Y (GDP) AE 0 AE= Y 45 degree Y1Y1 AE 1

Graphical illustration of the Keynesian Equilibrium  It is the intersection of the AE line and the 45 degree line.

Keynesian equilibrium 0 YY* AE AE=Y $

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

Income-Expenditure Diagram

Demand-side equilibrium Y* and Potential GDP Yp  Potential GDP, Yp, is the full employment GDP  Y* does not have to equal Yp  Y* < Yp: recessionary gap. –Why a prolonged recessionary gap?  Y* > Yp: inflationary gap.

Recessionary Gap 0 Y Y* AE AE=Y $ YpYp Recessionary gap

 Y* < Yp: recessionary gap.  Recessionary Gap: when the Keynesian equilibrium output is less than potential GDP  Implies prolonged high unemployment  Implies a prolonged recession  Why prolonged?

Inflationary Gap 0 Y Y* AE AE=Y $ YpYp Inflationary gap

Equation form for the Keynesian equilibrium A Model Economy is described as follows: C = DI I = 150 G = 200 X - IM = -50 T = 0 T = 0 Solve for the Keynesian equilibrium Y*

Equation form for the Keynesian equilibrium  Consumption function C = DI Assume T = 0 C = (Y - T) = Y = Y  I = 150  G = 200  X - IM = -50

Approach Solve for the equilibrium level Y*  Find the AE schedule equation  Utilize the equilibrium condition, AE = Y  Solve for the equilibrium Y: Y*

Step 1  Add together to get AE, AE = C + I + G + X - IM AE = Y = Y = Y

Step 2  Using the Keynesian equilibrium condition Y = AE = Y

Step 3  Solve for equilibrium Y: Y* = 1/(1-0.9) X 400 = 10 X 400 = 4000