Chapter 9 Demand Side Equilibrium

Rest of World Interest Rent Profits Wages Goods and Services Households Firms S I T G G Circular Flow Diagram C Total Incom e Total Producti on Total Spending NX

Inventories are part of Investment. Inventories are of two kinds: Planned (desired) inventories. Firms build up inventories to be able to fulfill future orders. Unplanned (unwanted) inventories. Firms end up with unsold inventories because sales decreased unexpectedly.

Investment Includes… Residential Construction consumer purchases of new houses and condominiums. Non-residential construction Equipment, software, buildings, tools, etc. Changes in Inventories: unsold goods are included as investment. Firms Control: Firms DO NOT Control: Planned Inventories Unplanned Inventories Planned Investment Unplanned Investment

Inventories do not change… Production 100 Planned Inventories 20 Actual Inventories 20 Actual Sales 100 Total Production = 100 Firms do not change production THE ECONOMY IS IN EQUILIBRIUM =

Firms end only with WANTED inventories: their actual Investment and their planned Investment are the same. Firms will not change their production levels. Total Production = Total Spending

Inventories are “too high” Production 100 Planned Inventories 20 Planned Inventories 20 Unplanned Inventories 40 Actual Sales 60 Total Production = 100 Firms react by reducing production Actual Inventories =60

If firms’ inventories pile up unsold, their actual investment is greater than their planned Investment. Firms will decrease production to adjust their inventories to the desired level. Total Production > Total Spending

Inventories are “too low” Production 100 Wanted Inventories 20 Total Production = 100 Firms react by increasing production Actual Sales 110 Actual Inventories 10 Actual Inventories 10Inventories

Firms sell part of their inventories, their actual investment is lower than their planned Investment. Firms will increase their production levels to adjust their inventories to the desired level. Total Production < Total Spending

Determining Output In the short run, Aggregate Expenditures determine output. Firms adjust production to the level of sales

Aggregate Expenditures Households decide how much to consume. Firms decide how much to invest. The Government decides how much to spend. Foreigners and Nationals decide how much to purchase.

Aggregate Expenditures Actual Sales 100 Planned Inventories 20 Total Production Net Exports Consumption Government Spending Investment

Building Aggregate Expenditures AE = C + I + G + NX C = Y I = 1,000 G = 500 NX = 300 I + G + NX = 1,800 Purchases of buildings and equipment PLUS planned inventories Planned Investment

Aggregate Expenditures Aggregate Expenditures =AE Real Income = Real GDP = Y I = 1000 AE = C+I+G+NX AE G = 500 NX = 30 0 Y = 5,000 C = Y C = 9,100 I = 1000 G = 500 NX= 300 Y = 10,000 C = 17,200 I = 1000 G = 500 NX= 300 Y = 19,000 AE = 10,900AE = 19,000 C = 4600 AE = 6,400C = 22,600 I = 1000 G = 500 NX= 300 Y = 25,000 AE = 24,400

Aggregate Expenditures Aggregate Expenditures =AE Real Income = Real GDP = Y I = 1000 AE = C+I+G+NX AE G = 500 NX = 30 0 Y = 5,000 C = Y C = 9,100 I = 1000 G = 500 NX= 300 Y = 10,000 C = 17,200 I = 1000 G = 500 NX= 300 Y = 19,000 AE = 10,900AE = 19,000 C = 4600 AE = 6,400C = 22,600 I = 1000 G = 500 NX= 300 Y = 25,000 AE = 24,400

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

The Keynesian Cross 45 degree line 1000 The 45 line Converts Horizontal Distances into Vertical Distances. Income 100 C D B A Output

AE Y = 5,000Y = 10,000Y = 19,000 AE = 10,900AE = 6,400AE = 19,000AE = 24,400 Y = 25,

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

AE Y = 5,000Y = 10,000Y = 19,000Y = 25,000 Inventories Decrease Inventories Increase No change in Inventories AE Total Sales=Aggregate Expenditures Total Production

If firms end only with WANTED inventories: their actual investment and their planned investment are the same. With inventories only at the planned level Total Production = C + I + G + NX

45 Aggregate Expenditures Real GDP Y No unwanted change in Inventories Y Y C+I+G+NX AE

45 Aggregate Expenditures Real GDP Y Firms will decrease Output Equilibrium Y C+I+G+NX AE Too High Y Y C+I+G+NX Unwanted increase in Inventories

45 Aggregate Expenditures Real GDP Y Firms will increase Output Y C+I+G+NX Equilibrium Y Unwanted decrease in Inventories Low Y AE

6,000 is the equilibrium output

Condition for Equilibrium Total Sales = Total Production (Otherwise inventories either increase or decrease and we need inventories to remain the same for equilibrium)

Hypothetical Economy: No government and no foreign sector (closed economy) In such economy, total sales are sales to consumers and firms only. AE = C + I Only these two groups purchase total production.

Condition that must be satisfied for equilibrium: Y = C + I Since: Y = C + S (Income is either consumed or saved) We can rewrite the equilibrium condition as: C + S = C + I S = I leakages = Injections In a closed economy without government the equilibrium condition is that Savings must be equal to Investment Interest Rent Profits Wages Goods and Services Households Firms S I C Total Incom e Total Producti on Total Spending Closed Economy without Government

What is the equilibrium GDP? For what value of GDP is: Y = AE? For what value of GDP is: S = I? At Y = 5,000 are inventories rising? Falling? Unchanged? For what value of GDP is: Y = AE? At Y = 3,000 are inventories rising? Falling? Unchanged? Investment

Hypothetical Economy: Trades with the rest of the world (open economy) but no government In such economy, total sales are sales to consumers, firms and foreing countries only. AE = C + I + NX Only these three groups purchase total production.

Condition that must be satisfied for equilibrium: Y = C + I + X-M Since: Y = C + S We can rewrite the equilibrium condition as: C + S = C + I +X-M S = I + X-M S+M = I + X S = I +(X-M) leakages = Injections In an open economy without government the equilibrium condition says that our savings must be enough to finance private Investment plus the trade deficit. Rest of World Interest Rent Profits Wages Goods and Services Households Firms S I C Total Incom e Total Producti on Total Spending NX Open Economy without Government

What is the equilibrium GDP? For what value of GDP is: Y = AE? For what value of GDP is: S = I+(X-M)? At Y = 5,000 are inventories rising? Falling? Unchanged? For what value of GDP is: Y = AE? At Y = 3,000 are inventories rising? Falling? Unchanged?

Real World Economy: With government and foreign sector In such economy, total sales are sales to consumers, firms, foreigners and the government. AE = C + I+ G + NX These four groups purchase total production.

Condition that must be satisfied for equilibrium: Y = C + I + G + X-M Since: Y = C + S + T (Income is used to consume, save and pay taxes) We can rewrite the equilibrium condition as: C + S + T= C + I + G +X-M S = I + (G – T)+(X-M) leakages = Injections Rest of World Interest Rent Profits Wages Goods and Services Households Firms S I T G G C Total Incom e Total Producti on Total Spending NX Open Economy with Government S+T = I + G + X-M S+T+M = I + G + X Savings must finance Investment, the government’s deficit and the trade deficit.

What is the equilibrium GDP? For what value of GDP is: Y = AE? For what value of GDP is: S = I +(G-T) +(X-M)? At Y = 5,000 are inventories rising? Falling? Unchanged? For what value of GDP is: Y = AE? At Y = 3,000 are inventories rising? Falling? Unchanged? I + (G-T) + (X-M)

Shifts in the Aggregate Expenditures Line I = 1000 AE G = 500 NX = 30 0 Y = 5,000 C = Y C = 9,100 I = 1000 G = 500 NX= 300 Y = 10,000 C = 17,200 I = 1000 G = 500 NX= 300 Y = 19,000 AE = 10,900AE = 19,000 C = 4600 AE = 6,400C = 22,600 I = 1000 G = 500 NX= 300 Y = 25,000 AE = 24,400 When C, I, G or net exports increase The AE line shifts up When C, I, G or net exports decrease The AE line shifts down

AE Y = 5,000Y = 10,000 AE = 10,900AE = 6,400AE = 19,000AE = 6,400 Y = 25,000 If AE line shifts down Equilibrium Y = 19,000

AE Y = 5,000 AE = 10,900AE = 6,400AE = 19,000AE = 6,400 Y = 25,000 Equilibrium Y = 19,000 Y = 10,000 Equilibrium If AE line shifts down Equilibrium output decreases

AE Y = 5,000Y = 10,000 AE = 10,900AE = 6,400AE = 19,000AE = 6,400 Y = 25,000 If AE line shifts up Equilibrium Y = 19,000

AE AE = 19,000 If AE line shifts up Equilibrium Y = 19,000 Y = 25,000 Equilibrium output increases

Potential GDP The real gross domestic product (GDP) the economy would produce if its labor force were fully employed

Equilibrium output occurs below Potential GDP A Recessionary Gap

Equilibrium output occurs above Potential GDP An Inflationary Gap B Potential GDP

At Y = 3000 a) Total Spending > Output b) Inventories fall c) Total Spending < Output d) Inventories rise e) Total Spending = Output f) There is no change in Inventories g) The economy experiences a recessionary gap h) The economy experiences a recessionary gap At Y = 4,000At Y = 5000 i) Economy is at equilibrium

Building Aggregate Demand Matches each price level with the corresponding equilibrium value of output

Aggregate Demand Price Level Equilibrium Output AD P0P0 Y0Y0 Real GDP Demanded

When prices increase from P 0 to P 1, the value of wealth decreases and consumption decreases from C 0 to C 1. The AE line shifts down and the equilibrium value of output decreases from Y0 Y0 to Y1.Y1.

Aggregate Demand Price Level Equilibrium Output AD P0P0 Y0Y0 When prices increase from P 0 to P 1, the equilibrium value of output decreases from Y 0 to Y 1. P1P1 Y1Y1 Real GDP Demanded A movement ALONG the AD line NOT a SHIFT!

When prices decrease from P 0 to P 2, the value of wealth increases and consumption increases from C0 C0 to C2.C2. The AE line shifts up and the equilibrium value of output increases from Y0 Y0 to Y2.Y2.

Aggregate Demand Price Level Equilibrium Output AD P0P0 Y0Y0 P2P2 Y2Y2 When prices decrease from P 0 to P 2, the equilibrium value of output increases from Y 0 to Y 2. Real GDP Demanded A movement ALONG the AD line NOT a SHIFT!

When prices increase from P 0 to P 1, Output Y1Y1 correspond s to P1P1 Output Y2Y2 correspond s to P2P2 the value of wealth decreases and consumption decreases from C 0 to C 1. The AE line shifts down and the equilibrium value of output decreases from Y 0 to Y 1. When prices decrease from P 0 to P 2, the value of wealth increases and consumption increases from C 0 to C 2. The AE line shifts up and the equilibrium value of output increases from Y 0 to Y 2. Building the Aggregate Demand Curve

AE 0 = C+I+G+NX 45 AE 1 = C+I+G+NX If G,I,C, NX increase AE line Shifts up Equilibrium Income increase Y0Y0 Y1Y1 AD 0 AD 1 Price level Real GDP P0P0 Y0Y0 Y1Y1 Aggregate Expenditures Real GDP Demanded A shift of the AD line NOT a movement ALONG ! The size of the change in equilibrium Y is the size of the shift in AD

Shifts in the Aggregate Demand Line Price Level AD 0 P0P0 Y0Y0 Y1Y1 AD 1 When C, I, G or net exports increase the AE line shifts up and the equilibrium value of output increases: AD line shifts right (outward). Real GDP Demanded

AE 0 = C+I+G+NX AE 1 = C+I+G+NX If G,I,C, NX decrease AE line Shifts down Equilibrium Income decrease Y0Y0 Y1Y1 AD 0 AD 1 Price level P0P0 Y0Y0 Y1Y1 Real GDP Aggregate Expenditures Real GDP Demanded A shift of the AD line NOT a movement ALONG ! The size of the change in equilibrium Y is the size of the shift in AD

Shifts in the Aggregate Demand Line Price Level AD 0 P0P0 Y0Y0 Y1Y1 AD 1 When C, I, G or net exports decrease the AE line shifts down and the equilibrium value of output decreases AD line shifts left (inward). Real GDP Demanded

Factors that shift the consumption function 1. Changes in wealth shift the consumption function. Example: value of stocks, bonds, consumer durables. 2. Changes in consumer expectations Shift the consumption function. Example: Pessimistic expectations decrease autonomous consumption. 3. Taxes and Transfers Tax increase or decrease in transfers: decrease disposable income and shift the consumption function down. 4. Prices Affect the purchasing power of assets. Shift up in AE line Shift right in AD line Shift up in AE line Movement Along AD line

Determinants of Investment Interest Rates: Tax Incentives: Technical Change: Expectations about the strength of demand: Political Stability and the rule of law: Shift AE line Shift AD line

Government expenditures are determined by the budget process: The president, Congress and the Senate. Fiscal Policy Shift AE line Shift AD line

National Incomes GDP of other countries Relative Prices Exchange Rates Shift AE line Shift AD line

= 7,000-6,000 =1,000 A recessionary gap occurs when actual GDP falls SHORT of full employment GDP To increase AE, we need an increase in C, I, G or NX To eliminate a recessionary gap, AE must rise.

To Eliminate a Recessionary/Deflationary Gap Increase Consumption by a sufficiently large price drop or a decrease in taxes. Increase Investment using tax incentives. Increase Government Spending: Fiscal Policy Increase Exports and reduce Imports.

= 7,000-8,000 =-1,000 An inflationary gap occurs when equilibrium GDP is higher than full employment GDP To decrease AE, we need a decrease in C, I, G or NX To eliminate an inflationary gap, AE must fall.

To Eliminate an Inflationary Gap Decrease Consumption by a sufficiently large price increase or an increase in taxes. Decrease Government Spending: Fiscal Policy Decrease Exports and increase Imports.

1. Determine the effect on AE, AD, Equilibrium output a) Prices Increase (decrease): in red because changes in prices do not shift the AD line! b) NX Increase (decrease) c) Exports Increase (decrease) d) Imports Increase (decrease) e) Wealth Increase (decrease) f) Interest rates Increase (decrease) g) Technological Improvement h) Government spending Increase (decrease) i) Taxes Increase (decrease) j) Transfers Increase (decrease) Questions to prepare for test

2. Use the table in the next slide to answer the following: a) Calculate the MPC and the intercept. b) Write the consumption function: C = intercept (a) + slope (MPC)* Y c) Calculate Aggregate Expenditures (add a Col. to the table for AE). d) Find the equilibrium value of output. e) If output is 4000 calculate the change in inventories. Given your answer for the change in inventories, how would firms react to this change in inventories? f) If investment increase from 500 to 800 (a 300 increase in investment). Recalculate the entire table and find the new equilibrium value of output. g) If autonomous consumption (the intercept) increases by 300 what is the new equilibrium value of output?

OutputConsumptionInvestmentNet Exports

3. If the economy is at equilibrium, is total spending greater, less than or equal to Output? Do Inventories fall, rise or remain unchanged? Does the economy experience a recessionary gap or an inflationary gap? If an inflationary (recessionary) gap exists, how can the gap be closed?

4. If the economy is at equilibrium, is total spending greater, less than or equal to Output? Do Inventories fall, rise or remain unchanged? Does the economy experience a recessionary gap or an inflationary gap? If an inflationary (recessionary) gap exists, how can the gap be closed?

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

Questions to prepare continued Label the two lines in the next slide. Use the information in the graph to find the following:  Find the slope of the AE line. Recall the slope of the AE line is the MPC.  Find the intercept of the AE line.  Write down the equation of the AE line.  Find the value of AE when income is 40,000  What is the equilibrium value of income/output in this case?  Find the value of AE when income is 50,000 and when income is 25,000.  Fill in the values for each box in the graph. Repeat the exercise with the graph in slide #73.

40,000 50,000 25,000 49,000 26,500