Chapter 9 Demand Side Equilibrium

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

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

Aggregate Expenditures Real Income = Real GDP = Y I = 1000 AE = C+I+G+NX AE G = 500 NX= 300 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 C = 4600 C = 22,600 I = 1000 G = 500 NX= 300 Y = 25, I+G+NX I+G+NX AE = Y

AE = 1, Y 5,00010,00019,00025,000 6,400 10,900 19,000 24,400 C = Y

AE = 1, Y 5,00010,00019,00025,000 6,400 10,900 19,000 24,400 Sold Produced Produced 10,000 Sold10,900 Inventories fall Firms increase Production Produced 10,000 Sold10,900 Inventories fall Firms increase Production Produced 5,000 Sold 6,400 Inventories fall Firms increase Production Produced 5,000 Sold 6,400 Inventories fall Firms increase Production Produced 19,000 Sold19,000 Inventories do not change Firms do not change Production Produced 19,000 Sold19,000 Inventories do not change Firms do not change Production Produced 25,000 Sold 24,400 Inventories rise Firms decrease Production Produced 25,000 Sold 24,400 Inventories rise Firms decrease Production AE Y Y

5,00010,000 19,000 25,000 6,400 10,900 19,000 24,400 Produced 19,000 Sold19,000 Inventories do not change Firms do not change Production: Equilibrium: Y = 19,000 Produced 19,000 Sold19,000 Inventories do not change Firms do not change Production: Equilibrium: Y = 19,000 AE Y Y

AE = 10,900AE = 6,400AE = 19,000AE = 24,400 AE

Y = 5,000Y = 10,000Y = 19,000 If total production Y = 5,000 and Aggregate Expenditures AE = 6,400 Change in Inventories = 5, ,400 = - 1,400 (decrease) If total production Y = 10,000 and Aggregate Expenditures AE =10,900 Change in Inventories = 10,000 – 10,900 = (decrease) If total production Y = 19,000 and Aggregate Expenditures AE = 19,000 Change in Inventories = 19,000 – 19,900 = 0 (no change) and Aggregate Expenditures AE = 24,400 If total production Y = 25,000 Change in Inventories = 25,000 – 24,400 = 600 (increase) Y = 25,000 Firms will increase production Firms will not change production Firms will decrease production AE 5,000 6,400 10,900 19,000 25,000 24,400 10,000

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 45 0

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

6,000 is the equilibrium output

Real Income = Real GDP = Y I = 1000 AE = C+I+G+NX AE G = 500 NX = 300 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 = 10,900 AE = 19,000 C = 4600 AE = 6,400 C = 22,600 I = 1000 G = 500 NX= 300 Y = 25,000 AE = 24,400 When C, I, G or NX decrease The AE line shifts down When C, I, G or NX increase The AE line shifts up

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

AE Y = 5,000Y = 25,000 Equilibrium Y = 19,000 Y = 10,000 Equilibrium If AE line shifts down Inventories increase Firms decrease output Equilibrium output decreases

AE Equilibrium Y = 19,000 Y = 25,000 Inventories Decrease Equilibrium output increases Firms Increase Output If AE line shifts up

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 Open Economy with Government S+T = I + G + X-M S+T+M = I + G + X S+T = I + G + X-M S+T+M = I + G + X Savings must finance Investment, the government’s deficit and the trade deficit.

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

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)

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

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

AE Equilibrium GDP Equilibrium Equilibrium GDP: where the economy is stuck AE 45 0 Potential GDP Potential GDP: where we want to be: zero cyclical unemployment, no excess capacity

= 7,000-6,000 =1,000 Or Distance EB Recessionary gap: 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. Recessionary Gap

How does the Government Close a Recessionary Gap? Inducing an Increase in AE

How does the Government Induce an Increase in AE? Inducing an Increase in C, I, G or NX

28 C = a + bY d National Income, Taxes and Transfers, Wealth, CPI, Expectations I = I planned Interest rates, Tax incentives, Technical change, Expectations, Political Stability G = G Government Spending NX = NX Relative Prices U.S/Abroad, Incomes U.S/Abroad, Exchange Rates Taxes Transfers Government Spending Tax Incentives

29 C = a + bY d National Income, Taxes and Transfers, Wealth, CPI, Expectations I = I planned Interest rates, Tax incentives, Technical change, Expectations, Political Stability G = G Government Spending NX = NX Relative Prices U.S/Abroad, Incomes U.S/Abroad, Exchange Rates Exchange Rates Weaker Dollar Interest Rates

To Eliminate a Recessionary/Deflationary Gap To increase Consumption: Decrease taxes or increase transfers. To increase Investment Give more tax incentives. Lower interest rates Increase Government Spending To increase Exports and decrease Imports: Make dollar weaker (increasing supply of dollars)

= 7,000-8,000 =-1,000 Inflationary gap 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: increase taxes or decrease in transfers. Decrease Government Spending Increase interest rates Decrease exports and increase imports: stronger dollar.

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

1. GDP = ? 2. Is total spending >, <, = to Output? 3. Do Inventories fall, rise or remain unchanged? 4. Does the economy experience a recessionary/inflationary gap? 5. What is the size of the gap? 6. How can the gap be closed? Assume the Economy is at Equilibrium

1. GDP = ? 2. Is total spending >, <, = to Output? 3. Do Inventories fall, rise or remain unchanged? 4. Does the economy experience a recessionary/inflationary gap? 5. What is the size of the gap? 6. How can the gap be closed? Assume the Economy is at Equilibrium

At Y = Is the economy at equilibrium ? 2. Total Spending( > = < )Output 3. Inventories (rise, fall, remain the same) 4. Firms will (increase, decrease, not change)output. 5. Once the Economy reaches equilibrium, will the economy experience a (recessionary, inflationary) gap? At Y = 4,000At Y = 5000 Potential GDP C+I+G+N X 1. Is the economy at equilibrium ? 2. Total Spending( > = < )Output 3. Inventories (rise, fall, remain the same) 4. Firms will (increase, decrease, not change)output. 5. Does the economy experience a (recessionary, inflationary) gap? 1. Is the economy at equilibrium ? 2. Total Spending( > = < )Output 3. Inventories (rise, fall, remain the same) 4. Firms will (increase, decrease, not change)output. 5. Once the Economy reaches equilibrium, will the economy experience a (recessionary, inflationary) gap?

Aggregate Expenditures Match Expenditures (C+I+G+NX) with the corresponding value of output/income. Real Income = Real GDP = Y Aggregate Expenditures =AE

Aggregate Expenditures Matches Aggregate Expenditures with the corresponding value of output

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

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

45 0 C 0 +I+G+NX C 1 +I+G+NX Y C When prices increase from P 0 to P 1, When prices increase from P 0 to P 1, The AE line shifts down The AE line shifts down the value of wealth decreases and consumption decreases from C 0 to C 1. the value of wealth decreases and consumption decreases from C 0 to C 1. The equilibrium value of output decrease from Y 0 to Y 1. The equilibrium value of output decrease from Y0Y0 to Y1.Y1. Y1Y1 Y0Y0

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 AD NOT a SHIFT!

45 0 C 0 +I+G+NX C 2 +I+G+NX Y C When prices decrease from P 0 to P 2 When prices decrease from P 0 to P 2 The AE line shifts up The AE line shifts up The value of wealth increase and consumption increase from C 0 to C 2. The value of wealth increase and consumption increase from C 0 to C 2. The equilibrium value of output increase from Y 0 to Y 2. The equilibrium value of output increase from Y0 Y0 to Y2.Y2. Y2Y2 Y0Y0

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 AD NOT a SHIFT!

When prices increase from P 0 to P 1, Output Y 1 correspond s to P 1 Output Y1Y1 correspond s to P1P1 Output Y 2 correspond s to P 2 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 Equilibrium Output drops 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 Equilibrium output increases from Y 0 to Y 2. Building the Aggregate Demand Curve Inverse Relationship between Aggregate Output Demanded and Price Level

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 NX increase the AE shifts up and the equilibrium value of output increases: AD shifts right (outward). Real GDP Demanded

When Prices Drop… 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!

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 NX decrease AE shifts down, equilibrium output decrease, AD shifts left (inward). When C, I, G or NX decrease AE shifts down, equilibrium output decrease, AD shifts left (inward). Real GDP Demanded

When Prices Increase… 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!

Factors that shift the consumption function  Changes in wealth Example: value of stocks, bonds, consumer durables.  Changes in consumer expectations Example: Pessimistic expectations decrease autonomous consumption.  Taxes and Transfers Tax increase or decrease in transfers: decrease disposable income and shift the consumption function down.  Prices Affect the purchasing power of assets. Shift up in AE line Shift right in AD line Or Shift down in AE line Shift left in AD line Shift up in AE line Shift right in AD line Or Shift down in AE line Shift left in AD line Shift AE Move Along AD Shift AE Move Along AD

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

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

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

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

AE component affected Shift? Movement Along? AE Shifts Equilibrium Y AD Prices Increase C drops due to wealth effect: consumers feel poorC shifts downdowndecreases Movement up along Prices Decrease C increases due to wealth effect: consumers feel richC shifts upupincreases Movement down along NX IncreaseNX increaseNX shifts upupincreases shifts right NX DecreaseNX decreaseNX shifts downdowndecreases shifts left Exports IncreaseNX increaseNX shifts upupincreases shifts right Exports DecreaseNX decreaseNX shifts downdowndecreases shifts left Imports increaseNX decreaseNX shifts downdowndecreases shifts left Imports DecreaseNX increaseNX shifts upupincreases shifts right Wealth Increase C increases due to wealth effectC shifts upupincreases shifts right Wealth Decrease C drops due to wealth effectC shifts downdowndecreases shifts left

AE component affected Shift? Movement Along? AE Shifts Equilibrium YAD Interest rates increaseInvestment dropsI shifts downdowndecrease shifts left Interest rates DecreaseInvestment IncreasesI shifts upupincrease shifts right Technological ImprovementInvestment increasesI shifts upupincrease shifts right Government Spending IncreaseG increasesG shifts upupincrease shifts right Government Spending DecreaseG dropsG shifts downdowndecrease shifts left Taxes Increase C dropsC shifts downdowndecrease shifts left Taxes Decrease C increasesC shifts upupincrease shifts right Transfers Increase C increasesC shifts upupincrease shifts right Transfers Decrease C dropsC shifts downdowndecrease shifts left

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 the next slide.

40,000 50,00025,000 49,000 26,500

40,00050,00025,000 49,000 26,500 Slope  AE /  Y = 22,500/25,000 = 0.9 AE

40,00050,00025,000 49,000 26,500 4,000 Slope  AE /  Y = 22,500/25,000 = AE =4, Y AE =intercept+0.9Y  =Intercept +0.9*25,000  -0.9*25,000 =Intercept  -0.9*25,000 =4,000

40,000 50,00025,000 49,000 26, degree line 4,000 25,000 AE 40,000 50,000 Output/Income (Y) AE

 Find the slope of the AE line. Recall the slope of the AE line is the MPC = 0.9  Find the intercept of the AE line = 4,000  Write down the equation of the AE line= 4, Y  Find the value of AE when income is 40,000: AE = 4, *40,000 = 40,000  What is the equilibrium value of income/output in this case? Y = 40,000  Find the value of AE when income is 50,000: AE = 4, *50,000 = 49,000  and when income is 25,000: AE = 4, *25,000 = 26,500

35,00050,00020,000 48,500 21,500

35,000 50,00020,000 48,500 21, degree line 3,500 20,000 AE 35,000 50,000 Output/Income (Y) AE

AE AE 2 Y0Y0 Y1Y1

68 YCIGNX

69 YC = YIGNXAES= *Y

OutputConsumptionInvestmentNet Exports Write the AE equation: Write the AE equation: Y

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

73 OutputC = 0.8YInvestment Net Exports AE Change in Inventories Firms willS= 0.2*Y Increase Y Increase Y Increase Y Increase Y No change Decrease Y Decrease Y 800 Equilibrium

74 OutputC = YInvestment Net Exports AE Change in Inventories Firms will Increase Y Increase Y Increase Y Increase Y Increase Y Increase Y Increase Y No change Decrease Y Decrease Y New equilibrium

OutputC = 0.8YInvestment Net Exports AE Change in Inventories Firms will Increase Y Increase Y Increase Y Increase Y Increase Y Increase Y Increase Y No change Decrease Y Decrease Y New equilibrium

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 Households Firms S I C Total Income Total Production Total Spending leakages = Injections Closed Economy without Government In a closed economy without government the equilibrium condition is that Savings must be equal to Investment

C+I 45 S I Y Equilibrium AE I=S Leakages = Injections Y above equilibrium Inventories increase Inventories fall Y below equilibrium

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 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 Firms S I C Total Income Total Production Total Spending NX Households Open Economy without Government

C+I+NX 45 S+M I+X Y Equilibrium AE I+X=S+M Leakages = Injections Y above equilibrium Inventories increase Inventories fall Y below equilibrium

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?

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

37,00045,00030,000 Label