1. 9 9 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

2. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Define Equilibrium and graph it using a Expenditure Schedule. Goal #1

3. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●.●.●.●.●.●. ●.●.●.●.●.●. The Meaning of Equilibrium GDP

4. TABLE 2: The Determination of Equilibrium Output Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

5. FIGURE 2: Construction of the Expenditure Schedule Copyright © 2006 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

6. Copyright© 2006 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

7. FIGURE 3: Income-Expenditure Diagram Copyright © 2006 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

8. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●.♦.♦.●.♦.♦. ●.♦.♦.●.♦.♦. The Aggregate Demand Curve

9. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●.♦.♦.●.♦.♦. ●.♦.♦.●.♦.♦. The Aggregate Demand Curve

10. FIGURE 5: The Effect of the Price Level on Equilibrium AD Copyright © 2006 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

11. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Aggregate Demand Curve ●.●.●.●. ●.●.●.●.

12. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Identify Recessionary and Inflationary Gap and graph them using a Expenditure Schedule. Goal #2

13. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●.●.●.●.●.●. ●.●.●.●.●.●. Demand-Side Equilibrium and Full Employment

14. FIGURE 7: A Recessionary Gap Copyright © 2006 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

15. FIGURE 8: An Inflationary Gap Copyright © 2006 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

16. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Coordination of Saving and Investment ●.●.●.●. ●.●.●.●.

17. FIGURE 9: A Simplified Circular Flow Copyright © 2006 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

18. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Changes on the Demand Side: Multiplier Analysis ●Multiplier =.

19. FIGURE 10: Illustration of the Multiplier Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Real Expenditure 45  $200 billion 6,800 0 6,000 Real GDP C + I1I1 + G + (X –IM) C + I0I0 + G + (X –IM) E 1 E 0

20. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Changes on the Demand Side: Multiplier Analysis ●Demystifying the Multiplier: How It Works ♦. ♦  spending   income ♦. ●Demystifying the Multiplier: How It Works ♦. ♦  spending   income ♦.

21. TABLE 4: The Multiplier Spending Chain Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

22. Copyright© 2006 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.

23. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Algebraic Statement of the Multiplier ♦Factors that reduce the size of the multiplier ■. ■\ ●Algebraic Statement of the Multiplier ♦Factors that reduce the size of the multiplier ■. ■\ Changes on the Demand Side: Multiplier Analysis

24. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Multiplier Is a General Concept ●.●. ●.●.

25. TABLE 5: Consumers Spend $200 Billion More Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

26. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Other multiplier effects: ♦. ●Other multiplier effects: ♦. The Multiplier Is a General Concept

27. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●.●.●.●.●.●. ●.●.●.●.●.●. The Multiplier Is a General Concept

28. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Multiplier and the Aggregate Demand Curve ●.●. ●.●.

29. FIGURE 12: Two Views of the Multiplier Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 45  C+ I 1 + G+ (X– IM) $200 billion C+ I 0 + G+ (X– IM) 0 6,000 100 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

30. Appendix A: The Simple Algebra of Income Determination and the Multiplier

31. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Simple Algebra of Income Determination & Multiplier ●All of the relationships discussed can be represented in simple algebra.

32. Copyright© 2006 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

33. Copyright© 2006 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)

34. Copyright© 2006 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)

35. Appendix B: The Multiplier With Variable Imports

36. Copyright© 2006 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.

37. TABLE 6: Equilibrium Income with Variable Imports Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

38. FIGURE 13: The Dependence of Net Exports on GDP Copyright © 2006 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 200 100 0 –100 –200 –300 7,2006,8006,4006,000 5,600 5,200 4,800 950 850 750 650 550 450 7,2006,8006,4006,0005,6005,20004,800

39. FIGURE 14: Equilibrium GDP with Variable Imports Copyright © 2006 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

40. FIGURE 15: The Multiplier with Variable Imports Copyright © 2006 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

41. TABLE 7: Equilibrium Income after a $160 Billion Increase Copyright © 2006 South-Western/Thomson Learning. All rights reserved.