1. Chapter 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

2. Outline AD equilibriumSuppose AS is given, how does AD affect the equilibrium?

3. The Meaning Of Equilibrium GDP Assumptions –Constant Government expenditure G Price level Rate of interest → I constant International value of the dollar → X-IM constant Total production (Y) = Total income (NI) Total expenditure (AD) = C + I + G + (X- IM) 3

4. The circular flow diagram Figure 1 4

5. The Meaning Of Equilibrium GDP Equilibrium –Consumers & firms No incentive to change behavior Content - continue with things as they are If Total spending > Output –No equilibrium GDP –Firms - Depleting inventory stocks Increase production –Meet higher demand Raise prices 5

6. The Meaning Of Equilibrium GDP If Total spending < Output –No equilibrium GDP –Firms Inventory increase Decrease production Cut prices –Stimulate demand 6

7. The Meaning Of Equilibrium GDP If Total Spending = Output –Equilibrium level of GDP - demand side –Firms Inventories - desired levels No incentive to change –Output –Prices 7

8. Mechanics of Income Determination Assumption –I, G, and X-IM are fixed Total expenditure = C + I + G +(X-IM) Induced investment –Part of investment spending Rises - GDP rises Falls - GDP falls 8

9. The total expenditure schedule Table 1 9 (1)(2)(3)(4)(5)(6) GDP (Y) Consumption (C) Investment (I) Government Purchases (G) Net Exports (X-IM) Total Expenditure 4,800 5,200 5,600 6,000 6,400 6,800 7,200 3,000 3,300 3,600 3,900 4,200 4,500 4,800 900 1,300 -100 5,100 5,400 5,700 6,000 6,300 6,600 6,900

10. Construction of the expenditure schedule Figure 2 10 Real Expenditure 5,2005,6006,00006,4006,800 Real GDP 7,200 3,900 4,800 C 6,000 6,100 C+I C+I+G C+I+G+(X-IM) I=$900 G=$1,300 X-IM=-$100

11. Mechanics of Income Determination Expenditure schedule –Relationship National income (GDP) Total spending Condition for equilibrium GDP (Y) Y = C + I + G + (X-IM) 11

12. The determination of equilibrium output Table 2 12 (1)(2)(3)(4)(5) Output (Y) Total Spending [C+I+G+(X-IM)] Balance of Spending & Output Inventory Status Producer Response 4,800 5,200 5,600 6,000 6,400 6,800 7,200 5,100 5,400 5,700 6,000 6,300 6,600 6,900 Spending exceeds output Spending = output Output exceeds spending Falling Constant Rising Produce more No change Produce less

13. Mechanics of Income Determination Income-expenditure diagram –45° line diagram –Plots Total real expenditure - vertical axis Real income - horizontal axis –Specific price level 45° line –Marks off points: Income = expenditure 13

14. Income-expenditure diagram Figure 3 14 4,8005,200 5,600 0 6,0006,400 Real GDP 6,800 7,200 4,800 5,200 5,600 6,000 6,400 Real Expenditure 6,800 7,200 45° C+I+G+(X-IM) E Equilibrium Spending exceeds output Output exceeds spending

15. Mechanics of Income Determination If Expenditure line – above 45° line –Total spending > Total output –Production – below equilibrium Inventories – fall Firms - increase production If Expenditure line- below 45° line –Total spending < Total output –Production – above equilibrium Inventories – rise Firms - cut back production 15

16. Aggregate Demand Curve Higher prices –Decrease demand for goods & services –Erode purchasing power Of consumer wealth –Lower real wealth –Less spending Any given level of real income –Lower consumption function Shift downward 16

17. Aggregate Demand Curve Lower prices –Increase demand for goods & services –Enhance purchasing power Of consumer wealth –Higher real wealth –More spending Any given level of real income –Higher consumption function Shift upward 17

18. Shift of the consumption function Figure 4 18 C0C0 Real Consumer Spending Real Disposable Income A C2C2 C1C1 Movements along consumption function Shifts of consumption function

19. Aggregate Demand Curve Higher prices Lower consumption function –Total expenditure – shift downward –Equilibrium quantity of real GDP demanded Decreases Lower prices Higher consumption function –Total expenditure – shift upward –Equilibrium quantity of real GDP demanded Increases 19

20. Effect of the price level on equilibrium aggregate quantity demanded Figure 5 20 Real GDP Real Expenditure 45° Y0Y0 C 0 +I+G+(X-IM) E0E0 C 1 +I+G+(X-IM) Y1Y1 E1E1 (a) Rise in price level Real GDP Real Expenditure 45° Y0Y0 C 0 +I+G+(X-IM) E0E0 C 2 +I+G+(X-IM) Y2Y2 E2E2 (b) Fall in price level

21. The aggregate demand curve Figure 6 21 Real GDP Price Level Y1Y1 Y0Y0 Y2Y2 P2P2 P0P0 P1P1 E0E0 E2E2 E1E1

22. Demand-Side Equilibrium&Full Employment Potential GDP –Full-employment level of output Equilibrium GDP < potential GDP –Occurs: Low spending (consumers C↓, investors I↓) Low government spending (G↓) Weak foreign demand (X↓) Price level - too high (X↓, IM↑) 22

23. A recessionary gap Figure 7 23 0 Real GDP Real Expenditure 45° C+I+G+(X-IM) 6,000 7,000 Potential GDP F B E Recessionary gap 45°

24. Demand-Side Equilibrium&Full Employment Equilibrium GDP < potential GDP –Unemployment & Recession –Recessionary –Recessionary gap - amount Equilibrium level of real GDP Falls short of potential GDP –To reach full employment Increase Increase total expenditure line 24

25. Demand-Side Equilibrium&Full Employment Equilibrium GDP > potential GDP –Occurs because High spending (consumer C↑, investment I↑) Strong foreign demand (X↑) Government spends too much (G↑) Low price level (X↑, IM↓) 25

26. An inflationary gap Figure 8 26 0 Real GDP Real Expenditure 45° C+I+G+(X-IM) 8,000 7,000 Potential GDP F B E Inflationary gap 45°

27. Demand-Side Equilibrium&Full Employment Equilibrium GDP > potential GDP –Inflation –Inflationary –Inflationary gap Equilibrium real GDP Exceeds full-employment level of GDP –To reach full employment Decrease Decrease total expenditure line 27

28. Demand-Side Equilibrium&Full Employment Full employment –Occurs: Spending plans – just right Price level – just right –No recessionary gap –No inflationary gap 28

29. Coordination of Saving & Investment If S = I –Equilibrium at full employment On demand side AD=C+I=GDP=NI=C+S → S=I If S ≠ I –Full employment is not an equilibrium S<I → inflationary gap S>I → recessionary gap 29

30. A simplified circular flow Figure 9 30

31. Coordination of Saving & Investment Unemployment –Total spending - too low –Stems from coordination failure Savers are different from Investors Coordination failure –Party A – want to change behavior, if Party B – changes –No changes – no coordination 31

32. Changes on Demand Side: Multiplier Analysis Question: What’s the effect of changes in C, I, G, (X-IM) on Y? Multiplier – Ratio of Change in equilibrium GDP (Y) by original change in spending Multiplier principle more –GDP – rises by more than Change in spending Multiplier > 1 32

33. Total expenditure after a $200 billion increase in investment spending Multiplier = ∆Y/ ∆I = 800/200 = 4 Table 3 33 (1)(2)(3)(4)(5)(6) GDP (Y) Consumption (C) Investment (I) Government Purchases (G) Net Exports (X-IM) Total Expenditure 4,800 5,200 5,600 6,000 6,400 6,800 7,200 3,000 3,300 3,600 3,900 4,200 4,500 4,800 1,100 1,300 -100 5,300 5,600 5,900 6,200 6,500 6,800 7,100

34. Illustration of the multiplier Figure 10 34 0 Real GDP Real Expenditure 45° C+I 1 +G+(X-IM) 6,800 6,000 C+I 0 +G+(X-IM) E0E0 E1E1 $200 billion

35. Multiplier Analysis Multiplier = = 1 + MPC + (MPC)^2 + (MPC)^3 +… Oversimplified multiplier formula Actual multiplier –Much lower 35

36. The multiplier spending chain Table 4 36 (1)(2)(3) Round Number Spending in This Round Cumulative Total 1 2 3 4 5 6 7 8 9 10... 20... “Infinity” $1,000,000 750,000 562,500 421,875 316,406 237,305 177,979 133,484 100,113 75,085 … 4,228 … 0 $1,000,000 1,750,000 2,312,500 2,734,375 3,050,781 3,288,086 3,466,065 3,599,549 3,600,622 3,774,747.. 3,987,317 … 4,000,000

37. How the multiplier builds Figure 11 37

38. Multiplier is a General Concept InducedInduced increase in consumption spending –From: increase in consumer incomes along –Movement along consumption function AutonomousAutonomous increase in consumption –Independently of consumer incomes –Shift –Shift of consumption function Only autonomous increase brings multiplier effect Change in C, I, G, or (X-IM) –Same –Same multiplier effect 38

39. Total expenditure after consumers decide to spend $200 billion more (Autonomous increase) Table 5 39 (1)(2)(3)(4)(5)(6) GDP (Y) Consumption (C) Investment (I) Government Purchases (G) Net Exports (X-IM) Total Expenditure 4,800 5,200 5,600 6,000 6,400 6,800 7,200 3,200 3,500 3,800 4,100 4,400 4,700 5,000 900 1,300 -100 5,300 5,600 5,900 6,200 6,500 6,800 7,100

40. Multiplier is a General Concept GDPs of major economies –Linked by trade Boom in one country –Raise its imports –Other countries More exports Increase GDP Recession in one country –Other countries Decrease GDP 40

41. Multiplier is a General Concept transmittedBooms and recessions tend to be transmitted across national borders

42. Multiplier & Aggregate Demand Curve Income-expenditure diagrams –Given –Given price level Different price levels –Different total expenditure curves Increase in spending –Given price level –Multiplier effect –Horizontal shift of aggregate demand 42

43. Multiplier & Aggregate Demand Curve horizontal shiftAn autonomous increase in spending leads to a horizontal shift of the AD curve by an amount given by the oversimplified multiplier formula.

44. Two view of the multiplier Figure 12 44 0 Real GDP Real Expenditure 45° C+I 1 +G+(X-IM) 6,800 6,000 C+I 0 +G+(X-IM) E0E0 E1E1 $200 billion 0 Real GDP Price Level 6,800 6,000 D0D0 D 0 (I=$900) D1D1 D 1 (I=$1,100) E1E1 100 E0E0

45. Summary Demand side equilibrium Y = AD = C + I +G +(X-IM) Income-expenditure diagram Derivation of AD curve Inflationary gap vs. Recessionary gap Multiplier is same for an autonomous increase in C, I, G, and (X-IM) Multiplier = 1/(1-MPC)

46. APPENDIX A Algebra of income determination & multiplier b = MPC 46

47. APPENDIX B Multiplier with variable imports Our GDP – increase –Our imports – increase Our exports –Relatively insensitive to own GDP –Sensitive – other countries GDP International trade –Lowers – value of multiplier 47

48. Equilibrium income with variable imports Table 6 48 (1)(2)(3)(4)(5)(6)(7)(8) Gross Domestic Product (Y) Consumer Expenditures (C) Investment (I) Government Purchases (G) Exports (X) Imports (IM) Net Exports (X-IM) Total Expenditure [C+I+G+(X-IM)] 4,800 5,200 5,600 6,000 6,400 6,800 7,200 3,000 3,300 3,600 3,900 4,200 4,500 4,800 900 1,300 650 570 630 690 750 810 870 930 +80 +20 -40 -100 -160 -220 -280 5,280 5,520 5,760 6,000 6,240 6,480 6,720

49. The dependence of net exports on GDP Figure 13 49 4,8005,200 5,600 0 6,0006,400 Real GDP 6,800 7,200 450 550 650 750 850 Real Exports & Imports 950 IM X Negative net exports Positive net exports 4,8005,200 5,600 6,000 6,400 Real GDP 6,800 7,200 -300 -200 -100 0 100 Real Net Exports 200 X-IM Negative net exports Positive net exports

50. APPENDIX B Multiplier with variable imports Our GDP – increase –Net exports – decline International trade –Lowers – value of multiplier Any autonomous increase in spending –Partly dissipated Purchases of foreign goods –Additional income – foreigners 50

51. Equilibrium GDP with variable imports Figure 14 51 0 Real GDP Real Expenditure 45° C+I+G+(X-IM) (variable imports) 6,000 C+I+G+(X-IM) (fixed imports) E X-IM Positive net exports Negative net exports

52. Equilibrium income after a $160 billion increase in exports Table 7 52 (1)(2)(3)(4)(5)(6)(7)(8) Gross Domestic Product (Y) Consumer Expenditures (C) Investment (I) Government Purchases (G) Exports (X) Imports (IM) Net Exports (X-IM) Total Expenditure [C+I+G+(X-IM)] 4,800 5,200 5,600 6,000 6,400 6,800 7,200 3,000 3,300 3,600 3,900 4,200 4,500 4,800 900 1,300 810 570 630 690 750 810 870 930 +240 +180 +120 +60 0 -60 -120 5,440 5,680 5,920 6,160 6,400 6,640 6,800

53. The multiplier with variable Exports Figure 15 53 0 Real GDP Real Expenditure 45° 6,000 C+I+G+(X 0 -IM) E C+I+G+(X 1 -IM) 6,400 Rise in exports = $160 Rise in GDP = $400 A