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Chapter 9 - Demand-Side Equilibrium - unemployment or inflation

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Chapter 9 - Demand-Side Equilibrium - unemployment or inflation Powered By Docstoc
					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
               Outline

• Suppose AS is given, how does AD
  affect the equilibrium?
 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
Figure 1
The circular flow diagram




                            4
 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
 The Meaning Of Equilibrium GDP
• If Total spending < Output
  – No equilibrium GDP
  – Firms
    • Inventory increase
    • Decrease production
    • Cut prices
       – Stimulate demand




                                  6
 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
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
Table 1
The total expenditure schedule

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




                                                                             9
Figure 2
Construction of the expenditure schedule

                                                                       C+I+G
                                                                       C+I+G+(X-IM)

                                    X-IM=-$100
                     6,100
                     6,000
  Real Expenditure




                                                                       C+I
                                                 G=$1,300


                     4,800                                             C
                                                 I=$900

                     3,900


                             0   5,200 5,600 6,000 6,400 6,800 7,200
                                                                                      10
                                             Real GDP
Mechanics of Income Determination
• Expenditure schedule
  – Relationship
    • National income (GDP)
    • Total spending
• Condition for equilibrium GDP (Y)
     Y = C + I + G + (X-IM)




                                      11
Table 2
The determination of equilibrium output

 (1)          (2)                   (3)                (4)             (5)

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




                                                                             12
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
Figure 3
Income-expenditure diagram
                                                                            45°
                                                  Output exceeds
                    7,200
                                                    spending                C+I+G+(X-IM)
                    6,800
 Real Expenditure




                    6,400
                                                   E
                    6,000

                    5,600                              Equilibrium

                    5,200
                                          Spending exceeds output
                    4,800


                            0   4,800 5,200 5,600 6,000 6,400 6,800 7,200
                                                                                           14
                                                 Real GDP
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
     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
     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
Figure 4
Shift of the consumption function
                               Movements along
                                                       C1
                             consumption function
    Real Consumer Spending


                                                            C0

                                                                 C2


                                           A



                                                       Shifts of consumption
                                                              function




                              Real Disposable Income
                                                                               18
     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
Figure 5
Effect of the price level on equilibrium aggregate
  quantity demanded
                                               45°                                                       45°




                                                         Real Expenditure
Real Expenditure




                                                                                               E2
                                   E0
                                                                                                     C2+I+G+(X-IM)
                                         C0+I+G+(X-IM)

                         E1                                                         E0
                                        C1+I+G+(X-IM)                                        C0+I+G+(X-IM)



                   45°                                                      45°
                          Y1       Y0                                              Y0           Y2
                          Real GDP                                                 Real GDP

                     (a) Rise in price level                                  (b) Fall in price level
                                                                                                               20
Figure 6
The aggregate demand curve



                           E1
                     P1
       Price Level




                                E0
                     P0
                                      E2
                     P2



                          Y1 Y0      Y2
                          Real GDP


                                           21
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
Figure 7
A recessionary gap
                                           Potential          45°
                                             GDP

                                           F             C+I+G+(X-IM)
   Real Expenditure




                                 E
                                                 B

                                                       Recessionary gap




                          45°
                      0         6,000       7,000
                                                                          23
                                Real GDP
Demand-Side Equilibrium&Full Employment
 • Equilibrium GDP < potential GDP
   – Unemployment & Recession
   – Recessionary gap - amount
     • Equilibrium level of real GDP
     • Falls short of potential GDP
   – To reach full employment
     • Increase total expenditure line




                                         24
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
Figure 8
An inflationary gap
                                                   Potential              45°
                                                     GDP
                                Inflationary gap
                                                                E
                                                    B                  C+I+G+(X-IM)
   Real Expenditure




                                                    F




                          45°
                      0                              7,000     8,000
                                                                                      26
                                                   Real GDP
Demand-Side Equilibrium&Full Employment
 • Equilibrium GDP > potential GDP
   – Inflation
   – Inflationary gap
     • Equilibrium real GDP
     • Exceeds full-employment level of GDP
   – To reach full employment
     • Decrease total expenditure line




                                              27
Demand-Side Equilibrium&Full Employment
 • Full employment
   – Occurs:
     • Spending plans – just right
     • Price level – just right
   – No recessionary gap
   – No inflationary gap




                                     28
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
Figure 9
A simplified circular flow




                             30
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
  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
  – GDP – rises by more than
     • Change in spending
• Multiplier > 1
                                            32
Table 3
Total expenditure after a $200 billion increase in
  investment spending

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



• Multiplier = ∆Y/ ∆I = 800/200 = 4
                                                                            33
Figure 10
Illustration of the multiplier
                                                          45°


                                                          C+I1+G+(X-IM)
                                                   E1
    Real Expenditure




                                                          C+I0+G+(X-IM)

                           $200 billion

                                             E0




                       0                  6,000   6,800
                                                                          34
                                            Real GDP
           Multiplier Analysis
• Multiplier =
  = 1 + MPC + (MPC)^2 + (MPC)^3 +…
• Oversimplified multiplier formula
                         1
        Multiplier 
                     1  MPC

• Actual multiplier
  – Much lower


                                      35
Table 4
The multiplier spending chain
         (1)           (2)          (3)
       Round       Spending in   Cumulative
      Number       This Round      Total
           1       $1,000,000    $1,000,000
           2        750,000      1,750,000
           3        562,500      2,312,500
           4        421,875      2,734,375
           5        316,406      3,050,781
           6        237,305      3,288,086
           7        177,979      3,466,065
           8        133,484      3,599,549
           9        100,113      3,600,622
          10         75,085      3,774,747
          ...          …             ..
          20         4,228       3,987,317
          ...          …             …
      “Infinity”        0        4,000,000
                                              36
Figure 11
How the multiplier builds




                            37
   Multiplier is a General Concept
• Induced increase in consumption spending
  – From: increase in consumer incomes
  – Movement along consumption function
• Autonomous increase in consumption
  – Independently of consumer incomes
  – Shift of consumption function
• Only autonomous increase brings
  multiplier effect
• Change in C, I, G, or (X-IM)
  – Same multiplier effect                38
Table 5
Total expenditure after consumers decide to spend
  $200 billion more (Autonomous increase)

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




                                                                            39
   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
  Multiplier is a General Concept

• Booms and recessions tend to be
  transmitted across national borders
Multiplier & Aggregate Demand Curve
• Income-expenditure diagrams
  – Given price level
• Different price levels
  – Different total expenditure curves
• Increase in spending
  – Given price level
  – Multiplier effect
  – Horizontal shift of aggregate demand

                                           42
Multiplier & Aggregate Demand Curve

• An autonomous increase in spending
  leads to a horizontal shift of the AD
  curve by an amount given by the
  oversimplified multiplier formula.
Figure 12
Two view of the multiplier
                                                                 45°            C+I1+G+(X-IM)
                                                       E1                       C+I0+G+(X-IM)
                                       $200 billion
                Real Expenditure




                                               E0


                                   0        6,000     6,800                Real GDP
                                                D1
                                       D0
  Price Level




                                                E0          E1
                            100
                                                                       D1 (I=$1,100)
                                                                       D0 (I=$900)
                                                                                                44
                                   0        6,000     6,800                Real GDP
               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)
APPENDIX A
Algebra of income determination & multiplier
Y  C  I  G  ( X  IM )
                              a  bT  I  G  (X  IM)
DI  Y  T                 Y
                                         1 b
C  a  bDI               

• b = MPC
                1
 Change in Y 
               1- b


                                                      46
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
Table 6
Equilibrium income with variable imports

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




                                                                                                48
Figure 13
The dependence of net exports on GDP
Real Exports & Imports


                                                                                      IM
                         950
                         850
                                    Positive net exports                   Negative net exports
                         750
                         650                                                         X
                         550
                         450


                                0         4,800 5,200 5,600 6,000 6,400 6,800 7,200          Real GDP
 Real Net Exports




                          200
                          100
                            0
                         -100             4,800 5,200 5,600         6,400 6,800 7,200
                         -200                                 6,000           Negative net exports
                         -300       Positive net exports
                                                                                      X-IM
                                                   Real GDP
                                                                                                        49
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
Figure 14
Equilibrium GDP with variable imports
                                         45°
                                                 C+I+G+(X-IM)
   Real Expenditure


                                                 (fixed imports)

                                                 C+I+G+(X-IM)
                                 E
                                                 (variable imports)




                      0          6,000                  Real GDP
                                          X-IM
          Positive net exports
                                                 Negative net exports

                                                                        51
Table 7
Equilibrium income after a $160 billion increase in
  exports
  (1)          (2)           (3)            (4)          (5)       (6)       (7)          (8)
  Gross
Domestic    Consumer                                                         Net          Total
 Product   Expenditures   Investment   Government      Exports   Imports   Exports    Expenditure
   (Y)         (C)            (I)      Purchases (G)     (X)       (IM)     (X-IM)   [C+I+G+(X-IM)]
 4,800        3,000          900          1,300         810       570      +240          5,440
 5,200        3,300          900          1,300         810       630      +180          5,680
 5,600        3,600          900          1,300         810       690      +120          5,920
 6,000        3,900          900          1,300         810       750       +60          6,160
 6,400        4,200          900          1,300         810       810        0           6,400
 6,800        4,500          900          1,300         810       870       -60          6,640
 7,200        4,800          900          1,300         810       930      -120          6,800




                                                                                                52
Figure 15
The multiplier with variable Exports
                                                             45°

                                                                   C+I+G+(X1-IM)
                                               A
  Real Expenditure




                         Rise in exports                           C+I+G+(X0-IM)
                         = $160


                                           E

                                                   Rise in GDP = $400


                     0              6,000      6,400         Real GDP



                                                                                   53

				
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