Chapter 9
Demand Side Equilibrium
Circular Flow Diagram
G
Interest
Rent
Profits
Wages
Rest of
World
T
G
Households
S
C
I
NX
Firms
Total
Goods
and
Producti
Services
on
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…
Firms Control:
 Residential Construction


consumer purchases of new houses and
condominiums.
Non-residential construction

Equipment, software, buildings, tools, etc.
Firms DO NOT Control:
 Changes in Inventories: unsold goods are
included as investment.
Planned Inventories
Planned Investment
Unplanned Inventories
Unplanned Investment
Inventories do not change…
Planned
Inventories
20
Production
100
=
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”
Planned
Inventories
20
Production
100
Planned
Inventories
Actual
20
Inventories
=60
Unplanned
Inventories 40
Total
Production =
100
Actual Sales
60
Firms react by reducing production


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”
Wanted
Inventories
20
Production
100
Actual
Inventories
Inventories
Actual Sales
110
10
10
Total
Production =
100
Firms react by increasing production


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
Firms adjust
production to the
level of sales
In the short run, Aggregate
Expenditures determine output.
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
Planned
Inventories
20
Actual Sales
100
Government
Spending
Consumption
Net Exports
Total
Production
Building Aggregate Expenditures
AE = C + I + G + NX
Purchases of buildings and
equipment
Planned
PLUS
Investment
planned
C = 100 + 0.9Y
inventories
I = 1,000
I + G + NX = 1,800
G = 500
NX = 300
Y = 5,000
Y = 10,000
Real Income = Real GDP = Y
Y = 19,000
AE = 24,400
G=
500
G=
500
I = 1000
AE = 19,000 I = 1000
I = 1000
AE = 10,900
I = 1000
AE = 6,400
C = 100 + 0.9Y
C = 22,600
C = 17,200
C = 9,100
C = 4600
G=
500
I = 1000
NX
=
30
0
G=
500
NX=
300
NX=
300
G=
500
NX=
300
NX=
300
Aggregate
Expenditures
AE
Y = 25,000
Y = 5,000
Y = 10,000
Real Income = Real GDP = Y
Y = 19,000
AE = 24,400
G=
500
G=
500
I = 1000
AE = 19,000 I = 1000
I = 1000
AE = 10,900
I = 1000
AE = 6,400
C = 100 + 0.9Y
C = 22,600
C = 17,200
C = 9,100
C = 4600
G=
500
I = 1000
NX
=
30
0
G=
500
NX=
300
NX=
300
G=
500
NX=
300
NX=
300
Aggregate
Expenditures
AE
Y = 25,000
AE = 24,400
AE = 19,000
AE = 6,400
and Aggregate Expenditures AE = 24,400
and Aggregate Expenditures AE = 19,000
and Aggregate Expenditures AE =10,900
and Aggregate Expenditures AE = 6,400
Change
ChangeininInventories
Inventories== 5,000
10,000
19,000
25,000
10,900
19,900
0
600
-900
(no
- 6,400– =24,400
-1,400=(Inventories
(Inventories
change)
(increase)
decrease) decrease)
AE = 10,900
AE
If total
IfIftotal
total
production
production
production
Y =YY25,000
==19,000
5,000
10,000
Y = 5,000
Y = 10,000
Y = 19,000
Y = 25,000
The Keynesian Cross
Output
The
line line
4545
degree
Converts Horizontal
Distances into Vertical
Distances.
D
A
100
B C
1000
Income
AE = 24,400
AE = 19,000
AE = 10,900
AE = 6,400
AE
450
Y = 5,000
Y = 10,000
Y = 19,000
Y = 25,000
AE
Y = 5,000
Y = 10,000
Y = 19,000
Y = 25,000
No change in Inventories
AE
AE
Y = 5,000
Y = 10,000
Y = 19,000
Y = 25,000
If firms end only with WANTED inventories: their
actual investment and their planned investment
are the same.
Total
Production
= C + I + G + NX
With inventories only at the planned level
45
AE
C+I+G+NX
Y
C+I+G+NX
Y
Y
No unwanted change in
Inventories
Real GDP
45
AE
Unwanted
increase in
Inventories
C+I+G+NX
Y
Too High Y
Equilibrium Y
Y
C+I+G+NX
Firms will decrease
Output
Real GDP
45
AE
C+I+G+NX
Unwanted
decrease in
Inventories
Low Y
Y
Firms will increase
Output
Equilibrium Y
Real GDP
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.
Closed Economy without Government
Condition that must
Interest
Rent
be satisfied
Profits
Wages
for equilibrium:
Y=C+I
Since:
Y = C + S (Income is either
Firms
consumed or saved)
Households
We can rewrite the equilibrium condition as:
S
C + SS==CI + I
C = Injections
In a closedleakages
economy
without government
the
Total
Goods
and
equilibrium condition is that
Savings
Producti
Services
must be equal to Investment
on
I
What
At Y =is 3,000
5,000
the equilibrium
are inventories
GDP?rising? Falling? Unchanged?
For
Forwhat
whatvalue
valueofofGDP
GDPis:
is:
YY==AE?
AE?
For what value of GDP is:
S = I?
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.
Open Economy without Government
Condition that must
Since:
Interest
Rent
be satisfied
Profits
Wages
for equilibrium:
Y = C + I + X-MRest of
World
Y=C+S
Firms
We can rewrite the equilibrium condition
as:
NX
Households
C + S = C + I +X-M
SIn an open economy without government the equilibrium
S
=
I
+
X-M
C
condition says that our savings must be enough to finance
private Investment
deficit.
Total
S+M = I plus
+ Xthe trade
Goods
and
Producti
leakages = Injections Services
on
S = II+(X-M)
What
At Y =is 3,000
5,000
the equilibrium
are inventories
GDP?rising? Falling? Unchanged?
For
Forwhat
whatvalue
valueofofGDP
GDPis:
is:
YY==AE?
AE?
For what value of GDP is:
S = I+(X-M)?
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.
Open Economy with Government
Condition
G that must be
Since:
Interest
satisfied
Rent
Profits
Wages
for equilibrium:
Y = C + I + G + X-M
Rest of
Y = C + S + T (Income isWorld
used to
T
consume,
save and pay taxes)
Firms
NX
G
We can rewrite the equilibrium condition as:
Households
C + S + T= C + I + G +X-M
S
Savings
must= Ifinance
Investment, the
S+T
+
G
+
X-M
C
government’s deficit and the trade
deficit.
Total
S+T+M = I + G + X Goods
and
leakages = Injections
Producti
Services
on
I
S = I + (G – T)+(X-M)
What
At Y =is 3,000
5,000
the equilibrium
are inventories
GDP?rising? Falling? Unchanged?
For
Forwhat
whatvalue
valueofofGDP
GDPis:
is:
YY==AE?
AE?
For what value of GDP is:
S = I +(G-T) +(X-M)?
I + (G-T) + (X-M)
Shifts in the Aggregate
The
The AE
AE line
line shifts
shifts
Expenditures
Line
down
up
Y = 10,000
Y = 19,000
G=
500
I = 1000
AE = 24,400
AE = 19,000 I = 1000
C = 17,200
C = 9,100
C = 100 + 0.9Y
C = 22,600
G=
500
Y = 5,000
I = 1000
AE = 10,900
G=
500
C = 4600
G=
500
I = 1000
NX
=
30
0
I = 1000
AE = 6,400
When C, I, G or net
exports decrease
increase
G=
500
NX=
300
NX=
300
NX=
300
NX=
300
AE
Y = 25,000
Y = 5,000
Y = 10,000
Y = 19,000
AE = 6,400
AE = 19,000
AE = 10,900
If AE line
shifts down
AE = 6,400
AE
Equilibrium
Y = 25,000
AE = 6,400
AE = 10,900
AE = 19,000
If AE line
shifts down
AE = 6,400
AE
Equilibrium
Equilibrium
output
decreases
Y = 10,000
Y = 5,000
Y = 19,000
Y = 25,000
AE = 6,400
AE = 19,000
AE = 10,900
If AE line
shifts up
AE = 6,400
AE
Equilibrium
Y = 19,000
Y = 5,000
Y = 10,000
Y = 25,000
If AE line
shifts up
AE = 19,000
AE
Equilibrium
Equilibrium
output
increases
Y = 25,000
Y = 19,000
Potential GDP
The real gross domestic product (GDP) the
economy would produce if its labor force
were fully employed
A Recessionary Gap
Equilibrium output occurs below Potential GDP
An Inflationary Gap
Potential GDP
B
Equilibrium output occurs above Potential GDP
AtAtYY= =5000
4,000
3000
a)
b)
c)
d)
e)
f)
g)
h)
Total Spending > Output
i) Economy is at equilibrium
Inventories fall
Total Spending < Output
Inventories rise
Total Spending = Output
There is no change in Inventories
The economy experiences a recessionary gap
The economy experiences a recessionary gap
Building Aggregate Demand
Matches each price level with the
corresponding equilibrium value of
output
Aggregate Demand
Price Level
P0
Y0
AD
Real
Equilibrium
GDP Demanded
Output
When prices increase
from P0 to P1,
the value of wealth
decreases and
consumption decreases
from C0 to C1.
The AE line shifts down
and the equilibrium value
of output decreases from Y0
to Y1.
Aggregate Demand
Price Level
A movement ALONG the AD line NOT a SHIFT!
P1
When prices increase
from P0 to P1, the
equilibrium value of
output decreases from
Y0 to Y1.
P0
Y1
Y0
AD
Real
Equilibrium
GDP Demanded
Output
When prices decrease from
P0 to P2,
the value of wealth
increases and
consumption increases
from C0 to C2.
The AE line shifts up
and the equilibrium value
of output increases from Y0
to Y2.
Aggregate Demand
Price Level
A movement ALONG the AD line NOT a SHIFT!
When prices decrease from
P0 to P2, the equilibrium
value of output increases
from Y0 to Y2.
P0
P2
Y0
Y2
AD
Real
GDP Demanded
Equilibrium
Output
Building the Aggregate Demand Curve
Output Y1
corresponds
to P1
When prices increase
from P0 to P1,
the value of wealth
decreases and
consumption decreases
from C0 to C1.
The AE line shifts down
and the equilibrium value
of output decreases from Y0
to Y1.
Output Y2
corresponds
to P2
When prices decrease from
P0 to P2,
the value of wealth
increases and
consumption increases
from C0 to C2.
The AE line shifts up
and the equilibrium value
of output increases from Y0
to Y2.
If G,I,C, NX increase
AE line Shifts up
Aggregate Expenditures
AE1= C+I+G+NX
45
Price level
Equilibrium Income increase
A shift of the AD line NOT a
movement ALONG !
AE0=
C+I+G+NX P
0
AD1
AD0
Y0
Y1
Y0
Y1
Real GDP
Real GDP
Demanded
The size of the change in equilibrium Y is the size of the shift in AD
Real GDP
Shifts in the Aggregate Demand Line
Price Level
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).
P0
AD1
Y0
Y1
AD0
Real GDP Demanded
AE line Shifts down
Equilibrium Income decrease
Price level
If G,I,C, NX decrease
Aggregate Expenditures
AE0= C+I+G+NX
A shift of the AD line NOT a
movement ALONG !
AE1= C+I+G+NX
P0
AD0
AD1
Y1
Y0
Y1
Y0
Real GDP Demanded
The size of the change in equilibrium Y is the size of the shift in AD
Real GDP
Shifts in the Aggregate Demand Line
Price Level
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).
P0
AD1
Y1
Y0
AD0
Real GDP Demanded
Factors that shift the
consumption function
Changes in wealth
1.


Changes in consumer expectations
2.

Taxes and Transfers

4.
Shift up in AE line
Shift right in AD line
Shift the consumption function.
Example: Pessimistic expectations
decrease autonomous consumption.

3.
shift the consumption function.
Example: value of stocks, bonds,
consumer durables.
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
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
To increase
AE, we
need
A recessionary gap
occurs
To eliminate a recessionary
increase
in
when actual GDPanfalls
SHORT
gap, AE must
C, I, rise.
GGDP
or NX
of full employment
= 7,000-6,000 =1,000
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.
To
To eliminate
decrease
AE, weanneed a
inflationary
decrease
in C,
gap,
I, GAE
or must
NX
fall.
= 7,000-8,000 =-1,000
An inflationary gap
occurs when
equilibrium GDP is
higher than full
employment GDP
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.
Questions to prepare for test
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)
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?
Output
Consumption
Investment
Net Exports
1000
800
500
100
1500
1200
500
100
2000
1600
500
100
2500
2000
500
100
3000
2400
500
100
3500
2800
500
100
4000
3200
500
100
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:
A. Find the slope of the AE line. Recall the slope of the AE
line is the MPC.
B.
Find the intercept of the AE line.
C. Write down the equation of the AE line.
D. Find the value of AE when income is 40,000
E.
What is the equilibrium value of income/output in this
case?
F.
Find the value of AE when income is 50,000 and when
income is 25,000.
G. Fill in the values for each box in the graph.
Repeat the exercise with the graph in slide #73.
49,000
26,500
25,000
40,000
50,000