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 + (XIM)
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
(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
900
900
900
900
900
900
1,300
1,300
1,300
1,300
1,300
1,300
1,300
-100
-100
-100
-100
-100
-100
-100
5,100
5,400
5,700
6,000
6,300
6,600
6,900
9
Figure 2
Construction of the expenditure schedule
C+I+G
C+I+G+(X-IM)
X-IM=-$100
Real Expenditure
6,100
6,000
C+I
G=$1,300
C
4,800
I=$900
3,900
0
5,200 5,600 6,000 6,400 6,800 7,200
Real GDP
10
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
(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 exceeds output
Spending exceeds output
Spending = output
Output exceeds spending
Output exceeds spending
Output exceeds spending
Falling
Falling
Falling
Constant
Rising
Rising
Rising
Produce more
Produce more
Produce more
No change
Produce less
Produce less
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
spending
7,200
C+I+G+(X-IM)
Real Expenditure
6,800
6,400
E
6,000
Equilibrium
5,600
5,200
Spending exceeds output
4,800
0
4,800 5,200 5,600 6,000 6,400 6,800 7,200
Real GDP
14
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
Real Consumer Spending
Movements along
consumption function
C1
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°
E0
C0+I+G+(X-IM)
E1
C1+I+G+(X-IM)
Real Expenditure
Real Expenditure
45°
E2
C2+I+G+(X-IM)
E0
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
Price Level
E1
P1
P0
E0
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
GDP
Real Expenditure
F
45°
C+I+G+(X-IM)
E
B
Recessionary gap
45°
0
6,000
Real GDP
7,000
23
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
Inflationary gap
Potential
GDP
45°
E
Real Expenditure
B
C+I+G+(X-IM)
F
45°
0
7,000
Real GDP
8,000
26
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
(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
1,100
1,100
1,100
1,100
1,100
1,100
1,300
1,300
1,300
1,300
1,300
1,300
1,300
-100
-100
-100
-100
-100
-100
-100
5,300
5,600
5,900
6,200
6,500
6,800
7,100
• Multiplier = ∆Y/ ∆I = 800/200 = 4
33
Figure 10
Illustration of the multiplier
45°
C+I1+G+(X-IM)
Real Expenditure
E1
C+I0+G+(X-IM)
$200 billion
E0
0
6,000
6,800
Real GDP
34
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
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
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
(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
900
900
900
900
900
900
1,300
1,300
1,300
1,300
1,300
1,300
1,300
-100
-100
-100
-100
-100
-100
-100
5,300
5,600
5,900
6,200
6,500
6,800
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
Real Expenditure
$200 billion
C+I1+G+(X-IM)
C+I0+G+(X-IM)
E0
6,000
0
D0
Price Level
E1
45°
Real GDP
D1
E0
100
6,800
E1
D1 (I=$1,100)
D0 (I=$900)
0
6,000
6,800
Real GDP
44
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)
Gross
Domestic
Product
(Y)
Consumer
Expenditures
(C)
Investment
(I)
Government
Purchases (G)
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
900
900
900
900
900
900
1,300
1,300
1,300
1,300
1,300
1,300
1,300
(5)
(6)
(7)
(8)
Exports
(X)
Imports
(IM)
Net
Exports
(X-IM)
Total
Expenditure
[C+I+G+(X-IM)]
650
650
650
650
650
650
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
48
Figure 13
Real Net Exports
Real Exports & Imports
The dependence of net exports on GDP
IM
950
850
750
650
550
450
Positive net exports
0
200
100
0
-100
-200
-300
Negative net exports
X
4,800 5,200 5,600 6,000 6,400 6,800 7,200
4,800 5,200 5,600
Positive net exports
Real GDP
6,400 6,800 7,200
6,000
Negative 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
Real Expenditure
45°
C+I+G+(X-IM)
(variable imports)
E
0
Positive net exports
6,000
C+I+G+(X-IM)
(fixed imports)
X-IM
Real GDP
Negative net exports
51
Table 7
Equilibrium income after a $160 billion increase in
exports
(1)
(2)
(3)
(4)
Gross
Domestic
Product
(Y)
Consumer
Expenditures
(C)
Investment
(I)
Government
Purchases (G)
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
900
900
900
900
900
900
1,300
1,300
1,300
1,300
1,300
1,300
1,300
(5)
(6)
(7)
(8)
Exports
(X)
Imports
(IM)
Net
Exports
(X-IM)
Total
Expenditure
[C+I+G+(X-IM)]
810
810
810
810
810
810
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
52
Figure 15
The multiplier with variable Exports
45°
C+I+G+(X1-IM)
Real Expenditure
A
C+I+G+(X0-IM)
Rise in exports
= $160
E
Rise in GDP = $400
0
6,000
6,400
Real GDP
53