Economics Assignment 2

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Economics: Principles and Policy

William J. Baumol, Alan S. Blinder, John L. Solow

14th edition

Powerpoint Slides prepared by: Philip Heap, James Madison University

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in part.

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Part 2

The Macroeconomy: Aggregate Supply and Demand

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Chapter 9

Demand Side Equilibrium: Unemployment or Inflation?

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An Opening Quote

A definite ratio, to be called the Multiplier, can be established between income and investment.

John Maynard Keynes

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The Meaning of Equilibrium G D P 1 of 4

• Important issue in stabilization policy

• Would the economy automatically gravitate to full employment if the government left it alone?

• Keynes and The General Theory

• What do we mean by equilibrium?

• Total production = Total income

• What if total spending is greater or less than total production?

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Figure 1 The Circular Flow Diagram

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The Meaning of Equilibrium G D P 2 of 4

• What happens if total spending is greater than total production?

• Firms deplete inventories

• Increase production to meet the higher demand

• Prices may increase if high demand permanent

• Neither output nor the price level is in equilibrium

• Equilibrium

• A situation in which consumers and firms have no incentive to change their behavior

• They are content to continue with things as they are

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The Meaning of Equilibrium G D P 3 of 4

• What happens If total spending is less than total production?

• Firms see their inventories increase

• Signal to firms that output and pricing decisions wrong

• Firms cut back on production

• Eventually may cut prices

• So we have equilibrium on the demand side if

• If total spending equals total production

• Firms’ inventories at desired levels

• No incentive to change output or prices

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The Meaning of Equilibrium G D P 4 of 4

• Three important questions remain:

1. How large is the equilibrium level of G D P?

2. Will the economy suffer from unemployment, inflation, or both?

3. Is the equilibrium level of G D P on the demand side also consistent with firms’ desires to produce? Is there equilibrium on the supply side?

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The Mechanics of Income Determination

• Determining equilibrium G D P on the demand side

• Expenditure schedule

• Shows the relationship between national income or G D P and total spending

• Assume that I, G, and X – I M are fixed

• Induced investment

• Part of investment spending that rises when G D P rises and falls when G D P falls

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Table 1 The Expenditure Schedule

GDP Y

Consumption C

Investment I

Government Purchases

Net Exports X – IM

Total 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

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Figure 2 Construction of the Expenditure Schedule

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Table 2 The Determination of Equilibrium Output

Output Y

Total Spending C + I + G + (X – IM)

Balance of Spending and Output

Inventory Status Producer Response

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

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Figure 3 Income-Expenditure Diagram

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The Aggregate Demand Curve 1 of 2

• How can we derive the aggregate demand curve from our income expenditure analysis?

• Aggregate demand curve

• Shows the quantity of domestic product that is demanded at each possible value of the price level

• How does a change in the price level affect the consumption function

• Higher prices

• Erodes purchasing power of consumer wealth

• Less wealth leads to less spending for any level of real income

• So consumption function falls

• Lower prices . . .

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Figure 4 How the Price Level Shifts the Consumption Function

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The Aggregate Demand Curve 2 of 2

• Now bring in the entire economy

• A rise in prices

• Lowers consumption function

• Total expenditure line shifts downward

• Lower equilibrium of real aggregate quantity demanded

• A drop in prices

• Higher consumption function

• Total expenditure line shifts upward

• Higher equilibrium of real aggregate quantity demanded

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Figure 5 The Effect of the Price Level on Equilibrium Aggregate Quantity Demanded

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Figure 6 The Aggregate Demand Curve

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Demand-Side Equilibrium and Full Employment 1 of 3

• Will the economy’s equilibrium be at full employment without inflation, or will we see unemployment, inflation, or both?

• Two possible situations when not at full employment

1. Equilibrium output is less than full employment output or potential G D P

• Recessionary gap

▶ Amount by which the equilibrium level of real G D P falls short of potential G D P

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Figure 7 A Recessionary Gap

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Demand-Side Equilibrium and Full Employment 2 of 3

• Two possible situations when not at full employment

2. Equilibrium output is more than full employment output

• Inflationary gap

▶ Amount by which equilibrium real G D P exceeds potential G D P

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Figure 8 An Inflationary Gap

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Demand-Side Equilibrium and Full Employment 3 of 3

• Full employment

• Occurs when spending plans and the price level are “just right”

• No recessionary gap and no inflationary gap

• What would eliminate the recessionary or inflationary gaps?

• Expenditure schedules would need to shift up or down

• Price adjustments, changes in spending, government policy . . . (will come back to)

• Is there a reason to expect the economy to return to full employment on its own?

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The Coordination of Saving and Investment 1 of 3

• Must the full-employment level of GDP be a demand-side equilibrium?

• Consider an economy with no trade and no government

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Figure 9 A Simplified Circular Flow

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The Coordination of Saving and Investment 2 of 3

• For demand-side equilibrium to occur at full employment:

• Savings S = Investment I

• If S > I

▶ Total demand received by firms less than total output

▶ G D P falls below potential

▶ Recessionary gap

• If I > S

▶ Total demand > Potential G D P

▶ G D P rises above potential

▶ Inflationary gap

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The Coordination of Saving and Investment 3 of 3

• Why does this occur? Why doesn’t saving equal investment?

• Savers and investors are not the same people

• Coordination failure

• Party A would like change his behavior if Party B would change his

• The two changes do not take place because the decisions of A and B are not coordinated

• Coordination failure at football games

• Coordination and unemployment

• Coordination and inflation

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Changes on the Demand Side: Multiplier Analysis 1 of 4

• The Magic of the Multiplier

• Multiplier

• The ratio of the change in equilibrium G D P divided by the original change in spending that causes the change in G D P

• Multiplier principle

• G D P rises by more than the change in spending

• Multiplier > 1

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Table 3 Total Expenditure after a $200 Billion Increase in Investment Spending

GDP Y

Consumption C

Investment I

Government Purchases

Net Exports X – IM

Total 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 5,700

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

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Figure 10 Illustration of the Multiplier

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Changes on the Demand Side: Multiplier Analysis 2 of 4

• Demystifying the multiplier: how it works:

• Microhard spends $1 million on a new office building

• That money is income to construction workers

• If their M P C is 0.75, they spend . . .

• $750,000

• Now other people have $750,00, so they spend . . .

• $562,500

• But that spending represents . . .

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Table 4 The Multiplier Spending Chain

Round Number Spending in this Round Cumulative 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 3,466,064

8 133,484 3,599,548

9 100,113 3,699,661

10 75,085 3,774,746

20 4,228 3,987,315

Infinity 0 4,000,000

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Figure 11 How the Multiplier Builds

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Changes on the Demand Side: Multiplier Analysis 3 of 4

• In last example each round of spending was 0.75 of the last round

• 1 + 0.75 + 0.752 + 0.753

• 1 + R + R2 + R3 = 1/(1 – R)

• Multiplier = 1/(1 – 0.75) = 4

• In general

• 1 + M P C + M P C2 + M P C3 + . . .

• Oversimplified multiplier formula

• Multiplier = 1 over (1 – M P C)

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Changes on the Demand Side: Multiplier Analysis 4 of 4

• Why oversimplified?

• Simple versus real world multipliers

• M P C = 0.90, so in simple world, multiplier is 10

• In real world, mulitplier under 2

• Reasons (we will get to)

• International trade

• Inflation

• Income taxation, a point we will emphasize

• The financial system

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The Multiplier Is a General Concept 1 of 3

• Any increase in spending can set off the multiplier chain

• Two types of changes

• Induced increase in consumption

• An increase in consumer spending that stems from an increase in consumer incomes

• Movement along a fixed consumption function

• Autonomous increase in consumption

• An increase in consumer spending without any increase in consumer incomes

• Shift of the entire consumption function

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Table 5 Total Expenditure after Consumers Decide to Spend $200 Billion More

GDP Y

Consumption C

Investment I

Government Purchases

Net Exports X – IM

Total 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 5,700

6,000 4,100 900 1,300 -100 6,200

6,400 4,300 900 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

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The Multiplier Is a General Concept 2 of 3

• Change in C, I, G, or (X-I M) all have the same multiplier effect

• Recession of 2009

• Increase in Federal spending of $94 billion

• 40% offset by decrease in spending by state and local governments

• Net increase of $61 billion

• Multiplier = 1.2

• G D P increases by $73 billion

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The Multiplier Is a General Concept 3 of 3

• Booms and recessions tend to be transmitted across national borders

• A boom in China will lead to higher incomes

• Chinese imports from U.S will increase

• U.S exports and G D P will increase

• A recession in Canada will lead to lower incomes

• Canadian imports will decrease

• U.S exports and G D P will decrease

• In both case, the multiplier effect is present

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The Multiplier and the Aggregate Demand Curve

• How can we bring the multiplier effect into the aggregate demand curve model?

• An autonomous increase in spending causes

• The expenditure schedule to shift up

• Equilibrium real G D P will increase for a given price level

• The multiplier effect indicates the increase in real G D P, if the price level were fixed

• Horizontal shift of the aggregate demand curve by an amount given by the oversimplified multiplier formula

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Figure 12 Two Views of the Multiplier

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Appendix A

The Simple Algebra of Income Determination and the Multiplier

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Algebra of Income Determination & Multiplier 1 of 2

• Using the example from the chapter

• C = 300 + 0.75 D I

• C = 300 + 0.75(Y – T)

• w/ T = 1,200

• C = -600 + 0.75Y

• Y = C + I + G + (X – I M)

• w/ I = 900, G = 1,300, (X – I M) = -100

• Y = 1,500 + 0.75Y

• Y = 6,000

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Algebra of Income Determination & Multiplier 2 of 2

• Now generalize

• C = a + b D I

• C = a + b(Y – T)

• Y = a + b(Y – T) + I + G + (X – I M)

• (1 – b)Y = a – bT + I + G + (X – I M)

• Solving for Y:

• Y = [a – b T + I + G + (X – I M)] / (1 – b)

• Multiplier = 1/(1 – b), where b = M P C

• Applies to a change in a, I, G or (X – I M)

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Appendix

The Multiplier with Variable Imports

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Multiplier with Variable Imports 1 of 4

• What happens to the multiplier with international trade?

• Three main points

• Our imports rise (fall) as our G D P rises (falls)

• Our exports are relatively insensitive to our G D P, but sensitive to other countries G D P

• International trade lowers the value of multiplier

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Multiplier with Variable Imports 2 of 4

• We will use the same example that we have been working with

• Assume

• Exports are fixed at $650

• Imports rise by $60 billion for every $400 billion rise in G D P

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Table 6 Equilibrium Income with Variable Imports

GDP Y

Consumption C

Investment I

Government Purchases

G Exports Import

Net Exports X – IM

Total Expenditure

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

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Figure 13 The Dependence of Net Exports on GDP

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Figure 14 Equilibrium GDP with Variable Imports

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Multiplier with Variable Imports 3 of 4

• Now assume

• Exports rise by $160 billion

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Table 7 Equilibrium Income after a $160 Billion Increase in Exports

GDP Y

Consumption C

Investment I

Government Purchases

G Exports Import

Net Exports X – IM

Total Expenditure

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 6,880

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Figure 15 The Multiplier with Variable Imports

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Multiplier with Variable Imports 4 of 4

• How much is the multiplier?

• Exports rose by $160 billion

• Real G D P increased by $400

• Multiplier = $400/$160 = 2.5

• International trade lowers the numerical value of the multiplier

• Any autonomous increase in spending is partly offset by purchases of foreign goods

• Foreigners’ incomes increase rather than domestic citizens

• This is why the oversimplified multiplier, 1/(1 – M P C), overstates the true value