demand-side equilibrium: unemployment or inflation?
DESCRIPTION
9. Demand-Side Equilibrium: Unemployment or Inflation?. Contents. Meaning of Equilibrium GDP Mechanics of Income Determination Aggregate Demand Curve Demand-Side Equilibrium and Full Employment Coordination of Saving and Investment Changes on the Demand Side: Multiplier Analysis. - PowerPoint PPT PresentationTRANSCRIPT
![Page 1: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/1.jpg)
9
Demand-Side Equilibrium: Unemployment or
Inflation?
![Page 2: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/2.jpg)
● Meaning of Equilibrium GDP● Mechanics of Income Determination● Aggregate Demand Curve● Demand-Side Equilibrium and Full Employment● Coordination of Saving and Investment● Changes on the Demand Side: Multiplier
Analysis
Contents
![Page 3: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/3.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Real World Puzzle: Why does the Market Permit Unemployment?
● Market economies coordinate the decisions of millions of buyers and sellers to ensure the correct amount of C goods are produced with most efficient prod means.
● Yet market economies stumble with periodic episodes of mass UE and recessions.
● Widespread UE is a failure to coordinate economic activity.♦ If UE were hired, they could buy the goods firms can’t sell;
and revenues from these sales would allow firms to hire the UE.
![Page 4: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/4.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Recall: total production (GDP) = total income● But total production need not = total spending● If total expenditures > value of output produced
♦ (1) ↓inventory stocks → signals retailers ↑orders → signals manufacturers ↑ production
♦ (2) if high levels of spending continue to deplete inventories → firms ↑prices
● If total expenditures < value of output produced ♦ (1) ↑inventory stocks → signals retailers ↓orders → signals
manufacturers ↓ production♦ (2) if low levels of spending continue → firms ↓prices
The Meaning of Equilibrium GDP
![Page 5: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/5.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Equilibrium on the Demand-side of the Economy♦ GDP↑ when total expenditures > GDP♦ GDP↓ when total expenditures < GDP
● Equilibrium can only occur when there is just enough spending to absorb current level of prod. Then producers conclude their Q and P decisions were correct.
● Equilibrium: total spending = total production♦ Firms inventories remain at desired levels → no reason to ∆Q
or ∆P
The Meaning of Equilibrium GDP
![Page 6: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/6.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Mechanics of Income Determination
● Expenditure Schedule = table showing the relationship between GDP and total spending
● Table 1: ♦ C is the Consumption f(x)♦ I, G, and X-IM are all fixed regardless of the level of GDP♦ C + I + G + X-IM = total expenditure
![Page 7: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/7.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
TABLE 1. The Total Expenditure Schedule
GDP (Y) C I G X - IM Total Exp
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
![Page 8: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/8.jpg)
FIGURE 1. Construction of the Expenditure Schedule
G = $1,300
I = $900
C + I + G
C + I + G + (X – IM)
C + I
C
7,200 6,800 6,400 6,000 5,600
6,000 6,100
4,800
Rea
l Exp
endi
ture
Real GDP 5,200
3,900
X –IM = –$100
C is the C f(x). It is shifted up by the amount of I ($900) and G ($1,300) and shifted down by the amount of X-IM (-$100).
Slope of the expenditure schedule = MPC because I, G, and X-IM are assumed to be constant and do not vary with GDP.
![Page 9: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/9.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Use Table 2 to understand why $6,000B must be equilibrium level of output.
● Any output below $6,000B → total expenditures > GDP → ↓inventories → ↑production
● Any output above $6,000B → total expenditures < GDP → ↑inventories → ↓production
● Equilibrium only occurs when Y = C + I + G + X-IM or GDP = total expenditure, which happens at $6,000B.
The Mechanics of Income Determination
![Page 10: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/10.jpg)
TABLE 2. The Determination of Equilibrium Output
![Page 11: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/11.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Use Figure 2 to show why $6,000B must be the equilibrium level of output.
● 45 degree line shows all points where output and spending are equal. ♦ These are all points where the economy can possibly be in
equilibrium.♦ Economy is not always on the 45 degree line but it is always on
the expenditure schedule. ♦ Equilibrium is shown where 45 degree line intersects the total
expenditure schedule.
The Mechanics of Income Determination
![Page 12: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/12.jpg)
FIGURE 2. Income-Expenditure Diagram
Spending exceeds output
Output exceeds spending
Equilibrium
6,000
Rea
l Exp
endi
ture
45°
5,200 5,600 6,000 6,400 6,800 7,200 0
4,800
5,600
6,400
6,800
7,200
Real GDP 4,800
5,200
C + I + G + (X – IM)
E
Left of point E: total expenditure schedule is above the 45 degree line → spending > GDP → ↓inventories and firms ↑prod.
Right of point E: total expenditure schedule is below the 45 degree line → spending < GDP → ↑inventories and firms ↓prod.
![Page 13: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/13.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● The expenditure schedule is drawn for a fixed P level.● Derive AD curve using the expenditure schedule.● Recall P level shifts C f(x) downward
P level (at fixed levels of DI) purchasing power of wealth by lowering the value of money-fixed assets
P level shifts the expenditure schedule downward♦ ↓ P level shifts the expenditure schedule upward
The Aggregate Demand Curve
![Page 14: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/14.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● How do changes in the P level impact real GDP on the demand-side of the economy?♦ ↑P level → ↓expenditures → ↓Equil level of GDP♦ ↓P level → ↑expenditures → ↑Equil level of GDP
● We can now draw an AD curve (in Fig 3) where Y0, Y1, and Y2 correspond to the GDP levels depicted in the 45 degree line diagram.
The Aggregate Demand Curve
![Page 15: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/15.jpg)
FIGURE 3. The Effect of the Price Level on Equilibrium AD
Y2
Pric
e Le
vel
Real GDP
C0 + I + G + (X–IM)
Y0 Y1
45
45
C2 + I + G + (X–IM)
E0
C1 + I + G + (X–IM) E1
Change in P level Movement along AD curve
Real GDP
Rea
l Exp
endi
ture
E0
AD
E1
E2
Y1 Y2 Y0
P0
P2
P1
E2
![Page 16: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/16.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Aggregate Demand Curve
● AD has a (-) slope♦ ↑P level → ↓C via ↓wealth♦ ↑P level → ↓X-IM
■ Note: this also shifts the expenditure schedule down and lowers GDP.
● Each expenditure schedule describes only one P level. At different P levels, the expenditure schedule is different so equilibrium GDP is different.
![Page 17: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/17.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Will economy achieve full employment without inflation?
● If the economy always gravitates toward full employment, then gov should leave the economy alone.
● We’ve shown that equil GDP is where 45 degree line intersects the exp schedule, but we haven’t determined if that equil level of GDP is at full employment.
Demand-Side Equilibrium and Full Employment
![Page 18: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/18.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● If equil GDP > full employment level of GDP → economy has inflation.
● If equil GDP < full employment level of GDP → economy has unemployment.
Demand-Side Equilibrium and Full Employment
![Page 19: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/19.jpg)
FIGURE 4. A Recessionary Gap
Recessionary gap
C + I + G + (X – IM)
45°
45°
Potential GDP
7,000
Rea
l Exp
endi
ture
Real GDP 6,000
E
F
B
Full emp = $7,000B and equil GDP = $6,000B.
Here exp is too low to have full emp. Happens if C, I, G, or X are weak or P level is “too high.”
UE occurs because there isn’t enough output demanded to keep entire L force working.
Full emp can be reached if exp schedule shifts up to pt F. This could happen without gov intervention if ↓P level.
![Page 20: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/20.jpg)
FIGURE 5. An Inflationary Gap
Inflationary gap
45°
45°
Potential GDP
8,000
Rea
l Exp
endi
ture
Real GDP 7,000
C + I + G + (X – IM)
F
B E
Full emp = $7,000B and equil GDP = $8,000B.
Happens if C, I, G, or X are very high or P level is “too low.”
Full emp can be reached if exp schedule shifts down to pt F. This could happen without gov intervention if ↑P level.
![Page 21: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/21.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Coordination of Saving and Investment
● Must full employ level of GDP be an equilibrium? No!● Ignore G and X-IM then we can restate equil GDP:
♦ Y = C + I♦ Y – C = I♦ S = I
● Reach full employment equil only if S = I.♦ If S > I → spending is inadequate to support prod at full emp
→ GDP falls below potential and there is a recessionary gap.♦ If I > S → spending exceeds potential GDP → production is
above full emp level and there is an inflationary gap.
![Page 22: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/22.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Coordination of Saving and Investment
● S is decided by households and I is decided by corporate executives and home buyers.
● Their decisions are not well coordinated.● Not clear the gov can solve the coordination problem of
UE.
![Page 23: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/23.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Changes on the Demand Side: Multiplier Analysis
● Multiplier = (∆ in equil GDP) (∆ in spending that caused the ∆ in GDP)
● In Table 3, I rises by $200B (from $900B in Table 1), yet equil GDP rises by $800B (not just $200B). Why?♦ Multiplier > 1 because one person’s spending is another
person’s income. Note: multiplier = 4 here. spending income♦ A portion of the ↑ in income is spent on C, creating more
income, which in turn creates more C, etc.
![Page 24: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/24.jpg)
TABLE 3. Total Expenditure after a $200 Billion Increase in Investment
![Page 25: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/25.jpg)
FIGURE 6. Illustration of the Multiplier
Rea
l Exp
endi
ture
45
$200 billion
6,800 0 6,000 Real GDP (or Y)
C + I1 + G + (X – IM)
C + I0 + G + (X – IM) E1
E0
Multiplier = ∆Y/∆I = $800/$200 = 4
Or multiplier = 1/(1-MPC) = 1/(1-0.75) = 4
![Page 26: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/26.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Changes on the Demand Side: Multiplier Analysis
● Multiplier = 1 (1 - MPC)♦ MPC in U.S. has been estimated to be about 0.95, implying
that the multiplier is 20. ♦ In fact, the multiplier in U.S. is < 2.
● Factors that reduce the size of the multiplier♦ International trade♦ Inflation♦ Income taxation♦ Financial system
![Page 27: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/27.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● ∆I has same multiplier effect as a ∆C, ∆G, or ∆(X - IM).● Consequently, trade links the GDPs of major economies.
GDP in a foreign country its IM, a portion of which are X from U.S.
♦ Growth in U.S. X has a multiplier effect, ↑GDP in U.S.♦ Booms and recessions tend to be transmitted across national
borders.
The Multiplier Is a General Concept
![Page 28: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/28.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Multiplier and the Aggregate Demand Curve
spending shifts AD by an amount given by the oversimplified multiplier formula (1/(1-MPC)).
● In Fig 7, I has risen by $200B which shifts AD out by $800B (i.e., 4 (the multiplier) x $200B).
![Page 29: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/29.jpg)
FIGURE 7. Two Views of the Multiplier
45
C + I1 + G + (X – IM )
$200 billion
C + I0 + G + (X – IM )
0 6,000
100 Pric
e Le
vel
Rea
l Exp
endi
ture
6,800
6,800 6,000
Real GDP
(I = $1,100) D1
D1
(I = $900) D0
D0
E0
E0
E1
E1
![Page 30: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/30.jpg)
Supply-Side Equilibrium: Unemployment and
Inflation?
![Page 31: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/31.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Aggregate Supply Curve● Equilibrium of AD and AS● Inflation and the Multiplier● Recessionary and Inflationary Gaps Revisited● Adjusting to a Recessionary Gap or an
Inflationary Gap● Stagflation from an Adverse Supply Shock
Contents
![Page 32: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/32.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Aggregate Supply Curve
● Like AD, AS is a curve and not a fixed number.● Qs by firms depends on prices, wages, other input costs,
and technology.● AS represents the relationship between P level and GDP
supplied, holding all other determinants of Qs fixed.● AS has a (+) slope → ↑P → ↑Qs● Firms are motivated by profit.
♦ Profit per unit = P – AC
![Page 33: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/33.jpg)
FIGURE 1. An Aggregate Supply Curve
Pric
e Le
vel
Real GDP
S
S
![Page 34: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/34.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Why does the Aggregate Supply Curve have a Positive Slope?
● Many input prices are fixed for certain periods of time.♦ Long-term contracts for L or raw materials
● Firms choose Qs by comparing selling prices with production costs which depend on input prices.♦ If ↑selling prices while input costs are fixed → ↑Qs♦ If ↓selling prices while input costs are fixed → ↓Qs
![Page 35: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/35.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Shifts of the Aggregate Supply Curve
● Costs of production are constant along the AS curve. costs of production shifts AS curve1. Money wage rate
● wages account for more than 70% of all prod costs. ♦ ↑wages → ↓profit at any given P of output → ↓Qs♦ ↑wages → shifts AS inward and ↓wages → shifts AS outward
2. Prices of other inputs♦ ↑P of any input → shifts AS inward and ↓P of any input →
shifts AS outward
![Page 36: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/36.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Shifts of the Aggregate Supply Curve
3. Technology and productivity● Technological breakthrough that ↑L productivity → ↑output
per hour of L → ↑profit per unit → ↑Qs● Technological improvements shift AS outward
4. Available supplies of labor and capital● AS curve shifts out if L force↑; ↑L quality; or ↑K stock
because more output can be produced at any given P level.
![Page 37: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/37.jpg)
FIGURE 2. A Shift of the Aggregate Supply Curve
S1
S1 (higher wages)
S0
S0 (lower wages)
100
6,000
Pric
e Le
vel
5,500 Real GDP
A B
![Page 38: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/38.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Equilibrium of Aggregate Demand and Supply
● Intersection of AD and AS determine the equilibrium level of real GDP and the P level.
● Equilibrium (in Fig 3) occurs at a P level = 100 and GDP = $6,000B. ♦ At higher P levels, like 120, Qs > Qd by $800B → ↑inventories
→ ↓prices and ↓output.♦ At lower P levels, like 80, Qd > Qs by $800B → ↓inventories
→ ↑prices and ↑output.
![Page 39: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/39.jpg)
FIGURE 3. Equilibrium Real GDP and the Price Level
Pric
e Le
vel
90
130
110
80
120
D
D S
S
100
6,400 6,800 5,200 5,600 6,000 Real GDP
E
![Page 40: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/40.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Recall: multiplier effect suggests A’s spending becomes B’s income, and B’s spending becomes C’s income, etc.
● Earlier discussion focused on spending and assumed the P level was fixed.♦ Focused on the D-side equilibrium and ignored the reactions of
firms (i.e., the S-side).● Will firms supply the additional demand without ↑P?
♦ Not if AS slopes upward!● Inflation size of the multiplier
Inflation and the Multiplier
![Page 41: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/41.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● In Fig 4, ↑I by $200B which shifts AD out by $800B ($200B x oversimplified multiplier of 4). ♦ Shown by the movement from E0 to A.
● Firms react to higher levels of spending (shift of AD at P level = 100) by ↑output and ↑prices.♦ Shown by the movement from E0 to E1 –along AS curve.
● ↑P level → ↓purchasing power of money-fixed assets → ↓C and ↓X-IM♦ Shown by the movement from A to E1 –along new AD curve.
● Multiplier is only 2 now = ∆Y/∆I = $400B/ $200B.
Inflation and the Multiplier
![Page 42: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/42.jpg)
FIGURE 4. Inflation and the Multiplier
Real GDP (Y)
6,8006,400
100
120
6,000
$800billion
80
110
130
90
NOTE: Amounts are in billions of dollars per year.
Price
Lev
el (Y
)
D1
D1
D0
D0
S
S
E0
E1
Assume I rises by $200B. This raises total expenditure (or Q of AD) by $800 (= $200B x multiplier of 4).
If AS were horizontal → multiplier = 4 and equil GDP would rise to $6,800B.
If AS were vertical → multiplier = 0 and equil GDP would remain at $6,000B.
Here AS is upward sloping and ↑P level with the shift in AD. The multiplier is 2 (= $400B/$200B).
![Page 43: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/43.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Short run: equilibrium of AS and AD may or may not equal full employment GDP♦ Recessionary gap: equilibrium GDP < full employment or
potential GDP♦ Inflationary gap: equilibrium GDP > full employment or
potential GDP● Long run: wages adjust to labor market conditions to
make equilibrium GDP = full employment or potential GDP♦ But this may take a long time!
Recessionary and Inflationary Gaps Revisited
![Page 44: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/44.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Adjusting to a Recessionary Gap
● In Fig. 5, equil GDP falls below the full employment level.
● This might be caused by weak C or low I.● Loose L market
♦ There is UE and jobs are hard to find.♦ Employees may be anxious to keep their jobs.♦ Workers won’t win ↑wage and wages might fall.
● If ↓wages → AS shifts outward →↓P level and ↓UE● Deflation erodes the recessionary gap –but this process
happens very slowly!
![Page 45: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/45.jpg)
FIGURE 5. The Elimination of a Recessionary Gap
100
6,000
Recessionary gap
S0
S0
D
D
Potential GDP
Pric
e Le
vel
7,000 Real GDP
E
S1
S1
F
B
Recessionary gap = $1,000B.
Weak spending and UE at pt E.
Weak labor markets put pressure on wages to fall.
Falling wages shift AS outward which lowers prices.
Falling prices stimulate C and net X.
![Page 46: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/46.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● In the real economy, however, wage reductions are slow and uncertain, particularly in the post-WWII period.
● E.g., even with the severe recession of 1981-82 where UE reached 10%, prices and wages were not forced down –though their rates of increase were.
Adjusting to a Recessionary Gap
![Page 47: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/47.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Why haven’t wages fallen much since WWII?● Institutional factors: like min wages, union contracts, and
gov regulations that place legal floors on wages and prices. These were all developed since WWII.
● Psychological resistance: firms are reluctant to cut wages for fear their employees will resent it and reduce effort.♦ But why wasn’t this true prior to WWII?
Adjusting to a Recessionary Gap
![Page 48: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/48.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Business cycles were less severe: after WWII so firms and workers wait out the bad times rather than accept wage or price cuts.
● Firms lose their best workers: if a firm cuts wages, it may lose its best employees. Individual productivity is hard to measure. The best workers have the greatest opportunities elsewhere.♦ Should have been true before WWII.
● With sticky wages and prices, cyclical unemployment may last a long time.
Adjusting to a Recessionary Gap
![Page 49: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/49.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Adjusting to a Recessionary Gap
● Does the Economy Have a Self-Correcting Mechanism?♦ The economy will self-adjust eventually.
wages demand for labor prices demand for goods and services
♦ But many people believe that gov intervention should help to speed up the process.
● Eg., Recovery from 1990-91 recession took almost 4 years.♦ UE fell from 7.7% to 5.4%♦ Inflation fell from 6.1% to 2.7%
![Page 50: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/50.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Adjusting to a Recessionary Gap
● An Example from Recent History: Disinflation in Japan in the 1990s.♦ Recovery from the 1990-91 recession was weak and
long delayed, but it did eventually come.♦ Practical question: How long can we afford to wait?
![Page 51: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/51.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Adjusting to an Inflationary Gap
● When spending is strong, equil GDP > full employment GDP.
● Labor markets are tight.♦ Jobs are plentiful and L is in demand.♦ Firms will have trouble filling vacant positions and may offer
higher wages to lure workers away from their current jobs.● ↑wages → shifts AS inward →↓output and ↑prices● Inflation occurs because buyers are demanding more
than the economy is capable of producing at normal operating rates.
![Page 52: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/52.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Adjusting to an Inflationary Gap
● In Fig. 6, AS shifts inward → ↑P level → ↓purchasing power of consumer wealth →↓C and ↓X-IM.♦ Shown by the movement from E to F along AD curve.
● Stagflation occurs in the movement from E to F as ↓GDP and ↑P level.
● This process takes time because wages and prices adjust slowly!
![Page 53: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/53.jpg)
FIGURE 6. The Elimination of an Inflationary Gap
S1
S1
S0
S0
D
D
Real GDP
Pric
e Le
vel
E
Inflationary gap
Potential GDP
F
B
![Page 54: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/54.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Adjusting to an Inflationary Gap
● Demand Inflation and Stagflation● Inflationary gap is caused by high levels of spending.
♦ High demand for goods pushes prices and wages higher.♦ Often hear business managers and journalists claim that
↑wages are causing inflation. ♦ Yet, ↑wages are a symptom not the cause of inflation.
● Stagflation that follows a period of excessive AD is comparatively benign; output is falling, but it is still above potential GDP.
![Page 55: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/55.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Adjusting to an Inflationary Gap
● U.S. economy experienced an episode of stagflation between 1988 and 1990.♦ Economy reached UE rate of 5% (15 year low).♦ Inflation rose from 4.4% to 6.1% to cure the inflationary gap.♦ GDP growth rate fell from 3.5% in 1988 to -0.2% in 1990.
![Page 56: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/56.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Stagflation from an Adverse Supply Shock
● In 1973, OPEC x 4 the P of oil.♦ ↑costs of production for U.S. firms
● In 1979-80, OPEC struck again but P of oil x 2.● Same thing happened during 1990 Gulf War –but to a
smaller extent.● ↑P oil → inward shift of AS → ↓GDP and ↑P level.
![Page 57: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/57.jpg)
FIGURE 7. Stagflation from an Adverse Shift in AS
42.2 35.4
3,870
Pric
e Le
vel
3,900
Real GDP
D
D
S1
S1
S0
S0
A
E
In 1973, ↑P of oil x 4 → ↓real GDP by 1% and ↑P level by 19%.
Data from 1973
![Page 58: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/58.jpg)
Managing Aggregate Demand:
Fiscal Policy
![Page 59: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/59.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
● Great Fiscal Stimulus Debate● Income Taxes & the Consumption Schedule● The Multiplier Revisited● Planning Fiscal Policy● Choice Between Spending Policy & Tax Policy● Some Harsh Realities● Supply-Side Tax Cuts
Contents
![Page 60: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/60.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Great Fiscal Stimulus Debate of 2009-10
● Has the $787B stimulus worked?● Republicans: No
♦ Too much spending♦ Not enough tax cuts♦ ↑budget deficit
● Democrats: Yes♦ ↑AD and moderated the recession♦ ↑G impacts the economy sooner and with more certainty than
↓T
![Page 61: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/61.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Income Taxes & Consumption Schedule
● Fiscal policy♦ Government’s plan for spending & taxation♦ Shift AD in desired direction
● Disposable income (DI = Y-T)♦ Where Y = Real GDP and T = Taxes
![Page 62: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/62.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Income Taxes & Consumption Schedule
● Tax increase♦ C f(x) and expenditure schedule shift downward♦ Equilibrium GDP (on the demand side) is decreased
● Tax decrease♦ C f(x) and expenditure schedule shift upward♦ Equilibrium GDP (on the demand side) is increased
![Page 63: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/63.jpg)
FIGURE 1. How tax policy shifts the consumption schedule
Real GDP
Rea
l Con
sum
er S
pend
ing
C
Tax Increase
Tax Cut
![Page 64: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/64.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Multiplier Revisited
● ∆ in G♦ Impacts spending directly
■ through G component of C + I + G + X – IM
● ∆ in T♦ Impacts spending indirectly– through C component♦ Unlike G, not every dollar is spent, some is saved♦ So the multiplier is smaller for T than for G
![Page 65: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/65.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Multiplier Revisited
● Multiplier♦ Reduced by income tax♦ Income tax reduces the fraction of each dollar of GDP
that consumers actually receive and spend● Oversimplified multiplier of 1/(1-MPC)
♦ Overstates the economy’s actual multiplier1. Ignores variable imports 2. Ignores price-level changes 3. Ignores income tax
![Page 66: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/66.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Multiplier Revisited
● Two ways taxes modify the multiplier analysis:1. Tax changes have a smaller multiplier effect than
spending changes by gov or others.2. An income tax reduces the multipliers for both tax
changes and changes in spending.
![Page 67: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/67.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Multiplier Revisited
● Automatic stabilizer: feature of the economy that reduces its sensitivity to shocks
● Changes in spending components (C, I, G, or X-IM) occur all the time and they drive GDP up or down by a multiplied amount. ♦ If the multiplier is smaller → GDP is less sensitive to shocks
and the economy is less volatile● Ex.: personal income tax
♦ Taxes make DI and thereby C less volatile■ E.g., If ↑Y, ↑DI less sharply because part of the rise is absorbed by the
gov which helps limits any ↑C
![Page 68: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/68.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Multiplier Revisited
● UI is also an automatic stabilizer♦ If ↓GDP and ↑UE → UI prevents DI from fallings as
dramatically as earnings♦ UE can maintain their spending better, so C fluctuates less than
employment does● Automatic stabilizers act as shock absorbers and
therefore lower the multiplier♦ Stabilizers (like taxes or UI) work automatically without the
need for gov action
![Page 69: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/69.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Multiplier Revisited
● Gov transfer payments♦ Payments to individuals and not compensation for
production ♦ Intervene between GDP and DI in exactly the opposite
way from income taxes■ Add to earned income (rather than subtract from it)■ Function as negative taxes
![Page 70: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/70.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Planning Fiscal Policy
● Expansionary fiscal policy♦ ↑G, ↓taxes or ↑transfer payments♦ To close recessionary gap between actual and
potential GDP● Contractionary fiscal policy
♦ ↓G, ↑taxes or ↓transfer payments♦ To close inflationary gap between actual and potential
GDP
![Page 71: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/71.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Choice: Spending Policy & Tax Policy
● Any combination of higher spending and lower taxes that produces the same AD curve leads to the same increases in real GDP and prices
● So should policy makers use ↑G or ↓T to ↑AD?♦ How large a public sector do they want?♦ Conservatives argue for smaller government
■ Reduces taxes during recessions and cut spending during booms
♦ Liberals argue for larger government■ Increase spending during recessions and raise taxes during booms
![Page 72: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/72.jpg)
72
Real GDP
Pric
e Le
vel
D0
D0
S
S
D1
D1
A
E
Rise in real GDP
Rise in Price level
FIGURE 2. Expansionary fiscal policy
![Page 73: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/73.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Some Harsh Realities
● Why can’t fiscal policy drive GDP to its full-employment level?
● C, I, and X-IM schedules shift abruptly with changes in expectations, technology, and events abroad, etc.
● Multipliers are unknown● What is the full-employment level of GDP?● Time lag between fiscal policies and their impact on
spending● Congress members (not economists) enact “political”
fiscal policies
![Page 74: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/74.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Some Harsh Realities
● Should policy makers work to push UE lower?♦ ↑G or ↓T will ↑deficits; What are the LR costs of
running large budget deficits?♦ How large will the inflationary cost be?
● If costs are large, then gov may be hesitant to use fiscal policy to fight recessions.
● “Supply-side” economics♦ Battle UE without sparking inflation
![Page 75: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/75.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Idea Behind Supply-Side Tax Cuts
● Certain types of tax cuts♦ Shift AS out which can ↓inflation and ↑real GDP ♦ Raise the returns to working, saving and investing
■ If people respond → ↑SL and ↑SK
● Supply-siders typically advocate tax cuts on:♦ Personal income♦ Income from savings♦ Capital gains♦ Corporate income
![Page 76: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/76.jpg)
76
Real GDP
Pric
e Le
vel
D
DS0
S0
A
S1
S1
B
FIGURE 3. The goal of supply-side tax cuts
![Page 77: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/77.jpg)
77
Real GDP
Pric
e Le
vel
D0
D0
S0
S0
E
S1
S1
D1
D1
A
C
FIGURE 4. A successful supply-side tax reduction
A successful supply-side tax cut will shift both AD and AS.
![Page 78: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/78.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Idea Behind Supply-Side Tax Cuts
● Some complications and undesirable side effects♦ Small magnitude of supply-side effects
■ People may not save more in response to tax incentives.■ Charles Schultz: “There’s nothing wrong with supply-side
economics that division by 10 couldn’t cure.”♦ Demand-side effects
■ People may work more but they will certainly spend more.● Figure 5 (rather than Figure 4) may better represent the
impact of supply-side policies on AD and AS.
![Page 79: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/79.jpg)
79
Real GDP
Pric
e Le
vel
D0
D0
S0
S0
E
S1
S1
D1
D1
C
FIGURE 5. A more pessimistic view of supply-side tax cuts
A supply-side tax cut may shift AD much more than AS.
Inflation now rises as it did under “demand-side” fiscal stimulus in Figure 2.
![Page 80: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/80.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Idea Behind Supply-Side Tax Cuts
● Further complications♦ Problems with timing
■ I incentives are the most promising supply-side tax cuts but it may take years before we see the impact on GDP.
♦ Effects on income distribution■ Reductions in personal income-tax rates and capital gains
taxes increase income inequality.♦ Losses of tax revenue
■ Tax cuts raise the budget deficit.● 15 years to overcome the deficits created by Reagan’s tax cuts
![Page 81: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/81.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Idea Behind Supply-Side Tax Cuts
● Effectiveness of supply-side tax cuts?♦ Tax cuts to raise business I – have the greatest impact♦ Increase AS more slowly than AD
■ Leads to faster economic growth in LR but is not a substitute for SR stabilization policy
♦ Demand-side effects overwhelm supply-side effects in SR
♦ Likely to widen income inequalities♦ Lead to larger budget deficits
![Page 82: Demand-Side Equilibrium: Unemployment or Inflation?](https://reader035.vdocument.in/reader035/viewer/2022081418/56815bef550346895dc9df21/html5/thumbnails/82.jpg)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Great Fiscal Stimulus Debate of 2009-10
● Both political parties wanted to stimulate the economy in 2009 but Republicans wanted less G and more T cuts.
● Democrats argued that the supply-side effects of Republican-proposed tax cuts are small and uncertain and that the economy has too little AD (not too little AS).
● Republicans countered that business tax incentives are the best way to spur LR job creation and that the fiscal multiplier is small or even zero.