macro economics - demand side equilibrium

8/3/2019 Macro Economics - Demand Side Equilibrium

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Prof. Rushen Chahal

Demand-Side Equilibrium:Unemployment or Inflation?

2/12/2012 Prof. Rushen Chahal


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Chapter 8 Part 1

Equilibrium GDP

Income Determination

Aggregate Demand Revisited Demand Side Equilibrium, Employment,

and Inflation

The coordination of saving and investment



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Why Does the Market Permit

Unemployment? Generally Market economies are very good at

finding equilibrium.

But they have always had problems during

depressions and recessions, especially with

unemployment.

What causes this unemployment and why is it

so difficult for markets to fix this problem?



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Equilibrium GDP

Production and Income must be equal.

But what about spending?

Spending can be different from output.



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Equilibrium GDP

What happens if spending exceeds output? Firms begin to take things out of inventory to sell =>

inventories fall

This signals firms that they need to increase output.

Output rises to meet spending.

Possibly in the future prices rise as well.

As a result,

When spending equals output, we are at

equilibrium GDP



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Equilibrium GDP

What if spending is less than output?

Unsold output will be added to firms inventories.

Rising levels of inventories will signal firms to

reduce production

Perhaps in the future they will also decide to

lower prices



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Equilibrium GDP

If spending exceeds output, GDP will rise

If spending is less than output, GDP will fall

The equilibrium level of GDP on the demandside is the level at which total spending equalsproduction. In such a situation, firms find their

inventories remaining at desired levels, so th

eyhave no incentive to change output or prices.(Baumol)



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Three Questions

1. How large is the equilibrium level of GDP?

2. Will the economy suffer from unemployment, inflation,

or both?

3. Is the equilibrium level of GDP on the demand side alsoconsistent with firms desires to produce? That is, is it

also an equilibrium on the supplyside?



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We want to determine the equilibrium level of GDP

on the demand side

Look at the following expenditure schedule for

different levels of GDP in an economy

I, G, and (X IM) are assumed to be constant,

regardless of the levels of GDP C is dependent on GDP



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Total Expenditure Schedule

GDP

(Y)

Consumption

(C)

Investment

(I)

Government

Purchases

(G)

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 6,9002/12/2012 Prof. Rushen Chahal


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This can also be shown graphically.

Notice, again we assume that investmentremains constant at all levels of GDP (might

not happen in real life)



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FIGURE 25-2 Construction of the

Expenditure Schedule

Copyright 2003 South-Western/Thomson Learning. All rights reserved.

G = $1,300

I = $900

C+ I+ G

C+ I+ G + (XIM)

C+ I

C

7,2006,8006,4006,0005,600

6,0006,100

4,800

RealExpenditure

Real GDP

5,200

3,900

XIM =$100



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We can now determine the demand-side

equilibrium in this economy.

The following table explains why GDP of

$6,000 billion must be the equilibrium level



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Total Expenditure Schedule

GDP

(Y)

Consumption

(C)

Investment

(I)

Government

Purchases

(G)

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 6,9002/12/2012 Prof. Rushen Chahal


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TABLE 25-2 The Determination of

Equilibrium Output




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Thus it follows that the condition for

equilibrium GDP is:

Y = C + I + G + (X IM)

This is only true for a GDP level of $6,000billion for this economy



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This can also be shown graphically by

introducing a 45 degree line to the picture



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FIGURE 25-3 Income-Expenditure

Diagram


Spending exceedsoutput

Output exceeds spending

Equilibrium

6,000

RealExpenditure

45

5,200 5,600 6,000 6,400 6,800 7,2000

4,800

5,600

6,400

6,800

7,200

Real GDP4,800

5,200

C + I + G+

(X IM)

E



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The 45 degree line shows all the points at

which output and spending are equal.

The C + I + G + (X IM) shows the different

spending plans of consumers and investors at

different levels of output

Equilibrium is found where the two points

intersect



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FIGURE 25-3 Income-Expenditure

Diagram


Spending exceedsoutput

Output exceeds spending

Equilibrium

6,000

RealExpenditure

45

5,200 5,600 6,000 6,400 6,800 7,2000

4,800

5,600

6,400

6,800

7,200

Real GDP4,800

5,200

C + I + G+

(X IM)

E



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The Aggregate Demand Curve

We still have not introduced the concept of

price levels to the equation

How do we get from the income-expenditure

diagram weve been looking at to the AD

curve?



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The Aggregate Demand Curve

Remember:

At anygiven levelof realincome, higherpriceslead

to lower realconsumerspending. (Baumol)

When prices rise, consumers lose purchasing power, i.e.their real wealth declines

So spending in an economy can decrease with no change inreal income



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Aggregate Demand

The following diagrams show the effect of a rise or decline

in the real wealth in an economy on output.

A rise in the price level is accompanied by a decrease in

output

A drop in the price level is accompanied by an increase inoutput



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FIGURE 25-4 The Effect of the Price

Level on Equilibrium AD


(b)

Fall in Price Level

RealExpenditure

Real GDP

C0 + I+ G + (XIM)

Y0 Y2

(a)

Rise in Price Level

RealExpenditure

Real GDP

C0 + I+ G + (XIM)

Y0Y1

45

45

45

45

C2 + I+ G + (XIM)

E0E0

C1 + I+ G + (XIM)E1

E2



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Aggregate Demand Curve

Conclusion:

A rise in the price level leads to a lower

equilibrium level or real aggregate quantitydemanded



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FIGURE 25-5 The Aggregate Demand

Curve


E2

E0

E1

PriceLevel

Real GDP

P1

P0

P2

Y2Y0Y1



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FIGURE 25-4 The Effect of the Price

Level on Equilibrium AD


(b)

Fall in Price Level

RealExpenditure

Real GDP

C0 + I+ G + (XIM)

Y0 Y2

(a)

Rise in Price Level

RealExpenditure

Real GDP

C0 + I+ G + (XIM)

Y0Y1

45

45

45

45

C2 + I+ G + (XIM)

E0E0

C1 + I+ G + (XIM)E1

E2



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Aggregate Demand

AD slopes downwards because:

1. The effect of higher prices on consumer

wealth2. International trade (higher prices decrease

exports)

3. Interest rates and exchange rate



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Aggregate Demand

This means that:

An income expenditure diagram can only be

drawn for a specific price level

At different price levels, C + I + G + (X IM)

will be different, so it will be a different graph



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Aggregate Demand

We now know how we calculate the demand

side equilibrium of GDP for a given price level

Let us look at inflation and employment as it

relates to this concept



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Demand Side Equilibrium and Full

Employment Does the economy achieve an equilibrium at full

employment without inflation?

What if demand side equilibrium falls above or below

potential GDP?

Equilibrium below potential GDP:

Probably experience unemployment

Equilibrium above potential GDP

Probably experience inflation



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Employment To analyze this further, we introduce potential

GDP as a vertical line

Imagine that demand side equilibrium GDP now is lessthan potential GDP

The gap between potential GDP and Real GDP is a

recessionary gap



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FIGURE 25-6 A Recessionary Gap


Recessionary gap

C+ I + G+ (X IM)

45

45

PotentialGDP

7,000

RealExpenditure

Real GDP

6,000

E

F

B



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Employment

Why might equilibrium be below potential

GDP?

Possible Reasons:

1.Consumers or investors unwilling to spend

at normal rates

2. Government spending too low

3. Foreign demand is weak

4.The price level is too high



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FIGURE 22-2 Actual and Potential

GDP in the United States


9,500

8,500

7,500

Year

9,000

8,000

7,000

6,500

6,000

5,500

5,000

4,500

4,000

3,500

3,000

2,500

2,000

1,500

199919951991198719831979197519711967196319591955

Billionsof1996Dollars Potential GDP

Actual GDP

19821983Recession

19741975

Recession

1960sBoom

19601961Recession19571958

Recession



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Employment Clearly to get us up to potential GDP, there must be

an increase of expenditures

Question: Must a government intervene in order to achieve this?

A drop in price levels would push the

C + I + G + (X IM) line up

But is this possible?

More on this later



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Demand Side Equilibrium and

Inflation

What happens if Real GDP exceeds potential

GDP for a brief period?

This is what many people believe the U.S.

experienced in the late 90s



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Demand Side Equilibrium and

Inflation

Real GDP might exceed potential GDP

because:

1. Consumer or investor spending is unusuallyhigh

2. Foreign demand is strong

3. Government spending is too much4. The price levels are low



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FIGURE 25-7 An Inflationary Gap


Inflationary gap

45

45

PotentialGDP

8,000

RealExpenditure

Real GDP

7,000

C+ I + G+ (X IM)

F

B E



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Demand Side Equilibrium

Only if the price level and spending plans

are just right will the expenditure curve

intersect the 45 degree line precisely at fullemployment, so that neither a

recessionary gap nor an inflationary gap

occurs. (Baumol)



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FIGURE 25-7 An Inflationary Gap


45

45

PotentialGDP

8,000

RealExpenditure

Real GDP

7,000

C+ I + G+ (X IM)

F



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Some Questions to Consider

1. Will the expenditure curve meet the 45 degree line atpotential GDP?

2. Can an economy eliminate inflationary and recessionary

gaps by itself, or does it require government assistance?3. Why do inflation and unemployment sometimes rise

together?

More on this later



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The Coordination of Saving and

Investment

Must the full-employment level of GDP be a

demand-side equilibrium?

Keynes said not necessarily

Look at a simplified version of the circular flow

of money diagram



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Investment

The economy will reach an equilibrium at

full employment on the demand side only if

the amount that consumers wish to save

out of their full-employment incomes

happens to equal the amount that investors

want to invest. (Baumol)



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FIGURE 25-8 A Simplified Circular

Flow


1

3

Investors

Consumers

Financial System

Y

Firms(produce the

domestic product)

2



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Investment The people who save money are not the people who

invest

Their plans may not be coordinated

If saving and investment were always perfectly

coordinated, we never would experience inflation or

unemployment

What can the government do to better coordinate these

two groups?


macro economics - demand side equilibrium

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