chapter 9 demand side equilibrium rest of world interest rent profits wages goods and services...
TRANSCRIPT
Chapter 9
Demand Side Equilibrium
Rest of World
Interest
RentProfitsWages
Goods and
Services
HouseholdsFirms
S
I
T
G
G
Circular Flow Diagram
C
Total Income
Total Produc
tion
Tota
l
Spendin
g
NX
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… Residential Construction
consumer purchases of new houses and condominiums.
Non-residential construction Equipment, software, buildings, tools,
etc.
Changes in Inventories: unsold goods are included as investment.
Firms Control:
Firms DO NOT Control:
Planned Inventories Unplanned InventoriesPlanned Investment Unplanned Investment
Inventories do not change…
Production100
PlannedInventories
20
ActualInventories
20
Actual Sales100
Total Production = 100
Firms do not change productionTHE 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”
Production100
PlannedInventories
20
PlannedInventories
20
UnplannedInventories 40
Actual Sales60
Total Production = 100
Firms react by reducing production
Actual Inventories
=60
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”
Production100
WantedInventories
20
Total Production = 100
Firms react by increasing production
Actual Sales110
ActualInventories
10Actual
Inventories
10Inventories
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
In the short run, Aggregate Expenditures determine
output.
Firms adjust production to the level of
sales
Aggregate ExpendituresHouseholds 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
Actual Sales100
PlannedInventories
20
Total Productio
n
Net Exports
Consumption
GovernmentSpending
Investment
Building Aggregate Expenditures
AE = C + I + G + NXC = 100 + 0.9YI = 1,000G = 500NX = 300
I + G + NX = 1,800
Purchases of buildings and equipment PLUS planned inventories
Planned Investment
Aggregate Expenditures
Ag
gre
gate
Exp
end
itu
res
=A
E
Real Income = Real GDP = Y
I =
10
00
I =
10
00
AE = C+I+G+NX
AE
G =
5
00
G =
5
00
N X =
30 0
NX =
30
0
Y = 5,000
C = 100 + 0.9Y
C =
9,1
00
I =
10
00
G =
5
00
NX =
30
0
Y = 10,000
C =
17
,20
0I
= 1
00
0G
=
50
0N
X =
30
0
Y = 19,000A
E =
10
,90
0
AE =
19
,00
0
C =
46
00
AE =
6,4
00
C =
22
,60
0I
= 1
00
0G
=
50
0N
X =
30
0
Y = 25,000
AE =
24
,40
0
Aggregate Expenditures
Ag
gre
gate
Exp
end
itu
res
=A
E
Real Income = Real GDP = Y
I =
10
00
I =
10
00
AE = C+I+G+NX
AE
G =
5
00
G =
5
00
N X =
30 0
NX =
30
0
Y = 5,000
C = 100 + 0.9Y
C =
9,1
00
I =
10
00
G =
5
00
NX =
30
0
Y = 10,000
C =
17
,20
0I
= 1
00
0G
=
50
0N
X =
30
0
Y = 19,000A
E =
10
,90
0
AE =
19
,00
0
C =
46
00
AE =
6,4
00
C =
22
,60
0I
= 1
00
0G
=
50
0N
X =
30
0
Y = 25,000
AE =
24
,40
0
AE
Y = 5,000 Y = 10,000 Y = 19,000
AE =
10
,90
0
AE =
6,4
00
AE =
19
,00
0
If total production Y = 5,000
an
d A
gg
reg
ate
Exp
en
ditu
res A
E =
6,4
00
Change in Inventories = 5,000 - 6,400 = -1,400 (Inventories decrease)
If total production Y = 10,000
an
d A
gg
reg
ate
Exp
en
ditu
res A
E =
10
,90
0
Change in Inventories = 10,000 – 10,900 = -900 (Inventories decrease)
If total production Y = 19,000
an
d A
gg
reg
ate
Exp
en
ditu
res A
E =
19
,00
0Change in Inventories = 19,000 – 19,900 = 0 (no change)
AE =
24
,40
0
an
d A
gg
reg
ate
Exp
en
ditu
res A
E =
24
,40
0
If total production Y = 25,000
Change in Inventories = 25,000 – 24,400 = 600 (increase)
Y = 25,000
The Keynesian Cross45 degree line
1000
1000
The 45 lineConverts HorizontalDistances into VerticalDistances.
Income
100
C
D
100 BA
Output
AE
Y = 5,000 Y = 10,000 Y = 19,000
AE =
10
,90
0
AE =
6,4
00
AE =
19
,00
0
AE =
24
,40
0
Y = 25,000
450
AE
Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000
Tota
l Pro
duct
ion
Total Sales=Aggregate Expenditures
AE
Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000
Inventories Decrease
Inventories IncreaseNo change in Inventories
AE
Total Sales=Aggregate Expenditures
Tota
l Pro
duct
ion
If firms end only with WANTED inventories: their actual investment and their planned investment are the same.
With inventories only at the planned level
Total Production
=C + I + G + NX
45A
ggre
gate
Exp
en
dit
ure
s
Real GDPY
No unwanted change inInventories
Y
YC
+I+
G+
NX
C+I+G+NX
AE
45A
gg
reg
ate
Exp
en
dit
ure
s
Real GDPY
Firms will decreaseOutput
Equilibrium Y
C+I+G+NX
AE
Too High Y
Y
C+
I+G
+N
X
Unwanted increase inInventories
45
Ag
gre
gate
Exp
en
dit
ure
s
Real GDPY
Firms will increaseOutput
YC+I+
G+
NX
Equilibrium Y
Unwanted decrease inInventories
Low Y
AE
6,000 is the equilibrium output
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.
Condition that must be satisfied for equilibrium:
Y = C + ISince: Y = C + S (Income is
either consumed or saved)We can rewrite the equilibrium condition
as: C + S = C + I
S = I leakages = Injections
In a closed economy without government the equilibrium
condition is that Savings must be equal to Investment
Interest
RentProfitsWages
Goods and
Services
HouseholdsFirms
S
I
C
Total Income
Total Produc
tionTo
tal
Spendin
g
Closed Economy without Government
What is the equilibrium GDP?
For what value of GDP is:Y = AE?
For what value of GDP is:S = I?
At Y = 5,000 are inventories rising? Falling? Unchanged?For what value of GDP is:Y = AE?
At Y = 3,000 are inventories rising? Falling? Unchanged?
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.
Condition that must be satisfied for equilibrium:
Y = C + I + X-MSince: Y = C + S We can rewrite the equilibrium condition
as: C + S = C + I +X-MS = I + X-
MS+M = I + XS = I +(X-M)
leakages = Injections
In an open economy without government the equilibrium condition says that our savings must be enough to finance private Investment plus the
trade deficit.
Rest of World
Interest
RentProfitsWages
Goods and
Services
HouseholdsFirms
S
I
C
Total Income
Total Produc
tion
Total S
pending
NX
Open Economy without Government
What is the equilibrium GDP?
For what value of GDP is:Y = AE?
For what value of GDP is:S = I+(X-M)?
At Y = 5,000 are inventories rising? Falling? Unchanged?For what value of GDP is:Y = AE?
At Y = 3,000 are inventories rising? Falling? Unchanged?
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.
Condition that must be satisfied for equilibrium:
Y = C + I + G + X-MSince: Y = C + S + T (Income is
used to consume, save and pay taxes)
We can rewrite the equilibrium condition as: C + S + T= C + I + G +X-M
S = I + (G – T)+(X-M)
leakages = Injections
Rest of World
Interest
RentProfitsWages
Goods and
Services
HouseholdsFirms
S
I
T
G
G
C
Total Income
Total Produc
tion
Total S
pending
NX
Open Economy with Government
S+T = I + G + X-MS+T+M = I + G + X
Savings must finance Investment, the government’s deficit and the
trade deficit.
What is the equilibrium GDP?
For what value of GDP is:Y = AE?
For what value of GDP is:S = I +(G-T) +(X-M)?
At Y = 5,000 are inventories rising? Falling? Unchanged?For what value of GDP is:Y = AE?
At Y = 3,000 are inventories rising? Falling? Unchanged?
I + (G-T) + (X-M)
Shifts in the Aggregate Expenditures Line
I =
10
00
I =
10
00
AE
G =
5
00
G =
5
00
N X =
30 0
NX =
30
0
Y = 5,000
C = 100 + 0.9Y
C =
9,1
00
I =
10
00
G =
5
00
NX =
30
0
Y = 10,000
C =
17
,20
0I
= 1
00
0G
=
50
0N
X =
30
0
Y = 19,000A
E =
10
,90
0
AE =
19
,00
0
C =
46
00
AE =
6,4
00
C =
22
,60
0I
= 1
00
0G
=
50
0N
X =
30
0
Y = 25,000
AE =
24
,40
0
When C, I, G or net exports
increase
The AE line shifts up
When C, I, G or net exports
decrease
The AE line shifts down
AE
Y = 5,000 Y = 10,000
AE =
10
,90
0
AE =
6,4
00
AE =
19
,00
0
AE =
6,4
00
Y = 25,000
If AE line shifts down
Equilibrium
Y = 19,000
AE
Y = 5,000
AE =
10
,90
0
AE =
6,4
00
AE =
19
,00
0
AE =
6,4
00
Y = 25,000
Equilibrium
Y = 19,000
Y = 10,000
Equilibrium
If AE line shifts down
Equilibrium output
decreases
AE
Y = 5,000 Y = 10,000
AE =
10
,90
0
AE =
6,4
00
AE =
19
,00
0
AE =
6,4
00
Y = 25,000
If AE line shifts up
Equilibrium
Y = 19,000
AE
AE =
19
,00
0
If AE line shifts up
Equilibrium
Y = 19,000
Y = 25,000
Equilibrium output
increases
Potential GDP
The real gross domestic product (GDP) the economy would produce if its labor force were fully employed
Equilibrium output occurs below Potential GDP
A Recessionary Gap
Equilibrium output occurs above Potential GDP
An Inflationary Gap
B
Potential GDP
At Y = 3000
a) Total Spending > Outputb) Inventories fallc) Total Spending < Outputd) Inventories risee) Total Spending = Outputf) There is no change in Inventoriesg) The economy experiences a
recessionary gaph) The economy experiences a
recessionary gap
At Y = 4,000 At Y = 5000
i) Economy is at equilibrium
Building Aggregate Demand
Matches each price level with the corresponding equilibrium value of output
Aggregate DemandPrice Level
Equilibrium Output
AD
P0
Y0
Real GDP Demanded
When prices increase from P0 to P1, the value of wealth decreases and consumption decreases from C0 to C1.The AE line shifts downand the equilibrium value of output decreases from Y0 to Y1.
Aggregate DemandPrice Level
Equilibrium Output
AD
P0
Y0
When prices increase from P0 to P1, the equilibrium value of output decreases from Y0 to Y1.
P1
Y1
Real GDP Demanded
A movement ALONG the AD line NOT a SHIFT!
When prices decrease from P0 to P2, the value of wealth increases and consumption increases from C0 to C2.The AE line shifts upand the equilibrium value of output increases from Y0 to Y2.
Aggregate DemandPrice Level
Equilibrium Output
AD
P0
Y0
P2
Y2
When prices decrease from P0 to P2, the equilibrium value of output increases from Y0 to Y2.
Real GDP Demanded
A movement ALONG the AD line NOT a SHIFT!
When prices increase from P0 to P1,
Output Y1 corresponds to P1
Output Y2 corresponds to P2the value of wealth
decreases and consumption decreases from C0 to C1.The AE line shifts downand the equilibrium value of output decreases from Y0 to Y1.
When prices decrease from P0 to P2, the value of wealth increases and consumption increases from C0 to C2.The AE line shifts upand the equilibrium value of output increases from Y0 to Y2.
Building the Aggregate Demand Curve
AE0= C+I+G+NX
45AE1= C+I+G+NX
If G,I,C, NX increase
AE line Shifts up Equilibrium Income increase
Y0 Y1
AD0
AD1
Pri
ce level
Real GDP
P0
Y0Y1
Real GDP
Aggre
gate
Expendit
ure
s
Real GDP Demanded
A shift of the AD line NOT a movement
ALONG !
The size of the change in equilibrium Y is the size of the shift in AD
Shifts in the Aggregate Demand Line
Price Level
AD0
P0
Y0Y1
AD1
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).
Real GDP Demanded
AE0= C+I+G+NX
AE1= C+I+G+NX
If G,I,C, NX decrease
AE line Shifts down Equilibrium Income decrease
Y0Y1
AD0
AD1
Pri
ce level
P0
Y0Y1
Real GDP
Aggre
gate
Expendit
ure
s
Real GDP Demanded
A shift of the AD line NOT a movement
ALONG !
The size of the change in equilibrium Y is the size of the shift in AD
Shifts in the Aggregate Demand Line
Price Level
AD0
P0
Y0Y1
AD1
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).
Real GDP Demanded
Factors that shift the consumption function
1. Changes in wealth shift the consumption function. Example: value of stocks, bonds,
consumer durables.2. Changes in consumer expectations
Shift the consumption function. Example: Pessimistic expectations
decrease autonomous consumption.3. Taxes and Transfers
Tax increase or decrease in transfers: decrease disposable income and shift the consumption function down.
4. Prices Affect the purchasing power of
assets.
Shift up in AE lineShift right in AD line
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
= 7,000-6,000 =1,000
A recessionary gap occurs when actual GDP falls SHORT of
full employment GDP
To increase AE, we
need an increase in C, I, G
or NX
To eliminate a recessionary gap, AE
must rise.
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.
= 7,000-8,000 =-1,000
An inflationary gap occurs
when equilibrium GDP is higher than
full employment GDP
To decrease AE, we need a
decrease in C, I, G
or NX
To eliminate
an inflationary gap, AE must fall.
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.
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 Improvementh)Government spending Increase (decrease)i) Taxes Increase (decrease)j) Transfers Increase (decrease)
Questions to prepare for test
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 continuedLabel 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 40,000E. 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.
40,000 50,00025,000
49,000
26,500
