University:
California State University, Northridge
Course:
ECON 500 | Survey of Economics
Academic year:

2024
Views:

457

Pages:

29
Author:

Tyler Patton

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 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. The Meaning of Equilibrium GDP ● 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 ● 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 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 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 FIGURE 1. Construction of the Expenditure Schedule C +I+ G C + I + G + (X –IM) X –IM = –$100 6,100 6,000 C+I Real Expenditure G = $1,300 C 4,800 I = $900 3,900 5,200 5,600 6,000 6,400 Real GDP 6,800 7,200 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. The Mechanics of Income Determination ● 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. TABLE 2. The Determination of Equilibrium Output The Mechanics of Income Determination ● 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. FIGURE 2. Income-Expenditure Diagram Output exceeds spending 7,200 45° 6,800 C +I +G + (X – IM) Real Expenditure 6,400 E 6,000 Equilibrium 5,600 5,200 4,800 0 Spending exceeds output 4,800 5,200 5,600 6,000 6,400 6,800 7,200 Real GDP 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. The Aggregate Demand Curve ● 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 ● 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. FIGURE 3. The Effect of the Price Level on Equilibrium AD 45 Real Expenditure C0 + I + G + (X–IM) E0 Price Level C2 + I + G + (X–IM) E2 E1 P1 E0 P0 C1 + I + G + (X–IM) E1 E2 P2 AD 45 Y1 Y0 Y2 Real GDP Change in P level Y1 Y0 Real GDP Y2 Movement along AD curve 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. Demand-Side Equilibrium and Full Employment ● 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 ● If equil GDP > full employment level of GDP → economy has inflation. ● If equil GDP < full employment level of GDP → economy has unemployment. FIGURE 4. A Recessionary Gap Potential GDP Real Expenditure F E 45° C + I + G + (X – IM) Here exp is too low to have full emp. Happens if C, I, G, or X are weak or P level is “too high.” B UE occurs because there isn’t enough output demanded to keep entire L force working. Recessionary gap 45° 6,000 7,000 Real GDP Full emp = $7,000B and equil GDP = $6,000B. Full emp can be reached if exp schedule shifts up to pt F. This could happen without gov intervention if ↓P level. FIGURE 5. An Inflationary Gap Potential GDP 45° Inflationary gap B E Real Expenditure C + I + G + (X – IM) 45° Real GDP 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. F 7,000 Full emp = $7,000B and equil GDP = $8,000B. 8,000 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. 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. 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. TABLE 3. Total Expenditure after a $200 Billion Increase in Investment FIGURE 6. Illustration of the Multiplier 45° C + I1 + G + (X – IM) Real Expenditure E1 $200 billion E0 0 6,000 6,800 Real GDP (or Y) C + I0 + G + (X – IM) Multiplier = ∆Y/∆I = $800/$200 = 4 Or multiplier = 1/(1-MPC) = 1/(1-0.75) = 4 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 The Multiplier Is a General Concept ● ∆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 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). FIGURE 7. Two Views of the Multiplier 45° C + I1 + G + (X – I M ) C + I0 + G + (X – I M ) Real Expenditure E1 $200 billion E0 6,000 0 Price Level D0 100 6,800 D1 E0 E1 D 1 (I = $1,100) D 0 (I = $900) 6,000 6,800 Real GDP

Demand-Side Equilibrium: Unemployment or Inflation?

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