Demand Side Equilibrium

1
Chapter 9

• Demand Side Equilibrium

2
Consumption changes with Disposable Income
C a MPCYd
C a MPC(Y-TxTr)
C1
Y National Income Wages Profits Interest Rents
Move UP Along C
C0
Yd Y- Tx Tr
Yd0
Yd1
3
Aggregate Expenditures change with National Income
AE
NX 300
NX 300
G 500
NX 300
AE C I G NX
NX 300
G 500
G 500
G 500
I 1000
I 1000
AE 24,400
I 1000
AE 19,000
AE 10,900
I 1000
AE 6,400
C a MPC(Y-TxTr)
C 22,600
C 17,200
C 100 0.9Y
C 9,100
C 4600
Y 5,000
Y 10,000
Y 19,000
Y 25,000
National Income Y
4
C a MPC(Y Tr Tx) C a MPC (Tr Tx)
MPCY
New Intercept increase with an increase in Tr or
a drop in TX
New Intercept A
Old C a MPCYd
New C shifts with a change in Tr or TX
C1
New C A MPCY
Move UP Along C
C0
Y National Income Wages Profits Interest Rents
Increase in National Income Y
Y
Y0
Y1
5
Aggregate Expenditures
AE
NX 300
NX 300
G 500
AE CIGNX
NX 300
NX 300
G 500
G 500
G 500
1001800
I 1000
AE 1900 0.9Y
I 1000
1900
I 1000
IGNX1800
I 1000
C 22,600
C 17,200
New C 100 0.9Y
C 9,100
C 4600
100
Y 5,000
Y 10,000
Y 19,000
Y 25,000
National Income/GDP (Y)
6
Produced 19,000 Sold19,000 Inventories do not
change Firms do not change Production
AE Total sales to consumers, firms, government
and other countries
Produced 5,000 Sold 6,400 Inventories fall Firms
increase Production
AE 1,900 0.9 Y
Produced 10,000 Sold 10,900 Inventories
fall Firms increase Production
Sold
24,400
19,000
Produced 25,000 Sold 24,400 Inventories
rise Firms decrease Production
10,900
6,400
Produced
Y
5,000
10,000
19,000
25,000
7
AE
24,400
Equilibrium
19,000
Produced 19,000 Sold19,000 Inventories do not
change Firms do not change Production
10,900
6,400
Y
5,000
10,000
19,000
25,000
8
Firms will decrease production
Firms will not change production
AE
AE
Firms will increase production
Change in Inventories 19,000 19,900 0 (no
change)
Change in Inventories 25,000 24,400 600
(increase)
Change in Inventories 10,000 10,900 -900
(decrease)
Change in Inventories 5,000 - 6,400 -1,400
(decrease)
25,000
19,000
24,400
19,000
10,900
and Aggregate Expenditures AE 19,000
and Aggregate Expenditures AE 24,400
6,400
and Aggregate Expenditures AE 6,400
10,000
and Aggregate Expenditures AE 10,900
If total production Y 10,000
If total production Y 25,000
If total production Y 5,000
If total production Y 19,000
5,000
Y 5,000
Y 10,000
Y 19,000
Y 25,000
9
The Keynesian Cross
The 45 line Converts Horizontal Distances into
Vertical Distances.
Output
45 degree line
Income
10
AE
450
Y 5,000
Y 10,000
Y 19,000
Y 25,000
11
AE
Total SalesAggregate Expenditures
Total Production
450
Y 5,000
Y 10,000
Y 19,000
Y 25,000
12
At Equilibrium there is NO change in Inventories
Inventories Increase
Y
AE
AECIGX-M
AE
AE
AE (Sales)
Aggregate Expenditures
Total Production
Inventories Decrease
Y(Production)
For any output level below equilibrium
For any output level above equilibrium
Total Production (Y)
13
AE
The AE line shifts up
NX 300
NX 300
G 500
AE CIGNX
NX 300
The AE line shifts down
NX 300
G 500
G 500
G 500
If C, I, G or NX increase
I 1000
I 1000
AE 24,400
I 1000
AE 19,000
If C, I, G or NX drop
C 100 0.9Y
AE 10,900
I 1000
AE 6,400
C 22,600
C 17,200
C 9,100
C 4600
I 1000
G 500
NX 300
Y 5,000
Y 10,000
Y 19,000
Y 25,000
Real Income Real GDP Y
14
AE
Equilibrium
450
Y
15
Equilibrium
Equilibrium
AE
If AE line shifts down
Y gt AE Inventories increase
Firms decrease output
Equilibrium output decreases
Lower Y
16
Equilibrium
New Equilibrium
AE
If AE line shifts up
AEgtY Inventories Decrease
Firms Increase Output
Equilibrium output increase
Higher Y
Y
17
Spending Leakages
Income that does not come back to buy goods and
services
18
Imports
Taxes
Government spending
Exports
Spending Injections
Saving
Investment
19
Equilibrium
Not enough spending Inventories accumulate
Spending Output inventories do not change
Leakages
STM
Leakages larger than Injections
IGX
IGXSTM
Injections Larger than Leakages
Injections
Y below equilibrium
Y Equilibrium
Y above equilibrium
Too much spending inventories fall
20
AE Total Purchases of Goods and Services
AE 1,900 0.9 Yd
AE 100 1,800 0.9Yd
22,600 1,800 24,400
AE C (IGNX) AE C 1,800
17,200 1,800 19,000
AE 100 0.9Y 1,800
9,100 1,800 10,900
4,600 1,800 6,400
Y
5,000
10,000
19,000
25,000
Find the value of AECIGNX for each of these
values of Y
21
(No Transcript)
22
Find the value of consumption for each of these
values of Y
C 1000.9Y
22,600
17,200
9,100
4,600
Y
5,000
10,000
19,000
25,000
23
I 1,000 G 500 NX 300
IGNX
1,800
1,800
1,800
1,800
1,800
5,000
10,000
19,000
25,000
Find the value of IGNX for each of these values
of Y
24
45
Too much Demand for output
Y gt AE
Inventories increase
CIGNX
Y lt AE
AE
Inventories fall
Not enough Demand for output
Equilibrium
Leakages Injections
STM
Y Equilibrium
Leakages gt Injections
Injections gt Leakages
IGX
IGXSTM
Y Equilibrium
Y below equilibrium
Y above equilibrium
25

• At equilibrium,
• Leakages Injections
• STM I G X
• Rearrange
• S I (G-T) (X-M)

Savings finance
Investment
26
What is the equilibrium GDP?
At Y 5,000 are inventories rising? Falling?
Unchanged?
At Y 3,000 are inventories rising? Falling?
Unchanged?
For what value of GDP is Y AE?
For what value of GDP is Y AE?
For what value of GDP is S I (G-T) (X-M)?
I (G-T) (X-M)
27
Aggregate Expenditures

• Matches
• Aggregate Expenditures C I G NX
• with the corresponding value of
• output

28
Aggregate Demand

• Matches the
• price level with the corresponding value of
  equilibrium
• output

29
Aggregate Demand
Price Level
P0
AD
Real GDP Demanded
Y0
30
Two things to remember when you use the AD line
1. An increase in prices, decrease the purchasing
power of Wealth
31
Two things to remember when you use the AD line
2. An increase in prices, decrease Consumption
C
C0
C1
Consumption Decrease
Y
Y0
32
Two things to remember when you use the AD line
An increase in prices,
1. Decrease the purchasing power wealth
2. Decrease Consumption
33
The equilibrium value of output decrease from Y0
to Y1.
When prices increase from P0 to P1,
The real value of wealth decreases and
consumption decreases from C0 to C1.
C
C0IGNX
The AE line shifts down
C1IGNX
450
Y
Y1
Y0
34
Aggregate Demand
Price Level
A movement ALONG AD NOT a SHIFT!
P1
Y1
Y0
When prices increase equilibrium output decreases
P0
AD
Y0
Y1
Equilibrium Output
Real GDP Demanded
35
The equilibrium value of output increase from Y0
to Y2.
When prices decrease from P0 to P2
The real value of wealth increase and consumption
increase from C0 to C2.
C
C2IGNX
The AE line shifts up
C0IGNX
450
Y
Y2
Y0
36
Aggregate Demand
Price Level
A movement ALONG AD NOT a SHIFT!
When prices drop, equilibrium output increases
P0
P2
AD
Y0
Y2
Equilibrium Output
Real GDP Demanded
37
Lower Output Y1 corresponds to higher prices P1
Building the Aggregate Demand Curve
When prices increase from P0 to P1,
When prices decrease from P0 to P2,
Equilibrium Output drops from Y0 to Y1.
Equilibrium output increases from Y0 to Y2.
Higher Output Y2 corresponds to lower prices P2
Inverse Relationship between Aggregate Output
Demanded and Price Level
38
The Consumption Function

• C a MPC Yd

Consumption responds to changes in after tax
income
Consumption responds to changes in wealth, prices
and expectations
Changes in income Movement Along the C line.
Changes in wealth, prices and expectations Shift
C line
Shift C
39
If G,I,C, NX increase
AD shifts NOT a movement ALONG !
AE line Shifts up
Price level
45
AE1 CIGNX
Aggregate Expenditures
Prices are the same
AE0 CIGNX
P0
AD1
The size of the change in equilibrium Y
Is the size of the shift in AD
AD0
Y1
Y0
Y0
Y1
Equilibrium Income increase
40
AD Shifts
If C, I, G or NX increase, AE shifts up
Equilibrium output increases AD shifts right
(outward).
When prices drop, C shifts up, AE shifts up
Equilibrium output increases AD does NOT shift!
But move along
Price Level
Except when prices drop!
P0
P1
AD1
AD0
Real GDP Demanded
Y1
Y0
41
If G,I,C, NX decrease
AD shifts NOT a movement ALONG !
AE line Shifts down
Price level
AE0 CIGNX
Aggregate Expenditures
AE1 CIGNX
Prices are the same
P0
The size of the change in equilibrium Y
Is the size of the shift in AD
AD0
AD1
Y0
Y1
Y0
Y1
Equilibrium Income decrease
42
AD Shifts
If C, I, G or NX decrease, AE shifts down,
Equilibrium output decrease, AD shifts left
(inward).
When prices increase, C shifts down, AE shifts
down, Equilibrium output decrease, A movement
along AD
Price Level
P1
Except when prices rise!
P0
AD1
AD0
Y0
Y1
43
Interest Rates drop Investment increase by DI
AE1CGI1NX
AE0CGI0NX
DAEDI
AE shifts up
AE1AE1CGI1NX
AE0CGI0NX
Equilibrium Output Increase
DY
44
The Shift in AD is the same as the increase in
Equilibrium output
DI
Da
DG
DI
DG
DNX
AE1
AE0
DAE
AE1
AE0
DY
45
The increase in GDP Shift in AD
DY
Excess Demand AE gt Y, inventories drop. If
there is excess capacity and Unemployment, firms
increase output but DO NOT raise prices
Price level
DY
P0
AD1
AD0
Y0
Y2
Real GDP
46
The increase in GDP SMALLER than Shift in AD
DY
AS1
Excess Demand AE gt Y, inventories drop. With
some excess capacity and lower unemployment,
firms increase both production and prices.
Price level
P1
)
DY DG (1/1-MPC)
P0
DY
AD1
AD0
Real GDP
Y0
Y1
Y2
47
No Increase in GDP
DY0
Price level
Excess Demand AE gt Y, inventories drop. With NO
excess capacity and zero unemployment, firms
cannot increase production, only prices rise.
AS1
P1
DY DG (1/1-MPC)
P0
AD1
AD0
DY0
Y0
48
450
Potential GDP
Where we want to be zero cyclical unemployment,
no excess capacity
AE
AE
Equilibrium
Equilibrium GDP where the economy is stuck
Equilibrium GDP
Potential GDP
49
To increase AE, we need an increase in C, I, G or
NX
To eliminate a recessionary gap, AE must rise.
B
E
Recessionary gap when actual GDP is lower than
full employment GDP
Distance E-B
Economy is producing less than desired output
Recessionary Gap
7,000-6,000 1,000
50
Increase AE to Eliminate a Recessionary/Deflationa
ry Gap

• To increase Consumption Decrease taxes or
  increase transfers.
• To increase Investment
• Tax incentives.
• Lower interest rates
• Increase Government Spending
• To increase Exports and decrease Imports Make
  dollar weaker (increasing supply of dollars)

51
To decrease AE, we need a decrease in C, I, G or
NX
To eliminate an inflationary gap, AE must fall.
Labor shortages Firms trying to hire workers who
already have a job
Inflationary gap when Equilibrium GDP is higher
than Full Employment GDP
7,000-8,000 -1,000
52
Decrease AE to o Eliminate an Inflationary Gap

• Decrease Consumption increase taxes or decrease
  in transfers.
• Decrease Government Spending
• Increase interest rates
• Decrease exports and increase imports stronger
  dollar.

53
Which AE line will cause a recessionary gap?
Which AE line will cause an Inflationary gap?
54
Assume the Economy is at Equilibrium

1. GDP ?
2. Is total spending larger than/smaller than/equal
   to Output?
3. Do Inventories fall, rise or remain unchanged?
4. Does the economy experience a recessionary/inflati
   onary gap?
5. What is the size of the gap?
6. How can the gap be closed?

55
Assume the Economy is at Equilibrium

1. GDP ?
2. Is total spending larger than/smaller than/equal
   to Output?
3. Do Inventories fall, rise or remain unchanged?
4. Does the economy experience a recessionary/inflati
   onary gap?
5. What is the size of the gap?
6. How can the gap be closed?

56
Potential GDP
CIGNX
At Y3000
At Y4000
At Y5000

1. Is the economy at equilibrium ?
2. Total Spending( gt lt )Output
3. Inventories (rise, fall, remain the same)
4. Firms will (increase, decrease, not
   change)output.
5. Once the Economy reaches equilibrium, will the
   economy experience a (recessionary, inflationary)
   gap?
6. Is the economy experiencing unemployment or labor
   shortages?

1. Is the economy at equilibrium ?
2. Total Spending( gt lt )Output
3. Inventories (rise, fall, remain the same)
4. Firms will (increase, decrease, not
   change)output.
5. Does the economy experience a (recessionary,
   inflationary) gap?
6. Is the economy experiencing unemployment or labor
   shortages?

1. Is the economy at equilibrium ?
2. Total Spending( gt lt )Output
3. Inventories (rise, fall, remain the same)
4. Firms will (increase, decrease, not
   change)output.
5. Once the Economy reaches equilibrium, will the
   economy experience a (recessionary, inflationary)
   gap?
6. Is the economy experiencing unemployment or labor
   shortages?

57
Effect of an increase in Autonomous Spending
DNX
DG
DI
Da
C a MPCYd
AE shifts up
AE1
AE0
DAE
AE1
AE0
DY
Equilibrium Output Increase
Aggregate Demand shifts Right
58
Using the MPC DC/DY
DC DYMPC
DC DYMPC
DC 10000.7
2250700 2950
?
DC 700
MPC 0.7
2250
a
DY 1000
1000
2000
59
45
The Multiplier effect
AE1
Government Spending has a multiplicative effect
on equilibrium output
Output Increase by MORE than DG
AEo
Increase in induced consumption Move up along C
and AE
AE1Y1
Dc 810.9
Sum DC
Dc 900.9
81
90
Newly employed buy more goods and services
DG
Inventories Drop-100
AE0Y0
DY DG sum Dc
DY DAE
DY90
DY81
Y
Y0
Y1
60
We can write the total change in spending as


100 0.9
100 0.9 0.9
100
100
100 0.9
DG

• C

• C

100 0.9 0.9 0.9 0.9
100 0.9 0.9
100 0.9 0.9 0.9
100 0.9 0.9 0.9

• C

• C

and so on


61
Factor out 100
This infinite sum of terms equals
For any increase in autonomous spending and any
MPC
Da
DI


1
0.9
100(
0.92
DG
100 0.9
100
100 0.9 0.9
100
100
DNX


0.94
0.93
100
100
100 0.9 0.9 0.9
100 0.9 0.9 0.9 0.9
MPC

)
0.95 0.96
Autonomous Spending Multiplier
62
Use the Autonomous Spending Multiplier
To calculate the chain of spending generated from
an increase in Government Spending Investment Au
tonomous Consumption Net exports
DG
DI
Da
DNX
63
45
The Multiplier
AE1
AEo
Da
DI
DNX
AE0Y0
DI
DG
Da
DY DG (multiplier)
DNX
Y
Y0
Y1 Y0DY
64
G increase by DG 700
MPC0.9
To calculate the change in Equilibrium Y use the
Multiplier formula
AE1
(1- MPC)
1
AE0
D Y DG x
DAE 700
AE1
(1- 0.9)
1

• D Y

700 x
AE0
D Y 700 (1/0.1) 7000
10
DY 7000
A 700 increase in government spending generates a
7000 increase in output.
65
The Shift in AD is the same as the increase in
Equilibrium output
AE1
AE0
DAE 700
AE1
AE0
DY 7000
DY 7000
66
Output increases by Full Multiplier Amount
AD Shifts by the full multiplier amount DY DG
(1/1-MPC)
Excess Demand AE gt Y, inventories drop. If
there is excess capacity and Unemployment, firms
increase output but DO NOT raise prices
Price level
DY DG (1/1-MPC)
P0
AD1
AD0
Y0
Y2
Real GDP
67
Inflation Reduces the Size of the Multiplier
Excess Demand AE gt Y, inventories drop. With
some excess capacity and lower unemployment,
firms increase both production and prices.
AS1
Price level
P1
DY DG (1/1-MPC)
DY DG (1/1-MPC)
P0
AD1
AD0
Real GDP
Y0
Y1
Y2
Output increase by less than the multiplier amount
68
At Full Employment there is NO multiplier effect
Price level
AS1
Excess Demand AE gt Y, inventories drop. With NO
excess capacity and zero unemployment, firms
cannot increase production, only prices rise.
P1
DY DG (1/1-MPC)
DY DG (1/1-MPC)
P0
AD1
AD0
Y0
Real GDP
69
What is the necessary DG ?
MPC0.9
AE1
(1- MPC)
1
AE0
DY DG x
DAE ?
(1- 0.9)
1

• 1,000

DG x
AE1
AE0
1,000 DG (1/0.1)
DG 1,000 /10 100
DY 1,000
70
Effect of Expansionary Policy
As the economy gets closer to Potential GDP, the
slope of AS increase (steeper)
At Full Employment
Only Prices rise
Closer to Full Employment
Prices Increase
Prices do Not change
Below full employment
Output Increases by full multiplier
Output Increases by less than multiplier
Output can not increase no multiplier effect
71
5,500
4,750
4,000
3,250
2,500
6,000
7,000
2,000
3,000
4,000
5,000
72
MPC0.9

• The economy must be operating in segment
• A - B
• B D
• D G
• None of the above

Labor costs are rising due to labor shortages.
The main effect of an increase in G is an
increase in prices.
After a 40 billion increase in G , inflation rose
and output remained the same
An increase in investment has the largest
multiplier effect.
A 50 billion increase in G resulted in a 500
increase in output
A 50 billion increase in G resulted in a 400
increase in output
73
Y C I G X M NX AE S Change in Inventories Firms react by LeakagesSTM Injections IGX
15000 15000 900 500 700 500              
19000 18200 900 500 700 500              
23000 21400 900 500 700 500              
27000 24600 900 500 700 500              
31000 27800 900 500 700 500              

1. Calculate the MPC and the intercept of the
   consumption function. Show your work
2. Write the Consumption equation
3. Write the Savings equation
4. Calculate NX(fill in the values in the table)
   Show your work
5. Write the AE equation
6. Calculate AE (fill in the values in the table)
   Show your work
7. Calculate S (fill in the values in the table)
   Show your work
8. Calculate the Change in Inventories (fill in the
   values in the table) be sure to write a sign (
   or -) for increase or decrease. Show your work
9. Write in each space in the table how do firms
   react to the change in inventories? Do they
   increase/decrease production?
10. Calculate Leakages and Injections (fill in the
    values in the table) Show your work
11. What is the equilibrium value of GDP?
12. Are Leakages Injections at equilibrium?
13. Why is the economy at equilibrium at this Output
    level?
14. Fill in ALL blank boxes in the graphs

74
Y C I G X M NX AE S Change in Inventories Firms react by LeakagesSTM Injections IGX
15000 15000 900 500 700 500 200 16600 0 -1600 Inc Y 500 2100
19000 18200 900 500 700 500 200 19800 800 -800 Inc Y 1300 2100
23000 21400 900 500 700 500 200 23000 1600 0 No change 2100 2100
27000 24600 900 500 700 500 200 26200 2400 800 Dec Y 2900 2100
31000 27800 900 500 700 500 200 29400 3200 1600 Dec Y 3700 2100
75
Questions for review

1. Determine the effect on AE, AD, Equilibrium
   output

1. Prices Increase (decrease) in red because
   changes in prices do not shift the AD line!
2. NX Increase (decrease)
3. Exports Increase (decrease)
4. Imports Increase (decrease)
5. Wealth Increase (decrease)
6. Interest rates Increase (decrease)
7. Technological Improvement
8. Government spending Increase (decrease)
9. Taxes Increase (decrease)
10. Transfers Increase (decrease)

76
  AE component affected Shift? Movement Along? AE Shifts Equilibrium Y AD
Prices Increase C drops due to wealth effect consumers feel poor C shifts down down decreases Movement up along
Prices Decrease C increases due to wealth effect consumers feel rich C shifts up up increases Movement down along
NX Increase NX increase NX shifts up up increases shifts right
NX Decrease NX decrease NX shifts down down decreases shifts left
Exports Increase NX increase NX shifts up up increases shifts right
Exports Decrease NX decrease NX shifts down down decreases shifts left
Imports increase NX decrease NX shifts down down decreases shifts left
Imports Decrease NX increase NX shifts up up increases shifts right
Wealth Increase C increases due to wealth effect C shifts up up increases shifts right
Wealth Decrease C drops due to wealth effect C shifts down down decreases shifts left
77
  AE component affected Shift? Movement Along? AE Shifts Equilibrium Y AD
Interest rates increase Investment drops I shifts down down decrease shifts left
Interest rates Decrease Investment Increases I shifts up up increase shifts right
Technological Improvement Investment increases I shifts up up increase shifts right
Government Spending Increase G increases G shifts up up increase shifts right
Government Spending Decrease G drops G shifts down down decrease shifts left
Taxes Increase C drops C shifts down down decrease shifts left
Taxes Decrease C increases C shifts up up increase shifts right
Transfers Increase C increases C shifts up up increase shifts right
Transfers Decrease C drops C shifts down down decrease shifts left
78
Practice

1. Determine the effect on Aggregate Expenditures.
   Identify the component of AE which is affected
   (C, I, G, X or M) and explain how it is affected.

1. Prices in the US Increase (decrease) relative to
   prices abroad.
2. The U.S. dollar becomes weaker (stronger)
3. Home prices collapse (increase)
4. Stock prices collapse (increase)
5. Interest rates Increase (decrease)
6. A zero-emissions engine is developed.
7. Government announces an Increase (decrease) in
   the number of troops deployed abroad.
8. As the economy recovers (enters into a recession)
   incomes increase (drop).

79
AE component affected Shift? Movement Along? AE Shifts
Relative US Prices Increase US prices higher to foreigners X fall. Foreign prices seem lower to Americans M rise NX shifts down down
Relative US Prices Decrease US prices seem cheaper to foreigners X rise. Foreign prices seem higher to Americans M drop NX shifts up up
Dollar weaker Dollar buys less foreign currency US prices seem cheaper to foreigners X rise. Foreign prices seem higher to Americans M drop NX shifts up up
Dollar Stronger Dollar buys more foreign currency US prices seem higher to foreigners X drop. Foreign prices seem lower to Americans M rise NX shifts down down
80
  AE component affected Shift? Movement Along? AE Shifts
Home prices drop C drops (consumers are poorer) C shifts down down
Home prices rise C rise (consumers are richer) C shifts up up
Stock prices drop C drops (consumers are poorer) C shifts down down
Stock prices rise C rise (consumers are richer) C shifts up up
Interest rates increase Investment drops I shifts down down
Interest rates Decrease Investment Increases I shifts up up
Zero Emissions Engine invented Investment increases I shifts up up
Government Spending Increase (increase Troops) G increases G shifts up up
Government Spending Decrease (Decrease Troops) G drops G shifts down down
Recession (Income Drops) Disposable Income drops C drops Movement down along C down
Expansion (Incomes Increase) Disposable Income increase C increase Movement up along C up
81
Practice

• Label the two lines in the next slide.
• Use the information in the graph to find the
  following
• Find the slope of the AE line. Recall the slope
  of the AE line is the MPC.
• Find the intercept of the AE line.
• Write down the equation of the AE line.
• Find the value of AE when income is 40,000
• What is the equilibrium value of income/output in
  this case?
• Find the value of AE when income is 50,000 and
  when income is 25,000.
• Fill in the values for each box in the graph.