Demand-Side Equilibrium: Unemployment or Inflation?

Prof. Rushen Chahal

2/12/2012 Prof. Rushen Chahal

Chapter 8 Part 1
Equilibrium GDP Income Determination Aggregate Demand Revisited Demand Side Equilibrium, Employment, and Inflation The coordination of saving and investment

2/12/2012

Prof. Rushen Chahal

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?
2/12/2012 Prof. Rushen Chahal

Equilibrium GDP
Production and Income must be equal. But what about spending? Spending can be different from output.

2/12/2012

Prof. Rushen Chahal

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
2/12/2012 Prof. Rushen Chahal

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

2/12/2012

Prof. Rushen Chahal

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 demand side is the level at which total spending equals production. In such a situation, firms find their inventories remaining at desired levels, so they have no incentive to change output or prices. (Baumol)
2/12/2012 Prof. Rushen Chahal

Three Questions
1. 2. 3. How large is the equilibrium level of GDP? Will the economy suffer from unemployment, inflation, or both? Is the equilibrium level of GDP on the demand side also consistent with firms desires to produce? That is, is it also an equilibrium on the supply side?

2/12/2012

Prof. Rushen Chahal

Income Determination
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

2/12/2012

Prof. Rushen Chahal

Total Expenditure Schedule

GDP (Y) Consumption Investment Government Net Total (C) Purchases Exports Expenditure (I) (G) (X IM)

4,800 5,200 5,600 6,000 6,400 6,800

2/12/2012 7,200

3,000 3,300 3,600 3,900 4,200 4,500 4,800

900 900 900 900 900 900

1,300 1,300 1,300 1,300 1,300 1,300

-100 -100 -100 -100 -100 -100 -100

5,100 5,400 5,700 6,000 6,300 6,600 6,900

Prof. 900 Rushen Chahal 1,300

Income Determination
This can also be shown graphically. Notice, again we assume that investment remains constant at all levels of GDP (might not happen in real life)

2/12/2012

Prof. Rushen Chahal

FIGURE

25-2 Construction of the Expenditure Schedule

C + I+ G C + I + G + (X I M) X IM = $100 6,100 6,000 C+I Real Expenditure G = $1,300

4,800

I = $900

3,900

5,200

5,600

6,000

6,400 Real GDP

6,800

7,200

2/12/2012

Prof. Rushen Chahal

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

Income Determination
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

2/12/2012

Prof. Rushen Chahal

Total Expenditure Schedule

GDP (Y) Consumption Investment Government Net Total (C) Purchases Exports Expenditure (I) (G) (X IM)

4,800 5,200 5,600 6,000 6,400 6,800

2/12/2012 7,200

3,000 3,300 3,600 3,900 4,200 4,500 4,800

900 900 900 900 900 900

1,300 1,300 1,300 1,300 1,300 1,300

-100 -100 -100 -100 -100 -100 -100

5,100 5,400 5,700 6,000 6,300 6,600 6,900

Prof. 900 Rushen Chahal 1,300

TABLE

25-2 The Determination of Equilibrium Output

2/12/2012

Prof. Rushen Chahal

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

Income Determination
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 $6,000 billion for this economy

2/12/2012

Prof. Rushen Chahal

Income Determination
This can also be shown graphically by introducing a 45 degree line to the picture

2/12/2012

Prof. Rushen Chahal

FIGURE

25-3 Income-Expenditure Diagram

Output exceeds spending 45

7,200 6,800 6,400 Real Expenditure

C +I +G+ (X IM) E

6,000 Equilibrium 5,600 5,200 4,800 Spending exceeds output 4,800 5,200 5,600 6,000 6,400 6,800 7,200 Real GDP
Prof. Rushen Chahal
Copyright 2003 South-Western/Thomson Learning. All rights reserved.

2/12/2012

Income Determination
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
2/12/2012 Prof. Rushen Chahal

FIGURE

25-3 Income-Expenditure Diagram

Output exceeds spending 45

7,200 6,800 6,400 Real Expenditure

C +I +G+ (X IM) E

6,000 Equilibrium 5,600 5,200 4,800 Spending exceeds output 4,800 5,200 5,600 6,000 6,400 6,800 7,200 Real GDP
Prof. Rushen Chahal
Copyright 2003 South-Western/Thomson Learning. All rights reserved.

2/12/2012

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 we ve been looking at to the AD curve?

2/12/2012

Prof. Rushen Chahal

The Aggregate Demand Curve

Remember: At any given level of real income, higher prices lead to lower real consumer spending. (Baumol) When prices rise, consumers lose purchasing power, i.e. their real wealth declines So spending in an economy can decrease with no change in real income
2/12/2012 Prof. Rushen Chahal

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 in output

2/12/2012

Prof. Rushen Chahal

FIGURE

25-4 The Effect of the Price Level on Equilibrium AD

45 E2 45 C2 + I + G + (XIM)

Real Expenditure

Real Expenditure

C0 + I + G + (XIM) E0 C1 + I + G + (XIM)

E0

C0 + I + G + (XIM)

E1

45 Y1 Y0 Real GDP (a) Rise in Price Level

45 Y0 Y2 Real GDP (b) Fall in Price Level

2/12/2012

Prof. Rushen Chahal

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

Aggregate Demand Curve

Conclusion: A rise in the price level leads to a lower equilibrium level or real aggregate quantity demanded

2/12/2012

Prof. Rushen Chahal

FIGURE

25-5 The Aggregate Demand Curve

Price Level

P1 P0

E1 E0 E2

P2

Y1 Y0 Y2 Real GDP
2/12/2012 Prof. Rushen Chahal
Copyright 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE

25-4 The Effect of the Price Level on Equilibrium AD

45 E2 45 C2 + I + G + (XIM)

Real Expenditure

Real Expenditure

C0 + I + G + (XIM) E0 C1 + I + G + (XIM)

E0

C0 + I + G + (XIM)

E1

45 Y1 Y0 Real GDP (a) Rise in Price Level

45 Y0 Y2 Real GDP (b) Fall in Price Level

2/12/2012

Prof. Rushen Chahal

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

Aggregate Demand
AD slopes downwards because: 1. The effect of higher prices on consumer wealth 2. International trade (higher prices decrease exports) 3. Interest rates and exchange rate

2/12/2012

Prof. Rushen Chahal

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

2/12/2012

Prof. Rushen Chahal

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

2/12/2012

Prof. Rushen Chahal

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
2/12/2012 Prof. Rushen Chahal

Demand Side Equilibrium and Full Employment

To analyze this further, we introduce potential GDP as a vertical line Imagine that demand side equilibrium GDP now is less than potential GDP The gap between potential GDP and Real GDP is a recessionary gap

2/12/2012

Prof. Rushen Chahal

FIGURE

25-6 A Recessionary Gap

Potential GDP 45

F Real Expenditure C + I + G + (X IM)

E B Recessionary gap

45 6,000 7,000 Real GDP

2/12/2012 Prof. Rushen Chahal
Copyright 2003 South-Western/Thomson Learning. All rights reserved.

Demand Side Equilibrium and Full 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
2/12/2012 Prof. Rushen Chahal

FIGURE

22-2 Actual and Potential GDP in the United States

Actual GDP

9,500 9,000 8,500 8,000 7,500 7,000 Billions of 1996 Dollars 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 19571958 Recession 1 96 0 1961 Recession 1960s Boom 1 97 4 1975 Recession 1 98 2 1983 Recession

Potential GDP

1955

1959

1963

1967

1971

2/12/2012

Prof. Rushen Chahal

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

1975 Year

1979

1983

1987

1991

1995

1999

Demand Side Equilibrium and Full 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
2/12/2012 Prof. Rushen Chahal

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

2/12/2012

Prof. Rushen Chahal

Demand Side Equilibrium and Inflation

Real GDP might exceed potential GDP because: 1. Consumer or investor spending is unusually high 2. Foreign demand is strong 3. Government spending is too much 4. The price levels are low
2/12/2012 Prof. Rushen Chahal

FIGURE

25-7 An Inflationary Gap

Potential GDP Inflationary gap B E C + I + G + (X IM) 45

Real Expenditure

45 7,000 Real GDP

2/12/2012 Prof. Rushen Chahal
Copyright 2003 South-Western/Thomson Learning. All rights reserved.

8,000

Demand Side Equilibrium and Inflation

The gap between Real GDP and potential GDP is called the Inflationary Gap This means that something must push the expenditure schedule down in order to reach potential GDP

2/12/2012

Prof. Rushen Chahal

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 full employment, so that neither a recessionary gap nor an inflationary gap occurs. (Baumol)

2/12/2012

Prof. Rushen Chahal

FIGURE

25-7 An Inflationary Gap

Potential GDP 45

Real Expenditure

C + I + G + (X IM) F

45 7,000 Real GDP

2/12/2012 Prof. Rushen Chahal
Copyright 2003 South-Western/Thomson Learning. All rights reserved.

8,000

Some Questions to Consider

1. Will the expenditure curve meet the 45 degree line at potential 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

2/12/2012

Prof. Rushen Chahal

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

2/12/2012

Prof. Rushen Chahal

FIGURE

25-8 A Simplified Circular Flow

2

Financial System

Investors

Consumers

Firms (produce the domestic product)

2/12/2012

Prof. Rushen Chahal

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

The Coordination of Saving and 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)

2/12/2012

Prof. Rushen Chahal

FIGURE

25-8 A Simplified Circular Flow

2

Financial System

Investors

Consumers

Firms (produce the domestic product)

2/12/2012

Prof. Rushen Chahal

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

The Coordination of Saving and 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?
2/12/2012 Prof. Rushen Chahal