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Prof. Rushen Chahal
Demand-Side Equilibrium:Unemployment or Inflation?
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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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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
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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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Income Determination
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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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
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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
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TABLE 25-2 The Determination of
Equilibrium Output
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
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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 $6,000billion for this economy
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Income Determination
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
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
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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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
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FIGURE 25-3 Income-Expenditure
Diagram
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
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
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
(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
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
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
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
(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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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 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
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
Recessionary gap
C+ I + G+ (X IM)
45
45
PotentialGDP
7,000
RealExpenditure
Real GDP
6,000
E
F
B
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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
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FIGURE 22-2 Actual and Potential
GDP in the United States
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
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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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?
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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
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
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
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
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?
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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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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)
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FIGURE 25-8 A Simplified Circular
Flow
Copyright 2003 South-Western/Thomson Learning. All rights reserved.
1
3
Investors
Consumers
Financial System
Y
Firms(produce the
domestic product)
2
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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?
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