Chapter 9

The meaning of equilibrium GDP Total production = total income but not total spending Option 1: o If income (total spending) exceeds expenditures (output) o businesses will likely produce more (long term raise prices) o Output/price level is NOT in equilibrium when total spending exceeds current production Option 2: o If income (total spending) falls shorts of expenditures (output) o Businesses will likely produce less (reducing GDP) (long term lower prices) Equilibrium a situation in which neither consumers nor firms have any incentive to change their behavior; content to continue with things as they are The mechanics of income determination Expenditure schedule shows the relationship between national income (GDP) and total spending Induced investment the part of investment spending that rises when GDP rises and falls when GDP falls The 45 degree line displays all the points at which the economy can possibly be in demand-side equilibrium The economy will always be on the expenditure line (C + I + G + ( X IM )) because it is spending plans of consumers and investors If economy is in equilibrium, MUST be on the 45 degree line Whenever production is above equilibrium, markets will drive output down Whenever production is below equilibrium , markets will drive output up Income-expenditure diagrams/45 degree diagram plots total real expenditure (on the vertical axis) against real income (on the horizontal axis); the 45 degree line marks off points where income and expenditure are equal Aggregate Demand Curve shows the quantity of domestic product that is demanded at each possible value of the price level Higher prices decrease demand for goods because less purchasing power of consumer wealth (vice versa) A higher price level leads to lower real wealth and less spending at any given level of real income Higher prices leads to lower consumption function (vice versa) Income change moves along consumption function, wealth change shifts consumption function A rise in price level leads to a lower equilibrium level of real aggregate quantity demanded Why aggregate demand slopes down 1) Effect of higher prices on consumer wealth 2) International trade (higher US prices = less exports, more imports) Demand-side equilibrium and full employment Equilibrium below potential GDP arises when consumers or investors are unwilling to spend at normal rate, government spending is low, foreign demand is weak, or when price level is too high o Unemployment occurs because not enough output is demanded to keep the entire labor force at work o Recessionary gap - the amount by which the equilibrium level of real GDP falls short of potential GDP o The expenditure line (C + I + G + ( X IM )) must be raised to meet potential GDP on 45 degree line GDP exceeds full employment o Can happen when consumer or investment spending is unusually buoyant, foreign demand is strong, government spends too much, or a low price level pushes expenditure curve upward o Inflationary gap the amount by which equilibrium real GDP exceeds the full-employment level of GDP o Higher price level or some means to reduce total expenditure is necessary The coordination of saving and investment Full employment income will be maintained only if saving = investing Unemployment when total spending is too low to employ the entire labor force If savings > investment at full employment o Total demand received by firms will be short of total output because cant replace leakage o GDP falls below potential o Recessionary gap Investment > savings at full employment o Total demand will exceed potential GDP o Inflationary gap The people who invest are not the same people who save Coordination failure occurs when party A would like to change his behavior if party B would change his, and vice versa, and yet the two changes do not take place because the decisions of A and B are not coordinated

Demand-side Equilibrium: unemployment or inflation?

Y = C + I + G + ( X IM )

Changes on the Demand side: Multiplier analysis Multiplier the ratio of the change in equilibrium GDP (Y) divided by the original change in spending that causes the change in GDP Magic of the multiplier

o o On graph, increase parallel to original, but movement on 45 degree line (equilibrium line) How it works o One persons spending is another persons income o Multiplier is 4 after spending (MPC), saving (MPS), spending, saving.cumulative total Algebraic statement of the multiplier o Infinite geometric progression infinite series of numbers, each one of which is a fixed fraction of the previous number (fraction is a common ratio) o o o

OVERSIMPLIFIED MULTIPLIER FORMULA = Multiplier in real world cannot be calculated with the oversimplified formula because it is actually lower o Issues that reduce the multiplier: 1) International trade countrys imports depend on GDP 2) Inflation 3) income taxation 4) financial system Multiplier as a general concept Induced increase in consumption an increase in consumer spending that stems from an increase in consumer incomes; movement along a fixed consumption function Autonomous increase in consumption an increase in consumer spending without any increase in consumer incomes: a shift of the entire consumption function; consumption changes independently of income o It does not matter who injects an additional dollar of spending into the economy, investors or consumers o Leads to a horizontal shift of the aggregate demand curve by an amount given by the oversimplified multiplier formula Changes in the volume of government purchases of goods and services will change the equilibrium level of GDP on the demand side in the same direction, but by a multiplied amount Booms and recessions tend to be transmitted across national borders GDPs of major economies are linked by trade Multiplier and aggregate demand curve o Oversimplified multiplier formulas indicates the increase in real GDP demanded that would occur if the price level were fixed o