Demand Side Equilibrium

1
Chapter 9

• Demand Side Equilibrium

2
Circular Flow Diagram
Interest Rent Profits Wages
Total Income
Rest of World
Firms
G
Households
Total Spending
Goods and Services
Total Production
3
Inventories are part of Investment.

• Inventories are of two kinds
• Planned (desired) inventories.
• Firms build up inventories to be able to fulfill
  future orders.
• Unplanned (unwanted) inventories.
• Firms end up with unsold inventories because
  sales decreased unexpectedly.

4
Investment Includes

• Residential Construction
• consumer purchases of new houses and
  condominiums.
• Non-residential construction
• Equipment, software, buildings, tools, etc.
• Changes in Inventories unsold goods are included
  as investment.

5
Inventories do not change
Planned Inventories 20
Actual Inventories 20

Total Production 100
Production 100
Firms do not change production THE ECONOMY IS IN
EQUILIBRIUM
6
The economy is in equilibrium

• Firms end only with WANTED inventories their
  actual Investment and their planned Investment
  are the same.
• Firms will not change their production levels.

7
Inventories are too high
Planned Inventories 20
Planned Inventories 20
Actual Inventories 60
Total Production 100
Production 100
Unplanned Inventories 40
The economy is NOT in equilibrium
Firms react by reducing production
8
The economy is NOT in equilibrium

• If firms inventories pile up unsold, their
  actual investment is greater than their planned
  Investment.
• Firms will decrease production to adjust their
  inventories to the desired level.

9
Inventories are too low
Wanted Inventories 20
Production 100
Total Production 100
The economy is NOT in equilibrium
Firms react by increasing production
10
The economy is NOT in equilibrium

• Firms sell part of their inventories, their
  actual investment is lower than their planned
  Investment.
• Firms will increase their production levels to
  adjust their inventories to the desired level.

11
Determining Output
Firms adjust production to the level of sales

• In the short run, Aggregate Expenditures
  determine output.

12
Aggregate Expenditures
1.Consumption
Households decide how much to consume.
2. Investment
Firms decide how much to invest.
3. Government Spending
The Government decides how much to spend.
Foreigners and Nationals decide how much to
purchase.
4. Net Exports
13
Aggregate Expenditures
Planned Inventories 20
I
Investment
Actual Sales 100
Government Spending
G
C
Consumption
X-M
Net Exports
Total Production
Aggregate Expenditures
14
Building Aggregate Expenditures

• AE C I G NX
• C 100 0.9Y
• I 1,000
• G 500
• NX 300

Purchases of buildings and equipment PLUS planned
inventories
Planned Investment
I G NX 1,800
15
Aggregate Expenditures
AE
NX 300
NX 300
G 500
AE CIGNX
NX 300
NX 300
G 500
G 500
G 500
I 1000
I 1000
AE 24,400
I 1000
AE 19,000
C 100 0.9Y
AE 10,900
I 1000
AE 6,400
Aggregate Expenditures AE
C 22,600
C 17,200
C 9,100
C 4600
NX 300
I 1000
G 500
Y 5,000
Y 10,000
Y 19,000
Y 25,000
Real Income Real GDP Y
16
Aggregate Expenditures
AE
NX 300
NX 300
G 500
AE CIGNX
NX 300
NX 300
G 500
G 500
G 500
I 1000
I 1000
AE 24,400
I 1000
AE 19,000
C 100 0.9Y
AE 10,900
I 1000
AE 6,400
Aggregate Expenditures AE
C 22,600
C 17,200
C 9,100
C 4600
NX 300
I 1000
G 500
Y 5,000
Y 10,000
Y 19,000
Y 25,000
Real Income Real GDP Y
17
AE
Change in Inventories 10,000 10,900 -900
(Inventories decrease)
Change in Inventories 19,000 19,900 0 (no
change)
Change in Inventories 25,000 24,400 600
(increase)
Change in Inventories 5,000 - 6,400 -1,400
(Inventories decrease)
AE 24,400
AE 19,000
AE 10,900
and Aggregate Expenditures AE 19,000
and Aggregate Expenditures AE 24,400
AE 6,400
and Aggregate Expenditures AE 6,400
and Aggregate Expenditures AE 10,900
If total production Y 5,000
If total production Y 10,000
If total production Y 19,000
If total production Y 25,000
Y 5,000
Y 10,000
Y 19,000
Y 25,000
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The Keynesian Cross
The 45 line Converts Horizontal Distances into
Vertical Distances.
Output
45 degree line
Income
19
AE
AE 24,400
AE 19,000
AE 10,900
AE 6,400
450
Y 5,000
Y 10,000
Y 19,000
Y 25,000
20
AE
Total SalesAggregate Expenditures
Total Production
Y 5,000
Y 10,000
Y 19,000
Y 25,000
21
No change in Inventories
Inventories Increase
AE
AE
Total SalesAggregate Expenditures
Inventories Decrease
Total Production
Y 5,000
Y 10,000
Y 19,000
Y 25,000
22
The economy is in equilibrium

• If firms end only with WANTED inventories their
  actual investment and their planned investment
  are the same.

Total Production
C I G NX

With inventories only at the planned level
23
At equilibrium
45
AE
CIGNX
Aggregate Expenditures
Y
CIGNX
No unwanted change in Inventories
Y
Real GDP
Y
24
The economy is NOT in equilibrium
45
AE
Y
Unwanted increase in Inventories
CIGNX
Aggregate Expenditures
CIGNX
Firms will decrease Output
Too High Y
Y
Real GDP
Equilibrium Y
25
45
The economy is NOT in equilibrium
AE
Unwanted decrease in Inventories
Aggregate Expenditures
CIGNX
Firms will increase Output
Y
Low Y
Equilibrium Y
Real GDP
Y
26
6,000 is the equilibrium output
27
Condition for Equilibrium

• Total Sales Total Production
• (Otherwise inventories either increase or
  decrease and we need inventories to remain the
  same for equilibrium)

28
Hypothetical Economy No government and no
foreign sector (closed economy)

• In such economy, total sales are sales to
  consumers and firms only.
• AE C I
• Only these two groups purchase total production.

29
Closed Economy without Government

• Condition that must be satisfied for equilibrium
• Y C I
• Since Y C S (Income is either
  consumed or saved)
• We can rewrite the equilibrium condition as
• C S C I

S I
In a closed economy without government the
equilibrium condition is that Savings must be
equal to Investment
leakages Injections
30
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?
Investment
31
Hypothetical Economy Trades with the rest of the
world (open economy) but no government

• In such economy, total sales are sales to
  consumers, firms and foreing countries only.
• AE C I NX
• Only these three groups purchase total production.

32
Open Economy without Government

• Condition that must be satisfied for equilibrium
• Y C I X-M
• Since Y C S
• We can rewrite the equilibrium condition as
• C S C I X-M

S I X-M SM I X
In an open economy without government the
equilibrium condition says that our savings must
be enough to finance private Investment plus the
trade deficit.
leakages Injections
S I (X-M)
33
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(X-M)?
34
Real World Economy With government and foreign
sector

• In such economy, total sales are sales to
  consumers, firms, foreigners and the government.
• AE C I G NX
• These four groups purchase total production.

35
Open Economy with Government

• Condition that must be satisfied for equilibrium
• Y C I G X-M
• Since Y C S T (Income is used to
  consume, save and pay taxes)
• We can rewrite the equilibrium condition as
• C S T C I G X-M

Savings must finance Investment, the governments
deficit and the trade deficit.
ST I G X-M STM I G X
leakages Injections
S I (G T)(X-M)
36
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)
37
Shifts in the Aggregate Expenditures Line
AE
The AE line shifts up
The AE line shifts down
NX 300
NX 300
G 500
NX 300
NX 300
G 500
G 500
When C, I, G or net exports increase
When C, I, G or net exports decrease
G 500
I 1000
I 1000
AE 24,400
I 1000
AE 19,000
C 100 0.9Y
AE 10,900
I 1000
AE 6,400
C 22,600
C 17,200
C 9,100
C 4600
NX 300
I 1000
G 500
Y 5,000
Y 10,000
Y 19,000
Y 25,000
38
Equilibrium
AE
If AE line shifts down
AE 6,400
AE 19,000
AE 10,900
AE 6,400
Y 19,000
Y 5,000
Y 10,000
Y 25,000
39
Equilibrium
Equilibrium
AE
If AE line shifts down
Equilibrium output decreases
AE 6,400
AE 19,000
AE 10,900
AE 6,400
Y 10,000
Y 19,000
Y 5,000
Y 25,000
40
Equilibrium
AE
If AE line shifts up
AE 6,400
AE 19,000
AE 10,900
AE 6,400
Y 19,000
Y 5,000
Y 10,000
Y 25,000
41
Equilibrium
AE
If AE line shifts up
Equilibrium output increases
AE 19,000
Y 25,000
Y 19,000
42
Potential GDP

• The real gross domestic product (GDP) the economy
  would produce if its labor force were fully
  employed

43
A Recessionary Gap
Equilibrium output occurs below Potential GDP
44
An Inflationary Gap
Potential GDP
B
Equilibrium output occurs above Potential GDP
45
At Y 4,000
At Y 5000
At Y 3000

1. Total Spending gt Output
2. Inventories fall
3. Total Spending lt Output
4. Inventories rise
5. Total Spending Output
6. There is no change in Inventories
7. The economy experiences a recessionary gap
8. The economy experiences a recessionary gap

i) Economy is at equilibrium
46
Building Aggregate Demand

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

47
Aggregate Demand
Price Level
P0
AD
Equilibrium Output
Real GDP Demanded
Y0
48
When prices increase from P0 to P1,
the value of wealth decreases and consumption
decreases from C0 to C1.
The AE line shifts down
and the equilibrium value of output decreases
from Y0 to Y1.
49
Aggregate Demand
Price Level
A movement ALONG the AD line NOT a SHIFT!
P1
When prices increase from P0 to P1, the
equilibrium value of output decreases from Y0 to
Y1.
P0
AD
Equilibrium Output
Real GDP Demanded
Y0
Y1
50
When prices decrease from P0 to P2,
the value of wealth increases and consumption
increases from C0 to C2.
The AE line shifts up
and the equilibrium value of output increases
from Y0 to Y2.
51
Aggregate Demand
Price Level
A movement ALONG the AD line NOT a SHIFT!
When prices decrease from P0 to P2, the
equilibrium value of output increases from Y0 to
Y2.
P0
P2
AD
Real GDP Demanded
Equilibrium Output
Y0
Y2
52
Building the Aggregate Demand Curve
Output Y1 corresponds to P1
Output Y2 corresponds to P2
When prices increase from P0 to P1,
When prices decrease from P0 to P2,
the value of wealth decreases and consumption
decreases from C0 to C1.
the value of wealth increases and consumption
increases from C0 to C2.
The AE line shifts down
The AE line shifts up
and the equilibrium value of output decreases
from Y0 to Y1.
and the equilibrium value of output increases
from Y0 to Y2.
53
If G,I,C, NX increase
Equilibrium Income increase
AE line Shifts up
A shift of the AD line NOT a movement ALONG !
45
Price level
AE1 CIGNX
Aggregate Expenditures
AE0 CIGNX
P0
AD1
AD0
Y1
Y0
Y0
Y1
Real GDP Demanded
Real GDP
Real GDP
The size of the change in equilibrium Y is the
size of the shift in AD
54
Shifts in the Aggregate Demand Line
Price Level
When C, I, G or net exports increase the AE line
shifts up and the equilibrium value of output
increases AD line shifts right (outward).
P0
AD1
AD0
Real GDP Demanded
Y1
Y0
55
If G,I,C, NX decrease
Equilibrium Income decrease
AE line Shifts down
A shift of the AD line NOT a movement ALONG !
Price level
AE0 CIGNX
AE1 CIGNX
Aggregate Expenditures
P0
AD0
AD1
Y0
Y1
Y0
Y1
Real GDP Demanded
Real GDP
The size of the change in equilibrium Y is the
size of the shift in AD
56
Shifts in the Aggregate Demand Line
Price Level
When C, I, G or net exports decrease the AE line
shifts down and the equilibrium value of output
decreases AD line shifts left (inward).
P0
AD0
AD1
Real GDP Demanded
Y0
Y1
57
Factors that shift the consumption function

• Changes in wealth
• shift the consumption function.
• Example value of stocks, bonds, consumer
  durables.
• Changes in consumer expectations
• Shift the consumption function.
• Example Pessimistic expectations decrease
  autonomous consumption.
• Taxes and Transfers
• Tax increase or decrease in transfers decrease
  disposable income and shift the consumption
  function down.
• Prices
• Affect the purchasing power of assets.

Shift up in AE line Shift right in AD line
Shift up in AE line Movement Along AD line
58
Determinants of Investment

• Interest Rates
• Tax Incentives
• Technical Change
• Expectations about the strength of demand
• Political Stability and the rule of law

Shift AE line Shift AD line
59
Government Spending

• Government expenditures are determined by the
  budget process The president, Congress and the
  Senate.

Shift AE line Shift AD line
Fiscal Policy
60
Determinants of Net Exports

• National Incomes
• GDP of other countries
• Relative Prices
• Exchange Rates

Shift AE line Shift AD line
61
To increase AE, we need an increase in C, I, G or
NX
A recessionary gap occurs when actual GDP falls
SHORT of full employment GDP
To eliminate a recessionary gap, AE must rise.
7,000-6,000 1,000
62
To Eliminate a Recessionary/Deflationary Gap

• Increase Consumption by a sufficiently large
  price drop or a decrease in taxes.
• Increase Investment using tax incentives.
• Increase Government Spending Fiscal Policy
• Increase Exports and reduce Imports.

63
To decrease AE, we need a decrease in C, I, G or
NX
To eliminate an inflationary gap, AE must fall.
7,000-8,000 -1,000
An inflationary gap occurs when equilibrium GDP
is higher than full employment GDP
64
To Eliminate an Inflationary Gap

• Decrease Consumption by a sufficiently large
  price increase or an increase in taxes.
• Decrease Government Spending Fiscal Policy
• Decrease Exports and increase Imports.

65
Questions to prepare for test

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)

66

• Use the table in the next slide to answer the
  following
• Calculate the MPC and the intercept.
• Write the consumption function C intercept (a)
  slope (MPC) Y
• Calculate Aggregate Expenditures (add a Col. to
  the table for AE).
• Find the equilibrium value of output.
• If output is 4000 calculate the change in
  inventories. Given your answer for the change in
  inventories, how would firms react to this change
  in inventories?
• If investment increase from 500 to 800 (a 300
  increase in investment). Recalculate the entire
  table and find the new equilibrium value of
  output.
• If autonomous consumption (the intercept)
  increases by 300 what is the new equilibrium
  value of output?

67
Output Consumption Investment Net Exports
1000 800 500 100
1500 1200   500 100
2000 1600   500 100
2500 2000   500 100
3000 2400   500 100
3500 2800   500 100
4000 3200   500 100
68

1. If the economy is at equilibrium, is total
   spending greater, less than or equal to Output?
   Do Inventories fall, rise or remain unchanged?
   Does the economy experience a recessionary gap or
   an inflationary gap? If an inflationary
   (recessionary) gap exists, how can the gap be
   closed?

69

1. If the economy is at equilibrium, is total
   spending greater, less than or equal to Output?
   Do Inventories fall, rise or remain unchanged?
   Does the economy experience a recessionary gap or
   an inflationary gap? If an inflationary
   (recessionary) gap exists, how can the gap be
   closed?

70
Which AE line will cause a recessionary gap?
Which AE line will cause an Inflationary gap?
71
Questions to prepare continued

• 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.
• Repeat the exercise with the graph in slide 73.

72
49,000
26,500
25,000
40,000
50,000
73
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