Demand-side Equilibrium(Keynesian Equilibrium)

Consumption function in the DI-C Space

C

DI (Disposable Income)

C

0

C = constant + coefficient * DI

Consumption function in the Y-C Space

C

Y (GDP)

C

0

C = constant + coefficient * Y

Consumption Function in the Y-C Consumption Function in the Y-C spacespace

The equation form:The equation form:C = constant + coefficient * YC = constant + coefficient * Y

To convert from the old formTo convert from the old formC = a + b DIC = a + b DI = a + b (Y - T)= a + b (Y - T) = a + b Y - b T= a + b Y - b Twhere T is a (lump-sum) tax, and where T is a (lump-sum) tax, and

DI = Y - TDI = Y - T

Consumption function in the Y-C Space

C

Y (GDP)

C

0

C = ( a – bT) + b Y

a – bT

Consumption Function in the Y-C Consumption Function in the Y-C spacespace

T is assumed to be a lump-sum tax, it T is assumed to be a lump-sum tax, it is a constant.is a constant.

DI = Y – TDI = Y – T If T= 0, then C = a + bY, same as If T= 0, then C = a + bY, same as

beforebefore If T increases, then the C function If T increases, then the C function

line will shiftline will shift Note the C function does not shift in Note the C function does not shift in

the DI-C spacethe DI-C space

Other components in AE Other components in AE

AE = C + I + G + (X - IM) AE = C + I + G + (X - IM) In addition to C, there are In addition to C, there are

components: I, G, and X-IMcomponents: I, G, and X-IM

Investment (I)Investment (I)

Investment is the business firms' Investment is the business firms' purchase of new physical assets purchase of new physical assets (including adding in inventories, and (including adding in inventories, and house construction). house construction).

It very volatile.It very volatile.

Shifters of IShifters of I

Business confidence and Business confidence and expectationsexpectations

Growth of demand (sales)Growth of demand (sales) Interest rateInterest rate Product innovationProduct innovation Tax incentiveTax incentive

Government expenditure GGovernment expenditure G

Government expenditure is the Government expenditure is the purchases of goods and services by purchases of goods and services by all government levels.all government levels.

Determined by the governmentDetermined by the government

Net Exports: X - IM Net Exports: X - IM

Gross exports minus importsGross exports minus imports Shifters of net exports:Shifters of net exports:

– Other countries' income: affects XOther countries' income: affects X– Our income: affects IMOur income: affects IM– Relative prices of exports and importsRelative prices of exports and imports

The Circular Flow of Expenditures and Income

1

3

6

5

4

2

Investors

Government

Firms(produce the

domestic product)

Consumers

Financial SystemRest of the

World

Saving (S

)

Consumption (C

)

Inve

stm

ent (

I) C + I

Gov

ernm

ent

C + I + GImports

(IM)

Exports (X

)C

+ I +

G +

Tran

sfers

Disposable

Income (DI)

Taxes

Gross

National Income (Y)

(X – IM

)

Purch

ases

(G)

Flow in the circular flow diagramFlow in the circular flow diagram

As the flow circulates around the As the flow circulates around the circular flow system, will the volume circular flow system, will the volume grow larger, smaller, or keep the grow larger, smaller, or keep the same level? same level?

Keynesian answerKeynesian answer

Depends on AE and YDepends on AE and Y If AE > Y, Y increases, flow grows If AE > Y, Y increases, flow grows

bigger.bigger. Reasons: When AE > YReasons: When AE > Y

– Spending greater than outputSpending greater than output– Inventory fallsInventory falls– Firms find sale is strong, and increase Firms find sale is strong, and increase

outputoutput

Keynesian answerKeynesian answer

If AE < Y, Y falls, flow becomes If AE < Y, Y falls, flow becomes smaller.smaller.

Reasons: When AE < YReasons: When AE < Y– Spending less than outputSpending less than output– Unintended inventory increasesUnintended inventory increases– Firms find sale is slow and cut the Firms find sale is slow and cut the

productionproduction

Keynesian answerKeynesian answer

When AE = Y, remains the same When AE = Y, remains the same levellevel

Reasons: Firms found the current Reasons: Firms found the current output just satisfies the demand. So output just satisfies the demand. So keep the same output level.keep the same output level.

Keynesian equilibrium condition: Keynesian equilibrium condition:

AE = YAE = Y

The Keynesian EquilibriumThe Keynesian Equilibrium

Denote Y* (at Y*, AE=Y)Denote Y* (at Y*, AE=Y) Also called “Demand-side Also called “Demand-side

equilibrium”equilibrium” The output is determined by The output is determined by

spending, or the demand.spending, or the demand. It is stableIt is stable It does not imply full employmentIt does not imply full employment So recession can be prolongedSo recession can be prolonged

Construct the AE scheduleConstruct the AE schedule

The Aggregate Expenditure Schedule The Aggregate Expenditure Schedule (AE)(AE)

The AE refers to the relationship The AE refers to the relationship between AE and GDP (Y)between AE and GDP (Y)

AE = C + I + G + (X - IM)AE = C + I + G + (X - IM) It tells you what the total spending is It tells you what the total spending is

at different income Y levelat different income Y level

The AE function

C

Y (GDP)

AE

0

C+I

C+I+G

AE= C+I+G+X-IM

X-IM

G

I

The AE function

Y (GDP)

AE

0

AE

8000

7500

Y0

AE0

The 45 degree lineThe 45 degree line

PropertyProperty Any point on the 45 degree line has Any point on the 45 degree line has

the equal distance to the vertical the equal distance to the vertical axis and horizontal axis.axis and horizontal axis.

The 45 degree line

Y (GDP)

AE

0

AE= Y

45 degree

Y1

AE1

Graphical illustration of the Graphical illustration of the Keynesian EquilibriumKeynesian Equilibrium

It is the intersection of the AE line It is the intersection of the AE line and the 45 degree line.and the 45 degree line.

Keynesian equilibrium

0 YY*

AE

AE=Y$

The Determination of Equilibrium Output

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

Income-Expenditure Diagram

Spending exceeds output

Output exceeds spending

Equilibrium

6,000

Rea

l Exp

end

itu

re

45°

5,200 5,600 6,000 6,400 6,800 7,200 0

4,800

5,600

6,400

6,800

7,200

Real GDP 4,800

5,200

AE=C+I+G+ (X-IM)

E

5400

6600

Demand-side equilibrium Y*Demand-side equilibrium Y*andand

Potential GDP YpPotential GDP Yp Potential GDP, Yp, is the full Potential GDP, Yp, is the full

employment GDPemployment GDP Y* does not have to equal YpY* does not have to equal Yp Y* < Yp: recessionary gap.Y* < Yp: recessionary gap.

– Why a prolonged recessionary gap?Why a prolonged recessionary gap? Y* > Yp: inflationary gap.Y* > Yp: inflationary gap.

Recessionary Gap

0 YY*

AE

AE=Y$

Yp

Recessionary gap

Recessionary gapRecessionary gap

Y* < Yp: recessionary gap.Y* < Yp: recessionary gap. Recessionary Gap: when the Recessionary Gap: when the

Keynesian equilibrium output is less Keynesian equilibrium output is less than potential GDPthan potential GDP

Implies prolonged high Implies prolonged high unemploymentunemployment

Implies a prolonged recessionImplies a prolonged recession Why prolonged?Why prolonged?

Inflationary Gap

0Y

Y*

AE

AE=Y

$

Yp

Inflationary gap

Equation form forEquation form forthe Keynesian equilibriumthe Keynesian equilibrium

A Model Economy is described as A Model Economy is described as follows:follows:

C = 100 + 0.9 DIC = 100 + 0.9 DII = 150I = 150G = 200G = 200X - IM = -50X - IM = -50

T = 0T = 0Solve for the Keynesian equilibrium Y*Solve for the Keynesian equilibrium Y*

Equation form forEquation form forthe Keynesian equilibriumthe Keynesian equilibrium

Consumption functionConsumption functionC = 100 + 0.9 DIC = 100 + 0.9 DI

Assume T = 0Assume T = 0C = 100 + 0.9 (Y - T)C = 100 + 0.9 (Y - T) = 100 + 0.9 Y= 100 + 0.9 Y

I = 150I = 150 G = 200G = 200 X - IM = -50X - IM = -50

ApproachApproach

Solve for the equilibrium level Y*Solve for the equilibrium level Y* Find the AE schedule equationFind the AE schedule equation Utilize the equilibrium condition, AE Utilize the equilibrium condition, AE

= Y= Y Solve for the equilibrium Y: Y*Solve for the equilibrium Y: Y*

Step 1Step 1

Add together to get AEAdd together to get AE,,

AE = C + I + G + X - IMAE = C + I + G + X - IM

AE = 100 + 0.9 Y + 150 + 200 - 50AE = 100 + 0.9 Y + 150 + 200 - 50

= 400 + 0.9 Y= 400 + 0.9 Y

Step 2Step 2

Using the Keynesian equilibrium Using the Keynesian equilibrium condition condition

Y = AE = 400 + 0.9 YY = AE = 400 + 0.9 Y

Step 3Step 3

Solve for equilibrium Y: Solve for equilibrium Y:

Y* = 1/(1-0.9) X 400 Y* = 1/(1-0.9) X 400

= 10 X 400 = 10 X 400

= 4000= 4000