Demand-Side Equilibrium: Demand-Side Equilibrium: Demand-Side Equilibrium: Demand-Side Equilibrium: Multiplier Analysis Multiplier Analysis Multiplier Analysis Multiplier Analysis A definite ratio, to be called the A definite ratio, to be called the A definite ratio, to be called the A definite ratio, to be called the Multiplier, Multiplier, Multiplier, Multiplier, can be can be can be can be established between income and investment. established between income and investment. established between income and investment. established between income and investment. JOHN MAYNARD KEYNES JOHN MAYNARD KEYNES JOHN MAYNARD KEYNES JOHN MAYNARD KEYNES Asst. Prof. Dr. Serdar AYAN Asst. Prof. Dr. Serdar AYAN Asst. Prof. Dr. Serdar AYAN Asst. Prof. Dr. Serdar AYAN
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A definite ratio, to be called the A definite ratio, to be called the A definite ratio, to be called the A definite ratio, to be called the Multiplier, Multiplier, Multiplier, Multiplier, can be can be can be can be established between income and investment.established between income and investment.established between income and investment.established between income and investment.
JOHN MAYNARD KEYNESJOHN MAYNARD KEYNESJOHN MAYNARD KEYNESJOHN MAYNARD KEYNES
Asst. Prof. Dr. Serdar AYANAsst. Prof. Dr. Serdar AYANAsst. Prof. Dr. Serdar AYANAsst. Prof. Dr. Serdar AYAN
● GDP cannot be at its equilibrium if total spending differs from the value of output.
● If spending exceeds output, inventories fall and firms increase production.
● If output exceeds spending, inventories rise and firms reduce production.
● GDP cannot be at its equilibrium if total spending differs from the value of output.
● If spending exceeds output, inventories fall and firms increase production.
● If output exceeds spending, inventories rise and firms reduce production.
The Meaning of Equilibrium The Meaning of Equilibrium The Meaning of Equilibrium The Meaning of Equilibrium GDPGDPGDPGDPThe Meaning of Equilibrium The Meaning of Equilibrium The Meaning of Equilibrium The Meaning of Equilibrium GDPGDPGDPGDP
FIGUREFIGUREFIGUREFIGURE 1 1 1 1.... The Circular Flow The Circular Flow The Circular Flow The Circular Flow DiagramDiagramDiagramDiagram
FIGUREFIGUREFIGUREFIGURE 1 1 1 1.... The Circular Flow The Circular Flow The Circular Flow The Circular Flow DiagramDiagramDiagramDiagram
....
1111
3333
6666
5555
4444
2222
InvestorsInvestorsInvestorsInvestors
GovernmentGovernmentGovernmentGovernment
FirmsFirmsFirmsFirms(produce the(produce the(produce the(produce the
● The equilibrium level of GDP on the demand side is the one at which total spending equals production.
● In such a situation, firms find their inventories remaining at desired levels, so there is no incentive to change output or prices.
● The equilibrium level of GDP on the demand side is the one at which total spending equals production.
● In such a situation, firms find their inventories remaining at desired levels, so there is no incentive to change output or prices.
The Meaning of Equilibrium The Meaning of Equilibrium The Meaning of Equilibrium The Meaning of Equilibrium GDPGDPGDPGDPThe Meaning of Equilibrium The Meaning of Equilibrium The Meaning of Equilibrium The Meaning of Equilibrium GDPGDPGDPGDP
The Mechanics of Income The Mechanics of Income The Mechanics of Income The Mechanics of Income DeterminationDeterminationDeterminationDeterminationThe Mechanics of Income The Mechanics of Income The Mechanics of Income The Mechanics of Income DeterminationDeterminationDeterminationDetermination
● Constructing the total expenditure schedule♦ Expenditure Schedule = table showing the
relationship between GDP and total spending♦ Induced Investment = the part of investment
spending that rises when GDP rises, and falls when GDP falls.
● Constructing the total expenditure schedule♦ Expenditure Schedule = table showing the
relationship between GDP and total spending♦ Induced Investment = the part of investment
spending that rises when GDP rises, and falls when GDP falls.
TABLETABLETABLETABLE 1.1.1.1. The Determination of The Determination of The Determination of The Determination of Equilibrium OutputEquilibrium OutputEquilibrium OutputEquilibrium Output
TABLETABLETABLETABLE 1.1.1.1. The Determination of The Determination of The Determination of The Determination of Equilibrium OutputEquilibrium OutputEquilibrium OutputEquilibrium Output
FIGUREFIGUREFIGUREFIGURE 2 2 2 2.... Construction of the Construction of the Construction of the Construction of the Expenditure ScheduleExpenditure ScheduleExpenditure ScheduleExpenditure Schedule
FIGUREFIGUREFIGUREFIGURE 2 2 2 2.... Construction of the Construction of the Construction of the Construction of the Expenditure ScheduleExpenditure ScheduleExpenditure ScheduleExpenditure Schedule
....
G = $1,300 $1,300 $1,300 $1,300
I = $900 $900 $900 $900
C + + + + I + + + + G
C + + + + I + + + + G + ( + ( + ( + (X –––– IM) ) ) )
Real GDP Real GDP Real GDP Real GDP 5,200 5,200 5,200 5,200
3,900 3,900 3,900 3,900
X X X X ––––IM =IM =IM =IM = ––––$100 $100 $100 $100
● Both the expenditure table and the corresponding “income-expenditure diagram” or “45 degree line diagram” show the equilibrium level of GDP.
● All other levels of GDP are disequilibrium points, at which GDP will move in the direction of the equilibrium.
● Both the expenditure table and the corresponding “income-expenditure diagram” or “45 degree line diagram” show the equilibrium level of GDP.
● All other levels of GDP are disequilibrium points, at which GDP will move in the direction of the equilibrium.
The Mechanics of Income The Mechanics of Income The Mechanics of Income The Mechanics of Income DeterminationDeterminationDeterminationDeterminationThe Mechanics of Income The Mechanics of Income The Mechanics of Income The Mechanics of Income DeterminationDeterminationDeterminationDetermination
The Aggregate Demand The Aggregate Demand The Aggregate Demand The Aggregate Demand CurveCurveCurveCurveThe Aggregate Demand The Aggregate Demand The Aggregate Demand The Aggregate Demand CurveCurveCurveCurve
FIGUREFIGUREFIGUREFIGURE 4 4 4 4.... The Effect of the Price The Effect of the Price The Effect of the Price The Effect of the Price Level on Equilibrium ADLevel on Equilibrium ADLevel on Equilibrium ADLevel on Equilibrium AD
FIGUREFIGUREFIGUREFIGURE 4 4 4 4.... The Effect of the Price The Effect of the Price The Effect of the Price The Effect of the Price Level on Equilibrium ADLevel on Equilibrium ADLevel on Equilibrium ADLevel on Equilibrium AD
((((b) b) b) b)
Fall in PricFall in PricFall in PricFall in Price Level e Level e Level e Level
The Aggregate Demand The Aggregate Demand The Aggregate Demand The Aggregate Demand CurveCurveCurveCurveThe Aggregate Demand The Aggregate Demand The Aggregate Demand The Aggregate Demand CurveCurveCurveCurve
● The negatively-sloped aggregate demand curve shows all the equilibria of price levels and GDP.
● Remember that any income-expenditure diagram is drawn for a specific price level.
● The negatively-sloped aggregate demand curve shows all the equilibria of price levels and GDP.
● Remember that any income-expenditure diagram is drawn for a specific price level.
FIGUREFIGUREFIGUREFIGURE 5 5 5 5.... The Aggregate The Aggregate The Aggregate The Aggregate Demand CurveDemand CurveDemand CurveDemand Curve
FIGUREFIGUREFIGUREFIGURE 5 5 5 5.... The Aggregate The Aggregate The Aggregate The Aggregate Demand CurveDemand CurveDemand CurveDemand Curve
E2 2 2 2
E0 0 0 0
E1 1 1 1
Pric
e Le
vel
Pric
e Le
vel
Pric
e Le
vel
Pric
e Le
vel
Real GDP Real GDP Real GDP Real GDP
P1 1 1 1
P0 0 0 0
P2 2 2 2
Y2 2 2 2 Y0 0 0 0 Y1 1 1 1
● Equilibrium GDP may not = full-employment GDP.
● Recessionary gap: amount by which equilibrium GDP < potential GDP
● Inflationary gap: amount by which equilibrium GDP > potential GDP
● Equilibrium GDP may not = full-employment GDP.
● Recessionary gap: amount by which equilibrium GDP < potential GDP
● Inflationary gap: amount by which equilibrium GDP > potential GDP
Demand-Side Equilibrium Demand-Side Equilibrium Demand-Side Equilibrium Demand-Side Equilibrium and Full Employmentand Full Employmentand Full Employmentand Full EmploymentDemand-Side Equilibrium Demand-Side Equilibrium Demand-Side Equilibrium Demand-Side Equilibrium and Full Employmentand Full Employmentand Full Employmentand Full Employment
FIGUREFIGUREFIGUREFIGURE 6 6 6 6.... A Recessionary GapA Recessionary GapA Recessionary GapA Recessionary GapFIGUREFIGUREFIGUREFIGURE 6 6 6 6.... A Recessionary GapA Recessionary GapA Recessionary GapA Recessionary Gap
Recessionary gap Recessionary gap Recessionary gap Recessionary gap
The Coordination of Saving The Coordination of Saving The Coordination of Saving The Coordination of Saving and Investmentand Investmentand Investmentand InvestmentThe Coordination of Saving The Coordination of Saving The Coordination of Saving The Coordination of Saving and Investmentand Investmentand Investmentand Investment
● Equilibrium GDP = full employment only if saving out of full-employment incomes = investment
● Savers are not the same people as investors, so it is unlikely that this condition will hold.
● Equilibrium GDP = full employment only if saving out of full-employment incomes = investment
● Savers are not the same people as investors, so it is unlikely that this condition will hold.
FIGUREFIGUREFIGUREFIGURE 8 8 8 8.... A Simplified Circular A Simplified Circular A Simplified Circular A Simplified Circular FlowFlowFlowFlow
FIGUREFIGUREFIGUREFIGURE 8 8 8 8.... A Simplified Circular A Simplified Circular A Simplified Circular A Simplified Circular FlowFlowFlowFlow
1111
3333
InvestorsInvestorsInvestorsInvestors
ConsumersConsumersConsumersConsumers
Financial SystemFinancial SystemFinancial SystemFinancial System
Saving (Saving (Saving (Saving (SSSS))))
Consumption (
Consumption (
Consumption (
Consumption (CCCC))))
Inve
stm
ent (
I)
Inve
stm
ent (
I)
Inve
stm
ent (
I)
Inve
stm
ent (
I) CCCC + + + + IIII
CCCC + + + + IIII
YYYY
FirmsFirmsFirmsFirms(produce the(produce the(produce the(produce the
Changes on the Demand Changes on the Demand Changes on the Demand Changes on the Demand Side: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier AnalysisChanges on the Demand Changes on the Demand Changes on the Demand Changes on the Demand Side: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier Analysis
● Multiplier = ratio of the change in equilibrium GDP (Y) divided by the original change in spending that caused the change in GDP
● Multiplier = ratio of the change in equilibrium GDP (Y) divided by the original change in spending that caused the change in GDP
Changes on the Demand Changes on the Demand Changes on the Demand Changes on the Demand Side: Multiplier Analysis Side: Multiplier Analysis Side: Multiplier Analysis Side: Multiplier Analysis Changes on the Demand Changes on the Demand Changes on the Demand Changes on the Demand Side: Multiplier Analysis Side: Multiplier Analysis Side: Multiplier Analysis Side: Multiplier Analysis
● Demystifying the Multiplier: How It Works♦ The multiplier is greater than 1 because one
person’s spending is another person’s income.♦ ↑ spending ⇒ ↑ income♦ A portion of the increase in income is spent on
consumption, creating more income, which in turn creates more consumption spending, and so on.
● Demystifying the Multiplier: How It Works♦ The multiplier is greater than 1 because one
person’s spending is another person’s income.♦ ↑ spending ⇒ ↑ income♦ A portion of the increase in income is spent on
consumption, creating more income, which in turn creates more consumption spending, and so on.
TABLETABLETABLETABLE 4 4 4 4.... The Multiplier The Multiplier The Multiplier The Multiplier Spending ChainSpending ChainSpending ChainSpending Chain
TABLETABLETABLETABLE 4 4 4 4.... The Multiplier The Multiplier The Multiplier The Multiplier Spending ChainSpending ChainSpending ChainSpending Chain
FIGUREFIGUREFIGUREFIGURE 10 10 10 10.... How the Multiplier How the Multiplier How the Multiplier How the Multiplier BuildsBuildsBuildsBuilds
FIGUREFIGUREFIGUREFIGURE 10 10 10 10.... How the Multiplier How the Multiplier How the Multiplier How the Multiplier BuildsBuildsBuildsBuilds
Changes on the Demand Changes on the Demand Changes on the Demand Changes on the Demand Side: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier AnalysisChanges on the Demand Changes on the Demand Changes on the Demand Changes on the Demand Side: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier Analysis
● Algebraic Statement of the Multiplier♦ Multiplier = 1 ÷ (1 - MPC)♦ The MPC has been estimated to be about 0.9,
implying that the multiplier is 10. ♦ In fact, the multiplier is < 2.
● Algebraic Statement of the Multiplier♦ Multiplier = 1 ÷ (1 - MPC)♦ The MPC has been estimated to be about 0.9,
implying that the multiplier is 10. ♦ In fact, the multiplier is < 2.
● Algebraic Statement of the Multiplier♦ Factors that reduce the size of the multiplier
■International trade■Inflation■Income taxation■Financial system
● Algebraic Statement of the Multiplier♦ Factors that reduce the size of the multiplier
■International trade■Inflation■Income taxation■Financial system
Changes on the Demand Changes on the Demand Changes on the Demand Changes on the Demand Side: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier AnalysisChanges on the Demand Changes on the Demand Changes on the Demand Changes on the Demand Side: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier AnalysisSide: Multiplier Analysis
The Multiplier Is a General The Multiplier Is a General The Multiplier Is a General The Multiplier Is a General ConceptConceptConceptConceptThe Multiplier Is a General The Multiplier Is a General The Multiplier Is a General The Multiplier Is a General ConceptConceptConceptConcept
● An autonomous change in consumer spending (caused by something other than an increase in income) shifts the consumption function and has a multiplier effect, just the same as a change in I does.
● An autonomous change in consumer spending (caused by something other than an increase in income) shifts the consumption function and has a multiplier effect, just the same as a change in I does.
●Other multiplier effects:♦ A change in G has the same multiplier effect as
a change in I or a change in autonomous C.♦ The multiplier effect of a change in (X - IM) is
the same as for the other components of spending.
♦ Consequently, trade links the GDPs of the major economies.
●Other multiplier effects:♦ A change in G has the same multiplier effect as
a change in I or a change in autonomous C.♦ The multiplier effect of a change in (X - IM) is
the same as for the other components of spending.
♦ Consequently, trade links the GDPs of the major economies.
The Multiplier Is a General The Multiplier Is a General The Multiplier Is a General The Multiplier Is a General ConceptConceptConceptConceptThe Multiplier Is a General The Multiplier Is a General The Multiplier Is a General The Multiplier Is a General ConceptConceptConceptConcept
●↑ GDP in a foreign country ⇒ ↑ its imports, a portion of which are exports from the U.S.
● The growth in U.S. exports has a multiplier effect, raising GDP in the U.S.
● Booms and recessions tend to be transmitted across national borders.
●↑ GDP in a foreign country ⇒ ↑ its imports, a portion of which are exports from the U.S.
● The growth in U.S. exports has a multiplier effect, raising GDP in the U.S.
● Booms and recessions tend to be transmitted across national borders.
The Multiplier Is a General The Multiplier Is a General The Multiplier Is a General The Multiplier Is a General ConceptConceptConceptConceptThe Multiplier Is a General The Multiplier Is a General The Multiplier Is a General The Multiplier Is a General ConceptConceptConceptConcept
The Multiplier and the The Multiplier and the The Multiplier and the The Multiplier and the Aggregate Demand CurveAggregate Demand CurveAggregate Demand CurveAggregate Demand CurveThe Multiplier and the The Multiplier and the The Multiplier and the The Multiplier and the Aggregate Demand CurveAggregate Demand CurveAggregate Demand CurveAggregate Demand Curve
●∆ autonomous spending ⇒ horizontal shift of the AD curve by an amount given by the oversimplified multiplier formula.
●∆ autonomous spending ⇒ horizontal shift of the AD curve by an amount given by the oversimplified multiplier formula.
FIGUREFIGUREFIGUREFIGURE 12 12 12 12.... Two Views of the Two Views of the Two Views of the Two Views of the MultiplierMultiplierMultiplierMultiplier
FIGUREFIGUREFIGUREFIGURE 12 12 12 12.... Two Views of the Two Views of the Two Views of the Two Views of the MultiplierMultiplierMultiplierMultiplier
45454545°
C C C C ++++ I I I I1111 ++++ G G G G ++++ (X (X (X (X –––– IIIIMMMM ) ) ) )
Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Determination & MultiplierDetermination & MultiplierDetermination & MultiplierDetermination & MultiplierSimple Algebra of Income Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Determination & MultiplierDetermination & MultiplierDetermination & MultiplierDetermination & Multiplier
● All of the relationships discussed can be represented in simple algebra.
● All of the relationships discussed can be represented in simple algebra.
Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Determination & MultiplierDetermination & MultiplierDetermination & MultiplierDetermination & MultiplierSimple Algebra of Income Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Determination & MultiplierDetermination & MultiplierDetermination & MultiplierDetermination & Multiplier
● Consumption function: C = a + b(DI)♦ Positive linear relationship between C and DI♦ a = autonomous consumption, determined by
factors aside from DI♦ b = marginal propensity to consume = ∆C/ ∆DI
♦ b(DI) = induced consumption, determined by DI
● Consumption function: C = a + b(DI)♦ Positive linear relationship between C and DI♦ a = autonomous consumption, determined by
factors aside from DI♦ b = marginal propensity to consume = ∆C/ ∆DI
♦ b(DI) = induced consumption, determined by DI
Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Determination & MultiplierDetermination & MultiplierDetermination & MultiplierDetermination & MultiplierSimple Algebra of Income Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Determination & MultiplierDetermination & MultiplierDetermination & MultiplierDetermination & Multiplier
● Equilibrium Y = C + I + G + (X - IM), so Equilibrium Y = a + b(DI) + I + G + (X - IM)
● Since DI = Y - T, Equilibrium Y = a + b(Y - T) + I + G + (X - IM)
● Therefore Equilibrium Y = a + bY - bT + I + G + (X - IM)
● Equilibrium Y = C + I + G + (X - IM), so Equilibrium Y = a + b(DI) + I + G + (X - IM)
● Since DI = Y - T, Equilibrium Y = a + b(Y - T) + I + G + (X - IM)
● Therefore Equilibrium Y = a + bY - bT + I + G + (X - IM)
Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Determination & MultiplierDetermination & MultiplierDetermination & MultiplierDetermination & MultiplierSimple Algebra of Income Simple Algebra of Income Simple Algebra of Income Simple Algebra of Income Determination & MultiplierDetermination & MultiplierDetermination & MultiplierDetermination & Multiplier
● Then solve for Y: Equilibrium Y = [a - bT + I + G + (X - IM)] / (1 - b)
● Then solve for Y: Equilibrium Y = [a - bT + I + G + (X - IM)] / (1 - b)