Demand-Side Equilibrium:
Multiplier Analysis
A definite ratio, to be called the Multiplier, can be
established between income and investment.
JOHN MAYNARD KEYNES
Asst. Prof. Dr. Serdar AYAN
The
The Meaning
Meaning of
of Equilibrium
Equilibrium
GDP
GDP
●●GDP
GDP cannot
cannot be
be at
at its
its equilibrium
equilibrium ifif total
total
spending
spending differs
differs from
from the
the value
value of
of output.
output.
●●IfIf spending
spending exceeds
exceeds output,
output, inventories
inventories fall
fall
and
and firms
firms increase
increase production.
production.
●●IfIf output
output exceeds
exceeds spending,
spending, inventories
inventories rise
rise
and
and firms
firms reduce
reduce production.
production.
FIGURE
1.
The Circular
Circular Flow
Flow
1
1... The
FIGURE 1
Diagram
Diagram
Financial System
)
(
Go
ve
rnm
en
t P
ur
ch
as
es
Inv
es
tm
en
t (I
)
G
I+
G
4
G + (X – IM)
Government
s
Taxe s
fer
Trans
le
ab
os
sp
Di
In
co
m
e
(D
I)
5
)
(IM X)
s
t
(
r
po orts
m
I
p
Ex
C+I+
1
3
2
+
Investors
Consumers
C+I
)
(C
C
S)
g(
vin
Sa
n
ti o
p
m
su
n
Co
Rest of the
World
Firms
(produce the
domestic product)
6
)
e (Y
s
s
m
o
Gr Inco
al
o
Nati n
.
The
The Meaning
Meaning of
of Equilibrium
Equilibrium
GDP
GDP
●●The
The equilibrium
equilibrium level
level of
of GDP
GDP on
on the
the
demand
demand side
side isis the
the one
one at
at which
which total
total
spending
spending equals
equals production.
production.
●●In
In such
such aa situation,
situation, firms
firms find
find their
their
inventories
inventories remaining
remaining at
at desired
desired levels,
levels, so
so
there
there isis no
no incentive
incentive to
to change
change output
output or
or
prices.
prices.
The
The Mechanics
Mechanics of
of Income
Income
Determination
Determination
●●Constructing
Constructing the
the total
total expenditure
expenditure schedule
schedule
♦♦Expenditure
Expenditure Schedule
Schedule == table
table showing
showing the
the
relationship
relationship between
between GDP
GDP and
and total
total spending
spending
♦♦Induced
Induced Investment
Investment == the
the part
part of
of investment
investment
spending
spending that
that rises
rises when
when GDP
GDP rises,
rises, and
and falls
falls
when
when GDP
GDP falls.
falls.
TABLE
The Determination
Determination of
of
1. The
TABLE 1.
Equilibrium
Equilibrium Output
Output
FIGURE
2.
Construction of
of the
the
2
2... Construction
FIGURE 2
Expenditure
Expenditure Schedule
Schedule
C+I+ G
C + I + G + ( X – IM )
X – IM = –$100
6,100
6,000
C+I
Real Expenditure
G = $1,300
C
4,800
I = $900
3,900
5,200
5,600
6,000
6,400
Real GDP
6,800
7,200
.
The
The Mechanics
Mechanics of
of Income
Income
Determination
Determination
●●Both
Both the
the expenditure
expenditure table
table and
and the
the
corresponding
corresponding “income-expenditure
“income-expenditure
diagram”
diagram” or
or “45
“45 degree
degree line
line diagram”
diagram” show
show
the
the equilibrium
equilibrium level
level of
of GDP.
GDP.
●●All
All other
other levels
levels of
of GDP
GDP are
are disequilibrium
disequilibrium
points,
points, at
at which
which GDP
GDP will
will move
move in
in the
the
direction
direction of
of the
the equilibrium.
equilibrium.
FIGURE
3.
3
3... Income-Expenditure
Income-Expenditure
FIGURE 3
Diagram
Diagram
7,200
Output exceeds spending
45
45°°
6,800
C +I +G +
( X – IM )
Real Expenditure
6,400
6,000
E
Equilibrium
5,600
5,200
4,800
0
Spending exceeds
output
4,800 5,200 5,600 6,000 6,400 6,800 7,200
Real GDP
The
The Aggregate
Aggregate Demand
Demand
Curve
Curve
●●↑↑ price
price level
level ⇒
⇒ ↓↓ consumption
consumption
●●Therefore,
Therefore, ↑↑ price
price level
level ⇒
⇒ ↓↓ total
total
expenditures
expenditures and
and ↓↓ equilibrium
equilibrium GDP
GDP
●●Therefore,
Therefore, ↑↑ price
price level
level ⇒
⇒ ↓↓ equilibrium
equilibrium
level
level of
of real
real aggregate
aggregate quantity
quantity demanded
demanded
FIGURE
4.
The Effect
Effect of
of the
the Price
Price
4
4... The
FIGURE 4
Level
Level on
on Equilibrium
Equilibrium AD
AD
45
45
C2 + I + G + (X – IM )
E2
E0
C1 + I + G + (X – IM)
E1
45
Real Expenditure
Real Expenditure
C0 + I + G + (X – IM )
E0
C0 + I + G + (X – IM)
45
Y1
Y0
Real GDP
( a)
Y0
Y2
Real GDP
( b)
Rise in Pric
e Level
Price
Fall in Pric
e Level
Price
The
The Aggregate
Aggregate Demand
Demand
Curve
Curve
●●The
The negatively-sloped
negatively-sloped aggregate
aggregate demand
demand
curve
curve shows
shows all
all the
the equilibria
equilibria of
of price
price levels
levels
and
and GDP.
GDP.
●●Remember
Remember that
that any
any income-expenditure
income-expenditure
diagram
diagram isis drawn
drawn for
for aa specific
specific price
price level.
level.
FIGURE
5.
The Aggregate
Aggregate
5
5... The
FIGURE 5
Price Level
Demand
Demand Curve
Curve
P1
P0
P2
E1
E0
E2
Y1 Y0 Y2
Real GDP
Demand-Side
Demand-Side Equilibrium
Equilibrium
and
and Full
Full Employment
Employment
●●Equilibrium
Equilibrium GDP
GDP may
may not
not == fullfullemployment
employment GDP.
GDP.
●●Recessionary
Recessionary gap:
gap: amount
amount by
by which
which
equilibrium
equilibrium GDP
GDP << potential
potential GDP
GDP
●●Inflationary
Inflationary gap:
gap: amount
amount by
by which
which
equilibrium
equilibrium GDP
GDP >> potential
potential GDP
GDP
6.
FIGURE
A Recessionary
Recessionary Gap
Gap
6
6... A
FIGURE 6
Potential
GDP
45
45°°
F
Real Expenditure
C + I + G + (X – I M )
E
B
Recessionary gap
45
45°°
7,000
6,000
Real GDP
7.
FIGURE
An Inflationary
Inflationary Gap
Gap
7
7... An
FIGURE 7
Potential
GDP
45
45°°
Inflationary gap
B
E
Real Expenditure
C + I + G + (X – I M )
F
45
45°°
7,000
Real GDP
8,000
The
The Coordination
Coordination of
of Saving
Saving
and
and Investment
Investment
●●Equilibrium
Equilibrium GDP
GDP == full
full employment
employment only
only ifif
saving
saving out
out of
of full-employment
full-employment incomes
incomes ==
investment
investment
●●Savers
Savers are
are not
not the
the same
same people
people as
as investors,
investors,
so
so itit isis unlikely
unlikely that
that this
this condition
condition will
will hold.
hold.
FIGURE
8.
A Simplified
Simplified Circular
Circular
8
8... A
FIGURE 8
Flow
Flow
S)
g(
vin
Sa
C+I
2
Investors
C+I
Consumers
)
(C
n
io
pt
m
u
ns
o
C
Inv
es
tm
en
t (I
)
Financial System
1
3
Y
Firms
(produce the
domestic product)
Changes
Changes on
on the
the Demand
Demand
Side:
Side: Multiplier
Multiplier Analysis
Analysis
●●Multiplier
Multiplier == ratio
ratio of
of the
the change
change in
in
equilibrium
equilibrium GDP
GDP (Y)
(Y) divided
divided by
by the
the
original
original change
change in
in spending
spending that
that caused
caused the
the
change
change in
in GDP
GDP
Changes
Changes on
on the
the Demand
Demand
Side:
Side: Multiplier
Multiplier Analysis
Analysis
●●Demystifying
Demystifying the
the Multiplier:
Multiplier: How
How ItIt Works
Works
♦♦The
The multiplier
multiplier isis greater
greater than
than 11 because
because one
one
person’s
person’s spending
spending isis another
another person’s
person’s income.
income.
♦♦↑↑ spending
spending ⇒
⇒ ↑↑ income
income
♦♦A
A portion
portion of
of the
the increase
increase in
in income
income isis spent
spent on
on
consumption,
consumption, creating
creating more
more income,
income, which
which in
in
turn
turn creates
creates more
more consumption
consumption spending,
spending, and
and
so
so on.
on.
TABLE
4.
The Multiplier
Multiplier
4
4... The
TABLE 4
Spending
Spending Chain
Chain
FIGURE
10.
How the
the Multiplier
Multiplier
10
10... How
FIGURE 10
Builds
Builds
Cumulative Spending Total
$4.0
3.0
2.0
1.0
0
2
4
6
8
10
Spending Round
15
20
Changes
Changes on
on the
the Demand
Demand
Side:
Side: Multiplier
Multiplier Analysis
Analysis
●●Algebraic
Algebraic Statement
Statement of
of the
the Multiplier
Multiplier
♦♦Multiplier
Multiplier == 11 ÷÷ (1
(1 -- MPC)
MPC)
♦♦The
The MPC
MPC has
has been
been estimated
estimated to
to be
be about
about 0.9,
0.9,
implying
implying that
that the
the multiplier
multiplier isis 10.
10.
♦♦In
In fact,
fact, the
the multiplier
multiplier isis << 2.
2.
Changes
Changes on
on the
the Demand
Demand
Side:
Side: Multiplier
Multiplier Analysis
Analysis
●●Algebraic
Algebraic Statement
Statement of
of the
the Multiplier
Multiplier
♦♦Factors
Factors that
that reduce
reduce the
the size
size of
of the
the multiplier
multiplier
■International
■International trade
trade
■Inflation
■Inflation
■Income
■Income taxation
taxation
■Financial
■Financial system
system
The
The Multiplier
Multiplier Is
Is aa General
General
Concept
Concept
●●An
An autonomous
autonomous change
change in
in consumer
consumer
spending
spending (caused
(caused by
by something
something other
other than
than
an
an increase
increase in
in income)
income) shifts
shifts the
the
consumption
consumption function
function and
and has
has aa multiplier
multiplier
effect,
effect, just
just the
the same
same as
as aa change
change in
in II does.
does.
The
The Multiplier
Multiplier Is
Is aa General
General
Concept
Concept
●Other
multiplier effects:
effects:
●Other multiplier
♦♦A
A change
change in
in G
G has
has the
the same
same multiplier
multiplier effect
effect as
as
aa change
change in
in II or
or aa change
change in
in autonomous
autonomous C.
C.
♦♦The
The multiplier
multiplier effect
effect of
of aa change
change in
in (X
(X -- IM)
IM) isis
the
the same
same as
as for
for the
the other
other components
components of
of
spending.
spending.
♦♦Consequently,
Consequently, trade
trade links
links the
the GDPs
GDPs of
of the
the
major
major economies.
economies.
The
The Multiplier
Multiplier Is
Is aa General
General
Concept
Concept
●●↑↑ GDP
GDP in
in aa foreign
foreign country
country ⇒
⇒ ↑↑ its
its
imports,
imports, aa portion
portion of
of which
which are
are exports
exports from
from
the
the U.S.
U.S.
●●The
The growth
growth in
in U.S.
U.S. exports
exports has
has aa multiplier
multiplier
effect,
effect, raising
raising GDP
GDP in
in the
the U.S.
U.S.
●●Booms
Booms and
and recessions
recessions tend
tend to
to be
be transmitted
transmitted
across
across national
national borders.
borders.
The
The Multiplier
Multiplier and
and the
the
Aggregate
Aggregate Demand
Demand Curve
Curve
●●∆∆ autonomous
autonomous spending
spending ⇒
⇒ horizontal
horizontal
shift
shift of
of the
the AD
AD curve
curve by
by an
an amount
amount given
given
by
by the
the oversimplified
oversimplified multiplier
multiplier formula.
formula.
FIGURE
12.
Two Views
Views of
of the
the
12
12... Two
FIGURE 12
Multiplier
Multiplier
45
45°
C + I1 + G + (X – I M )
Real Expenditure
E1
$200 billion
E0
6,000
0
D0
Price Level
C + I0 + G + ( X – I M )
6,800
D1
E0
E1
100
D 1 ( I = $1,100)
D 0 ( I = $900)
6,000
6,800
Real GDP
The Simple Algebra of
Income Determination
and the Multiplier
Simple
Simple Algebra
Algebra of
of Income
Income
Determination
Determination &
& Multiplier
Multiplier
●●All
All of
of the
the relationships
relationships discussed
discussed can
can be
be
represented
represented in
in simple
simple algebra.
algebra.
Simple
Simple Algebra
Algebra of
of Income
Income
Determination
Determination &
& Multiplier
Multiplier
●●Consumption
Consumption function:
function: CC == aa ++ b(DI)
b(DI)
♦♦Positive
Positive linear
linear relationship
relationship between
between CC and
and DI
DI
♦♦aa == autonomous
autonomous consumption,
consumption, determined
determined by
by
factors
factors aside
aside from
from DI
DI
♦♦bb == marginal
∆C/
marginal propensity
propensity to
to consume
consume == ∆C/
∆DI
∆DI
♦♦b(DI)
b(DI) == induced
induced consumption,
consumption, determined
determined by
by
DI
DI
Simple
Simple Algebra
Algebra of
of Income
Income
Determination
Determination &
& Multiplier
Multiplier
●●Equilibrium
Equilibrium Y
Y == CC ++ II ++ G
G ++ (X
(X -- IM),
IM), so
so
Equilibrium
Equilibrium Y
Y == aa ++ b(DI)
b(DI) ++ II ++ G
G ++ (X
(X -IM)
IM)
●●Since
Since DI
DI == Y
Y -- T,
T, Equilibrium
Equilibrium Y
Y == aa ++ b(Y
b(Y -T)
T) ++ II ++ G
G ++ (X
(X -- IM)
IM)
●●Therefore
Therefore Equilibrium
Equilibrium Y
Y == aa ++ bY
bY -- bT
bT ++ II
++ G
G ++ (X
(X -- IM)
IM)
Simple
Simple Algebra
Algebra of
of Income
Income
Determination
Determination &
& Multiplier
Multiplier
●●Then
Then solve
solve for
for Y:
Y: Equilibrium
Equilibrium Y
Y == [a
[a -- bT
bT
++ II ++ G
G ++ (X
(X -- IM)]
IM)] // (1
(1 -- b)
b)