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the same. So there are no entries corresponding to “income received
In this context, disposable income is national income plus transfer
12
from other countries” or “income paid to other countries,” as in
payments minus taxes.
Table 4.




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Part 2
174 The Macroeconomy: Aggregate Supply and Demand



| DISCUSSION QUESTIONS |
1. Explain the difference between final goods and interme- 3. Explain why national income and gross domestic product
diate goods. Why is it sometimes difficult to apply this would be essentially equal if there were no depreciation.
distinction in practice? In this regard, why is the concept
of value added useful?
2. Explain the difference between government spending
and government purchases of goods and services (G).
Which is larger?




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Licensed to:




Demand-Side Equilibrium:
Unemployment or Inflation?
A definite ratio, to be called the Multiplier, can be established between income and investment.
J O H N M AY NA R D K EY N E S



L et™s briefly review where we have just been. In Chapter 5, we learned that the
interaction of aggregate demand and aggregate supply determines whether the
economy will stagnate or prosper, whether our labor and capital resources will be fully
employed or unemployed. In Chapter 8, we learned that aggregate demand has four
components: consumer expenditure (C), investment (I), government purchases (G), and
net exports (X 2 IM). It is now time to start building a theory that puts the pieces together
so we can see where the aggregate demand and aggregate supply curves come from.
Because it is best to walk before you try to run, our approach is sequential. We begin
in this chapter by assuming that taxes, the price level, the rate of interest, and the inter-
national value of the dollar are all constant. None of these assumptions is true, of
course, and we will dispense with all of them in subsequent chapters. But we reap two
important benefits from making these unrealistic assumptions now. First, they enable
us to construct a simple but useful model of how the strength of aggregate demand in-
fluences the level of gross domestic product (GDP)”a model we will use to derive
specific numerical solutions. Second, this simple model enables us to obtain an initial
answer to a question of great importance to policy makers: Can we expect the economy
to achieve full employment if the government does not intervene?




CONTENTS
ISSUE: WHY DOES THE MARKET PERMIT THE COORDINATION OF SAVING THE MULTIPLIER AND THE AGGREGATE
UNEMPLOYMENT? AND INVESTMENT DEMAND CURVE
THE MEANING OF EQUILIBRIUM GDP CHANGES ON THE DEMAND SIDE: | APPENDIX A | The Simple Algebra of Income
MULTIPLIER ANALYSIS Determination and the Multiplier
THE MECHANICS OF INCOME
The Magic of the Multiplier
DETERMINATION | APPENDIX B | The Multiplier with Variable
Demystifying the Multiplier: How It Works Imports
THE AGGREGATE DEMAND CURVE Algebraic Statement of the Multiplier
DEMAND-SIDE EQUILIBRIUM AND FULL THE MULTIPLIER IS A GENERAL CONCEPT
EMPLOYMENT




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Part 2
176 The Macroeconomy: Aggregate Supply and Demand



ISSUE: WHY DOES THE MARKET PERMIT UNEMPLOYMENT?
Economists are fond of pointing out, with some awe, the amazing achieve-
ments of free markets. Without central direction, they somehow get busi-
nesses to produce just the goods and services that consumers want”and to
do so cheaply and efficiently. If consumers want less meat and more fish,
markets respond. If people subsequently change their minds, markets
respond again. Free markets seem able to coordinate literally millions of
decisions effortlessly and seamlessly.
Yet for hundreds of years and all over the globe, market economies have stumbled
over one particular coordination problem: the periodic bouts of mass unemployment
that we call recessions and depressions. Widespread unemployment represents a failure
to coordinate economic activity in the following sense. If the unemployed were hired,
they would be able to buy the goods and services that businesses cannot sell. The rev-
enues from those sales would, in turn, allow firms to pay the workers. So a seemingly
straightforward “deal” offers jobs for the unemployed and sales for the firms. But
somehow this deal is not made. Workers remain unemployed and firms get stuck with
unsold output.
Thus, free markets, which somehow manage to get rough diamonds dug out of the
ground in South Africa and turned into beautiful rings that grooms buy for brides in
Los Angeles, cannot seem to solve the coordination problem posed by unemployment.
Why not? For centuries, economists puzzled over this question. By the end of the chap-
ter, we will be well on the way toward providing an answer.




THE MEANING OF EQUILIBRIUM GDP
First, let™s put the four components of aggregate demand together to see how they inter-
act, using as our organizing framework the circular flow diagram from the last chapter. In
doing so, we initially ignore a possibility raised in earlier chapters: that the government
might use monetary and fiscal policy to steer the economy in some desired direction.
Aside from pedagogical simplicity, there is an important reason for doing so. One of the
crucial questions surrounding stabilization policy is whether the economy would automat-
ically gravitate toward full employment if the government simply left it alone. Contradict-
ing the teachings of generations of economists before him, Keynes claimed it would not.
But Keynes™s views are controversial to this day. We can study the issue best by imagining
an economy in which the government never tries to manipulate aggregate demand, which
is just what we do in this chapter.
To begin to construct such a model, we must first understand what we mean by equilib-
rium GDP. Figure 1, which repeats Figure 1 from the last chapter, is a circular flow diagram
that will help us do this. As explained in the last chapter, total production and total income
must be equal. But the same need not be true of total spending. Imagine that, for some rea-
son, the total expenditures made after point 4 in the figure, C 1 I 1 G 1 (X 2 IM), exceed
the output produced by the business firms at point 5. What happens then?
Because consumers, businesses, government, and foreigners together are buying more
than firms are producing, businesses will start pulling goods out of their warehouses to
meet demand. Thus, inventory stocks will fall”which signals retailers that they need to
Equilibrium refers to a increase their orders and manufacturers that they need to step up production. Conse-
situation in which neither
quently, output is likely to rise.
consumers nor firms have
At some later date, if evidence indicates that the high level of spending is not just a
any incentive to change
temporary aberration, manufacturers and retailers may also respond to buoyant sales per-
their behavior. They are
formances by raising their prices. Economists therefore say that neither output nor the
content to continue with
price level is in equilibrium when total spending exceeds current production.
things as they are.




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Licensed to:
Chapter 9 177
Demand-Side Equilibrium: Unemployment or Inflation?



The definition of equilibrium in the
Expenditures Rest of the
margin tells us that the economy cannot World
Financial System C+
(I) l
)
be in equilibrium when total spending (C
n




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tio




en
3
exceeds production, because falling in- p




tm
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um




C
(G




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(IM )




ns
s
ventories demonstrate to firms that their




Inv




l+
rts s (X




Co




se
in g
o
Impxport




ha




G
production and pricing decisions were




(S




rc
E




Pu
)
Investors
not quite right.1 Thus, because we nor-



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