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mally use GDP to measure output:

Go v

+ G + (X “ IM)
The equilibrium level of GDP on the 1
demand side cannot be one at which Government
total spending exceeds output because
firms will notice that they are deplet-

ing their inventory stocks. Firms may Firms


Ta x e s
first decide to increase production

(produce the

domestic product)
sufficiently to meet the higher de-


mand. Later they may decide to raise I) Y)
Gros me (
prices. c
National In
Now imagine the other case, in which
F I GU R E 1
the flow of spending reaching firms falls
short of current production. Unsold output winds up as additional inventories. The inven- The Circular Flow
tory pile-up signals firms that either their pricing or output decisions were wrong. Once
again, they will probably react first by cutting back on production, causing GDP to fall (at
point 5 in Figure 1). If the imbalance persists, they may also lower prices to stimulate sales.
But they certainly will not be happy with things as they are. Thus:
The equilibrium level of GDP on the demand side cannot be one at which total spend-
ing is less than output, because firms will not allow inventories to pile up. They may
decide to decrease production, or they may decide to cut prices in order to stimulate
We have now determined, by process of elimination, the only level of output that is
consistent with people™s desires to spend. We have reasoned that GDP will rise whenever
it is less than total spending, C 1 I 1 G 1 (X 2 IM), and that GDP will fall whenever it ex-
ceeds C 1 I 1 G 1 (X 2 IM). Equilibrium can occur, then, only when there is just enough
spending to absorb the current level of production. Under such circumstances, producers
conclude that their price and output decisions are correct and have no incentive to change.
We conclude that
The equilibrium level of GDP on the demand side is the level at which total spending
equals production. In such a situation, firms find their inventories remaining at desired
levels, so they have no incentive to change output or prices.
Thus, the circular flow diagram has helped us to understand the concept of equilibrium
GDP and has shown us how the economy is driven toward this equilibrium. It leaves
unanswered, however, three important questions:
• How large is the equilibrium level of GDP?
• Will the economy suffer from unemployment, inflation, or both?
• Is the equilibrium level of GDP on the demand side also consistent with firms™
desires to produce? That is, is it also an equilibrium on the supply side?
The first two questions will occupy our attention in this chapter; the third is reserved to
the next.

All the models in this book assume, strictly for simplicity, that firms seek constant inventories. Deliberate

inventory changes are treated in more advanced courses.

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Licensed to:
Part 2
178 The Macroeconomy: Aggregate Supply and Demand

Our first objective is to determine precisely the equilibrium level of GDP on the demand
side. To make the analysis more concrete, we turn to a numerical example. Specifically, we
examine the relationship between total spending and GDP in the hypothetical economy
we introduced in the last chapter.
Columns 1 and 2 of Table 1 repeat the relationship
between consumption and GDP that we first encountered
in the preceding chapter. They show how consumer
The Total Expenditure Schedule
spending, C, depends on GDP, which we symbolize by the
(1) (2) (3) (4) (5) (6)
letter Y. Columns 3 through 5 provide the other three com-
Government Net ponents of total spending”I, G, and X 2 IM”through the
GDP Consumption Investment Purchases Exports Total
simplifying assumptions that each is just a fixed number
(X 2 IM) Expenditure
(Y) (C) (I) (G)
regardless of the level of GDP. Specifically, we assume that
4,800 3,000 900 1,300 2100 5,100
investment spending is $900 billion, government pur-
5,200 3,300 900 1,300 2100 5,400
chases are $1,300 billion, and net exports are 2$100 bil-
5,600 3,600 900 1,300 2100 5,700
lion”meaning that in this hypothetical economy, as in the
6,000 3,900 900 1,300 2100 6,000
6,400 4,200 900 1,300 2100 United States at present, imports exceed exports.
6,800 4,500 900 1,300 2100 6,600 By adding columns 2 through 5, we calculate C 1 I 1
7,200 4,800 900 1,300 2100 6,900
G 1 (X 2 IM), or total expenditure, which appears in col-
umn 6 of Table 1. Columns 1 and 6 are highlighted in blue
to show how total expenditure de-
F I GU R E 2
pends on income. We call this rela-
Construction of the Expenditure Schedule
tionship the expenditure schedule.
Figure 2 shows the construction
of the expenditure schedule graph-
ically. The black line labeled C is
C + I + G + (X“ IM)
the consumption function; it plots
on a graph the numbers given in
columns 1 and 2 of Table 1.
X “IM = “$100 The blue line, labeled C 1 I,
displays our assumption that in-
vestment is fixed at $900 billion. It
lies a fixed distance (correspon-
ding to $900 billion) above the C
line. If investment were not
G = $1,300
Real Expenditure

always $900 billion, the two lines
would either move closer together
or grow farther apart. For exam-
ple, our analysis of the determi-
nants of investment spending
C suggested that I might be larger
when GDP is higher. Such added
investment as GDP rises”which
I = $900
is called induced investment”
would give the resulting C 1 I
line a steeper slope than the C
line. But we ignore that possibility
3,900 here for simplicity.
The green line, labeled C 1 I 1 G,
adds government purchases. Be-
cause they are assumed to be $1,300
5,200 5,600 6,000 6,400 6,800 7,200
billion regardless of the size of GDP,
Real GDP
the green line is parallel to the blue
line and $1,300 billion higher.
NOTE: Figures are in billions of dollars per year.

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Licensed to:

Chapter 9 179
Demand-Side Equilibrium: Unemployment or Inflation?

Finally, the brick-colored line labeled C 1 I 1 G 1 (X 2 IM) adds in net exports. It is An expenditure schedule
parallel to the green line and $100 billion lower, reflecting our assumption that net exports shows the relationship
are always 2$100 billion. Once again, if imports depended on GDP, as the previous chap- between national income
(GDP) and total spending.
ter suggested, the C 1 I 1 G and C 1 I 1 G 1 (X 2 IM) lines would not be parallel. We
deal with this more complicated case in Appendix B to this chapter. Induced investment is
We are now ready to determine demand-side equilibrium in our hypothetical economy. the part of investment
Table 2 presents the logic of the circular flow argument in tabular form. The first two columns spending that rises when
reproduce the expenditure schedule that we have just constructed. The other columns ex- GDP rises and falls when
GDP falls.
plain the process by which the economy approaches equilibrium. Let us see why a GDP of
$6,000 billion must be the equilibrium level.
Consider first any output
level below $6,000 billion. For TA BL E 2
example, at output level The Determination of Equilibrium Output
Y 5 $5,200 billion, total expendi-
(1) (2) (3) (4) (5)
ture is $5,400 billion, as shown in
Output Total Spending Balance of Inventory Producer
column 2. This is $200 billion
[C 1 I 1 G 1 (X 2 IM)]
(Y ) Spending and Output Status Response
more than production. With
4,800 5,100 Spending exceeds output Falling Produce more
spending greater than output, as
5,200 5,400 Spending exceeds output Falling Produce more
noted in column 3, inventories
5,600 5,700 Spending exceeds output Falling Produce more
will fall (see column 4). As the
6,000 6,000 Spending 5 output Constant No change
table suggests in column 5, this 6,400 6,300 Output exceeds spending Rising Produce less
will signal producers to raise 6,800 6,600 Output exceeds spending Rising Produce less
7,200 6,900 Output exceeds spending Rising Produce less
their output. Clearly, then, no
output level below Y 5 $6,000 NOTE: Amounts are in billions of dollars.
billion can be an equilibrium,
because output is too low.
A similar line of reasoning eliminates any output level above $6,000 billion. Consider,
for example, Y 5 $6,800 billion. The table shows that total spending would be $6,600 bil-
lion if output were $6,800 billion, so $200 billion would go unsold. This would raise pro-


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