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ducersâ€™ inventory stocks and signal them that their rate of production was too high.
Just as we concluded from our circular flow diagram, equilibrium will be achieved only
when total spending, C 1 I 1 G 1 (X 2 IM), exactly equals GDP, Y. In symbols, our con- F I GU R E 3
dition for equilibrium GDP is Income-Expenditure
Diagram
Y 5 C 1 I 1 G 1 (X 2 IM)
Table 2 shows that this equation holds only at a
Output exceeds spending
7,200
GDP of \$6,000 billion, which must therefore be the 45
equilibrium level of GDP.
Figure 3 depicts the same conclusion graphically, 6,800
by adding a 45Â° line to Figure 2. Why a 45Â° line? Re-
call from the appendix to Chapter 1 that a 45Â° line C+I+G+
6,400
(X â€“ IM)
marks all points on a graph at which the value of
the variable measured on the horizontal axis (in this
Real Expenditure

E
6,000
case, GDP) equals the value of the variable meas-
Equilibrium
ured on the vertical axis (in this case, total expendi-
ture).2 Thus, the 45Â° line in Figure 3 shows all the 5,600
points at which output and spending are equalâ€”
that is, where Y 5 C 1 I 1 G 1(X 2 IM). The 45Â° line 5,200
therefore displays all the points at which the economy can
possibly be in demand-side equilibrium, for firms will Spending exceeds
4,800
be content with current output levels only if total output
spending equals production.
0 4,800 5,200 5,600 6,000 6,400 6,800 7,200
Real GDP
If you need review, see the appendix to Chapter 1, especially
2

pages 16â€“17. NOTE: Figures are in billions of dollars per year.

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Part 2
180 The Macroeconomy: Aggregate Supply and Demand

Now we must compare these potential equilibrium points with the actual combinations
of spending and output that are consistent with the current behavior of consumers and
investors. That behavior is described by the C 1 I 1 G 1 (X 2 IM) line in Figure 3, which
shows how total expenditure varies as income changes. The economy will always be on the
expenditure line because only points on the C 1 I 1 G 1 (X 2 IM) line describe the spend-
ing plans of consumers and investors. Similarly, if the economy is in equilibrium, it must
be on the 45Â° line. As Figure 3 shows, these two requirements imply that the only viable
equilibrium is at point E, where the C 1 I 1 G 1 (X 2 IM) line intersects the 45Â° line.
Only this point is consistent with both equilibrium and peopleâ€™s actual desires to
consume and invest.
Notice that to the left of the equilibrium point, E, the expenditure line lies above the 45Â°
line. This means that total spending exceeds total output, as we have already noted.
Hence, inventories will be falling and firms will conclude that they should increase pro-
duction. Thus, production will rise toward the equilibrium point, E. The opposite is true
to the right of point E. Here spending falls short of output, inventories rise, and firms will
cut back productionâ€”thereby moving closer to E.
In other words, whenever production is above the equilibrium level, market forces will
An income-expenditure
diagram, or 45Â° line drive output down. And whenever production is below equilibrium, market forces will
diagram, plots total real drive output up. In either case, deviations from demand-side equilibrium will gradually
expenditure (on the vertical
be eliminated.
axis) against real income
Diagrams such as Figure 3 will recur so frequently in this and the next several chapters
(on the horizontal axis). The
that it will be convenient to have a name for them. We call them income-expenditure
45Â° line marks off points
diagrams, because they show how expenditures vary with income, or simply 45Â° line
where income and expendi-
diagrams.
ture are equal.

THE AGGREGATE DEMAND CURVE
Chapter 5 introduced aggregate demand and aggregate supply curves relating aggregate
quantities demanded and supplied to the price level. The expenditure schedule graphed
in Figure 3 is certainly not the aggregate demand curve, for we have yet to bring the price
level into our discussion. It is now time to remedy this omission and derive the aggregate
demand curve.
To do so, we need only recall something we learned in the last chapter. As we noted on
page 162, households own a great deal of money-fixed assets whose real value declines
when the price level rises. The money in your bank account is a prime example. If prices
rise, it will buy less. Because of that fact, consumersâ€™ real wealth declines whenever the
price level risesâ€”and that affects their spending. Specifically:
Higher prices decrease the demand for goods and services because they erode the pur-
chasing power of consumer wealth. Conversely, lower prices increase the demand for
goods and services by enhancing the purchasing power of consumer wealth.
For these reasons, a change in the price level will shift the entire consumption function.
To represent this shift graphically, Figure 4 (which looks just like Figure 6 from the previ-
ous chapter) shows that
A higher price level leads to lower real wealth and therefore to less spending at any
given level of real income. Thus, a higher price level leads to a lower consumption
function (such as C1 in Figure 4), and a lower price level leads to a higher consumption
function (such as C2 in Figure 4).
Because students are sometimes confused by this point, it is worth repeating that the
depressing effect of the price level on consumer spending works through real wealth, not
through real income. The consumption function is a relationship between real consumer
income and real consumer spending. Thus, any decline in real income, regardless of its

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Licensed to:

Chapter 9 181
Demand-Side Equilibrium: Unemployment or Inflation?

cause, moves the economy leftward along a fixed consump-
Effect of changes in
tion function; it does not shift the consumption function.
real income
By contrast, a decline in real wealth will shift the entire con- C2
sumption function downward, meaning that people spend

Real Consumer Spending
C0
less at any given level of real income.
C1
In terms of the 45Â° line diagram, a rise in the price level Lower price
level
will therefore pull down the consumption function depicted
in Figure 2 and hence will pull down the total expenditure A
schedule as well. Conversely, a fall in the price level will
raise both the C and C 1 I 1 G 1 (X 2 IM) schedules in Higher price
level
the diagram. The two panels of Figure 5 illustrate both of
these shifts.
How, then, do changes in the price level affect the equi-
librium level of real GDP on the demand side? Common
sense says that, with lower spending, equilibrium GDP
Real Disposable Income
should fall; and Figure 5 shows that this conclusion is
correct. Figure 5(a) shows that a rise in the price level, by
F I GU R E 4
shifting the expenditure schedule downward, leads to a
How the Price Level
reduction in the equilibrium quantity of real GDP demanded from Y0 to Y1. Conversely,
Shifts the Consumption
Figure 5(b) shows that a fall in the price level, by shifting the expenditure schedule
Function
upward, leads to a rise in the equilibrium quantity of real GDP demanded from Y0 to Y2.
In summary:
A rise in the price level leads to a lower equilibrium level of real aggregate quantity de-
manded. This relationship between the price level and real GDP (depicted in Figure 6 on
the next page) is precisely what we called the aggregate demand curve in earlier chap-
ters. It comes directly from the 45Â° line diagrams in Figure 5. Thus, points E0, E1, and E2
in Figure 6 correspond precisely to the points bearing the same labels in Figure 5.
The effect of higher prices on consumer wealth is just one of several reasons why the
aggregate demand curve slopes downward. A second reason comes from international
trade. In Chapter 8â€™s discussion of the determinants of net exports (see pages

F I GU R E 5
The Effect of the Price Level on Equilibrium Aggregate Quantity Demanded

45
45

C2 + I + G + (Xâ€“ IM)
E2
C 0 + I + G + (Xâ€“IM)
Real Expenditure

Real Expenditure

C0 + I + G + (X â€“IM)
E0
E0

C1 + I + G + (X â€“IM)
E1

45 45
Y1 Y0 Y0 Y2
Real GDP Real GDP

(a) Rise in Price Level (b) Fall in Price Level

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

165â€“166), we pointed out that higher U.S. prices (holding foreign
F I GU R E 6
prices constant) will depress exports (X) and stimulate imports (IM).
The Aggregate Demand Curve
That means that, other things equal, a higher U.S. price level will re-
duce the (X 2 IM) component of total expenditure, thereby shifting the
C 1 I 1 G 1 (X 2 IM) line downward and lowering real GDP, as de-
picted in Figure 5(a).
Later in this book, after we have studied interest rates and exchange
E1 rates, we will encounter still more reasons for a downward-sloping ag-
P1
Price Level

gregate demand curve. All of them imply that
E0
P0
An income-expenditure diagram like Figure 3 can be drawn only for
a specific price level. At different price levels, the C 1 I 1 G 1
E2
P2
(X 2 IM) schedule will be different and, hence, the equilibrium
quantity of GDP demanded will also be different.
Y1 Y0 Y2
As we will now see, this seemingly technical point about graphs is crit-
Real GDP
ical to understanding the genesis of unemployment and inflation.

DEMAND-SIDE EQUILIBRIUM AND FULL EMPLOYMENT

We now turn to the second major question posed on page 177: Will the economy achieve
an equilibrium at full employment without inflation, or will we see unemployment, infla-
tion, or both? This question is a crucial one for stabilization policy, for if the economy
always gravitates toward full employment automatically, then the government should
simply leave it alone.
In the income-expenditure diagrams used so far, the equilibrium level of GDP de-
manded appears as the intersection of the expenditure schedule and the 45Â° line, regard-
less of the GDP level that corresponds to full employment. However, as we will see now,
when equilibrium GDP falls above potential GDP, the economy probably will be plagued
by inflation, and when equilibrium falls below potential GDP, unemployment and reces-
sion will result.
This notable fact was one of the principal messages
F I GU R E 7
of Keynesâ€™s General Theory of Employment, Interest, and
A Recessionary Gap
Money. Writing during the Great Depression, it was
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