Northeastern University

University College

Economic Principles I

ECN 4115, Summer 1994

Handout # 6

Equilibrium domestic output in equilibrium

1. Expenditure-output approach

2. Leakage-injection approach

Expenditure-output approach

Tabular analysis

Graphical analysis

Determination of equilibrium level of output and income: closed economy private sector

Employment (millions)	GDP = DI	Consumption, C	Saving, S	Investment, Ig	Aggregate Expenditure (C+Ig)	Inventories (+ or -)	Tendency of Employment, output
40	370	375	-5	20	395	-25	Increase
45	390	390	0	20	410	-20	Increase
50	410	405	5	20	425	-15	Increase
55	430	420	10	20	440	-10	Increase
60	450	435	15	20	455	-5	Increase
65	470	450	20	20	470	0	Equilibrium
70	490	465	25	20	485	+5	Decrease
75	510	480	30	20	500	+10	Decrease
80	530	495	35	20	515	+15	Decrease
85	550	510	40	20	530	+20	Decrease

Graphical analysis

Consumption is directly related to income. A fixed level of investment causes a shift in aggregate demand parallel to the consumption function. At equilibrium total spending is just enough to the income generated by producing that level of output. If the total production is more than spending, inventory accumulates, therefore business cut back output, employment level declines as well. In contrast if spending is more than output, inventory decumulates; this means business tends to supply more to meet demand. At equilibrium spending there is no incentive to overproduce or cut back the level of production.

Leakage-injection Approach

Compare level of saving and investment

Saving is positive function of the level of income; Investment is exogenous.

Equality of planned investment and planned saving guarantees the equilibrium level of GDP. If planned investment is not equal to the planned saving then business adjusts by increasing or decreasing the level of output.

Multiplier Effect = (Change in real GDP/Initial Change in Spending)

Initial change in spending will cause a spending chain reaction.

Tabular and Graphical example.

Multiplier = (1/MPS); Higher the MPC, larger the multiplier;

Equilibrium versus Full Employment GDP

Recessionary Gap

Inflationary Gap

Net export and equilibrium GDP

Positive net export has expansionary effect on GDP

Negative net export has contractionary effect on GDP

Derivation of Aggregate Demand Curve from Keynesian Analysis

Role of Fiscal Policy

Tabulr and Graphical analysis of equilibrium GDP with government spending and taxes

GDP = DI	Consumption, C	Saving, S	Net exports X M	Investment, Ig	Government Expenditure	Aggregate Expenditure (C+Ig +Xn + G)
370	375	-5	10 10	20	20	415
390	390	0	10 10	20	20	430
410	405	5	10 10	20	20	445
430	420	10	10 10	20	20	460
450	435	15	10 10	20	20	475
470	450	20	10 10	20	20	490
490	465	25	10 10	20	20	505
510	480	30	10 10	20	20	520
530	495	35	10 10	20	20	535
550	510	40	10 10	20	20	550

Determination of equilibrium output, income and employment: with public, private and foreign sectors

GDP = DI	Taxes, T	Disposable Income	Consumption, C	Saving, S	Net exports X M	Investment, Ig	Government Expenditure	Aggregate Expenditure (C+Ig +Xn + G)
370	20	350	360	-10	10 10	20	20	400
390	20	370	375	-5	10 10	20	20	415
410	20	390	390	0	10 10	20	20	430
430	20	410	405	5	10 10	20	20	445
450	20	430	420	10	10 10	20	20	460
470	20	450	435	15	10 10	20	20	475
490	20	470	450	20	10 10	20	20	490
510	20	490	465	25	10 10	20	20	505
530	20	510	480	30	10 10	20	20	520
550	20	530	495	35	10 10	20	20	535

Leakage-injection approach:

Ig + X+G= S + M + T

Balanced Budget Multiplier

Discretionary Fiscal policy

Expansionary Fiscal Policy : Increased G, lower taxes

Contractionary Fiscal policy: decreased spending, higher taxes

Built-in Stabilizers: Progressive or proportional tax system (revenue automatically increases during economic expansion and automatically decreases during recession)

Problems of Timing

Recpgnition lag

Administrative lag

Operating lag

Crowding-out effect

Fiscal policy in an open economy

Supply side effect of fiscal policy