Quiz 26: Demand-Side Equilibrium: Unemployment or Inflation
If the imports of an economy consistently exceed the exports of an economy, then the net exports will be negative. Negative net exports will push down the equilibrium level of GDP Based on the discussion in the chapter, increase in net exports will have a multiplier effect on GDP. It means a small increase in net exports will cause an increase in GDP at a higher rate. On the other hand, a small fall in net exports will cause the GDP to fall at a higher rate. Thereby, the multiplier effect of negative net exports will push the equilibrium level of GDP down.
Using the information given in Table (2), the following graph is drawn to derive the equilibrium level of GDP. Figure - 1 In Figure (1), GDP is measured on horizontal axis and consumption expenditure is measured on vertical axis. The plotted line of GDP and consumption expenditure combination intersects the 45-degree line at E 1 where both GDP and domestic expenditure are at $3,800. Hence, the equilibrium level of GDP is $3,800. Since the investment increased to $260, the consumption expenditure has changed. The consumption expenditure can be written as follows: ……(2) Table (3) shows the consumption expenditure schedule. Table - 3 After increasing the investment level, the equilibrium level of GDP and consumption expenditure is changed. The new equilibrium level of GDP and consumption expenditure is plotted in Figure (2). Figure - 2 In Figure (2), GDP is measured on horizontal axis and consumer expenditure is measured on vertical axis. Increase in investment level shifts the consumption expenditure from to . Hence, the new equilibrium point is obtained at , where consumption expenditure is equal to the level of GDP, and it intersects the 45-degree line. The $20 (from $240 to $260) increase in investment increases the equilibrium level of GDP to $200 ($3,800 to $4,000).
The equilibrium level of GDP is $6,000. If the real GDP is greater than or less than the equilibrium level, the following problem will occur. If real GDP is below equilibrium level If the level of GDP falls to $5,000, then the actual GDP will be less than the planned GDP. When the actual GDP is less than the planned GDP, it will increase the recessionary gap. It implies that the actual GDP is below the potential level. If real GDP is above equilibrium level If the level of GDP increases to $7,000, then the actual GDP will be higher than the planned GDP. When the actual GDP is greater than the planned GDP, it will increase the inflationary pressure. It implies that the actual GDP is higher than the potential level.