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Business Activity, Employment, & Inflation
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Business Activity, Employment, & InflationThe determination of business activity
How much will business as a whole produce? How many people will be employed? The
analysis of output and employment, at least in the short run, can be explained most simply in
terms of the circular flow of income.
If injections (J) do not equal withdrawals (W), a state of disequilibrium exists. What will
bring them back into equilibrium is a change in national income (GDP) and employment.
Start with a state of equilibrium, where injections equal withdrawals. If there is now a rise in
injections aggregate demand will be higher. Firms will respond to this increased demand by
using more labour and other resources and thus paying out more incomes (Y) to households.
Household consumption will rise and so firms will sell more. Firms will respond by
producing ore, and thus using more labour and other resources. Household incomes will rise
again. Consumption and hence production will rise again, and so on. There will thus be a
multiplied rise in incomes and employment (known as multiplier effect) i.e. change in AD =
greater change in national income). The process, however, does not go on forever. Each time
household incomes rise, households save more, pay more taxes, and buy more imports i.e.
withdrawals rise. When withdrawals have risen to match the increase in injections,
equilibrium will be restored, and national income (GDP) and employment will stop rising.
The process can be summarised as follows:
J > W = increase in incomes (Y) = increase in withdrawals (W) until J = W
Similarly, an initial fall in injections or rise in withdrawals will lead to a multiplied fall in
GDP and employment:
J < W = decrease in incomes (Y) = decrease in withdrawals (W) until J = W
Thus, equilibrium in the circular flow of income can be at any level of GDP and employment.
Identifying the equilibrium level of GDP
Cd, E, W, J
(£bn) GDP = Cd + W
E = Cd + J
c
e d
Cd
a
J
b
45 GDP (£bn)
GDP 1 GDP e GDP 2
, Equilibrium can be shown on a ‘Keynesian 45-degree line diagram’. Keynes argued that GDP
is determined by aggregate demand. A rise in aggregate demand will cause GDP to rise; a fall
in aggregate demand will cause GDP to fall.
Equilibrium GDP can be at any level of capacity. If aggregate demand is high, equilibrium
GDP can be where businesses are operating at full capacity with full employment. If
aggregate demand is low, however, equilibrium GDP can be at well below full capacity with
high unemployment (i.e. recession). Keynes argued that it is important, therefore, for
governments to manage the level of aggregate demand to avoid recessions.
• The 45-degree line plots various elements of the circular flow of income.
• The 45-degree line plots Cd + W against GDP. It is a 45-degree line because, by
definition, GDP = Cd + W. To understand this, consider what can happen to the
income earned from GDP. It must either be spent on domestically produced goods
(Cd) or it must be withdrawn from the circular flow (W), nothing else can happen to
it.
• The other continuous line plots aggregate demand. In this diagram, it is known as the
aggregate expenditure line (E), it consists of Cd + J. To show how this line is
constructed, consider the dashed line (Cd). It is flatter than the 45-degree line as only
part of any given rise in GDP (and hence people’s incomes) will be spent on domestic
products, the remainder will be withdrawn i.e. Cd rises less quickly than GDP. The E
line is simply the Cd line shifted upwards by the amount of J.
If aggregate expenditure exceeded GDP (GDP 1), there would be excess demand in the
economy (a – b). Firms would thus find their stocks dwindling and would therefore increase
their level of production. In doing so, they would employ more factors of production. GDP
would thus rise. As it did so, Cd and hence E would rise (there would be movement along the
E line). But because not all the extra incomes earned from the rise in GDP would be
consumed (i.e. some would be withdrawn), expenditure would rise less quickly than income
(the E line is flatter than the GDP line). As income rises towards GDP e, the gap between the
GDP and E lines gets smaller. Once point E is reached, GDP = E. There is then no further
tendency for GDP to rise.
If GDP exceeded aggregate expenditure (GDP 2), there would be insufficient demand for the
goods and services currently being produced (c – d). Firms would find their stocks of unsold
goods building up. They would thus respond by producing less and employing less factors of
production. GDP would thus fall and go on falling until GDP e was reached.
The multiplier
The multiplier refers to the number of times a rise in GDP is bigger than the initial rise in
aggregate expenditure that caused it. Using the letter k to stand for the size of the multiplier,
the multiplier is defined as k = GDP/ E.
The marginal propensity to consume domestically produced goods (MPCd) determines the
size of the multiplier. It is the proportion of any rise in GDP that gets spent on domestically
produced goods. MPCd = Cd/ GDP. The higher the MPCd the greater the proportion of
income generated from GDP that recirculates around the circular flow of income and thus
generates extra output.
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