cover that some employees are often idle. Profit-maximizing firms can react to this situation in one of three main ways:
1. Adjust quantity: lay off workers or cut back workers' hours to stop producing the unwanted output.
2. Adjust price: decrease prices to induce people to increase aggregate demand by enough to buy all of the output being produced.
3. Adopt some combination of the two preceding options, adjusting both price and quantity at the same time.
Quantity adjustment is the most natural reaction because it directly attacks the inventory buildup and the problem of idle employees. Cutting price is not likely to be a profit-maximizing move, even in tandem with output reduction, unless costs fall as well. The most likely scenario is that national income/output will adjust to match aggregate demand. As noted earlier, this is the heart of the Keynesian analysis: aggregate demand is the driving force that determines the level of national income.
4.3 The Multiplier
The policy conclusion of this Keynesian analysis is that by increasing aggregate demand the government can increase national income. An obvious way of doing so is by increasing government spending G. By this is meant a permanent increase in the level of government spending, say from $700 billion to $708 billion. (A one-time increase in government spending would increase income only temporarily.)
Suppose G is increased by $8 billion, creating an excess demand of $8 billion. Inventories fall and business is turned away, signaling to producers that there is excess demand, so they react by increasing output/income. Suppose national output/income increases by $8 billion. Will this result stop the forces pushing up output/income?
Although the initial excess demand of $8 billion has now been met by $8 billion of extra output, and it would seem that the forces pushing up income/output would be eliminated, this assumption is not so. This $8 billion increase in income itself creates extra demand. Consumers will want to increase consumption demand now that their income is higher, reopening the excess demand gap. This reaction renews the forces that stimulate the economy, causing this process to repeat itself and thus leading to an ever larger income level.
This repetitive process is outlined in figure 4.1, where the notation should be obvious. (For example, agg D for g & s stands for an increase in aggregate demand for goods and services.) For those interested, this process can also be illustrated on a classic macroeconomic diagram, the 45 -line diagram, shown in appendix 4.3 at the end of this chapter.
At first glance it seems as though the process outlined in figure 4.1 could go on forever, but it does not. Although the excess demand is continually being renewed, the magnitude of
