3. The Goods Market

Question 1

The composition of GDP

Answer 1

1) Consumption (C) - goods and services purchased by consumers (68% of GDP)
2) Investment (I) = nonresidential investment (the purchase by firms of new plants and new machines) + residential investments (the purchase by people of new houses or apartments)
3) Government spending (G) - the purchase of good and services by the federal, state and local governments (to provide these services to the public, free of charge)

4) Exports (X) - the purhase of goods and services by foreigners
Imports (IM) - the purchases of foreign goods and services by consumers, firms and government
Trade balance (net exports) - the difference between exports and imports ( X-IM )
Exports > Imports => trade surplus
Exports < Imports => trade deficit

5) Inventory investment - the difference between good produced and good sold (production - sales)
In any given year, production and sales need to be equal
Production > Sales => positive inventory investment
Production < Sales => negative inventory investment

Question 2

The Demand for Goods

Answer 2

•Demand for goods (Z)
Z = C + I + G + X - IM
•Demand for goods (Z) in a closed economy (exports and imports are zero) => X = IM = 0
Z = C + I + G
↳ Endogenous variable:
1. Consumption (C) - a function of disposable income C=C(Yd) or C= c0 + c1 (Yd) = c0 + c1 (Y-T) , where Yd = Y(total income) -T(taxes-transfers)
- c0 - what people would consume if Yd=0; c0 > 0
- c1 - propensity to consume - gives the effect of an additional dollar on consumption; 0 < c1 < 1
↳ Exogenous variables:
2. Investment (I)
- I= Ī - taken as given (does not respond to changes in production)
3. Government spending (G)

Question 3

The Determination of Equilibrium Output in the goods market

production Y = demand Z

Answer 3

• Demand for goods Z = c0 + c1 (Y-T) + I + G
• Equilibrium in the goods market Y=Z - PRODUCTION EQUALS DEMAND => Y=c0 + c1 (Y-T) + I + G => Y = [1/(1-c1)]*(c0+I+G-c1T) => Y = multiplier * autonomous spending
• Multiplier effect - an increase in autonomous spending has a more than one-for-one effect on equilibrium output (Demand ↑ => production ↑ => Income ↑ => demand ↑ => production ↑ => ….=> increase in output that is larger than the initial shift in demand)

Question 4

Investment equals Saving : The alternative Equilibrium in the goods market

Answer 4

• Saving = Private saving + Public saving
↳ Private saving - disposable income minus consumption S = Yd-C = Y-T-C
↳Public saving - taxes minus government spending T-G
↳ T>G => budget surplus => public saving > 0
T budget deficit => public saving < 0

•Y = Z = C+I+G
Y-T-C = I+G-T => S = I+G-T => I = S+(T-G) - INVESTMENT EQUALS SAVING (IS relation)

• S = Y-T-C = Y-T-c0 + c1 (Y-T) = -c0 + (1-c1)(Y-T)
- (1-c1) - the propensity to save - how much of an additional unit of income people save

Question 5

Private Saving = disposable income - consumption

Answer 5

S = Yd - C
= Y - T - C
= I + G -T

Question 6

Investment = private saving + public saving

Answer 6

I = S + ( T - G )

Question 7

Equilibrium output

Answer 7

Y = 1/(1-c1) *[ c0 + I + G - c1T ]