Closed Economy: The Goods Market (topic 2)

Question 1

What are the interactions between demand, production, and income?

Answer 1

Changes in demand lead to changes in production –> changes in production lead to changes in income –> Changes in income lead to changes in demand for goods.

Question 2

What is an exogenous variable?

Answer 2

A variable that is taken as a given.

Question 3

What is an endogenous variable?

Answer 3

A variable that is explained within the model.

Question 4

What happens when the IS relation is in equilibrium?

Answer 4

Firms investments is equal to public and private savings.

Question 5

What determines output/production in the short run?

Answer 5

Demand determines output in the short run.

Question 6

What does the function of Y show?

Answer 6

The decomposition of GDP. The sum of consumption, investment, government spending and export minus imports.
Y = C + I + G + X - IM

Question 7

What does the determinant C show?

Answer 7

Services and goods purchased by consumers.

Question 8

What does the determinant C depend on?

Answer 8

C depends on income Y and taxes T.

Question 9

How is disposable income (YD) determined?

Answer 9

Y - T = YD

C =c0+ c1 * (Y – T)

Question 10

How does C depend on disposable income? and how does changes in Y and T affect C?

Answer 10

Depends positively on YD, when it goes up, C goes up.

T increases or Y decreases: YD decreases and therefore C decreases.

Y increases or T decreases:
YD increases and therefore C increases.

Question 11

What does the determinant c1 show?

Answer 11

The effect that an additional euro of disposable income has on consumption.
The propensity to consume.

Question 12

What is the natural restriction of c1?

Answer 12

c1 will be smaller than 1 (c1 < 1) because people won’t spend all of their disposable income, they will save some of it.

Question 13

What does (1 - c1) show?

Answer 13

The propensity to save.

How much of the additional euro of income will be saved (under the assumption that c1 < 1)

Question 14

What does c0 show?

Answer 14

Consumer confidence.

What would people consume if their disposable income in the current year = 0.

Question 15

What is the natural restriction of c0?

Answer 15

C will be positive with or without income (people need to eat) - instead of consuming through their disposable income, people will dissave or borrow.

Question 16

Explain C = c0 + c1 * YD.

Answer 16

The consumption function. It is the assumed (linear) relation between C and YD.
c0 intercepts with the vertical axis and c1 is the slope of the line (since c1 < 1, it is flatter than a 45-degree line).

Question 17

What does the determinant I show?

Answer 17

Sum of capital investments (i.e., firms buying new plants and machines and people buying houses and apartments).

Question 18

What does the determinant G show?

Answer 18

Government spending.
States and local governments purchases of goods and services.
Does NOT include government transfers (i.e., pensions, subsidies, and other transfers to households or firms).

Question 19

What determinants can tell what type of fiscal policy is being used?

Answer 19

G and T.

Question 20

Explain the multiplier effect on autonomous spending.

c0 + I + G - c1 * T

Answer 20

Through the multiplier, 1 / (1 - c1), any increase in autonomous spending will lead to an increase in output that is larger than the increase in autonomous spending (because demand will increase).
Example:
increase in c0 by €1 billion where c1 = 0.6
1 / (1-0.6) ⟷ 1 / 0.4 = 2.5
Output will then be = 2.5 * €1 billion = €2.5 billion

Question 21

Explain how the equilibrium in the goods market looks graphically.

Answer 21

On the vertical axis: Demand Z, Production Y.

On the horizontal axis: income Y.

Production line: a function of income. production and income are identically equal. Thus, the relation between them is the 45-degree line, the line with a slope equal to 1.

Demand line, ZZ: demand as a function of income - Z = (c0 + I + G - c1 * T) + c1 * Y.
The intercept with the vertical axis – the value of demand when income is equal to zero – equals autonomous spending. The slope of the line is the propensity to consume, c1 (< 1).

Point A: equilibrium - production = demand.

Question 22

What happens graphically if there’s an increase in c0 (consumer confidence)?

Answer 22

Increase in demand = demand line shifts upwards (to point B, where were are not in equilibrium).

Production/output increases to fulfill higher demand = output increases (moving right on the vertical axis to point C where we have an equilibrium).

Increase in production leads to increase in income and demand (point D, moving upwards out of equilibrium) = further increase in output (moving right on the vertical axis to point E, back in equilibrium and to point A’).

Graph on p. 61-62.

Question 23

What happens graphically when implementing a contractionary fiscal policy?

Answer 23

The government decreases G or increases T to slow down the economy.
The demand curve will shift downwards.

Question 24

What happens graphically when an expansionary fiscal policy is implemented?

Answer 24

The government increases G or decreases T to boost the economy.
The demand curve will shift upwards.

Question 25

Why do fiscal policies involve changes in T or G?

Answer 25

Changes in taxes creates changes in consumption and changes in government spending creates direct changes in demand.

Question 26

How is private savings determined?

Answer 26

S = YD - C
disposable income - consumption

or

S = Y - T - C
income - taxes - consumption

Question 27

How is public savings determined?

Answer 27

T - G

taxes - government spending

Question 28

In public savings (T - G), what does it mean that the government can run a budget surplus or deficit?

Answer 28

T > G = budget surplus (positive saving)

T < G = budget deficit (negative saving/dissaving)

Question 29

What is the function for demand for goods, Z?

Answer 29

Z = C + I + G

Question 30

What is the equilibrium condition in the goods market (closed economy)?

Answer 30

Y = Z
Production = demand for goods
Rewrite: Y = c0 + c1 * (Y - T) + I + G

Question 31

What are the 3 types of equations that models can include?

Answer 31

Identities: e.g., the equation defining disposable income (YD = Y - T)

Behavioural: e.g., the consumption function (C = c0 + c1 * YD)

Equilibrium conditions: e.g., production = demand (Y = Z)

Question 32

How do you solve for equilibrium output?

Answer 32

Y= 1 / (1 - c1) * (c0 + I + G - c1 * T)

Equilibrium condition:  
S = Y - T - C = Y - T - c0 - c1 * (Y - T)
When rearranged, 
S = -c0 + (1 - c1 ) * (Y - T)
Equilibrium, investment must be equal to the sum of public and private saving. 
So, 
I = -c0 + (1 - c1 ) * (Y - T) + (T - G)
And when solving for output,
Y=  1 / (1 - c1) * (c0 + I + G - c1 * T)