Closed Economy: The Goods Market (topic 2) Flashcards
Interaction between demand, production, and income (how does fiscal policy affect output?) Equilibrium can be: o Production = demand o Investment = saving
What are the interactions between demand, production, and income?
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.
What is an exogenous variable?
A variable that is taken as a given.
What is an endogenous variable?
A variable that is explained within the model.
What happens when the IS relation is in equilibrium?
Firms investments is equal to public and private savings.
What determines output/production in the short run?
Demand determines output in the short run.
What does the function of Y show?
The decomposition of GDP. The sum of consumption, investment, government spending and export minus imports.
Y = C + I + G + X - IM
What does the determinant C show?
Services and goods purchased by consumers.
What does the determinant C depend on?
C depends on income Y and taxes T.
How is disposable income (YD) determined?
Y - T = YD
C =c0+ c1 * (Y – T)
How does C depend on disposable income? and how does changes in Y and T affect C?
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.
What does the determinant c1 show?
The effect that an additional euro of disposable income has on consumption.
The propensity to consume.
What is the natural restriction of c1?
c1 will be smaller than 1 (c1 < 1) because people won’t spend all of their disposable income, they will save some of it.
What does (1 - c1) show?
The propensity to save.
How much of the additional euro of income will be saved (under the assumption that c1 < 1)
What does c0 show?
Consumer confidence.
What would people consume if their disposable income in the current year = 0.
What is the natural restriction of c0?
C will be positive with or without income (people need to eat) - instead of consuming through their disposable income, people will dissave or borrow.
Explain C = c0 + c1 * YD.
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).
What does the determinant I show?
Sum of capital investments (i.e., firms buying new plants and machines and people buying houses and apartments).
What does the determinant G show?
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).
What determinants can tell what type of fiscal policy is being used?
G and T.
Explain the multiplier effect on autonomous spending.
c0 + I + G - c1 * T
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
Explain how the equilibrium in the goods market looks graphically.
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.
What happens graphically if there’s an increase in c0 (consumer confidence)?
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.
What happens graphically when implementing a contractionary fiscal policy?
The government decreases G or increases T to slow down the economy.
The demand curve will shift downwards.
What happens graphically when an expansionary fiscal policy is implemented?
The government increases G or decreases T to boost the economy.
The demand curve will shift upwards.
Why do fiscal policies involve changes in T or G?
Changes in taxes creates changes in consumption and changes in government spending creates direct changes in demand.
How is private savings determined?
S = YD - C
disposable income - consumption
or
S = Y - T - C
income - taxes - consumption
How is public savings determined?
T - G
taxes - government spending
In public savings (T - G), what does it mean that the government can run a budget surplus or deficit?
T > G = budget surplus (positive saving)
T < G = budget deficit (negative saving/dissaving)
What is the function for demand for goods, Z?
Z = C + I + G
What is the equilibrium condition in the goods market (closed economy)?
Y = Z
Production = demand for goods
Rewrite: Y = c0 + c1 * (Y - T) + I + G
What are the 3 types of equations that models can include?
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)
How do you solve for equilibrium output?
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)
