The Goods Market Flashcards
When economists think about year-to-year movements in economic activity, they focus on
the interactions among production, income, and demand
1) changes in the demand for goods lead to changes in
production
2) changes in production lead to
changes in income
3) changes in income lead to
changes in the demand for goods
demand for goods Z =
Z = C + I + G + X - IM
In a closed economy
X = IM = 0
Closed economy Z =
Z = C + I + G
Composition of GDP: Consumption
goods and services purchased by consumers
Composition of GDP: Investment
the sum of non-residential investment and residential (houses) investment
Composition of GDP: Government spending
purchases of goods and services by the federal, state, and local governments; excluding government transfers
Composition of GDP: Exports
purchases of US goods and services by foreigners
Composition of GDP: Imports
purchases of foreign goods and services by US consumers, US firms and the US government
Composition of GDP: Net exports or trade balance
trade surplus: exports > imports
trade deficit: imports > exports
Composition of GDP: inventory investment
products made but not sold
% consumption in GDP 2014
68.3%
Consumption is a function of
disposable income (YD), which is the income that remains once consumers have received government transfers and paid their taxes
the consumption function
a behavioural equation that captures the behaviour of consumers
Consumption function is
a linear relation with two parameters, c0 and c1
Keynesian consumption function
C = c0 + c1YD
c1 in Keynesian consumption function
marginal propensity to consume, or the effect of an additional dollar of disposable income on consumption with 0 < c1 < 1
c0 in Keynesian consumption function
what people would consume if their disposable income equals zero with c0 > 0
Changes in c0 reflect
changes in consumption for a given level of disposable
income
Consumption increases with disposable income but
less than one for one (shallow gradient)
disposable income is
Yd = Y - T
T in disposable income is
taxes minus government
endogenous variables
variables depend on other variables in the model
exogenous variables
variables not explained within the model but are taken as given instead
investment =
I = I (bar)
bar on investment means
investment is a given
G and T describe
fiscal policy - the choice of spending taxes by the government
reason 1 why G and T are exogenous
governments do not behave with the same regularity as consumers or firms
Reason 2 why G and T are exogenous
we will typically treat G and T as variables chosen by the government and will not try to explain them within this model
Determination of Equilibrium Output step 1
Assume X = IM = 0 (closed economy), so
Z = C + I + G
Determination of equilibrium Output step 2
Replacing C and I from equations (3) and (4)
Z = c0 + c1 (Y - T) + I(bar) + G
Determination of Equlibrium Output step 3
Equilibrium in the goods markets requires
Y = Z
determination of equilibrium output step 4
Replacing Z in (6) by equation (5) gives
Y = c0 + c1 (Y - T) + I(bar) + G
determination of equilibrium output step 5
In equilibrium, production (Y ) is equal to demand, which in turn depends
on income (Y ), which is itself equal to production
first tool macroeconomists use
algebra to make sure that the logic is correct
second tool macroeconomists use
graphs to explain the results
third tool macroeconomists use
words to explain the results
To characterise equilibrium output in algebra step 1
Rewrite equation (7)
Y = c0 + c1Y - c1T + I(bar) + G
To characterise equilibrium output in algebra step 2
Reorganize the equation
(1 - c1) Y = c0 + I(bar) + G - c1T
T o characterise equilibrium output in algebra
Y = (1/(1 - c1))(c0 + I + G - c1T
i)
autonomous spending
(c0 + I + G ¡ c1T)
is the part of the demand for goods that does not depend on output
autonomous spending is positive because
if T = G (balanced budget) and c1 is between 0 and 1, then (G - c1T) is positive, and so is autonomous spending
multiplier
The term 1/(1 - c1) r, which is larger than 1 as 0 < c1 <
1.
the multiplier is larger when
c1 is closer to 1
an increase of consumption will increase output by
multiplier
* consumption increase
To characterise the equilibrium graphically step 1
Plot production as a function of income. Because production equals income, their relation is the 45-degree line
to characterise the equilibrium graphically step 2
Plot demand as a function of income
Z = (c0 + I(bar) + G - c1T) + c1Y
to characterise the equilibrium graphically part 3
in equilibrium, production equals demand
equilibrium output is determined by the condition that
production is equal to demand
if c0 increases by $1 bil, an increase in autonomous spending has a ________- effect on equilibrium output
more than one-for-one
pattern to get to equilibrium after demand shifts up
first round increase in demand -> first round increace in production -> second round increase in demand -> second round increase in production
the total increase in production after n+1 rounds is
a geometric series with a limit of 1/(1 - c1) which is the multiplier
equilibrium output in words 1
Production depends on demand, which depends on income, which is itself equal to production
equilibrium output in words 2
an increase in demand leads to an increase in production and income which in turn leads to a future increase in demand
equilibrium output in words 3
the increase in output is larger then the initial shift in demand, by a factor equal to the multiplier
equilibrium output in words 4
The multiplier depends on the propensity to consume, which can be estimated using econometrics – the set of statistical methods used in economics
dynamics of adjustment
the adjustment of output over time
how long the adjustment takes depends on
how and when firms revise their production schedule
John Maynard Keynes articulated an alternative model that focuses instead on …
investment and saving in the General Theory of Employment, Interest and Money in 1936
Private saving (S) is
S ≡ YD - C
S ≡ Y - T - C
by definition public saving =
T - G
budget surplus
public saving >0
budget deficit
public saving < 0
Generating IS relation step 1
In equilibrium Y = C + I + G
Generating IS relation step 2
Subtract T from both sides and move C to the left side
Y - T - C = I + G - T
Generating IS relation step 3
The left side of the equation is simply S, so
S = I + G - T
Generating the IS relation step 4
Or equivalently I = S + (T - G)
Two equivalent ways of stating the condition for equilibrium in the goods market
production = Demand
investment = saving
Algebra of output equilibrium using IS relation step 1
Because consumption behaviour implies that
S = Y - T - C
= Y - T - c0 - c1(Y - T)
Rearranging terms, so
S = -c0 + (1 - c1) (Y - T)
marginal propensity to save
1 - c1 between zero and 1
Algebra of output using IS relation step 2
In equilibrium, I = S + (T - G), so that equation (10) becomes
I = -c0 + (1 - c1)(Y - T) + (T - G)
Algebra of output equilibrium using IS relation step 3
Solve for output
Y =
(1/(1 - c1))
[c0 + I + G - c1T]
Algebra of output equilibrium using IS relation step 4
this is the same as equation (8) where I = I(bar)
