The Goods Market

Question 1

circular flow of economy

Answer 1

total production = total expenditure = total income implies a circular flow where

i. Any change in the demand for goods leads to changes in production

ii. Any change in production leads to changes in income

iii. Any change in income leads to changes in the demand for goods

demand is driving force behind business cycles

Question 2

consumption

Answer 2

domestic goods and services purchased by households

Question 3

Investment

Answer 3

purchase of capital goods by firms (non-residential) or households (residential investment)

assumed to be exogenous, determined outside the model and taken as given (unrealistic but helps us focus on other mechanisms)

Question 4

inventory investment

Answer 4

unsold products (difference between production and sales)

Question 5

government spending

Answer 5

purchase of goods and services by the public sector - national, regional, local government

does not include government transfers (e.g. unemployment benefits)

exogenous too (helps analyse effects of government’s change in fiscal policy on endogenous variables)

Question 6

net exports

Answer 6

purchase of domestic g+s by foreigners minus domestic purchase of foreign g+s

aka trade balance

trade surplus: exports exceed imports
trade deficit: exports less than imports

Question 7

assumptions for total demand formula

Answer 7

1. only one good: output (Y)
2. effective demand: firms are price takers and supply any amount of the good at the given price level to meet demand
3. economy is closed: X=IM=0

Question 8

determinants of consumption

Answer 8

wealth
access to credit
expectations of the future

main determinant is disposable income (income after taxes)

Question 9

propensity to consume

Answer 9

effect of an additional unit of disposable income on consumption

consumption increases with disposable income but less than one for one

change in consumption divided by change in income.

Question 10

autonomous consumption

Answer 10

what people would consume if their disposable income equals zero

Question 11

fiscal policy

Answer 11

stems from government’s discretionary decision, rather than circular flow of economy

Question 12

multiplier

Answer 12

1/1-c1
0<c1<1 therefore multiplier > 1

size is directly and positively related to propensity to consume

implies that any change in autonomous spending will change output by more than the amount changed

Question 13

income tax

Answer 13

automatic stabiliser which reduces multiplier

Question 14

lump sum tax

Answer 14

tax on income applied to all regardless of levels of income whereas income tax is applied in bands

Question 15

inventory investment

Answer 15

production and sales need not be equal.

difference between production and sales

partly involuntary (reflecting fact firms did not anticipate sales accurately in making production plans)

Question 16

production formula

Answer 16

production = sales + inventory investment

Question 17

disposable income

Answer 17

income that remains once consumers have received transfers from the gov and paid their taxes.

Question 18

why is c0 (autonomous spending) > 0 ?

Answer 18

what people would consume if their disposable income equals zero.

consumption would be still positive; with or without income, people still need to eat.

possible by dissaving; selling some of their assets or borrowing.

changes in c0 reflect changes in consumption for a given level of consumption, reflects an increase in consumption given income

Question 19

paradox of thrift

Answer 19

if people save more in a recession, it will reduce consumption and thus aggregate demand will fall, impeding economic growth and, in fact, lowering the general level of savings

if everyone increases their marginal propensity to save, Keynesian model predicts that total saving will not increase.