Week 1 - The Goods Market

Question 1

What is the basic closed economy Aggregate Demand Function (z)

Answer 1

z = C + I + G

z = aggregate demand
C = household Consumption
I = Investment
G = government expenditure

Question 2

Explain consumption

What is the consumption function?

Answer 2

Consumption is the spending of households

Is a function of disposable income (Yd)

Consumption function is a behavioural equation
C = C_0 + C_1*(Yd)

C_0 = consumption if Yd was 0
C_1 = Marginal propensity to consumer (MPC): between 0 and 1

Question 3

What does a change in c_0 reflect?

Answer 3

Reflects changes in consumption for a given level of disposable income

Question 4

How is disposable income (Yd) calculated?

Answer 4

Disposable income:
Yd = (Y-T)

Y = income
T = Taxes

Question 5

What is the expanded consumption function?

Answer 5

C = C_0 + c_1(Y-T)

Question 6

What is an endogenous variable?

Answer 6

Variable dependent on other variables in model

Question 7

What is an exogenous variable?

Answer 7

an unexplainable variable within a model that is given

Question 8

What type of variable are T & G?

Why?

Answer 8

Taxes and Government spending are exogenous variables as they represent fiscal policy

Question 9

What is the equilibrium condition of the goods market?

Assume a close economy

Answer 9

Y = Z = c_0 + c_1(Y-T) + I + G

Question 10

What three tools do economist use?

Answer 10

1. Algebra
2. Graphs
3. Words to explain results

Question 11

What is autonomous spending?

Answer 11

(c_0 + I + G - c_1T)

Always positive

Question 12

What is the autonomous spending multiplier?

Answer 12

1 / (1 - c_1)

larger when c_1 is closer to 1

Question 13

How is equilibrium in the goods market graphed?

Answer 13

1. Plot production as a function of income (45 degree line)
2. Plot demand as a function of income
   Z = (c_0 + I + G - c_1T) + c_1Y

Question 14

What is demand as a function of income?

Answer 14

Z = (c_0 + I + G - c_1T) + c_1Y

Question 15

What is the dynamics of adjustment?

Answer 15

The adjustment of output over time

Question 16

True or false

An increase in demand leads to an increase in production and income, which in turn leads to a future increase in demand.

Answer 16

True

An increase in demand leads to an increase in production and income, which in turn leads to a future increase in demand.

Question 17

What are the effects of an increase in autonomous spending?

Answer 17

Effects:
Output increases exponentially but gets smaller with every run

1+ C_1+ C_1^2 + C_1^3 …… + C_1^n
limited by multiplier 1 / (1 - c_1)

Question 18

What is the IS relation?

Answer 18

Investment = Savings

S = I + G - T
or
I = S + (T - G)

S = Private saving
I = Investment
G = government spending
T = Tax

Question 19

What is the equation for private savings

Answer 19

Private savings = S

S = Yd - C
S = Y - T - C

Question 20

Define public savings

How is it interpreted in relation to the budget?

Answer 20

Public savings = T - G

If T - G > 0 => budget surplus
If T - G < 0 => budget deficit

Question 21

What is the goods market equilibrium condition using the IS model

Answer 21

I = S

S = -c_0 + (1 - c_1) ( Y - T)

= >

I = -c_0 + (1 - c_1) ( Y - T)

Question 22

Define Propensity to save

Answer 22

(1 - c_1)

Between 0 and 1

Question 23

What is the paradox of saving?

Answer 23

The idea that saving money is good for the economy when it actually isnt

By spending less c_0 decreases
Because production is determined by demand, output decreases

I = S + (T - G)

Question 24

Why is it difficult for governments to influence output

Answer 24

• Changing T & G is not easy
• Investments and imports may change
• Expectations matter
• Effects on output may be unsustainable in the medium run
• Changing T or G can lead to large budget deficits and long run public debt