Week 1 - The Goods Market Flashcards
What is the basic closed economy Aggregate Demand Function (z)
z = C + I + G
z = aggregate demand
C = household Consumption
I = Investment
G = government expenditure
Explain consumption
What is the consumption function?
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
What does a change in c_0 reflect?
Reflects changes in consumption for a given level of disposable income
How is disposable income (Yd) calculated?
Disposable income:
Yd = (Y-T)
Y = income
T = Taxes
What is the expanded consumption function?
C = C_0 + c_1(Y-T)
What is an endogenous variable?
Variable dependent on other variables in model
What is an exogenous variable?
an unexplainable variable within a model that is given
What type of variable are T & G?
Why?
Taxes and Government spending are exogenous variables as they represent fiscal policy
What is the equilibrium condition of the goods market?
Assume a close economy
Y = Z = c_0 + c_1(Y-T) + I + G
What three tools do economist use?
- Algebra
- Graphs
- Words to explain results
What is autonomous spending?
(c_0 + I + G - c_1T)
Always positive
What is the autonomous spending multiplier?
1 / (1 - c_1)
larger when c_1 is closer to 1
How is equilibrium in the goods market graphed?
- Plot production as a function of income (45 degree line)
- Plot demand as a function of income
Z = (c_0 + I + G - c_1T) + c_1Y
What is demand as a function of income?
Z = (c_0 + I + G - c_1T) + c_1Y
What is the dynamics of adjustment?
The adjustment of output over time
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.
True
An increase in demand leads to an increase in production and income, which in turn leads to a future increase in demand.
What are the effects of an increase in autonomous spending?
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)
What is the IS relation?
Investment = Savings
S = I + G - T
or
I = S + (T - G)
S = Private saving
I = Investment
G = government spending
T = Tax
What is the equation for private savings
Private savings = S
S = Yd - C
S = Y - T - C
Define public savings
How is it interpreted in relation to the budget?
Public savings = T - G
If T - G > 0 => budget surplus
If T - G < 0 => budget deficit
What is the goods market equilibrium condition using the IS model
I = S
S = -c_0 + (1 - c_1) ( Y - T)
= >
I = -c_0 + (1 - c_1) ( Y - T)
Define Propensity to save
(1 - c_1)
Between 0 and 1
What is the paradox of saving?
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)
Why is it difficult for governments to influence output
- 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
