Download - The Goods Market Lecture 11 – academic year 2013/14 Introduction to Economics Fabio Landini
The Goods Market
Lecture 11 – academic year 2013/14Introduction to Economics
Fabio Landini
Where we are…
• Lectures 1-7: Microeconomics • Lecture 8: Computation of GDP
• Lecture 8: Evolution of GDP and differences among countries
• Lecture 9: Inflation, unemployment and aggregate demand
• How is the level of GDP determined?
• The answer is different if we consider different time horizon
• In this lecture: How the level of GDP is determined the short period
Question of the day
• Premise: short, medium and long period
• Analysis of the different components of demand
• Determination of the aggregate demand function
• Determination of the equilibrium level of production (GDP) in the short period
What do we do today…
We can distinguish three different time horizons:
•Short period = 1-2 years
•Medium period = 10 years
•Long period = 20-50 year
Premise: short, medium and long period
Why do we use this differentiation?
1)Empirical evidence shows that depending on the time time horizon that we consider production is lead by different factors
•Short period -> Dynamics of the demand (how many goods are purchased)
•Medium period -> Dynamics of the supply (adjustment of production capacity)
•Long period -> Structural factors (saving, quality of education, features of institutions, etc.)
Premise: short, medium and long period
2) Depending on the time horizons, we make different hypotheses on the functioning of the economy
a) Price adjustments
Short period: prices are fixed (or with reduced flexibility)
As the market conditions change firms do not adjust their price list immediately. To change prices is indeed costly.
Before doing so, a firm want: • To verify the stability of the new conditions• To see the reaction of competitors
Premise: short, medium and long period
Medium and long period: Prices are perfectly flexible
If we consider a longer time horizon firms have the time to perfectly adjust prices
Price adjustments -> medium period analysis
b) Accuracy of previsions on the future value of some variables (expectations)
Premise: short, medium and long period
In this class we will look at the functioning of the goods market in the short period.
Underlying question: what is it that determine the level of GDP in the short period?
Aim: to develop a macroeconomic model of the good market
Premise: short, medium and long period
The components of aggregate demand
Following the decomposition presented in the preceding class, aggregate demand is the sum of:•Consumption (C)•Investments (I)•Government expenditure (G)•Balance between export and import (XQ)
Aggregate demand (Z):
Z C + I + G + XQ
To illustrate the model that examines the good market we introduce some simplifying assumptions:
1)We ignore international exchanges We assume, X = Q = 0 and Z = C + I + G
We examine a closed economy
2) We assume that there exist only one good used for consumption, investments and public expenditure -> only one market
The components of aggregate demand
3) With respect to the variables that we examine we employ two alternative approaches:
For some variables, we define a behavioural equation: equation that describes the decisional rule followed by the relevant subjects in making their decisions -> endogenous variables (determined inside the model)
For the other variables, we consider a given and fixed value (no behavioural equation) -> exogenous variables (determined outside the model)
The components of aggregate demand
Under our hypotheses
Z = C + I + G
Let’s now examine the distinct components of demand (C, I, G)
The components of aggregate demand
Consumption (C)
To describe aggregate consumption we use a behavioural equation -> endogenous variable
Consumers’ behaviour:
• Consumers purchase more goods the greater their income
• The type of income that we have to consider is the income neat of taxes (“disposable income”)
The components of aggregate demand
It means that: C=C(YD) +
Consumption is an increasing function of disposable income (YD)
Important: Disposable income (YD) is the income minus the taxes
YD = Y –T
where, Y is income and T is taxes
The components of aggregate demand
For simplicity we use a linear function
C = C0 + c1YD where C0, c1 are parameters
Interpretation of parameters:
a) C0 – Autonomous consumption
•It is the term that captures all that part of consumption that do not depend on disposable income
•It is affected by several factors, such as: financial wealth, trust in the feature, preferences
The components of aggregate demand
C = C0 + c1YD
b) c1 – Marginal propensity to consume
It captures how the increase in consumption if the disposable income increases by one unit
Assumption 0 < c1<1
It means that:• Consumption increases with disposable income• The increase in consumption is smaller than the
increase in disposable income (a portion of income is saved)
The components of aggregate demand
For instance, if c1 = 0,6
For every euro additional unit of disposable income 60 cents will be used to finance consumption and 40 cents will be saved.
The components of aggregate demand
Graphically: C = C0+c1YD
C
C0 c1
YD
Investments (I) and Government expenditure (G)
Let’s consider their value as a constant (exogenous variable)
I I0 and G G0 where I0, G0 are parameters
Similarly, let’s consider taxes (T) as exogenous, so that
T T0 where T0 is a parameter
The components of aggregate demand
Exogeneity of I = Simplifying assumption it will be removed later
Exogeneity of G and T = Variables that are “chosen” buy the Government
The analysis of fiscal policy looks at the effects of the choices of different values for G and T
The components of aggregate demand
Let’s start again from the aggregate demand equation Z = C + I + G
Let’s plug in the equation for C Z = C0 + c1YD + I + G
Substituting away for the definition of YD we get Z = C0 + c1 (YT) + I + G
Replacing the constant values of I, G e T we obtain Z = C0 + c1 (YT0) + I0 + G0
The components of aggregate demand
Given the equation Z = C0 + c1 (YT0) + I0 + G0
Let’s change the order of the terms Z = c1 Y + C0 c1T0 + I0 + G0
Let’s collect the components of demand that do not depend on income, and let’s call them AE (autonomous expenditure) Z = c1 Y + AE
Equation of aggregate demand -> it represents aggregate demand as a function of income.
The components of aggregate demand
Graficamente: Z = c1Y+AE
Determination of the equilibrium level of income
The analysis of a market usually represents the analysis of its equilibrium
Market in equilibrium -> Microeconomics (Part I)
The equilibrium of a market is the state in which demand is equal supply
Equilibrium condition in the goods market:Demand of goods = Supply of goods
Aggregate demand of goods = Z
What is the aggregate supply of goods?
Let’s assume that firms do not have goods in stock:
Supply = Goods that are produced in the economy = Aggregate supply
We know from lectures 8 and 9 that:•The measure of aggregate production is GDP•GDP = Total income of the economy =
= Aggregate income = Y
Determination of the equilibrium level of income
Therefore, the equilibrium condition in the market for goods is: Z =Y
Given the equations Z c1 Y + AE
Z Y
We obtain that in equilibrium: Y c1Y + AE
Determination of the equilibrium level of income
From which we obtain that:
(1c1 )Y AE
YE AE
where YE is the equilibrium level of production
This result shows the value of production in equilibrium as a function of constants and parameters
In particular YE is equal to the product of:•AE = autonomous expenditure
• = the “multiplier”1c11
1c11
Determination of the equilibrium level of income
The multiplayer:
•It is called multiplier because it “multiplies” autonomous expenditure•It is always greater than 1 (0<c1<1, by assumption)
•It grows with c1
•It depends on the assumptions concerning the exogenous and endogenous variables (it is not always 1/(1 – c1) )
1c11
Determination of the equilibrium level of income
Graphical analysis of equilibrium: Demand -> Z = AE+c1Y Supply -> Y -> 45° linesEquilibrium -> Y=Z -> intersection between the two curves (E)Equilibrium -> point E -> Y=YE
Z
Z
45°
E
Y
YE
, Y
AE
What is the effect of a tax reduction on income (GDP)? Z = AE+c1Y where AE = C0 c1T0 + I0 + G0
T0 -> AE -> AE’
Z
Z
45°
E
Y
YE
, Y
AE
AE’
Z’
E’YE’
In the short period, the equilibrium in the good market is found by equalizing aggregate demand and aggregate supply
This condition allows us to identify the equilibrium level of income (i.e. the level of GDP).
Changes in some of the exogenous variables (e.g. T, G) affects the short period level of income
Do these effects persist also in the long-period? …. more on this in future classes…..
Conclusion
Financial Markets
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