macroeconomics - licence 1 economie gestionremi.bazillier.free.fr/coursmacro_chap4_en.pdfthe goods...

Macroeconomics - Licence 1 EconomieGestion

Chapter 4: The Goods market

Rémi Bazillier 1

1 [email protected]://remi.bazillier.free.fr

Université d’Orléans

Rémi Bazillier Chapter 3: Investment

[email protected]

http://remi.bazillier.free.fr

Plan


The Goods market

When economists think about year-to-year movements ineconomic activity, they focus on the interactions betweenproduction, income and demand.

Changes in the demand for goods lead to changes inproductionChanges in production lead to changes in incomeChanges in income lead to changes in the demand forgoods


The composition of French GDP, 2008

Billions of euros Percent of GDPGDP (Y) 1950Consumption (C) 1114 57.1Investment (I) 427 21.9Government spendings (G) 452 23.2Net Exports -48 -2.5Exports (X) 516 26.4Imports (M) 564 29.8Inventory investment (Is) 4 0.2


The demand for Goods

Denote the total demand for goods by Z . Using thedecomposition of GDP, we can write Z as:

Z ≡ C + I + G + X − M (1)

This equation is an identity (using ≡ rather than =). It definesZ as the sum of consumption, plus investment, plusgovernment spending, plus exports, minus imports


Assumptions

All firms produce the same good, which can be used byconsumers for consumption, by firms for investment or bygovernment. Only one market. What determines supplyand demand in that market.Firms are willing to supply any amount of the good at agiven price. We focus on the demand-side of theequilibrium. This asumption is only valid in the short run.The economy is closed (no trade with the rest of the World)

Z ≡ C + I + G (2)


Consumption (C)

See chapter 2C is a function of disposable income (Yd ).

C = C(Yd ) (3)(+) (4)

C = C0 + cYD (5)

c is the marginal propensity to consume (0 < c < 1)C0: fixed consumption


Consumption (C)

Yd ≡ Y − T (6)

C = C0 + c(Y − T ) (7)


Investment (I)

Investment will be treated as an exogenous variable(taken as given)

I ≡ I (8)

It means that we suppose that investment does not repondto changes in productionNot realistic (see chapter 3 on investment). We will risethis assumption later.


Government Spending (G)

T and G describe fiscal policy. They are exogenous (butnot for the same reason than I)Governments do not behave with the same regularity asconsumers or firms. (no clear behavioral rules)The tasks of macroeconomists is to study the implicationsof alternative spending and tax decisions. We do not wantto explain fiscal policies but to study their effects.


The determination of equilibrium output

Z ≡ C + I + G (9)

Z = C0 + c(Y − T ) + I + G (10)

Equilibrium in the goods market: Production (Y ), be equalto the demand for goods (Z )

Y = Z (11)

Y = C0 + c(Y − T ) + I + G (12)

In equilibrium, production Y (the left side of the equation)is equal to demand (the right side). Demand in turndepends on income, Y , which is itself equal to production.


The three tools of macroeconomists

1 Algebra to make sure that the logic is correct2 Graphs to build the intuition3 Words to explain the results


Using Algebra

Rewrite the equilibrium condition:

Y = C0 + cY − cT + I + G (13)

Move cY to the left side and reorganize the right side

(1 − c)Y = C0 + I + G − cT (14)

Y =1

1 − c[CO + i + G − cT ] (15)


Using Algrebra (II)

(1 − c)Y = C0 + I + G − cT (16)

Y =1

1 − c[CO + I + G − cT ] (17)

The term [CO + i + G − cT ] is called autonomousspending (part of demand for goods that do not dependon output).

Is autonomous spending positive? Yes, except whenbudget surplus is very large


The Keynesian multiplier

11−c is the Keynesian multiplier

because the propensity to consume is between 0 and 1,1

1−c > 1The closer c is to 1, the larger the multiplierAn increase of consumption, investment or public spendingwill change output by more than its direct effect onautonomous spending

Where does the multiplier effect come from?An increase of autonomous spending increases demand.The increase in demand then lead to an increase inproductionThe increase in production leads to an increase in incomeThe increase in income leads to a further increase indemand (...)


Using a graph

First, plot production as a function of income. Productionand income are identically equal. The relation betweenthem is the 45-degreee line, the line with a slope equal to 1Second, plot demand as a function of income (see how toplot consumption)In equilibrium, production equals demand


Using a graph


The effects of an increase in autonomous spending onoutput


The effects of an increase in autonomous spending onoutput

The initial increase in consumption leads to an increase ofdemand of 1 millionTo satisfy this higher level of demand: increase ofproduction by 1 million (and increase of income)The increase of income by 1 million leads to an increase ofdemand by c x 1 million (and so one)the final effect on output is 1

1−c ∆C0


Using words

Production depends on demand, which depends onincome, which is itself equal to productionAn increase in demand, such as an increase ingovernment spending, leads to an increase in productionand a corresponding increase in demand, which leads to afurther increase in production, and so oneThe end result is an increase in output larger than theinitial shift in demand, by a factor equal to the multiplier


Investment = Saving: an alternative way of seeingequilibrium

Private saving (S) is equal to:

S ≡ Yd − C (18)S ≡ Y − T − C (19)

Public saving is equal to T − GEquation for equilibrium:

Y = C + I + G (20)Y − T − C = I + G − T (21)

S = I + G − T (22)I = S + (T − G) (23)


Investment = Saving: an alternative way of seeingequilibrium

The saving function

S = −C0 + (1 − c)(Y − T ) (24)

Replacing private saving in equation I = S + (T − G):

I = −C0 + (1 − c)(Y − T ) + (T − G) (25)

Y =1

1 − c[C0 + I + G − cT ] (26)


The paradox of saving

The “Cricket and the Ant” story: those who save arepromised a happy lifeHere, savings have depressive effects (eg. a decrease ofC0)

Y =1

1 − c[C0 + I + G − cT ] (27)

Which effects on savings?

S = −C0 + (1 − c)(Y − T ) (28)

−C0 is higher but Y is lowerSaving will be unchanged:

I = S + (T − G) (29)


The paradox of saving

The paradox of saving: as people attempt to save more,the result is both a decline in output and unchanged savingBut this is valid only in the short run:

Other mechanisms come into play over time

Policies that encourage saving might be good in themedium run and in the long run but they can lead to arecession in the short run


Can the government really choose the level of output?

Y =1

1 − c[C0 + I + G − cT ] (30)

According to this equation, governments can choose the level of outputby increasing or decreasing G or T

But it is more complex in reality:Changing government spending or taxes is not always easy.Getting to the parliament to pass bills take time..Here investment remained constant. But Investment is likely torespond. The same for imports: some of the increased demand byconsumers and firms will be for foreign goods.Anticipations are likely to matter. The reaction of consumers to atax cut is likely to depend on whether they think of the tax cut astransitory or permanentToo high level of output may lead to inflationLarge public deficit and accumulation of public debt may becomeproblematic (the “AAA” phenomenom)


macroeconomics - licence 1 economie gestionremi.bazillier.free.fr/coursmacro_chap4_en.pdfthe goods...

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