slides 2e chap3

8/18/2019 Slides 2E Chap3

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Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective PowerPoints on the Web, 2nd edition © Pearson Education Limited 2014

THE CORETHE SHORT RUN

CHAPTER 3:THE GOODS MARKET


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Slide3.2


3.1 The Composition of GDP

Table 3.1 The composition of GDP, EU-15, 2010Source: Eurostat.

Goods that have to be produced

Shares of GDP


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Slide3.3



(Continued)

GDP defined by purchases/demand in a closed

economy:

Consumption (C) refers to the goods and services purchased byconsumers – you and I shopping….

Investment (I), sometimes called fixed investment, is the purchaseof capital goods. It is the sum of nonresidential investment andresidential investment….firms and others investing….

Government Spending (G) refers to the purchases of goods andservices by the federal, state, and local governments - provision ofhealth services, education services, military, public administrationetc. either through public employment or purchase in privatesector … It does not include government transfers, nor interestpayments on the government debt

Demand in a closed economy


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Slide3.4



(Continued)

…additions from opening up the economy withtrade:

Imports (IM) are the purchases of goods and servicesproduced abroad by domestic consumers, business firms,and the government – the goods and services we need topurchase abroad…

Exports (X) are the purchases of domestically producedgoods and services by foreigners – the goods and servicesconsumers, business firms and governments in othercountries need to purchase in our country….

Demand through trade


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Slide3.5



(Continued)

Inventory investment is the difference betweenproduction and sales – if your are unable to sell yourgoods produced just now, you will have to stock them up

in your inventory….which then becomes inventory

investments to be sold in future….

Net exports (X IM) is the difference between exports

and imports, also called the trade balance.

Exports > imports trade surplus

Exports < imports trade deficit

Exports = imports trade balance

Net exports – trade balance/deficit/surplus


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Slide3.6


3.2 The Demand for Goods

The total demand (net sum of all purchases) for goods

is written as:

Z C I G X IM

The symbol “” means that this equation is an identity, ordefinition – it must always be true and there are no caseswhere it is not true.

This is the baseline identity for macroeconomics…..so it isvery important to understand…..

Goods market equilibrium condition


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Slide3.7



(continued)

Some simplifying assumptions (#1) will initially be madeto determine Z…..some are relaxed later in the course:

Assume that all firms produce the same good, which can then beused by consumers for consumption, by firms for investment, orby the government.

Assume that firms are willing to supply any amount of the good at agiven price, P, and demand in that market. Dinstinction between Y and$Y is less important in goods market – we suppress $ in front of allvariables in the following

Assume that the economy is closed, that it does not trade with the restof the world, then both exports and importsare zero.

Under the assumption that the economy is closed, X = IM = 0, then:

G I C Z

Simplifying assumptions


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Slide3.8



(Continued)

Disposable income, (YD), is the income that remains onceconsumers have paid taxes and received transfers from thegovernment (YD=Y-taxes+transfers).

C C Y D ( )

( )The function C(YD) is called the consumption function. It isa behavioral equation, that is, it captures the behavior ofconsumers – if you have a higher income at your disposition,

you will increase you consumption, as indicated by the (+).

Consumption (C in Z=C+I+G identity)

A more specific form of the consumption function is this linear

relation – higher YD leads to higher C:

C c c Y D 0 1

Consumption (C)


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Slide3.9



(Continued)

This function has two parameters, c0 and c1 (parameters reflectthe implicit behavior in the relations – what do we assume about

consumers behaviour?) :

c1 is called the (marginal) propensity to consume, orthe effect of an additional unit of disposable income on

consumption – how much do I consume out of every extraunit disposable income…my marginal consumption

behavior .

c0 is the intercept of the consumption function – mightthink of this as subsistence level of consumption.

Disposable income is given by (T=taxes-transfers):

Y Y T D

Consumption (C)


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Slide3.10



(Continued)

Figure 3.1 Consumption and disposable income

Consumption increases with disposable income, but less than one for one.

A lower value of c0 will shift the entire line down.

Consumption increases with

disposable income but less than

one for one,c1


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Slide3.11



(Continued)

I I

Investment (I in Z=C+I+G identity)

Some simplifying assumptions (#2) on I and G will next bemade to determine Z…..some are relaxed later in thecourse:

Investments and government spending is exogenous,meaning that:

Variables that depend on other variables within the model

are called endogenous. Variables that are not explain within the model are calledexogenous. These will in the following be indicated by

having a bar above

Endogenous or exogenous


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Slide3.12



(Continued)

Government Spending (G in Z=C+I+G identity))

Government spending, G, together with taxes, T, describes fiscal

policy—the choice of taxes and spending by the government.

GG

We shall throughout assume that G and T are also exogenous fortwo reasons:

1. Governments do not behave with the same regularity asconsumers or firms – ad hoc political not depending on othervariables.

2. Macroeconomists must think about the implications of alternative

spending and tax decisions of the government – if the governmentdoes this policy the implications on other variables are…..policy

Government spending


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Slide3.13


3.3 The Determination of

Equilibrium Output

In the closed economy with net exports equal to zero, thedemand for goods is the sum of consumption, investment, andgovernment spending:

Then if we substitute the assumed linear form of consumptionand the exogenous values of I and G, the total demand can bewritten as:

G I C Z

G I T Y cc Z )(10

Goods market equilibrium – linear model


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Slide3.14


3.3 The Determination of Equilibrium

Output (Continued)Equilibrium in the goods market requires that production,Y, be equal to the demand for goods, Z – the goods market

equilibrium condition there becomes:

Y Z

The equilibrium condition is that, production, Y, be equal todemand. Demand, Z, in turn depends on income, Y, which itself isequal to production (any value produced must be income tosomeone in the economy).

The goods marked equilibrium is therefore described bythe following equation – inserting the expression for Z onthe previous slide in the equilibrium condition Y=Z:

G I T Y ccY )(10

Goods market equilibrium – linear model


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Slide3.15



Output (Continued)Macroeconomists always use these three tools:

1. Algebra to make sure that the logic is correct – whichwe just did by substituting the expression for Z in theequilibrium condition Y=Z arriving at the expressionon bottom of last slide

2. Graphs to build the intuition – which we did on theslide to illustrate the linear consumption function witha constant marginal propensity to consume

3. Words to explain the results – how do we understandthe different results and dependencies on underlyingbehaviours indicated by parameters of expressions

Approaches to analysis


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Slide3.16


Using algebra


Output (Continued)

Rewrite the equilibrium equation:

1. Using Algebra to arrive at goods market equilibrium

G I T Y ccY )(10Subtract c1*Y on both sides of the equation and reorganize toarrive at:

T cG I cY c 101)1(

)(

1

110

1

T cG I c

c

Y

Divide both sides of equation by (1-c1) ´to arrive at expressionfor goods market equilibrium:


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Slide3.17


Using algebra


Output (Continued)

1. Using Algebra to arrive at goods market equilibrium

1. Autonomous spending: is that part ofthe demand for goods that does not depend on output Y),it is called autonomous spending. If the government rana balanced budget, then T=G.

2. The multiplier: Because the propensity to consume (c1) is

between zero and one, is a number greater thanone. For this reason, this number is called the multiplier .Multiplier processes is what is particular formacroeconomics, as it implies that several individualsparticipate…..not just one consumer or a firm as in

microeconomics…..what you do will influence what I do…

The equilibrium equation can be manipulated to derive twoimportant terms – autonomous spending and the multiplier :

T cG I c 10

1

1 1 c


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Slide3.18


Using a graph

Figure 3.2 Equilibrium in the goods market

Equilibrium output is determined by the condition that production be equal todemand.


Output (Continued)

)( 11 T cG I cY c Z o

Equilibrium output is determined bythe condition that production be equal

to demand Y=Z –using the Z defined

above.

1. Plot production (Y) as a function of

income (Y) – recalling that all value inproduction must be income to

someone….45 degree line (all points

with Y=Y)

2. Plot the total demand Z as a function of

income (Y) –ZZ line3. Equilibrium is at the intersection of ZZ

and 45 degree line where Y=Z, i.e. point

A in the diagram


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Slide3.19


Using a graph




Output (Continued)


An increase in autonomous spending (1

billion) has a more than one- for-one effect

on equilibrium output (more than 1 billion).

This can be seen by comparing the

vertical distance between ZZ and ZZ’ (AB )

with the horizontal distance between Y

and Y’ (YY’) – why is this….the

multiplier….


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Slide3.20


Using a graph




Output (Continued)


First- round of multiplier process:

The autonomous spending is increased by 1billion (e.g. increase in government spending)moving the demand function vertically by 1billion from ZZ to ZZ’

To arrive at a goods marked equilibrium theincrease in demand leads to an equal increasein production, or $1 billion, which is also shownby the distance in AB.

An increase in production must lead toequivalently higher incomes, shown by thedistance in BC, also equal to $1 billion.


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Slide3.21


Using a graph




Output (Continued)


Second- round of multiplier process:

The first-round lead to a increase in income by1 billion to some individuals increasing theirdisposable income.

As these individuals consume out of disposableincome, they will use a share (c1) of increasedincome for consumption buying goods fromothers in market.

The second-round increase in demand equals$c1 billion or $ 1 billion times c1, the marginalpropensity to consume – shown by the

distance DC, which increases income by DE in

equilibrium


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Slide3.22


Using a graph




Output (Continued)


Third- round of multiplier process:

The second-round lead to a increase in incomeby $c1 billion to some individuals increasing theirdisposable income.

As these individuals consume out of disposableincome, they will use a share (c1) of increasedincome for consumption buying goods fromothers in market.

The third-round increase in demand equals $c12

billion or $c1 billion times c1, the marginalpropensity to consume ……try to argue for the

fourth-round, fifth-round……


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Slide3.23


Using a graph


Output (Continued)

Following this logic, the total increase in production after,

say, n + 1 rounds, equals $1 billion multiplied by the sum:

1 + c1 + c12 + …+ c1

n

Such a sum is called a geometric series. This can in thelimit as n increases be written as:

This is the multiplier also arrived at when using algebra inarriving at the goods market equilibrium

11

1

c


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Slide3.24



Output (Continued)

To summarize:

An increase in demand (autonomous) leads to an increasein production and a corresponding increase in income.The end result is an increase in output that is larger than

the initial shift in demand (autonomous), by a factor equalto the multiplier.

To estimate the value of the multiplier, and more generally,to estimate behavioral equations and their parameters (c1

– the marginal propensity to consume), economists useeconometrics—a set of statistical methods used ineconomics.

We see that the outcome depends on the autonomousspending and the multiplier

Using Words

Using words


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Slide3.25


How long does it take for output to adjust?


Output (Continued)

Describing formally the adjustment process of output over time iswhat economists call the dynamics of adjustment. Thinks aboutthe following….not discrete changes but continual adjustment:

Suppose that firms make decisions about their production levels at

the beginning of each quarter (Y set at beginning of each quarter).

Now suppose consumers decide to spend more, that they increasec0 (Z changes during quarter from change in autonomousspending)

Having observed an increase in demand during period, firms arelikely to set a higher level of production in the following quarter.

In response to an increase in consumer spending, output does not

jump to the new equilibrium, but rather increases over time.

How Long Does It Take for Output to Adjust?


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Slide3.26


The Lehman bankruptcy, fear of another Depression

and shifts in the consumption function

Figure 3.4 Disposable income, consumption and consumption of durables,

USA, 2008:1 to 2009:3

Consumption anticipating crisis:

As you get worried about a crisis hittingthe economy, you might change youconsumption behavior even if incomehas not changed

Anticipating a crisis you might want to

cut down on consumption, but youmight particularly postpone purchasesof some types of goods

Even if income has not fallen yet, youmight cut back on consumption of

durables – postpone purchasing a newcar, a new washing maschine, a newTV, a new sofa etc.

Consumption and the crisis


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Slide3.27


3.4 Investment Equals Saving: An Alternative Way of

Thinking About the Goods–Market Equilibrium

An alternative approach to a goods market equilibrium: Saving isthe sum of private plus public saving (suppressing bars on I, T andG):

Private saving (S), is saving by consumers – what I do notconsume out of income will be my savings:

S Y C D S Y T C

Public saving equals taxes minus government spending.

If T > G, the government is running a budget surplus—publicsaving is positive.

If T < G, the government is running a budget deficit—publicsaving is negative.

An alternative approach


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Slide3.28




(Continued)

Return to the baseline goods market equation Y=Z using expressionfor Z=C+I+G, which gives the expression:

To proceed try to subtract T and C on both sides of the equation,

arriving at the expression:

The income level Y reduced by the transfers T and the consumptionlevel C is the savings S, as seen on the previous slide:

Subtracting (G-T) on both sides of the equation, this can also bewritten as:

Y C I G

Y T C I G T

S I G T

I S T G ( )


3 4 I t t E l S i A Alt ti W f


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(Continued)

The equation above states that equilibrium in thegoods market requires that investment (I) equalssaving—the sum of private (S) plus public (T-G)

saving.

This equilibrium condition for the goods market iscalled the IS relation (Investments and Savings

equilibrium). What firms want to invest must beequal to what people and the government want tosave. This is an alternative approach to the goodsmarket equilibrium and we can arrive at theequilibrium using this expression……on next slide

I S T G ( )


3 4 I t t E l S i A Alt ti W f


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Slide3.30




(Continued)

Consumption and saving decisions are one and the same – for anyYD, what is not consumed must be saved:

S Y T C

0 1( )S Y T c c Y T

S c c Y T 0 11( )( )

The term (1 c1) is called the propensity to save.

In equilibrium we know that I=S+(T-G):

0 1

1

1[ ]

1

Y c I G c T

c

I c c Y T T G 0 11( )( ) ( )Rearranging terms, we get the same result as before:



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Slide3.31


The Paradox of Saving

The paradox of saving (or the paradox of thrift) is

that as people attempt to save more, the result isboth a decline in output and unchanged saving.

The Paradox of Saving

The paradox of saving (or the paradox of thrift)

is that as people attempt to save more, the resultis both a decline in output and unchanged saving.

If (1-c1) – the marginal propensity of saveout of income – increases, then the output will

be reduced…but why?

Underlying reason is that the multiplierprocess is weakened from higher marginalsavings rates out of income

If you consume less out of an increases inincome, then this will increase the income ofothers from whom you buy your goods withless…weaker multiplication of initial change

3 5 I th G t


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Slide3.32


3.5 Is the GovernmentOmnipotent? A Warning

Changing government spending or taxes is not always easy –political support.

The responses of consumption, investment, imports, etc, areoften hard to assess with much certainty.

Anticipations are likely to matter – do you surprise economy bychanging policy and is that positive?

Achieving a given level of output can come with unpleasant sideeffects – more inflation or unemployment?

Budget deficits and public debt may have adverse implications inthe long run – you may run a deficit for a short while but aftersome time, no one will lend you money to run the deficit.

Why not just increase G or decrease T to get higher incomeand output through the multiplicator process (dynamic effects)?

So does G (government expenditures) have an effect


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Slide3.33


Key Terms

Consumption (C) Investment (I) Fixed investment

Nonresidential investment Residential investment Government spending (G) Government transfers Imports (IM) Exports (X) Net exports (X-IM) Trade balance Trade surplus Trade deficit Inventory investment Identity Disposable income (YD) Consumption function Behavioral equation Linear relation Parameter Propensity to consume (c1) Endogenous variables

Exogenous variables

Fiscal policy Equilibrium

Equilibrium in the goods market Equilibrium condition

Autonomous spending

Balanced budget

Multiplier

Geometric series

Econometrics Dynamics

Forecast error

Consumer confidence index

Private saving (S)

Public saving (T-G)

Budget surplus Budget deficit

Saving

IS relation

Propensity to save

Paradox of saving

Keywords

slides 2e chap3

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