the goods market chapter 3. © 2013 pearson education, inc. all rights reserved.3-2 3-1 the...

The Goods Market

Chapter 3

© 2013 Pearson Education, Inc. All rights reserved. 3-2

3-1 The Composition of GDPTable 3-1 The Composition of U.S. GDP, 2010


The composition of GDP• Consumption (C): The goods and services

purchased by consumers. • Nonresidential Investment: The purchase by firms

of new plants or new machines.• Residential Investment: the purchase by people of

houses or apartments.• Government Spending (G): The purchases of goods

and services by the state and local governments. G does not include transfer payments.

• Net Exports: The difference between exports and imports.

• Inventory Investment: The difference between production and sales


The Demand for Goods

Three assumptions: • There is only one good. • Firms are willing to supply any amount of

the good at a given price. • The economy is closed.


Consumption

The function is a linear relation. c1, is (marginal) propensity to consume, the increase in

consumption for every extra unit of disposable income.c0, which represents how much consumption would occur even if

disposable income were zero, is called autonomous consumption.


3-2 The Demand for GoodsFigure 3-1 Consumption and disposable income


3-2 The Demand for Goods

C is a function of income and taxes. Higher income and lower taxes increases consumption, but less than one for one.

I is an exogenous variable, which is not explained in the model but are instead taken as given. C is endogenous variable because it depends on other variables in the model.


3-3 The Determination of Equilibrium Output

In equilibrium, production, Y, is equal to demand. Demand in turn depends on income, Y, which is itself equal to production.



Equation (3.8) is the algebraic solution. The second term is autonomous spending. It is positive, assuming budget surplus (T-G) is not very large. First term is multiplier.

An increase in c0 increases demand. The increase in demand then leads to an increase in production. The increase in production leads to an equivalent increase in income. The increase in income further increases consumption, and so on.



Figure 3-2 Equilibrium in the goods market

When income increases by 1, demand increases by c1. ZZ is upward sloping but has a slope less than 1.

1. Plot production as a function of income, 45-degree line.

2. Plot demand as a function of income, ZZ.

3. In equilibrium, production equals demand.



Figure 3-3 The effects of an increase in autonomous spending on output

The increase in output is larger than the initial increase in consumption of 1 billion. This is the multiplier effect.


Multiplier Effect

• The first round increase in demand of 1 billion (AB) 1 billion increase in production (AB) 1 billion increase in income (BC) the second round of increase in demand is 1 billion multiplied by c1 – hence, $c1 billion (CD) equal increase in production (CD) and income (DE)

the third round of increase in demand is $c1 billion multiplied by c1, which is $c1

2 billion.


Multiplier

• The total increase in production after n+1 rounds is 1 billion multiplied by:

1+ $c1 + $c1

2 + ... + $c1n

• The eventual increase in output is $1/(1- c1) billion.

• The size of the multiplier depends on the value of propensity to consume.

• The higher the propensity, the higher the multiplier.


Focus: The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the Consumption Function

Figure 1 Disposable income, consumption, and consumption of durables in the United States, 2008:1 to 2009:3


Focus: The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the Consumption Function

Figure 2 Google search volume for “Great Depression,” January 2008 to September 2009


3-4 Investment Equals Saving: An AlternativeWay of Thinking about Goods—Market Equilibrium

S= YD - CS=Y –T - C.Y=C + I+ GY – T – C = I + G - T

Equilibrium in the goods market requires that investment equal saving- the sum of private saving and public saving.


S= YD - CS=Y –T - C. =Y – T - c0 - c1 ( Y –T )

S= 1-c1 is the propensity to save

Equation (3.8) is equivalent to equation (3.12).

the goods market chapter 3. © 2013 pearson education, inc. all rights reserved.3-2 3-1 the...

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