Macro Econom I e

Professor Yamin Ahmad, Intermediate Macroeconomics ECON 302
dd Intermediate Macroeconomics Intermediate Macroeconomics

ECON 302
Professor Yamin Ahmad Professor Yamin Ahmad
Lecture 4:
Introduction to the Goods
Market
R i f th A t Review of the Aggregate
Expenditures model and
the Keynesian Cross
Components of Aggregate Demand Components of Aggregate Demand
Aggregate Expenditures/Keynesian Model:
The Consumption Function
The Keynesian Cross
Autonomous Expenditures Autonomous Expenditures
Multipliers
Equilibrium in the Goods Market/Loanable Funds
Market
The IS Relation
Note: These lecture notes are incomplete without having attended lectures
2
The Composition of GDP The Composition of GDP
Y = C + I + G + NX
Recall that:
Y = C + I + G + NX
Recall that:
Consumption (C) refers to the goods and services
purchased by consumers.
Investment (I), sometimes called fixed investment,
i th h f it l d It i th f is the purchase of capital goods. It is the sum of
nonresidential investment and residential
investment.
3
Government Spending (G) refers to the purchases
of goods and services by the federal, state, and local
governments. It does not include government
transfers, nor interest payments on the government transfers, nor interest payments on the government
debt.
Imports (IM) are the purchases of foreign goods and
services by consumers, business firms, and the U.S.
government government.
Exports (X) are the purchases of U.S. goods and
4
p ( ) p g
services by foreigners.
Net exports (X IM) is the difference between
exports and imports, also called the trade balance.
Exports > imports trade surplus
Exports = imports trade balance
Exports imports trade surplus
Exports < imports trade deficit
Inventory investment is the difference Inventory investment is the difference
between production and sales.
5
The Demand for Goods
The total demand for goods is written as: The total demand for goods is written as: gg
IM X G I C AE
The symbol The symbol means that this means that this equation is an equation is an
identity, or definition. , or definition.
Under the assumption that the economy is closed, Under the assumption that the economy is closed,
X IM X IM 0 th 0 th X = IM X = IM =0, then: =0, then:
G I C AE
6
The Demand for Goods The Demand for Goods
To determine AE, some simplifications must be made:
Assume that all firms produce the same good, which
can then be used by consumers for consumption, by
firms for investment or by the government firms for investment, or by the government.
Assume that firms are willing to supply and demand ssu e a s a e g o suppy a d de a d
in that market
Assume that the economy is closed, that it does not
trade with the rest of the world, then both exports
and imports are zero.
7
and imports are zero.
Consumption (C) Consumption (C)
Disposable income (Y
D
) is the income that remains Disposable income, (Y
D
), is the income that remains
once consumers have paid taxes and received
transfers from the government.
C C Y
D
( )
( )
The function The function CC((YY
DD
) is called the ) is called the consumption
function.. It is a It is a behavioral equation, that is, it , that is, it
captures the behavior of consumers captures the behavior of consumers captures the behavior of consumers. captures the behavior of consumers.
Disposable income is defined as: Disposable income is defined as: Y Y T
D

8
pp
D
A more specific form of the consumption function is
this linear relation:
C c c Y
D

0 1
This function has two This function has two parameters, , cc
00
and and cc
11
::
c
1
is called the (marginal) propensity to consume,
1
( g ) p p y ,
or the effect of an additional dollar of disposable
income on consumption.
i th i t t f th ti f ti d c
0
is the intercept of the consumption function, and
is known as autonomous consumption, i.e. the
amount of consumption expenditures households
9
wish to purchase, independent of income.
Fi gur e 1
Consumption and
Disposable Income
Consumption increases
with disposable income,
but less than one for
one.
C C Y
D
( )
Y Y T
D
Y Y T
D
C c c Y T
0 1
( )
10
Investment (I)
Variables that depend on other variables within the
model are called endogenous. Variables that are not
explain within the model are called exogenous explain within the model are called exogenous.
Investment here is taken as given, or treated as an
exogenous variable:
I I
11
Government Spending (G)
Government spending G together with taxes T Government spending, G, together with taxes, T,
describes fiscal policy the choice of taxes and
spending by the government.
We shall assume that G and T are also exogenous for
two reasons: two reasons:
Governments do not behave with the same regularity as
consumers or firms.
M i t t thi k b t th i li ti f Macroeconomists must think about the implications of
alternative spending and tax decisions of the government.
12
The Determination of The Determination of
Equilibrium Output
Equilibrium in the goods market requires that Equilibrium in the goods market requires that
production, Y, be equal to the demand for goods, AE:
AE Y
Y c c Y T I G
0 1
( )
Then: Then:
AE Y
0 1
( )
The equilibrium condition is that, production, Y, be
equal to demand Demand AE in turn depends on equal to demand. Demand, AE, in turn depends on
income, Y, which itself is equal to production..
13
Using Algebra
The equilibriumequation can be manipulated to The equilibrium equation can be manipulated to
derive some important terms:
Autonomous spending and the multiplier:
The term is that part of the demand for
goods that does not depend on output, it is called
autonomous spending. If the government ran a balanced
[ ] c I G c T
0 1

p g g
budget, then T=G.
Because the propensity to consume (c
1
) is between
zero and one is a number greater than one For this
1
zero and one, is a number greater than one. For this
reason, this number is called the multiplier.
Y c I G c T
1
[ ]
1
1
c
14
Y
c
c I G c T

1
1
0 1
[ ]
The Keynesian Cross The Keynesian Cross
Fi gur e 2
Y c T c G I c AE
1 1 0

Equilibrium in the Goods
Market
Equilibrium output is determined
b th diti th t d ti
AE
AE
=Y
by the condition that production
be equal to demand.
First plot demand as a
AE =C +I +G
Sl
First, plot demand as a
function of income.
Second, plot production
as a function of income
Slope=c
1
Autonomous as a function of income.
In Equilibrium,
production equals
demand income output Y
Autonomous
Spending
15
demand. income, output, Y
Equilibrium
income
Practice Example 1: Practice Example 1:
Suppose that:
C=475 +0.75(Y-T)
T =100
I 150 I =150
G =250
1. Calculate the equation for the AE (Aggregate
Expenditure) curve
2. What is real GDP in equilibrium?
16
The Multiplier
Definition: The multiplier is the amount Definition: The multiplier is the amount
by which a change in autonomous
expenditure is magnified or multiplied to expenditure is magnified or multiplied to
determine the change in equilibrium
expenditure and real GDP expenditure and real GDP.
17
The Basic Idea of the Multiplier
An increase in investment (or any other component of An increase in investment (or any other component of
autonomous expenditure) increases aggregate
expenditure and real GDP and the increase in real GDP
leads to an increase in induced expenditure.
The increase in induced expenditure leads to a further The increase in induced expenditure leads to a further
increase in aggregate expenditure and real GDP.
So real GDP increases by more than the initial increase
in autonomous expenditure.
18
Th M lti li Eff t The Multiplier Effect
Figure 3 illustrates the
multiplier multiplier.
The Multiplier Effect: p
The amplified change
in real GDP that
f ll i i follows an increase in
autonomous
expenditure is the
multiplier effect.
19
Th M lti li Eff t The Multiplier Effect
When autonomous
expenditure increases,
i t i k inventories make an
unplanned decrease, so
firms increase
production and real GDP
increases to a new
equilibrium equilibrium.
20
Th M lti li The Multiplier
Why Is the Multiplier Greater than 1?
The multiplier is greater than 1 because an increase
in autonomous expenditure induces further increases
in expenditure in expenditure.
The Size of the Multiplier The Size of the Multiplier
The size of the multiplier is the change in equilibrium
expenditure divided by the change in autonomous
expenditure.
21
The Multiplier
Ignoring induced imports and income taxes,
the marginal propensity to consume
determines the magnitude of the multiplier.
The multiplier equals 1/(1 MPC) or,
alternatively, 1/MPS.
22
Imports and Income Taxes
Income taxes and induced imports both
reduce the size of the multiplier. p
Including income taxes and induced Including income taxes and induced
imports, the multiplier equals 1/(1
slope of the AE curve) slope of the AE curve).
23
The Multiplier
Fi 4 h th Figure 4 shows the
relation between the
multiplier and the slope p p
of the AE curve.
In part (a) with no
imports (or imports are
autonomous ) and no )
income taxes, the slope
of the AE curve is 0.75
and the multiplier is 4
24
and the multiplier is 4.
The Multiplier
In part (b), when you p ( ), y
include either income
taxes or induced imports,
the slope of the AE curve p
is 0.5 and the multiplier
is 2.
25
Summary of Impact on Multiplier Magnitude
The multiplier is larger: p g
The greater the marginal propensity to consume (c
1
)
The smaller the marginal tax rate (t
1
)
The smaller the marginal propensity to import (m
1
)
Note: Autonomous/Lump sumtaxes i e T=t Note: Autonomous/Lump sum taxes, i.e. T=t
0
and autonomous imports m
0
do not affect the
value of the multiplier p
26
Using Words Using Words
Summary (cont.):
An increase in demand leads to an increase in
production and a corresponding increase in
income. The end result is an increase in output income. The end result is an increase in output
that is larger than the initial shift in demand, by a
factor equal to the multiplier.
To estimate the value of the multiplier, and more
generally, to estimate behavioral equations and their g y q
parameters, economists use econometricsa set of
statistical methods used in economics.
27
Practice Example 2: Practice Example 2:
Consider once again the scenario in example 1.
C=475 +0.75(Y-T)
T =100 T 100
I =150
G =250
Suppose that firms increase investment by 100.
Wh t h t l GDP i ilib i ? H What happens to real GDP in equilibrium? How
much does it change by?
28
How Long Does It Take for Output to Adjust?
Describing formally the adjustment of output over time
is what economists call the dynamics of adjustment.
Suppose that firms make decisions about their production
levels at the beginning of each quarter.
Now suppose consumers decide to spend more, that they
increase c
0.
.
Having observed an increase in demand, firms are likely to set
hi h l l f d ti i th f ll i t a higher level of production in the following quarter.
In response to an increase in consumer spending, output does
not jump to the newequilibrium but rather increases over time
29
not jump to the new equilibrium, but rather increases over time.
An Alternative Characterization of the
Goods Market Equilibrium
- Investment, Savings and the
Market for Loanable Funds
30
Market For Loanable Funds Market For Loanable Funds
Saving is the sum of private plus public saving.
Private saving (S), is saving by consumers.
S Y C
D
S Y T C
Public saving equals taxes minus government spending. equals taxes minus government spending.
If T >G, the government is running a budget surplus
public saving is positive public saving is positive.
If T <G, the government is running a budget deficit
public saving is negative.
Y C I G Y T C I G T
S I G T I S T G ( )
p g g
31
S I G T I S T G ( )
Investment Equals Saving: An Alternative q g
Way of Thinking about Goods-Market Equilibrium
I S T G ( )
The equation above states that equilibrium in the goods
market requires that investment equals saving the sum
I S T G ( )
market requires that investment equals savingthe sum
of private plus public saving.
This equilibrium condition for the goods market is called
the IS relation. What firms want to invest must be equal
t h t l d th t t t to what people and the government want to save.
32
Investment Equals Saving: An Alternative
Consumption and saving decisions are one and the
same
Way of Thinking about Goods-Market Equilibrium
same.
S Y T C
S Y T c c T T
0 1
( )
S c c Y T 1 ( )( ) S c c Y T
0 1
1 ( )( )
The term (1c
1
) is called the marginal propensity to
save save.
In equilibrium: In equilibrium:
I c c Y T T G
0 1
1 ( )( ) ( )
Y c I G c T
1
[ ]
Rearranging terms, we get the same result as before Rearranging terms, we get the same result as before::
33
Y
c
c I G c T

1
1
0 1
[ ]
Summary Summary
1. The Consumption Function depicts the relationship between
(household) consumption expenditures and its direct relationship to
disposable income. dsposabe co e
2. The marginal propensity to consume represents the fraction of every g p p y p y
dollar increase in disposable income that is consumed. The level of
autonomous consumption represents the amount of consumption
expenditures households would purchase, independent of
disposable income.
34
Summary Summary
3. The Aggregate Expenditures/Keynesian model focuses on the
demand side of the economy. Prices are held fixed (short run) and
supply adjusts to meet demand. Hence, changes in demand lead to
fluctuations in the business cycle.
4. Goods Market Equilibrium is given by setting supply equal to
demand In the workhorse Keynesian (Aggregate Expenditures) demand. In the workhorse Keynesian (Aggregate Expenditures)
model, it is where aggregate planned expenditure (AE curve) equals
actual production (45 line)
5. A change in autonomous expenditures (the intercept of the AE line)
leads to a more than one for one change in equilibriumGDP This
35
leads to a more than one for one change in equilibrium GDP. This
concept is the Multiplier.
Summary Summary
6. The size of the multiplier in a closed economy depends
on the marginal propensity to consume (mpc) and the
marginal tax rate (t
1
). In an open economy, it also
depends on the marginal propensity to import m
1
The depends on the marginal propensity to import, m
1
. The
multiplier is higher:
1. The higher the mpc
2 Th l th i l t t t 2. The lower the marginal tax rate, t
1
3. (And in an open economy, the lower the marginal propensity to
import, m
1
.)
7. The IS equation is an alternative way to think about
goods market equilibriumand represents equilibriumin
36
goods market equilibrium and represents equilibrium in
the loanable funds market

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Professor Yamin Ahmad, Intermediate Macroeconomics ECON 302

dd Intermediate Macroeconomics Intermediate Macroeconomics

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