ECON2123 (Spring 2012)

22 & 23.2.2012 (Tutorial 3)

Chapter 3: The Goods Market

Composition of GDP
GDP = Y = C + I + G + X IM
Consumption (C): purchases of goods and services by consumers
Investment (I): purchases of new capital goods (residential and nonresidential investment)
Government spending (G): purchases of goods and services by the government.
(Government transfers are not included)
Export (X): purchases of domestic good and services by foreigners
Import (IM): purchases of foreign good and services
Inventory investment: difference between production and sales

Consumption function
The consumption function shows the relationship between consumption and disposable
income

Disposable income: YD = Y T ( T = taxes transfers)

C = C (YD)
C = c0 + c1YD

c0: Autonomous consumption: the amount of consumption which is independent of Y

Example: Y = 0, C = 200, then 200 is the autonomous consumption

c1: Marginal propensity to consume (MPC): the effect of an additional dollar of

disposable income on consumption
Example: Y =1000, C = 800, then MPC = 0.8

Graphical representation of consumption function

Suppose a = 0, MPC = 1, then C = Y (Consume all income)
Suppose a = 0, MPC = 0.8, then C = 0.8Y (Consume 80% of income)
Suppose a = 200, MPC = 0.8, then C = 200 + 0.8Y

C C = Y (45) C
C = 200 + 0.8Y

C = 0.8Y

C = 0.8Y

200
Slope = MPC = 0.8

Y Y

The consumption function is a linear function.

The consumption function is upward sloping, meaning that Y and C are positively related
The slope of the consumption function is MPC and it is constant at different level of Y.
When MPC changes, the slope of the consumption function will change.

1
Saving function
The saving function shows the relationship between the amount of saving and disposable
income.
Y=C+S
S = Y C T = YD C
S = S(YD)
S = c0 + (1 c1) YD

(1 c1): Marginal propensity to save (MPS): the effect of an additional dollar of

disposable income on saving

The determination of equilibrium output

Assumption: price is fixed (SR assumption), which implies supply responds to demand
passively, i.e. any quantity demanded would be supplied.

The equilibrium GDP is achieved when Production = Demand, i.e. Y = Z

Aggregate demand : Z = C + I + G (c0 I G c1T ) c1Y

Y-intercept of the demand curve is (c0 I G c1T ) and slope is c1

Algebraic representation
The equilibrium GDP is achieved when Y = Z
Y c0 c1 (Y T ) I G
Y c0 c1Y c1T I G
(1 c1 )Y c0 I G c1T
1 1
Y [c0 I G c1T ] where is the multiplier
1 c1 1 c1

Graphical representation
The equilibrium GDP is achieved when. Y = Z (point E)

ZZ / Y 45 (Production)
Y2
Excess Supply
AD2
ZZ = C + I + G
E

AD1
Excess Demand
Y1

Y
Y1 Y* Y2

2
 Suppose Y = Y1
Excess demand (AD1 > Y1)
The price is fixed and the producer would response to the demand and increases
production
Y increases and then AD increases
This process continues until point E is reached.

Suppose Y = Y2
Excess supply (Y2 > AD2)
The price is fixed and the producer would response to the demand and reduces production
Y falls and AD falls
This process continues until point E is reached.

The Multiplier effect

(1) Change in autonomous spending
An increase in autonomous demand (autonomous G, I or C) would rise Y by more than
the original increase in demand.

Multiplier: the ratio of the change in Y to a change in the government expenditure, i.e.
Y
G

Period 1 G by 200 AD by 200 Y by 200

Period 2 Y by 200 C by (200 MPC) AD and Y by (200 MPC)
Period 3 Y by (200 MPC) C by (200 MPC2) AD and Y by (200 MPC2)
Period 4 Y by (200 MPC2) C by (200 MPC3) AD and Y by (200 MPC3)

Period N Y by (200 MPCn-2) C by (200 MPCn-1) AD and Y by (200 MPC n-1)

Y G (G MPC ) (G MPC 2 ) (G MPC n1 )

1
Y G
1 MPC
Y 1
Multiplier
G 1 MPC

The size of the multiplier (i.e. Y/G) depends on the size of MPC: the higher (lower)
the value of MPC, the larger (smaller) the multiplier effect.

(2) Change in Tax (assuming lump-sum tax)

Y (T MPC ) (T MPC 2 ) (T MPC n1 )
MPC
Y T
1 MPC
Y MPC
Multiplier
T 1 MPC

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Examples and Problems

Question 1
Consider an economy in which tax collections are always $200

GDP Taxes DI C I G
480 200 210 100 215
540 200 255 100 215
600 200 300 100 215
660 200 345 100 215
720 200 390 100 215

(a) Fill in the column for DI, disposable income

GDP Taxes DI C I G AD
480 200 280 210 100 215 525
540 200 340 255 100 215 570
600 200 400 300 100 215 615
660 200 460 345 100 215 660
720 200 520 390 100 215 705

(b) Find the equilibrium level of GDP for this economy

Equilibrium = 660 when Y = AD

(c) What is the marginal propensity to consume?

MPC =

(d) What is the simple multiplier for the economy?

Multiplier = 1/(1-MPC) = 4

4
Question 2
Giving the consumption function, C = 200 + 0.8Y
(a) Derive the saving function.

Y=C+S
S = Y C S = Y 200 0.8Y S = 200 + 0.2Y

(b) Graph the saving function (Try to derive it from the consumption function!). How much
is saving/ dissaving when Y = 400 and Y = 2000

C
45 Saving = 200
2000
1800
C = 200 + 0.8Y

520
Dissaving = 120
400
200
Y
400 1000 2000
S

S
200
Y
120 1000 2000
200

At Y = 0, C = 200, which means S = 200

At Y = 400, C = 520, which means S = 120
At Y = 1000, C = 1000, which means S = 0
At Y = 2000, C = 1800, which means S = 200

The saving function is a linear function.

The saving function is upward sloping, meaning that Y and S are positively related.
The slope of the saving function is MPS and it is constant at different level of Y.
When MPS changes, the slope of the saving function will change

(c) Identify the autonomous saving and the marginal propensity to save (MPS). What is the
relationship between MPS and MPC?

Autonomous saving = 200 (borrowing) and MPS = 0.2 (MPS = S/Y).

MPC + MPS = 1

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Question 3
Suppose the economy is characterized by the following equations:
C = 160 + 0.6 YD
I = 150
G = 150
T = 100
Solve for the following questions and put your answers in a graph.
45
ZZ/ Y AD
(a) Equilibrium output (Y) AD
E
Y = 160 + 0.6 (Y 100) + 150 +150 AD
Y* = 1000
E
(b) Disposable income (YD)

YD = Y T = 1000 100 = 900 440

400 E
(c) Consumption spending
360

C = 160 + 0.6 (900) = 700
Y
Y**=900

Y**=1100
(d) Suppose now G falls to 110. Solve for the new equilibrium. Y*=1000

1 1
Multiplier 2.5
1 MPC 1 0.6
G = 40, Y = -40 Multiplier = -40 2.5 = -100
Y** = Y* + Y = 900

(e) Suppose the government increases taxes and government expenditure by 100 at the same
time. Solve for the new equilibrium.

Y = 160 + 0.6 (Y 100-100) + 150 +250

Y*** = 1100

Alternatively,
Y = 100 [1/(1 MPC) C1 /(1 MPC)] = 100
Y*** = Y* + Y = 1100

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Example 4: Taxes and Transfers
Recall that we define T as net of transfers. In other words, T = taxes transfer payments.
(a) Suppose that the government increases transfer payments to private households, but
these transfer payments are not financed by tax increases. Instead, the government
borrows to pay for the transfer payments. Show in the diagram (like Figure 3-2) how this
policy affects equilibrium output. Explain.

AD
45 (Production)

ZZ
ZZ Disposable income and hence consumption both
Y E
increases for any level of Y, so the ZZ curve
shifts up, and equilibrium output increases.

E
Y*

Y
Y* Y

(b) Suppose instead that the government pays for the increase in transfer payments with an
equivalent increase in taxes. How does the increase in transfer payments affect
equilibrium output in this case?
There is no effect on equilibrium output, since T does not change.

(c) Now suppose that the population includes two kinds of people, those with high
propensity to consume and those with low propensity to consume. Suppose that transfer
policy increases taxes on those with low propensity to consume to pay for the transfers
to people with high propensity to consume. How does this policy affect equilibrium
output?
The ZZ line shifts up and output increases. The reduction in demand due to the tax
increase on low MPC group is smaller than the increase in demand due to the increase in
transfers on high MPC group. Therefore, this policy increases equilibrium output.
Effectively the income transfers increases the propensity to consume for the economy as
a whole.

(d) The propensity to consume is likely to be higher for low-income taxpayers. Do you
think tax cuts will be more effective at stimulating output when they are directed toward
high-income or toward low-income taxpayers?
People with high wealth probably have a lower propensity to consume than people with
low wealth. At the extreme, those in poverty may spend most of any additional dollar on
basic needs.
Since wealth and income are usually related, people with high income probably have a
lower propensity to consume than people with low income. Therefore, tax cuts are likely
to be more effective at stimulating output when they are directed toward people with low
income, who are likely to spend more of the extra disposable income.