Intermediate Macroeconomics ECON 302 Professor Yamin Ahmad Lecture 4: + Introduction tothe Goods Market 22 + Review of the Aggregate Expenditures model and the Keynesian Cross 2 Components of Aggregate Demand + Aggregate Expencitures/Keynesian Model: > The Consumption Function > Tha Keynesian Cross > Autonomous Expanciures > Nutipiees + Equlixium in the Goods Merket/Loanable Funds Market + The IS Relation The Composition of GDP Y C+I+G@+ NX Recall that: = Consumption (C) refers tothe goods and services purchased by consumers, + Investment (9, sometimes called fixed investment, isthe purchase of capital goods. ttis the sum of nonresidential investment and residential investment. The Composition of GDP * 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 an the government debt. * Imports (if) are the purchases of foreign goods and services by consumers, business firms, and the U S. governmant. * Exports (X) are the purchases of U.S. goods and services by foreigners.The Composition of GDP + Net exports (X —IM) is the difference betwee ‘exports and imports, also called the trade balance. Exports imports = trade balance Rxport > imports ade surplus Expors < impor = wade deft + Inventory investment isthe difference between production and sales. Daye ‘The Demand for Goods + The total demand for goods is written as: AE =C+1+G+X-IM + The symbol =" means that this equation is an identity, or definition, ‘+ Under the assumption that the economy is closed, X= IM =0, then: AE =C+I+6 Sees The Demand for Goods ‘To determine AE, some simplifications must be made: * Assume that ll fms produce the same good, which can then be used by consumers for consumption, by firms for investment, or by the government. Assume that fms are willing to supply and demand 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. ja) Consumption (C) + Disposable income, (Y,), isthe income that remains once consumers have paid taxes and received transfers from the government c= CU) + The function C1Y,) is called the consumption function. Itis a behavioral equation, that i, tt ‘captures the behavior of consumers, + Disposable income is defined as: Y= Y-T.ea Consumption (C) + Amore specific form of the consumption function is this linear relation: C= et ely ‘This function has two parameters, cand ¢, * ¢;|s called the (marginal) propensity to consume, of the effect of an additional dolar of disposable income on consumption * is the intercept ofthe consumption function, and \s known 2s autonomous consumption, Le. the ‘amount of consumption expenditures households Wish to purchase, independent of income ja) Consumption (C) Figure 1 | ‘Sensumpon ae (Sonsimnpon ‘Beporalncome ‘uncton Censunpionncreases Cxcyrea¥ wih dpesale reams buless tenon consumption, c= CO) Disposable ome, Yo Investment (/) + Variables that depend on other variables within the model are called endogenous. Variables that are not ‘explain within the model are called exogenous, Investment here is taken as given, or teated as an ‘exogenous variable: Government Spending (G) ‘Government spending, G, together with taxes, T, oscribes fiscal poliey — the choice of taxes and ‘spending by the government. We shall assume that G and Tare also exogenous for ‘two reasons: + Governments do rot behave wi te sare regulary as + Macroacencmists must think about he implications of ‘Stematve spending and ax decisions ofthe governmentea The Determination of Equilibrium Output Equilibrium in the goods market requires that production, ¥, be equal to the demand for goods, AE: Y =AE Then 14 Yee,+e(0-1)+14+G The equilibrium condition is that, production, Y, be equal to demand. Demand, AE, in tun depends on Income, Y, which itself is equal to production. Using Algebra The equilibrium equation can be manipulated to derive some important term: > Autonomous spending and the multiplier: + The torm t+ 16~ is that pat ofthe demand for ‘goods that does not depend: on output, tis called Autonomous spending. If the government ran a balanced budget, then *+ Because the propensity to consume (eis between 2er0 and one, = lea number greater than one, For thie reason, this numbers called the mulipier e+ 1+E- eT] The Keynesian Cross Figure2 AE=()+T+G-eT}eq¥ Eien oats AE, aultrum puts tena by ne codon at posicion esgaltocenara| 1+ Fat plot demand ae a funciona income, + Second, plot production se. Snaton of income, + Ia Equiorm, production equals ‘demand came out aie 7 Practice Example 1 Suppose that + C2475 + 075-1) 1. Caloulate the equation for the AE (Aggregate Expenditure) curve 2. What is real GDP in equilibrium?The Multiplier Definition: The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP. The Basic Idea of the Multiplier + An increase in investment (or any other component of ‘autonomous expenditure) increases aggregate expenditure and real GOP and the increase in real GOP leads to an increase in induced expenditure, +The increase in induced expenditure leads to a further Increase in aggregate expenditure and real GOP. + S0,real GDP increases by more than the inital increase In autonomous expenditure. The Multiplier Effect + Figure 3 illustrates the muttiplier. + The Multiplier Effect: = The amplified change 4 inveal GOPtrat | folows an increesein | autonomous } ‘expenditure is the ‘mutipler effect. 1s The Multiplier Effect + When autonomous expenditure increases, Inventories make an Unplanned dectease, so firms increase production and real GDP Increases to a new cequilirium,The Multiplier + Why Is the Muttiplier Greater than 12 > The multiplier is greater than 1 because an increase in autonomous expenditure induces further increases in expenciture, + The Size of the Multiplier > The size of the multiplier is the change in equilibrium ‘expenditure divided by the change in autonomous ‘expenditure. The Multiplier * Ignoring induced imports and income taxes, the marginal propensity to consume determines the magnitude of the multiplier. + The muttiplier equals 1/(1— MPC) or, alternatively, 1/MPS. Imports and Income Taxes + Income taxes and induced imports both reduce the size of the multiplier. + Including income taxes and induced imports, the multiplier equals 1/(1 — slope of the AE curve). The Multiplier + Figure 4 shows the relation between the ‘multiplier and the slope of the AE curve + Inpart a) with no Imports (or imports are autonomous } and no income taxes, the slope of the AE cure is 0.75 ‘and the mutiplier is 4Dae The Multiplier + In part (b), when you include erther income taxes or induced imports, the slope of the AE curve 's 05nd ine mutiper ‘Summary of Impact on Multiplier Magnitude + The multiplier is larger: > The greater the marginal propensity to consume (c,) > The smaller the marginal tax rate (t,) » The smaller the marginal propensity to import (m,) + Note: Autonomous/Lump sum taxes, Le. and autonomous imports m, do not affect the value of the multiplier 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 that is larger than the intial 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 thelr parameters, economists use econometrics—a set of statistical methods used in economics, Practice Example 2: Consider once again the scenero in example 1 75 + 0.75(Y-T) + T= 100 + 12450 + G=250 ‘Suppose that firms increase investment by 100. ‘What happens to real GOP in equilibrium? How ‘much does it change by?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 fms make decisions about ther production levels atthe boginning ef each quarter + Now suppose consumers deci to spand more, that they bers * Having observed an ncroase in domand fms are thy to st 23 hight velo production nthe falling quarter + Inrespones to an incrasse in consumer spending, ttput does notjunp to te new equllonum, bu rather mreabes over Ue An Alternative Characterization of the Goods Market Equilibrium - Investment, Savings and the Market for Loanable Funds Daa Market For Loanable Funds ‘Saving isthe sum of private plus public saving + Private saving (S), i saving by consumers, S2¥-C S=¥-T-C + Public saving equals taxes minus government spending + IFT G, the government is running a budget eurplue — public saving is positive + If <6, the government is running a budget deficit — public saving is negative, Y-T-C=1+G-T I=S+(T-G) Investment Equals Saving: An Alternative ‘Way of Thinking about Goods-Market Equilibrium 1=S+(T-G) The equation above states that equilibrium in the goods market requires that investment equals saving—the sum of private plus public saving This equilibrium condition forthe goods market is called the IS relation. What firms want fo invest must be equal to what people and the government want to save.Investment Equals Saving” An Aternatve \Way of Thinking about Goods-Market Equilibrium + Consumption and saving decisions are one and the seme : -T-c -T-¢,-¢(T-T) ey + - &XY-T) + The term (1-¢)) is called the marginal propensity to In equitbrium: T= -0,+(1- 6)" T)+(T- 6) Rearranging terms, we get the same result as before: l a gle tt+G-erl S= Y= Summary 1. The Consumption Functon depicts the relationship betwen (ousehold) sonsumplion expenditures ard is dec latnshlp 0 Ssposabia nome 2. The marginal propansy to consume represents th ration of evary Golarintease ncisposabe income that's consumed. The level of autonomous consumption represents the aroun of consumption ‘xpenctreshousehelés would purchase, independent of Ssposabie income, Summary 45. The Aggregate Exponctues Keynesian nosel focuses onthe sernand sie othe economy, Piles ae hed ed (shor Un) ang Supply adjusts to moot demand, Hence, changes mn demand Wad to Tuctuatonsin he busines cx, 4. Goods Market Equlitrum i given by setting supply equa io omnand. Inthe wotkhoise Keynesian (Aggfegae Expendlures) model its where aggregate panned expenditure (AE cure) equals Sctal prosveton (4° Ine) 5. A change in autonomous expenditures (the itercept ofthe AE line) Ioade les more than one fer one change in equliriam GOP. The concepts the Multiple. Summary 6 The size of the multiplier ina closed economy depends ‘on the marginal propensity to consume (mpc) and the ‘marginal tax rate (|). In an open economy. it also depends on the marginal propensity to import, m,. The ‘multiplier is higher: 1. Tehigher the mpe 2, Thelowe the marginal taxa, ty 3. (andinan open coamy, he marh maria propre impor. 7. The IS equation isan alternative way to think about {goods market equilibrium and represents equilbrium in the loanable funds market 7