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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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Outline of today‘s lecture

• • • • • • •

Brief review Aggregate expenditure function Consumption Investment IS-Equilibrium in a closed economy The mulitplier Another way to look at the equilibrium • Paradox of saving • An application: private surpluses and public deficits

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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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GDP: expenditures, nominal

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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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GDP: expenditures, real

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GDP: income

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GDP by category of output (1/2)

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GDP by category of output (2/2)

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**The Goods Market The Goods Market CHAPTER 3
**

Prepared by: Fernando Quijano and Yvonn Quijano

**3-1 The Composition of GDP
**

Table 3-1 The Composition of UK GDP, 2008

Billions of £ GDP (Y) 1 2 3 4 Consumption by HH & NPO (C) Government consumption (G) Investment (I) Net exports Exports (X) Imports (IM)

Source: ONS UK output, income, expenditure. 3rd quarter 2009, Table C1

Percent of GDP 100 64 21 17 3 422 459 29 32

1448 926 313 243 − 37

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**3-1 The Composition of GDP
**

Consumption (C) refers to the goods and services purchased by consumers. Investment (I), sometimes called fixed investment, is the purchase of capital goods. It is the sum of nonresidential investment and residential investment. 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 debt.

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3-1 The Composition of GDP

Imports (IM) are the purchases of foreign goods and services by consumers, business firms, and the U.S. government. Exports (X) are the purchases of U.S. goods and services by foreigners.

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**3-1 The Composition of GDP
**

Net exports (X − IM) is the difference between exports and imports, also called the trade balance.

E E E

x p =o x p >o x p <o

ri mt s p ⇔o ri mt s p ⇔o ri mt s p ⇔o

r t rt s a r t rt s a r t rt s a

da en

cb e a

l r

dp el u s su d i ce i td

e f

Inventory investment is the difference between production and sales.

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**3-2 The Demand for Goods
**

The total demand for goods is written as:

Z ≡ C + I + G + X − I M

The symbol “≡ ” means that this equation is an identity, or definition. To determine Z, 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.

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**3-2 The Demand for Goods
**

Assume that firms are willing to supply any amount of the good at a given price, P, 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. Under the assumption that the economy is closed, X = IM = 0, then:

Z ≡ C + I + G

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**3-2 The Demand for Goods
**

Consumption (C)

Disposable income, (YD), is the income that remains once consumers have paid taxes and received transfers from the government.

C = C (Y D )

(+ )

The function C(YD) is called the consumption function. It is a behavioral equation, that is, it captures the behavior of consumers. A more specific form of the consumption function is this linear relation:

C = c 0 + c 1Y D

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Determinants of consumption

• • • •

Permanent income hypothesis Wealth effects Income distribution Uncertainty, unemployment …

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BoE MacroModel version 2000

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**3-2 The Demand for Goods
**

Consumption (C)

This function has two parameters, c0 and c1: c1 is called the (marginal) propensity to consume, or the effect of an additional dollar of disposable income on consumption. c0 is the intercept of the consumption function. Disposable income is given by:

YD ≡ Y − T

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**3-2 The Demand for Goods
**

Consumption (C)

Figure 3 - 1 Consumption and Disposable Income Consumption increases with disposable income but less than one for one.

C = C (Y D ) YD ≡ Y − T C = c 0 + c1 (Y − T )

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**3-2 The Demand for Goods
**

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. Investment here is taken as given, or treated as an exogenous variable:

I = I

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Determinants of investment

• • • • •

Demand (!) Interest rates Uncertainty Profits Shareholder value orientation

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Investment

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• Note: What was the R2 in the consumption function and what in the investment function? • • • • BoE first disaggregates Investment I = IB + IH + IG Then estimates IB Then assumes that IH grows with B

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3-2 The Demand for Goods

Government Spending (G)

Government spending, G, together with taxes, T, describes fiscal policy—the choice of taxes and spending by the government.

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3-2 The Demand for Goods

We shall assume that G and T are also exogenous for two reasons: Governments do not behave with the same regularity as consumers or firms. Macroeconomists must think about the implications of alternative spending and tax decisions of the government.

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**3-3 The Determination of Equilibrium Output
**

Assuming that exports and imports are both zero, the demand for goods is the sum of consumption, investment, and government spending:

Z ≡C + I +G

Then:

Z = c0 + c1 ( Y - T ) + I + G

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**3-3 The Determination of Equilibrium Output
**

Equilibrium in the goods market requires that production, Y, be equal to the demand for goods, Z:

Y = Z

The equilibrium condition is that, production, Y, be equal to demand. Demand, Z, in turn depends on income, Y, which itself is equal to production. Then:

Y = c0 + c1 (Y − T ) + I + G

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**3-3 The Determination of Equilibrium Output
**

Macroeconomists always use these three tools: 1. Algebra to make sure that the logic is correct 2. Graphs to build the intuition 3. Words to explain the results

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**3-3 The Determination of Equilibrium Output
**

Using Algebra

Rewrite the equilibrium equation:

Y = c0 + c1Y − c1T + I + G

Move

c1Y to the left side and reorganize the right side:

(1− c ) Y = c

1

0

+ I + G − c1T

Divide both sides by

(1 − c1 ) :

1 c0 + I + G − c1T Y= 1 − c1

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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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**3-3 The Determination of Equilibrium Output
**

Using Algebra

The equilibrium equation can be manipulated to derive some important terms: Autonomous spending and the multiplier: The term [c0 + I + G − c1T ] 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 budget, then T=G. Because the propensity to consume (c1) is between zero and one, 1 − c 1 is a number greater than one. For this reason, this number is called the multiplier.

1

Y =

C

1 1 − c1

[c 0 + I + G − c1T ]

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**3-3 The Determination of Equilibrium Output
**

Using a Graph

Figure 3 - 2 Equilibrium in the Goods Market Equilibrium output is determined by the condition that production be equal to demand.

Z = (c0 + I + G − c1T ) + c1Y

First, plot production as a function of income. Second, plot demand as a function of income. In Equilibrium, production equals demand.

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**3-3 The Determination of Equilibrium Output
**

Using a Graph

Figure 3 - 3 The Effects of an Increase in Autonomous Spending on Output An increase in autonomous spending has a more than onefor-one effect on equilibrium output.

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**3-3 The Determination of Equilibrium Output
**

Using a Graph

The first-round increase in demand, shown by the distance AB equals $1 billion. This first-round increase in demand leads to an equal increase in production, or $1 billion, which is also shown by the distance in AB. This first-round increase in production leads to an equal increase in income, shown by the distance in BC, also equal to $1 billion.

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**3-3 The Determination of Equilibrium Output
**

Using a Graph

The second-round increase in demand, shown by the distance in CD, equals $1 billion times the propensity to consume. This second-round increase in demand leads to an equal increase in production, also shown by the distance DC, and thus an equal increase in income, shown by the distance DE. The third-round increase in demand equals $c1 billion, times c1, the marginal propensity to consume; it is equal to $c1 x c1 = $ c12billion.

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**3-3 The Determination of Equilibrium Output
**

Using a Graph

Following this logic, the total increase in production after, say, n + 1 rounds, equals $1 billion multiplied by the sum: 1 + c1 + c12 + …+ c1n

Such a sum is called a geometric series.

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**3-3 The Determination of Equilibrium Output
**

Using Words

To summarize: 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 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 parameters, economists use econometrics—a set of statistical methods used in economics.

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**3-3 The Determination of Equilibrium Output
**

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 c0. . Having observed an increase in demand, firms are likely 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.

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**3-4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium
**

Saving is the sum of private plus public saving. Private saving (S), is saving by consumers.

S ≡ YD − C

S ≡ Y − T − C

Public saving equals taxes minus government spending. If T > G, the government is running a budget surplus—public saving is positive. If T < G, the government is running a budget deficit—public saving is negative.

Y = C + I + G S = I + G − T

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Y − T − C = I + G − T

I = S + (T − G )

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3-4 Investment Equals Saving: An Alternative 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 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 to what people and the government want to save.

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Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium

Consumption and saving decisions are one and the same.

S = Y − T − C S = Y − T − c0 − c1 (Y − T ) S = − c 0 + ( 1 − c 1 ) Y( − T )

The term (1−c1) is called the propensity to save. In equilibrium:

I = − c 0 + ( 1 − c 1 ) Y( − T ) + ( T − G )

Rearranging terms, we get the same result as before:

1 Y= [c0 + I + G − c1T ] 1 − c1

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The Paradox of Saving

The paradox of saving (or the paradox of thrift) is that as people attempt to save more, the result is both a decline in output and unchanged saving.

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• • • •

Let’s got back to S=I+G–T We can rewrite this as S–I=G–T • What is the meaning of these terms? • Private surplus (PS) • Budget deficit (BD) = – BS • PS = BD or 0 = PS + BS

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**An application: deficits saved the world
**

• http://krugman.blogs.nytimes.com/2009/07/15/deficits-saved-the-world/ Deficits saved the world Jan Hatzius of Goldman Sachs has a new note (no link) responding to claims that government support for the economy is postponing the necessary adjustment. He doesn’t think much of that argument; neither do I. But one passage in particular caught my eye: “The private sector financial balance—defined as the difference between private saving and private investment, or equivalently between private income and private spending —has risen from -3.6% of GDP in the 2006Q3 to +5.6% in 2009Q1. This 8.2% of GDP adjustment is already by far the biggest in postwar history and is in fact bigger than the increase seen in the early 1930s.” That’s an interesting way to think about what has happened — and it also suggests a startling conclusion: namely, government deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression.

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Here I show the private sector surplus and the public sector deficit, both as functions of GDP; the private sector line is upward-sloping because higher GDP means higher income and more savings, the public-sector line is downward-sloping because higher GDP means higher revenues. In equilibrium the private surplus equals the government deficit (not strictly true for any one country if you add in international capital flows, but think of this as a picture for the world economy). To make the figure cleaner I’ve shown an initial position of balance in both sectors, but this isn’t important. What we’ve had is a sharp increase in the desired private surplus at any given level of GDP, due to a combination of higher personal saving and reduced investment demand. This is shown as an upward shift in the private-surplus curve. In the 1930s the public sector was very small. As a result, GDP basically had to shrink enough to keep the private-sector surplus equal to zero; hence the fall in GDP labeled “Great Depression”. This time around, the fall in GDP didn’t have to be as large, because falling GDP led to rising deficits, which absorbed some of the rise in the private surplus. Hence the smaller fall in GDP labeled “Great Recession.” What Hatzius is saying is that the initial shock — the surge in desired private surplus — was if anything larger this time than it was in the 1930s. This says that absent the absorbing role of budget deficits, we would have had a full Great Depression experience. What we’re actually having is awful, but not that awful — and it’s all because of the rise in deficits. Deficits, in other words, saved the world.

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**3-5 Is the Government Omnipotent? A Warning
**

Changing government spending or taxes is not always easy. The responses of consumption, investment, imports, etc, are hard to assess with much certainty. Anticipations are likely to matter. Achieving a given level of output can come with unpleasant side effects. Budget deficits and public debt may have adverse implications in the long run.

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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 50 of 32

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