The Goods Market

1
The Goods Market

• Some definitions (or identities)
• Value of final production ?
• Total output ? total output
  
• If aggregate sales is the same as aggregate
  purchases, we can break down Y into the
• for it.
• i.e. we can focus on the
• 
  for output Y.

2
Composition of aggregate demand Z

• C
• I
• Fixed
• Residential (consumers)
• Non residential (firms)
• Inventories
• G
• NX
• X
• Less IM

3

• Consumption
• Consumer
• Some might be some sort of consumers investment
  like
• Investment (not financial)
• Firms
• Consumers
• Government (on goods and services
  only)
• Excludes (e.g. medicare, S.S.)
• and
• (total would be called government
  )

4

• Exports are
• 
  (demand for Y) so they should be included in
  Y as they are demand for domestic output.
• Imports are
  (goods produced abroad) - they
  should not be included in Y as they are not
  demand for domestic output. However as they are
  already included in consumption and other
  purchases, they
• Net Exports

5

• Inventories corresponds to goods
• To get an accurate account of production during
  the year, we must
• inventories at the beginning of
  the year (they were produced in the previous
  year)
• inventories at the end of the
  year (produced this year but not sold)

6
Determination of aggregate demand Z

• By definition (identity)
• Z ? in an economy
• Z ? in a economy
• Assumptions of the model
• prices (short run Keynesian model)
• (everything is in real term)
• economy

7
Short run - medium run - long run

• Short run - period too short to allow prices to
  adjust - fixed prices - unemployment possible
• Medium run - economy is always at full employment
  (labor market must adjust) - prices adjust to
  bring economy back to full employment - capital
  stock is fixed
• Long run - growth theory - capital stock
  increases through investment in the economy

8
Determinants of consumption C

• Lets define YD -
  - as
• YD ?
• Consumption is determined by disposable income
  C as YD
• so consumption is a function of
  YD
• C
• this is a relation which can be
  specified with the following linear form
• C c1 is the

9
Consumption function
C
YDY-T
10
Endogenous versus exogenous variables

• Definition
• Endogenous variables are determined
  
• Exogenous variables are determined
  of the model, i.e. they are
• Investment I is considered as an
• variable in this chapter
• Government spending G and taxes T are
• variables - they are policy
  instruments for the government.

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Model

• C
• I (exogenous - given)
• G (exogenous - policy variable)
• Z ? by definition
• Y (equilibrium condition)

12
Algebraic Solution

• Since in equilibrium,
• by replacing we get
• Y
• Ye

is the multiplier m
and is autonomous spending Z0
13
Graphical solution
Z

Y
Ye
14
The multiplier

• Assume a specific consumption function
• C i.e. MPC
• The multiplier m 1/(1-c1)
• Since Ye m (c0 I G - c1T)
• If G increases by ?G, Y will increase by
• ?Y
• In the example above an increase in G equal to
  100 will result in an increase in Y of

15
Effect of an increase in G
Z
YZ
Z Z0c1Y
1
?G
Z0
Y
Ye
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Explanation

• Starting at 1, the economy is in equilibrium.
• An increase in G equal to ?G immediately
  translates into an equal increase in aggregate
  demand 1 to 2
• In 2 the economy is not in equilibrium as Z gt Y
  so firms must increase production by ?G to meet
  the additional demand from 2 to 3
• In 3 the economy is still not in equilibrium
  (below ZZ)
• As production increases by ?G , income increases
  equally so consumption demand will increase by c1
  ?G this is an additional increase in aggregate
  demand 3 to 4
• Then production must increase again by c1 ?G
  this time to meet this new increase in aggregate
  demand and so on

17
Rational

• Production depends on
• as Y in equilibrium
• Demand depends on
• as Z
• and C

18

• When there is an exogenous increase in demand,
  production will increase equally, and this
  increase in production (i.e. in income) results
  in an additional increase in demand.
• However the additional increase in demand is
  smaller than the original increase because the
  marginal propensity to consume is less than 1
  (some of the increase in income is saved) this
  process will not result in an infinite increase
  in output as the additional increases in demand
  get smaller and smaller and tend towards zero.

19
Alternative calculation of the multiplier
Period 1 2 3 4 Total increase (many periods)
?G ?G ?G
?Y ?G c1 ?G c12 ?G (1c1c12 ) ?G
?C c1 ?G c12 ?G c13 ?G (c1c12c13 ) ?G
?Z ?G c1 ?G c12 ?G c13 ?G (1c1c12c13 ) ?G
20
Alternative approach Investment saving

• Approach used by in the General Theory
  of Employment, Interest and Money 1936
• By definition, private saving is what
• Sp ?
• Hence Sp ?
• or Y ?
• The equilibrium condition of the model above was
• Y
• By replacing, it becomes I

21
Interpretation

• In a one person economy, investment equals
  savings because the decision to save and to
  invest is made by the same person.
• e.g. Robinson Crusoes island

22
Role of government

• In the above equation, the government
• takes a share of income in the form of tax
• spends it in the economy in the form of G
• so T - G corresponds to the amount of tax
  receipts that the government did not spend, i.e.
  that the government saved.
• In sum, T - G (the budget surplus) can be
  interpreted as the

23
Solution of the model using the alternative
equilibrium condition

• Lets derive the saving function from the
  consumption function (c1 is the MPC)
• C and Sp ?
• SP YD
• Sp with MPS
• Note that MPC MPS 1 as mentioned earlier
• We can now use the saving function and the new
  equilibrium condition to find equilibrium Y (Ye)

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• I Sp (T - G) (equilibrium condition)
• - c0 (1 - c1)(Y - T) T - G
• - c0 (1 - c1)Y - (1 - c1)T T - G
• - c0 (1 - c1)Y - T c1T T - G
• (1 - c1)Y c0 I G - c1T
• Finally
• as before.

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Problem 2 P. 62

• C 160 0.6 YD
• I 150
• G 150
• T 100
• In equilibrium Y
• i.e. Y - 0.6Y
• Y
• Y

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• b. YD Y - T
• c. C
• Problem 3
• Z C I G
• so Y Z (equilibrium condition)
• If G 110 ?G
• as the multiplier m 2.5 and ?Y m ?G
• ?Y and the new equilibrium Y is
• consumption drops by c1 ?Y or
• and Z C I G

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• Private savings Sp Y - T - C
• Government savings Sg T - G
• Equilibrium condition I Sp Sg
• I 150
• Sp Sg