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The goods market: Exercises and applications

The goods market: Exercises and applications. Lecture 13 – academic year 2013/14 Introduction to Economics Fabio Landini. Exercises. Numerical examples to determine the equilibrium level of GDP Effects of variation in autonomous expenditure Explanation of multiplier

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The goods market: Exercises and applications

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  1. The goods market: Exercises and applications Lecture 13 – academic year 2013/14 Introduction to Economics Fabio Landini

  2. Exercises • Numerical examples to determine the equilibrium level of GDP • Effects of variation in autonomous expenditure • Explanation of multiplier • Expansion in US during the 90s • Great recession in Italy (2008-2009) • Savings and investments in equilibrium

  3. Examples on the determination of GDP C0 = 100, c1 = 0,6 Consumption is endogenous (behavioural equation) C = 100 + 0,6YD Investments, public expenditure and taxes are exogenous (constant values) I = 50 G = 250 T = 100 Which is the value of production in equilibrium (YE)?

  4. Examples on the determination of GDP Aggregate demand Z is equal to Z = C + I + G By substituting the equation C = 100 + 0,6 YD Z = 100 + 0,6YD + I + G By substituting the definition YD = Y-T Z = C0 + c1 (Y-T) + I + G By substituting the constant value for I, G e T Z = 100 + 0,6 (Y-100) + 50 + 250 So that Z = 0,6Y + 340

  5. Examples on the determination of GDP We impose the equilibrium condition Z=Y, so that Y= 0,6Y + 340 (1- 0,6) Y= 340 Y = 340 = 850 Equilibrium income -> YE = 850 Which is the value of the multiplier? Multiplier = = 2,5

  6. Variations in autonomous expenditure Let’s examine the effects of a variations in one component of autonomous expenditure on final product. Let’s suppose that something changes that affect the consumption choices -> Aut. Consumption (C0) C0 = 100 -> 200 For the other variables we maintain the same values.

  7. Variations in autonomous expenditure Which is the equilibrium value of final product ? Z = C + I + G = = 200 + 0,6 (Y-100) + 50 + 250 = 0,6Y + 440 Let’s impose the equilibrium condition Z=Y Y= 0,6Y + 440 from which we get YE = 440 = 1100

  8. Variations in autonomous expenditure We obtained that C0 = 100 -> 200 caused YE = 850 -> 1100 An increase in C0 of about 100 caused an increase in YE of about 250 Why?

  9. Variations in autonomous expenditure Explanation: a) Autonomous consumption (C0) -> b) Since consumption is a component of aggregate demand (Z=C+I+G) Aggregate Dem. ( Δ Z= Δ C0) -> c) Since in equilibrium Y=Z Production of the same degree (Δ Y = Δ Z = Δ C0) If the effect of C0 stopped here we would have Δ Y = Δ C0

  10. Variations in autonomous expenditure However the effects continuous. Indeed: d) Since GDP =Σ incomes Δ Y = Δ Aggregate income -> e) Since consumption depends on income (C=C0+c1YD), new Consumption (equal to c1 × ΔYD = c1 × ΔC0) -> f) Since consumption is a component of aggregate demand (Z=C+I+G), new Aggregate demand (ΔZ = c1 × ΔC0) ->

  11. Variations in autonomous expenditure g) Since in equilibrium Y=Z New Production of the same dimension (ΔY = ΔZ =c1 ×ΔC0) -> h) New Aggregate income -> … The above described mechanisms starts again…

  12. Variations in autonomous expenditure In conclusion: • C0 causes a sequence of Y • This happens because every increase in the product causes an increase in income and therefore a new increase in demand • The increases get smaller and smaller because at each new “passage” only a portion of the new income is consumed (c1<1)

  13. Variations in autonomous expenditure The final increase in Y is greater than the initial one in C0 in because of the mechanism that we have just described Analytically this mechanism is represented by the multiplier (Multiplier -> “multiplies” the variations in autonomous expenditure) The mechanism the we have just described can be expressed also graphically

  14. Z Demand -> Z = SA+c1Y Supply -> Line at 45° Equilibrium -> Y=Z -> point A -> Y=YA , Y ZZ YA A 45° Y

  15. Z,Y Let’s see the effects of an increase in C0 C0 -> Z Z -> Y ZZ’ ZZ B C A 45°

  16. Z,Y Y -> C -> Z Z -> Y and so on… ZZ’ ZZ D B E C A 45°

  17. Z,Y Final effect: A -> A’ , so that YA -> YA’ The increase in Y is greater then the one in C0 ZZ’ A’ ZZ YA’ D B E C YA A 45°

  18. Variations in autonomous expenditure The previous results hold for all component of autonomous expenditure In particular, since YE = AE -> ΔYE = ΔAE where ΔAE is the variation in autonomous expenditure

  19. Variations in autonomous expenditure ΔAE = Δ of its components so that ΔYE = (ΔC0- c1 ×ΔT0 + ΔI0 + ΔG0) This implies that, in the short period, GDP depends on: • Variations in autonomous consumption (C0) • Variations in the choices of investors (I0) • Variations in the choices of government on taxes (T0) and public expenditures (G0)

  20. Variations in autonomous expenditure The decomposition of demand in its different component can be used to interpret some recent events. In particular: • Expansion of the United States in the 90s • Great recession during the period 2008-09 in Italy

  21. Expansion of the US during the 90s In the period 1993 - 2000 the US underwent a phase of great expansion (on average +3,7% a year; +4,1% from 1996 to 2000) The average growth was superior to the average of the other industrialized countries (for instance UE on average +2%) The previous analysis can help us to understand this fact

  22. Expansion of the US during the 90s We saw that ΔYE = (ΔC0- c1 ×ΔT0 + ΔI0 + ΔG0) What happened in the US economy? Mainly two things: a) The development of new Information and Communication Technologies (ICTs) lead firms to innovate the productive processes -> I0

  23. Expansion of the US during the 90s b) There had been a very good trend in the stock exchange indices (in particular the stocks associated with the “new economy”) -> households’ financial wealth -> C0

  24. Expansion of the US during the 90s In particular, on average: 1993-2000 1996-2000 Consumption + 3,4% + 4% Investments + 6,7% + 8,4% GDP + 3,7% + 4,1% I0 and C0 explain Y Important: Another component that contributed to growth was the increase in productivity (medium/long period phenomenon)

  25. 2008-2009 Great Recession 2nd semester of 2008 -> World financial crisis (“subprime crisis”) Recession (negative growth) in (almost) all biggest world economies

  26. 2008-2009 Great Recession Let’s focus on the Italian economy During the 2008-09 period the Italian economy underwent a deep recession with a total decrease in GDP greater than 5% in the two years. What does this trend depend on? How do we link this result with the trend in the components of aggregate demand?

  27. 2008-2009 Great Recession The financial crisis had an effect on investment and consumption On the investment side: • Difficulties in firms’ external financing -> (in the current model) I0 • Worsening of the expectations on profit -> (in the current model) I0

  28. 2008-2009 Great Recession On the consumption side: • Decrease in income (reduction of employment) -> Yd -> c1 Yd -> C • Fall in stock indices (cause by the worsening of the expectations on firms’ profitability) -> households’ financial wealth -> C0 • Worsening of the expectations on the future -> C0

  29. 2008-2009 Great Recession The dynamics of consumption and investments explain the dynamics of GDP

  30. Savings and investments in equilibrium The equilibrium condition on the good market is Y=Z We can obtain an equivalent condition based on investment and savings Let’s start from Y = Z = C + I + G We have Y - C - G = I By subtracting and summing T from/to the first term Y - T - C + T - G = I

  31. Savings and investments in equilibrium Y - T - C + T - G = I The expression Y - T – C is the difference between the available income and consumption -> private saving (Spr) The expression T – G is the difference between the earnings and costs of the Government -> public saving(Spu) By substituting in the original expression, we get Spr + Spu= I Private saving + public saving = saving (S) Therefore, the equilibrium condition suggests that S = I

  32. Savings and investments in equilibrium In equilibrium, investments equal savings -> Say’s Law It is an alternative way of defining the equilibrium in the goods market

  33. Now break… and then financial markets

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