The Goods Market

1. The Goods Market

2. The Composition of GDP 3-1

3. The Composition of GDP • Consumption (C) • The goods and services purchased by consumers. • Investment (I), • Sometimes called fixed investment • The purchase of capital goods. • Capital goods: durable goods used to produce other goods. • It is the sum of nonresidential investment and residential investment.

4. The Composition of GDP • Government Spending (G) • 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. • Imports (IM) • Purchases of foreign goods and services by consumers, business firms, and the U.S. government. • Exports (X) • Purchases of U.S. goods and services by foreigners.

5. The Composition of GDP • Net exports (X  IM) • The difference between exports and imports, also called the trade balance.

6. The Composition of GDP • Inventory investment is the difference between production and sales. • If production exceeds sales, there is inventory accumulation. • If sales exceed production, there is inventory deaccumulation.

7. Expenditure on Goods 3-2 • Total expenditure on goods is written as: • The symbol “” means that this equation is an identity, or definition. • If we assume that the economy is closed,X = IM = 0, then: • We also assume that prices are fixed. This defines the short run.

8. Consumption (C) • The function C(YD) is called the consumption function. • It is a behavioral equation, that is, it captures the behavior of consumers. • There’s a positive relation between consumption and disposable income.

9. 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. Assume that firms 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. The Demand for Goods

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

11. Consumption (C) • A more specific form of the consumption function is this linear relation: • 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. 0 < c1 < 1 • c0 is the intercept of the consumption function. c0 > 0

12. Consumption (C) Consumption and Disposable Income Consumption increases with disposable income, but less than one for one.

13. Investment (I) • Variables that depend on other variables within the model are called endogenous. • Variables that are not explained within the model are called exogenous.

14. Investment (I) • Investment here is taken as given, or treated as an exogenous variable: • Clearly, investment is not exogenous. • Firms will invest more in prosperities and when interest rates are low. • But we make this simplification for the moment.

15. Government Spending (G) • Government spending, G, together with taxes, T, describes fiscal policy—the choice of taxes and spending by the government. • We shall assume that G and T are also exogenous. • G and T (mostly) depend on policy, which is not automatically determined by the model.

16. The Determination ofEquilibrium Output 3-3 • Equilibrium in the goods market requires that production, Y, be equal to expenditure on goods, Z: Then: • The equilibrium condition is:production, Y, must be equal to expenditure. Expenditure, Z, in turn depends on income, Y, which is equal to production.

17. multiplier autonomous spending Using Algebra • The equilibrium equation can be manipulated to derive some important terms: • Autonomous spending and the multiplier:

18. Using Algebra • The Multiplier: if 0<c1<1, then • If Autonomous Spending changes, the change will be multiplied by 1/[1-c1] • For example, if c1=0.5 and G changes by 200, Z (and Y) will change by 200x 1/[1-0.5]=400

19. Using a Graph Equilibrium in the Goods Market 45 degree The ZZ line: expenditure Equilibrium output is determined by the condition that production be equal to expenditure. The equilibrium point

20. Expenditure (Z), Production (Y) c0 = 5,000 Income (Y) Solving for Equilibrium Graphically Production 14,000 12,000 Expenditure (ZZ) 10,000 = 5,000 + 0.5Y Equilibrium 7,000 5,000 4,000 4,000 10,000 14,000

21. The Equilibrium Level of Aggregate Income • Suppose Expenditure > Production • Sales > Production • Inventories fall • Businesses produce more: Production  • Suppose Expenditure < Production • Sales < Production • Inventories rise • Businesses produce less: Production 

22. Z<Y Expenditure (Z), Production (Y) Z>Y Income (Y) Solving for Equilibrium Graphically Y 14,000 ZZ 12,000 10,000 Equilibrium 7,000 5,000 4,000 10,000 14,000

23. Using a Graph The Effects of an Increase in Autonomous Spending on Output An increase in autonomous spending has a more than one-for-one effect on equilibrium output.

24. Fiscal Policy and the Multiplier Fighting Recessions and Overheating

25. Fiscal Policy and the Multiplier • Suppose the government thinks output is too high. • The economy may be “overheated”: operating above its long-run potential, which causes inflation and social unrest. • For example, the government may think output should fall by $400 billion.

26. Fiscal Policy and the Multiplier • To lower output, the government can raise taxes or lower spending. • If c1 = 0.5, the multiplier = 2. • Then G-c1T need only fall by $200 billion. DY = multiplier x D(autonomous spending) 400 billion = 2 x 200 billion

27. Shifts in the Aggregate Expenditure Curve ZZ=5000+0.5Y Y 200 200 ZZ=4800+0.5Y 100 50 25 400

28. Fiscal Policy and the Multiplier • Suppose the government thinks output is too low. • A recession may be causing the economy to operate below its long-run potential. • To avoid unemployment and social unrest, the government may choose an activist policy. • For example, the government may think output should rise by $400 billion.

29. Fiscal Policy and the Multiplier • To raise output, the government can lower taxes or raise spending. • If c1 = 0.75, the multiplier = 4. • Then G-c1T need only rise by $100 billion. DY = multiplier x D(autonomous spending) 400 billion = 4 x 100 billion

30. Shifts in the Aggregate Expenditure Curve ZZ=4900+0.75Y Y ZZ=4800+0.75Y 42.19 56.25 75 100 400

31. Using a Graph • The multiplier is the sum of successive increases in production resulting from an increase in expenditure. • When expenditure is, say, $1 billion higher, the total increase in production after n rounds of increase in expenditure equals • The sum is called a geometric series.

32. Is the Government Omnipotent?A Warning 3-5 • Changing government spending or taxes may be far from easy. • The lags of fiscal policy. • The responses of consumption, investment, imports, etc, are hard to assess with much certainty. • Imports and investment are volatile and affected by scores of volatile factors. • Anticipations: is the policy permanent or not?

33. Is the Government Omnipotent?A Warning • If target output is too high, inflation may accelerate. • It is (nearly) impossible to estimate full-employment output. • Budget deficits and public debt may have adverse implications in the long run. • Such as high interest rates, inflation, political business cycles, etc.

34. Using Words • To summarize: • An increase in expenditure leads toan 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 expenditure, by a factor equal to the multiplier.

35. Using Words • 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. • We use known data on income and expenditure, and we figure out their average historical relation.

36. Sample data points for consumptionand income . C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Y

37. Sample data points for C and Y, plus Regression Line, plus forecast error . E(C|Y) = c0+ c1Y C . . . . . . . . . . . . . . . . . . . . . . . . . . . . u (forecast error) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Y See Appendix 3, or take ECO 403, for more details.

41. Consumer Confidence and the 1990-1991 Recession • Can we predict recessions? • More or less, but we can make mistakes. • A forecast error is the difference between the actual value of GDP and the value that had been forecast by economists one quarter earlier. • Forecasts errors were negative before and during the 1991 recession: • Economists thought the economy would grow faster than it did.

42. Consumer Confidence and the 1990-1991 Recession • What component of Z is to blame for the recession? • Forecast errors were particularly bad for c0, autonomous consumption. • c0 fell because of a fall in consumer confidence • The consumer confidence index is computed from a monthly survey of about 5,000 households who are asked how confident they are about both current and future economic conditions.

43. Consumer Confidence and the 1990-1991 Recession

44. 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. • 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.

45. 3-4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium • Private Saving is simply what consumers don’t spend out of YD • … Recall YD = Y – T. • Now, Y is equal to Z in equilibrium. • Putting it all together … • Then investment is …

46. Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium • The equation above states that equilibrium in the goods market requires that investmentequals 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. • If we want to use goods for future production, we can’t consume them (we must save them).

47. Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium • Consumption and saving decisions are one and the same. • The term (1c1) is called the propensity to save. In equilibrium: Rearranging terms, we get the same result as before:

48. The Natural Rate of Interest • Notice that the relation is an equilibrium relation. • Quantity of investment and quantity of saving are only equal in equilibrium. • We can imagine Saving as the “supply of loanable funds” • It increases as the interest rate rises. • And Investment as the “demand of loanable funds.” • Businesses demand fewer loans if the interest rate rises.

49. Saving as a Function ofthe Interest Rate National Saving S People save more when the interest rate is higher. Also, people save because of uncertainty. Government saving (T-G) is part of National Saving. r’ Real interest rate (%) r S S’ Saving

50. Investment as a Function ofthe Interest Rate Firms invest less when the cost of borrowing rises. Investment can also shift because of confidence or expectations of future sales. Real interest rate (%) r r’ Investment I I I’ investment