BlCh31 The Goods Market Some definitions (or identities): –Value of final production –Total output total output If aggregate sales is the same as aggregate.

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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.

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Composition of aggregate demand Z

• C • I

– Fixed• Residential (consumers)• Non residential (firms)

– Inventories

• G• NX

– X– Less IM

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• 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 )

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• 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 =

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• 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)

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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

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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

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Determinants of consumption C

• Let’s 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

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Consumption function

C

YD=Y-T

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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)

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Algebraic SolutionSince in equilibrium,

by replacing we get:

Y =

=

Ye =

is the multiplier m

and is autonomous spending Z0

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Graphical solution

Z

Y

Ye

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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

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Effect of an increase in G

Z

Y

Z0

Z = Z0+c1Y

Y=Z

Ye

∆G 1

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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 > 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…

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Rational

• Production depends on

as Y = in equilibrium

• Demand depends on

as Z =

and C =

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• 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.

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Alternative calculation of the multiplier

Period

1 2 3 4Total increase

(many periods)

∆G ∆G ∆G

∆Y ∆G c1 ∆G c1

2 ∆G(1+c1+c1

2+ …) ∆G

∆C c1 ∆G c12 ∆G c1

3 ∆G (c1+c12+c1

3+ …) ∆G

∆Z ∆G c1 ∆G c12 ∆G c1

3 ∆G (1+c1+c12+c1

3+ …) ∆G€

= 1

1- c1

ΔG

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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 =

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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 Crusoe’s island

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Role of government:

• In the above equation, the government

1. takes a share of income in the form of tax

2. 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

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Solution of the model using the alternative equilibrium condition

• Let’s 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 - c1TFinally

as before.

€

Ye =1

1- c1

(c0 + I_

+ G - c1T)

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Problem # 2 P. 62

C = 160 + 0.6 YD

I = 150

G = 150

T = 100

a. In equilibrium Y =

i.e. Y - 0.6Y =

Y =

Y =

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b. YD = Y - T = c. C = Problem # 3a. Z = C + I + G = so Y = Z = (equilibrium condition)b. 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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c. Private savings Sp = Y - T - C

=

Government savings Sg = T - G

=

Equilibrium condition: I = Sp + Sg

I =150

Sp + Sg =