1. 3 C H A P T E R Prepared by Fernando Quijano and Yvonn Quijano And Modified by Gabriel Martinez The Goods Market

2. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Composition of GDP 3-1 Table 3-1 The Composition of U.S. GDP, 2001 Billions of dollars Percent of GDP GDP (Y) 10,208100 1.Consumption (C) 7,06469 2.Investment (I) 1,69217 Nonresidential1,24612 Residential4465 3.Government spending (G) 1,83918 4.Net exports  329 3333 Exports (X) Exports (X)1,09711 Imports (IM) Imports (IM)  1,468  14 5.Inventory investment  58 1111

3. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Composition of GDP  Net exports (X  IM) –The difference between exports and imports, also called the trade balance.

6. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Expenditure on Goods  Total expenditure on goods is written as: 3-2  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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Consumption (C)  The function C(Y D ) 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Goods  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.

10. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Consumption (C)  Disposable income, (Y D ), is the income that remains once consumers have paid taxes and received transfers from the government.

11. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Consumption (C)  A more specific form of the consumption function is this linear relation:  This function has two parameters, c 0 and c 1 :  c 1 is called the (marginal) propensity to consume, or the effect of an additional dollar of disposable income on consumption. 0 < c 1 < 1  c 0 is the intercept of the consumption function. c 0 > 0

12. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Consumption (C) Consumption and Disposable Income Consumption increases with disposable income, but less than one for one.

13. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Determination of Equilibrium Output  Equilibrium in the goods market requires that production, Y, be equal to expenditure on goods, Z: 3-3 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Using Algebra  The equilibrium equation can be manipulated to derive some important terms: –Autonomous spending and the multiplier: multiplierautonomous spending

18. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Using Algebra  The Multiplier: if 0<c 1 <1, then  If Autonomous Spending changes, the change will be multiplied by 1/[1-c 1 ]  For example, if c 1 =0.5 and G changes by 200, Z (and Y) will change by 200x 1/[1-0.5]=400

19. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Using Algebra  How do we know Autonomous Spending is positive?  c 0 and I are both positive.  G-c 1 T will be positive if the budget is balanced, in deficit, or in a moderate surplus. –Only if there’s a HUGE surplus will it be negative.

20. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Using a Graph Equilibrium in the Goods Market Equilibrium output is determined by the condition that production be equal to expenditure. 45 degree The ZZ line: expenditure The equilibrium point

21. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Income (Y) Expenditure (Z), Production (Y) Solving for Equilibrium Graphically 14,000 12,000 10,000 7,000 5,000 4,00010,00014,000 Production Expenditure (ZZ) c 0 = 5,000 = 5,000 + 0.5Y Equilibrium 4,000

22. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 

23. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Income (Y) Expenditure Expenditure (Z), Production (Y) Solving for Equilibrium Graphically 14,000 12,000 10,000 7,000 5,000 4,00010,00014,000 Y Equilibrium ZZ Z>Y Z<Y

24. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

25. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Long Does It Take for Output to Adjust?  In response to an increase in consumer spending, output does not jump to the new equilibrium, but rather increases over time. The adjustment depends on how and how often firms revise their production schedule.  Describing formally the adjustment of output over time is what economists call the dynamics of adjustment.

26. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Long Does It Take for Output to Adjust?  The dynamics of adjustment: –If G falls, some people receive less income – and buy fewer goods and services.  Sales are less than production, so inventories accumulate. Production falls, which reduces the income of the wage-earners. –The sellers (and makers) of those goods and services now have less income, so they consume fewer goods and services, and so on. –The shock to autonomous spending is multiplied.

27. Fiscal Policy and the Multiplier Fighting Recessions and Overheating

28. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

29. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Fiscal Policy and the Multiplier  To lower output, the government can raise taxes or lower spending. –If c 1 = 0.5, the multiplier = 2. –Then G-c 1 T need only fall by $200 billion.  Y = multiplier x  (autonomous spending) 400 billion = 2 x 200 billion

30. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Shifts in the Aggregate Expenditure Curve 200 ZZ=5000+0.5Y Y 200 25 50 100 ZZ=4800+0.5Y 400

31. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

32. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Fiscal Policy and the Multiplier  To raise output, the government can lower taxes or raise spending. –If c 1 = 0.75, the multiplier = 4. –Then G-c 1 T need only rise by $100 billion.  Y = multiplier x  (autonomous spending) 400 billion = 4 x 100 billion

33. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Shifts in the Aggregate Expenditure Curve ZZ=4900+0.75Y Y 42.19 100 ZZ=4800+0.75Y 400 75 56.25

34. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

35. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Is the Government Omnipotent? A Warning  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? 3-5

36. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

37. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Using Words  To summarize: –An increase in expenditure 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 expenditure, by a factor equal to the multiplier.

38. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

39. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard.... Y C............................................................................................................................. Sample data points for consumption and income

40. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard.... Y C............................................................................................................................. Sample data points for C and Y, plus Regression Line, plus forecast error E(C|Y) = c 0 + c 1 Y u (forecast error) See Appendix 3, or take ECO 403, for more details.

41. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard

44. 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.

45. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Consumer Confidence and the 1990-1991 Recession  What component of Z is to blame for the recession?  Forecast errors were particularly bad for c 0, autonomous consumption.  c 0 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.

46. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Consumer Confidence and the 1990-1991 Recession Table 1 GDP, Consumption, and Forecast Errors, 1990-1991 Quarter (1) Change in Real GDP (2) Forecast Error for GDP (3) Forecast Error for c 0 (4) Index of Consumer Confidence 1990:219  17  23 105 1990:3  29  57 111190 1990:4  63  88  37 61 1991:1  31  27  30 65 1991:22747877

47. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Investment Equals Saving:  Saving is the sum of private plus public saving. Private saving (S), is saving by consumers. 3-4  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. An Alternative Way of Thinking about Goods- Market Equilibrium

48. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Investment Equals Saving:  Private Saving is simply what consumers don’t spend out of Y D  … Recall Y D = Y – T.  Now, Y is equal to Z in equilibrium.  Putting it all together …  Then investment is … 3-4 An Alternative Way of Thinking about Goods- Market Equilibrium

49. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Investment Equals Saving:  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. –If we want to use goods for future production, we can’t consume them (we must save them). An Alternative Way of Thinking about Goods- Market Equilibrium

50. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Investment Equals Saving:   Consumption and saving decisions are one and the same.  The term (1  c 1 ) is called the propensity to save. In equilibrium: Rearranging terms, we get the same result as before: An Alternative Way of Thinking about Goods- Market Equilibrium

51. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

52. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Saving as a Function of the Interest Rate Saving Real interest rate (%) National Saving S S r r’ 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.

53. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Investment as a Function of the Interest Rate investment Real interest rate (%) Investment I I r r’ I’ Firms invest less when the cost of borrowing rises. Investment can also shift because of confidence or expectations of future sales.

54. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Saving and investment Real interest rate (%) Investment I Saving S S, I r The Supply and Demand For Loanable Funds

55. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Saving and investment Real interest rate (%) I r E S I’ r’ F New Technology Raises the marginal productivity of capital This increases the demand for capital The Effect of a New Technology on National Saving and Investment

56. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Saving and investment Real interest rate (%) S I r E r’ F S’ Increases in the government budget deficit: Reduces S public and national saving r will increase S & I will fall The Effects of An Increase in the Government Budget Deficit On S and I

57. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard  The Natural Rate of Interest –Is the interest rate that makes National Saving equal to Investment. The Natural Rate of Interest

58. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Paradox of Saving  When consumers save more, spending decreases and equilibrium output is lower.  Attempts by people to save more lead both to a decline in output and to unchanged saving. This surprising pair of results is known as the paradox of saving (or the paradox of thrift). –Hence the cartoon at the beginning of the chapter. –IT IS A SHORT RUN EFFECT.

59. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard What did I learn in this chapter?  Tools and Concepts –The notation of functions. Appendix 2 discusses functions in more detail. –Modeling terminology: exogenous and endogenous variables, behavioral equations, identities, and equilibrium conditions. –The Keynesian cross model (i.e., the Y/Z model), the (marginal) propensity to consume, disposable income, and autonomous expenditure. –Fiscal policy.