BlCh31 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.

BlCh32 Composition of aggregate demand Z C I –Fixed Residential (consumers) Non residential (firms) –Inventories G NX – X – Less IM

BlCh33 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 )

BlCh34 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 =

BlCh35 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)

BlCh36 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

BlCh37 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

BlCh38 Determinants of consumption C Let’s define Y D - - as Y D  Consumption is determined by disposable income: C as Y D so consumption is a function of Y D C = this is a relation which can be specified with the following linear form: C = c 1 is the

BlCh39 Consumption function C Y D =Y-T

BlCh310 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.

BlCh311 Model C = I = (exogenous - given) G = (exogenous - policy variable) Z  by definition Y = (equilibrium condition)

BlCh312 Algebraic Solution Since in equilibrium, by replacing we get: Y = = Y e = is the multiplier m and is autonomous spending Z 0

BlCh313 Graphical solution Z Y YeYe

BlCh314 The multiplier Assume a specific consumption function C = i.e. MPC = The multiplier m = 1/(1-c 1 ) = Since Y e = m (c 0 + I + G - c 1 T) 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

BlCh315 Effect of an increase in G Z Y Z0Z0 Z = Z 0 +c 1 Y Y=Z YeYe ∆G 1

BlCh316 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 c 1 ∆G: this is an additional increase in aggregate demand : 3 to 4 Then production must increase again by c 1 ∆G this time to meet this new increase in aggregate demand and so on…

BlCh317 Rational Production depends on as Y = in equilibrium Demand depends on as Z = and C =

BlCh318 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.

BlCh319 Alternative calculation of the multiplier Per iod 1234 Total increase (many periods) ∆G ∆Y∆Gc 1 ∆Gc 1 2 ∆G (1+c 1 +c …) ∆G ∆Cc 1 ∆Gc 1 2 ∆Gc 1 3 ∆G(c 1 +c 1 2 +c …) ∆G ∆Z∆Gc 1 ∆Gc 1 2 ∆Gc 1 3 ∆G(1+c 1 +c 1 2 +c …) ∆G

BlCh320 Alternative approach: Investment = saving Approach used by in the “General Theory of Employment, Interest and Money” 1936 By definition, private saving is what S p  Hence S p  or Y  The equilibrium condition of the model above was: Y = By replacing, it becomes I =

BlCh321 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

BlCh322 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

BlCh323 Solution of the model using the alternative equilibrium condition Let’s derive the saving function from the consumption function (c 1 is the MPC) C = and S p  S P = Y D = S p = 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 (Y e )

BlCh324 I = S p + (T - G) (equilibrium condition) = - c 0 + (1 - c 1 )(Y - T) + T - G = - c 0 + (1 - c 1 )Y - (1 - c 1 )T + T - G = - c 0 + (1 - c 1 )Y - T + c 1 T + T - G (1 - c 1 )Y = c 0 + I + G - c 1 T Finally as before.

BlCh325 Problem # 2 P. 62 C = Y D I = 150 G = 150 T = 100 a.In equilibrium Y = i.e. Y - 0.6Y = Y =

BlCh326 b. Y D = Y - T = c.C = Problem # 3 a.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 c 1 * ∆Y or and Z = C’ + I + G’ =

BlCh327 c.Private savings S p = Y - T - C = Government savings S g = T - G = Equilibrium condition: I = S p + S g I =150 S p + S g =