the goods market

33C H A P T E RC H A P T E R

Prepared by Fernando Quijano and Yvonn Quijano

And Modified by Gabriel Martinez

The Goods MarketThe Goods Market

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

The Composition of GDPThe Composition of GDP3-1

Table 3-1 The Composition of U.S. GDP, 2001Billions of

dollars Percent of

GDPGDP (Y)GDP (Y) 10,20810,208 100100

1.1. Consumption (Consumption (CC) ) 7,0647,064 69692.2. Investment (Investment (II)) 1,6921,692 1717

NonresidentialNonresidential 1,2461,246 1212ResidentialResidential 446446 55

3.3. Government spending (Government spending (GG)) 1,8391,839 18184.4. Net exportsNet exports 329329 33 Exports (Exports (XX)) 1,0971,097 1111 Imports (Imports (IMIM)) 1,4681,468 14145.5. Inventory investmentInventory investment 5858 11


The Composition of GDPThe Composition of GDP Consumption (C)Consumption (C)

– The goods and services purchased by The goods and services purchased by consumers.consumers.

Investment (I),Investment (I),– Sometimes called Sometimes called fixed investmentfixed investment– The purchase of capital goods.The purchase of capital goods.

Capital goods: durable goods used to produce other Capital goods: durable goods used to produce other goods.goods.

– It is the sum of It is the sum of nonresidential investmentnonresidential investment and and residential investment.residential investment.


The Composition of GDPThe Composition of GDP

Government Spending (G)Government Spending (G)– Purchases of goods and services by the federal, state, Purchases of goods and services by the federal, state,

and local governments.and local governments.– It does not include It does not include government transfersgovernment transfers, nor interest , nor interest

payments on the government debt.payments on the government debt. Imports (IM)Imports (IM)

– Purchases of foreign goods and services by consumers, Purchases of foreign goods and services by consumers, business firms, and the U.S. government.business firms, and the U.S. government.

Exports (X)Exports (X)– Purchases of U.S. goods and services by foreigners.Purchases of U.S. goods and services by foreigners.



Net exports (X Net exports (X IM) IM)– The difference between exports and imports, also called The difference between exports and imports, also called

the the trade balancetrade balance..

E xports > im ports trade surp lus

E xports < im ports trade de fic it

E xports = im ports trade ba lance



Inventory investment Inventory investment is the difference is the difference between production and sales.between production and sales.– If production exceeds sales, there is If production exceeds sales, there is inventory inventory

accumulationaccumulation..– If sales exceed production, there is If sales exceed production, there is inventory inventory

deaccumulationdeaccumulation..


Expenditure on GoodsExpenditure on Goods Total expenditure on goods is written as:Total expenditure on goods is written as:

3-2

Z C I G X IM The symbol “The symbol “” means that this equation is an ” means that this equation is an

identityidentity, or , or definitiondefinition.. If we assume that the economy is closed,If we assume that the economy is closed,

X = IMX = IM = 0, then: = 0, then:Z C I G

We also assume that prices are fixed. This We also assume that prices are fixed. This defines defines the short runthe short run..


Consumption (Consumption (CC))

C C YD ( )( )

The function The function CC((YYDD) is called the ) is called the consumption function.consumption function.

It is a It is a behavioral equationbehavioral equation, that is, it , that is, it captures the behavior of consumers.captures the behavior of consumers.

There’s a positive relation between There’s a positive relation between consumption and disposable income.consumption and disposable income.


The Demand for GoodsThe Demand for Goods

To determine To determine ZZ, some simplifications must be , some simplifications must be made:made: Assume that all firms produce the same good, Assume that all firms produce the same good,

which can then be used by consumers for which can then be used by consumers for consumption, by firms for investment, or by the consumption, by firms for investment, or by the government.government.

Assume that firms are willing to supply and Assume that firms are willing to supply and demand in that marketdemand in that market

Assume that the economy is Assume that the economy is closedclosed, that it does , that it does not trade with the rest of the world, then both not trade with the rest of the world, then both exports and imports are zero.exports and imports are zero.


Consumption (Consumption (CC))

Disposable income,Disposable income, ( (YYDD),), is the income that remains is the income that remains once consumers have paid taxes and received transfers once consumers have paid taxes and received transfers from the government.from the government.

Y Y TD


Consumption (Consumption (CC)) A more A more specificspecific form of the consumption form of the consumption

function is this function is this linear relationlinear relation::C c c YD 0 1

This function has two This function has two parametersparameters, , cc00 and and cc11:: cc11 is called the (marginal) is called the (marginal) propensity to propensity to

consumeconsume, or the effect of an additional dollar , or the effect of an additional dollar of disposable income on consumption.of disposable income on consumption.

0 < 0 < cc11 < 1 < 1 cc00 is the intercept of the consumption is the intercept of the consumption

function. function. cc00 > 0 > 0


Consumption (Consumption (CC))Consumption and Consumption and Disposable IncomeDisposable Income

Consumption increases with disposable income, but less than one for one.

C c c Y T 0 1 ( )

010

0

1

cc


Investment (Investment (II))

Variables that depend on other variables Variables that depend on other variables within the modelwithin the model are called are called endogenousendogenous..

Variables that are not explained within the Variables that are not explained within the model are called model are called exogenousexogenous..


Investment (Investment (II)) Investment here is taken as given, or treated Investment here is taken as given, or treated

as an exogenous variable:as an exogenous variable:

Clearly, investment is not exogenous.Clearly, investment is not exogenous.– Firms will invest more in prosperities and when Firms will invest more in prosperities and when

interest rates are low.interest rates are low. But we make this But we make this simplificationsimplification for the for the

moment.moment.

I I


Government Spending (Government Spending (GG)) Government spending, Government spending, GG, together with , together with

taxes, taxes, TT, describes , describes fiscal policyfiscal policy—the —the choice of taxes and spending by the choice of taxes and spending by the government.government.

We shall assume that We shall assume that GG and and TT are also are also exogenous.exogenous.– GG and and TT (mostly) depend on (mostly) depend on policypolicy, which is , which is

not automatically determined by the model.not automatically determined by the model.

TTGG


The Determination ofThe Determination ofEquilibrium OutputEquilibrium Output

Equilibrium in the goods marketEquilibrium in the goods market requires that requires that production, production, YY, be equal to expenditure on goods, , be equal to expenditure on goods, ZZ::

3-3

Y c c Y T I G 0 1 ( )

Y ZThen:Then:

The The equilibrium conditionequilibrium condition is: is:production, production, YY, must be equal to expenditure. , must be equal to expenditure. Expenditure, Expenditure, ZZ, in turn depends on income, , in turn depends on income, YY, , which is equal to production.which is equal to production.


Using AlgebraUsing Algebra The equilibrium equationThe equilibrium equation

can be manipulated to derive some can be manipulated to derive some important terms:important terms:

– Autonomous spending and the multiplierAutonomous spending and the multiplier::

Y c c Y T I G 0 1 ( )

( )1 1 0 1 1 c Y c c I G c T

Yc

c I G c T

1

1 10 1[ ]

multiplier autonomous spending


Using AlgebraUsing Algebra The Multiplier: if 0<The Multiplier: if 0<cc11<1, then<1, then

If Autonomous Spending changes, the change If Autonomous Spending changes, the change will be will be multipliedmultiplied by 1/[1-c by 1/[1-c11]]

For example, if cFor example, if c11=0.5 and G changes by 200, =0.5 and G changes by 200, Z (and Y) will change by 200x 1/[1-0.5]=400Z (and Y) will change by 200x 1/[1-0.5]=400

11

1

1

c


Using a GraphUsing a Graph

Equilibrium in the Equilibrium in the Goods MarketGoods Market

Equilibrium output is determined by the condition that production be equal to expenditure.

Z c I G c T c Y ( )0 1 1Y Z45 degree The ZZ line: expenditure

Yc

c I G c T

1

1 10 1[ ]

The equilibrium point


Income (Y)

Expe

nditu

re (Z

), Pr

oduc

tion

(Y)

Solving for Equilibrium Solving for Equilibrium GraphicallyGraphically

14,000

12,000

10,000

7,000

5,000

4,000 10,000 14,000

Production

Expenditure (ZZ)

c0 = 5,000

= 5,000 + 0.5YEquilibrium

4,000


The Equilibrium Level of The Equilibrium Level of Aggregate IncomeAggregate Income

Suppose Expenditure > ProductionSuppose Expenditure > ProductionSales > ProductionSales > ProductionInventories fallInventories fallBusinesses produce more: Production Businesses produce more: Production

Suppose Expenditure < ProductionSuppose Expenditure < ProductionSales < ProductionSales < ProductionInventories riseInventories riseBusinesses produce less: Production Businesses produce less: Production


Income (Y)

Exp

endi

ture

Exp

endi

ture

(Z),

Pro

duct

ion

(Y)

Solving for Equilibrium Solving for Equilibrium GraphicallyGraphically

14,000

12,000

10,000

7,000

5,000

4,000 10,000 14,000

Y

Equilibrium

ZZ

Z>Y

Z<Y


Using a GraphUsing a GraphThe Effects of an The Effects of an Increase in Autonomous Increase in Autonomous Spending on OutputSpending on Output

An increase in autonomous spending has a more than one-for-one effect on equilibrium output.

Fiscal Policy and the MultiplierFiscal Policy and the Multiplier

Fighting Recessions and Fighting Recessions and OverheatingOverheating


Fiscal Policy and the MultiplierFiscal Policy and the Multiplier Suppose the government thinks output is Suppose the government thinks output is

too high.too high.– The economy may be “overheated”: operating The economy may be “overheated”: operating

above its long-run potential, which causes above its long-run potential, which causes inflation and social unrest.inflation and social unrest.

– For example, the government may think output For example, the government may think output should fall by $400 billion.should fall by $400 billion.


Fiscal Policy and the MultiplierFiscal Policy and the Multiplier To lower output, the government can raise To lower output, the government can raise

taxes or lower spending.taxes or lower spending.– If If cc11 = 0.5, the multiplier = 2. = 0.5, the multiplier = 2.

– Then G-Then G-cc11T need only fall by $200 billion.T need only fall by $200 billion.

Y = multiplier x Y = multiplier x (autonomous spending)(autonomous spending)

400 billion = 2 x 200 billion400 billion = 2 x 200 billion


Shifts in the Aggregate Shifts in the Aggregate Expenditure CurveExpenditure Curve

200

ZZ=5000+0.5Y

Y

200

2550

100

ZZ=4800+0.5Y

400

400

)200(0.5-11Y

(G)c-1

1Y1



Suppose the government thinks output is Suppose the government thinks output is too low.too low.– A recession may be causing the economy to A recession may be causing the economy to

operate below its long-run potential.operate below its long-run potential.– To avoid unemployment and social unrest, the To avoid unemployment and social unrest, the

government may choose an activist policy.government may choose an activist policy.– For example, the government may think output For example, the government may think output

should rise by $400 billion.should rise by $400 billion.



To raise output, the government can lower To raise output, the government can lower taxes or raise spending.taxes or raise spending.– If If cc11 = 0.75, the multiplier = 4. = 0.75, the multiplier = 4.

– Then G-Then G-cc11T need only rise by $100 billion.T need only rise by $100 billion.

Y = multiplier x Y = multiplier x (autonomous spending)(autonomous spending)

400 billion = 4 x 100 billion400 billion = 4 x 100 billion


Shifts in the Aggregate Shifts in the Aggregate Expenditure CurveExpenditure Curve

400

)100(0.75-11Y

(G)c-1

1Y1

ZZ=4900+0.75YY

42.19

100

ZZ=4800+0.75Y

400

75

56.25


Using a GraphUsing a Graph The multiplier is the sum of successive The multiplier is the sum of successive

increases in production resulting from an increases in production resulting from an increase in expenditure.increase in expenditure.

When expenditure is, say, When expenditure is, say, $1 billion$1 billion higher, higher, the total increase in production after the total increase in production after nn rounds of increase in expenditure equalsrounds of increase in expenditure equals

nccc 1211 ...1bn x $1

nccc 1211 ...1 The sum is called a The sum is called a

geometric seriesgeometric series..


Is the Government Omnipotent?Is the Government Omnipotent?A WarningA Warning

Changing government spending or taxes may Changing government spending or taxes may be far from easy.be far from easy.– The The lagslags of fiscal policy. of fiscal policy.

The responses of consumption, investment, The responses of consumption, investment, imports, etc, are hard to assess with much imports, etc, are hard to assess with much certainty.certainty.– Imports and investment are volatile and affected by Imports and investment are volatile and affected by

scores of volatile factors.scores of volatile factors. Anticipations: is the policy permanent or not?Anticipations: is the policy permanent or not?

3-5


Is the Government Omnipotent?Is the Government Omnipotent?A WarningA Warning

If If target outputtarget output is too high, inflation may is too high, inflation may accelerate.accelerate.– It is (nearly) impossible to estimate full-It is (nearly) impossible to estimate full-

employment output.employment output. Budget deficits and public debt may have Budget deficits and public debt may have

adverse implications in the long run.adverse implications in the long run.– Such as high interest rates, inflation, political Such as high interest rates, inflation, political

business cycles, etc.business cycles, etc.


Using WordsUsing Words To summarize:To summarize:

– An increase in expenditure leads toAn increase in expenditure leads toan increase in production and a an increase in production and a corresponding increase in income.corresponding increase in income.

– The end result is an increase in output The end result is an increase in output that is larger than the initial shift in that is larger than the initial shift in expenditure, by a factor equal to expenditure, by a factor equal to the multiplier.the multiplier.


Using WordsUsing Words To estimate the value of the multiplier, To estimate the value of the multiplier,

and more generally, to estimate and more generally, to estimate behavioral equations and their behavioral equations and their parameters,parameters,economists use economists use econometricseconometrics—a set of —a set of statistical methods used in economics.statistical methods used in economics.– We use known data on income and We use known data on income and

expenditure, and we figure out their average expenditure, and we figure out their average historical relation.historical relation.


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Sample data points for consumptionSample data points for consumptionand incomeand income


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Sample data points for C and Y, plus Sample data points for C and Y, plus Regression Line, plus Regression Line, plus forecast errorforecast error

E(C|Y) = c0+ c1Y

u(forecast error)

See Appendix 3, or take ECO 403, for more details.


Levels

0.02000.04000.06000.08000.0

10000.012000.014000.0

0.0 2000.0 4000.0 6000.0 8000.0 10000.0

Income (GDP)

Con

sum

ptio

n (C

)


Levels

C = 127.02 + 1.4441 Y

0.02000.04000.06000.08000.0

10000.012000.014000.0

0.0 2000.0 4000.0 6000.0 8000.0 10000.0

Income (GDP)

Con

sum

ptio

n (C

)


% Changes

C = 0.0035 + 0.7839 Y

-0.04

-0.02

0

0.02

0.04

0.06

0.08

-0.04 -0.02 0 0.02 0.04 0.06 0.08

% Change in GDP

% C

hang

e in

C


Consumer Confidence and the Consumer Confidence and the 1990-1991 Recession1990-1991 Recession

Can we predict recessions?Can we predict recessions?– More or less, but we can make mistakes.More or less, but we can make mistakes.

A A forecast errorforecast error is the difference between is the difference between the actual value of GDP and the value that the actual value of GDP and the value that had been forecast by economists one had been forecast by economists one quarter earlier.quarter earlier.– Forecasts errors were negative before and Forecasts errors were negative before and

during the 1991 recession:during the 1991 recession:– Economists thought the economy would grow Economists thought the economy would grow

faster than it did.faster than it did.



What component of Z is to blame for the What component of Z is to blame for the recession?recession?

Forecast errors were particularly bad for cForecast errors were particularly bad for c00, , autonomous consumption.autonomous consumption.

cc00 fell because of a fall in consumer fell because of a fall in consumer confidenceconfidence– The The consumer confidence indexconsumer confidence index is computed is computed

from a monthly survey of about 5,000 from a monthly survey of about 5,000 households who are asked how confident they households who are asked how confident they are about both current and future economic are about both current and future economic conditions.conditions.



Table 1 GDP, Consumption, and Forecast Errors, 1990-1991

Quarter(1)

Change inReal GDP

(2)Forecast Error

for GDP

(3)Forecast

Error for c0

(4)Index of Consumer

Confidence

1990:21990:2 1919 1717 2323 1051051990:31990:3 2929 5757 11 90901990:41990:4 6363 8888 3737 61611991:11991:1 3131 2727 3030 65651991:21991:2 2727 4747 88 7777


Investment Equals Saving:Investment Equals Saving:

SavingSaving is the sum of private plus public saving. is the sum of private plus public saving. Private savingPrivate saving ( (SS), is saving by consumers.), is saving by consumers.

3-4

Public savingPublic saving equals taxes minus government equals taxes minus government spending.spending. If T > G, the government is running a If T > G, the government is running a budget surplusbudget surplus

—public saving is positive.—public saving is positive. If T < G, the government is running a If T < G, the government is running a budget deficitbudget deficit

—public saving is negative.—public saving is negative.

An Alternative Way of Thinking about Goods-An Alternative Way of Thinking about Goods-Market EquilibriumMarket Equilibrium



Private Private SavingSaving is simply what consumers don’t is simply what consumers don’t spend out of Yspend out of YDD

… … Recall YRecall YDD = Y – T. = Y – T. Now, Y is equal to Z in equilibrium.Now, Y is equal to Z in equilibrium.

Putting it all together …Putting it all together …

Then investment is …Then investment is …

3-4

S Y CD

S Y T C

Y C I G

S I G T

I S T G ( )


TGICTGICCTYS )(



The equation above states that equilibrium in The equation above states that equilibrium in the goods market requires that the goods market requires that investmentinvestment equalsequals saving—the sum of saving—the sum of private plus public private plus public savingsaving..

This equilibrium condition for the goods market This equilibrium condition for the goods market is called the is called the IS relationIS relation..– What firms want to invest must be equal to what What firms want to invest must be equal to what

people and the government want to save.people and the government want to save.– If we want to use goods for future production, we If we want to use goods for future production, we

can’t consume them (we must save them).can’t consume them (we must save them).

I S T G ( )




Consumption and saving decisions are one and the Consumption and saving decisions are one and the same.same.

S Y T C

S c c Y T 0 11( )( ) The term (1The term (1cc11) is called ) is called the the propensity to save.propensity to save.

In equilibrium:In equilibrium:

Yc

c I G c T

1

1 10 1[ ]

I c c Y T T G 0 11( )( ) ( )

Rearranging terms, we get the same result as Rearranging terms, we get the same result as before:before:


)(10 TYccTYS


The Natural Rate of InterestThe Natural Rate of Interest

Notice that the relation is an Notice that the relation is an equilibriumequilibrium relation. relation.– Quantity of investment and quantity of saving Quantity of investment and quantity of saving

are only equal in equilibrium.are only equal in equilibrium.– We can imagine Saving as the “supply of We can imagine Saving as the “supply of

loanable funds”loanable funds” It increases as the interest rate rises.It increases as the interest rate rises.

– And Investment as the “demand of loanable And Investment as the “demand of loanable funds.”funds.” Businesses demand fewer loans if the interest rate Businesses demand fewer loans if the interest rate

rises.rises.

I S T G ( )


Saving as a Function ofSaving as a Function ofthe Interest Ratethe Interest Rate

Saving

Rea

l int

eres

t rat

e (%

)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.


Investment as a Function ofInvestment as a Function ofthe Interest Ratethe Interest Rate

investment

Rea

l int

eres

t rat

e (%

)

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.


Saving and investment

Rea

l int

eres

t rat

e (%

)

Investment I

Saving S

S, I

r

The Supply and DemandThe Supply and DemandFor Loanable FundsFor Loanable Funds



Rea

l int

eres

t rat

e (%

)

I

rE

S

I’

r’F

New Technology• Raises the marginal

productivity of capital• This increases the

demand for capital

The Effect of a New Technology The Effect of a New Technology on National Saving and Investmenton National Saving and Investment



Rea

l int

eres

t rat

e (%

)S

I

rEr’

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 The Effects of An Increase in the Government Budget Deficit On S and IBudget Deficit On S and I


The Natural Rate of InterestThe Natural Rate of Interest– Is the interest rate that makes National Is the interest rate that makes National

Saving equal to Investment.Saving equal to Investment.

The Natural Rate of InterestThe Natural Rate of Interest

)()()( GTrSrI


The Paradox of SavingThe Paradox of Saving When consumers save more, spending When consumers save more, spending

decreases and equilibrium output is lower.decreases and equilibrium output is lower. Attempts by people to save more lead both Attempts by people to save more lead both

to a decline in output and to unchanged to a decline in output and to unchanged saving. This surprising pair of results is saving. This surprising pair of results is known as the known as the paradox of savingparadox of saving (or the (or the paradox of thrift).paradox of thrift).– Hence the cartoon at the beginning of the Hence the cartoon at the beginning of the

chapter.chapter.– IT IS A IT IS A SHORT RUNSHORT RUN EFFECT. EFFECT.


What did I learn in this chapter?What did I learn in this chapter?

Tools and ConceptsTools and Concepts– The The notationnotation of of functionsfunctions. Appendix 2 discusses . Appendix 2 discusses

functions in more detail.functions in more detail.– Modeling terminology: Modeling terminology: exogenousexogenous and and endogenousendogenous

variablesvariables, , behavioral equationsbehavioral equations, , identitiesidentities, and , and equilibrium conditionsequilibrium conditions..

– The The Keynesian crossKeynesian cross model (i.e., the Y/Z model), the model (i.e., the Y/Z model), the (marginal) (marginal) propensity to consumepropensity to consume, , disposable disposable incomeincome, and , and autonomous expenditureautonomous expenditure..

– Fiscal policyFiscal policy. .

the goods market

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