Economics302( (Sec.

001) ) IntermediateMacroeconomic TheoryandPolicy

(Spring2011)
Instructor:Prof.MenzieChinn Lecture3 Monday,January30,2012

RealSector&KeynesianCross
Compositionofoutput(accounting) AggregateDemand Equilibrium ilib i ParadoxofThrift

31TheCompositionofGDP

Y C + I +G+ X IM
Table 3-1
The Composition of U.S. GDP, 2006 Billions of dollars GDP (Y) 1 2 Consumption (C) Investment (I) N Nonresidential id ti l Residential 3 4 Government spending (G) Net exports Exports (X) Imports (IM) 5 Inventory investment 49
Source: Survey of Current Business, April 2007, Table 1-1-5. 3 of32

Percent of GDP 100 0 100.0 70.0 16.3 1 396 1,396 767 10 5 10.5 5.8 19.0 5.8 1,466 2,229 0 11.0 16.8

13 246 13,246 9,269 2,163

2,528 763

31TheCompositionofGDP
Consumption(C)referstothegoodsandservices purchasedbyconsumers. Investment(I),sometimescalledfixedinvestment,is thepurchaseofcapitalgoods goods.Itisthesumof nonresidentialinvestment andresidential investment. GovernmentSpending p g(G) referstothep purchasesof goodsandservicesbythefederal,state,andlocal governments.Itdoesnotincludegovernment transfers,norinterestpaymentsonthegovernment 4 of32 debt.

31TheCompositionofGDP
Imports(IM) arethepurchasesofforeign goodsandservicesbyconsumers,business firms,andtheU.S.government. Exports(X) arethepurchasesofU.S.goods andservicesbyforeigners foreigners.

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31TheCompositionofGDP
Net exports (X IM) is the difference between exports and imports, also called the trade balance. Exports = imports trade balance

Exports > imports trade surplus E Exports t < imports i t trade t d deficit d fi it
Inventory investment is the difference between production and sales.
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32TheDemandforGoods
We now move from accounting to modeling. The total (or aggregate) aggregate ) demand for goods is written as:

Z C + I + G + X IM
Where C, Wh C I I, G G, X X, IM are now all ll planned l d amounts of expenditures. To determine Z, some simplifications must be made:
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32TheDemandforGoods
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 any amount of the good at a given price, P, and demand in that market market. Assume that the economy is closed, then both exports and imports are zero. Under the assumption that the economy is closed, X = IM = 0, then:
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Z C+ I + G

32TheDemandforGoods
Consumption (C)

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

C = C(YD )
(+ )

The function C(YD) is called the consumption function. It is a behavioral equation, that is, is it captures the behavior of consumers.

C = c0 + c1YD
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32TheDemandforGoods
Consumption (C)

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. c0 is the intercept of the consumption function. Disposable income is given by:

YD Y T
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32TheDemandforGoods
Consumption (C)
Fi Figure 3-1 Consumption and Disposable Income Consumption increases with disposable income but less than one for one.

C = C(YD ) YD Y T C = c0 + c1 (Y T )

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32TheDemandforGoods
Investment (I )

Variables that depend p on other variables within the model are called endogenous. Variables that are not explain within the model are called exogenous. g Investment here is taken as given, or treated as an exogenous variable:

I = b0

Government Spending (G)

Government spending, G, together with taxes, T, describes fiscal policythe choice of t taxes and d spending di b by th the government. t
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32TheDemandforGoods
Textbook assumes both G and T are also exogenous. In the derivation, I take only G as exogenous , with T partly exogenous Governments do not behave with the same regularity as consumers or firms. Macroeconomists M i t must t think thi k about b t the th implications of alternative spending and tax decisions of the government government.

G = GO0
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T = t 0 + t1Y

33TheDeterminationofEquilibrium Output
Assuming Assuming that exports and imports are both zero, the demand for goods is the sum of consumption, investment, and government spending:

Z C + I +G
Then:

Y = Z = (c0 + c1YD ) + (b0 ) + (GOo )

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33TheDeterminationofEquilibrium Output
Equilibrium in the goods market requires that production, d ti Y, be b equal lt to th the d demand df for goods, d Z:

Y= Z

The equilibrium condition is that that, production, production Y, be equal to demand. Demand, Z, in turn depends p on income, Y, which itself is equal q to production. . Then:

Y = (c0 + c1 (Y (t0 + t1Y ))) + (b0 ) + (GOo )

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33TheDeterminationofEquilibrium Output
Macroeconomists always use these th three tools: t l 1. Algebra to make sure that the logic is correct 2. Graphs to build the intuition 3. Words to explain the results

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Using Algebra

33TheDeterminationofEquilibrium p Output
Rewrite the equilibrium equation:

Y = Z = (c0 + c1 (Y (t 0 + t1Y ))) + (b0 ) + (GOo )

Y = c1 (1 t1 )Y + 0 0 c0 c1(t0 ) +b0 +GO o Y c1 (1 t1 )Y = 0

Y [1 c1 (1 t1 )] = 0
1 = [1 c1 (1 t1 )]
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Y0 = 0

33TheDeterminationofEquilibrium Output Using Algebra

The equilibrium equation can be manipulated to derive some important terms: The term 0 c0 c1 (t 0 ) + b0 + GOo is that part of the demand for goods that does not depend on output, it is called autonomous spending. If the g government ran a balanced budget g , then T=G. Because the p propensity p y to consume (c1) is 1 between zero and one, = [1 c ( is a number 1 1 t1 )] greater than one. For this reason, this number is called the multiplier.
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33TheDeterminationofEquilibrium O t t Output Using a Graph

Z = 0 + c1 (1 t1 )Y
Equilibrium in the Goods Market Equilibrium output is determined by the condition that production be equal to demand. demand First, plot production as a function of income. Second, S plot demand as a function of income. In Equilibrium, production d i equals l demand.
19 of32 Z Y=Z Z=c1(1-t1)Y+0

0
45

Slope = c1(1-t1)

Y0

33TheDeterminationofEquilibrium O t t Output Using a Graph

Fi Figure 3-3

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

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33TheDeterminationofEquilibrium O t t Output Using a Graph

The first-round increase in demand, shown by the distance AB equals $1 billion. This first-round increase in demand leads to an equal increase in production or $1 billion, production, billion which is also shown by the distance in AB. This first-round increase in production leads to an equal increase in income, shown by the distance in BC, also equal to $1 billion.
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33TheDeterminationofEquilibrium O t t Output Using a Graph

The second-round increase i d in demand, d shown h b by th the distance in CD, equals $1 billion times the propensity to consume. This second-round increase in demand leads to an equal increase in production, also shown by the distance DC, and thus an equal increase in income, shown by the distance DE. The third-round increase in demand equals $c1 billion, times c1, the marginal propensity to consume; it is equal q to $c1 x c1 = $ c12billion.

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33TheDeterminationofEquilibrium O t t Output Using a Graph

Following F ll i this thi logic, l i th the t total t li increase i in production after, say, n + 1 rounds, equals $1 billion multiplied by the sum: 1 + c1 + c12 + + + c 1n Such a sum is called a geometric series.

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Change g inEquilibrium: q TotalDifferentials

Y0 = 0

1 = [1 c1 (1 t1 )]

0 c0 c1 (t 0 ) + b0 + GOo

Y =
Y = [a 0 c1 t 0 + b0 + GO]
Y = GO

33TheDeterminationofEquilibrium O t t Output
Using Words

To summarize: An increase in demand leads to an increase in production d ti and d a corresponding di i increase i in income. The end result is an increase in output that is larger than the initial shift in demand, by a factor equal to the multiplier. To estimate the value of the multiplier, p , and more generally, to estimate behavioral equations and their parameters, economists use econometricsa set of statistical methods used in economics. 25 of32

33TheDeterminationof E ilib i O Equilibrium Output t t

How Long Does It Take for Output to Adjust? Describing formally the adjustment of output over time is what economists call the dynamics of adjustment. Suppose that firms make decisions about their production levels at the beginning of each quarter. Now suppose consumers decide to spend more, that they increase c0. 0. Having observed an increase in demand, firms are likely to set a higher level of production in the following quarter. t In response to an increase in consumer spending, p does not j jump p to the new equilibrium, q but rather output increases over time.
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34InvestmentEqualsSaving:An AlternativeWayofThinking

S YD C Y T C

Y C + I +G

Y T C I + G T
S I + G T
I S + (T G )

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3-4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium

I = S + (T G )
The equation above states that equilibrium in the goods d market k t requires i th that t investment i t t equals l savingthe 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 save.
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 Consumption and saving decisions are one and the same. S= YTC

InvestmentEqualsSaving:An AlternativeWayofThinking
S = Y T c0 c1 (Y T ) S = c0 + (1 c1 )(Y T )

The term (1c1) is called the propensity to save. In equilibrium I = c0 + (1 c1 )(Y T ) + (T G ) Rearranging terms, we get the same result as before: 1

Y=

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1 c1

[c0 + I + G c1T ]

The TheParadoxofThrift Thrift

Set government to zero (no G, no T):

S Y C = Y (c0 + c1Y ) S = Y c0 c1 Y = c0 + (1 c1 )Y

Y = c 0
1 = [1 c1 ]

v S = c0 +(1c1)c0
S = c0 + c0 = 0

35IstheGovernmentOmnipotent? AWarning W i
Changing government spending or taxes is not always easy. The responses p of consumption, p , investment, , imports, etc, are hard to assess with much certainty. Anticipations are likely to matter. Achieving a given level of output can come with unpleasant side effects. Budget deficits and public debt may have adverse implications in the long run.
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