Prof.

Fei DING

QUOTE OF THE DAY

The Hong Kong University of Science and Technology

ECON 2123: Macroeconomics

THE GOODS MARKET

2

PREVIOUSLY
Ch1: A Tour of the World
Ch2: A Tour of the Book

Ch3: The Goods Market

LEARNING OBJECTIVES

LEARNING OBJECTIVES

Obtain a big picture of the macro economy around the world: US, EU, and China.

Understand sources and determinants of demand from decomposition of GDP.

Define output, unemployment, inflation.

Define and derive the short run equilibrium output using two approaches.

Understand the components of the national income and product accounts.

Describe effects of fiscal policy on equilibrium output, and its limitations.

Understand key terms at the end of Ch2.

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Chinese Economic Stimulus Program (From Wikipedia, the free encyclopedia)

CHINA VS. WORLD IN THE CRISIS

The 200809 Chinese economic stimulus plan () is a RMB 4 trillion (US$ 586 billion)
stimulus package announced by the State Council of the People's Republic of China on 9 November 2008 as an
attempt to minimize the impact of the global financial crisis on the world's second largest economy.[2][3] Critics of
China's stimulus package have maintained that it has made matters worse by pumping excessive investments
into an economy that was overheated and marked by overcapacity and overinvestment.[4][5][6]

Table 1-4 Output Growth in China, 19802012

On June 2009, the World Bank raised its growth forecast in China for 2009 from 6.5% to 7.2% amid signs that
the economy is doing better than expected, which has been helped by the stimulus package. But it says the
country's exports are still down, as the rest of the world struggles with the global recession. It was previously
predicted in March 2009 that the Chinese economy would grow by 6.5% in 2009, several percentage points
down on 2008's growth.

Table 1-1 World Output Growth since 2000

A statement on the government's website said the State Council had approved a plan to invest 4 trillion yuan in
infrastructure and social welfare by the end of 2010.[3][7] This stimulus, equivalent to US$586 billion, represented
a pledge comparable to that subsequently announced by the United States, but which came from an economy
only one third the size.[8] The stimulus package will be invested in key areas such as housing, rural
infrastructure, transportation, health and education, environment, industry, disaster rebuilding, income-building,
tax cuts, and finance.[9]
China's export driven economy started to feel the impact of the economic slowdown in the United States and
Europe, and the government had already cut key interest rates three times in less than two months in a bid to
spur economic expansion.

ALMOST NO SIGNS OF THE GLOBAL FINANCIAL CRISIS IN CHINA!

WHY???
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THE GOODS MARKET OVERVIEW

Production

The stimulus package was welcomed by world leaders and analysts as larger than expected and a sign that by
boosting its own economy, China is helping to stabilize the world economy. World Bank President Robert
Zoellick declared that he was delighted and believed that China was well positioned given its current account
surplus and budget position to have fiscal expansion.'[8] News of the announcement of the stimulus package
sent markets up across the world.[10]
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THE COMPOSITION OF US GDP, 2010

Income

Demand

The term goods is generally used

to refer to both physical goods and services.
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COMPOSITION OF GDP
Consumption (C)
consumers.
Investment (I)

ECONOMIC VS. FINANCIAL INVESTMENT

goods and services purchased by

purchases of new capital goods.

Sum of nonresidential investment (e.g., new plants and

machines) and residential investment (e.g., new houses)
Sometimes called fixed investment to distinguish it from
inventory investment.

Government spending (G)

services by governments.

purchases of goods and

Does not include government transfers or interest payments

on the government debt.
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REFRESH

COMPOSITION OF GDP

Which of the following should NOT be considered as part

of fixed investment?
1.

Toyota buys a new robot for its automobile assembly line.

2.

Apple computer builds a new factory.

3.

Exxon increases its holding of bonds and stocks in

financial markets.

4.

An accountant buys a newly built home for herself and her

family.

5.

10

None of the above.

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Imports (IM) purchases of foreign goods and

services by domestic consumers, firms, and
governments.
Exports (X) purchases of domestic goods
and services by foreigners.
Net exports (NX = X IM) also called trade
balance
X > IM
X < IM

trade surplus
trade deficit
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COMPOSITION OF GDP

QUICK CHECK

Goods produced may not get sold right away.

Inventory investment difference between
production and sales.

How would the following situations change HK GDP this year and
its components?
Last weekend, I spent HK$5000 on a seafood dinner with
family and friends in Sai Kung.
Econ Dept. spent HK$20,000 last spring on a new IBM server,
made in USA.
How would the following situations change US GDP last year and
its components?
Last year, GM produced US$500 million worth of cars, but only
sold $450 million.
My friend bought a 5-year old GM last year at a bargain price of
US$8000.

Inventory investment = production sales

Production = sales + inventory investment
Sales = production inventory investment

Inventory investment is typically small.

Positive when inventories accumulate.
Negative when inventories fall.
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THE DEMAND FOR GOODS

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ASSUMPTIONS
Only one good economy

The composition of GDP reveals the sources

of the demand.

Supply any amount at a given price

The total demand for goods (Z):

Fixed price level in the short run (relax later)

No inflation concerns

Z C + I + G + X IM

Focus on the demand in the market.

The symbol means by definition the

equation is an identity.

Closed economy, no trade (relax later)

Both exports and imports are zero.

Inventory investment is NOT part of demand.

Thus, demand becomes Z C + I + G.

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CONSUMPTION (C)

C = C0 + C1YD TWO PARAMETERS

Determined by disposable income (YD Y T)

the income after paying taxes to (and
receiving transfers from) the government.

c0: consumption for any given level of

disposable income, reflects autonomous
consumption or consumer confidence.

Consumption function: C

c1: effect of an additional dollar of disposable

income on consumption marginal
propensity to consume

C (YD )
( )

A behavioral equation captures general behavior

of consumers.

c1 > 0: higher income, higher consumption

Assume a simple linear relation for the ease of

analysis C = c0 + c1YD

c1 < 1: saving motive

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CONSUMPTION (C)
Figure 3 - 1

The marginal propensity to consume (MPC) is the amount by

which consumption changes when disposable income (Y-T)
increases by one dollar. To understand the MPC, consider a
shopping scenario. A person who loves shopping probably has a
large MPC, lets say (0.99). This means that for every extra dollar
he or she earns after tax deductions, he or she spends $0.99 of it.
The MPC measures the sensitivity of the change in one variable
(C) with respect to a change in the other variable (Y-T).

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

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T)

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REFRESH

REFRESH

The marginal propensity to consume represents

Which of the following occurs when disposable

income is zero?

1.

2.

3.
4.

5.

the level of consumption that occurs if disposable

income is zero.
the ratio of total consumption to disposable
income.
total income minus total taxes.
the change in output caused by a one-unit change
in autonomous demand.
the change in consumption caused by a one-unit
change in disposable income.

1.

consumption must be zero.

2.

saving must be zero.

3.

saving must be positive.

4.

consumption is negative.

5.

none of the above.

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INVESTMENT (I)
Assume investment is given or exogenous

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GOVERNMENT SPENDING (G)

I

Government spending (G), together with taxes (T),

describes fiscal policy the choice of taxes and
spending by the government.

Exogenous variables are taken as given, not explained

within the model.

G > T: budget deficit

Endogenous variables depend on other variables and

are explained within the model.

G < T: budget surplus

G = T: balanced budget

Are c0 and c1 from the consumption function

endogenous or exogenous?

Treat G and T as exogenous because

No reliable rule to describe government behavior

Unrealistic assumption? We will fix it later.

Want to study implications of fiscal policy on the economy.

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Z C + I + G + (X-IM)

Assumptions
Firms do not hold inventories.

Total demand
for domestic
output (GDP)

Investment
spending by
firms and
households

is composed of

At fixed prices, firms produce as needed to satisfy demand.

Net exports
or net foreign
demand

Equilibrium condition: production = demand

Then recall the triangle diagram:

Consumption
spending by
households

Government
purchases of goods
and services

Production equals demand. (equilibrium condition)

Demand depends on income. (behavioral observation)

Assuming closed economy eliminates the last term, net exports (NX).
The remaining three components of GDP are
Consumption (C), Investment (I), and Government spending (G).

c0

c1 Y - T

Income equals production. (identity)

c0

c1 Y - T

G
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25

EQUILIBRIUM OUTPUT ALGEBRA

Y

c0

c1 (Y T ) I

1
1 c1

c0

1 c1 Y

c0

THE MULTIPLIER EFFECT ON OUTPUT

I

G c1T

G c1T

c1 (Y T ) I

G Y

1
1 c1

c0

G c1T

An increase in c0 increases demand.

The increase in demand leads to an increase in production.
The increase in production leads to an equivalent increases in income.

1
The multiplier
> 1 because c1 < 1 and so (1 c1) < 1.
1 c1

The increase in income further increases consumption, which further

increases demand, and so on

Any change in autonomous spending will change output by more than

one for one.
the multiplier

c0

Suppose c0 increases by $1 billion, output will increase by more than $1 billion.

If c1 =0.6, output increases by 1/(1-0.6)*$1 billion = $2.5 billion.

Autonomous spending [c0 I G c1T ]

part of the
demand that does not depend on output (usually positive).

c1

Recall the triangle diagram again!!

Lets see this using a graph.

(the blow-up effect becomes larger)

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EQUILIBRIUM OUTPUT GRAPH

Z

c0

c1 Y - T

THE MULTIPLIER EFFECT ON OUTPUT

G
Figure 3 - 3

Figure 3 - 2

The Effects of an
increase in autonomous
spending on output

Equilibrium in the
Goods Market

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

1. Plot production as a
function of income.
2. Plot demand as a
function of income.
3. In equilibrium,
production equals
demand.
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THE MULTIPLIER EFFECT ON OUTPUT

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THE MULTIPLIER EFFECT ON OUTPUT

FIRST ROUND

SECOND ROUND

1) demand = $1b

1) income
demand
= $1b c1 (C D).

(A

B).

2) demand
equal production

3) production
equal
income = $c1 (D E).

= $1b (AB).

THIRD ROUND
1) income
demand
= $c1 c1 = $c12 (E F).

3) production
equal income
= $1b (B

equal
2) demand
production = $c1 (CD).

production
2) demand
income, and so on

C).

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THE MULTIPLIER EFFECT ON OUTPUT

THE MULTIPLIER EFFECT ON OUTPUT

An initial $1 increase in demand leads to an output

increase of 1 + c1 + c12 + c13 + c14 + = 1/(1c1).

How long does this multiplier effect last to reach the

new equilibrium?

This is a geometric series which sums to the multiplier in the

limit, as long as c1 < 1.

The multiplier effect: an original increase in demand

triggers successive increases in production, in income,
in demand, then further in production, and so on.
The multiplier is the sum of all these successive increases in
production.

In reality, adjustments take time.

Firms cannot adjust production/output immediately and frequently.
They face many constraints, such as locating new materials,
recruiting new workers, advanced planning, administrative
procedures, etc.
Consumers do not change consumption right away.

In the model, we assume firms and consumers respond

instantaneously an over-simplification.

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WHAT HAPPENED IN THE CRISIS?

34

WHAT HAPPENED IN THE CRISIS?

Figure 2 Google search volume for Great Depression, January 2008 to

September 2009

Figure 1 Disposable income, consumption, and consumption of durables in

the United States, 2008:1 to 2009:3

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WHAT HAPPENED IN THE CRISIS?

REFRESH

Fears of another great depression shift the consumption function down.

Equilibrium in the goods market requires that

1.

production equals income.

2.

production equals demand.

3.

consumption equals saving.

4.

consumption equals income.

5.

government spending equals taxes minus

transfers.

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ANOTHER WAY TO DEFINE EQUILIBRIUM

38

ANOTHER WAY TO DEFINE EQUILIBRIUM

We defined the goods market equilibrium as

demand = production (by looking at income
and spending).

EQ: Y = Z = C + I + G

PRODUCTION = DEMAND

YT=C+I+GT
YTC=I+GT
S=I+GT

Alternative view looks at saving and

investment.

S + (T G) = I

SAVING = INVESTMENT

The equilibrium condition for the goods market is also

known as the IS relation.

Private saving: S Y T C
Public saving: T G

John Maynard Keynes first articulated this model in

1936 in his masterpiece.

Whats the relationship between public saving and

budget surplus/deficit?
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ANOTHER WAY TO DEFINE EQUILIBRIUM

S

Y T C

The Paradox of Saving

S Y T c c (Y T )
0

c0

(1 c1 )(Y

As people attempt to save more, the result is a decline in output.

(Why?)

T)

This decline of output then reduces how much people can save.
(Why?)

propensity to save

In equilibrium:

I
c0

(T

G)

(1 c1 )(Y

1
1 c1

[c0

So, as we try to save more, the result is unchanged saving in the

short run.

I = S + (T-G): By assumption in the short run, investment does

not change, nor do T or G
S cannot change.

T ) (T

G)

In general, S = c0 + (1c1)(YT).
Suppose consumers want to save more and consume less at a
the first term increases,
given level of disposable income (c0)
and the second item deceases because lower consumption
lowers income in the short run
ambiguous effect on S.

G c1T ]
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CAN FISCAL POLICY FIX ALL PROBLEMS?

Y

1
1

c1

[c0

c 1T ]

: G, T

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CH3 QUICK CHECK (TEXTBOOK)

Changing fiscal policy is not always easy.

Impacts on I, IM, exchange rate, etc., are hard to assess.
Not just policy but expectations will affect behavior.
May come with unpleasant side effects such as high inflation.
Lead to large budget deficits and public debt in the long run.

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True or False?
(a) The largest component of GDP is consumption.
(b) The propensity to consume has to be positive, but
otherwise it can take on any positive value.
(c) Fiscal policy describes the choice of government
spending and taxes and is treated as exogenous in our
goods market model.
(d) The equilibrium condition for the goods market states
that consumption equals output.
(e) An increase of one unit in government spending leas to
an increase of one unit in equilibrium output.
(f)
An increase in the propensity to consume leas to a
decrease in output.

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SEE YOU NEXT TIME

Assigned reading:
Textbook Chap. 3
Textbook, Chap. 4 (for next time)

Now you can work out all problems in Problem

Set 1.
Submit ONLINE via CANVAS.
Late submission = zero mark.
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