Macroeconomics I: Understanding the Goods Market Equilibrium and Consumption Function, Apuntes de Negocios Internacionales

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MACROECONOMICS I

TOPIC 2: THE GOODS

MARKET

Academic Year 2017-2018MACROECONOMICS I. UNIVERSIDAD DE ALCALÁ^1

IN THIS TOPIC WE AIM TO:

1) Study the components of the demand

for Goods in a closed economy:

Consumption, Investment and

Government Spending.

2) Analyze how an economy achieves an

equilibrium in the Goods Market.

3) Learn the functioning of the Keynesian

Multiplier.

THE COMPOSITION OF

GDP

• (^) Consumption (C) all resident’s purchases of goods (durable and non-durable) and services produced by residents.
• Investment (I), all resident’s (firms and individuals) purchase of new capital goods (machinery, plants, housing, etc…). It excludes inventory investment and does not include investment in financial products (“saving”). It can be divided into residential and non- residential.
• (^) Government Spending (G) all government purchases of goods and services (health, education, administration, justice, etc..). It does not include government transfers or public debt interest payments.
• (^) Imports (IM) all residents’ and government’s purchases of foreign resident’s produced goods and services. It includes expenses on travels abroad by residents.
• (^) Exports ( X ) all foreign resident’s purchases of goods and services produced by residents.

DEMAND FOR GOODS

The total demand for goods in an economy: The “” symbol means that this equation is an identity or a definition. Under the assumption that we are in a closed economy, X = IM = 0 , then:

Z  C  I  G  X  I M

Z  C  I  G

CONSUMPTION (C) &

DISPOSABLE INCOME (Y

D

Consumption grows with disposable income but not in a 1:1 proportion: If we asume a linear relationship: MACROECONOMICS I. UNIVERSIDAD DE ALCALÁ Disposable Income YD Consumption C co slope= Autonomous Consumption 7 T is taxes minus monetary transfers from the government and may comprise social

C C Y

D

Y Y T

D

C  c  c Y  T 0 1

D Y C c    1

INVESTMENT (I), GOVERNMENT SPENDING (G) & PUBLIC TAXES (T)  (^) Investment, for now, is considered given (we treat it as an exogenous variable)  (^) Government spending (G) and Government income (T) are also exogenous variables, because:  (^) The behaviour of governments is not automatic or predictable as that of, to a great extent, consumers or firms.  (^) Government spending and Taxes are a result of political decisions and thus they are part of what we call macroeconomic analysis.

I  I

AUTONOMOUS SPENDING AND THE MULTIPLIER  (^) Autonomous spending is that part of the demand for goods that does not depend on income/production:  (^) The (Keynesian) multiplier is: [ c I G c T ] 0 1    1 1 1  c

GOODS MARKET

EQUILIBRIUM

Equilibrium production is determined by the condition that production is equal to demand Z  ( c  I  G  c T )  c Y 0 1 1

MARGINAL PROPENSITY

TO CONSUME

MACROECONOMICS I. UNIVERSIDAD DE ALCALÁ 13 Japelli & Pistaferri (2013) Fiscal policy and MPC heterogeneity (Italy) http:// voxeu.org/art icle/fiscal-pol icy-and-cons umption

FOCUS: THE LEHMAN BANKRUPTCY, FEARS OF ANOTHER GREAT DEPRESSION, AND SHIFTS IN THE CONSUMPTION FUNCTION Figure 1 Disposable income, consumption, and consumption of durables in the United States, 2008:1 to 2009:

ANOTHER WAY TO LOOK AT THE GOODS MARKET EQUILIBRIUM Consumption decisions are Savings decisions: (1 c 1 ) is the propensity to save (complementary to the propensity to consume). In equilibrium: Reorganizing the terms…we get: S  Y  T  C S^ ^ ^ c^ 0 ^ (^1 ^ c^ 1 ) (^ Y^  T ) Y c  c I G c T 

1 0 1

[ ]

I   c   c Y  T  T  G 0 1

HOW LONG DOES IT TAKE PRODUCTION TO ADJUST? We need to understand the adjustment dynamics , for instance:  (^) Assume that firms make production decisions at the beginning of each quarter.  (^) Imagine that consumers decide to spend more, increasing c

.  (^) The impact on production will be felt at the beginning of the following quarter.  (^) Production will grow gradually, at a decreasing trend, and the process will last for a long time.

THE SAVINGS PARADOX

Is a high level of savings a virtue?  (^) In the short-run, savings reduce income and can promote a recession.  (^) In the medium and long run, policies that promote savings are likely to increase income and savings.

A FIRST NUMERICAL EXAMPLE

MACROECONOMICS I. UNIVERSIDAD DE ALCALÁ Y ZZ Demand (Z), Production (Y) Y Income Equilibrium Y=Z Demand Production Find equilibrium production given these data and verify that at that production level Savings are equal to Investment Y’ Y’ ZZ’ T=200 I=220 G=180 c 1 =3/5 c 0 = Analize to what extent the production equilibrium will be affected if the government increases spending to make public spending equal 20