LearningObjectives

Studythedeterminantsofthedemandforgoods
Showhowequilibriumoutputisdeterminedinthegoodsmarket
Consideranalternativewayofthinkingabouttheequilibrium,based
ontheequalityofsavingandinvestment
Takeafirstlookathowfiscalpolicyaffectsequilibriumoutput

InteractionamongDemand,Production,andIncome

InteractionamongDemand,Production,andIncome
Changesinthedemand forgoodsleadtochangesinproduction

Changesinproductionleadtochangesinincome

Changesinincome resultinchangesinthedemand forgoods

Intheshortrun,yeartoyearmovementsinoutput areprimarily
drivenbydemand.
Changesindemandcanleadtoadecrease inoutput (a recession)or
anincrease inoutput (anexpansion).

TheCompositionofGDP
Tounderstandwhatdeterminesthedemandforgoods,itmakes
sensetodecomposeaggregateoutput(GDP)fromthepointofview
ofdifferentgoodsbeingproduced,andfromthepointofviewof
differentbuyersforthesegoods.
Consumption,denotedbytheletter ,representsthegoodsand
servicespurchasedbyconsumers.Consumptionisbythelargest
componentofGDP.
Inthefirstquarterof2016,itaccountsfor68.7% ofGDP.

TheCompositionofGDP
Investment,denotedbytheletter ,issometimescalledfixed
investment todistinguishitfrominventory investment.
Investmentisthesumofnonresidential investment (thepurchaseby
firmsofnewplantsornewmachines)andresidential investment
(thepurchasebypeopleofnew housesorapartments).
Thedecisionsbehindthemhavemoreincommonthanmightfirst
appear.Firmsbuymachinesorplantstoproduceoutputinthefuture.
Peoplebuyhousesorapartmentstogethousingservicesinthefuture.
Inbothcases,thedecisiontobuydependsontheservicesthesegoods
willyieldinthefuture,soitmakessensetotreatthemtogether.

TheCompositionofGDP:Investment
*Thepurchaseofland isnot countedaspartofGDP(landisnot
produced!!)
*Stock purchasesarenot countedaspartofGDP(stocktransactions
donot representproduction theyaresaving!)
Thereisadifferencebetweenfinancial andeconomic investment!!!!!
Thepurchaseofnewcapitalgoods,suchas(new)machines,(new)
buildings,or(new)housesisreferredtoasinvestmentby
economists.Thepurchaseofgold,orsharesofGoogle,orother
financialassetsisconsideredtobefinancial investmentby
economists.

TheCompositionofGDP
Governmentspending
representsthepurchaseofgoodsand
servicesbythefederal,state,andlocal government.Thegoodsrange
fromairplanetoofficeequipment.Theservicesincludeprovidedby
governmentemployees:Ineffect,thenationalincomeaccountstreat
governmentasbuyingtheservicesprovidedbygovernmentemployees
andthenprovidingtheseservicestothepublic,freeofcharge.
,like
Note that doesnotincludegovernment transfers
MedicareorSocialSecuritypayments,norinterest paymentsonthe
governmentdebt.Althoughtheseareclearlygovernment
expenditures,theyarenot purchasesofgoodsandservices.

Table3.1:TheCompositionofU.S.GDP,2016I

1
2
3
4

GDP
Consumption
Investment
Nonresidential
Residential
Government spending
Net exports
Exports
Imports

Billions of Dollars
18,221.1
12,511.0
2,935.5
2,275.9
659.6
3,213.8
-508.2
2170.9
2,679.1

Percent of GDP
100
68.7
16.1
12.5
3.6
17.6
-2.8
11.9
14.7

Inventory investment

69

0.4

TheCompositionofGDP
1+2+3:ThepurchasesofgoodsandservicesbyU.S.consumers,
U.S.firms,andtheU.S.government.
Netexports ortradebalance
betweenexportsandimports.
Exports imports

Exports imports

isthedifference

TheCompositionofGDP
Inanygivenyear,productionandsalesneednot beequal.
Someofthegoodsproducedinagivenyeararenot soldinthatyear,
butinlateryears.Andsomeofthegoodssoldinagivenyearmayhave
beenproducedinanearlieryear.
Inventoryinvestment isthedifferencebetweengoodsproducedand
goodssoldinagivenyear;thatis,
Inventoryinvestment=production sales.
Production =sales +inventory investment
Sales =production inventory investment

TheCompositionofGDP
Production sales

inventory investment firms accumulate inventories

Production sales

inventory investment firms inventories

Inventoryinvestmentistypicallysmall positiveinsomeyearsand
negativeinothers.

TheDemandforGoods

,
whereZ (totaldemandforgoods)=aggregatedemand(AD)forgoods
=aggregateexpenditure(AE)forgoods.
Inventory investment isnot partofdemand.
Investment,sometimescalledfixed investment(I),ispartofdemand:
Thesumofnonresidential investment thepurchaseofnewplants
ornewmachinesbyfirms andresidential investment the
purchaseofnewhousesorapartmentsbypeople.

SomeAssumptionsabouttheDemandforGoodsModel:
(i)Allfirmsproducethesame goodandarewillingtosellany amount
ofoutputatthegiven level ofprice.
(ii)Thepriceofagoodisfixed orsticky fixedP.Thatis,production
adjustsautomaticallytooutput withoutchanges inprice.This
assumptionisvalidonlyintheshort run.
(iii)Investmentdoesnotrespondtotheinterest rate.Thisisolatesthe
goodsmarketfromthefinancial market.
(iv)Investmentisexogenous:Itdoesnot dependonoutput,noris
thereinventory investment,eitherplannedorunplanned.
Theeconomyisclosed:NX =0.

TwoTypesofVariables
Economicmodelhavetwotypesofvariables:
(i) Endogenous variable:Variablethatdependsonother variables in
theeconomicmodelandisexplained bytheeconomicmodel
(ii)Exogenous variable:Variablethatistakenasgiven andsoisnot
explained bytheeconomicmodel

a)Consumption(C)

KeynessConjecturesabouttheConsumptionFunction:
First,Keynesconjecturedthatthemarginal propensity toconsume
(MPC)isbetweenzero andone.
Menaredisposed,asaruleandontheaverage,toincrease their
consumptionastheirincomeincreases,butnotbyasmuchasthe
increaseintheirincome.
Second,Keynespositedthattheratioofconsumptiontoincome,
calledtheaverage propensity toconsume (APC)falls asincomerises.
Third,Keynesthoughtthatincome istheprimarydeterminantof
consumptionandthattheinterest rate doesnot haveanimportant
role.

a)Consumption(C)
Consumptionfunction:

3.1 :

EconomistscallEq(3.1)abehavior equation toindicatethatthe

equationcapturessomeaspectofbehavior thebehaviorof
consumers.
(Disposable incomeoraftertax income)

=incomeincludingtransfer payments taxes

3.2 :

(Keynesianconsumptionfunction)

a)Consumption(C)
Therelationbetween and ischaracterizedbytwoparameters
and :
(slope)iscalledthepropensity toconsumer orthemarginal
propensity toconsume

Theeffectofanadditional dollarofdisposable incomeon
consumption
Fractionofadditional currentincomeconsumed incurrentperiod
Foragivenlevelof
tosave:

, howmuchtoconsume willdecidehowmuch

a)Consumption(C)

1
rises,C rises,butnot byasmuchasY,
Whencurrentincome
soS rises:0
1.

a)Consumption(C)
Theparameter (intercept),calledautonomousconsumptionor
consumer confidence,iswhatpeoplewouldconsumeiftheir
disposable income inthecurrentyearwereequaltozero.
Itistoreflectfactorsaffectingconsumptionotherthanincome.
Changesin reflectschangesinconsumptionforagivenlevelof
disposableincome:Increases in reflectsanincreasein
consumption foragivenlevelofincome,decreases in reflectsa
decreaseinconsumption foragivenlevelofincome.
Q:Whymaypeopledecidetoconsumemoreorless,giventheirlevel
ofincome?

Figure 3.1:ConsumptionandDisposableIncome

a)Consumption(C)

3.3 :

ConsumptionC isafunctionofincome
andtaxes T.
Higherincomeincreases consumption,butlessthanoneforone.
Highertaxesdecrease consumptionbutlessthanoneforone.

As

rises,

falls,andsotheaverage propensity toconsume falls.

a)Consumption(C)
Keynesexpectedthe rich tosaveahigher proportionoftheirincome
thanthe poor.
Keynesianconsumptionfunctiondoesnot seemtomatchshortrun
(household)data,althoughitdoesmatchlongrun (crosscountryand
loneruntimeseries)data.

OtherFactorsThatMayAffectCurrentConsumption
Effectofchangesinexpected future income:Higher expectedfuture
incomeleadstomore consumptiontoday,sosavingfalls.
Effectofchangesinwealth:Increases inwealthraises current
consumption,solowers currentsaving.
Effectofchangesinreal interest rate
:Increased realinterestrate
hastwoopposing effects

OtherFactorsThatMayAffectCurrentConsumption
(i)Substitution effect:Positive effectonsaving,sincerateofreturnis
higher;greater rewardforsavingelicitsmore saving
(ii)Income effect:Forasaver,negative effect,sinceittakesless
savingtoobtainagivenamountinthefuture(targetsaving).
Foraborrower,positive effectonsaving,sincethehigherrealinterest
ratemeansaloss ofwealth.
*Empiricalstudieshavemixedresults;probablyaslightincreasein
aggregatesaving.

b)Investment(I)
Q:Whyisinvestmentimportant?
A:(i)Investmentsharplyfluctuates overthebusiness cycle
(morethananyotherspendingcomponent!Only1/6oftotalGDP,
butinthetypicalrecessioninvestmentaccountsformorethanof
totaldeclineinspending),
soweneedtounderstandinvestmenttounderstandthebusiness
cycle.
(ii)Investmentplaysacrucialroleineconomic growth thelongrun
productivecapacityoftheeconomy(capital,K,affects .

3.4 :

Investmentwillbetreatedasgiven tokeepthemodelsimple.

c)Governmentpurchases(G)
TogetherwithtaxesT,G describesfiscal policy thechoice
oftaxes andspending bythegovernment.G,TR andT will
betakenasexogenous.

TheDeterminationofEquilibriumOutput

3.5 :

Output isdeterminedbyequilibriuminthegoods market.

Theequilibriumconditionisproduction (supply)equalsdemand.
Thus,intheshortrun,outputisfullydeterminedbydemand without
anychangeinprice.
Assumingthatfirmsdontholdinventories,equilibriumcondition:
3.6

TheDeterminationofEquilibriumOutput

3.7 :
Inequilibrium,production (oroutput),Y,isequaltodemand.
Demand inturndependsonincome,Y,whichisitselftoproduction.
Production andincome areidenticallyequal.
Macroeconomistsalwaysusethreetoolstodetermineequilibrium:
Algebratomakesurethatthelogiciscorrect
Graphstobuildtheintuition
Wordstoexplaintheresult

TheDeterminationofEquilibriumOutput
From

3.7 , 1
3.8 :

3.8 characterizesequilibriumoutput(endogenous variable),

thelevelofoutputsuchthatproduction (orsupply)equalsdemand
thequantityofoutputproduced=thequantitydemanded.

iscalledautonomous (or
Theterm
independent)spending partofthedemandforgoodsthatdoesnot
dependonoutput (orincome).
When

, unplanned inventoryordisinvestment
.

TheDeterminationofEquilibriumOutput
Q:Isautonomousspendingpositive?
A:Notalways,butitisverylikelytobe!
, and arepositive.
Balancedbudget:
If
(balancedbudget),then
1
0 andso

autonomousspendingispositive.
Onlyifthegovernmentwererunningaverylargebudget surplus if
taxes weremuchlargerthangovernment spending could
autonomousspendingbenegative.

TheDeterminationofEquilibriumOutput

iscalledthemultiplier (anumbergreaterthanone).

Thecloser isto1,thelarger themultiplier;thehigher MPC,the

larger themultiplier.
Forexample,if

0.6, themultiplier

2.5,

sooutputincreasesonaverageby2.5x$1billion=$2.5billionif
increasesby$1billion.

MultiplierEffect
Q:Wheredoesthemultipliereffect comefrom?
A:Anincreasein increasesdemand.Theincreaseindemand then
leadstoanincreaseinproduction.Theincreaseinproduction leads
toanequivalentincreaseinincome.Theincreaseinincome further
increaseconsumption,whichfurtherincreasesdemand,andsoon.
Multipliereffect
Aseriesofinduced increases(ordecreases)inconsumption
spendingthatresultsfromanincrease(oradecrease)inautonomous
spending;thiseffectamplifiestheeffectofeconomicshockson
production (Y orrealGDP)

Multipliers

3.8 :

Spending(orexpenditure)multiplier:

Governmentpurchasesmultiplier:

Taxmultiplier: