ECON5002 Topic02

PowerPoint to accompany
Chapter 3
The Goods
Market
Section 3.1: The Composition of GDP
• Consumption (C) refers to the goods and

services purchased by consumers.
• Investment (I), sometimes called fixed
investment, is the purchase of capital
goods. It is the sum of non-residential
investment and residential investment.
Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 2

The Composition of Australian GDP, 2008

The Composition of GDP
• Government Spending (G) refers to the

purchases of goods and services by the
federal, state, and local governments. It does
not include government transfers, nor
interest payments on the government debt.
• Imports (IM) are the purchases of foreign
goods and services by consumers, business
firms, and the Australian government.
• Exports (X) are the purchases of Australian
goods and services by foreigners.

The Composition of GDP
• Net exports (X − IM) is the difference

between exports and imports, also called the
trade balance.
E x p =o ri mt s p ⇔o r t rt s a da en cb e a l
E x p >o ri mt s p ⇔o r t rt s a dp el u s su r
E x p <o ri mt s p ⇔o r t tr s a d i ce i td e f
• Inventory investment is the difference

between production and sales.

Section 3.2: The Demand for Goods
• The total demand for goods is written as:
Z ≡ C + I + G + X − I M
• The symbol “≡ ” means that this equation is an

identity, or definition.
• Under the assumption that the economy is
closed, X = IM = 0, then:
Z ≡ C + I + G

Consumption (C)
C = C (Y D )
(+ )
• The function C(YD) is called the consumption

function. It is a behavioural equation, that is, it
captures the behaviour of consumers.
• Disposable income, (YD), is the income that
remains once consumers have paid income taxes
and received transfers from the government.
YD ≡ Y − T
Consumption (C)
Consumption and
Disposable
Income
Consumption
increases with
disposable
income, but less
than one for one.
C = C (Y D )
YD ≡ Y − T
C = c 0 + c1 (Y − T )

Investment (I)
• Investment is taken as given (until Chapter

5), or treated as an exogenous variable:
I = I

Government Spending (G)
• Government spending, G, together with

taxes, T, describes fiscal policy—the
choice of taxes and spending by the
government.
• We shall assume that G and T are also
exogenous.

Section 3.3: The Determination of
Equilibrium Output
• Equilibrium in the goods market requires

that production, Y, be equal to the demand
for goods, Z:
Y = Z
Then:
Y = c 0 + c1 (Y − T ) + I + G
• The equilibrium condition is that,
production, Y, be equal to demand.
Demand, Z, in turn depends on income, Y,
which itself is equal to production.
Using Algebra
• The equilibrium equation can be

manipulated to derive some important terms:
• Autonomous spending and the multiplier:
Y = c 0 + c1 (Y − T ) + I + G
(1 − c1 )Y = c0 + I + G − c1T
1
Y = [c 0 + I + G − c1T ]
1 − c1
multiplier autonomous spending

Using a Graph
• The multiplier is the sum of successive

increases in production resulting from an
increase in demand.
• When demand is, say, $1 billion higher, the
total increase in production after n rounds of
increase in demand equals $1 billion
multiplied by:
1 + c 1 + c 1 + . . .+ c 1
2 n
• This sum is called a geometric series.

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

Using Words
• To summarise:
• An increase in demand leads to an increase in
production and a corresponding increase 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, and
more generally, to estimate behavioural
equations and their parameters, economists
use econometrics—a set of statistical
methods used in economics.

Section 3.4: Investment = Saving: An Alternative
Approach to Goods-Market Equilibrium
• Saving is the sum of private plus public saving.

Private saving (S), is saving by consumers.
S ≡ YD − C • If T > G, the government is

running a budget surplus—
S ≡ Y − T − C public saving is positive.
Y = C + I + G • If T < G, the government is
running a budget deficit—
Y − T − C = I + G − T public saving is negative.
S = I + G − T
This equilibrium condition for the
I = S + (T − G ) goods market is called the IS
relation.
The Paradox of Saving
• When consumers save more, spending

decreases and equilibrium output is lower.
• Attempts by people to save more lead both
to a decline in output and to unchanged
saving. This surprising pair of results is
known as the paradox of saving (or the
paradox of thrift).

Section 3.5: Is the Government Omnipotent?
A Warning
• Changing government spending or taxes may be far

from easy.
• The responses of consumption, investment,
imports, etc, are hard to assess with much certainty.
• Anticipations are likely to matter – e.g. do
consumers think a tax cut is temporary or
permanent?
• Achieving a given level of output may come with
unpleasant side effects – e.g. inflation.
• Budget deficits and accumulating public debt may
have adverse implications in the long run.

Section 5.1: The Goods Market and the IS
Relation
• Equilibrium in the goods market exists when

production, Y, is equal to the demand for
goods, Z.
• In the simple model developed in chapter 3,
the interest rate did not affect the demand
for goods. The equilibrium condition was
given by:
Y = C (Y − T ) + I + G

Investment, Sales and the Interest Rate
• In this chapter, we capture the effects

of two factors affecting investment:
• The level of sales (+)
• The interest rate (-)
I = I (Y ,i)

The Determination of Output
I = I (Y ,i)
• Taking into account the investment relation

above, the equilibrium condition in the
goods market becomes:
Y = C (Y − T ) + I (Y ,i) + G

Deriving the IS Curve
The Effects of an
Increase in the
Interest Rate on
Output
An increase in the
interest rate
decreases the
demand for goods
at any level of
output.

Deriving the IS Curve
Equilibrium in the
goods market
implies that an
increase in the
interest rate leads
to a decrease in
output. The IS
curve is downward
sloping.

Shifts of the IS Curve
An increase in
taxes shifts the
IS curve to the
left.

Chapter 4
Financial
Markets

Section 4.1: The Demand for Money
• Money, which can be used for transactions, pays

no interest. There are two types of money:
* currency; and
* current account deposits (accessed by
EFTPOS or cheques).
• Bonds, pay a positive interest rate, i, but they
cannot be used for transactions. Term deposits
are equivalent – they pay interest and cannot be
accessed at any time.
• The proportions of money and ‘bonds’ you wish to
hold depend on your level of transactions and the
interest rate on bonds.

Semantic Traps: Money, Income and
Wealth
• Income is what you earn from working plus

what you receive in interest and dividends.
It is a flow—that is, it is expressed per unit
of time.
• Saving is that part of after-tax income that is
not spent. It is also a flow.
• Savings is sometimes used as a synonym
for wealth (a term we will not use in this
course).

Semantic Traps: Money, Income and
Wealth
• Your financial wealth, or simply wealth, is the

value of all your financial assets minus all your
financial liabilities. Wealth is a stock variable—
measured at a given point in time.
• Financial assets that can be used directly to buy
goods are called money. Money includes currency
and current account deposits – but NOT credit
cards (= a type of loan).
• Investment is a term economists reserve for the
purchase of new capital goods, such as machines,
plants, or office buildings. The purchase of shares
of stock or other financial assets is financial
investment.

Deriving the Demand for Money
M d
= $ Y ( Li )
• The demand for
money:
• increases in proportion
to nominal income ($Y),
and
• depends negatively on
the interest rate (L(i)).

Section 4.2: Money Market Equilibrium and
the Interest Rate: I
• In this section, we assume that only the

central bank supplies money, in an amount
equal to M, so M = Ms. People hold only
currency as money.
• The role of banks as suppliers of money
(and current account deposits) is introduced
in the next section.
• Equilibrium in financial markets requires that
money supply be equal to money demand:
M = $ Y ( Li )
Money Demand, Money Supply and the
Equilibrium Interest Rate
The Determination
of the Interest Rate
The interest rate
must be such that
the supply of money
(which is
independent of the
interest rate) be
equal to the demand
for money (which
does depend on the
interest rate).

The Demand for Money and the Interest
Rate
The ratio of money (M1) to nominal income decreased from 1960 to

1985, & increased from 1985 to 2008. The interest rate (ten-year
Treasury bonds) moved in the opposite direction.
The Demand for Money and the Interest
Rate

Monetary Policy and Open-Market
Operations
The Effects of an
Increase in the
Money Supply on
the Interest Rate
An increase in the
supply of money
leads to a decrease
in the interest rate.
Equivalently, if the
central bank wants
to lower the interest
rate, it must
increase the supply
of money

Money Demand, Money Supply and the
Equilibrium Interest Rate
The Effects of an
Increase in
Nominal Income
on the Interest
Rate i′ • A′
An increase in
nominal income
leads to an increase
Md for Y′>Y
in the interest rate, if
the central bank
keeps the money
supply constant.

Operations
• Open-market
operations, which take
place in the “open market”
for bonds, are the
standard method central
banks use to change the
money stock in modern
economies.

Monetary Policy and Expansionary
Open-Market Operations
The assets of the central bank are the bonds it holds. The
liabilities are the stock of money in the economy. An open-
market operation in which the central bank buys bonds and
issues money increases both assets and liabilities by the
same amount.
Operations
• In an expansionary open market

operation, the central bank buys $1 million
worth of bonds, increasing the money
supply by $1 million – the interest rate falls.
• In a contractionary open market
operation, the central bank sells $1 million
worth of bonds, decreasing the money
supply by $1 million – the interest rate rises.

Operations
• Bonds issued by the government, promising

a payment in a year or less, are called
Treasury bills, or T-bills.
• When the central bank buys bonds, the
demand for bonds goes up, increasing the
price of bonds. Equivalently, the interest
rate on bonds goes down.
$ 1 −0 $ P0 B $ 1 0 0
i = ⇒ $ PB =
$ PB 1 + i

Section 5.2: Financial Markets and the LM
Relation
• Taking into account the investment relation

above, the equilibrium condition in the goods
market becomes: M = $ Y ( Li )
M = nominal money stock
$YL(i) = demand for money
$Y = nominal income
i = nominal interest rate
• For now, assume the central bank keeps M constant.
Therefore i is market-determined. When we study
policy mixes in 5-4, we will look at the more realistic
policy where the central bank chooses i.

Real Money, Real Income and the Interest
Rate
• The LM relation: In equilibrium, the real money

supply is equal to the real money demand, which
depends on real income, Y, and the interest rate, i:
M
= Y ( Li )
P

Deriving the LM Curve
The Effects of an
Increase in Income
on the Interest Rate
An increase in income
leads, at a given
interest rate, to an
increase in the demand
for money. Given the
money supply, this
leads to an increase in
the equilibrium interest
rate.

Deriving the LM Curve
Equilibrium in financial markets implies that an

increase in income leads to an increase in the interest
rate. The LM curve is upward-sloping.
Shifts of the LM Curve
An increase in
money leads
the LM curve
to shift down.

Section 5.3: Putting the IS and the LM
Relations Together
The IS-LM Model I S r en l : Ya = tC i( Y o − T ) + I ( Y , i ) + G

M
Equilibrium in the goods L M r n e : l a = Yt i ( Loi )
market implies that an P
increase in the interest
rate leads to a decrease in
output.
Equilibrium in financial
markets implies that an
increase in output leads to
an increase in the interest
rate.
When the IS curve
intersects the LM curve,
both goods and financial
markets are in equilibrium.

Fiscal Policy, Activity and the Interest
Rate
• Fiscal contraction, or fiscal

consolidation, refers to fiscal policy that
reduces the budget deficit.
• An increase in the deficit is called a fiscal
expansion.
• Taxes affect the IS curve, not the LM curve.

Fiscal Policy, Activity and the Interest
Rate
The Effects of
an Increase in
Taxes
An increase in
taxes shifts the
IS curve to the
left, and leads
to a decrease in
the equilibrium
level of output
and the
equilibrium
interest rate.

Monetary Policy, Activity and the Interest
Rate
• Monetary contraction, or monetary

tightening, here refers to a decrease in the
money supply.
• An increase in the money supply is called
monetary expansion.
• Monetary policy does not affect the IS curve,
only the LM curve. For example, an increase
in the money supply shifts the LM curve down.
NB: We are still assuming the central bank keeps M fixed at some value

Monetary Policy, Activity and the Interest
Rate
The Effects of
a Monetary
Expansion
Monetary
expansion
leads to higher
output and a
lower interest
rate.

In Summary

Section 5.4: Using a Policy Mix
• Monetary and fiscal policy is never conducted in

complete isolation.
• The combination of monetary and fiscal policies is
known as the monetary-fiscal policy mix, or
simply, the policy mix.
• To see the importance, consider fiscal contraction
(↓G or ↑T), with 2 alternative approaches to
monetary policy:
1. Central bank keeps M constant
2. Central bank keeps i constant at i0
(Most central banks use 2. They decide on i and allow M to

be determined endogenously in market equilibrium)

Using a Policy Mix
Using a Policy
Mix
Fiscal contraction
leads to lower
output (Y´´<Y´) if
central bank
keeps the
interest rate
constant.

Five Australian Policy Mixes, 1986-2008
Hawke- Keating-Fraser Howard-Macfarlane Howard- Macfarlane Rudd-

Johnston/ Fraser Easy fiscal, Tight fiscal, /Stevens Stevens
Tight fiscal, easy monetary. easy monetary. Tight fiscal, Easy fiscal,
tight monetary. tight monetary. easy monetary.

1. The Hawke-Johnston/Fraser Policy
Mix, 1986-1991
Deficit Reduction and

Monetary Contraction
Tight fiscal and tight
monetary policy has
severe adverse effects
on output. Created the
1990-91 recession.
Equilibrium went from A
to A′ in the figure.

2. The Keating-Fraser Policy Mix,
1991-1996
Deficit and Monetary

Expansion
Easy fiscal and easy
monetary policy helped
Australia out of the 1991
recession.
Equilibrium went from A′
back to A in the figure.

3. The Howard-Macfarlane Policy Mix,
1996-2002
Fiscal Contraction
and Monetary
Expansion
Tight fiscal and easy
monetary policy
allowed Australian
output to continue to
grow modestly.
Equilibrium went from A
to A′ in the figure.

4. The Howard-Macfarlane Policy Mix,
2002-2008
Fiscal Contraction and

Monetary Contraction
LM'
With the global economy
growing pushing out the IS
Interest Rate. i
LM
curve, tight fiscal (pushing it in
a little) and monetary policy i2 •
allowed Australian output to
continue to grow without i1´ • IS’
hitting capacity constraints.
IS
Y1´ Y2
Output, Y

5. The Rudd-Stevens Policy Mix, 2008-?
BIG Fiscal Deficit and

BIG Monetary LM2
Expansion
The global financial crisis i2 •
Interest Rate. i
pushed the IS curve far to IS1
the left. Monetary and LM3
fiscal stimulus packages
lowered the interest rate
and shifted the IS curve to i3 • IS2
the right (a little?) Y3 Y2
Output, Y

Policy Responses to the U.S. Recession of
2001

Policy Responses to the U.S. Recession of
2001

Section 4.3: Money Market Equilibrium and
the Interest Rate: II
• Financial
intermediaries are
institutions that receive
funds from people and
firms, and use these
funds to buy bonds or
stocks, or to make loans
to other people and firms.

What Banks Do
• Banks keep as reserves some of the funds

they have received, for three reasons:
• To honour depositors’ withdrawals.
• To pay what the bank owes to other banks.
• In some countries (but not Australia), to maintain
the legal reserve requirement:
• The actual reserve ratio (which we will define as θ )
is currently about 10.5% in Australia.
• The required reserve ratio is currently about 10% in
the United States.

The Balance Sheet of Banks and the
Balance Sheet of the Central Bank Revisited

What Banks Do
• In Australia today, loans represent 63% of

banks’ non-reserve assets. Bonds account
for the other 37%.
• The assets of a central bank are the bonds it
holds. The liabilities are the money it has
issued, central bank money, which is held
as currency by the public, and as reserves
by banks.

Bank Runs
• Rumours that a bank is not doing well and some loans will
not be repaid, will lead people to close their accounts at
that bank. If enough people do so, the bank will run out of
reserves—a bank run.
• To avoid bank runs, the U.S. government provides federal
deposit insurance.
• Until recently, there has been no deposit insurance in
Australia – instead, Australia relied on high quality
supervision of banks by APRA.
• In response to the global financial crisis in 2008, the
Australian government (like most others) guaranteed all
bank deposits up to $1m at APRA-regulated banks until
2011.
• An alternative solution is narrow banking, which would
restrict banks to holding liquid, safe, government bonds,
such as T-bills.

Determinants of the Demand and the
Supply of Central Bank Money
]
]

The Demand for Money, Reserves and
Central Bank Money
Demand for currency:

C U = c Md
d
Demand for current account deposits: D d

= (1 − c ) M d
Relation between deposits (D) and reserves (R): R = θ D

Demand for reserves by banks: Rd = θ (1-c) Md
Demand for central bank money: H d
= C U+ R
d d
Then: Hd = c Md + θ (1-c) Md = [ c + θ (1-c) ] Md
Since M d
= $ Y ( Li ) then: Hd = [ c + θ (1-c) ] $Y L(i)

The Determination of the Interest Rate
• In equilibrium, the
supply of central bank
money (H) is equal to
the demand for
central bank money
(Hd):
H = H d
• Or restated as:
H = [ c + θ (1-c) ] $Y L(i)

4-4: Two Alternative Ways to Think About
The Equilibrium
Figure 4.8 The equilibrium interest rate is such that the supply of central
bank money is equal to the demand for central bank money.

The Interbank Overnight Market and The
Cash Rate
• This is a market for bank reserves.

In equilibrium, demand (Rd) must equal
supply (H-CUd).
• The interest rate determined in the market is
called the cash rate.
• This market is under the control of the RBA.
By varying H, it can obtain the interest rate it
desires.
• For more details on monetary policy implementation, read Ch26-3

The Supply of Money, the Demand for
Money and the Money Multiplier
H = [ c + θ (1-c) ] $Y L(i)
1
H = $Y L(i )
[c + θ (1 − c )]
Supply of money = Demand for money

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PowerPoint to accompany

• Consumption (C) refers to the goods and

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 2

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 3

• Government Spending (G) refers to the

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 4

• Net exports (X − IM) is the difference

• Inventory investment is the difference

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 5

• The total demand for goods is written as:

• The symbol “≡ ” means that this equation is an

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 6

• The function C(YD) is called the consumption

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 8

• Investment is taken as given (until Chapter

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 9

• Government spending, G, together with

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 10

• Equilibrium in the goods market requires

• The equilibrium equation can be

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 12

• The multiplier is the sum of successive

• This sum is called a geometric series.

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 14

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 15

• Saving is the sum of private plus public saving.

S ≡ YD − C • If T > G, the government is

• When consumers save more, spending

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 17

• Changing government spending or taxes may be far

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 18

• Equilibrium in the goods market exists when

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 19

• In this chapter, we capture the effects

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 20

• Taking into account the investment relation

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 21

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 22

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 23

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 24

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 25

• Money, which can be used for transactions, pays

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 26

• Income is what you earn from working plus

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 27

• Your financial wealth, or simply wealth, is the

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 28

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 29

• In this section, we assume that only the

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 31

The ratio of money (M1) to nominal income decreased from 1960 to

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 33

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 34

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 35

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 36

• In an expansionary open market

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 38

• Bonds issued by the government, promising

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 39

• Taking into account the investment relation

Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia 40

• The LM relation: In equilibrium, the real money