Lecture 3.
The Goods (and
Services) Market
Reading: Blanchard, Chapter 3.
In the previous lecture…
• Major macroeconomic variables
1) GDP
2) The unemployment rate
3) The inflation rate
Announcements
• The Economics Student Society
• Problem Set 1 will be posted today.
• Due: September 23, 10 pm.
Outline
• The Composition of GDP
•
• The Consumption Function and the Keynesian Cross
• Investment – Saving interpretation
• Government, Fiscal Policy, and Multipliers
Outline
• The Composition of GDP
• The Consumption Function and the Keynesian Cross
• Investment – Saving interpretation
• Government, Fiscal Policy, and Multipliers
The demand / expenditure side of GDP
The final goods and services are purchased by either a consumer, a
firm, the government, or a foreign agent.
•
•
•
•
(1)
(2)
•
Y = C + I + G + NX (+ Inventory Inv.)
• Consumption
• by (domestic) consumers
• Food, haircut, (new) cars, etc.
Y = C + I + G + NX (+ Inventory Inv.)
• (Fixed) Investment to distinguish from inventory investment
• Fixed Inv. = Inv.
(by firms, new plants, machines, … )
+ Inv.
(new houses or apartments )
• Remark) Investment in macroeconomics
≠ Financial investment (bond, stocks, forward, etc.)
Y = C + I + G + NX (+ Inventory Inv.)
• Government spending
• Military spending, office equipment, and
• Services provided by government employees
• ex) police officer, fire fighter, teachers, etc.
• Government employees produce services. The government
purchases the services and pays salaries to the employee.
• Government transfers ∉ G
Y = C + I + G + NX (+ Inventory Inv.)
• Net exports = = -
• Trade : Exports > Imports ⇒ NX > 0
• Trade : Exports < Imports ⇒ NX < 0
Y = C + I + G + NX (+ Inventory Inv.)
• Inventory investment
• What is produced but not sold becomes inventory.
• What if a consumer buys a good produced in the last year?
The Composition of U.S. GDP, 2014
Implications
• Inventory investment is very very small.
Therefore, from now on, we assume that 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋.
• NX is small in the U.S. (and in HK).
We assume that 𝑁𝑋 = 0.
• 𝐺 is chosen by the government. So we take it as given.
• We will investigate 𝐼 more carefully after we study interest rates.
• So, for now, we focus on , the largest component in 𝑌.
Outline
• The Composition of GDP
• Y = C + I + G + NX
• The Consumption Function and the Keynesian Cross
• Investment – Saving interpretation
• Government, Fiscal Policy, and Multipliers
The consumption function
• Which factors affect how much a person consume?
• C = a function of
• We ASSUME that
• When disposable income changes, we move along the curve.
• When something else changes, 𝑐0 and/or 𝑐1 vary and the curve shifts.
𝐶 = 𝑐0 + 𝑐1 𝑌 − 𝑇
• a behavioral equation
• 𝑐0 : autonomous consumption includes
• subsistence level of consumption
• effects of all the factors other than the disposable income (𝑌𝐷 )
• 𝑐1 :
• The effect an additional dollar of disposable income has on
consumption.
What is the value of 𝑐1 ?
• Source: Carroll et al. (2017), The distribution of wealth and the marginal propensity to consume.
What is the value of 𝑐1 ?
• There is no consensus among economists…
• A substantial heterogeneity across consumers exists.
• ex) The poor usually have higher MPCs than the rich.
• Any value which is not extremely low or high would be okay for
the purpose of this course.
Announcements (September 17)
• In-class midterm on Oct 22nd.
• Chain-type index for real GDP:
Calculation of the measure will not be tested in exams.
• Sign of import (IM) in the table on Slide #12 and the problem set.
• Check whether you can access the course page via Gradescope.
The Keynesian Cross
• Demand: 𝑍
• People want to purchase Z amount of goods and services
given income 𝑌.
• Supply: production 𝑌
• Equilibrium condition for the goods and services market
• Demand : 𝑍 = 𝑐0 + 𝐼 ҧ + 𝐺 − 𝑐1 𝑇 + 𝑐1 𝑌
• Supply : 𝑌 (production) = 𝑌 (income)
What happens if 𝑐0 ↑ ?
• When does the autonomous consumption increase?
The total effect on equilibrium output
• 1 + 𝑐1 + 𝑐12 + 𝑐13 + ⋯ = : “ ”
• Ex) Suppose that 𝑐1 = 0.5. When 𝑐0 increases by $1, the
1
equilibrium output 𝑌 increases by $2 = .
1−0.5
• The higher the MPC (𝑐1 ), the higher the multiplier.
Graphical illustration
Algebra
• Demand: 𝑍 = 𝑐0 + 𝐼 ҧ + 𝐺 − 𝑐1 𝑇 + 𝑐1 𝑌
• Equilibrium condition: 𝑌 = 𝑍
• Derive the equilibrium output:
1
𝑌= 𝑐0 + 𝐼 ҧ + 𝐺 − 𝑐1 𝑇
1 − 𝑐1
Outline
• The Composition of GDP
• Y = C + I + G + NX
• The Consumption Function and the Keynesian Cross
• Investment – Saving Interpretation
• Government, Fiscal Policy, and Multipliers
𝑍 = 𝑌 ⇔ 𝐼 = 𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔
• Private saving (𝑆) : 𝑆 = 𝑌𝐷 − 𝐶 = 𝑌 − 𝑇 − 𝐶
• Public saving : 𝑇−𝐺
• Show that 𝑍=𝑌 ⇔ 𝐼 = 𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔.
•𝐶+𝐼+𝐺 =𝑌 ⇔
• 𝐼𝑆 relation: What firms want to invest must equal what people
and the government want to save.
More on saving
• 𝑆 = 𝑌𝐷 − 𝐶 = 𝑌𝐷 − 𝑐0 + 𝑐1 𝑌𝐷 = −𝑐0 + 1 − 𝑐1 𝑌𝐷
• Marginal Propensity to Save (𝑀𝑃𝑆) = 1 − 𝑐1
• The paradox of saving (or the paradox of thrift)
• Suppose that consumers decide to save more by reducing 𝑐0
by 1 unit.
• Will 𝑌𝐷 be the same? If not, how much will it change?
• What is the ultimate effect on the private saving 𝑆?
• Exercise) What if consumers lower the MPC?
Outline
• The Composition of GDP
• Y = C + I + G + NX
• The Consumption Function and the Keynesian Cross
• Investment – Saving interpretation
• Government, Fiscal Policy, and Multipliers
A crash course on the fiscal policy
• Most of the materials here are borrowed from Professor Saez’
lecture slides for the undergraduate public economics course in
UC Berkeley.
Taxes and Expenditures by governments
• Taxes: governments in advanced economies collect 35-50% of
National Income in taxes.
• Expenditures: taxes fund
• public goods (infrastructure, public order and safety, defence),
• welfare state (education, retirement benefits, health care,
income support), and
• fiscal stimulus to stabilize business cycles.
Key facts on taxes and expenditures
1) Government Growth: Size of government relative to National
Income grows dramatically over the process of development from
less than 10% in less developed economies to 30-50% in most
advanced economies
2) Government Size Stable in richest countries after 1980
3) Government Growth is due to the expansion of the welfare
state: (a) public education, (b) public retirement benefits, (c) public
health insurance, (d) income support programs
4) Govt expenditures > Taxes: Most rich countries run deficits and
have significant public debt (relative to GDP), particularly during
Great Recession of 2008-10
• Source: https://taxfoundation.org/where-do-your-tax-dollars-go/
• Source: https://www.cbpp.org/federal-spending-fiscal-year-2017
Two forms of expenditures
• Entitlement (Mandatory) spending: Mandatory funds for
programs for which funding levels are automatically set by the
number of eligible recipients (ex: Medicare, social security)
• Discretionary spending: Optional spending set by appropriation
levels each year, at Congress's discretion (ex: defense)
• Q) To fight against recessions, which type of expenditure can be
expanded?
Government Budgeting (Ch. 22.2)
• Debt (B): The amount borrowed by government through bonds
to individuals, firms, or foreign governments. Debt is a stock.
• Deficit: government's spending + interest payments on debt
minus government revenues in a given year. A negative deficit is
called a surplus. Deficit is a flow.
• 𝐵𝑡+1 = 𝐵𝑡 + 𝐷𝑒𝑓𝑖𝑐𝑖𝑡𝑡 = 1 + 𝑟𝑡 𝐵𝑡 + 𝐺𝑡 − 𝑇𝑡
with 𝑟𝑡 interest paid on government debt
• Primary Deficit = 𝐺 − 𝑇
• Two methods to finance 𝐺: (1) , and (2) .
Short-run effects of 𝐺 and 𝑇 on the economy
Three different scenarios of the fiscal stimulus
1) 𝐺: 1 ↑
2) 𝑇: 1 ↓
3) 𝐺: 1 ↑ and 𝑇: 1 ↑
• Recall that the equilibrium output is given by
1
𝑌= 𝑐0 + 𝐼 ҧ + 𝐺 − 𝑐1 𝑇 .
1 − 𝑐1
1) Spending multiplier
• Remember that
𝑍 = 𝐶 + 𝐼 + 𝐺 = 𝑐0 + 𝑐1 𝑌 − 𝑇 + 𝐼 ҧ + 𝐺
• What will happen to 𝑌 if we increase 𝐺 while not changing 𝑇?
• Multiplier?
2) Tax multiplier
• Remember that
𝑍 = 𝐶 + 𝐼 + 𝐺 = 𝑐0 + 𝑐1 𝑌 − 𝑇 + 𝐼 ҧ + 𝐺
• What will happen to 𝑌 if we decrease 𝑇 while not changing 𝐺?
• Multiplier?
3) Balanced budget multiplier
• Remember that
𝑍 = 𝐶 + 𝐼 + 𝐺 = 𝑐0 + 𝑐1 𝑌 − 𝑇 + 𝐼 ҧ + 𝐺
• What will happen to 𝑌 if we increase 𝐺 and 𝑇 by one unit?
• Multiplier?
In the next class…
• We will look at the financial markets and the determination of
the interest rate. We focus on how monetary policy can (and
cannot) affect the interest rate.
• Blanchard, Chapter 4.
