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CHAPTER 3
The Goods Market
CHAPTER 3
Prepared by:
Fernando Quijano and Yvonn Quijano
The Goods Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 2 of 32
3-1 The Composition of GDP
Table 3-1 The Composition of U.S. GDP, 2006
Billions of dollars Percent of GDP
GDP (Y) 13,246 100.0
1 Consumption (C) 9,269 70.0
2 Investment (I) 2,163 16.3
Nonresidential 1,396 10.5
Residential 767 5.8
3 Government spending (G) 2,528 19.0
4 Net exports 763 5.8
Exports (X) 1,466 11.0
Imports (IM) 2,229 16.8
5 Inventory investment 49 0
Source: Survey of Current Business, April 2007, Table 1-1-5.
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 3 of 32
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 nonresidential
investment and residential investment.
 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.
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 4 of 32
3-1 The Composition of GDP
 Imports (IM) are the purchases of foreign goods and
services by consumers, business firms, and the U.S.
government.
 Exports (X) are the purchases of U.S. goods and services
by foreigners.
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 5 of 32
3-1 The Composition of GDP
 Inventory investment is the difference between
production and sales.
 Net exports (X  IM) is the difference between exports
and imports, also called the trade balance.
Exports > imports trade surplus

Exports < imports trade deficit

Exports = imports trade balance

Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 6 of 32
3-2 The Demand for Goods
The total demand for goods is written as:
Z C I G X IM
    
The symbol “” means that this equation is an identity, or definition.
To determine Z, some simplifications must be made:
 Assume that all firms produce the same good, which can
then be used by consumers for consumption, by firms for
investment, or by the government.
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 7 of 32
3-2 The Demand for Goods
 Assume that firms are willing to supply any amount of the
good at a given price, P, and demand in that market.
 Assume that the economy is closed, that it does not trade
with the rest of the world, then both exports and imports
are zero.
 Under the assumption that the economy is closed,
X = IM = 0, then:
Z C I G
  
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 8 of 32
3-2 The Demand for Goods
Disposable income, (YD), is the income that remains once
consumers have paid taxes and received transfers from the
government.
C C YD
 ( )
( )

The function C(YD) is called the consumption function. It is
a behavioral equation, that is, it captures the behavior of
consumers.
Consumption (C)
A more specific form of the consumption function is this linear
relation:
C c c YD
 
0 1
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 9 of 32
3-2 The Demand for Goods
This function has two parameters, c0 and c1:
 c1 is called the (marginal) propensity to consume, or the
effect of an additional dollar of disposable income on
consumption.
 c0 is the intercept of the consumption function.
Disposable income is given by:
Consumption (C)
Y Y T
D  
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 10 of 32
3-2 The Demand for Goods
C C YD
 ( )
Y Y T
D  
C c c Y T
  
0 1 ( )
Consumption (C)
Consumption increases with
disposable income but less
than one for one.
Consumption and
Disposable Income
Figure 3 - 1
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 11 of 32
3-2 The Demand for Goods
Variables that depend on other variables within the model are
called endogenous. Variables that are not explain within the
model are called exogenous. Investment here is taken as given,
or treated as an exogenous variable:
I I

Investment (I )
Government Spending (G)
Government spending, G, together with taxes, T, describes fiscal
policy—the choice of taxes and spending by the government.
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 12 of 32
3-2 The Demand for Goods
We shall assume that G and T are also exogenous for two
reasons:
 Governments do not behave with the same regularity as
consumers or firms.
 Macroeconomists must think about the implications of
alternative spending and tax decisions of the government.
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 13 of 32
3-3 The Determination of Equilibrium Output
Assuming that exports and imports are both zero, the demand
for goods is the sum of consumption, investment, and
government spending:
Z C I G
  
Then:  
0 1
Z c c Y -T I G
   
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 14 of 32
Equilibrium in the goods market requires that production,
Y, be equal to the demand for goods, Z:
0 1
( )
Y c c Y T I G
    
Y Z

Then:
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.
3-3 The Determination of Equilibrium Output
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 15 of 32
3-3 The Determination of Equilibrium Output
Macroeconomists always use these three tools:
1. Algebra to make sure that the logic is correct
2. Graphs to build the intuition
3. Words to explain the results
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 16 of 32
3-3 The Determination of Equilibrium Output
 
1 0 1
1 c Y c I G cT
    
0 1 1
Y c cY cT I G
    
Rewrite the equilibrium equation:
Using Algebra
Move to the left side and reorganize the right side:
1
cY
0 1
1
1
1
Y c I G cT
c
 
   
 

Divide both sides by 1
(1 ) :
c

Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 17 of 32
The equilibrium equation can be manipulated to derive some
important terms:
 Autonomous spending and the multiplier:
 The term is that part of the demand for goods
that does not depend on output, it is called autonomous
spending. If the government ran a balanced budget, then
T=G.
 Because the propensity to consume (c1) is between zero and
one, is a number greater than one. For this reason, this
number is called the multiplier.
0 1
[ ]
c I G cT
  
Y
c
c I G c T


  
1
1 1
0 1
[ ]
1
1 1
 c
3-3 The Determination of Equilibrium Output
Using Algebra
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 18 of 32
3-3 The Determination of Equilibrium Output
0 1 1
( )
Z c I G cT cY
    
 First, plot production as
a function of income.
 Second, plot demand as
a function of income.
 In Equilibrium,
production equals
demand.
Equilibrium output is determined
by the condition that production
be equal to demand.
Equilibrium in the
Goods Market
Figure 3 - 2
Using a Graph
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 19 of 32
Using a Graph
An increase in autonomous
spending has a more than one-
for-one effect on equilibrium
output.
The Effects of an
Increase in Autonomous
Spending on Output
Figure 3 - 3
3-3 The Determination of Equilibrium Output
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 20 of 32
Using a Graph
 The first-round increase in
demand, shown by the
distance AB equals $1
billion.
 This first-round increase
in demand leads to an
equal increase in
production, or $1 billion,
which is also shown by
the distance in AB.
 This first-round increase
in production leads to an
equal increase in income,
shown by the distance in
BC, also equal to $1
billion.
3-3 The Determination of Equilibrium Output
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 21 of 32
Using a Graph
 The second-round increase
in demand, shown by the
distance in CD, equals $1
billion times the propensity
to consume.
 This second-round increase
in demand leads to an equal
increase in production, also
shown by the distance DC,
and thus an equal increase
in income, shown by the
distance DE.
 The third-round increase in
demand equals $c1 billion,
times c1, the marginal
propensity to consume; it is
equal to $c1 x c1 = $
c1
2billion.
3-3 The Determination of Equilibrium Output
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 22 of 32
Following this logic, the total increase in production
after, say, n + 1 rounds, equals $1 billion multiplied
by the sum:
1 + c1 + c1
2 + …+ c1
n
Such a sum is called a geometric series.
3-3 The Determination of Equilibrium Output
Using a Graph
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 23 of 32
To summarize:
 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 behavioral equations and their
parameters, economists use econometrics—a set
of statistical methods used in economics.
3-3 The Determination of Equilibrium Output
Using Words
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 24 of 32
Describing formally the adjustment of output over time is what
economists call the dynamics of adjustment.
 Suppose that firms make decisions about their production
levels at the beginning of each quarter.
 Now suppose consumers decide to spend more, that they
increase c0..
 Having observed an increase in demand, firms are likely to
set a higher level of production in the following quarter.
 In response to an increase in consumer spending, output
does not jump to the new equilibrium, but rather increases
over time.
3-3 The Determination of Equilibrium Output
How Long Does It Take for Output to Adjust?
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 25 of 32
3-4 Investment Equals Saving: An Alternative Way of
Thinking about Goods-Market Equilibrium
Saving is the sum of private plus public saving.
 Private saving (S), is saving by consumers.
S Y C
D
  S Y T C
  
Y C I G
   Y T C I G T
    
S I G T
   I S T G
  
( )
 Public saving equals taxes minus government
spending.
 If T > G, the government is running a budget
surplus—public saving is positive.
 If T < G, the government is running a budget
deficit—public saving is negative.
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 26 of 32
The equation above states that equilibrium in the
goods market requires that investment equals
saving—the sum of private plus public saving.
This equilibrium condition for the goods market is
called the IS relation. What firms want to invest
must be equal to what people and the government
want to save.
I S T G
  
( )
3-4 Investment Equals Saving: An Alternative Way
of Thinking about Goods-Market Equilibrium
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 27 of 32
 Consumption and saving decisions are one and the
same.
S Y T C
  
0 1
( )
S Y T c c Y T
    
S c c Y T
    
0 1
1
( )( )
 The term (1c1) is called the propensity to save.
In equilibrium:
0 1
1
1
[ ]
1
Y c I G cT
c
   

I c c Y T T G
      
0 1
1
( )( ) ( )
Rearranging terms, we get the same result as before:
Investment Equals Saving: An Alternative
Way of Thinking about Goods-Market Equilibrium
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 28 of 32
The Paradox of Saving
The paradox of saving (or the paradox of
thrift) is that as people attempt to save more,
the result is both a decline in output and
unchanged saving.
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 29 of 32
3-5 Is the Government Omnipotent?
A Warning
 Changing government spending or taxes is not always easy.
 The responses of consumption, investment, imports, etc, are
hard to assess with much certainty.
 Anticipations are likely to matter.
 Achieving a given level of output can come with unpleasant
side effects.
 Budget deficits and public debt may have adverse implications
in the long run.
Chapter
3:
The
Goods
Market
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 30 of 32
Key Terms
 Consumption (C)
 Investment (I)
 Fixed investment
 Nonresidential investment
 Residential investment
 Government spending (G)
 Government transfers
 Imports (IM)
 Exports (X)
 Net exports (X-IM)
 Trade balance
 Trade surplus
 Trade deficit
 Inventory investment
 Identity
 Disposable income (YD)
 Consumption function
 Behavioral equation
 Linear relation
 Parameter
 Propensity to consume (c1)
 Endogenous variables
 Exogenous variables
 Fiscal policy
 Equilibrium
 Equilibrium in the goods market
 Equilibrium condition
 Autonomous spending
 Balanced budget
 Multiplier
 Geometric series
 Econometrics
 Dynamics
 Forecast error
 Consumer confidence index
 Private saving (S)
 Public saving (T-G)
 Budget surplus
 Budget deficit
 Saving
 IS relation
 Propensity to save
 Paradox of saving

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ch03_5e.ppt

  • 1. CHAPTER 3 The Goods Market CHAPTER 3 Prepared by: Fernando Quijano and Yvonn Quijano The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
  • 2. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 2 of 32 3-1 The Composition of GDP Table 3-1 The Composition of U.S. GDP, 2006 Billions of dollars Percent of GDP GDP (Y) 13,246 100.0 1 Consumption (C) 9,269 70.0 2 Investment (I) 2,163 16.3 Nonresidential 1,396 10.5 Residential 767 5.8 3 Government spending (G) 2,528 19.0 4 Net exports 763 5.8 Exports (X) 1,466 11.0 Imports (IM) 2,229 16.8 5 Inventory investment 49 0 Source: Survey of Current Business, April 2007, Table 1-1-5.
  • 3. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 3 of 32 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 nonresidential investment and residential investment.  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.
  • 4. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 4 of 32 3-1 The Composition of GDP  Imports (IM) are the purchases of foreign goods and services by consumers, business firms, and the U.S. government.  Exports (X) are the purchases of U.S. goods and services by foreigners.
  • 5. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 5 of 32 3-1 The Composition of GDP  Inventory investment is the difference between production and sales.  Net exports (X  IM) is the difference between exports and imports, also called the trade balance. Exports > imports trade surplus  Exports < imports trade deficit  Exports = imports trade balance 
  • 6. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 6 of 32 3-2 The Demand for Goods The total demand for goods is written as: Z C I G X IM      The symbol “” means that this equation is an identity, or definition. To determine Z, some simplifications must be made:  Assume that all firms produce the same good, which can then be used by consumers for consumption, by firms for investment, or by the government.
  • 7. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 7 of 32 3-2 The Demand for Goods  Assume that firms are willing to supply any amount of the good at a given price, P, and demand in that market.  Assume that the economy is closed, that it does not trade with the rest of the world, then both exports and imports are zero.  Under the assumption that the economy is closed, X = IM = 0, then: Z C I G   
  • 8. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 8 of 32 3-2 The Demand for Goods Disposable income, (YD), is the income that remains once consumers have paid taxes and received transfers from the government. C C YD  ( ) ( )  The function C(YD) is called the consumption function. It is a behavioral equation, that is, it captures the behavior of consumers. Consumption (C) A more specific form of the consumption function is this linear relation: C c c YD   0 1
  • 9. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 9 of 32 3-2 The Demand for Goods This function has two parameters, c0 and c1:  c1 is called the (marginal) propensity to consume, or the effect of an additional dollar of disposable income on consumption.  c0 is the intercept of the consumption function. Disposable income is given by: Consumption (C) Y Y T D  
  • 10. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 10 of 32 3-2 The Demand for Goods C C YD  ( ) Y Y T D   C c c Y T    0 1 ( ) Consumption (C) Consumption increases with disposable income but less than one for one. Consumption and Disposable Income Figure 3 - 1
  • 11. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 11 of 32 3-2 The Demand for Goods Variables that depend on other variables within the model are called endogenous. Variables that are not explain within the model are called exogenous. Investment here is taken as given, or treated as an exogenous variable: I I  Investment (I ) Government Spending (G) Government spending, G, together with taxes, T, describes fiscal policy—the choice of taxes and spending by the government.
  • 12. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 12 of 32 3-2 The Demand for Goods We shall assume that G and T are also exogenous for two reasons:  Governments do not behave with the same regularity as consumers or firms.  Macroeconomists must think about the implications of alternative spending and tax decisions of the government.
  • 13. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 13 of 32 3-3 The Determination of Equilibrium Output Assuming that exports and imports are both zero, the demand for goods is the sum of consumption, investment, and government spending: Z C I G    Then:   0 1 Z c c Y -T I G    
  • 14. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 14 of 32 Equilibrium in the goods market requires that production, Y, be equal to the demand for goods, Z: 0 1 ( ) Y c c Y T I G      Y Z  Then: 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. 3-3 The Determination of Equilibrium Output
  • 15. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 15 of 32 3-3 The Determination of Equilibrium Output Macroeconomists always use these three tools: 1. Algebra to make sure that the logic is correct 2. Graphs to build the intuition 3. Words to explain the results
  • 16. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 16 of 32 3-3 The Determination of Equilibrium Output   1 0 1 1 c Y c I G cT      0 1 1 Y c cY cT I G      Rewrite the equilibrium equation: Using Algebra Move to the left side and reorganize the right side: 1 cY 0 1 1 1 1 Y c I G cT c          Divide both sides by 1 (1 ) : c 
  • 17. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 17 of 32 The equilibrium equation can be manipulated to derive some important terms:  Autonomous spending and the multiplier:  The term is that part of the demand for goods that does not depend on output, it is called autonomous spending. If the government ran a balanced budget, then T=G.  Because the propensity to consume (c1) is between zero and one, is a number greater than one. For this reason, this number is called the multiplier. 0 1 [ ] c I G cT    Y c c I G c T      1 1 1 0 1 [ ] 1 1 1  c 3-3 The Determination of Equilibrium Output Using Algebra
  • 18. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 18 of 32 3-3 The Determination of Equilibrium Output 0 1 1 ( ) Z c I G cT cY       First, plot production as a function of income.  Second, plot demand as a function of income.  In Equilibrium, production equals demand. Equilibrium output is determined by the condition that production be equal to demand. Equilibrium in the Goods Market Figure 3 - 2 Using a Graph
  • 19. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 19 of 32 Using a Graph An increase in autonomous spending has a more than one- for-one effect on equilibrium output. The Effects of an Increase in Autonomous Spending on Output Figure 3 - 3 3-3 The Determination of Equilibrium Output
  • 20. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 20 of 32 Using a Graph  The first-round increase in demand, shown by the distance AB equals $1 billion.  This first-round increase in demand leads to an equal increase in production, or $1 billion, which is also shown by the distance in AB.  This first-round increase in production leads to an equal increase in income, shown by the distance in BC, also equal to $1 billion. 3-3 The Determination of Equilibrium Output
  • 21. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 21 of 32 Using a Graph  The second-round increase in demand, shown by the distance in CD, equals $1 billion times the propensity to consume.  This second-round increase in demand leads to an equal increase in production, also shown by the distance DC, and thus an equal increase in income, shown by the distance DE.  The third-round increase in demand equals $c1 billion, times c1, the marginal propensity to consume; it is equal to $c1 x c1 = $ c1 2billion. 3-3 The Determination of Equilibrium Output
  • 22. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 22 of 32 Following this logic, the total increase in production after, say, n + 1 rounds, equals $1 billion multiplied by the sum: 1 + c1 + c1 2 + …+ c1 n Such a sum is called a geometric series. 3-3 The Determination of Equilibrium Output Using a Graph
  • 23. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 23 of 32 To summarize:  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 behavioral equations and their parameters, economists use econometrics—a set of statistical methods used in economics. 3-3 The Determination of Equilibrium Output Using Words
  • 24. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 24 of 32 Describing formally the adjustment of output over time is what economists call the dynamics of adjustment.  Suppose that firms make decisions about their production levels at the beginning of each quarter.  Now suppose consumers decide to spend more, that they increase c0..  Having observed an increase in demand, firms are likely to set a higher level of production in the following quarter.  In response to an increase in consumer spending, output does not jump to the new equilibrium, but rather increases over time. 3-3 The Determination of Equilibrium Output How Long Does It Take for Output to Adjust?
  • 25. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 25 of 32 3-4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium Saving is the sum of private plus public saving.  Private saving (S), is saving by consumers. S Y C D   S Y T C    Y C I G    Y T C I G T      S I G T    I S T G    ( )  Public saving equals taxes minus government spending.  If T > G, the government is running a budget surplus—public saving is positive.  If T < G, the government is running a budget deficit—public saving is negative.
  • 26. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 26 of 32 The equation above states that equilibrium in the goods market requires that investment equals saving—the sum of private plus public saving. This equilibrium condition for the goods market is called the IS relation. What firms want to invest must be equal to what people and the government want to save. I S T G    ( ) 3-4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium
  • 27. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 27 of 32  Consumption and saving decisions are one and the same. S Y T C    0 1 ( ) S Y T c c Y T      S c c Y T      0 1 1 ( )( )  The term (1c1) is called the propensity to save. In equilibrium: 0 1 1 1 [ ] 1 Y c I G cT c      I c c Y T T G        0 1 1 ( )( ) ( ) Rearranging terms, we get the same result as before: Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium
  • 28. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 28 of 32 The Paradox of Saving The paradox of saving (or the paradox of thrift) is that as people attempt to save more, the result is both a decline in output and unchanged saving.
  • 29. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 29 of 32 3-5 Is the Government Omnipotent? A Warning  Changing government spending or taxes is not always easy.  The responses of consumption, investment, imports, etc, are hard to assess with much certainty.  Anticipations are likely to matter.  Achieving a given level of output can come with unpleasant side effects.  Budget deficits and public debt may have adverse implications in the long run.
  • 30. Chapter 3: The Goods Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 30 of 32 Key Terms  Consumption (C)  Investment (I)  Fixed investment  Nonresidential investment  Residential investment  Government spending (G)  Government transfers  Imports (IM)  Exports (X)  Net exports (X-IM)  Trade balance  Trade surplus  Trade deficit  Inventory investment  Identity  Disposable income (YD)  Consumption function  Behavioral equation  Linear relation  Parameter  Propensity to consume (c1)  Endogenous variables  Exogenous variables  Fiscal policy  Equilibrium  Equilibrium in the goods market  Equilibrium condition  Autonomous spending  Balanced budget  Multiplier  Geometric series  Econometrics  Dynamics  Forecast error  Consumer confidence index  Private saving (S)  Public saving (T-G)  Budget surplus  Budget deficit  Saving  IS relation  Propensity to save  Paradox of saving