mankiwchapter3.ppt

Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 1
3. Determinants of Demand for
Goods and Services
• Examine: how the output from production
is used
• Four components of GDP:
– Consumption (C)
– Investment (I)
– Government purchases (G)
– Net exports (NX)
• Assume a closed economy. NX = 0

Determinants of Goods and
Services
• Closed economy, three components of
GDP, expressed as the National Income
Accounts Identity: Y = C + I + G
• Households consume some of the
economy’s output
• Firms and households use some output to
invest
• Government buys some of the output

Determinants of Goods and
Services
• Consumption:
– We consume some of the output produced in
the economy (e.g. food, clothing, going to the
cinema)
– Consumption makes up two thirds of GDP
– Households get income from their labour and
ownership of capital, pay taxes to the
government and decide how much of what is
left to consume and/or save

Consumption
• Income households receive equals output
in the economy (Y)
• Y = income
• T = taxes
• Y – T = disposable income i.e. income left
after taxes have been paid
• Disposable income is divided between
consumption and saving

Consumption
• C = C(Y-T)
• Consumption is a function of disposable
income
• Consumption function – Graph
• Marginal Propensity to Consume (MPC):
amount by which consumption changes
when disposable income increases by one
Euro.

Consumption
0<MPC<1: MPC is between 0 and 1
For example if MPC = 0.7, households
spend 70 cents of each additional Euro
they get and they save 30 cents

Investment
• Firms and households purchase
investment goods
• Firms buy goods to add to or replace
existing capital
• Households buy new houses
• Quantity of investment demanded
depends on the interest rate
• Interest rate measures the cost of funds to
finance the investment

Investment
• For investment to be profitable: return on
investment (increased production of goods
and services) must exceed the cost (the
payments for borrowed funds
• Same decision is made even if firm does
not have to borrow for the investment
– Uses own funds and forgoes the interest that
would have been earned from leaving money
in the financial institution

Investment
• Nominal and real interest rates
• Real interest rate is corrected for the
effects of inflation
• Real interest rates measure the true cost
of borrowing and determines the quantity
of investment
I = I(r)
Graph: the investment function

Government Purchases
• Government purchases e.g. services of public
employees, schools, colleges etc.
• Transfer payments are not included in G:
– e.g. social welfare, social security payments to
elderly. Payments are not made in exchange for some
of the economy’s output
• Transfer payments are opposite to taxes:
– Transfer payments increase disposable income
– Taxes decrease disposable income
• Y-T: disposable income includes negative impact
of taxes and positive impact of transfer
payments)

Government Purchases
• If Government purchases equal taxes
minus transfer payments, then:
G = T: balanced budget
• G>T: budget deficit
• G<T: bduget surplus
• Here, we assume G and T are exogenous
variables i.e. given or fixed variables
outside our model
• G = G, T = T

4. Equilibrium
• How can we be certain that all the flows of
goods and services in the economy
balance?
• i.e. What ensures that the sum of
consumption, investment and government
purchases equals the amount of out put
produced?
– The interest rate has a crucial role of
equilibriating supply and demand

Equilibrium
Y = C + I + G
C = C(Y – T)
I = I(r)
G = G
T = T
• Demand for economy’s output comes from C, I
and G
• C depends on disposable income, I depends on
the real interest rate and G and T are exogenous
variables

Equilibrium
• Factors of production and production
function determine the quantity of output
supplied:
Y = F(K,L) = Y
• Combine Y = C(Y – T) + I(r) + G with
output supplied
• G and T are fixed by policy, Y is fixed by
the factors of production and production
function

Equilibrium
Y = C(Y – T) + I(r) + G
• Supply equals demand
• Interest rate, r, is the only variable not
already determined in the equation
• r must adjust to ensure that the demand
for goods equals supply
• The greater the interest rate, the lower the
level of investment thus the lower the
demand for goods and services

Equilibrium
• If r is too high, I is too low and
demand < supply
• If r is too low, I is too high and
demand > supply
• At equilibrium interest rate: demand for
goods and services equals supply
• How interest rates get to balance supply
and demand?

Equilibrium
• Supply and demand for loanable funds:
• Interest rate = cost of borrowing and return
to lending
• Rearrange National Income Accounts
Identity:
Y – C – G = I
Y – C – G: output that remains after
demands of consumers and government

Equilibrium
• Y – C – G: National saving (S)
• Y – C – G = I
• Savings = Investment
• National saving = private saving + public
saving
• Y – T – C : private saving
• T – G: Public saving
• (Y – T – C) + (T – G) = I

Equilibrium
• Substitute:
I for I(r) and
C for C(Y – T)
Y – C(Y – T) – G = I(r)
G and T are fixed by policy
Y is fixed by factors of production and
production function

Equilibrium
• Y – C(Y – T) – G = I(r)
S = I(r)
• National saving depends on Y, G and T,
which are all fixed, so National Saving is
fixed
• Graph of saving and investment
• The interest rate adjusts to bring saving
and investment into balance

Equilibrium
• Saving and investment – supply and demand of
loanable funds
• Price of loanable funds = the interest rate
• Interest adjusts until the amount that households
want to save equals amount firms want to invest
• If r is too low: investors want more of economy’s
output that households want to save
• If r is too high: households want to save more
than firms want to invest

Changes in saving
An increase in government purchases:
• No increase in taxes
• So the government finances additional spending
by borrowing or reducing public spending
• No change in private saving
• So national saving decreases: S shifts to the left
• Interest rate rises
• Increase in G causes r to rise
• See Graph

Changes in saving
A decrease in taxes:
• Raises disposable income (Y - T)
• Consumption increases
• National Saving, (Y – C – G), falls by the
same amount as consumption rises
• S shifts to the left
• r rises
• Decrease in taxes causes r to rise

Changes in investment demand
• An increase in the demand for investment
might be because of an increase in
technological innovation
• An increase in demand for investment
shifts I to the right and raises interest rates
• See graph

Summary
1. What determines a nation’s total income or level of
production? Answer: factors of production and
production function
2. Who gets the income from production? Answer: wages
paid to labour, rent paid to capital-owners and
economic profit
3. What determines demand for output? Answer:
Consumption, Investment, Government purchases
4. What equilibrates the demand and supply of goods
and services? Answer: The real interst rate adjusts to
equilibriate the supply and demand of the economy’s
output

mankiwchapter3.ppt

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