Macroeconomics Prof. Juan Gabriel Rodríguez Chapter 2 The Goods Market

Question How is output determined in the short run? Output is determined by equilibrium in the goods market, i.e., by the condition that supply equals demand. In the short run, we assume that production adjusts automatically to demand without changes in price (output is effectively determined by demand). [We assume that investment is exogenous (independent of the interest rate), so there is no need to consider simultaneous equilibrium in the goods and financial markets.]

The composition of GDP: Z  C + I + G + (X-IM) Consumption (C): current expenditure of families in consumption goods and services in one year. Investment (I): expenditure of firms in nonresidential investment, families in residential investment and inventory investment in one year. Government Spending (G): purchases of goods and services by central, state and local governments in one year. Net Exports (X-IM): difference between exports (X) and imports (IM). GDP - METHOD OF OUTPUT

Figure 1: The Composition of U.S. GDP Source: EUROSTAT

Figure 2: The Composition of Japan GDP Source: EUROSTAT

Figure 3: The Composition of Euro Area GDP Source: EUROSTAT

Figure 4: The Composition of Sweden GDP Source: EUROSTAT

Figure 5: The Composition of Argentina GDP Source: ECOWIN

Figure 6: The Composition of Spain GDP Source: EUROSTAT

Figure 7: The Degree of Openess in Spain Source: EUROSTAT

A good index of openness is the proportion of aggregate output composed of tradable goods—or goods that compete with foreign goods in either domestic markets or foreign markets. Estimates are that tradable goods represent around 60% of aggregate output in the United States today. Openness in Goods Markets

Figue 8: Government Spending (% GDP). International Comparison Source: Eurostat

Figure 9: Government Revenue (% GDP). International Comparison Source: Eurostat

Figure 10: Economic Structure of Government Spending

Figure 11: Functional Structure of Government Spending

Figure 12: Evolution of US GDP and its components (volatility). Yearly Data ( ) Source: EUROSTAT

Figure 13: Evolution of Japan GDPand its components. Volatility Yearly Data ( ) Source: EUROSTAT

Figure 14: Evolution of Euro Area GDP and its components. Volatility Yearly Data ( ) Source: EUROSTAT

Figure 15: Evolution of Germany GDP and its components. Volatility Quarterly Data ( ) Source: EUROSTAT

Figure 16: Evolution of Spain GDP and its components. Volatility Quarterly Data ( )

Figure 17: Evolution of Investment components in Spain ( )

Assumptions 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.  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. Then:

The Demand for Goods Disposable income, (Y D ), is the income that remains once consumers have paid taxes and received transfers from the government. The function C(Y D ) 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:

The Demand for Goods This function has two parameters, c 0 and c 1 :  c 1 is called the (marginal) propensity to consume, or the effect of an additional dollar of disposable income on consumption.  c 0 is the intercept of the consumption function (autonomous consumption). Disposable income is given by:

The Demand for Goods Consumption increases with disposable income but less than one for one. c0c0 c1c1 Disposable Income Consumption

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. Investment (I ) Government Spending (G) Government spending, G, together with taxes, T, describes fiscal policy—the choice of taxes and spending by the government.

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.

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:

The Determination of Equilibrium Output Equilibrium in the goods market requires that production, Y, be equal to the demand for goods, Z: : Demand, Z, in turn depends on income, Y, which itself is equal to production:

Some important terms: – 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 (c 1 ) is between zero and one, is a number greater than one. For this reason, this number is called the multiplier. The Determination of Equilibrium Output

Equilibrium output is determined by the condition that production be equal to demand. c 0 +I+G-c 1 T c1c1 Y (Income) Z,Y (Production) Equilibrium point Production

An increase in autonomous spending has a more than one- for-one effect on equilibrium output. The Determination of Equilibrium Output c 0 +I+G-c 1 T c1c1 Y (Income) Z,Y (Production) Equilibrium point Production Z’ – The first-round increase in demand, leads to an equal increase in production. – This first-round increase in production leads to an equal increase in income.

– The second-round increase in demand, equals  Y times the propensity to consume. This increase in demand leads to an equal increase in production, and thus an equal increase in income. – The third-round increase in demand equals  Y·c 1, times c 1. An so on. The Determination of Equilibrium Output c 0 +I+G-c 1 T c1c1 Y (Income) Z,Y (Production) Equilibrium point Production Z’

Assume that  Y = 1. Then, the total increase in production after, say, n + 1 rounds, equals the sum: 1 + c 1 + c …+ c 1 n This sum is a geometric series. The Determination of Equilibrium Output

– 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 economists use econometrics—a set of statistical methods used in economics. The Determination of Equilibrium Output

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 (they increase c 0 ). – 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. How Long Does It Take for Output to Adjust?

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. equals taxes minus government spending.  Public saving equals taxes minus government spending.  In a close economy, total net saving is…  Equilibrium in the goods market requires that investment equals saving:  Equilibrium in the goods market requires that investment equals saving: the IS relation (what firms want to invest must be equal to what people and the government want to save).

 Consumption and saving decisions are one and the same.  The term (1  c 1 ) is called the propensity to save. In equilibrium: Rearranging terms, we get the same result as before: An Alternative way of Thinking about Goods-Market Equilibrium

The Paradox of Saving The paradox of saving is that as people attempt to save more (c 0 decreases), the result is both a decline in output and unchanged saving. So large increases of savings are bad…..but only in the short-run!!! The paradox of saving

A Government choosing the level of output  Changing government spending or taxes is not always easy (it takes time and sometimes is forbidden...)  The responses of consumption, investment, imports, etc, are hard to assess with much certainty.  Anticipations are likely to matter (people reaction to transitory and permanent changes).  Achieving a given level of output can come with unpleasant side effects (i.e. inflation).  Budget deficits and public debt may have adverse implications in the long run…