The goods market: Exercises and applications Lecture 19 – academic year 2014/15 Introduction to Economics Fabio Landini

What explains the variation of GDP in the short period? How much does the GDP vary following changes in the demand components? How can we explain phenomena such as the expansion of US during the 90s or the recent great recession ( )? Questions of the day

Numerical examples to determine the equilibrium level of GDP Effects of variation in autonomous expenditure Explanation of multiplier Expansion in US during the 90s Great recession in Italy ( ) Savings and investments in equilibrium Plan of the day

We write the equations which describe the components of aggregate demand Consumption is endogenous (behavioural equation) C = ,6Y D Investments, public expenditure and taxes are exogenous (constant values) I = 50 G = 250 T = 100 Which is the value of production in equilibrium (Y E )? Examples on the determination of GDP

Aggregate demand Z is equal to Z = C + I + G By substituting the equation C = ,6 Y D Z = ,6Y D + I + G By substituting the definition Y D = Y  T Z = C 0 + c 1 (Y  ) + I + G By substituting the constant value for I, G e T Z = ,6 (Y  100) So that Z = 0,6Y Examples on the determination of GDP

We impose the equilibrium condition Z=Y, so that Y = 0,6Y (1  0,6) Y = 340 Y = 340 = 850 Equilibrium income -> Y E = 850 Which is the value of the multiplier? Multiplier  = 2,5 Examples on the determination of GDP

Variations in autonomous expenditure Let’s examine the effects of a variations in one component of autonomous expenditure on final product. Let’s suppose that something changes which affects the consumption choices -> Aut. Consumption (C 0 ) C 0 = 100 -> 200 For the other variables we maintain the same values.

Which is the equilibrium value of final product ? Z = C + I + G = = ,6 (Y  100) = 0,6Y Let’s impose the equilibrium condition Z=Y Y = 0,6Y from which we get Y E = 440 = 1100 Variations in autonomous expenditure

We obtained that C 0 = 100 -> 200 caused Y E = 850 -> 1100 An increase in C 0 of about 100 caused an increase in Y E of about 250 Why? Variations in autonomous expenditure

Explanation: a) Autonomous consumption (C 0 ) -> b) Since consumption is a component of aggregate demand (Z=C+I+G) Aggregate Dem. ( Δ Z  Δ C 0 ) -> c) Since in equilibrium Y=Z Production of the same degree  (Δ Y  Δ Z  Δ C 0 ) If the effect of C 0 stopped here we would have Δ Y  Δ C 0 Variations in autonomous expenditure

However the effects continues. Indeed: d) Since GDP  Σ incomes Δ Y = Δ Aggregate income -> e) Since consumption depends on income (C=C 0 +c 1 Y D ), new Consumption (equal to c 1 × ΔY D ) -> f) Since consumption is a component of aggregate demand (Z=C+I+G), new Aggregate demand (Δ  Z = c 1 × ΔY D ) -> Variations in autonomous expenditure

g) Since in equilibrium Y=Z New Production of the same dimension (ΔY = ΔZ ) -> h) New Aggregate income -> … The above described mechanisms starts again… Variations in autonomous expenditure

In conclusion: C 0 causes a sequence of Y This happens because every increase in the product causes an increase in income and therefore a new increase in demand The increases get smaller and smaller because at each new “passage” only a portion of the new income is consumed (c 1 <1) Variations in autonomous expenditure

The final increase in Y is greater than the initial one in C 0 in because of the mechanism that we have just described Analytically this mechanism is represented by the multiplier (Multiplier -> “multiplies” the variations in autonomous expenditure) The mechanism the we have just described can be expressed also graphically Variations in autonomous expenditure

Demand -> Z = SA+c 1 Y Supply -> Line at 45° Equilibrium -> Y=Z -> punto A -> Y=Y A ZZ Z 45° A Y YAYA, Y

Let’s see the effects of an increase in C 0 C 0 -> Z Z -> Y ZZ Z,Y 45° A ZZ’ B C

Y -> C -> Z Z -> Y and so on… ZZ Z,Y 45° A ZZ’ B C D E

Final effect: A -> A’, so that Y A -> Y A ’ The increase in Y is greater then the one in C 0 ZZ Z,Y 45° A ZZ’ A’A’ YAYA YA’YA’ B C D E

The previous results hold for all component of autonomous expenditure In particular, since Y E = AE -> ΔY E = ΔAE where ΔAE is the variation in autonomous expenditure Variations in autonomous expenditure

 Δ  AE = Δ of its components so that Δ  Y E = (Δ  C 0  c 1 × Δ  T 0 + Δ  I 0 + Δ  G 0 ) This implies that, in the short period, GDP depends on: Variations in autonomous consumption (C 0 ) Variations in the choices of investors (I 0 ) Variations in the choices of government on taxes (T 0 ) and public expenditures (G 0 ) Variations in autonomous expenditure

The decomposition of demand in its different component can be used to interpret some recent events. In particular: Expansion of the United States in the 90s Great recession during the period in Italy Variations in autonomous expenditure

Expansion of the US during the 90s In the period the US underwent a phase of great expansion (on average +3,7% a year; +4,1% from 1996 to 2000) The average growth was superior to the average of the other industrialized countries (for instance UE on average +2%) The previous analysis can help us to understand this fact

We saw that Δ  Y E = (Δ  C 0  c 1 × Δ  T 0 + Δ  I 0 + Δ  G 0 ) What happened in the US economy? Mainly two things: a) The development of new Information and Communication Technologies (ICTs) lead firms to innovate the productive processes -> I 0 Expansion of the US during the 90s

b) There had been a very good trend in the stock exchange indices (in particular the stocks associated with the “new economy”) -> households’ financial wealth -> C 0 Expansion of the US during the 90s

In particular, on average: Consumption + 3,4% + 4% Investments + 6,7% + 8,4% GDP + 3,7% + 4,1%  I 0 and C 0 explain Y Important: Another component that contributed to growth was the increase in productivity (medium/long period phenomenon) Expansion of the US during the 90s

Great Recession 2 nd semester of > World financial crisis (“subprime crisis”) Recession (negative growth) in (almost) all biggest world economies Italy1.6%-1.3%-5.1% France2.1%0.3%-2.5% Germany2.5%1 %-4.9% EU2.7%0.5%-4.1% US2%0.4%-2.4%

Let’s focus on the Italian economy During the period the Italian economy underwent a deep recession with a total decrease in GDP greater than 5% in the two years. What does this trend depend on? How do we link this result with the trend in the components of aggregate demand? Great Recession

The financial crisis had an effect on investment and consumption On the investment side: Difficulties in firms’ external financing -> (in the current model) I 0 Worsening of the expectations on profit -> (in the current model) I Great Recession

On the consumption side: Decrease in income (increased unemployment) -> Y d -> c 1 Y d -> C Fall in stock indices (cause by the worsening of the expectations on firms’ profitability) -> households’ financial wealth -> C 0 Worsening of the expectations on the future -> C Great Recession

The dynamics of consumption and investments explain the dynamics of GDP ITALY GDP1.6%-1.3%-5.1% Consumption1.6%-0,4%-1.2% Investments1.3%-4%-12.1% Great Recession

The equilibrium condition on the good market is Y=Z We can obtain an equivalent condition based on investment and savings Let’s start from Y = Z = C + I + G We have Y - C - G = I By subtracting and summing T from/to the first term Y - T - C + T - G = I Savings and investments in equilibrium

Y - T - C + T - G = I The expression Y - T – C is the difference between the available income and consumption -> private saving (S pr ) The expression T – G is the difference between the earnings and costs of the Government -> public saving(S pu ) By substituting in the original expression, we get S pr + S pu = I Private saving + public saving = saving (S) Therefore, the equilibrium condition suggests that S = I Savings and investments in equilibrium

In equilibrium, investments equal savings -> Say’s Law It is an alternative way of defining the equilibrium in the goods market Savings and investments in equilibrium