The Goods Market Lecture 11 – academic year 2013/14 Introduction to Economics Fabio Landini

Where we are… Lectures 1-7: Microeconomics Lecture 8: Computation of GDP Lecture 8: Evolution of GDP and differences among countries Lecture 9: Inflation, unemployment and aggregate demand

How is the level of GDP determined? The answer is different if we consider different time horizon In this lecture: How the level of GDP is determined the short period Question of the day

Premise: short, medium and long period Analysis of the different components of demand Determination of the aggregate demand function Determination of the equilibrium level of production (GDP) in the short period What do we do today…

We can distinguish three different time horizons: Short period = 1-2 years Medium period = 10 years Long period = year Premise: short, medium and long period

Why do we use this differentiation? 1)Empirical evidence shows that depending on the time time horizon that we consider production is lead by different factors Short period -> Dynamics of the demand (how many goods are purchased) Medium period -> Dynamics of the supply (adjustment of production capacity) Long period -> Structural factors (saving, quality of education, features of institutions, etc.) Premise: short, medium and long period

2) Depending on the time horizons, we make different hypotheses on the functioning of the economy a) Price adjustments Short period: prices are fixed (or with reduced flexibility) As the market conditions change firms do not adjust their price list immediately. To change prices is indeed costly. Before doing so, a firm want: To verify the stability of the new conditions To see the reaction of competitors Premise: short, medium and long period

Medium and long period: Prices are perfectly flexible If we consider a longer time horizon firms have the time to perfectly adjust prices Price adjustments -> medium period analysis b) Accuracy of previsions on the future value of some variables (expectations) Premise: short, medium and long period

In this class we will look at the functioning of the goods market in the short period. Underlying question: what is it that determine the level of GDP in the short period? Aim: to develop a macroeconomic model of the good market Premise: short, medium and long period

The components of aggregate demand Following the decomposition presented in the preceding class, aggregate demand is the sum of: Consumption (C) Investments (I) Government expenditure (G) Balance between export and import (X  Q) Aggregate demand (Z): Z  C + I + G + X  Q

To illustrate the model that examines the good market we introduce some simplifying assumptions: 1)We ignore international exchanges We assume, X = Q = 0 and Z = C + I + G We examine a closed economy 2) We assume that there exist only one good used for consumption, investments and public expenditure -> only one market The components of aggregate demand

3)With respect to the variables that we examine we employ two alternative approaches: For some variables, we define a behavioural equation: equation that describes the decisional rule followed by the relevant subjects in making their decisions -> endogenous variables (determined inside the model) For the other variables, we consider a given and fixed value (no behavioural equation) -> exogenous variables (determined outside the model) The components of aggregate demand

Under our hypotheses Z = C + I + G Let’s now examine the distinct components of demand (C, I, G) The components of aggregate demand

Consumption (C) To describe aggregate consumption we use a behavioural equation -> endogenous variable Consumers’ behaviour: Consumers purchase more goods the greater their income The type of income that we have to consider is the income neat of taxes (“disposable income”) The components of aggregate demand

It means that: C=C(Y D ) + Consumption is an increasing function of disposable income (Y D ) Important: Disposable income (Y D ) is the income minus the taxes Y D = Y –  T where, Y is income and T is taxes The components of aggregate demand

For simplicity we use a linear function C = C 0 + c 1 Y D whereC 0, c 1 are parameters Interpretation of parameters: a) C 0 – Autonomous consumption It is the term that captures all that part of consumption that do not depend on disposable income It is affected by several factors, such as: financial wealth, trust in the feature, preferences The components of aggregate demand

C = C 0 + c 1 Y D b) c 1 – Marginal propensity to consume It captures how the increase in consumption if the disposable income increases by one unit Assumption 0 < c 1 <1 It means that: Consumption increases with disposable income The increase in consumption is smaller than the increase in disposable income (a portion of income is saved) The components of aggregate demand

For instance, if c 1 = 0,6 For every euro additional unit of disposable income 60 cents will be used to finance consumption and 40 cents will be saved. The components of aggregate demand

Graphically: C = C 0 +c 1 Y D

Investments (I) and Government expenditure (G) Let’s consider their value as a constant (exogenous variable) I  I 0 and G  G 0 where I 0, G 0 are parameters Similarly, let’s consider taxes (T) as exogenous, so that T  T 0 where T 0 is a parameter The components of aggregate demand

Exogeneity of I = Simplifying assumption it will be removed later Exogeneity of G and T = Variables that are “chosen” buy the Government The analysis of fiscal policy looks at the effects of the choices of different values for G and T The components of aggregate demand

Let’s start again from the aggregate demand equation Z = C + I + G Let’s plug in the equation for C Z = C 0 + c 1 Y D + I + G Substituting away for the definition of Y D we get Z = C 0 + c 1 (Y  T) + I + G Replacing the constant values of I, G e T we obtain Z = C 0 + c 1 (Y  T 0 ) + I 0 + G 0 The components of aggregate demand

Given the equation Z = C 0 + c 1 (Y  T 0 ) + I 0 + G 0 Let’s change the order of the terms Z = c 1 Y + C 0  c 1 T 0 + I 0 + G 0 Let’s collect the components of demand that do not depend on income, and let’s call them AE (autonomous expenditure) Z = c 1 Y + AE Equation of aggregate demand -> it represents aggregate demand as a function of income. The components of aggregate demand

Graficamente: Z = c 1 Y+AE

Determination of the equilibrium level of income The analysis of a market usually represents the analysis of its equilibrium Market in equilibrium -> Microeconomics (Part I) The equilibrium of a market is the state in which demand is equal supply Equilibrium condition in the goods market: Demand of goods = Supply of goods Aggregate demand of goods = Z

What is the aggregate supply of goods? Let’s assume that firms do not have goods in stock: Supply = Goods that are produced in the economy = Aggregate supply We know from lectures 8 and 9 that: The measure of aggregate production is GDP GDP = Total income of the economy = = Aggregate income = Y Determination of the equilibrium level of income

Therefore, the equilibrium condition in the market for goods is: Z =Y Given the equations Z  c 1 Y + AE Z  Y We obtain that in equilibrium: Y  c 1 Y + AE Determination of the equilibrium level of income

From which we obtain that: (1  c 1 )Y  AE Y E  AE where Y E is the equilibrium level of production This result shows the value of production in equilibrium as a function of constants and parameters In particular Y E is equal to the product of: AE = autonomous expenditure = the “multiplier” Determination of the equilibrium level of income

The multiplayer: It is called multiplier because it “multiplies” autonomous expenditure It is always greater than 1 (0<c 1 <1, by assumption) It grows with c 1 It depends on the assumptions concerning the exogenous and endogenous variables (it is not always 1/(1 – c 1 ) ) Determination of the equilibrium level of income

Graphical analysis of equilibrium: Demand -> Z = AE+c 1 Y Supply -> Y -> 45° lines Equilibrium -> Y=Z -> intersection between the two curves (E) Equilibrium -> point E -> Y=Y E Z Z 45° E Y YEYE, Y AE

What is the effect of a tax reduction on income (GDP)?  Z = AE+c 1 Y where AE = C 0  c 1 T 0 + I 0 + G 0  T 0 -> AE -> AE’ Z Z 45° E Y YEYE, Y AE AE’ Z’Z’ E’E’ YE’YE’

In the short period, the equilibrium in the good market is found by equalizing aggregate demand and aggregate supply This condition allows us to identify the equilibrium level of income (i.e. the level of GDP). Changes in some of the exogenous variables (e.g. T, G) affects the short period level of income Do these effects persist also in the long-period? …. more on this in future classes….. Conclusion

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