The Goods Market Chapter 3

© 2013 Pearson Education, Inc. All rights reserved The Composition of GDP Table 3-1 The Composition of U.S. GDP, 2010

© 2013 Pearson Education, Inc. All rights reserved.3-3 The composition of GDP Consumption (C): The goods and services purchased by consumers. Nonresidential Investment: The purchase by firms of new plants or new machines. Residential Investment: the purchase by people of houses or apartments. Government Spending (G): The purchases of goods and services by the state and local governments. G does not include transfer payments. Net Exports: The difference between exports and imports. Inventory Investment: The difference between production and sales

© 2013 Pearson Education, Inc. All rights reserved.3-4 The Demand for Goods Three assumptions: There is only one good. Firms are willing to supply any amount of the good at a given price. The economy is closed.

© 2013 Pearson Education, Inc. All rights reserved.3-5 Consumption The function is a linear relation. c 1, is (marginal) propensity to consume, the increase in consumption for every extra unit of disposable income. c 0, which represents how much consumption would occur even if disposable income were zero, is called autonomous consumption.

© 2013 Pearson Education, Inc. All rights reserved The Demand for Goods Figure 3-1 Consumption and disposable income

© 2013 Pearson Education, Inc. All rights reserved The Demand for Goods C is a function of income and taxes. Higher income and lower taxes increases consumption, but less than one for one. I is an exogenous variable, which is not explained in the model but are instead taken as given. C is endogenous variable because it depends on other variables in the model.

© 2013 Pearson Education, Inc. All rights reserved The Determination of Equilibrium Output In equilibrium, production, Y, is equal to demand. Demand in turn depends on income, Y, which is itself equal to production.

© 2013 Pearson Education, Inc. All rights reserved The Determination of Equilibrium Output Equation (3.8) is the algebraic solution. The second term is autonomous spending. It is positive, assuming budget surplus (T-G) is not very large. First term is multiplier. An increase in c 0 increases demand. The increase in demand then leads to an increase in production. The increase in production leads to an equivalent increase in income. The increase in income further increases consumption, and so on.

© 2013 Pearson Education, Inc. All rights reserved The Determination of Equilibrium Output Figure 3-2 Equilibrium in the goods market When income increases by 1, demand increases by c 1. ZZ is upward sloping but has a slope less than 1. 1.Plot production as a function of income, 45-degree line. 2.Plot demand as a function of income, ZZ. 3.In equilibrium, production equals demand.

© 2013 Pearson Education, Inc. All rights reserved The Determination of Equilibrium Output Figure 3-3 The effects of an increase in autonomous spending on output The increase in output is larger than the initial increase in consumption of 1 billion. This is the multiplier effect.

© 2013 Pearson Education, Inc. All rights reserved.3-12 Multiplier Effect The first round increase in demand of 1 billion (AB) 1 billion increase in production (AB) 1 billion increase in income (BC) the second round of increase in demand is 1 billion multiplied by c 1 – hence, $c 1 billion (CD) equal increase in production (CD) and income (DE) the third round of increase in demand is $c 1 billion multiplied by c 1, which is $c 1 2 billion.

© 2013 Pearson Education, Inc. All rights reserved.3-13 Multiplier The total increase in production after n+1 rounds is 1 billion multiplied by: 1+ $c 1 + $c $c 1 n The eventual increase in output is $1/(1- c 1 ) billion. The size of the multiplier depends on the value of propensity to consume. The higher the propensity, the higher the multiplier.

© 2013 Pearson Education, Inc. All rights reserved.3-14 Focus: The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the Consumption Function Figure 1 Disposable income, consumption, and consumption of durables in the United States, 2008:1 to 2009:3

© 2013 Pearson Education, Inc. All rights reserved.3-15 Focus: The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the Consumption Function Figure 2 Google search volume for “Great Depression,” January 2008 to September 2009

© 2013 Pearson Education, Inc. All rights reserved Investment Equals Saving: An Alternative Way of Thinking about Goods—Market Equilibrium S= Y D - C S=Y –T - C. Y=C + I+ G Y – T – C = I + G - T Equilibrium in the goods market requires that investment equal saving- the sum of private saving and public saving.

© 2013 Pearson Education, Inc. All rights reserved.3-17 S= Y D - C S=Y –T - C. =Y – T - c 0 - c 1 ( Y –T ) S= 1-c 1 is the propensity to save Equation (3.8) is equivalent to equation (3.12).