The goods market: some exercise

academic year 2015/16Introduction to Economics

Augusto Ninni

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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 (2008-09)?

Questions of the day

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• 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 (2008-2009)• Savings and investments in equilibrium

Plan of the day

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We write the equations which describe the components of aggregate demand

Consumption is endogenous (behavioural equation) C = 100 + 0,6YD

Investments, public expenditure and taxes are exogenous (constant values) I = 50 G = 250 T = 100

Which is the value of production in equilibrium (YE)?

Examples on the determination of GDP

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Aggregate demand Z is equal to Z = C + I + G

By substituting the equation C = 100 + 0,6 YD

Z = 100 + 0,6YD + I + G

By substituting the definition YD = YT Z = C0 + c1 (Y) + I + G

By substituting the values for I, G e T Z = 100 + 0,6 (Y100) + 50 + 250

So that Z = 0,6Y + 340

Examples on the determination of GDP

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We impose the equilibrium condition Z=Y, so that

Y = 0,6Y + 340

(10,6) Y = 340

Y = 340 = 850

Equilibrium income -> YE = 850

Which is the value of the multiplier?

Multiplier = 2,5

6,011

6,011

Examples on the determination of GDP

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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 (C0)

C0 = 100 -> 200

For the other variables we maintain the same values.

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Which is the equilibrium value of final product ?

Z = C + I + G =

= 200 + 0,6 (Y100) + 50 + 250 = 0,6Y + 440

Let’s impose the equilibrium condition Z=Y

Y = 0,6Y + 440

from which we get

YE = 440 = 1100601

1,

Variations in autonomous expenditure

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We obtained that C0 = 100 -> 200 caused YE = 850 -> 1100

An increase in C0 of about 100 caused an increase in YE of about 250

Why?

Variations in autonomous expenditure

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Explanation:

a) Autonomous consumption (C0) ->

b) Since consumption is a component of aggregate demand (Z=C+I+G) Aggregate Dem. ( Δ Z Δ C0) ->

c) Since in equilibrium Y=Z Production of the same degree (Δ Y Δ Z Δ C0)

If the effect of C0 stopped here we would have Δ Y Δ C0

Variations in autonomous expenditure

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However the effects continues. Indeed:

d) Since GDP Σ incomes Δ Y = Δ Aggregate income ->

e) Since consumption depends on income (C=C0+c1YD),

new Consumption (equal to c1 × ΔYD ) ->

f) Since consumption is a component of aggregate demand (Z=C+I+G), new Aggregate demand (ΔZ = c1 × ΔYD) ->

Variations in autonomous expenditure

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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

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In conclusion:

• C0 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 (c1<1)

Variations in autonomous expenditure

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The final increase in Y is greater than the initial one in C0 because of the mechanism that we have just described

Analytically this mechanism is represented by the multiplier (Multiplier -> “multiplies” the variations in autonomous expenditure)

Variations in autonomous expenditure

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Multiplier• Suppose an increase in autonomous

expenditure: ↑ C0

• If the enterprises have spare capacity they react to the increase of the demand by increasing the utilization of the factors: by buying new equipment and hiring more workers (or letting the existing ones to work for a longer time)→ new demand for capital and labour

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• The managers of the capital equipment industry react by buying new capital equipment and by hiring more workers (or letting the existing ones to work for a longer time)→ new demand for capital and labour

• The workers utilize their new income by increasing their consumption expenditure..

• ↑ C, ↑ I• So on, at decreasing rates…

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Demand -> Z = SA+c1Y Supply -> Line at 45°Equilibrium -> Y=Z -> punto A -> Y=YA

ZZ

Z

45°

A

Y

YA

, Y

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The mechanism the we have just described can be expressed also graphically

Let’s see the effects of an increase in C0

C0 -> Z Z -> Y

ZZ

Z,Y

45°

A

ZZ’

BC

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Y -> C -> Z Z -> Yand so on…

ZZ

Z,Y

45°

A

ZZ’

BC

DE

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Final effect: A -> A’ , so that YA -> YA’

The increase in Y is greater then the one in C0

ZZ

Z,Y

45°

A

ZZ’

A’

YA

YA’B

C

DE

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The previous results hold for all component of autonomous expenditure

In particular, since

YE = AE -> ΔYE = ΔAE

where ΔAE is the variation in autonomous expenditure

111c 11

1c

Variations in autonomous expenditure

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ΔAE = Δ of its components

so that

ΔYE = (ΔC0 + ΔI0 + ΔG0 c1 * ΔT0)

This implies that, in the short period, GDP depends on: •Variations in autonomous consumption (C0)

•Variations in the choices of investors (I0)

•Variations in the choices of government on taxes (T0) and public expenditures (G0)

111c

Variations in autonomous expenditure

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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 2008-09 in Italy

Variations in autonomous expenditure

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Expansion of the US during the 90s

In the period 1993 - 2000 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

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We saw that

ΔYE = (ΔC0 c1 * ΔT0 + ΔI0 + ΔG0)

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 -> I0

111c

Expansion of the US during the 90s

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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 -> C0

Expansion of the US during the 90s

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In particular, on average:

1993-2000 1996-2000Consumption + 3,4% + 4%Investments + 6,7% + 8,4%GDP + 3,7% + 4,1%

I0 and C0 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

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2008-2009 Great Recession2nd semester of 2008 -> World financial crisis (“subprime crisis”)

Recession (negative growth) in (almost) all biggest world economies

2007 2008 2009 Italy 1.6% -1.3% -5.1%France 2.1% 0.3% -2.5%Germany 2.5% 1 % -4.9%EU 2.7% 0.5% -4.1%US 2% 0.4% -2.4%

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Let’s focus on the Italian economy

During the 2008-09 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?

2008-2009 Great Recession

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The financial crisis had an effect on investment and consumption

On the investment side:

•Difficulties in firms’ external financing -> (in the current model) I0

•Worsening of the expectations on profit -> (in the current model) I0

2008-2009 Great Recession

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On the consumption side:

•Decrease in income (increased unemployment) -> Yd -> c1 Yd -> C

•Fall in stock indices (cause by the worsening of the expectations on firms’ profitability) -> households’ financial wealth -> C0

•Worsening of the expectations on the future -> C0

2008-2009 Great Recession

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The dynamics of consumption and investments explain the dynamics of GDP

ITALY 2007 2008 2009 GDP 1.6% -1.3% -5.1%Consumption 1.6% -0,4% -1.2%Investments 1.3% -4% -12.1%

2008-2009 Great Recession

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The equilibrium condition on the goods 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

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Y - T - C + T - G = I

The expression Y - T – C is the difference between the available income and consumption -> private saving (Spr)

The expression T – G is the difference between the earnings and costs of the Government -> public saving(Spu)

By substituting in the original expression, we get

Spr + Spu= I

Private saving + public saving = saving (S)

Therefore, the equilibrium condition suggests thatS = I

Savings and investments in equilibrium

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In equilibrium, investments equal savings -> Say’s Law

It is an alternative way of defining the equilibrium in the goods marketBUT PAY ATTENTION, WE ARE REFERRING TO A CLOSED ECONOMY…..

Savings and investments in equilibrium

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