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© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/eMacroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

33C H A P T E RC H A P T E R

The Goods MarketThe Goods Market

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

The Composition of GDPThe Composition of GDP3-1

Table 3-1 The Composition of U.S. GDP, 2001

Billions of dollars

Percent of GDP

GDP (Y)GDP (Y) 10,20810,208 100100

1.1. Consumption (Consumption (CC) ) 7,0647,064 6969

2.2. Investment (Investment (II)) 1,6921,692 1717

NonresidentialNonresidential 1,2461,246 1212

ResidentialResidential 446446 55

3.3. Government spending (Government spending (GG)) 1,8391,839 1818

4.4. Net exportsNet exports 329329 33

Exports (Exports (XX)) 1,0971,097 1111

Imports (Imports (IMIM)) 1,4681,468 1414

5.5. Inventory investmentInventory investment 5858 11


The Composition of GDPThe Composition of GDP

Consumption (C)Consumption (C) refers to the goods and refers to the goods and services purchased by consumers.services purchased by consumers.

Investment (I),Investment (I), sometimes called sometimes called fixed fixed investment,investment, is the purchase of capital goods. is the purchase of capital goods. It is the sum of It is the sum of nonresidential investmentnonresidential investment and and residential investment.residential investment.



Government Spending (G)Government Spending (G) refers to the refers to the purchases of goods and services by the purchases of goods and services by the federal, state, and local governments. It does federal, state, and local governments. It does not include not include government transfersgovernment transfers, nor , nor interest payments on the government debt.interest payments on the government debt.

Imports (IM)Imports (IM) are the purchases of foreign are the purchases of foreign goods and services by consumers, business goods and services by consumers, business firms, and the U.S. government.firms, and the U.S. government.

Exports (X)Exports (X) are the purchases of U.S. goods are the purchases of U.S. goods and services by foreigners.and services by foreigners.



Net exports (X Net exports (X IM) IM) is the difference between is the difference between exports and imports, also called the exports and imports, also called the trade trade balancebalance..

E xports > im ports trade surp lus

E xports < im ports trade defic it

E xports = im ports trade ba lance

Inventory investmentInventory investment is the difference is the difference between production and sales.between production and sales.


The Demand for GoodsThe Demand for Goods

The total demand for goods is written as:The total demand for goods is written as:

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Z C I G X IM The symbol “The symbol “” means that this equation is an ” means that this equation is an

identityidentity, or definition., or definition. Under the assumption that the economy is Under the assumption that the economy is

closed, closed, X = IMX = IM = 0, then: = 0, then:

Z C I G


Consumption (Consumption (CC))

Disposable income,Disposable income, ( (YYDD),), is the income that is the income that

remains once consumers have paid taxes and remains once consumers have paid taxes and received transfers from the government.received transfers from the government.

C C YD ( )( )

The function The function CC((YYDD) is called the ) is called the consumption consumption

function.function. It is a It is a behavioral equationbehavioral equation, that is, , that is, it captures the behavior of consumers.it captures the behavior of consumers.

Y Y TD



A more specific form of the consumption A more specific form of the consumption function is this function is this linear relationlinear relation::

C c c YD 0 1

This function has two This function has two parametersparameters, , cc00 and and cc11::

cc11 is called the (marginal) is called the (marginal) propensity to propensity to

consumeconsume, or the effect of an additional dollar , or the effect of an additional dollar of disposable income on consumption.of disposable income on consumption.

cc00 is the intercept of the consumption is the intercept of the consumption

function.function.



Consumption and Consumption and Disposable IncomeDisposable Income

Consumption increases with disposable income, but less than one for one.

C C YD ( )

Y Y TD C c c Y T 0 1 ( )


Investment (Investment (II))

Variables that depend on other variables Variables that depend on other variables within the model are called within the model are called endogenousendogenous. . Variables that are not explain within the model Variables that are not explain within the model are called are called exogenousexogenous. Investment here is . Investment here is taken as given, or treated as an exogenous taken as given, or treated as an exogenous variable:variable:

I I


Government Spending (Government Spending (GG))

Government spending, Government spending, GG, together with taxes, , together with taxes, TT, describes , describes fiscal policyfiscal policy—the choice of taxes —the choice of taxes and spending by the government.and spending by the government.

We shall assume that We shall assume that GG and and TT are also are also exogenous.exogenous.


The Determination ofThe Determination ofEquilibrium OutputEquilibrium Output

Equilibrium in the goods marketEquilibrium in the goods market requires requires that production, that production, YY, be equal to the demand for , be equal to the demand for goods, goods, ZZ::

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Y c c Y T I G 0 1 ( )

Y ZThen:Then:

The The equilibrium conditionequilibrium condition is that, is that, production, production, YY, be equal to demand. Demand, , be equal to demand. Demand, ZZ, in turn depends on income, , in turn depends on income, YY, which itself , which itself is equal to production.is equal to production.


Using AlgebraUsing Algebra

The equilibrium equation can be manipulated The equilibrium equation can be manipulated to derive some important terms:to derive some important terms: Autonomous spending and the multiplierAutonomous spending and the multiplier::

Y c c Y T I G 0 1 ( )

( )1 1 0 1 1 c Y c c I G c T

Yc

c I G c T

1

1 10 1[ ]

multiplier autonomous spending


Using a GraphUsing a Graph

Equilibrium in the Goods Equilibrium in the Goods MarketMarket

Equilibrium output is determined by the condition that production be equal to demand.

Z c I G c T c Y ( )0 1 1



The Effects of an The Effects of an Increase in Autonomous Increase in Autonomous Spending on OutputSpending on Output

An increase in autonomous spending has a more than one-for-one effect on equilibrium output.



The multiplier is the sum of successive The multiplier is the sum of successive increases in production resulting from an increases in production resulting from an increase in demand.increase in demand.

When demand is, say, $1 billion higher, the When demand is, say, $1 billion higher, the total increase in production after total increase in production after nn rounds of rounds of increase in demand equals $1 billion times:increase in demand equals $1 billion times:

This sum is called a This sum is called a geometric seriesgeometric series..

1 1 12

1 c c c n. . .


Using WordsUsing Words

To summarize:To summarize: An increase in demand leads to an increase in An increase in demand leads to an increase in

production and a corresponding increase in income. production and a corresponding increase in income. The end result is an increase in output that is larger The end result is an increase in output that is larger than the initial shift in demand, by a factor equal to than the initial shift in demand, by a factor equal to the multiplier.the multiplier.

To estimate the value of the multiplier, and To estimate the value of the multiplier, and more generally, to estimate behavioral more generally, to estimate behavioral equations and their parameters, economists equations and their parameters, economists use use econometricseconometrics—a set of statistical —a set of statistical methods used in economics.methods used in economics.


How Long Does It TakeHow Long Does It Takefor Output to Adjust?for Output to Adjust?

In response to an increase in consumer In response to an increase in consumer spending, output does not jump to the new spending, output does not jump to the new equilibrium, but rather increases over time. equilibrium, but rather increases over time. The adjustment depends on how and how The adjustment depends on how and how often firms revise their production schedule.often firms revise their production schedule.

Describing formally the adjustment of output Describing formally the adjustment of output over time is what economists call the over time is what economists call the dynamicsdynamics of adjustment. of adjustment.


Consumer Confidence and the 1990-Consumer Confidence and the 1990-1991 Recession1991 Recession

A A forecast errorforecast error is the difference between the is the difference between the actual value of GDP and the value that had actual value of GDP and the value that had been forecast by economists one quarter been forecast by economists one quarter earlier.earlier.

The The consumer confidence indexconsumer confidence index is is computed from a monthly survey of about computed from a monthly survey of about 5,000 households who are asked how 5,000 households who are asked how confident they are about both current and confident they are about both current and future economic conditions.future economic conditions.


Consumer Confidence and the 1990-Consumer Confidence and the 1990-1991 Recession1991 Recession

Table 1 GDP, Consumption, and Forecast Errors, 1990-1991

Quarter

(1)Change inReal GDP

(2)Forecast Error

for GDP

(3)Forecast

Error for c0

(4)Index of Consumer

Confidence

1990:21990:2 1919 1717 2323 105105

1990:31990:3 2929 5757 11 9090

1990:41990:4 6363 8888 3737 6161

1991:11991:1 3131 2727 3030 6565

1991:21991:2 2727 4747 88 7777


Investment Equals Saving: An AlternativeInvestment Equals Saving: An AlternativeWay of Thinking about Goods-Market EquilibriumWay of Thinking about Goods-Market Equilibrium

SavingSaving is the sum of private plus public saving. is the sum of private plus public saving. Private savingPrivate saving ( (SS), is saving by consumers.), is saving by consumers.

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S Y CD S Y T C

Y C I G Y T C I G T S I G T I S T G ( )

Public savingPublic saving equals equals taxes minus government taxes minus government spending.spending. If T > G, the government is If T > G, the government is

running a running a budget surplusbudget surplus——public saving is positive.public saving is positive.

If T < G, the government is If T < G, the government is running a running a budget deficitbudget deficit——public saving is negative.public saving is negative.



The equation above states that equilibrium in The equation above states that equilibrium in the goods market requires that investment the goods market requires that investment equals saving—the sum of private plus public equals saving—the sum of private plus public saving.saving.

This equilibrium condition for the goods market This equilibrium condition for the goods market is called the is called the IS relationIS relation. What firms want to . What firms want to invest must be equal to what people and the invest must be equal to what people and the government want to save.government want to save.

I S T G ( )



Consumption and saving decisions are one Consumption and saving decisions are one and the same.and the same.S Y T C S Y T c c T T 0 1 ( )S c c Y T 0 11( )( )

The term (1The term (1cc) is ) is called the called the propensity to save.propensity to save.

In equilibrium:In equilibrium:

Yc

c I G c T

1

1 10 1[ ]

I c c Y T T G 0 11( )( ) ( )

Rearranging terms, we get the same result as Rearranging terms, we get the same result as before:before:


The Paradox of SavingThe Paradox of Saving

When consumers save more, spending When consumers save more, spending decreases and equilibrium output is lower.decreases and equilibrium output is lower.

Attempts by people to save more lead both to Attempts by people to save more lead both to a decline in output and to unchanged saving. a decline in output and to unchanged saving. This surprising pair of results is known as the This surprising pair of results is known as the paradox of savingparadox of saving (or the paradox of thrift). (or the paradox of thrift).


Is the Government Omnipotent?Is the Government Omnipotent?A WarningA Warning

Changing government spending or taxes may Changing government spending or taxes may be far from easy.be far from easy.

The responses of consumption, investment, The responses of consumption, investment, imports, etc, are hard to assess with much imports, etc, are hard to assess with much certainty.certainty.

Anticipations are a likely matter.Anticipations are a likely matter. Achieving a given level of output may come Achieving a given level of output may come

with unpleasant side effects.with unpleasant side effects. Budget deficits and public debt may have Budget deficits and public debt may have

adverse implications in the long run.adverse implications in the long run.

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Key TermsKey Terms

consumption (consumption (CC),), investment (investment (II),), fixed investment,fixed investment, nonresidential investment,nonresidential investment, government spending (government spending (GG),), government transfers,government transfers, Imports (Imports (IMIM),), exports (exports (XX),), net exports (net exports (XX IMIM),), trade balance,trade balance, trade surplus,trade surplus,

trade deficit, inventory investment, identity, disposable income (YD),

consumption function, behavioral equation, linear equation, parameter, propensity to consume (c1),

endogenous variables, exogenous variables, fiscal policy,

continued…continued…


Key TermsKey Terms

equilibrium,equilibrium, equilibrium in the goods market,equilibrium in the goods market, equilibrium condition,equilibrium condition, autonomous spending,autonomous spending, balanced budget,balanced budget, multiplier,multiplier, geometric series,geometric series, econometrics,econometrics, dynamics,dynamics,

forecast error,forecast error, consumer confidence index,consumer confidence index, private saving (S),private saving (S), public saving (T public saving (T G) G) budget surplus,budget surplus, budget deficit,budget deficit, saving,saving, IS relation,IS relation, propensity to save,propensity to save, paradox of saving,paradox of saving,

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