The Goods Market

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MACROECONOMICS II

November 5th, 2013

Lecture 7. The Core:

The Goods Market

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• Business Cycle

•Aggregate spending

• Equilibrium in the goods’ market

• Fiscal policy

• The Savings paradox

Class Outline

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The Short Run

Business cycle: short-run (year-to-year) fluctuations in real output and employment

The starting date: peak The ending date: trough

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The Short Run (Cont.)

• Fluctuations in real GDP are irregular and not predictable

Recession (contraction): a period of falling output and rising unemployment Recession rule of thumb: 2 consecutive quarters of negative GDP growth NBER Business Cycle Dating Committee

- Chooses a starting date of each recession The last cycle: December 2007 - June 2009 Number of cycles (1945-2009): 11 cycles

Out objectives

Study causes of the short-run fluctuations in real GDP

The role of government policies’ response to the business cycle fluctuations

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The US Real GDP in the Long Run

Source: Mankiw, 2012

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The US Real GDP Growth Rate

The average growth rate in the US economy was 3 %

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-3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0

2000Q2 2000Q4 2001Q2 2001Q4 2002Q2 2002Q4 2003Q2 2003Q4 2004Q2 2004Q4 2005Q2 2005Q4 2006Q2 2006Q4 2007Q2 2007Q4 2008Q2 2008Q4 2009Q2 2009Q4 2010Q2 2010Q4

Growth Rate, %

Greece Real GDP Growth Rate

Source: Eurostat

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So What?

%

• As the GDP

components, C and I decline during

recessions.

• Investments are more volatile

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So What? (Cont.)

Okun’s Law (1962)

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Explaining Short-Run Economic Fluctuations

J. Keynes (1936) The General Theory of Employment, Interest, and Money

• The economy is driven by demand

• Aggregate demand: spending plans of all economic agents

Expenditure approach to GDP

Y     C I G NX

N!B! The major reason behind recession is inadequate spending

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Spending Plans of Economic Agents

• Group I: Households

• Group II: Businesses

• Group III: Government

• Group IV: Foreign sector

Y     C I G NX

Closed economy

Y    C I G

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Components of GDP

USA (% of GDP)

EU

(% of GDP)

Consumption

67 57.3

Investment

15 20.8

Gov. spending

19 20.9

Net exports

-0.3 0.6

Inventories

-0.7 0.4

Source: Eurostat

Structure of GDP (2007)

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Firms Households

Labor

THE CIRCULAR FLOW MODEL

Bicycles

Expenditure ($)

Income ($)

Y

Total production = =Total income =

=Total expenditure

1

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The Goods’ Market

Goods market equilibrium

Y    C I G

Supply Firm’s output

Demand: Desired purchases Assumptions:

• One composite good => one market

• Prices and interest rates are fixed

• Closed economy (no international trade)

Aggregate Expenditure (AE)

AE    C I G

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Household Expenditure: Consumption (C)

 Determinants of household consumption

• Income (+)

Households

If Y => C but by a smaller amount, as people save

What does MPC=0.5 mean?

Marginal propensity to consume (MPC)

The proportion of extra dollar of income that consumers spend

•Always positive

• Between 0 and 1

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Consumption (Cont.)

Households

• Consumption is not constrained by current income

Autonomous consumption: consumption under zero income

C   a bY

Autonomous consumption

MPC

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What about your own consumption behavior?

What are your a and b?

C   a bY

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Consumption (Cont.)

C   a bY

C

Y a

0

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Investment (I)

Firms

I: Purchase of goods and services for the increase in future production I: Accumulation of inventories for the purpose of future sales

__

I  I

Assumption: Fixed investments

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Consumption + Investment

__

AE   C I

AE, C

Y a

0

C C+I

_

I

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Equilibrium in the Goods’ Market

Equilibrium: Aggregate demand = Aggregate supply

45⁰

AE  Y

AE

Y 100

100

C+I

Y*

Equilibrium

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Equilibrium in the Goods’ Market (Cont.)

 Convergence to equilibrium

45⁰

AE  Y

AE

Y

C+I

Y*

2

Y^H Y^L

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Equilibrium in the Goods’ Market (Cont.)

Aggregate demand = Output

N!B! From the circular flow diagram

__

AE Y

a bY I Y



  

Income Output Deriving equilibrium output Y*

*

1

__

( )

(1 )

Y a I

 b 



Autonomous spending Multiplier

What determines equilibrium output?

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The Multiplier

*

1

__

( )

(1 )

Y a I

 b 



As MPC < 1 => Multiplier > 1 What does it imply?

• Increase in autonomous spending would lead to a much larger increase in Y*

What effect on Y* would have an increase in MPC? Y* increases

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The Multiplier (Cont.)

TE For a given level of income consumers decide to consume more c₀ => C =>

Demand (AE) => Production (Y) ≡ Income (Y) => C => AE => Y => so on

TE Lets a increase by $1 mil.

If b=0.6, what is the size of the multiplier?

1 1

0.6 2.5

(1 ) 0.4 b   b  



2.5 $2.5

Y a mil

    

N!B! Any increase in autonomous spending will yield an effect on Y* 2.5 larger than the initial increase in spending

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The Multiplier (Cont.)

1. Buying a cake for 300 CZK

2. The pastry-cook spent 180 CZK on a dinner at his favorite Italian restaurant and saved the rest

3. Italian owner of the restaurant bough a T-shirt with a logo of his favorite music band for 108 CZK and saved the rest

And so on….

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The Multiplier (Cont.)

Total effect of your purchase on GDP

Consumption Savings (60 %) 300

180 120

108 72

64.8 43.2

….. …..

Total increase in Y = 300+180+108+64.8 + …… = 750

300 300 0.6 300 0.6 0.6 ....

300 1

1 0.6 300 2.5 750

      

 



  

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The Multiplier (Cont.)

 Comparative statics: Increase in autonomous consumption

45⁰

AE  Y

AE

Y

C+I

Y*

C`+I

Y`*

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The Role of the Government

Government

__

G  G

Direct effect: Government spending (G) Indirect effect: Taxes (T)

Budget deficit: G-T > 0 Balanced budget: G = T

Assumption: Fixed government spending

Fiscal policy

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The Effect of Taxation

Disposable Income = Income - Taxes Households

Y

D

  Y T

If Y^D => C , but by a smaller amount

( )

C   a bY

D

  a b Y  T

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Equilibrium in the Goods’ Market

Aggregate demand

Equilibrium output: Supply = Demand

__ __

AE   a bY

D

  I G

*

1

__

( )

(1 )

Y a I G bT

 b   



Multiplier Autonomous spending

AE 3

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AE

Y

4

Equilibrium in the Goods’ Market

*

1

__

( )

(1 )

Y a I G bT

 b   



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__ __

0 1 1

( )

AE  c    I G c T  c Y

Demand Z, Production Y

Income Y Autonomous

spending

Autonomous spending

Y*

AE

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Income Y

Y*

5

• Show the effect

of the increase in government

spending on GDP

• What is the

magnitude of this effect?

__ __

( )

AE  a    I G bT  bY

AE

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Income Y Y*

Y*

Increase in G

=> Larger increase in Y*

 G

Y`*

*

 Y

*

 Y

__ __

( )

AE  a    I G bT  bY

AE AE’

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Income Y

Y*

6

• Show the effect

of the increase in taxes on GDP

• What is the

magnitude of this effect?

__ __

( )

AE  a    I G bT  bY

AE

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Example

Suppose that the economy is characterized by the following

180 0.8 160

160 120

C Y

D

I G T

 



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Solve for the following variables:

1. Equilibrium GDP 2. Disposable income 3. Consumption spending

4. Compute total demand. Does it equal to production?

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An Alternative (Equivalent) Approach

The role of savings

• Savings are just non-consumption

S  Y

D

 C

_ _

( )

Y C I G Y C G I

S T G I

  

  

  

The equilibrium:

Public savings

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The Paradox of Savings

TE At the given level of disposable income households decide to save more

(1 )( )

S  Y

D

     C a b Y  T

The equilibrium:

• If a declines (people consume less) => people save more

• In the equilibrium S is fixed

• The only effect of the drop in consumption is a decrease in Y

N!B! As people attempt to save more => declining output and unchanged savings

Policies that encourage savings in the short run may lead to recessions TE German Recession of 2002-2003 due to increase in savings from 9 to 15 %

Marginal

propensity to save

_ _

( )

S  T  G  I