Chapter 3 eco202

The goods market

The composition of GDP
Consumption (C) these are the goods and services purchased by
consumers, ranging from food to airline tickets to vacations to new
cars.
Consumption is by far the largest component of GDP
Investment (I) called fixed investment to distinguish it from inventory
investment. Investment is the sum of non-residential
investment (the purchases by firms of new plants or new
machines) and residential investment (the purchases of new
houses)
Government Spending (G) represents the purchases of goods and
services by the federal, provincial and local governments. The goods
range from airplanes to office equipment. The services include services
provided by govt employees.
Govt transfers are not included in govt spending.
(employment insurance, old age security or interest payments
on govt debt)
Exports Imports = Net exports = Trade balance
Exports > Imports - Trade surplus
Exports < Imports Trade deficit

The difference between goods produced and goods sold (production

and sales) is called inventory investment (Is)subscript S for stocks
of goods
o If production exceeds sales, firms accumulate inventories.
Inventory investment is positive
o If production is less than sales, firms decrease inventories.
Inventory investment is negative.

The demand for goods

Z=C+I+G+XQ
*Note that this equation is an identity. Defines Z as the
sum of consumption, plus investment, plus government spending, plus
exports, minus imports.
When an economy is closed, X = Q = 0 (exports = imports = 0)
Z= C + I + G

Consumption ( C )
o Disposable income as main determinant (received govt transfers
and paid taxes)
o Disposable income increases, consumption increases.
Consumption function:
C = C(Yd)
(+)
Disposable income :
Yd = Y T (identity equation)
(Where Y is income and T is taxes paid minus govt
transfers)
*two major taxes are income tax and payroll tax
Behavioural equation Equation that reflects some aspect of
behavior. When the disposable income goes up, so does consumption.
(equation affected by behavior of consumers)
Relationship between consumption and disposable income:
C = c0 + c1(Yd)
C = c0 + c1( Y- T)

The function is a linear relation

Characterized by two parameters, c0 and c1.
C1 is the propensity to consumer (aka marginal
propensity to consume) - gives the effect of an
additional dollar of disposable income on
consumption.
o If c1 equals to 0.6 then the additional dollar of
income incrases consumption by $1 x 0.6 = 60
cents
o A natural restriction on c1 is that it be
positive : An increase in disposable income is
likely to lead to an increase in consumption

o Another natural restriction is that c1 be less

than 1 : People are likely to consume only part
of any increase in income and to save the rest
C0 - is what people would consume if their
disposable income(Yd) in the current year were
equal to zero : If Yd equals zero, C = c0.
o A natural restriction is that if current
income(c0) is equal to zero, consumption is
still positive : People must eat!
o How is consumption positive when income is
zero?
Dissaving by selling some assets or by
borrowing
o If this value(c0) is larger , then consumers
increase their consumption(decrease their
savings) at the same level of disposable
income
o It is possible that consumption falls(savings
increase) at the level of disposable income
would be represented by a smaller value of c0.

* consumption is a function of income and taxes

Investment ( I )
o Two types of variables :
Endogenous depends on other variables in the model and
are therefore explained within the model.
Exogenous Are not explained within the model but are
instead taken as a given.
I = I (theres a bar on top , indicating we take
investment as a given)

Innocuous - When we look at the effects of changes in production later, we

Government Spending ( G )
o Together with taxes ( T ) , G describes fiscal policy the choice
of taxes and spending by government.
o We will take G and T as exogenous , based on two considerations
:

Govt do not behave with the same regularity as do

consumers or firms, there is no reliable rule. They are
however predictable.
One of the tasks of macroeconomists is to advise
governments on spending and tax decisions. Meaning we
do not want to look at a model in which we have already
assumed something about their behavior.

The determination of equilibrium output

Z = C + I + G *(identity equation)

Z = c0 + c1(Y T) + I + G

Assume that firms do not hold inventories so that the supply of goods
is equal to production (Y). Then, equilibrium in the goods market
requires that the supply of goods(Y) equal to the demand for goods(Z):
Y=Z
(Y is the supply of goods and Z is the demand for goods)
(Equilibrium condition)

Models include three types of equation :

Identities the equation defining disposable income is an
identity
Behavioral equation the consumption function is a
behavioral equation
Equilibrium condition the condition that supply equals
demand
Y = c0 + c1 ( Y T ) + I + G
(Production (Y) must equal to demand)
o Two ways of looking at GDP production and
income
o Demand determines production ( equilibrium
condition), production is equal to income and
income determines demand

3 tools
1. Algebra to make sure that the logic is right
2. Graphs to build the intuition
3. Words to explain the results
Using Algebra
Y = c0 + c1Y c1T + I + G
Move c1Y to the left side and reorganize the right and the left sides:
(1-c1)Y = c0 + I + G c1T
( c0 + I + G - c1T )
(the part of the demand for goods that does not depend on output (autonomous
spending)(independent of output)

Divide both sides by (1-c1)

Y = (c0 + I + G c1T) / 1-c1
(c0 and I are positive)

o C0 and I are positive, suppose that government is having a balanced

budget (taxes equal govt spending) T=G, and the propensity to
consumer (c1) is less than 1, then (G-c1T) is positive and so is
autonomous spending.
o Only if govt ran a very large budget surplus if taxes were much
larger than govt spending could autonomous spending be negative
If T = G
G = c1T = G c1G
= G(1 c1)
> 0 if c1 < 1
Multiplier
o 1/(1-c1) , c1 being the marginal propensity to consume is between 0
and 1, 1/(1-c1) is a number greater than 1. Multiplies autonomous
spending. The closer c1 is to 1 , the larger the multiplier
o Any increase in autonomous spending from an increase in investment
to an increase in govt spending to a reduction in taxes will have the
same qualitative effect as an increase in consumption/c0. It will
increase output by more than its direct effect on autonomous spending

Using a graph (pg49)

The relationship between demand and income function :

Z = c0 + c1(Y-T) + I + G
Demand depends on autonomous spending and income through its effect

o The effects of an increase in autonomous spending on output

An increase in autonomous spending has a more than onefor-one effect on equilibrium output
o Equilibrium holds when production equals demand
o Geometric series
1 + c1 + c1^2 + . + c1^n
main property is that when c1 is less than one and as n
gets larger and larger, the sum keeps increasing but
approaches a limit.
Limit is 1/(1-c1) (aka the multiplier)
Using words
o Production depends on demand, which depends on income, which is
itself equal to production
o An increase in demand, such as an increase in govt or in consumer
spending, leads to an increase in production and a corresponding
increase in income.
o The end result is an increase in output that is larger than the initial
shift in demand, by a factor equal to the multiplier
o The size of the multiplier is directly related to the value of the
propensity to consume : the higher the MPC, the higher the multiplier
o Ex. The MPC in Canada today is around 0.6 , an additional dollar
of disposable income(Yd) leads on average to an increase in
consumption of 60 cents. This implies that the multiplier equals
to 1/(1-0.6) = 2.5
Dynamics of adjustment describing the adjustment of output over time
o How long firms take to adjust depends on how and how often
they revise their production schedule.
o The more often firms adjust their production schedule and the
larder the response of production to past increase in purchases,
the faster is the adjustment
o Output does not jump to the new equilibrium just because
income increases but rather increases over time from Y to Y
Investment equals saving : An alternative way of thinking about goods
Market Equilibrium
Focusing on investment and saving
o The General Theory of Employment , Interest and Money
Private saving (S) saving by consumers, is equal to their
disposable income minus their consumption
S = Yd - C

Using the definition of disposable income, we can rewrite

private savings as income minus taxes(minus govt trans)
minus consumption
S = Y T C (*identity equation)
Now return the equation for equilibrium in the goods
market. Production must be equal to demand, which, is the
sum of consumption , investment and govt spending
Y = C + I +G
Subtract taxes(T) from both sides and move consumption
to the left side
Y-TC=I+GT
The left side of this equation is simply private savings (S)
so that
S=I+GT
Or
I = S + (T G)

I = S + (T G)
(Investment = private savings + public savings)

Equilibrium in the goods market requires that

investment equals saving ( the sum of private
and public saving )
Investment equal saving (IS relation) what
firms want to invest must be equal to what
people and the government want to save
Investment decisions are made by firms and
saving decisions are made by consumers and
the government
o Has to be consistent investment has to
equal to savings
o Consumption and saving decisions are
one and the
same

The way we specified consumption behavior implies that

private saving is given by:
S = -c0 +(1-c1)(Y T)

C1 is the propensity to consumer , (1-c1) is the propensity to save

MPS tells us how much people save out of an additional
unit of income
MPC is between zero and one as well as MPS (private
saving increases with disposable income but by less than
one dollar for each additional dollar of disposable income
Replacing the private saving in equilibrium
I = -c0 + (1-c1)(Y T) + (T G)
Solving for output
Y = 1/(1-c1) (c0 + I + G c1T)

Is Government Omnipotent? A warning

The effects of spending and taxes on demand are much less
mechanical. They happen slowly, consumers and firms may be scared
of the budget deficit and change their behavior.
Maintaining a desired level of output may come with unpleasant side
effects. Trying to achieve too high a level of output maybe lead to
accelerating inflation and may become unsustainable in the medium
run
Cutting taxes or increasing government spending may lead to large
budget deficits and an accumulation of public debt. Such debt will have
adverse implications in the long run
Summary
GDP is the sum of consumption plus investment plus govt spending plus
exports minus imports plus inventory investment
Consumption (C) is the purchase of goods and services by consumers.
Consumption is the largest component of GDP/demand
Investment (I) is the sum of non-residential and residential investment
the purchase of new plants or machines and of new hours or apartments
Government spending (G) is the purchase of goods and services by
federal , provincial and local governments
Exports (X) are purchases of Canadian goods by foreigners. Imports (Q)
are purchases of foreign goods by Canadian consumers, Canadian firms
and the Canadian government.
Inventory Investment (Is) is the difference between production and sales.
It can be positive or negative
In short run, demand determines production. Production is equal to
income and income determines demand
The consumption function shows how consumption depends on
disposable income. The propensity to consume describes how much
consumption increases for a given increase in disposable income

 Equilibrium output if the point at which supply equals demand. In

equilibrium, output equals autonomous spending times the multiplier.
Autonomous spending is that part of demand that does not depend on
income. The multiplier is equal to 1/1(1-c1) , where c1 is the propensity
to consume
Increases in consumer confidence, in investment demand or in
government spending or decrease in taxes all increase equilibrium
output in the short run
An alternative way of stating the goods-market equilibrium condition is
that investment must equal to saving, the sum of private and public
saving. For this reason, the equilibrium condition in goods market is also
called the IS relation(Investment saving)

I,G,T are exogenous (taken as given)

We can solve for equilibrium output Y* and obtain the multiplier
Y = 1/ (1-G) [1+G + c0 c1T] -> example of multiplier equation
Remember that Y=Z and I=S and vice versa

Missing tow related features

1. Interest rates investment decisions are driven by how costly it is to
borrow
2. Money modern economies have central banks that try to effect the
interest rate, and economic activity through adjusting money supply
What is money?
Why do we use it?
o Double coincidence of wants
o Samuelson store of value
Other savings
Bonds
o A bond is an IOU
o Firm issue these to fund their businesses
o Government issue them to pay the bills when tax revenue does not
cover expenditures
Financial markets
- Income : a flow of compensation per unit of time
- Wealth : a stock variable at a given point in time. Equal to financial
assets minus financial liabilities
- Money : a stock variable equal to financial assets used for transactions.
Is equal to currency plus chequable deposits
- Investment : the purchase of new capital goods
Assumptions
o One type of bond
With an associated interest rate
o Two financial assets
Money : used for transactions
Bond
o