AITANA ROMEO GARCA

CHAPTER 2: THE GOODS MARKET

Quick Check
1. Using the information in this chapter, label each of the following statements
true, false or uncertain. Explain briefly.
a) The largest component of GDP is consumption.
TRUE: Consumption are the goods and services purchased by consumers,.
Consumption is by far the largest component of GDP. In 2008, it accounted, on
average, for 57.3% of GDP in the EU (EU15). In general, consumption is close to 60%
or more of national income in the largest European economies. in smaller countries
consumption tends to be closer to 50% of GDP.
b) Government spending, including transfers, was equal, on average, to 20.9% of
GDP in EU15 in 2008.
FALSE: Government spending does not include transfers(for instance, unemployment
benefits and pensions), or interest payments on the government debt.
c) The propensity to consume has to be positive, but other- wise it can take on
any positive value.
FALSE:It gives the effect an additional euro of disposable income has on consumption.
It must be positive; an increase in disposable income leads to an increase in
consumption. Also c1 must be less than 1: People are likely to consume only part of
any increase in disposable income and sabe the rest

d) Fiscal policy describes the choice of government spending and taxes and is
treated as exogenous in our goods mar- ket model.
TRUE: Government spending describes fiscal policy (the choice of taxes and spending
by the government. Just as we did for investment), we will take G and T as exogenous
because governments do not behave with the same regularity as consumers or firms
and also due to the implications of alternative spending and tax decisions.

e) The equilibrium condition for the goods market states that consumption equals
output.
FALSE: In equilibrium, production, Y (the left side of the equation), is equal to demand
(the right side). Demand in turn depends on income, Y, which is itself equal to
production.

f) An increase of one unit in government spending leads to an increase of one

unit in equilibrium output.
FALSE:Government spending belongs to the term [c0 + L + G c1T] is that part of the
demand for goods that does not depend on output. For this reason, it is called
autonomous spending (Autonomous means independent in this case, independent of
output).

g) An increase in the propensity to consume leads to a decrease in output.

TRUE: An increase in the propensity to consume leads to an increase in the final
output produced because there is an increase in demand.

2.Suppose that the economy is characterised by the following behavioural equations:

C = 180 + 0.8YD
I = 160
G = 160
T = 120
Solve for the following variables.
a. Equilibrium GDP (Y)
b. Disposable income (Y ) D
c. Consumption spending (C)

3.Use the economy described in problem 2.

a) Solve for equilibrium output. Compute total demand. Is it equal to production?
Explain.
The equilibrium output in problema 2 was 2020. As demand (Z) is equal to Z= C+I+G ,
the result would be 2020, the same as demand. This is due to the equilibrium condition
In equilibrium, production, Y (the left side of the equation), is equal to demand (the
right side). Demand in turn depends on income, Y, which is itself equal to production.

b) Assume that G is now equal to 110. Solve for equilibrium output. Compute total
demand. Is it equal to production? Explain.

c)Assume that G is equal to 110, so output is given by your answer to (b). Compute
private plus public saving. Is the sum of private and public saving equal to investment?
Explain.
Investment equals saving. IS relation, which stands for investment equals saving:
what firms want to invest must be equal to what people and the government want to
save.

Dig Deeper
4. The balanced budget multiplier
For both political and macroeconomic reasons, governments are often reluctant to run
budget deficits. Here, we examine whether policy changes in G and T that maintain a
balanced budget are macroeconomically neutral. Put another way, we examine
whether it is possible to affect output through changes in G and T so that the
government budget remains balanced.
Start from equation (3.8).
Y=

1=

1
( c 0+ I +Gc 1 T )
1c 1

a) By how much does Y increase when G increases by one unit?

Y increases by 1/ (1-c1)
b) By how much does Y decrease when T increases by one unit?
Y decreases by c1/ (1-c1)
c) Why are your answers to (a) and (b) different?
The answers are different because spending affects demand directly, but taxes
affect demand indirectly through consumption, and the propensity to consume is
less than one.
Suppose that the economy starts with a balanced budget: G = T. If the increase in G is
equal to the increase in T, then the budget remains in balance. Let us now compute the
balanced budget multiplier.

d) Suppose that G and T increase by one unit each. Using your answers to (a) and
(b), what is the change in equilibrium GDP? Are balanced budget changes in G
and T macroeconomically neutral?
The change in Y equals 1/(1-c1) c1/(1-c1)=1. Balance budgets changes in G are T
are

not

macroeconomically

neutral:

have

an

effect

on

demand.

e) How does the specific value of the propensity to consume affect your answer to
(a)? Why?
The propensity to consume has no effect because the balanced Budget tax increase
interrupts the multiplier process. Y and T both increase by one unit, so disposable
income, and hence consumption, do not change.
5. Automatic stabilisers
So far in this chapter, we have assumed that the fiscal policy variables G and T are
independent of the level of income. In the real world, however, this is not the case.
Taxes typically depend on the level of income and so tend to be higher when income is
higher. In this problem, we examine how this automatic response of taxes can help
reduce the impact of changes in autonomous spending on output.
Consider the following behavioural equations:
C=c0 +c1Yd
T= T0+T1Y
Yd=Y-T
G and I are both constant. Assume that t1 is between 0 and 1.

a) Solve for equilibrium output.

b) What is the multiplier? Does the economy respond more to changes in

autonomous spending when t1 is 0 or when t1 is positive? Explain.

The multiplier= 1/(1-c1+c1t1)<1/(1-c1), so the economy responds less to changes in
autonomous spending when t1 is positive. After a positive change in autonomous
spending, the increase in total taxes (because of the increase in income) tends to
reduce the increase in output. After a negative change in autonomous spending, the fall
in total taxes tends to reduce the decrease in output.

c) Why is fiscal policy in this case called an automatic stabiliser?

Because of the autonomic effect of taxes, the economy responds less to changes in
autonomous spending than in the case were taxes are independent of income. Since
output tends to vary less (to be more stable), fiscal policy is called an automatic
stabilizer.
6. Balanced budget versus automatic stabilisers
It is often argued that a balanced budget amendment would actually be destabilising.
To understand this argument, consider the economy of problem 5.
a) Solve for equilibrium output.
b) Solve for taxes in equilibrium.

Suppose that the government starts with a balanced budget and that there is a drop in
c0.
c) What happens to Y? What happens to taxes?

d) Suppose that the government cuts spending in order to keep the budget
balanced. What will be the effect on Y? Does the cut in spending
required to balance the budget counteract or reinforce the effect of the
drop in c0 on out- put? (Dont do the algebra. Use your intuition and give
the answer in words.)

Find the Spanish Total Public Sector Budget.

Plot S in Spain from 2005 onwards.

As we can see, savings in Spain were around 60,000 million eur between 2000-2005.
In 2006 they started to grow progressively, reaching a maximum og 130,000 million in
2009. Then, they started to fall down in the years 2010 and 2012 with a rate higher
than in 2005 but not as high as it was in 2009.

Chapter 9
QUICK CHECK
1. Using the information in this chapter, label each of the following statements true,
false or uncertain. Explain briefly.
a) Income and financial wealth are both examples of stock variables.
TRUE: financial wealth is the value of all your financial assets minus all your financial
liabilities, financial wealth is a stock variable. It is the value of wealth at a given moment
in time. At a given moment in time, you cannot change the total amount of your

financial wealth. In contrast to income, which is a flow variable.

b) The term investment, as used by economists, refers to the purchase of

bonds and shares of stock.
FALSE: Investment is a term economists reserve for the purchase of new capital
goods, from machines to plants to office buildings. If we want to talk about the purchase of shares or other financial assets, we should refer them as financial investment.