Lecture 3

The Goods Market
Chapter 3: The Goods Market
Chapter 3
1
Copyright 2012 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 6/e Olivier Blanchard
The Circular Flow
2
Introduction
in the Demand
in the Production
in the Income
In conclusion, the interactions between production,

income and demand determine the output (GDP) in
short run.
3
4
Introduction
Equilibrium Condition in Goods Market:
From the scope of Micro:
QS = QD , for commodity i
From the scope of Macro:

Production=Aggregate Demand
=Aggregate Expenditure
A different perspective on the components of GDP
5
Introduction:
The Expenditure Approach to Measuring GDP
Different sources of the demand for goods
The decision to go to a restaurant - by a consumer.
The purchase of a new car - by a consumer.
Building a new factory - by a firm.
The purchase of combat airplanes - by the government.
Etc.
Different buyers Different demand Different expenditure
Decomposing aggregate demand(expenditure)

into several categories is useful.
6
Introduction:
Components of Expenditure
The four groups of final users and their expenditures:
Households Consumption (C)

Firms Investment (I)
Governments Government Purchases (G)
Foreign Sectors Net Exports (NX)
Aggregate Expenditure = C + I + G + NX
7
3-1 The Composition of GDP

Consumption (C) refers to the (final) goods and services
purchased by consumers. (including those produced
abroad)
Three categories
- Consumer durables (examples: cars, TV sets, furniture,
major appliances)
- Nondurable goods (examples: food, clothing, fuel)
- Services (examples: education, health care, financial
services, transportation)
8

Investment (I), sometimes called fixed investment, is the purchase
of capital goods. It is the sum of nonresidential investment and
residential investment.
Business (or nonresidential) fixed investment: spending by
businesses on structures and equipment and software
Residential fixed investment: spending on the new

construction of houses and apartment buildings
Notes: Distinguish from fixed investment, the third type of investment is

inventory investment, which is the difference between production and
sales.
9
Government Spending (G) refers to the purchases of goods and

services by the federal, state, and local governments. It does not
include government transfers, nor interest payments on the
government debt.
10

Imports (IM) are the purchases of foreign goods and
services by consumers, business firms, and the U.S.
government.
Exports (X) are the purchases of U.S. goods and services
by foreigners.
Net exports (X IM) is the difference between exports

and imports, also called the trade balance.
E x p o r ts = im p o r ts
tr a d e b a la n c e
E x p o r ts > im p o r ts
tr a d e s u r p lu s
E x p o r ts < im p o r ts
tr a d e d e fic it
11
Table 3-1 The Composition of U.S. GDP, 2010
12
Examples
GDP Composition of Hong Kong, by end use (2012):

C: household consumption: 63.7%
G: government consumption: 9.1%
I: investment in fixed capital: 26.4% investment in inventories: -0.4%
NX: net exports: 1.3%
exports of goods and services: 224.8% imports of goods and
services: -223.5%
13
Practice
1. When calculating investment (I), which of the following expenditures would not be
included?
a) Dell computer buys a new robot for its assembly line.
b) A local auto dealer increases its inventories of unsold automobiles.
c) Ford Motor Company builds a new factory.
d) An individual buys a newly built house.
e) all of the above
2. Which of the following is included in U.S. GDP?
a) A newly constructed house
b) Obama receives a watch as a gift from a Swiss company
c) The sale of a new car from a manufacturer's inventory produced in previous
year
d) The sale of a used car
e) None of the above
3. Which of the following Item will NOT be included in consumption expenditure
a) A consumer purchases an bottle of imported wine.
b) A student purchases a new book from the book store
c) A family purchase a newly built house.
d) A family purchase a new car.
e) None of the above.
14
Practice
4. A consumer in Hong Kong Purchased a brand new BMW at $2 million directly

from Germany. Which of the following is correct in Hong Kong
a) Consumption increases by$2 million
b) GDP increases by $ 2million
c) Investment increase by $ 2millon
d) Net Export increases by $ 2 millon
e) None of the above
5. Which of the following is included in government spending?
a) A. The interests payment on government bonds.
b) B. Government subsidy for exporting firms.
c) C. Government donation for other countries
d) D. Government purchases for military aircrafts
e) E. None of the above
15
3-2 The Demand for Goods

The aggregate demand (Z) for goods is written as:
Z C I G X IM
The symbol means that this equation is an identity, or definition.
Component discussions:
Consumption C is a function of disposable income, YD
Investment I is as given, I
X = IM = 0, the economy is closed, then
Z C I G
16

Consumption (C)
Disposable income, (YD), is the income that remains once
consumers have paid taxes and received transfers from the
government.
YD Y T
The function C(YD) is called the consumption function. It is a

behavioral equation, that is, it captures the behavior of
consumers.
C C (Y D )
()
A more specific form of the consumption function is this linear

relation:
C c 0 c 1Y D
17

Consumption (C)
This function has two parameters, c0 and c1:
c1 is called the (marginal) propensity to consume, or the effect

of an additional dollar of disposable income on consumption.
0<c1<1
c0 - autonomous consumption, is the intercept of the
consumption function.
c0>0
18

Consumption (C)
Figure 3 - 1
Consumption and
Disposable Income
Consumption increases with

disposable income but less
than one for one.
C C (Y D )
YD Y T
C c 0 c1 (Y T )
19

Investment (I )
Variables that depend on other variables within the model are
called endogenous. Variables that are not explain within the
model are called exogenous.
Investment here is taken as given, or treated as an exogenous
variable:
I I
(Inventory investment is assumed to be zero.)
20

Government Spending (G)
Government spending, G, together with taxes, T, describes fiscal
policythe choice of taxes and spending by the government.
We shall assume that G and T are also exogenous for two

reasons:
Governments do not behave with the same regularity as

consumers or firms.
Macroeconomists must think about the implications of

alternative spending and tax decisions of the government.
21
3-3 The Determination of Equilibrium Output

Assuming that exports and imports are both zero, the demand
for goods is the sum of consumption, investment, and
government spending:
Then,
Equilibrium Condition: production, Y, is equal to demand, Z.

(Production/Income = Aggregate Demand)
As a result, equilibrium equation becomes:
22

Macroeconomists always use these three tools:
1. Algebra to make sure that the logic is correct
2. Graphs to build the intuition
3. Words to explain the results
23

Using Algebra
Rewrite the equilibrium equation:
Y c0 c1Y c1T I G
Move
c1Y to the left side and reorganize the right side:
1 c Y c
Divide both sides by
I G c1T
(1 c1 ) :
1
c0 I G c1T
Y
1 c1
24

Using Algebra
The equilibrium equation can be manipulated to derive some important
terms:
[c0 I G c1T]: autonomous(independent) spending.
Its likely to be positive, but not necessary.

If the government ran a balanced budget, then T=G.
Then, (G - c1T) = (T - c1T) = (1 - c1)T>0
If the government were running a very large budget surplus,
then autonomous spending could be negative.
Because the propensity to consume (c1) is between zero and one,

1
is 1a number
greater than one. For this reason, this number is
c
1
called the multiplier.
1
c0 I G c1T
Y
1 c1
25

Using a Graph
Z (c0 I G c1T ) c1Y
Figure 3 - 2
Equilibrium in the Goods
Market
Equilibrium output is determined

by the condition that production
be equal to demand.
First, plot production as

a function of income.
Second, plot demand as
a function of income.
In Equilibrium,
production equals
demand.
26
Sample Question
Suppose that the economy is characterized by the

following equations:
C=180+0.8(Y-T)
I=160
G=160
T=120
Solve for the following variables.
a.Equilibrium GDP (Y)
b.Disposable Income
c.Consumption
d.Assume now G=136. Solve for the equilibrium output.
27

Using a Graph
Figure 3 - 3
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.
28
Using a Graph
The first-round increase in
demand, shown by the
distance AB equals $1
billion.
This first-round increase
in demand leads to an
equal increase in
production, or $1 billion,
which is also shown by
the distance in AB.
This first-round increase
in production leads to an
equal increase in income,
shown by the distance in
BC, also equal to $1
billion.
29
Using a Graph
The second-round increase
in demand, shown by the
distance in CD, equals $1
billion times the propensity
to consume.
This second-round increase
in demand leads to an equal
increase in production, also
shown by the distance DC,
and thus an equal increase
in income, shown by the
distance DE.
The third-round increase in
demand equals $c1 billion,
times c1, the marginal
propensity to consume; it is
equal to $c1 x c1 = $
c12billion.
30

Using a Graph
Following this logic, the total increase in production after,
say, n + 1 rounds, equals $1 billion multiplied by the sum:
1 + c1 + c12 + + c1n
Such a sum is called a geometric series.

The limit is 1/(1-c1), the multiplier, making the eventual
increase in output $1/(1-c1) billion.
31

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

production and a corresponding increase in income.
The end result is an increase in output that is larger
than the initial shift in demand, by a factor equal to
the multiplier.
To estimate the value of the multiplier, and more
generally, to estimate behavioral equations and their
parameters, economists use econometricsa set
of statistical methods used in economics.
32
Sample Question
Complete the following Tables:
Productio Consumpti Investme

n
on
nt
$8,000
$6,900
$500
Governme
nt
Spending
$1000
Inventory
Investme
nt
Deman
d
$9,000
7,700
500
1000
$10,000
8,500
500
1000
$11,000
9300
500
1000
$12,000
10,100
500
1000
33
Practice
1.
2.
3.
4.
What is the equilibrium level of real GDP?

What is the MPC?
What is the multiplier of government spending?
If government spending and Tax both increase by
$1000, what is GDP, Consumption and Investment in
equilibrium?
34
3-4 Investment Equals Saving: An Alternative

Way of Thinking about Goods-Market
Equilibrium
Saving and Wealth

Wealth
the value of assets minus the value of liabilities.
Saving
the economic units current income minus its spending on current needs.
saving rate = saving/income
an important determinant of wealth
Measure of Aggregate Saving

Private saving
Public (Government) saving
National saving
35

Equilibrium
Saving is the sum of private plus public saving.
Private saving (S), is saving by consumers.
S YD C Y T C
Public saving equals taxes minus government
spending, T G
If T > G, budget surpluspublic saving is positive.

If T < G, budget deficitpublic saving is negative.
36

Equilibrium
An other way of thinking equilibrium

At equilibrium:
Y C I G
Subtract taxes (T) from both sides and move C to the left side:
Y T C I GT
Or equivalently,
YD C I G T
S I G T
I S (T G)
Investment = Saving(the sum of pvt and govt savings)

Another way of stating equilibrium condition in goods market
IS relation: What firms want to invest must be equal to what

people and the government want to save.
37

Equilibrium
To summarize:
There are two equivalent ways of stating the condition of equilibrium in

the goods market:
Production = Demand
Investment = Saving
38

Equilibrium
Consumption and saving decisions are one and the
same.
(1-c1) the propensity to save.
In equilibrium (Investment = Saving):
Rearranging terms, we get the same result as before:
1
Y
[c0 I G c1T ]
1 c1
39
The Paradox of Saving
The paradox of saving (or the paradox of

thrift) is that as people attempt to save more,
the result is both a decline in output and
unchanged saving.
40
40
3-5 Is the Government Omnipotent?

A Warning
Changing government spending or taxes is not always easy.
The responses of consumption, investment, imports, etc, are
hard to assess with much certainty.
Anticipations are likely to matter.
Achieving a given level of output can come with unpleasant

side effects.
Budget deficits and public debt may have adverse implications
in the long run.
41
Summary
This Chapter includes five parts:
Part 1: Divided GDP into five categories according to expenditure
purpose (C, I, G, X, IM).
Part 2:Consumption Function.
Part 3: We present a model for equilibrium output determination

using the consumption function.
Part 4: We study the equilibrium output from saving and investment
relationship.
Part 5: We use the above model to study the effect of fiscal policy:
taxes and government spending and some interesting paradox.
42
In-class experiment:
Computing the Candy price index
43

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The Goods Market

Chapter 3: The Goods Market

Chapter 3: The Goods Market

The Circular Flow

Chapter 3: The Goods Market

In conclusion, the interactions between production,

Chapter 3: The Goods Market

Chapter 3: The Goods Market

From the scope of Macro:

Chapter 3: The Goods Market

Decomposing aggregate demand(expenditure)

The four groups of final users and their expenditures:

Chapter 3: The Goods Market

Households Consumption (C)

3-1 The Composition of GDP

Chapter 3: The Goods Market

3-1 The Composition of GDP

Chapter 3: The Goods Market

Residential fixed investment: spending on the new

Notes: Distinguish from fixed investment, the third type of investment is

3-1 The Composition of GDP

Chapter 3: The Goods Market

Government Spending (G) refers to the purchases of goods and

3-1 The Composition of GDP

Chapter 3: The Goods Market

Net exports (X IM) is the difference between exports

3-1 The Composition of GDP

Chapter 3: The Goods Market

Table 3-1 The Composition of U.S. GDP, 2010

Chapter 3: The Goods Market

GDP Composition of Hong Kong, by end use (2012):

Chapter 3: The Goods Market

Chapter 3: The Goods Market

4. A consumer in Hong Kong Purchased a brand new BMW at $2 million directly

3-2 The Demand for Goods

Chapter 3: The Goods Market

3-2 The Demand for Goods

Chapter 3: The Goods Market

The function C(YD) is called the consumption function. It is a

A more specific form of the consumption function is this linear

3-2 The Demand for Goods

Chapter 3: The Goods Market

c1 is called the (marginal) propensity to consume, or the effect

3-2 The Demand for Goods

Chapter 3: The Goods Market

Consumption increases with

3-2 The Demand for Goods

Chapter 3: The Goods Market

(Inventory investment is assumed to be zero.)

3-2 The Demand for Goods

Chapter 3: The Goods Market

We shall assume that G and T are also exogenous for two

Governments do not behave with the same regularity as

Macroeconomists must think about the implications of

3-3 The Determination of Equilibrium Output

Chapter 3: The Goods Market

Equilibrium Condition: production, Y, is equal to demand, Z.

3-3 The Determination of Equilibrium Output

Chapter 3: The Goods Market

3. Words to explain the results

3-3 The Determination of Equilibrium Output

c1Y to the left side and reorganize the right side: