Economics 302 (Sec. 001)( )Intermediate Macroeconomic Theory and Policy(Spring 2011)Theory and Policy (Spring 2011)1/26/2011Instructor: Prof. Menzie ChinnInstructor: Prof. Menzie ChinnUW MadisonReal Sector & Keynesian CrossReal Sector & Keynesian Cross•Composition of output (accounting)Composition of output (accounting)• Aggregate Demandilib i• Equilibrium• Paradox of Thrift3‐1 The Composition of GDPIMXGICY −+++≡Table 3-1The Composition of U.S. GDP, 2006Billions of dollars Percent of GDPGDP (Y)13 246100 0GDP (Y)13,246100.01 Consumption (C) 9,269 70.02 Investment (I) 2,163 16.3Nidtil1 39610 5Nonresidential1,39610.5Residential 767 5.83 Government spending (G) 2,528 19.04 Net exports−763 −5.8Exports (X) 1,466 11.0Imports (IM)−2,229 −16.83of 325 Inventory investment 49 0Source: Survey of Current Business, April 2007, Table 1-1-5.3‐1 The Composition of GDP Consumption (C) ref ers to the goods and services purchased by consumers. Investment (I), sometimes called fixed investment, is the purchase of capital goods It is the sum ofthe purchase of capital goods. It is the sum of nonresidential investment and residential investment.investment. Government Spending (G)ref ers to the purchases of pg()pgoods and services by the federal, state, and local governments. It does not include government 4of 32transfers, nor interest payments on the government debt.3‐1 The Composition of GDP31 The Composition of GDP 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 foreignersand services by foreigners.5of 323‐1 The Composition of GDP31 The Composition of GDP Net exports (X −IM) is the difference between exportsbetween exports and imports, also called the trade balance.balance.Exports = imports trade balance⇔Exports > imports trade surplus⇔Et<ittddfiit⇔Inventory investmentis the differenceExports <imports trade deficit⇔6of 32Inventory investmentis the difference between production and sales.3‐2 The Demand for GoodsWe now move from accounting to modeling.The total (or“aggregate”)demand for goodsisThe total (or aggregate ) demand for goods is written as:ZCIGXIMZCIGXIM≡+++−WhCIGXIMll “ l d”Where C, I, G, X, IM are now all “planned” amounts of expenditures.To determine Z, some simplifications must be made:7of 323‐2 The Demand for Goods32 The Demand for Goods– Assume that all firms produce the same good, which can then be used by consumers forwhich can then be used by consumers for consumption, by firms for investment, or by the government.– Assume that firms are willing to supply any amount of the good at a given price, P, and demand in that marketdemand in that market.Assume that the economy is closed, then both exports and imports are zero.– Under the assumption that the economy is closed, X = IM = 0, then:8of 32ZCIG≡++3‐2 The Demand for Goods•Disposable income(Y) is the income thatConsumption (C)•Disposable income, (YD), is the income that remains once consumers have paid taxes and received transfers from the government.gCCYD=()()+()+The function C(YD) is called the consumption functionIt is abehavioral equationthat isfunction.It is a behavioral equation, that is, it captures the behavior of consumers.CY+9of 32CccYD=+013‐2 The Demand for Goods32 The Demand for GoodsConsumption (C)This function has two parameters, c0and c1: c1is called the (marginal) propensity to consumeor the effect of an additional dollarconsume, or the effect of an additional dollar of disposable income on consumption.c0is the intercept of the consumption function.c0is the intercept of the consumption function.Disposable income is given by:YYTD≡−10 of 32YYTD3‐2 The Demand for Goods32 The Demand for GoodsConsumption (C)Fi 31Consumption increases with Consumption and Disposable IncomeFigure 3 -1CCY()Consumption increases with disposable income but less than one for one. CCYD=()YYTD≡−CccYT=+−01()11 of 323‐2 The Demand for Goods32 The Demand for Goods• Variables that depend on other variables Investment (I )pwithin the model are called endogenous. Variables that are not explain within the model are called exogenous. Investment here is gtaken as given, or treated as an exogenous variable:bI=Government Spending (G)0bI=Government spending, G, together with taxes, T, describes fiscal policy—the choice of tddibth t12 of 32taxes and spending by the government.3‐2 The Demand for Goods32 The Demand for Goods• Textbook assumes both G and T are also exogenous. In the derivation, I take only G as exogenous , with T partly exogenous–Governments do not behave with the same regularity as consumers or firms.Mittthi k b tth–Macroeconomists must think about the implications of alternative spending and tax decisions of the governmentdecisions of the government.GOG=YttT+=13 of 320GOG=YttT10+=3‐3 The Determination of Equilibrium Output•Assuming that exports and imports are bothAssuming that exports and imports are both zero, the demand for goods is the sum of consumption, investment, and government spending:ZCIG≡++Then:)()()(GObYccZY+++==14 of 32)()()(010 oDGObYccZY+++==3‐3 The Determination of Equilibrium •Equilibrium in the goods market requires that dtiYbltthddfdOutputproduction, Y, be equal to the demand for goods, Z:YZYZ=Theequilibrium conditionis that productionYThe equilibrium conditionis that, production, Y, be equal to demand. Demand, Z, in turn depends on income, Y, which itself is equal to pqproduction. Then:. Then:)()()))(((GObYttYccY++++15 of 32)()()))(((01010 oGObYttYccY+++−+=3‐3 The Determination of Equilibrium OutputOutputMacroeconomists always use these th t lthree tools:1. Algebra to make sure that the logic is correct2. Graphs to build the intuition3. Words to explain the results16 of 323‐3 The Determination of Equilibrium OutputpRewrite the equilibrium equation:Using Algebra)()()))(((01010 oGObYttYccZY+++−+==011)1(Λ+−=YtcYoGObtcc++−≡Λ00100)(011)1(Λ=−− YtcY011)]1(1[Λ=−− tcY00Λ=γY1=γ17 of 3200ΛγY)]1(1[11tc−−γ3‐3 The Determination of Equilibrium Output•The equilibrium equation can be manipulated to OutputUsing Algebraderive some important terms:– The term is that part of the demand for goods that does not depend onoGObtcc++−≡Λ00100)(the demand for goods that