Economics 302 Sec 001 Intermediate Macroeconomic Theory and Policy Spring 2011 1 26 2011 Instructor Prof Menzie Chinn UW Madison Real Sector Keynesian Cross Composition of output accounting Aggregate Demand Equilibrium ilib i Paradox of Thrift 3 1 The Composition of GDP Y C I G X IM Table 3 1 The Composition of U S GDP 2006 Billions of dollars GDP Y Percent of GDP 13 246 13 246 100 0 100 0 1 Consumption C 9 269 70 0 2 Investment I 2 163 16 3 N Nonresidential id ti l Residential 1 396 1 396 10 5 10 5 767 5 8 3 Government spending G 2 528 19 0 4 Net exports 763 5 8 5 Exports X 1 466 11 0 Imports IM 2 229 16 8 Inventory investment Source Survey of Current Business April 2007 Table 1 1 5 3 of 32 49 0 3 1 The Composition of GDP Consumption C refers to the goods and services purchased by consumers Investment I sometimes called fixed investment is the purchase of capital goods goods It is the sum of nonresidential investment and residential investment Government Spending p g G refers to the p purchases of goods and services by the federal state and local governments It does not include government transfers nor interest payments on the government 4 of 32 debt 3 1 3 1 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 foreigners foreigners 5 of 32 3 1 3 1 The Composition of GDP Net exports X IM is the difference between exports and imports also called the trade balance Exports imports trade balance Exports imports trade surplus E Exports t imports i t trade t d deficit d fi it Inventory investment is the difference between production and sales 6 of 32 3 2 The Demand for Goods We now move from accounting to modeling The total or aggregate aggregate demand for goods is written as Z C I G X IM Where C Wh C II G G X X IM are now allll planned l d amounts of expenditures To determine Z some simplifications must be made 7 of 32 3 2 3 2 The Demand for Goods Assume that all firms produce the same good which 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 market 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 8 of 32 Z C I G 3 2 The Demand for Goods Consumption C Disposable income income YD is the income that remains once consumers have paid taxes and received transfers from the government g C C YD The function C YD is called the consumption function It is a behavioral equation function equation that is is it captures the behavior of consumers C c0 c1YD 9 of 32 3 2 3 2 The Demand for Goods 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 consume of disposable income on consumption c0 is the intercept of the consumption function Disposable income is given by YD Y T 10 of 32 3 2 3 2 The Demand for Goods Consumption C Fi Figure 3 1 Consumption and Disposable Income Consumption increases with disposable income but less than one for one C C YD YD Y T C c0 c1 Y T 11 of 32 3 2 3 2 The Demand for Goods Investment I Variables that depend p on other variables within the model are called endogenous Variables that are not explain within the model are called exogenous g Investment here is taken as given or treated as an exogenous variable I b0 Government Spending G Government spending G together with taxes T describes fiscal policy the choice of t taxes and d spending di b by th the government t 12 of 32 3 2 3 2 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 Macroeconomists M i t mustt think thi k about b t the th implications of alternative spending and tax decisions of the government government G GO0 13 of 32 T t 0 t1Y 3 3 The Determination of Equilibrium Output Assuming Assuming that exports and imports are both zero the demand for goods is the sum of consumption investment and government spending Z C I G Then Y Z c0 c1YD b0 GOo 14 of 32 3 3 The Determination of Equilibrium Output Equilibrium in the goods market requires that production d ti Y be Y b equall tto th the d demand d ffor goods d Z Y Z The equilibrium condition is that that production production Y Y be equal to demand Demand Z in turn depends p on income Y which itself is equal q to production Then Y c0 c1 Y t0 t1Y b0 GOo 15 of 32 3 3 The Determination of Equilibrium Output Macroeconomists always use these th three tools t l 1 Algebra to make sure that the logic is correct 2 Graphs to build the intuition 3 Words to explain the results 16 of 32 3 3 The Determination of Equilibrium p Output Using Algebra Rewrite the equilibrium equation Y Z c0 c1 Y t 0 t1Y b0 GOo Y c1 1 t1 Y 0 0 c0 c1 t0 b0 GOo Y c1 1 t1 Y 0 Y0 0 Y 1 c1 1 t1 0 1 1 c1 1 t1 17 of 32 3 3 The Determination of Equilibrium Output Using Algebra The equilibrium equation can be manipulated to derive some important terms The term 0 c0 c1 t 0 b0 GOo is that part of the demand for goods that does not depend on output it is called autonomous spending If the g government ran a balanced budget g then T G Because the p propensity p y to consume c1 is between zero and one 1 c 11 t is a number 1 1 greater than one For this reason this number is called the multiplier 18 of 32 3 3 The Determination of Equilibrium O t t Output Using a Graph Z 0 c1 1 t1 Y Equilibrium in the Goods Market Z Y Z Equilibrium output is determined by the condition that production be equal to demand demand First plot production as a function of income Second S plot demand as a function of income In Equilibrium production d i equals l demand 19 of 32 Z c1 1 t1 Y 0 Slope c1 1 t1 0 45 Y0 Y 3 3 The Determination of Equilibrium …