The Goods Market Lecture 11 – academic year 2013/14 Introduction to Economics Fabio Landini

The Goods Market

Lecture 11 – academic year 2013/14Introduction to Economics

Fabio Landini

Where we are…

• Lectures 1-7: Microeconomics • Lecture 8: Computation of GDP

• Lecture 8: Evolution of GDP and differences among countries

• Lecture 9: Inflation, unemployment and aggregate demand

• How is the level of GDP determined?

• The answer is different if we consider different time horizon

• In this lecture: How the level of GDP is determined the short period

Question of the day

• Premise: short, medium and long period

• Analysis of the different components of demand

• Determination of the aggregate demand function

• Determination of the equilibrium level of production (GDP) in the short period

What do we do today…

We can distinguish three different time horizons:

•Short period = 1-2 years

•Medium period = 10 years

•Long period = 20-50 year

Premise: short, medium and long period

Why do we use this differentiation?

1)Empirical evidence shows that depending on the time time horizon that we consider production is lead by different factors

•Short period -> Dynamics of the demand (how many goods are purchased)

•Medium period -> Dynamics of the supply (adjustment of production capacity)

•Long period -> Structural factors (saving, quality of education, features of institutions, etc.)


2) Depending on the time horizons, we make different hypotheses on the functioning of the economy

a) Price adjustments

Short period: prices are fixed (or with reduced flexibility)

As the market conditions change firms do not adjust their price list immediately. To change prices is indeed costly.

Before doing so, a firm want: • To verify the stability of the new conditions• To see the reaction of competitors


Medium and long period: Prices are perfectly flexible

If we consider a longer time horizon firms have the time to perfectly adjust prices

Price adjustments -> medium period analysis

b) Accuracy of previsions on the future value of some variables (expectations)


In this class we will look at the functioning of the goods market in the short period.

Underlying question: what is it that determine the level of GDP in the short period?

Aim: to develop a macroeconomic model of the good market


The components of aggregate demand

Following the decomposition presented in the preceding class, aggregate demand is the sum of:•Consumption (C)•Investments (I)•Government expenditure (G)•Balance between export and import (XQ)

Aggregate demand (Z):

Z C + I + G + XQ

To illustrate the model that examines the good market we introduce some simplifying assumptions:

1)We ignore international exchanges We assume, X = Q = 0 and Z = C + I + G

We examine a closed economy

2) We assume that there exist only one good used for consumption, investments and public expenditure -> only one market


3) With respect to the variables that we examine we employ two alternative approaches:

For some variables, we define a behavioural equation: equation that describes the decisional rule followed by the relevant subjects in making their decisions -> endogenous variables (determined inside the model)

For the other variables, we consider a given and fixed value (no behavioural equation) -> exogenous variables (determined outside the model)


Under our hypotheses

Z = C + I + G

Let’s now examine the distinct components of demand (C, I, G)


Consumption (C)

To describe aggregate consumption we use a behavioural equation -> endogenous variable

Consumers’ behaviour:

• Consumers purchase more goods the greater their income

• The type of income that we have to consider is the income neat of taxes (“disposable income”)


It means that: C=C(YD) +

Consumption is an increasing function of disposable income (YD)

Important: Disposable income (YD) is the income minus the taxes

YD = Y –T

where, Y is income and T is taxes


For simplicity we use a linear function

C = C0 + c1YD where C0, c1 are parameters

Interpretation of parameters:

a) C0 – Autonomous consumption

•It is the term that captures all that part of consumption that do not depend on disposable income

•It is affected by several factors, such as: financial wealth, trust in the feature, preferences


C = C0 + c1YD

b) c1 – Marginal propensity to consume

It captures how the increase in consumption if the disposable income increases by one unit

Assumption 0 < c1<1

It means that:• Consumption increases with disposable income• The increase in consumption is smaller than the

increase in disposable income (a portion of income is saved)


For instance, if c1 = 0,6

For every euro additional unit of disposable income 60 cents will be used to finance consumption and 40 cents will be saved.


Graphically: C = C0+c1YD

C

C0 c1

YD

Investments (I) and Government expenditure (G)

Let’s consider their value as a constant (exogenous variable)

I I0 and G G0 where I0, G0 are parameters

Similarly, let’s consider taxes (T) as exogenous, so that

T T0 where T0 is a parameter


Exogeneity of I = Simplifying assumption it will be removed later

Exogeneity of G and T = Variables that are “chosen” buy the Government

The analysis of fiscal policy looks at the effects of the choices of different values for G and T


Let’s start again from the aggregate demand equation Z = C + I + G

Let’s plug in the equation for C Z = C0 + c1YD + I + G

Substituting away for the definition of YD we get Z = C0 + c1 (YT) + I + G

Replacing the constant values of I, G e T we obtain Z = C0 + c1 (YT0) + I0 + G0


Given the equation Z = C0 + c1 (YT0) + I0 + G0

Let’s change the order of the terms Z = c1 Y + C0 c1T0 + I0 + G0

Let’s collect the components of demand that do not depend on income, and let’s call them AE (autonomous expenditure) Z = c1 Y + AE

Equation of aggregate demand -> it represents aggregate demand as a function of income.


Graficamente: Z = c1Y+AE

Determination of the equilibrium level of income

The analysis of a market usually represents the analysis of its equilibrium

Market in equilibrium -> Microeconomics (Part I)

The equilibrium of a market is the state in which demand is equal supply

Equilibrium condition in the goods market:Demand of goods = Supply of goods

Aggregate demand of goods = Z

What is the aggregate supply of goods?

Let’s assume that firms do not have goods in stock:

Supply = Goods that are produced in the economy = Aggregate supply

We know from lectures 8 and 9 that:•The measure of aggregate production is GDP•GDP = Total income of the economy =

= Aggregate income = Y


Therefore, the equilibrium condition in the market for goods is: Z =Y

Given the equations Z c1 Y + AE

Z Y

We obtain that in equilibrium: Y c1Y + AE


From which we obtain that:

(1c1 )Y AE

YE AE

where YE is the equilibrium level of production

This result shows the value of production in equilibrium as a function of constants and parameters

In particular YE is equal to the product of:•AE = autonomous expenditure

• = the “multiplier”1c11

1c11


The multiplayer:

•It is called multiplier because it “multiplies” autonomous expenditure•It is always greater than 1 (0<c1<1, by assumption)

•It grows with c1

•It depends on the assumptions concerning the exogenous and endogenous variables (it is not always 1/(1 – c1) )

1c11


Graphical analysis of equilibrium: Demand -> Z = AE+c1Y Supply -> Y -> 45° linesEquilibrium -> Y=Z -> intersection between the two curves (E)Equilibrium -> point E -> Y=YE

Z

Z

45°

E

Y

YE

, Y

AE

What is the effect of a tax reduction on income (GDP)? Z = AE+c1Y where AE = C0 c1T0 + I0 + G0

T0 -> AE -> AE’

Z

Z

45°

E

Y

YE

, Y

AE

AE’

Z’

E’YE’

In the short period, the equilibrium in the good market is found by equalizing aggregate demand and aggregate supply

This condition allows us to identify the equilibrium level of income (i.e. the level of GDP).

Changes in some of the exogenous variables (e.g. T, G) affects the short period level of income

Do these effects persist also in the long-period? …. more on this in future classes…..

Conclusion

Financial Markets

Next class

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The Goods Market Lecture 11 – academic year 2013/14 Introduction to Economics Fabio Landini