TOC
Motivation
Explain how is output determined in the short run:
- the output is determined by equilibrium in the goods market, the condition that supply of goods equals demand
- we assume that production adjusts automatically (without price changes). Thus, in the short run, output is effectively determined by demand
- Introduce Keynesian cross model (goods market in isolation)
The composition of GDP
what is produced and who buys it
- Consumption (C): goods and service purchased by consumers.
- Investment (I): sum of non-residential fixed investment, residential fixed investment, and inventory investment.
- Government spending (G): purchases of goods and services by the federal, state and local governments.
- Exports (X): purchases of goods and services by foreigners.
- Imports (IM): purchases of foreign goods and services by residents.
this is the allocation of output among alternative uses and is the Expenditure Approach to GDP
The Demand for Goods
denoted by Z, definition
Basic Assumptions:
assume the economy is closed:
- there is no trade with the rest of the world
- both X and IM are zero
thus,
Consumption (CοΌ
- main dependent factor is income
- Households(HHs) receive income from labour and capital
- define income after the payment (receipt) of taxes (transfers) as disposable income ()
(Y is the income)
Modelize:
assume consumption C is a function of disposable income:
- we assume that higher , higher consumption, thus is increasing
- behavioural equation that captures consumersβ behaviour
Assumption here
- : an increase in lead to an increase in C; , people are likely to save part of the increase in
- : if , still . Consumers dissave (selling assets or borrowing)
Investment (I)
- Investment is an exogenous variable, thus it is not explained within the model.
- we will take investment as given and write:
- Note: the assumption implies that investment does not respond to changes in production
Government Spending (G)
- Government spending (G) is an exogenous variable
- Together with taxes (T), describes fiscal policy
- (G) and (T) are exogenous because:
- Governments do not behave with the same regularity as consumers or firms.
Determination of Equilibrium Output
Equilibrium Output
in closed economy:
thus,
- Equilibrium in goods market requires production (Y) equals the demand for goods (Z):
- thus
- In equilibrium, production (left) is equal to demand (right), demand in turn depends on income Y, which is itself equal to production/output (income equals to production/output)
Model for Output Determination
- 3 types of equations
- Identities ()
- Behavioural equations ()
- Equilibrium conditions ()
Arrange the equation:
- is larger than 1 and is called multiplier
- is autonomous spending: part of demand for goods that does not depend on output
we have expressed the endogenous variable (Y) in terms of the exogenous variables (), () and () and the parameters
Plotting
production is equal to income, demand is a function of income
- An increase in autonomous spending has a more that one-for-one effect on equilibrium output
arrows represent the loop: (dynamic of adjustment)
- demand increases β an increase in production and income β equivalent increase in income β increase consumption β increase demand
the total increase in production after n+1 rounds:
whose limit is , the multiplier
Example
Keynes believed that the problem during recessions is inadequate spending, comment.
Solution
Government spending is part of the autonomous spending. Any increase in government spending has more than a one-to-one effect on equilibrium output. If demand determines the level of output in the short run, it should be possible.
Investment Equals Saving
Saving
Alternative way of thinking about equilibrium (in a closed economy): investment and saving
- Private saving (S):
- Public saving:
- Total saving = Private saving + Public saving
Government Budget
- Budget surplus:
- Budget deficit:
Equation (IS relation)
- β
- thus, , which can be written as
The Paradox of Saving
- , S do not change.
- Since , by assumption: investment does not change & T and G are the same.
β Private saving cannot change
Β
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