MACROECONOMICS

SEVENTH EDITION

OLIVIER BLANCHARD

ALWAYS LEARNING

The Goods Market

Chapter 3
PEARSON

Chapter 3 Outline

The Goods Market

3-1

3-2

3-3

3-4

3-5
The Composition of GDP
The Demand for Goods

The Determination of Equilibrium Output

Investment Equals Saving: An Alternative Way
of Thinking about Goods-Market Equilibrium
Is the Government Omnipotent? A Warning
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3-2

Learning Objectives

1. Demonstrate understanding of how interactions

among production, income and demand determine
economic activity in the short run
-Production depends on demand
-Demand depends on income
-Income depends on production
2. Know the major components of demand and the
relative size of each component

3. Explain the characteristics of The Consumption

Function

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3-3

Learning Objectives
(continued)

4. Discuss and explain what is meant by equilibrium

output

5. Know the difference between autonomous

spending and the other components of spending that
depend on income

6. Recognize that models have 3 equations

- Behavioral equations
-Equilibrium conditions and -Identities

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3-4

Interactions among Aggregate

Production, Income and Demand
Suppose the economy is in equilibrium. Thus,
there is no pressure on output to change

• Now, if demand increases at each level of output (say,

due to increase in government spending)
• Firms respond to this increase by increasing
production (without any change in Prices)

This leads to an increase in income (since income is

always equal to production)

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3-5

Interactions among Aggregate Production,

Income and Demand (continued)

Increase in income will lead to further increase in demand

and production
reached
This process will continue till a new equilibrium
output is

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3-6

The Goods Market

• When economists think about year-to-year

movements in economic activity, they focus
on the interactions among production,
income, and demand:
- Changes in the demand for goods lead to changes
in
production

- Changes in production lead to changes in income

—

Changes in income lead to changes in the demand for

goods

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3-7

3-1 The Composition of GDP

• Consumption (C): goods and services

purchased by consumers
• Investment (I) or fixed investment: the
sum of nonresidential investment and residential
investment

• Government spending (G): purchases of

goods and services by the federal, state,
and local governments; excluding
government transfers

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3-8

3-1 The Composition of GDP

Exports (X): purchases of U.S. goods

and services by foreigners
• Imports (IM): purchases of foreign
goods and
services by U.S. consumers, U.S. firms and
the U.S. government
• Net exports or trade balance: X - IM
• Exports > Imports

• Imports > Exports

trade surplus
trade deficit
Inventory investment: difference between
production and sales

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3-9

3-1 The Composition of GDP

Table 3-1 The Composition of U.S. GDP, 2014

GDP (Y)
Billions of Dollars
Percent of GDP

17,348
100.0

1
Consumption (C)
11,865
68.3

2
Investment (1)
2,782
16.0

Nonresidential
2,233
12.9

Residential
549
3.1

3
Government spending (G)
3,152
18.1

4
Net exports
-530
-3.1

Exports (X)
2,341
13.5

Imports (IM)
-2,871
-16.6

5
Inventory investment
77
0.4

Source: Survey of Current Business, July 2015, Table 1-1-5

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3-10

3-2 The Demand for Goods

Z=C+I+G+X-IM

• The above identity defines the total demand

for goods (Z) as consumption, plus
investment, plus government, plus export
minus imports.
• In a closed economy (X = IM = 0):

Z=C+I+G

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3-11

3-2 The Demand for Goods

·

Consumption (C) is a function of disposable

income (YD), which is the income that
remains once
consumers have received government
transfers and paid their taxes.

C = C(YD)
(+)

C(YD) is called the consumption

function.
(3.1)
• This is a behavioral equation that
captures the behavior of consumers.

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3-12

3-2 The Demand for Goods

• Assume that the consumption function is a

linear relation with two parameters, co
and C1:
Co

C = Co + C1 YD
(3.2)

• c1 is the propensity to consume.

C1

• co is what people would consume if their

disposable income equals zero.
• Changes in co reflect changes in
consumption for a given level of disposable
income.

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3-13

Example - The Consumption Function

Suppose C= 200 + .75YD

• What is the value of autonomous
consumption i.e. what is C when Yp = 0
D

Answer: Autonomous consumption =

200
• What is the marginal propensity to
consume (mpc)?
Answer-mpc = .75
• If disposable income increases by
100 by how much will C change?
Answer-C will change by 75 when
disposable income changes by 100

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3-14

3-2 The Demand for Goods

Figure 3-1 Consumption and Disposable Income

Consumption increases. with disposable income but less than one

for one.
A lower value of co will shift the entire line down.
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Consumption, C
Co
Slope = C1
Consumption Function
C = C2+ C1YD

Disposable Income,YD

3-15

3-2 The Demand for Goods

• Disposable income is:

YD=Y-T

where Y is income and T is taxes minus

government transfers.
Replacing Yo in equation (3.2) gives:
D

C = Co + C1(YT)

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(3.3)

3-16

3-2 The Demand for Goods

• Endogenous variables: variables

depend on other variables in the model
• Exogenous variables: variables not
explained within the model but are instead
 taken as given

I=Ī
(3.4)

• A bar on investment means investment is taken as

given.

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3-17

3-2 The Demand for Goods

• T and G describe fiscal policy-the choice

of taxes and spending by the government.
• G and T are exogenous because:
—

Governments do not behave with the same regularity

as consumer or firms.
- This book will typically treat G and T as variables
chosen
by the government and will not try to explain them
within the model.

3-18
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3-3 The Determination of

Equilibrium Output
• Assume X=IM=0, so

Z=C+I+G

• Replacing C and I from equations (3.3)

and (3.4):
·

Z = Co + C1( Y − T) + Ī + G

Equilibrium in the goods markets

requires

Y=Z

• This is an equilibrium condition.

(3.5)

(3.6)
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3-19

3-3 The Determination of

Equilibrium Output
·

Replacing Z in (3.6) by equation (3.5) gives

Y = Co + C1(Y− T) + I + G
(3.7)

• In equilibrium, production (Y) is equal to

demand, which in turn depends on income
(Y), which is itself equal to production.

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3-20
3-3 The Determination of
Equilibrium Output
• Rewrite equation (3.7):

Y = co + c1Y
-

c1T+I+G
·

Reorganize the equation:

(1 − c1)Y = co + I + G- c1T
-

• Divide both sides by (1 C1):

—

1
Y =
[co + I + G- c1T]
(3.8)
which characterizes equilibrium output in
algebra.

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3-21

3-3 The Determination of

Equilibrium Output
• Autonomous spending: [co + I + G-
c1T]

• Autonomous spending is positive

because if T = G (balanced budget) and
c1is between 0 and 1, then (G-c1T) is
positive, and so is autonomous
spending.

• The term 1/(1-c1) is the multiplier,

which is larger when c1 is closer to 1.

• If c1 equals 0.6, the multiplier equals

1/(1 - 0.6) 2.5, meaning that an
increase of consumption by $1 billion will
increase output by 2.5 x $1 billion $2.5
billion.
=

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3-22

3-3 The Determination of

Equilibrium Output
• Macroeconomists always use three tools:
1. Algebra to make sure that the logic is correct 2.
Graphs to build the intuition

3. Words to explain the results

3-23
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Example: The Determination of

Equilibrium Output

Suppose
• Z=C+I+G
C=300+.9YD
T=1000

• YD
YpY-T
G=2000
I = 200
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3-24

Solution: Determination of
Equilibrium Output

Starting with the equation Z= C+I+G

and substituting the information given
• Z=300+.9(Y-T) + 200 +2000
=300+.9(Y-1000) +200+2000
=2500+.9Y-900

=1600+.9Y

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3-25

Solution-Equilibrium Level of Output

Z=1600+.9Y

• In equilibrium, Y=Z, so substitute Y for

Z
• Y=1600+.9Y

• Y-.9Y=1600

• Y(1-.9)=1600
• .1Y=1600

• Y=1600/.1=16000

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3-26

Solution-Consumption at Equilibrium
Level of
Output
Equilibrium Level of Output Y=16000
• YD = Y-T
=16000-1000-15000

C = 300+.9YD
=300+.9(15000) =300+13500=13800

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3-27

Solution-Savings at Equilibrium Level of

Output

• S=YD - C
=15000-13800

=1200

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3-28

Solution-Effect of change in autonomous

saving on equilibrium output

• If autonomous saving increases by 100

then autonomous consumption falls by
100
• Multiplier
=1/1-.9
=

=1/.1=10
1/1-C

Change in equilibrium output

AY =
multiplier x change in co = 10 x (-100)
= -1000

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3-29

Solution-New Equilibrium
Values
= 15000

= 15000 - 1000 =14000

• New Equilibrium Output (Y)
• New Disposable Income =
• New Consumption (C) =
200+.9(14000)=200+12600=12800
New Saving (S)=14000-12800-1200

• Note: New saving figure is the same as

before! Shows Paradox of Thrift

• Increase in autonomous savings leads to

saving returning to its original level in
equilibrium output/income
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3-30

3-3 The Determination of

Equilibrium Output
• Steps to characterize the equilibrium
graphically:

1. Plot production as a function of income. Because

production equals income, their relation is the 45-
degree line.

2. Plot demand as a function of income.

z=
(co + I + G- C1T) + c1Y

3. In equilibrium, production equals demand.

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(3.9)
3-31

3-3 The Determination of

Equilibrium Output

Figure 3-2
Equilibrium in the Goods Market

Equilibrium output is determined by the

condition that production is equal to demand.
Demand Z, Production Y

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Y

Autonomous
Spending
Production
Slope
= 1

ZZ
Demand
A

Slope = C1

Equilibrium Point: Y = Z

45°

Income, Y

3-32

3-3 The Determination of

Equilibrium Output
• Suppose co increases by $1 billion.

Figure 3-3 The effects of

an increase in autonomous spending on output

An increase in autonomous
spending has a more than one- for-one effect on equilibrium output.
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Demand Z, Production Y
ZZ'

Y'
>
A

D
$1 billion
B
‫דו‬
E
ZZ
C

Y
A

45°

Income, Y
y

3-33

3-3 The Determination of

Equilibrium Output
• To summarize our findings using words:
—
—

Production depends on demand, which depends on

income, which is itself equal to production.
- An increase in demand leads to an increase in
production and income, which in turn leads to a further
increase in demand.

The increase in equilibrium output is larger than the

initial shift in demand, by a factor equal to the multiplier.
The multiplier depends on the propensity to
consume, which can be estimated using econometrics-
the set of statistical methods used in economics.

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3-34

3-3 The Determination of

Equilibrium Output
• The adjustment of output over time is
called the dynamics of adjustment.
• How long the adjustment takes depends
on how and when firms revise their production
schedule.

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3-35

FOCUS: The Lehman Bankruptcy, Fears of

Another Great Depression, and Shifts in
the Consumption Function

• When people start worrying about the future, they

decide to save more even if their current income has
not changed.
• News about Lehman Brothers going bankrupt in
September 2008 reminded people of the Great
Depression, as confirmed by the number of searches
for "Great Depression" in Google.
• Consumption fell even if disposable income had not
yet changed.

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3-36

FOCUS: The Lehman Bankruptcy, Fears of

Another Great Depression, and Shifts in
the Consumption Function

Figure 1 Disposable Income, Consumption, and

Consumption Of Durables In the United States, 2008:1 to
2009:3
1.04

1.02-

1.00

II 0.98
Index, 2008 Q1 = 1.00
0.96 -

0.94

0.92
Disposable Income

Consumption

Consumption of Durable Goods

0.90

0.88
2008
2008
2008
2008

Q1
Q2
Q3
Q4
2009
Q1
2009
2009

Q2
Q3

Source: Calculated using series DPIC96, PCECC96, PGDGCC96: Federal Reserve Economic Data (FRED)
http://research.stlouisfed.org/fred2/

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3-37

3-4 Investment Equals Saving: An

Alternative Way of Thinking about Goods-
Market Equilibrium

• John Maynard Keynes articulated an

alternative model that focuses instead on investment
and saving in his book "the General Theory of
Employment, Interest and Money" in 1936.
• Private saving (S) is

S=YD - C

S=Y-T-C

• By definition, public saving = T - G.

• Public saving > 0

• Public saving < 0

Budget surplus

Budget deficit
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3-39

3-4 Investment Equals Saving: An

Alternative Way of Thinking about Goods-
Market Equilibrium

• In equilibrium:
Y=C+I+G

• Subtract T from both sides and move C to the left side:

Y-T-C=I+G-T

• The left side of the equation is simply S, so

S=I+G-T

• Or equivalently
I=S+ (TG)
(3.10)

• This is the IS relation, which stands for

"Investment equals Saving".
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3-40

3-4 Investment Equals Saving: An

Alternative Way of Thinking about Goods-
Market Equilibrium

• Two equivalent ways of stating the

condition for equilibrium in the goods
market:

Production = Demand

Investment = Saving

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3-41
3-4 Investment Equals Saving: An
Alternative Way of Thinking about Goods-
Market Equilibrium

• We can also derive equation (3.8) using

equation (3.10).

• Because consumption behavior implies that:

S=Y-T-C

=Y-T-co-c1(YT)
Rearranging terms, so

S = co + (1 - c1) (YT)

(1-c1) is called the propensity to save,

which is between zero and one.
(3.11)
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3-42

3-4 Investment Equals Saving: An

Alternative Way of Thinking about
Goods-Market Equilibrium

• In equilibrium, IS, so that equation (3.10)

becomes:

I = −co + (1 − c1)(YT)+(TG)
Co

Solve for output:

Y=
1

1-0
[Co + I + G- c1T]

which is the same as equation (3.8).

(3.12)
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3-43

FOCUS: The Paradox of Saving

• We are told about the virtues of thrift as we

grow up, but the model in this chapter tells a
different story.

Suppose that consumers decide to save

more, so co decreases.

Equation (3.12) implies that output

decreases.
• Saving cannot change either, because
equation (3.10) implies that at equilibrium:

I=S+ (TG)
S cannot change because I, T or G does not
change by assumption.

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3-44

3-5 Is the Government Omnipotent?

A Warning

• Equation (3.8) implies that the government

can choose the level of G or T to affect the level
of output it wants.

• However, there are many aspects of reality that

we have not incorporated in our model:
―

Changing G or 7 is not easy.

Investment and imports may change, making it hard for
governments to assess the effects of their policies
(Discussed in Chapters 5, 9, and 18 to 20).
- Expectations are likely to matter (Chapters 14 to 16).
- The effects on output may be unsustainable in the
medium run
(Chapter 9).
—

Cutting T or increasing G can lead to large budget

deficits and public debt in the long run (Chapters 9, 11, 16
and 22).
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3-45