CHAPTER
3
The Goods Market
Prepared by Fernando Quijano and
Yvonn Quijano
And Modified by Gabriel Martinez
3-1
The Composition of GDP
Table 3-1
The Composition of U.S. GDP, 2001
Billions of
dollars
GDP (Y)
Percent of
GDP
10,208
100
1.
Consumption (C)
7,064
69
2.
Investment (I)
1,692
17
1,246
12
446
5
Nonresidential
Residential
3.
Government spending (G)
1,839
18
4.
Net exports
329
3
Exports (X)
1,097
11
Imports (IM)
1,468
14
58
1
5.
Inventory investment
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Composition of GDP
 Consumption (C)
– The goods and services purchased by
consumers.
 Investment (I),
– Sometimes called fixed investment
– The purchase of capital goods.
 Capital goods: durable goods used to produce other
goods.
– It is the sum of nonresidential investment and
residential investment.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Composition of GDP
 Government Spending (G)
– Purchases of goods and services by the federal, state,
and local governments.
– It does not include government transfers, nor interest
payments on the government debt.
 Imports (IM)
– Purchases of foreign goods and services by consumers,
business firms, and the U.S. government.
 Exports (X)
– Purchases of U.S. goods and services by foreigners.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Composition of GDP
 Net exports (X  IM)
– The difference between exports and imports,
also called the trade balance.
Exports = imports  trade balance
Exports > imports  trade surplus
Exports < imports  trade deficit
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Composition of GDP
 Inventory investment is the difference
between production and sales.
– If production exceeds sales, there is inventory
accumulation.
– If sales exceed production, there is inventory
deaccumulation.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
3-2
Expenditure on Goods
 Total expenditure on goods is written as:
Z  C  I  G  X  IM
 The symbol “” means that this equation is an
identity, or definition.
 If we assume that the economy is closed,
X = IM = 0, then:
Z  C I  G
 We also assume that prices are fixed. This
defines the short run.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Consumption (C)
 The function C(YD) is called the
consumption function.
 It is a behavioral equation, that is, it
captures the behavior of consumers.
C  C(YD )
( )
 There’s a positive relation between
consumption and disposable income.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Demand for Goods
To determine Z, some simplifications must be
made:
 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 and
demand in that market
 Assume that the economy is closed, that it does
not trade with the rest of the world, then both
exports and imports are zero.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Consumption (C)
 Disposable income, (YD), is the income
that remains once consumers have paid
taxes and received transfers from the
government.
Y  YT
D
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Consumption (C)
 A more specific form of the consumption
function is this linear relation:
C  c0  c1YD
 This function has two parameters, c0 and c1:
 c1 is called the (marginal) propensity to
consume, or the effect of an additional dollar
of disposable income on consumption.
0 < c1 < 1
 c0 is the intercept of the consumption
function. c0 > 0
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Consumption (C)
Consumption and
Disposable Income
Consumption increases
with disposable income,
but less than one for
one.
C  c0  c1 (Y  T )
0  c1  1
c0  0
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Investment (I)
 Variables that depend on other variables
within the model are called endogenous.
 Variables that are not explained within the
model are called exogenous.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Investment (I)
 Investment here is taken as given, or treated
as an exogenous variable:
I I
 Clearly, investment is not exogenous.
– Firms will invest more in prosperities and when
interest rates are low.
 But we make this simplification for the
moment.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Government Spending (G)
 Government spending, G, together with
taxes, T, describes fiscal policy—the
choice of taxes and spending by the
government.
 We shall assume that G and T are also
exogenous.
– G and T (mostly) depend on policy, which is
not automatically determined by the model.
G G
T T
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
3-3
The Determination of
Equilibrium Output
 Equilibrium in the goods market requires
that production, Y, be equal to expenditure
on goods, Z:
Y Z
Then:
Y  c0  c1 (Y  T )  I  G
 The equilibrium condition is:
production, Y, must be equal to expenditure.
Expenditure, Z, in turn depends on income, Y,
which is equal to production.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Using Algebra
 The equilibrium equation
Y  c0  c1 (Y  T )  I  G
can be manipulated to derive some
important terms:
(1  c1 )Y  c0  c1  I  G  c1T
– Autonomous spending and the multiplier:
1
Y
[c0  I  G  c1T ]
1  c1
multiplier
© 2003 Prentice Hall Business Publishing
autonomous spending
Macroeconomics, 3/e
Olivier Blanchard
Using Algebra
 The Multiplier: if 0<c1<1, then
1
1
1  c1
 If Autonomous Spending changes, the change
will be multiplied by 1/[1-c1]
 For example, if c1=0.5 and G changes by 200,
Z (and Y) will change by 200x 1/[1-0.5]=400
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Using a Graph
Y Z
Z  (c0  I  G  c1T )  c1Y
45 degree
The ZZ line: expenditure
Equilibrium in the
Goods Market
Equilibrium output is
determined by the
condition that production
be equal to expenditure.
1
Y
[c  I  G  c1T ]
1  c1 0
The equilibrium point
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Solving for Equilibrium
Graphically
Expenditure (Z), Production (Y)
Production
14,000
12,000
Expenditure (ZZ)
= 5,000 + 0.5Y
10,000
Equilibrium
7,000
5,000
4,000
c0 = 5,000
4,000
© 2003 Prentice Hall Business Publishing
10,000 14,000
Macroeconomics, 3/e
Income (Y)
Olivier Blanchard
The Equilibrium Level of
Aggregate Income
 Suppose Expenditure > Production
Sales > Production
Inventories fall
Businesses produce more: Production 
 Suppose Expenditure < Production
Sales < Production
Inventories rise
Businesses produce less: Production 
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Solving for Equilibrium
Graphically
Expenditure (Z), Production (Y)
Y
14,000
Z<Y
ZZ
12,000
10,000
Equilibrium
7,000
5,000
Z>Y
4,000
© 2003 Prentice Hall Business Publishing
10,000 14,000
Macroeconomics, 3/e
Income (Y)
Olivier Blanchard
Using a Graph
The Effects of an
Increase in Autonomous
Spending on Output
An increase in
autonomous spending
has a more than onefor-one effect on
equilibrium output.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Fiscal Policy and the Multiplier
Fighting Recessions and
Overheating
Fiscal Policy and the Multiplier
 Suppose the government thinks output is
too high.
– The economy may be “overheated”: operating
above its long-run potential, which causes
inflation and social unrest.
– For example, the government may think output
should fall by $400 billion.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Fiscal Policy and the Multiplier
 To lower output, the government can raise
taxes or lower spending.
– If c1 = 0.5, the multiplier = 2.
– Then G-c1T need only fall by $200 billion.
DY = multiplier x D(autonomous spending)
400 billion = 2
© 2003 Prentice Hall Business Publishing
x
200 billion
Macroeconomics, 3/e
Olivier Blanchard
Shifts in the Aggregate
Expenditure Curve
ZZ=5000+0.5Y
DY 
1
D (G)
1 - c1
Y
200
1
( 200)
1 - 0.5
 400
DY 
200
ZZ=4800+0.5Y
100
50
25
400
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Fiscal Policy and the Multiplier
 Suppose the government thinks output is
too low.
– A recession may be causing the economy to
operate below its long-run potential.
– To avoid unemployment and social unrest, the
government may choose an activist policy.
– For example, the government may think output
should rise by $400 billion.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Fiscal Policy and the Multiplier
 To raise output, the government can lower
taxes or raise spending.
– If c1 = 0.75, the multiplier = 4.
– Then G-c1T need only rise by $100 billion.
DY = multiplier x D(autonomous spending)
400 billion = 4
© 2003 Prentice Hall Business Publishing
x
100 billion
Macroeconomics, 3/e
Olivier Blanchard
Shifts in the Aggregate
Expenditure Curve
ZZ=4900+0.75Y
Y
1
DY 
D (G)
1 - c1
1
(100)
1 - 0.75
 400
DY 
ZZ=4800+0.75Y
42.19
56.25
75
100
400
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Using a Graph
 The multiplier is the sum of successive
increases in production resulting from an
increase in expenditure.
 When expenditure is, say, $1 billion higher,
the total increase in production after n
rounds of increase in expenditure equals

$1bn x 1  c1  c  ... c
2
1
n
1

The sum 1  c1  c  ... c is called a
geometric series.
2
1
© 2003 Prentice Hall Business Publishing
n
1
Macroeconomics, 3/e
Olivier Blanchard
Is the Government Omnipotent?
A Warning
3-5
 Changing government spending or taxes
may be far from easy.
– The lags of fiscal policy.
 The responses of consumption, investment,
imports, etc, are hard to assess with much
certainty.
– Imports and investment are volatile and affected
by scores of volatile factors.
 Anticipations: is the policy permanent or not?
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Is the Government Omnipotent?
A Warning
 If target output is too high, inflation may
accelerate.
– It is (nearly) impossible to estimate fullemployment output.
 Budget deficits and public debt may have
adverse implications in the long run.
– Such as high interest rates, inflation, political
business cycles, etc.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Using Words
 To summarize:
– An increase in expenditure leads to
an increase in production and a
corresponding increase in income.
– The end result is an increase in output
that is larger than the initial shift in
expenditure, by a factor equal to
the multiplier.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Using Words
 To estimate the value of the multiplier,
and more generally, to estimate
behavioral equations and their
parameters,
economists use econometrics—a set of
statistical methods used in economics.
– We use known data on income and
expenditure, and we figure out their average
historical relation.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Sample data points for consumption
and income
C
.
.
.
.
.
.
..
.
.
.
.
.
.
... . .
. .
.. .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.. .. .... .... ... ............ ...... .. . ..
.. . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
. .. .... .... ... ... ..
.
.
.
.
. .
Y
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Sample data points for C and Y, plus
Regression Line, plus forecast error
C
E(C|Y) = c0+ c1Y
.
.
.
.
.
.
..
.
.
.
.
.
.
... . .
. .
.. .
u
.
.
.
.
.
.
.
.
.
.
.
(forecast
.
.
.
.
.
.
.
.
.
.
.
.
.
.. .. .. .... ... ........... ..... . . . error)
.. . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
. .. .... .... ... ... ..
.
.
.
.
. .
See Appendix 3, or take ECO 403, for more details.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Y
Olivier Blanchard
Consumption (C)
Levels
14000.0
12000.0
10000.0
8000.0
6000.0
4000.0
2000.0
0.0
0.0
2000.0
4000.0
6000.0
8000.0
10000.0
Income (GDP)
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Consumption (C)
Levels
14000.0
12000.0
10000.0
8000.0
6000.0
4000.0
2000.0
0.0
C = 127.02 + 1.4441 Y
0.0
2000.0
4000.0
6000.0
8000.0
10000.0
Income (GDP)
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
% Changes
% Change in C
0.08
C = 0.0035 + 0.7839 Y
0.06
0.04
0.02
0
-0.04
-0.02
-0.02
0
0.02
0.04
0.06
0.08
-0.04
% Change in GDP
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Consumer Confidence and the
1990-1991 Recession
 Can we predict recessions?
– More or less, but we can make mistakes.
 A forecast error is the difference between
the actual value of GDP and the value that
had been forecast by economists one
quarter earlier.
– Forecasts errors were negative before and
during the 1991 recession:
– Economists thought the economy would grow
faster than it did.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Consumer Confidence and the
1990-1991 Recession
 What component of Z is to blame for the
recession?
 Forecast errors were particularly bad for c0,
autonomous consumption.
 c0 fell because of a fall in consumer
confidence
– The consumer confidence index is computed
from a monthly survey of about 5,000
households who are asked how confident they
are about both current and future economic
conditions.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Consumer Confidence and the
1990-1991 Recession
Table 1
GDP, Consumption, and Forecast Errors, 1990-1991
Quarter
(1)
Change in
Real GDP
(2)
Forecast Error
for GDP
(3)
Forecast
Error for c0
(4)
Index of Consumer
Confidence
1990:2
19
17
23
105
1990:3
29
57
1
90
1990:4
63
88
37
61
1991:1
31
27
30
65
1991:2
27
47
8
77
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
3-4
Investment Equals Saving:
An Alternative Way of Thinking about GoodsMarket Equilibrium
 Saving is the sum of private plus public
saving. Private saving (S), is saving by
consumers.
 Public saving equals taxes minus government
spending.
 If T > G, the government is running a budget
surplus—public saving is positive.
 If T < G, the government is running a budget
deficit—public saving is negative.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
3-4
Investment Equals Saving:
An Alternative Way of Thinking about GoodsMarket Equilibrium
 Private Saving is simply what consumers don’t
spend out of YD
S  YD  C
 … Recall YD = Y – T.
S  Y T C
 Now, Y is equal to Z in equilibrium.
Y  C I  G
 Putting it all together …
S  Y  T  C  (C  I  G)  T  C  I  G  T
S  I  G T
 Then investment is …
I  S  (T  G )
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Investment Equals Saving:
An Alternative Way of Thinking about GoodsMarket Equilibrium
I  S  (T  G )
 The equation above states that equilibrium
in the goods market requires that investment
equals saving—the sum of private plus
public saving.
 This equilibrium condition for the goods
market is called the IS relation.
– What firms want to invest must be equal to what
people and the government want to save.
– If we want to use goods for future production,
we can’t consume them (we must save them).
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Investment Equals Saving:
An Alternative Way of Thinking about GoodsMarket Equilibrium
 Consumption and saving decisions are
one and the same.
S  Y T C
S  Y  T  c0  c1 (Y  T )
S   c0  (1  c1 )(Y  T )  The term (1c1) is called
the propensity to save.
In equilibrium:
I   c0  (1  c1 )(Y  T )  (T  G)
Rearranging terms, we get the same result as
before:
1
Y
[c0  I  G  c1T ]
1  c1
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Natural Rate of Interest
 Notice that the I  S  (T  G) relation is an
equilibrium relation.
– Quantity of investment and quantity of saving
are only equal in equilibrium.
– We can imagine Saving as the “supply of
loanable funds”
 It increases as the interest rate rises.
– And Investment as the “demand of loanable
funds.”
 Businesses demand fewer loans if the interest rate
rises.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Saving as a Function of
the Interest Rate
Real interest rate (%)
National
Saving S
People save
more when the
interest rate is
higher.
r’
Also, people
save because of
uncertainty.
r
Government
saving (T-G) is
part of National
Saving.
S
S’
Saving
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Investment as a Function of
the Interest Rate
Real interest rate (%)
Firms invest less
when the cost of
borrowing rises.
Investment can also
shift because of
confidence or
expectations of future
sales.
r
r’
Investment I
I
investment
© 2003 Prentice Hall Business Publishing
I’
Macroeconomics, 3/e
Olivier Blanchard
The Supply and Demand
For Loanable Funds
Real interest rate (%)
Saving S
r
Investment I
S, I
Saving and investment
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Effect of a New Technology
on National Saving and Investment
Real interest rate (%)
S
New Technology
• Raises the marginal
productivity of capital
• This increases the
demand for capital
F
r’
E
r
I’
I
Saving and investment
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Effects of An Increase in the Government
Budget Deficit On S and I
Real interest rate (%)
S’
S
Increases in the government
budget deficit:
•Reduces S public and
national saving
•r will increase
•S & I will fall
F
r’
E
r
I
Saving and investment
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Natural Rate of Interest
 The Natural Rate of Interest
– Is the interest rate that makes National
Saving equal to Investment.
I (r )  S (r )  (T  G)
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Paradox of Saving
 When consumers save more, spending
decreases and equilibrium output is lower.
 Attempts by people to save more lead both
to a decline in output and to unchanged
saving. This surprising pair of results is
known as the paradox of saving (or the
paradox of thrift).
– Hence the cartoon at the beginning of the
chapter.
– IT IS A SHORT RUN EFFECT.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
What did I learn in this chapter?
 Tools and Concepts
– The notation of functions. Appendix 2 discusses
functions in more detail.
– Modeling terminology: exogenous and endogenous
variables, behavioral equations, identities, and
equilibrium conditions.
– The Keynesian cross model (i.e., the Y/Z model), the
(marginal) propensity to consume, disposable
income, and autonomous expenditure.
– Fiscal policy.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard