Ch3. The Goods Market
Reading: 3.1 – 3.4
• Main Topics
- Composition of GDP and the demand for goods
- The determinants of the demand for goods
- Output market equilibrium
- Equilibrium as Investment vs. Saving
- The effects of fiscal policy on equilibrium output
In order to build a model that explains how the entire economy works, we need to first
analyze different important markets in the economy and the way those markets interact.
Markets
1) Market of goods
2) Money market
3) Labor Market
Start with the Markets of goods.
3.1 The Composition of GDP
• Consumption (C) = the goods and services purchased by consumers
• Investment (I) = fixed investment
= the purchase of capital goods
= nonresidential investment
+ residential investment
• Government Spending (G) = the purchases of goods and services by the government
- It does not include government transfers, nor interest payments on the government debt.
• Imports (IM) = the purchases of foreign goods and services by consumers, business firms,
and the U.S. government
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• Exports (X) = the purchases of U.S. goods and services by foreigners.
• Net exports (X  IM)
 trade balance
- X  IM
 trade surplus
- X  IM
 trade deficit
- X  IM
3.2 The Demand for Goods
• The total demand for domestic goods ( Z )
Z  C  I  G  X  IM
• Assumption
1) one good market for simplicity
2) the firms accept the given price, P .
3) the closed economy, X  IM  0
⇒ Z  C  I G
3.2.1 Consumption
• Consumption mainly depends on disposable income ( YD  Y  T )
• Consumption Function
C  C (YD ) where C
YD
0
()
- It is a behavioral equation, that is, it captures the behavior of consumers.
• Assume a Linear Consumption Function
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C  c0  c 1YD  c 0 c (1Y  T )
- 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 exogenous or independent consumption spending (how much would you spend at
zero income, through borrowing). 0< c0
• Consumption and Disposable Income
3.2.2 Investment (I)
• Investment here is taken as given, or treated as an exogenous variable:
- Variables that depend on other variables within the model are called endogenous.
- Variables that are not explained within the model are called exogenous.
- We treat investment as exogenous I  I
3.3.3 Government Spending (G)
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• Government spending, G, together with taxes, T, describes fiscal policy.
• G and T are assumed to be exogenous
3.3 Equilibrium in the goods market
⇒ Production is equal to the demand for goods in the equilibrium.
• Using Algebra
Y Z
⇒ Y  C  I  G  c0  c1 (Y  T )  I  G
⇒ Y

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c0  I  G  c1T
1  c1

- Note
i) The term, c0  I  G  c1T does not depend on output. ⇒ autonomous spending.
Autonomous spending is likely to be positive.
ii) Because 0< c1 <1,
1
 1 . For this reason, this number is called the multiplier.
1  c1
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Ex) Suppose c1 =0.6 and c0 increases by $1B.
Then output increases by 2.5*$1B = $2.5B
• Graph
i) Production
⇒ Production = Income in an economy ⇒ 45-degree line
ii) Demand for goods
Z  C  I G
 c0  c1 (Y  T )  I  G
 (c0  I  G  c1T )  c1Y
• The Effects of an Increase in Autonomous Spending on Output by $1 billion
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- The first-round increase in demand, shown by the distance AB equals $1 billion.
- This first-round increase in demand leads to an equal increase in production, or $1
billion, which is also shown by the distance in AB.
- This first-round increase in production leads to an equal increase in income, shown by
the distance in BC, also equal to $1 billion.
- The second-round increase in demand, shown by the distance in CD, equals $1 billion
times the propensity to consume.
- This second-round increase in demand leads to an equal increase in production, also
shown by the distance DC, and thus an equal increase in income, shown by the distance
DE.
- The third-round increase in demand equals $c1 billion, times c1, the marginal propensity
to consume; it is equal to $c1* c1 = $ c12billion.
- the total increase in production after, say, n rounds
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as n  
= 1  c1  c12  c13  c1n 
1  c1
• Remember
- An increase in demand 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 demand,
by a factor equal to the multiplier.
Ex) Z = C + I + G, C=300 + 0.5 YD , T=400, I =200, G=1000, YD =Y – T
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a) Calculate the equilibrium output
b) Describe the goods market equilibrium by using a graph.
c) Suppose consumer confidence increases c0 from 300 to 400. What is the multiplier?
What is the change in output level?
1/(1-c1 ) = 2, Y=2,800
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3.4 Investment equals Saving: An Alternative Way
• Agg. Saving (Agg. S) = private saving + public saving
- private saving (S) = saving by consumers
⇒
S  YD  C  Y  T  C
- public saving = T-G
- If T – G > 0, then budget surplus
- If T – G < 0, then budget deficit
Y  C  I G  Y C G  I
 Y T  C T  G  I
•
 S  (T  G )  I
• Remember
- Production = Demand is equivalent to Saving = Investment
- This equilibrium condition for the goods market is called the IS relation.
• Consumption and saving decisions are the same.
- S  Y  T  C  Y  T  c0  c1 (Y  T )  c0  (1  c1 )(Y  T )
⇒ I  T  G  c0  (1  c1 )(Y  T )
⇒ Y

1
c0  I  G  c1T
1  c1

- The term ( 1  c1 ) is called the propensity to save.
• Reading: The Paradox of Saving (pp 60)
- The paradox of saving is that as people attempt to save more, the result is both a decline
in output and unchanged saving.
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