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3. Determinants of Demand for Goods and Services • Examine: how the output from production is used • Four components of GDP: – Consumption (C) – Investment (I) – Government purchases (G) – Net exports (NX) • Assume a closed economy. NX = 0 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 1 Determinants of Goods and Services • Closed economy, three components of GDP, expressed as the National Income Accounts Identity: Y = C + I + G • Households consume some of the economy’s output • Firms and households use some output to invest • Government buys some of the output Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 2 Determinants of Goods and Services • Consumption: – We consume some of the output produced in the economy (e.g. food, clothing, going to the cinema) – Consumption makes up two thirds of GDP – Households get income from their labour and ownership of capital, pay taxes to the government and decide how much of what is left to consume and/or save Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 3 Consumption • Income households receive equals output in the economy (Y) • Y = income • T = taxes • Y – T = disposable income i.e. income left after taxes have been paid • Disposable income is divided between consumption and saving Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 4 Consumption • C = C(Y-T) • Consumption is a function of disposable income • Consumption function – Graph • Marginal Propensity to Consume (MPC): amount by which consumption changes when disposable income increases by one Euro. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 5 Consumption 0<MPC<1: MPC is between 0 and 1 For example if MPC = 0.7, households spend 70 cents of each additional Euro they get and they save 30 cents Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 6 Investment • Firms and households purchase investment goods • Firms buy goods to add to or replace existing capital • Households buy new houses • Quantity of investment demanded depends on the interest rate • Interest rate measures the cost of funds to finance the investment Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 7 Investment • For investment to be profitable: return on investment (increased production of goods and services) must exceed the cost (the payments for borrowed funds • Same decision is made even if firm does not have to borrow for the investment – Uses own funds and forgoes the interest that would have been earned from leaving money in the financial institution Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 8 Investment • Nominal and real interest rates • Real interest rate is corrected for the effects of inflation • Real interest rates measure the true cost of borrowing and determines the quantity of investment I = I(r) Graph: the investment function Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 9 Government Purchases • Government purchases e.g. services of public employees, schools, colleges etc. • Transfer payments are not included in G: – e.g. social welfare, social security payments to elderly. Payments are not made in exchange for some of the economy’s output • Transfer payments are opposite to taxes: – Transfer payments increase disposable income – Taxes decrease disposable income • Y-T: disposable income includes negative impact of taxes and positive impact of transfer payments) Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 10 Government Purchases • If Government purchases equal taxes minus transfer payments, then: G = T: balanced budget • G>T: budget deficit • G<T: bduget surplus • Here, we assume G and T are exogenous variables i.e. given or fixed variables outside our model • G = G, T = T Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 11 4. Equilibrium • How can we be certain that all the flows of goods and services in the economy balance? • i.e. What ensures that the sum of consumption, investment and government purchases equals the amount of out put produced? – The interest rate has a crucial role of equilibriating supply and demand Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 12 Equilibrium Y=C+I+G C = C(Y – T) I = I(r) G=G T=T • Demand for economy’s output comes from C, I and G • C depends on disposable income, I depends on the real interest rate and G and T are exogenous variables Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 13 Equilibrium • Factors of production and production function determine the quantity of output supplied: Y = F(K,L) = Y • Combine Y = C(Y – T) + I(r) + G with output supplied • G and T are fixed by policy, Y is fixed by the factors of production and production function Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 14 Equilibrium Y = C(Y – T) + I(r) + G • Supply equals demand • Interest rate, r, is the only variable not already determined in the equation • r must adjust to ensure that the demand for goods equals supply • The greater the interest rate, the lower the level of investment thus the lower the demand for goods and services Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 15 Equilibrium • If r is too high, I is too low and demand < supply • If r is too low, I is too high and demand > supply • At equilibrium interest rate: demand for goods and services equals supply • How interest rates get to balance supply and demand? Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 16 Equilibrium • Supply and demand for loanable funds: • Interest rate = cost of borrowing and return to lending • Rearrange National Income Accounts Identity: Y–C–G =I Y – C – G: output that remains after demands of consumers and government Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 17 Equilibrium • • • • Y – C – G: National saving (S) Y–C–G=I Savings = Investment National saving = private saving + public saving • Y – T – C : private saving • T – G: Public saving • (Y – T – C) + (T – G) = I Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 18 Equilibrium • Substitute: I for I(r) and C for C(Y – T) Y – C(Y – T) – G = I(r) G and T are fixed by policy Y is fixed by factors of production and production function Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 19 Equilibrium • Y – C(Y – T) – G = I(r) S = I(r) • National saving depends on Y, G and T, which are all fixed, so National Saving is fixed • Graph of saving and investment • The interest rate adjusts to bring saving and investment into balance Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 20 Equilibrium • Saving and investment – supply and demand of loanable funds • Price of loanable funds = the interest rate • Interest adjusts until the amount that households want to save equals amount firms want to invest • If r is too low: investors want more of economy’s output that households want to save • If r is too high: households want to save more than firms want to invest Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 21 Changes in saving An increase in government purchases: • No increase in taxes • So the government finances additional spending by borrowing or reducing public spending • No change in private saving • So national saving decreases: S shifts to the left • Interest rate rises • Increase in G causes r to rise • See Graph Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 22 Changes in saving A decrease in taxes: • Raises disposable income (Y - T) • Consumption increases • National Saving, (Y – C – G), falls by the same amount as consumption rises • S shifts to the left • r rises • Decrease in taxes causes r to rise Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 23 Changes in investment demand • An increase in the demand for investment might be because of an increase in technological innovation • An increase in demand for investment shifts I to the right and raises interest rates • See graph Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 24 Summary 1. 2. 3. 4. What determines a nation’s total income or level of production? Answer: factors of production and production function Who gets the income from production? Answer: wages paid to labour, rent paid to capital-owners and economic profit What determines demand for output? Answer: Consumption, Investment, Government purchases What equilibrates the demand and supply of goods and services? Answer: The real interst rate adjusts to equilibriate the supply and demand of the economy’s output Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 25