Download Aggregate demand

The Goods Market
Lecture 17 – academic year 2014/15
Introduction to Economics
Fabio Landini
Questions of the day
• In the preceding lectures we saw that GDP is a key
variable in the economic analysis
• How is the level of GDP determined?
• The answer is different if we consider different time
horizon
• In this lecture: How is the level of GDP determined in
the short period?
What do we do today…
• Premise: short, medium and long period
• Analysis of the different components of
demand
• Determination of the aggregate demand
function
• Determination of the equilibrium level of
production (GDP) in the short period
Premise: short, medium and long period
We can distinguish three different time horizons:
• Short period = 1-2 years
• Medium period = 10 years
• Long period = 20-50 year
Premise: short, medium and long period
Why do we use this differentiation?
1) Empirical evidence shows that depending on the time
time horizon that we consider production is led by
different factors
• Short period -> Dynamics of the demand (how many
goods are purchased)
• Medium period -> Dynamics of the supply (how much
the production capacity is)
• Long period -> Structural factors (savings, quality of
education, features of institutions, etc.)
Premise: short, medium and long period
2) Depending on the time horizons we make different
hypotheses on the functioning of the economy
a) Price adjustments
Short period: prices are fixed (or with reduced flexibility)
As the market conditions change firms do not adjust
their price list immediately. To change prices is indeed
costly.
Before doing so, a firm want:
• To verify the stability of the new conditions
• To see the reaction of competitors
Premise: short, medium and long period
Medium and long period: Prices are perfectly flexible
If we consider a longer time horizon firms have the
time to perfectly adjust prices
Price adjustments -> medium period analysis
b) Accuracy of previsions on the future value of some
variables (expectations)
Premise: short, medium and long period
In this class we will look at the functioning of the
goods market in the short period.
Underlying question: what is it that determine
the level of GDP in the short period?
The components of aggregate demand
Following the decomposition presented in
the preceding lecture, aggregate demand is
the sum of:
•
•
•
•
Consumption (C)
Investments (I)
Government expenditure (G)
Balance between export and import (X-Q)
Aggregate demand (Z):
Z = C + I + G + X-Q
The components of aggregate demand
To illustrate the model that examines the good
market we introduce some simplifying
assumptions:
1) We ignore international exchanges
We assume, X = Q = 0 and Z = C + I + G
We examine a closed economy
2) We assume that there exist only one good used
for consumption, investments and public
expenditure -> only one market
The components of aggregate demand
3) With respect to the variables that we examine we
employ two alternative approaches:
For some variables, we define a behavioural equation:
equation that describes the decisional rule followed by
the relevant subjects in making their decisions ->
endogenous variables (determined inside the model)
For the other variables, we consider a given and fixed
value (no behavioural equation) -> exogenous variables
(determined outside the model)
The components of aggregate demand
Under our hypotheses
Z=C+I+G
Let’s now examine the distinct components of
demand (C, I, G)
The components of aggregate demand
Consumption (C)
To describe aggregate consumption we use a
behavioural equation -> endogenous variable
Consumers’ behaviour:
• Consumers purchase more goods the greater their
income
• The type of income that we have to consider is the
income neat of taxes (“disposable income”)
The components of aggregate demand
It means that: C=C(YD)
+
Consumption is an increasing function of
disposable income (YD)
Important: Disposable income (YD) is the income
minus the taxes
YD = Y  T
where, Y is income and T is taxes
The components of aggregate demand
For simplicity we use a linear function
C = C0 + c1YD where C0, c1 are parameters
Interpretation of parameters:
a) C0  Autonomous consumption
•It is the term that captures all that part of
consumption that do not depend on disposable
income
•It is affected by several factors, such as: financial
wealth, trust in the feature, preferences
The components of aggregate demand
C = C0 + c1YD
b) c1 – Marginal propensity to consume
It captures how the increase in consumption if the
disposable income increases by one unit
Assumption 0 < c1<1
It means that:
• Consumption increases with disposable income
• The increase in consumption is smaller than the
increase in disposable income (a portion of income
is saved)
The components of aggregate demand
For instance, if c1 = 0,6
For every euro additional unit of disposable income
60 cents will be used to finance consumption and 40
cents will be saved.
Graphically: C = C0+c1YD
C
C0
c1
YD
The components of aggregate demand
Investments (I) and Government expenditure (G)
Let’s consider their value as a constant
(exogenous variable)
I = I0 and G = G0 where I0, G0 are
parameters
Similarly, let’s consider taxes (T) as exogenous, so
that
T = T0 where T0 is a parameter
The components of aggregate demand
Exogeneity of I = Simplifying assumption it will
be removed later
Exogeneity of G and T = Variables that are
“chosen” buy the Government
The analysis of fiscal policy looks at the effects of
the choices of different values for G and T
The components of aggregate demand
Let’s start again from the aggregate demand equation
Z =C+I+G
Let’s plug in the equation for C
Z = C0 + c1YD + I + G
Substituting away for the definition of YD we get
Z = C0 + c1 (Y-T) + I + G
Replacing the constant values of I, G e T we obtain
Z = C0 + c1 (Y-T0) + I0 + G0
The components of aggregate demand
Given the equation
Z = C0 + c1 (Y-T0) + I0 + G0
Let’s change the order of the terms
Z = c1 Y + C0 - c1T0 + I0 + G0
Let’s collect the components of demand that do not
depend on income, and let’s call them AE
(autonomous expenditure)
Z = c1 Y + AE
Equation of aggregate demand -> it represents
aggregate demand as a function of income.
Graficamente: Z = c1Y+AE
Z
ZZ
AE
c1
Y
Determination of the equilibrium
level of income
The analysis of a market usually represents the analysis
of its equilibrium
Market in equilibrium -> Microeconomics (Part I)
The equilibrium of a market is the state in which
demand is equal supply
Equilibrium condition in the goods market:
Demand of goods = Supply of goods
Aggregate demand of goods = Z
Determination of the equilibrium
level of income
What is the aggregate supply of goods?
Let’s assume that firms do not have goods in stock:
Supply = Goods that are produced in the economy
= Aggregate supply
We know from lectures 15 and 16 that:
•The measure of aggregate production is GDP
•GDP = Total income of the economy =
= Aggregate income = Y
Determination of the equilibrium
level of income
Therefore, the equilibrium condition in the market for
goods is:
Z =Y
Given the equations
Z = c1 Y + AE
Z=Y
We obtain that in equilibrium:
Y = c1Y + AE
Determinazione del reddito di equilibrio
From which we obtain that:
(1- c1 )Y = AE
1
YE =
AE
1 - c1
where YE is the equilibrium level of production
This result shows the value of production in equilibrium
as a function of constants and parameters
In particular YE is equal to the product of:
•AE = autonomous expenditure
1
•
= the “multiplier”
1 - c1
Determinazione del reddito di equilibrio
1
The multiplayer:
1 - c1
•It is called multiplier because it “multiplies”
autonomous expenditure
•It is always greater than 1 (0<c1<1, by assumption)
•It grows with c1
•It depends on the assumptions concerning the
exogenous and endogenous variables (it is not always
1/(1 – c1) )
Graphical analysis of equilibrium: Demand -> Z = SA+c1Y
Supply -> 45° lines
Equilibrium -> Y=Z -> intersection between the two curves (E)
Equilibrium -> point E -> Y=YE
Z, Y
Z
YE
E
45
°
Y