Last week we looked at GDP: the fact that there are at least three ways of defining GDP, and that we are interested in both Nominal and Real GDP. In this and next week’s lectures, we are going to look at: The composition of GDP Then: The goods market. The various components of demand for goods The determinants of these demand components The equilibrium in the goods market
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The Composition of GDP
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The Composition of GDP
Consumption (C) refers to the goods and services purchased by consumers. Investment (I), sometimes called fixed investment, is the purchase of capital goods. It is the sum of nonresidential investment and residential investment. Government Spending (G) refers to the 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.
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The Composition of GDP
Imports (IM) are the purchases of foreign goods and services by consumers, business firms, and the country’s government. Exports (X) are the purchases of the country’s goods and services by foreigners.
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The Composition of GDP
Net exports (X IM) is the difference between exports and imports, also called the trade balance.
Exports = imports trade balance
Exports > imports trade surplus Exports < imports trade deficit
Inventory investment is the difference between production and sales.
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The Demand for Goods
The total demand for goods is written as:
Z C I G X IM
The symbol “” means that this equation is an identity, or definition.
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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.
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Under the assumption that the economy is closed, X = IM = 0, then:
Z C I G
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Consumption (C)
C
depends mainly on disposable C C (YD ) income.
( )
The function C(YD) is called the consumption function. It is a behavioral equation, that is, it captures the behavior of consumers. YD is disposable income. That is, the income that remains once consumers have paid taxes and received transfers from the government. Disposable income is defined as total income minus taxes plus transfers.
YD Y T
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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. c0 is the intercept of the consumption function.
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Consumption Function
The following restrictions apply: 1) c1 is positive and less to 1. 2) c0 is positive. c0 is what people consume if disposable income is equal to 0. When disposable income is 0, people consume by dissaving.
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Consumption (C)
Figure 3 - 1
Consumption and Disposable Income
Consumption increases with disposable income, but less than one for one.
C C (YD ) YD Y T
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Consumption
Variables that depend on other variables within the model are called endogenous. Consumption (C) is an endogenous variable. Variables that are not explained within the model are called exogenous.
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Investment (I)
Investment
here is taken as given, or treated as an exogenous variable:
I I
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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
