Macroeconomic Analysis (ECM402) Engelbert Stockhammer

Macroeconomic Analysis (ECM402)
Lecture 2
Engelbert Stockhammer
C
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 1 of 31
Outline of today‘s lecture
• Brief review
• Aggregate expenditure function
• Consumption
• Investment
• IS-Equilibrium in a closed economy
• The mulitplier
• Another way to look at the equilibrium
• Paradox of saving
• An application: private surpluses and public
deficits
C
GDP: expenditures, nominal
C
GDP: expenditures, real
C
GDP: income
C
GDP by category of output (1/2)
C
GDP by category of output (2/2)
C
The
The Goods
Goods Market
Market
CHAPTER 3
Prepared by:
Fernando Quijano and Yvonn Quijano
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
3-1 The Composition of GDP
Table 3-1 The Composition of UK GDP, 2008

Billions of £ Percent of GDP
GDP (Y) 1448 100
1 Consumption by HH & NPO (C) 926 64
2 Government consumption (G) 313 21
3 Investment (I) 243 17
4 Net exports −37 3
Exports (X) 422 29
Imports (IM) 459 32
Source: ONS UK output, income, expenditure. 3rd quarter 2009, Table C1
C
 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.
C
 Imports (IM) are the purchases of foreign goods and

services by consumers, business firms, and the U.S.
government.
 Exports (X) are the purchases of U.S. goods and services

by foreigners.
C
 Net exports (X − IM) is the difference between exports

and imports, also called the trade balance.
E x p =o ri mt s p ⇔o r t rt s a da en cb e a l
E x p >o ri mt s p ⇔o r t rt s a dp el u s su r
E x p <o ri mt s p ⇔o r t rt s a d i ce i td e f
 Inventory investment is the difference between

production and sales.
C
3-2 The Demand for Goods
The total demand for goods is written as:
Z ≡ C + I + G + X − I M
The symbol “≡ ” means that this equation is an identity, or definition.
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.
C
 Assume that firms are willing to supply any amount of the

good at a given price, P, 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.
 Under the assumption that the economy is closed,

X = IM = 0, then:
Z ≡ C + I + G
C
Consumption (C)
Disposable income, (YD), is the income that remains once
consumers have paid taxes and received transfers from the
government.
C = C (Y D )
(+ )
The function C(YD) is called the consumption function. It is

a behavioral equation, that is, it captures the behavior of
consumers.
A more specific form of the consumption function is this linear

relation:
C = c 0 + c 1Y D
C
Determinants of consumption
• Permanent income hypothesis

• Wealth effects
• Income distribution
• Uncertainty, unemployment …
C
BoE MacroModel version 2000
C
C
C
Consumption (C)
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.
Disposable income is given by:
YD ≡ Y − T
C
Consumption (C)
Figure 3 - 1
Consumption and
Disposable Income
Consumption
increases with
disposable income but
less than one for one.
C = C (Y D )
YD ≡ Y − T
C = c 0 + c1 (Y − T )
C
Investment (I )
Variables that depend on other variables within the model are

called endogenous. Variables that are not explain within the
model are called exogenous. Investment here is taken as given,
or treated as an exogenous variable:
I = I
C
Determinants of investment
• Demand (!)
• Interest rates
• Uncertainty
• Profits
• Shareholder value orientation
C
Investment
C
C
• Note: What was the R2 in the consumption function
and what in the investment function?
• BoE first disaggregates Investment

• I = IB + IH + IG
• Then estimates IB
• Then assumes that IH grows with B
C
Government Spending (G)
Government spending, G, together with taxes, T, describes fiscal

policy—the choice of taxes and spending by the government.
C
We shall assume that G and T are also exogenous for two

reasons:
 Governments do not behave with the same regularity as

consumers or firms.
 Macroeconomists must think about the implications of

alternative spending and tax decisions of the government.
C
3-3 The Determination of Equilibrium Output
Assuming that exports and imports are both zero, the demand
for goods is the sum of consumption, investment, and
government spending:
Z ≡C + I +G
Then: Z = c0 + c1 ( Y - T ) + I + G
C
Equilibrium in the goods market requires that production,

Y, be equal to the demand for goods, Z:
Y = Z
The equilibrium condition is that, production, Y, be equal

to demand. Demand, Z, in turn depends on income, Y,
which itself is equal to production.
Then: Y = c0 + c1 (Y − T ) + I + G
C
Macroeconomists always use these three tools:
1. Algebra to make sure that the logic is correct
2. Graphs to build the intuition
3. Words to explain the results

C
Using Algebra
Rewrite the equilibrium equation:
Y = c0 + c1Y − c1T + I + G
Move c1Y to the left side and reorganize the right side:
(1− c ) Y = c
1 0
+ I + G − c1T
Divide both sides by (1 − c1 ) :

1
Y=  c0 + I + G − c1T 
1 − c1
C
Using Algebra
The equilibrium equation can be manipulated to derive some
important terms:
 Autonomous spending and the multiplier:

 The term [c0 + I + G − c1T ] is that part of the demand for goods
that does not depend on output, it is called autonomous
spending. If the government ran a balanced budget, then
T=G.
 Because the propensity to consume (c1) is between zero and
1
one, 1 − c 1 is a number greater than one. For this reason, this
number is called the multiplier.
1
Y = [c 0 + I + G − c1T ]
1 − c1
C
Using a Graph
Z = (c0 + I + G − c1T ) + c1Y
Figure 3 - 2
Equilibrium in the Goods
Market
Equilibrium output is
determined by the
condition that
production be equal to
demand.
 First, plot production as
a function of income.
 Second, plot demand as
a function of income.
 In Equilibrium,
production equals
demand.
C
Using a Graph
Figure 3 - 3
The Effects of an
Increase in Autonomous
Spending on Output
An increase in
autonomous spending
has a more than one-
for-one effect on
equilibrium output.
C
Using a Graph
 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.
C
Using a Graph
 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 x c1 = $
c12billion.
C
Using a Graph
Following this logic, the total increase in production

after, say, n + 1 rounds, equals $1 billion multiplied
by the sum:
1 + c1 + c12 + …+ c1n
Such a sum is called a geometric series.

C
Using Words
To summarize:
 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.
 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.
C
How Long Does It Take for Output to Adjust?

Describing formally the adjustment of output over time is what
economists call the dynamics of adjustment.
 Suppose that firms make decisions about their production

levels at the beginning of each quarter.
 Now suppose consumers decide to spend more, that they

increase c0. .
 Having observed an increase in demand, firms are likely to

set a higher level of production in the following quarter.
 In response to an increase in consumer spending, output

does not jump to the new equilibrium, but rather increases
over time.
C
3-4 Investment Equals Saving: An Alternative
Way of Thinking about Goods-Market
Equilibrium
Saving is the sum of private plus public saving.
 Private saving (S), is saving by consumers.
S ≡ YD − C S ≡ Y − T − C
 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.
Y = C + I + G Y − T − C = I + G − T
S = I + G − T I = S + (T − G )
C
3-4 Investment Equals Saving: An Alternative
Way of Thinking about Goods-Market
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.
C
Investment Equals Saving: An Alternative
Way of Thinking about Goods-Market Equilibrium
 Consumption and saving decisions are one and the

same.
S = Y − T − C
S = Y − T − c0 − c1 (Y − T )
S = − c 0 + ( 1 − c 1 ) Y( − T )
 The term (1−c1) is called the propensity to save.
In equilibrium:
I = − c 0 + ( 1 − c 1 ) Y( − T ) + ( T − G )
Rearranging terms, we get the same result as before:
1
Y= [c0 + I + G − c1T ]
1 − c1
C
The Paradox of Saving
The paradox of saving (or the paradox of

thrift) is that as people attempt to save more,
the result is both a decline in output and
unchanged saving.
C
• Let’s got back to
• S=I+G–T
• We can rewrite this as
• S–I=G–T
• What is the meaning of these terms?
• Private surplus (PS)
• Budget deficit (BD) = – BS
• PS = BD or 0 = PS + BS
C
An application: deficits saved the world
• http://krugman.blogs.nytimes.com/2009/07/15/deficits-saved-the-world/
Deficits saved the world
Jan Hatzius of Goldman Sachs has a new note (no link) responding to claims
that government support for the economy is postponing the necessary
adjustment. He doesn’t think much of that argument; neither do I. But one
passage in particular caught my eye:
“The private sector financial balance—defined as the difference between
private saving and private
investment, or equivalently between private income and private spending
—has risen from -3.6% of GDP in the 2006Q3 to +5.6% in 2009Q1. This
8.2% of GDP adjustment is already by far the biggest in postwar history
and is in fact bigger than the increase seen in the early 1930s.”
That’s an interesting way to think about what has happened — and it also
suggests a startling conclusion: namely, government deficits, mainly the
result of automatic stabilizers rather than discretionary policy, are the only
thing that has saved us from a second Great Depression.
C
C
Here I show the private sector surplus and the public sector deficit, both as functions of
GDP; the private sector line is upward-sloping because higher GDP means higher
income and more savings, the public-sector line is downward-sloping because higher
GDP means higher revenues. In equilibrium the private surplus equals the
government deficit (not strictly true for any one country if you add in international
capital flows, but think of this as a picture for the world economy). To make the figure
cleaner I’ve shown an initial position of balance in both sectors, but this isn’t
important.
What we’ve had is a sharp increase in the desired private surplus at any given level of
GDP, due to a combination of higher personal saving and reduced investment
demand. This is shown as an upward shift in the private-surplus curve.
In the 1930s the public sector was very small. As a result, GDP basically had to shrink
enough to keep the private-sector surplus equal to zero; hence the fall in GDP labeled
“Great Depression”.
This time around, the fall in GDP didn’t have to be as large, because falling GDP led to
rising deficits, which absorbed some of the rise in the private surplus. Hence the
smaller fall in GDP labeled “Great Recession.”
What Hatzius is saying is that the initial shock — the surge in desired private surplus —
was if anything larger this time than it was in the 1930s. This says that absent the
absorbing role of budget deficits, we would have had a full Great Depression
experience. What we’re actually having is awful, but not that awful — and it’s all
because of the rise in deficits. Deficits, in other words, saved the world.
C
3-5 Is the Government Omnipotent?
A Warning
 Changing government spending or taxes is not always easy.
 The responses of consumption, investment, imports, etc, are

hard to assess with much certainty.
 Anticipations are likely to matter.
 Achieving a given level of output can come with unpleasant

side effects.
 Budget deficits and public debt may have adverse

implications in the long run.
C
Key Terms
 Consumption (C)  Exogenous variables

 Investment (I)  Fiscal policy
 Fixed investment  Equilibrium
 Nonresidential investment  Equilibrium in the goods market
 Residential investment  Equilibrium condition
 Government spending (G)
 Autonomous spending
 Government transfers
 Imports (IM)
 Balanced budget
 Exports (X)  Multiplier
 Net exports (X-IM)  Geometric series
 Trade balance  Econometrics
 Trade surplus  Dynamics
 Trade deficit  Forecast error
 Inventory investment  Consumer confidence index
 Identity  Private saving (S)
 Disposable income (YD)  Public saving (T-G)
 Consumption function  Budget surplus
 Behavioral equation
 Budget deficit
 Linear relation
 Parameter  Saving
 Propensity to consume (c1)  IS relation
 Endogenous variables  Propensity to save
 Paradox of saving
C

Macroeconomic Analysis (ECM402) Engelbert Stockhammer

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Macroeconomic Analysis (ECM402)

Table 3-1 The Composition of UK GDP, 2008

 Consumption (C) refers to the goods and services

 Investment (I), sometimes called fixed investment, is the

 Government Spending (G) refers to the purchases of

 Imports (IM) are the purchases of foreign goods and

 Exports (X) are the purchases of U.S. goods and services

 Net exports (X − IM) is the difference between exports

 Inventory investment is the difference between

The total demand for goods is written as:

The symbol “≡ ” means that this equation is an identity, or definition.

To determine Z, some simplifications must be made:

 Assume that firms are willing to supply any amount of the

 Assume that the economy is closed, that it does not trade

 Under the assumption that the economy is closed,

The function C(YD) is called the consumption function. It is

A more specific form of the consumption function is this linear

• Permanent income hypothesis

This function has two parameters, c0 and c1:

 c1 is called the (marginal) propensity to consume, or the

 c0 is the intercept of the consumption function.

Disposable income is given by:

Variables that depend on other variables within the model are

• BoE first disaggregates Investment

Government Spending (G)

Government spending, G, together with taxes, T, describes fiscal

We shall assume that G and T are also exogenous for two

 Governments do not behave with the same regularity as

 Macroeconomists must think about the implications of

Equilibrium in the goods market requires that production,

The equilibrium condition is that, production, Y, be equal

Macroeconomists always use these three tools:

1. Algebra to make sure that the logic is correct

2. Graphs to build the intuition

3. Words to explain the results

Divide both sides by (1 − c1 ) :

 Autonomous spending and the multiplier:

 The first-round increase in

Following this logic, the total increase in production

Such a sum is called a geometric series.

 An increase in demand leads to an increase in

 To estimate the value of the multiplier, and more

How Long Does It Take for Output to Adjust?

 Suppose that firms make decisions about their production

 Now suppose consumers decide to spend more, that they

 Having observed an increase in demand, firms are likely to

 In response to an increase in consumer spending, output

 Private saving (S), is saving by consumers.

 If T > G, the government is running a budget

This equilibrium condition for the goods market is

 Consumption and saving decisions are one and the

The paradox of saving (or the paradox of

 The responses of consumption, investment, imports, etc, are

 Anticipations are likely to matter.

 Achieving a given level of output can come with unpleasant

 Budget deficits and public debt may have adverse

 Consumption (C)  Exogenous variables

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