Macroeconomics - Licence 1 Economie Gestion Chapter 4: The Goods market
Rémi Bazillier 1 1
[email protected] http://remi.bazillier.free.fr Université d’Orléans
Rémi Bazillier
Chapter 3: Investment
Plan
Rémi Bazillier
Chapter 3: Investment
The Goods market
When economists think about year-to-year movements in economic activity, they focus on the interactions between production, income and demand. Changes in the demand for goods lead to changes in production Changes in production lead to changes in income Changes in income lead to changes in the demand for goods
Rémi Bazillier
Chapter 3: Investment
The composition of French GDP, 2008
GDP (Y) Consumption (C) Investment (I) Government spendings (G) Net Exports Exports (X) Imports (M) Inventory investment (Is )
Rémi Bazillier
Billions of euros 1950 1114 427 452 -48 516 564 4
Chapter 3: Investment
Percent of GDP 57.1 21.9 23.2 -2.5 26.4 29.8 0.2
The demand for Goods
Denote the total demand for goods by Z . Using the decomposition of GDP, we can write Z as: Z ≡C+I+G+X −M
(1)
This equation is an identity (using ≡ rather than =). It defines Z as the sum of consumption, plus investment, plus government spending, plus exports, minus imports
Rémi Bazillier
Chapter 3: Investment
Assumptions
All firms produce the same good, which can be used by consumers for consumption, by firms for investment or by government. Only one market. What determines supply and demand in that market. Firms are willing to supply any amount of the good at a given price. We focus on the demand-side of the equilibrium. This asumption is only valid in the short run. The economy is closed (no trade with the rest of the World) Z ≡C+I+G
Rémi Bazillier
Chapter 3: Investment
(2)
Consumption (C)
See chapter 2 C is a function of disposable income (Yd ). C = C(Yd )
(3)
(+)
(4)
C = C0 + cYD
c is the marginal propensity to consume (0 < c < 1) C0 : fixed consumption
Rémi Bazillier
Chapter 3: Investment
(5)
Consumption (C)
Yd ≡ Y − T
(6)
C = C0 + c(Y − T )
(7)
Rémi Bazillier
Chapter 3: Investment
Investment (I)
Investment will be treated as an exogenous variable (taken as given) I≡I
(8)
It means that we suppose that investment does not repond to changes in production Not realistic (see chapter 3 on investment). We will rise this assumption later.
Rémi Bazillier
Chapter 3: Investment
Government Spending (G)
T and G describe fiscal policy. They are exogenous (but not for the same reason than I) Governments do not behave with the same regularity as consumers or firms. (no clear behavioral rules) The tasks of macroeconomists is to study the implications of alternative spending and tax decisions. We do not want to explain fiscal policies but to study their effects.
Rémi Bazillier
Chapter 3: Investment
The determination of equilibrium output
Z ≡C+I+G
(9)
Z = C0 + c(Y − T ) + I + G
(10)
Equilibrium in the goods market: Production (Y ), be equal to the demand for goods (Z ) Y =Z
(11)
Y = C0 + c(Y − T ) + I + G
(12)
In equilibrium, production Y (the left side of the equation) is equal to demand (the right side). Demand in turn depends on income, Y , which is itself equal to production. Rémi Bazillier
Chapter 3: Investment
The three tools of macroeconomists
1
Algebra to make sure that the logic is correct
2
Graphs to build the intuition
3
Words to explain the results
Rémi Bazillier
Chapter 3: Investment
Using Algebra
Rewrite the equilibrium condition: Y = C0 + cY − cT + I + G
(13)
Move cY to the left side and reorganize the right side (1 − c)Y = C0 + I + G − cT 1 Y = [C + i + G − cT ] 1−c O
Rémi Bazillier
Chapter 3: Investment
(14) (15)
Using Algrebra (II)
(1 − c)Y = C0 + I + G − cT 1 Y = [C + I + G − cT ] 1−c O
(16) (17)
The term [CO + i + G − cT ] is called autonomous spending (part of demand for goods that do not depend on output). Is autonomous spending positive? Yes, except when budget surplus is very large
Rémi Bazillier
Chapter 3: Investment
The Keynesian multiplier 1 1−c
is the Keynesian multiplier because the propensity to consume is between 0 and 1, 1 1−c > 1 The closer c is to 1, the larger the multiplier An increase of consumption, investment or public spending will change output by more than its direct effect on autonomous spending
Where does the multiplier effect come from? An increase of autonomous spending increases demand. The increase in demand then lead to an increase in production The increase in production leads to an increase in income The increase in income leads to a further increase in demand (...)
Rémi Bazillier
Chapter 3: Investment
Using a graph
First, plot production as a function of income. Production and income are identically equal. The relation between them is the 45-degreee line, the line with a slope equal to 1 Second, plot demand as a function of income (see how to plot consumption) In equilibrium, production equals demand
Rémi Bazillier
Chapter 3: Investment
Using a graph
Rémi Bazillier
Chapter 3: Investment
The effects of an increase in autonomous spending on output
Rémi Bazillier
Chapter 3: Investment
The effects of an increase in autonomous spending on output
The initial increase in consumption leads to an increase of demand of 1 million To satisfy this higher level of demand: increase of production by 1 million (and increase of income) The increase of income by 1 million leads to an increase of demand by c x 1 million (and so one) the final effect on output is
Rémi Bazillier
1 1−c ∆C0
Chapter 3: Investment
Using words
Production depends on demand, which depends on income, which is itself equal to production An increase in demand, such as an increase in government spending, leads to an increase in production and a corresponding increase in demand, which leads to a further increase in production, and so one The end result is an increase in output larger than the initial shift in demand, by a factor equal to the multiplier
Rémi Bazillier
Chapter 3: Investment
Investment = Saving: an alternative way of seeing equilibrium Private saving (S) is equal to: S ≡ Yd − C
(18)
S ≡Y −T −C
(19)
Public saving is equal to T − G Equation for equilibrium: Y =C+I+G
(20)
Y −T −C =I+G−T
(21)
S =I+G−T
(22)
I = S + (T − G)
(23)
Rémi Bazillier
Chapter 3: Investment
Investment = Saving: an alternative way of seeing equilibrium
The saving function S = −C0 + (1 − c)(Y − T )
(24)
Replacing private saving in equation I = S + (T − G): I = −C0 + (1 − c)(Y − T ) + (T − G) 1 [C0 + I + G − cT ] Y = 1−c
Rémi Bazillier
Chapter 3: Investment
(25) (26)
The paradox of saving The “Cricket and the Ant” story: those who save are promised a happy life Here, savings have depressive effects (eg. a decrease of C0 ) Y =
1 [C0 + I + G − cT ] 1−c
(27)
Which effects on savings? S = −C0 + (1 − c)(Y − T )
(28)
−C0 is higher but Y is lower Saving will be unchanged: I = S + (T − G) Rémi Bazillier
Chapter 3: Investment
(29)
The paradox of saving
The paradox of saving: as people attempt to save more, the result is both a decline in output and unchanged saving But this is valid only in the short run: Other mechanisms come into play over time
Policies that encourage saving might be good in the medium run and in the long run but they can lead to a recession in the short run
Rémi Bazillier
Chapter 3: Investment
Can the government really choose the level of output?
Y =
1 [C0 + I + G − cT ] 1−c
(30)
According to this equation, governments can choose the level of output by increasing or decreasing G or T But it is more complex in reality: Changing government spending or taxes is not always easy. Getting to the parliament to pass bills take time.. Here investment remained constant. But Investment is likely to respond. The same for imports: some of the increased demand by consumers and firms will be for foreign goods. Anticipations are likely to matter. The reaction of consumers to a tax cut is likely to depend on whether they think of the tax cut as transitory or permanent Too high level of output may lead to inflation Large public deficit and accumulation of public debt may become problematic (the “AAA” phenomenom) Rémi Bazillier
Chapter 3: Investment
