ECOS2002 – Intermediate Macroeconomics
Week 2: ’The Goods and Financial Market’
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The University of 2 – 2022
ECOS2002 – Intermediate Macroeconomics The University of Outline
The Goods Market
I Composition of GDP
I Keynesian Cross Review
I Investment-Saving Relationship
The Financial Market
Readings: Blanchard and 3 and 4, Atkin and LaCava
ECOS2002 – Intermediate Macroeconomics The University of Goods Market
Let’s start with the goods market
ECOS2002 – Intermediate Macroeconomics The University of Composition of GDP
Consumption (C):
I Goods and services purchased by consumers
I By far the largest component of GDP (2011: 56% of Australian GDP)
Investment (I):
I Also called fixed investment to distinguish it from inventory investment
I It is the sum of nonresidential investment, the purchase by firms of new
plants or new machines, and residential investment, the purchase by
people of new houses or apartments.
I Together, nonresidential and residential investment accounted for 23.5
per cent of Australian GDP in 2011.
ECOS2002 – Intermediate Macroeconomics The University of Composition of GDP
Government Spending (G):
I Purchases of goods and services by the federal, state and local
governments
I It does not include government transfers nor interest payments on the
government debt
I In 2011: 24.1 per cent of Australian GDP
Imports (IM):
I The purchases of foreign goods and services by Australian consumers,
firms and the government
Exports (EX):
I The purchases of Australian goods and services by foreigners.
ECOS2002 – Intermediate Macroeconomics The University of Composition of GDP
Net Exports (NX):
I The difference between exports and imports (X–IM) is called net ex-
ports, or the trade balance
I If exports > imports, the country is said to run a trade surplus
I If exports < imports, the country is said to run a trade deficit
I In 2011, Australian exports accounted for 19.1 per cent of GDP, and
Australian imports were equal to 22.8 per cent of GDP, so Australia
was running a trade deficit equal to 3.7 per cent of GDP
ECOS2002 - Intermediate Macroeconomics The University of Cross Review
Denote the total demand for goods by Z
Z ≡ C + I + G + (EX − IM) (1)
A model of the demand for goods and services
Assumptions:
I All firms produce the same good
I Firms are willing to supply any amount of the good at a given price
I The economy is closed (NX = EX − IM = 0)
Z ≡ C + I + G (2)
What determines output?
ECOS2002 - Intermediate Macroeconomics The University of Cross Review
Consumption (C):
I Consumption depends positively on disposable income Y D ≡ Y − T
I The consumption function
C = F (Y D
I When disposable income increases, so does consumption
I This is called a behavioural equation
ECOS2002 - Intermediate Macroeconomics The University of Cross Review
The consumption function can be defined as a linear relationship:
C = c0 + c1(Y − T ) (3)
c0: Autonomous consumption
I Changes in c0 reflect changes in consumption for a given level of
disposable income.
I How can people have positive consumption if their income is equal to
zero? Answer: They dissave.
c1: Marginal propensity to consume
I It gives the effect an additional dollar of disposable income has on
consumption
I If c1 is equal to 0.6, then an additional dollar of disposable income
increases consumption by 1× 0.6 = 60 cents.
I c1 is positive but smaller than one: 0 < c1 < 1
ECOS2002 - Intermediate Macroeconomics The University of Cross Review
Higher income increases consumption, but less than one for one
Higher taxes decrease consumption, also less than one for one
ECOS2002 - Intermediate Macroeconomics The University of Cross Review
For now let investment, government spending, and taxes be
Investment (I): I = Ī
I Investment does not respond to changes in production
I Is this realistic?
Government spending (G): G = Ḡ
Taxes (T): T = T̄
I G and T describe fiscal policy
I Governments typically follow not the same behavioural equations as
households and firms
I Helpful to discuss the implication of spending and tax decisions
ECOS2002 - Intermediate Macroeconomics The University of Cross Review
Equilibrium Condition:
Z = c0 + c1(Y − T̄ ) + Ī + Ḡ (4)
In equilibrium, supply equals demand (Y = Z ):
Y = c0 + c1(Y − T̄ ) + Ī + Ḡ (5)
Move c1Y to the left side and reorganise the right side:
(1− c1)Y = c0 − c1T̄ + Ī + Ḡ
Divide both sides by (1–c1):
1− c1︸ ︷︷ ︸
Multiplier
[c0 − c1T̄ + Ī + Ḡ ]︸ ︷︷ ︸
Autonomous Spending
ECOS2002 - Intermediate Macroeconomics The University of Cross Review
The Multiplier: 1
The propensity to consume c1 is between zero and one,
I Assume that c0 increases by AUD 1,000.
I Furthermore, c1 = 0.6: out of each dollar 60 cents are used for
1−0.6 = 2.5
I Output increases by 1000× 2.5 = 2, 500 dollars.
Intuition: One person’s spending is another person’s income
Geometric series: 1 + c1 + c
1 + ... + c
ECOS2002 - Intermediate Macroeconomics The University of Cross Review
ECOS2002 - Intermediate Macroeconomics The University of Cross Review
The Effects of an Increase in Autonomous Spending
Equilibrium output increases from Y to Y ′. The increase in output is
larger than the initial increase in consumption. This is the multiplier
ECOS2002 - Intermediate Macroeconomics The University of -Saving Relationship
Saving is the sum of private saving and public saving.
Private saving (S): Saving can be defined as remaining disposable
income after spending
Public saving is equal to taxes minus government spending
I If taxes > government spending, the government is running a budget
surplus, so public saving is positive
I If taxes < government spending, the government is running a budget deficit, so public saving is negative ECOS2002 - Intermediate Macroeconomics The University of -Saving Relationship So far we have discussed the equilibrium in the goods market in terms of production and demand Saving can be defined as remaining disposable income after spending S ≡ YD − C = Y − T − C (7) Recall the equilibrium condition in the goods market Y = C + I + G (8) Combine the two equations S = C + I + G − T − C ⇒ S = I + G − T (9) This can be simplified to: private saving + (T − G )︸ ︷︷ ︸ public saving ECOS2002 - Intermediate Macroeconomics The University of -Saving Relationship Two equivalent ways of stating the condition for equilibrium in the goods market which deliver the same result: Production = Demand Investment = Saving S = Y − T − C = Y − T̄ − c0 − c1(Y − T̄ ) (11) Rearranging, we get S = −c0 + (1− c1)(Y − T̄ ) (12) In equilibrium, investment must be equal to saving (private + public) I = −c0 + (1− c1)(Y − T̄ ) + (T̄ − Ḡ ) (13) [c0 − c1T̄ + Ī + Ḡ ] (14) ECOS2002 - Intermediate Macroeconomics The University of Question #823864 Assume that everyone in the economy starts to save more by reducing autonomous consumption c0. What do you think does the model predict about the effect on aggregate saving in the short run? a Aggregate saving will increase. b The effects depend on the current state of the economy. c Aggregate saving will decrease. d There will be no effect on aggregate saving. ECOS2002 - Intermediate Macroeconomics The University of of increase in autonomous saving leads to a decline in aggregate output and to no additional aggregate savings in equilibrium. Assume that everyone decided to save more and represent this by decreasing c0. From equation 14, we see that output decreases. Lower consumptions means less aggregate demand and hence less What happens to saving? + (1− c1)(Y − T̄ ) (15) Ambiguous effects: Lower c0 increases saving, lower Y decreases ECOS2002 - Intermediate Macroeconomics The University of of equation 10: Ī = S + (T̄ − Ḡ ) By assumption, Ī , Ḡ , and T̄ do not change, so S cannot change either This is a short run result, we will discuss long run effects later in the ECOS2002 - Intermediate Macroeconomics The University of Financial Market In this market we look at people’s liquidity preferences I Do people hold money in cash, saving accounts, money market, cd’s, bonds, other financial assets? For simplicity, consider just two choices: I One can hold money as M1 or one can hold bonds that pay the nominal interest rate i . Money: Used for transactions but pays no interest Bonds: Pays a positive interest rate, i , but cannot be used for transactions ECOS2002 - Intermediate Macroeconomics The University of Demand The demand for money is based on: I Nominal interest rates F Money does not earn interest F The opportunity cost of holding money is the nominal interest rate Money demand is a function of income (Y ) and the nominal interest In linear form: (M = L0Y − L1i (16) ECOS2002 - Intermediate Macroeconomics The University of Supply We assume supply of money is fixed The central bank decides to supply a certain amount of money This is a simplifying assumption and not how modern monetary policy ECOS2002 - Intermediate Macroeconomics The University of Market Equilibrium In equilibrium, money supply has to be equal to money demand ECOS2002 - Intermediate Macroeconomics The University of Market Equilibrium ECOS2002 - Intermediate Macroeconomics The University of Market Dynamics Increase in nominal income increases the level of transactions, which increases the demand for money at any interest rate ECOS2002 - Intermediate Macroeconomics The University of Market Dynamics An increase in the supply of money by the central bank leads to a decrease in the interest rate. The decrease in the interest rate increases the demand for money so it equals the now larger money ECOS2002 - Intermediate Macroeconomics The University of Policy In this model, the central bank is conducting quantity-setting monetary policy We describe the central bank as choosing the money supply and letting the interest rate be determined at the point where money supply equals money demand Instead, we could have described the central bank as choosing the interest rate and then adjusting the money supply to match that rate Modern central banks typically conduct monetary policy by setting interest rates ECOS2002 - Intermediate Macroeconomics The University of Policy Transmission of monetary policy in two stages: I Changes to the policy rate influence other interest rates in the economy (yield curve) I Changes in market interest rates affect the economy and inflation Central banks (CB) change the amount of money in the economy by buying or selling bonds in the bond market This is called open market operations (OMO): I Expansionary policy: CB buys bonds and expands money supply which leads to lower nominal interest rates I Contractionary policy: CB sells bonds and reduces money supply which leads to higher nominal interest rates ECOS2002 - Intermediate Macroeconomics The University of Yield Curve The yield curve (term structure of interest rates) is a representation of yields on bonds over different terms to maturity The level of the yield curve measures the general level of interest rates in the economy and is heavily influenced by policy rate Source: RBA, n.d. ECOS2002 - Intermediate Macroeconomics The University of Yield Curve The slope represents the difference between yields on short-term bonds (e.g. 1 year) and long-term bonds I Normal: Longer term yields are associated with more uncertainty I Inverted: Interest rates are expected to fall I Flat: Short-term yields are similar to long-term yields Source: RBA, n.d. ECOS2002 - Intermediate Macroeconomics The University of In the short run, demand determines production. Production is equal to income. Income in turn affects demand. Equilibrium output is the level of output at which production equals demand. In equilibrium, output equals autonomous spending times the multiplier. An alternative way of stating the goods–market equilibrium condition is that investment must be equal to saving—the sum of private and public saving ⇒ IS relation The demand for money depends positively on the level of transactions in the economy and negatively on the interest rate. The way the central bank changes the supply of money is through open market operations. Modern monetary policy is conducted by setting interest rates which transmit through the economy ECOS2002 - Intermediate Macroeconomics The University of Next week we will discuss a model that combines the goods and money market Mathematical representation of Keynesian macroeconomic theory Static IS-LM model Reading: Textbook Chapter 5 ECOS2002 - Intermediate Macroeconomics The University of Sydney 程序代写 CS代考 加微信: powcoder QQ: 1823890830 Email: powcoder@163.com