Transcript Aggregate demand - Dipartimento di Economia

The Goods Market
academic year 2015/16
Introduction to Economics
Augusto Ninni
 Z = C0 +c1 YD + G +I
 YD = Y –
T
 Z = c1Y + Co – c1T + G + I
 Z = c1Y + AE
 YE = Z
 YE = c1Y + AE
 YE – c1Y = AE
 (1-c1) Y = AE
 Y = AE * (1/1-c1)
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
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.
Premise: short, medium and long period
Before doing so, a firm wants:
• To verify the stability of the new conditions
• To foresee the reaction of the consumers
(elasticity of demand)
• To foresee the reaction of competitors
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
Premise: short, medium and long period
In this class we will look first 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) → something is depending on some
other thing
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: age,
financial wealth, trust, 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:
 All 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” by 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 substitute for C:
Z = C 0 + c 1Y D + I + G
Let’s substitute for YD :
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
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
c1 The same than in consumption
equation
AE > C0
ZZ
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 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 and Z = Y
We obtain that in equilibrium:
Y = c1Y + AE
Determination of the equilibrium
level of income
From which we obtain that:
(1- c1 )Y = AE
AE
*
1
1 - c1
= YE
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 (the supply) is equal to the product of:
AE = autonomous expenditure
1

= the “multiplier”
1 - c1
Determinazione del reddito di
equilibrio
1
The multiplier:
1 - c1
It is always greater than 0 and smaller than 1
(0<c1<1, by assumption)
Y grows with c1 (in the short period)
It depends on the assumptions concerning the
exogenous and endogenous variables
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