Prof.

Fei DING
The Hong Kong University of Science and Technology

ECON 2123: Macroeconomics

THE GOODS MARKET

PREVIOUSLY …

Ch1: A Tour of the World

Ch2: A Tour of the Book

LEARNING OBJECTIVES
 Obtain a big picture of the macro economy around the world: US, EU, and China.
 Define output, unemployment, inflation.
 Understand the components of the national income and product accounts.
 Understand key terms at the end of Ch2.

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TIME FRAME FOR DETERMINATION OF OUTPUT

 Short run  a few years – changes in output mainly

driven by changes in demand

 Medium run  a decade – output determined by

given supply factors: capital stock, technology, size
and skills of the labor force

 Long run  a few decades or more – output

determined by changes in supply factors:
accumulation of capital, technological growth,
education system, role of government, etc.
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 Ch3: The Goods Market

LEARNING OBJECTIVES
 Understand sources and determinants of demand from decomposition of GDP.
 Define and derive the short run equilibrium output using two approaches.
 Describe effects of fiscal policy on equilibrium output, and its limitations.

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CHINA VS. WORLD IN THE CRISIS
Table 1-4 Output Growth in China, 1980–2012

Table 1-1 World Output Growth since 2000

ALMOST NO SIGNS OF THE GLOBAL FINANCIAL CRISIS IN CHINA!

WHY???
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Chinese Economic Stimulus Program (From Wikipedia, the free encyclopedia)
The 2008–09 Chinese economic stimulus plan (擴大內需十項措施) is a RMB¥ 4 trillion (US$ 586 billion)
stimulus package announced by the State Council of the People's Republic of China on 9 November 2008 as an
attempt to minimize the impact of the global financial crisis on the world's second largest economy.[2][3] Critics of
China's stimulus package have maintained that it has made matters worse by pumping excessive investments
into an economy that was overheated and marked by overcapacity and overinvestment.[4][5][6]
On June 2009, the World Bank raised its growth forecast in China for 2009 from 6.5% to 7.2% amid signs that
the economy is doing better than expected, which has been helped by the stimulus package. But it says the
country's exports are still down, as the rest of the world struggles with the global recession. It was previously
predicted in March 2009 that the Chinese economy would grow by 6.5% in 2009, several percentage points
down on 2008's growth.

A statement on the government's website said the State Council had approved a plan to invest 4 trillion yuan in
infrastructure and social welfare by the end of 2010.[3][7] This stimulus, equivalent to US$586 billion, represented
a pledge comparable to that subsequently announced by the United States, but which came from an economy
only one third the size.[8] The stimulus package will be invested in key areas such as housing, rural
infrastructure, transportation, health and education, environment, industry, disaster rebuilding, income-building,
tax cuts, and finance.[9]
China's export driven economy started to feel the impact of the economic slowdown in the United States and
Europe, and the government had already cut key interest rates three times in less than two months in a bid to
spur economic expansion.
The stimulus package was welcomed by world leaders and analysts as larger than expected and a sign that by
boosting its own economy, China is helping to stabilize the world economy. World Bank President Robert
Zoellick declared that he was ‘delighted’ and believed that China was ‘well positioned given its current account
surplus and budget position to have fiscal expansion.'[8] News of the announcement of the stimulus package
sent markets up across the world.[10] 6
THE GOODS MARKET OVERVIEW

Production Income

Demand

The term “goods” is generally used

to refer to both physical goods and services.

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THE COMPOSITION OF US GDP, 2014

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COMPOSITION OF GDP
 Consumption (C)  goods and services purchased by
consumers.
 Investment (I)  purchases of new capital goods.
 Sum of nonresidential investment (e.g., new plants and
machines) and residential investment (e.g., new houses)
 Sometimes called fixed investment to distinguish it from
inventory investment.
 Government spending (G)  purchases of goods and
services by governments.
 Does not include government transfers or interest payments
on the government debt.
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ECONOMIC VS. FINANCIAL INVESTMENT

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REFRESH
Which of the following should NOT be considered as part
of fixed investment?
1. Toyota buys a new robot for its automobile assembly line.
2. Apple computer builds a new factory.
3. Exxon increases its holding of bonds and stocks in
financial markets.
4. An accountant buys a newly built home for herself and her
family.
5. None of the above.
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COMPOSITION OF GDP

 Imports (IM)  purchases of foreign goods and

services by domestic consumers, firms, and
governments.
 Exports (X)  purchases of domestic goods
and services by foreigners.
 Net exports (NX = X – IM) also called trade
balance
 X > IM  trade surplus
 X < IM  trade deficit

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COMPOSITION OF GDP
 Goods produced may not get sold right away.
 Inventory investment  difference between
production and sales.
 Inventory investment = production – sales
 Production = sales + inventory investment

 Sales = production – inventory investment

 Inventory investment is typically small.

 Positive when inventories accumulate.
 Negative when inventories fall.

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QUICK CHECK
How would the following situations change HK GDP this year and
its components?
 Last weekend, I spent HK$5000 on a seafood dinner with
family and friends in Sai Kung.
 Econ Dept. spent HK$20,000 on a new IBM server, made in
USA.
How would the following situations change US GDP last year and
its components?
 Last year, GM produced US$500 million worth of cars, but only
sold $450 million.
 My friend bought an un-used, 5-year old GM from GM dealer
last year at a bargain price of US$8000.
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THE DEMAND FOR GOODS

 The composition of GDP reveals the sources

of the demand.
 The total demand for domestic goods (Z):
Z ≡ C + I + G + X – IM
 The symbol “≡” means “by definition” – the
equation is an identity.
 Inventory investment is NOT part of demand.

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ASSUMPTIONS

 Only one good economy

 Supply any amount at a given price
 Fixed price level in the short run (relax in med run)
 No inflation concerns
 Focus on the demand in the market.

 Closed economy, no trade (relax later)

 Both exports and imports are zero.

Thus, demand becomes Z ≡ C + I + G.

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QUOTE OF THE DAY

17
CONSUMPTION (C)

 Determined by disposable income (YD ≡ Y – T)

– the income after paying taxes to (and
receiving transfers from) the government.
 Consumption function: C  C(YD )
( )
 A behavioral equation captures general behavior
of consumers.
 Assume a simple linear relation for the ease of
analysis  C = c0 + c1YD

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C = C0 + C1YD – TWO PARAMETERS

 c0:consumption for any given level of

disposable income, reflects autonomous
consumption or consumer confidence.
 c1:effect of an additional dollar of disposable
income on consumption  marginal
propensity to consume
 c1 > 0: higher income, higher consumption
 c1 < 1: saving motive
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 The marginal propensity to consume (MPC) is the amount by
which consumption changes when disposable income (Y-T)
increases by one dollar. To understand the MPC, consider a
shopping scenario. A person who loves shopping probably has a
large MPC, let’s say (0.99). This means that for every extra dollar
he or she earns after tax deductions, he or she spends $0.99 of it.
The MPC measures the sensitivity of the change in one variable
(C) with respect to a change in the other variable (Y-T).

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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
C  c0  c1 (Y  T )

21
REFRESH
The marginal propensity to consume represents
1. the level of consumption that occurs if disposable
income is zero.
2. the ratio of total consumption to disposable
income.
3. total income minus total taxes.
4. the change in output caused by a one-unit change
in autonomous demand.
5. the change in consumption caused by a one-unit
change in disposable income.
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REFRESH

Which of the following occurs when disposable

income is zero?
1. consumption must be zero.
2. saving must be zero.
3. saving must be positive.
4. consumption is negative.
5. none of the above.

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INVESTMENT (I)

 Assume investment is given or “exogenous”  I  I

 Exogenous variables are taken as given, not explained
within the model.
 Endogenous variables depend on other variables and
are explained within the model.
 Are c0 and c1 from the consumption function
endogenous or exogenous? What about Y?

 Unrealistic assumption? We will fix it later.

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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.
 G > T: budget deficit
 G < T: budget surplus
 G = T: balanced budget
 Treat G and T as exogenous because
 No reliable rule to describe government behavior
 Want to study implications of fiscal policy on the economy.

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 Z ≡ C + I + G + (X-IM)

Investment
Net exports
Total demand spending by
is composed of or net foreign
for domestic firms and
demand
output (GDP) households

Consumption Government
spending by purchases of goods
households and services
Assuming closed economy eliminates the last term, net exports (NX).
The remaining three components of GDP are
Consumption (C), Investment (I), and Government spending (G).

Z  c0  c1 Y - T   I  G
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 Assumptions
 Firms do not hold inventories.
 At fixed prices, firms produce as needed to satisfy demand.
 Equilibrium condition: production = demand
 Then recall the triangle diagram:
 Production equals demand. (equilibrium condition)
 Demand depends on income. (behavioral observation)
 Income equals production. (identity)

Y  Z  c0  c1 Y - T   I  G
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EQUILIBRIUM OUTPUT – ALGEBRA
Y  c0  c1 (Y  T )  I  G → 1  c Y  c 1 0
 I  G  c1T

1
→ Y c0  I  G  c1T 
1  c1

 Autonomous spending [c0  I  G  c1T ]  part of the

demand that does not depend on output (usually positive).
1
 The multiplier > 1 because c1 < 1 and so (1 – c1) < 1.
1  c1
 Any change in autonomous spending will change output by more than
one for one.
 c1   the multiplier  (the blow-up effect becomes larger)
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THE MULTIPLIER EFFECT ON OUTPUT
1
Y  c0  c1 (Y  T )  I  G →Y  c0  I  G  c1T 
1  c1
Suppose G increases by $1 billion, output will increase by more than $1 billion.
If c1 =0.6, output increases by 1/(1-0.6)*$1 billion = $2.5 billion.

 An increase in G increases demand.

 The increase in demand leads to an increase in production.
 The increase in production leads to an equivalent increases in income.
 The increase in income further increases consumption, which further
increases demand, and so on…

 Recall the triangle diagram again!!

 Let’s see this using a graph.

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EQUILIBRIUM OUTPUT – GRAPH

Z  c0  c1 Y - T   I  G →

Figure 3 - 2
Equilibrium in the
Goods Market

1. Plot production as a
function of income.
2. Plot demand as a
function of income.
3. In equilibrium,
production equals
demand.

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THE MULTIPLIER EFFECT ON OUTPUT

Figure 3 - 3
DY
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.

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THE MULTIPLIER EFFECT ON OUTPUT
FIRST ROUND

1) ↑ demand = $1
(A  B).

2) ↑ demand 
equal ↑ production
= $1 (AB).

3) ↑ production 
equal ↑ income
= $1 (B  C).

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THE MULTIPLIER EFFECT ON OUTPUT
SECOND ROUND

1) ↑ income  ↑ demand
= $1 × c1 (CD).
E
2) ↑ demand  equal ↑
production = $c1 (CD).

3) ↑ production  equal ↑
income = $c1 (DE).

THIRD ROUND

1) ↑ income  ↑ demand
= $c1 × c1 = $c12 (EF).

2) ↑ demand  ↑ production
 ↑ income, and so on…

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THE MULTIPLIER EFFECT ON OUTPUT
 An initial $1 increase in demand leads to an output
increase of 1 + c1 + c12 + c13 + c14 + … = 1/(1–c1).
 This is a geometric series which sums to the multiplier in the
limit, as long as c1 < 1.

 The multiplier effect: an original increase in demand

triggers successive increases in production, in income,
in demand, then further in production…, and so on.
 The multiplier is the sum of all these successive increases in
production.

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THE MULTIPLIER EFFECT ON OUTPUT
How long does this “multiplier effect” last to reach the
new equilibrium?
 In reality, adjustments take time.
 Firms cannot adjust production/output immediately and frequently.
They face many constraints, such as locating new materials,
recruiting new workers, advanced planning, administrative
procedures, etc.

 Consumers do not change consumption right away.

 In the model, we assume firms and consumers respond

instantaneously – an over-simplification.

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WHAT HAPPENED IN THE CRISIS?
Figure 2 Google search volume for “Great Depression,” January 2008 to
September 2009

36
WHAT HAPPENED IN THE CRISIS?
Figure 1 Disposable income, consumption, and consumption of durables in
the United States, 2008:1 to 2009:3

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WHAT HAPPENED IN THE CRISIS?
Fears of another great depression shift the consumption function down.

ZZ

ZZ’

38
REFRESH

Equilibrium in the goods market requires that

1. production equals income.
2. production equals demand.
3. consumption equals saving.
4. consumption equals income.
5. government spending equals taxes minus
transfers.

39
REFRESH

Which of the following will have the largest

impact on output, assuming c1 = 0.8?
1. G increases by 200.
2. T decreases by 200.
3. I increases by 150.
4. Both 1 and 2 have the same effect.
5. Both 2 and 3 have the same effect.

40
ANOTHER WAY TO DEFINE EQUILIBRIUM
 We defined the goods market equilibrium as
“demand = production” (by looking at income
and spending).
 Alternative view looks at saving and
investment.
 Private saving: S ≡ Y – T – C
 Public saving: T – G
 What’s the relationship between public saving and
budget surplus/deficit?
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ANOTHER WAY TO DEFINE EQUILIBRIUM
EQ: Y = Z = C + I + G PRODUCTION = DEMAND
Y–T=C+I+G–T
Y–T–C=I+G–T
S=I+G–T
 S + (T – G) = I SAVING = INVESTMENT

 The equilibrium condition for the goods market is also

known as the IS relation.
 John Maynard Keynes first articulated this model in
1936 in his masterpiece.

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ANOTHER WAY TO DEFINE EQUILIBRIUM
S  Y  T  C → S  Y  T  c0  c1 (Y  T )
→ S   c0  (1  c1 )(Y  T )
↑
propensity to save

In equilibrium: I  S  (T  G)
→ I   c0  (1  c1 )(Y  T )  (T  G)
1
→Y [c0  I  G  c1T ]
1  c1
43
The Paradox of Saving
 As people attempt to save more, the result is a decline in output.
(Why?)
 This decline of output then reduces how much people can save.
(Why?)
 So, as we try to save more, the result is unchanged saving in the
short run.
I = S + (T-G): By assumption in the short run, investment does
not change, nor do T or G  S cannot change.
 In general, S = –c0 + (1–c1)(Y–T).
Suppose consumers want to save more and consume less at a
given level of disposable income (c0↓)  the first term increases,
and the second item deceases because lower consumption
lowers income in the short run  ambiguous effect on S.

44
CAN FISCAL POLICY FIX ALL PROBLEMS?
1
Y  [c0  I  G  c1T ] : ↑ G, ↓ T  ↑ Y
1  c1
 Changing fiscal policy is not always easy.
 Impacts on I, IM, exchange rate, etc., are hard to assess.
 Not just policy but expectations will affect behavior.
 May come with unpleasant side effects such as high inflation.
 Lead to large budget deficits and public debt in the long run.

45
CH3 QUICK CHECK (TEXTBOOK)
True or False?
(a) The largest component of GDP is consumption.

(b) The propensity to consume has to be positive, but

otherwise it can take on any positive value.
(c) Fiscal policy describes the choice of government
spending and taxes and is treated as exogenous in our
goods market model.
(d) The equilibrium condition for the goods market states
that consumption equals output.
(e) An increase of one unit in government spending leads to
an increase of one unit in equilibrium output.
(f) An increase in the propensity to consume leads to a
decrease in output.
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SEE YOU NEXT TIME 

 Assigned reading:
 Textbook Chap. 3
 Textbook, Chap. 4 (for next time)
 Now you can work out all problems in Problem
Set 1.
 Submit ONLINE via CANVAS.
 Late submission = zero mark

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