Macroeconomics

Chapter 3. The goods market

I. Categories of Expenditure in The Goods
Market
II. The Determination of Equilibrium Output
III. Fiscal Policy

Pham Van Quynh

Foreign Trade University
[email protected]
 Learning outcomes
After studying this chapter students will:
• Know the basic asssumptions in the short run
theory of business cycle
• Be able to discuss the categories of
expenditure in the goods market
• Know how to find equilibrium output in the
goods market
• Discuss fiscal policy and its effect on output
 Assumptions
• Price level is unchanged (Ch 3,4,5)
• Firms will produce any level of output the
market demands
 The economy

Demand

Income Production
 I. Types of expenditure in the goods market

1. Consumption (C)
C = Co + mpc.Yd
• Co: autonomous consumption
• Yd: disposable income, Yd = Y – T
Y: income, T: tax (net)
• mpc: marginal propensity to consume
mpc = C’ (Yd): the increase in C as Yd
increases by 1 unit. 0 < mpc < 1
 Saving (S) = Yd - C
S = Yd – C = Yd – (Co + mpc.Yd)
= - Co + (1 – mpc)Yd
= - Co + mps.Yd
mps: marginal propensity to save.
mps = S’(Yd) = 1 - mpc
 consumption (C) and saving (S)
C, S 450
C
E

Co
S
0
Yd
- Co
2. Investment (I)
I = Io: investment is autonomous
(assumption)
3. Government spending on goods and
services (G)
G = Go (autonomous, because G depends
on government’s will)
 4. Exports (X) and imports (M)
X = Xo (X depends on the world demand for
domestic goods, this in turn depends on
their income, Y*)
M = Mo + mpm.Y
• Mo: autonomous import
• mpm: marginal propensity to import
(mpm > 0)
• mpm = M’(Y): the increase in M as Y
increases by 1 unit
 II. The Determination of Equilibrium Output (income)

Aggregate expenditure (AE): AE is the

output that the economy demands at
different levels of income (Y).
AE = f(Y)
AE = C + I + G + X – M
Equilibrium in the goods market:
Production (Y) = Demand (AE)
1. Closed economy and without government (X = M = G =
T = 0)

C = Co + mpc.Yd = Co + mpc.Y , I = Io
→ AE = Co + Io + mpc.Y
= A + mpc.Y
A = Co + Io: autonomous expenditure
Equilibrium: Y = AE
↔ Y = Co + Io + mpc.Y
Yo: equilibrium output in the goods market (Keynes’ model)

AE
450

AE
E
AE0

AE1
A

0 Y1 Y0 Y
Income/output
* Multiplier (α)

α = Y’(A) = Y’(Co) = Y’ (Io): is the change in

output (Y) as A (or Co, or Io) changes by 1
unit.
Multiplier (α)
Assume initially Co↑:
Co↑ → Y↑ → C↑→ Y↑ → ... → C↑→Y↑
This process takes place in n rounds

ΔY (the increase in Y)
Round 1: ΔC0
Round 2: mpc ΔC0
Round 3: mpc2 ΔC0
……… …………
Round n : mpcn-1 ΔC0
After n rounds:
ΔY = (1 + mpc + mpc2 + …… + mpcn-1)ΔC0
 geometric series
Make an arrangement:
(1 + mpc + mpc2 + …+ mpcn-1) =
= (1 + mpc + mpc2 + …+ mpcn-1)(1- mpc)/(1-mpc)
= (1 + mpc + mpc2 + … + mpcn-1 - mpc - mpc2 - … -
mpcn-1 - mpcn)/(1-mpc)
= (1- mpcn)/(1-mpc) ≈ 1/(1-mpc) = α > 1
(note: mpcn≈ 0)
→ ΔY = [1/(1-mpc)]ΔC0 → Y’(Co) = α
 Multiplier (α)
• 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.
2. Closed economy, with government (X = M = 0)
The inclusion of government into the model:
- Its spending: G = Go
- Tax: (T) (Assumption: there is direct tax
only), there are three types of tax collection:
• Lump-sum tax (or autonomous tax) T = T0
independent of income (Y)
• Proportional tax: T = tY (0 < t < 1), t is
marginal tax rate.
• Combined tax: T = T0 + tY
 Closed economy, lump-sum tax

Data:
C = Co + mpc.Yd = Co + mpc.(Y – T)
I = Io, G = Go
a) Lump sum tax: T = To
→ AE = Co + Io + Go + mpc.(Y - To)
= Co + Io + Go – mpc.To + mpcY
Y = AE →

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Closed economy, proportional tax
b) Proportional tax : T = t.Y (0 < t < 1)
C = Co + mpc.Yd = Co + mpc.(Y – t.Y)
→ AE = Co + Io + Go + mpc (1– t)Y

Y = AE →

Compare α in 2.a & in 2.b? which one is

greater?
 Why multiplier in lump-sum tax is higher
than in proportional tax (closed economy)
T = To T = t.Y
C = Co – mpcTo + mpcY C = Co + mpc.(1 – t).Y
If ∆Co = 1 If ∆Co = 1
∆Y in each round: ∆Y in each round:
Round 1: 1 Round 1: 1
Round 2: mpc Round 2: mpc(1 – t)
… …

After n rounds: ∆Y > ∆Y

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 Closed economy, combined tax
c) Combined Tax: T = To + t.Y (0 < t < 1)
C = Co + mpc.Yd = Co + mpc.(Y – To – t.Y)
→ AE = Co + Io + Go + mpc.(Y – To – t.Y)
= Co + Io + Go – mpcTo + mpc (1– t)Y
Y = AE →

compared α in 2.c & in 2.b? which one is

greater?
3. Open economy
Given: C = Co + mpc.Yd = Co + mpc(Y – T)
I = Io, G = Go, X = Xo, M = Mo + mpmY
a) Lump-sum tax : T = To
→ AE = Co + Io + Go + Xo – Mo – mpc.To +
+ mpcY – mpm.Y
Y = AE→
 Why multiplier in closed economy is greater
than in open economy
• Co↑ → A↑ → AE↑ → Y↑ (closed)
→ M↑ → AE↓ → Y↓ (open)

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 Open economy, proportional tax
b) Proportional tax : T = t.Y
AE = Co + Io + Go + Xo – Mo + mpc (1 –t) Y
– mpm.Y
Y = AE→
 Open economy, combined tax
c) Combined Tax : T = To + t.Y
AE = Co + Io + Go + Xo – Mo – mpcTo
+ mpc (1 – t) Y – mpm.Y
Y = AE→
 4. Balanced budget multiplier
Consider a closed economy, and government
imposes lump-sum tax only (2.a).

If G and T increase by the same amount (ΔG

=ΔT), how does equilibrium income (Y) change?
• Go↑ → Y↑
• To↑ →Y↓
 balanced budget multiplier

Using total differentiation:

ΔG =ΔT→
 5. Leakages and injections

• Leakaging items: reduce AE (directly)

• Injecting items: increase AE (directly)
AE = C + I + G + X – M
Yd = Y – T = C + S → Y = C + S + T
Y = AE ↔ C + S + T = C + I + G + X – M
↔S+T+M = I+G+X
(leakages) (injections)
 Leakages and Injections
X M
C
I

H T Gov G
F
S
Y
III. Fiscal policy
• Fiscal policy: government changes G or T
• Changes in G or T affect AE, Keynes:
demand management policy
From II 3.c:

As G, T change (Go, To, t) → Y changes

 Fiscal policy (FP)
Target of FP: change the current output (Y) into
potential output (Yp ≡ Yn)

The output gap (the neccesary amount of

change in output)
∆Y = Yp – Y
1. Change in G: αG = Y’(G) = ∆Y/∆G
→ ∆G = ∆Y/αG
2. Change in To: αTo = Y’(To) = ∆Y/∆To
→ ∆To = ∆Y/αTo
 G↑
AE
450
E1 AE1

AE
E

A + ∆G
A

0 Y Yp Y
 G↑
AE
450
E1 AE1

AE
E

A + ∆G
A

0 Y Yp Y
 Fiscal policy
3. Change in t
Replace Yp (for Y) into equation:

to find the new value of t → t = ?

4. Change in both G & To: countless
combinations, one choice is to change G
and To by the same amount:
∆G = ∆To
→ ∆G = ∆To = ∆Y/(αG + αTo)
 Budget surplus (BS)
BS = T – G

• Actual budget deficit (BD) :

BD = G – T = - BS
• Structural deficit (full-employment deficit):
is the BD measured at Yn.
• Cyclical deficit = Actual deficit - Structural
deficit

35
 Budget deficit (BD)
C = 100 + 0.75Yd I = 100 G = 100 T = 0.2Y
(*)
Yp = 1000
(*)→ Y = 750, T = 150
• Actual BD = G – T = 100 – 150 = -50
• Structural deficit = 100 – 200 = – 100 (T =
0.2*Yp = 200)
• Cyclical deficit = Actual deficit – Structural
deficit = – 50 – (– 100) = 50
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 Budget surplus (BS)
BS = T – G
budget deficit (BD) :
BD = G – T = - BS
C = Co + mpc.Yd = Co + mpc.Y
∆C ∆Y
mpc 1
? ∆Co
? mpc ∆Co
 Reference: total differentiation
• y = 2x + 1
→y’(x) = ∆y/∆x (= 2)
→∆y = y’(x).∆x (differentiation)
• y = 2x + 3z
→∆y = (∂y/∂x)∆x + (∂y/∂z)∆z (total differentiation )
= 2∆x + 3∆z

39
 Yo: equilibrium output
AE (Tổng cầu)
450

AE
E
C

300
200 I
100
0 1200 Y
income/output
 Notations

• C, Co, mpc, Yd, T, Y, S, mps, I,

G, X, Mo, M, mpm
• A, α
• C = 100 + 0,7Yd
• S= -100 + 0,3Yd
• I = 200, G = 150
• X = 80
• M = 120 + 0,05Y
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 Endogenous vs Exogenous variables
• Variables that depend on other variables within the
model are called endogenous.
• Variables that are not explain within the model are
called exogenous.
For example: demand : Q = -2P + 3I
Supply: Q = 2P - Pi
Where: I (consumer income) = 200
Pi (price of inputs)= 100
• endogenous : P, Q solved by the system of equations
(they are born inside the model)
• exogenous : I, Pi taken as given (they come from
outside the model)
 * Reference: Paradox of saving and
Automatic stabilizers
• Paradox of saving: an increase in saving leads
to the falls in income and consumption, in
equilibrium the saving unchanged.
• Automatic stabilizers: social insurance,
unemployment insurance, welfare subsidy
(food stamp, medical aids), income tax rate

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 Output gap
Recession Inflationary
gap gap

Y Yp Y

44
 Consumption function

C = 100 + 0.7.Yd
∆Yd = 1 → ∆C = 0.7
→ ∆S = 0.3
S = - 100 + 0.3.Yd
• T = 50 (lumpsum tax)
• t = 0.2 , Y = 100→ T = t.Y = 20
• T = 40 +0.2Y
 Multiplier
• A↑ → AE↑ → Y↑ → M ↑ →AE↓ → Y ↓
+ 10 -2
balanced budget multiplier = ∆Y/∆G = 1
 Midterm test
1. Suppose a woman marries her butler. After they
are married, her husband continues to wait on
her as before, and she continues to support
him as before (but as a husband rather than as
an employee). How does the marriage affect
GDP?
2. Is the statement “CPI overstates the increase
in cost of living” correct? Why?
3. How would multiplier change if there is an
increase in mpc, mps, or mpm?

49
4. Given AE = 1800 + 0,6Y; T=0,15Y; I = 500; G=700;
X=400; M=0,1Y. Find the values of marginal
propensity to save (mps) and equilibrium output.
5. In a closed economy and combined tax. If
government raises G and To by the same amount
(=∆G), calculate the increase in output, compare this
with ∆G.
6. In a closed economy, if autonomous consumption
increases by one unit. Illustrate the increases in
output in round 1, round 2,… and round n. Compute
the sum of these increases in output.
7. Excercises 6 (chapter 1), 9, 10 (chapter 3)
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 Questions for review
1. What are the key assumptions in this chapter?
2. What are the relationships among demand,
production, and income?
3. What are components of expenditure in the
goods market?
4. What does “autonomous” mean?
5. What is aggregate expenditure, how is it
calculated?
 Questions for review
6. Why income is the output by definition
7. What is the condition for equilibrium in the
goods market?
8. How does we calculate the disposable income?
9. How do we compute mpc, mps, and mpm, what
do them illustrate?
10. In a closed economy and proportional tax, if
autonomous consumption increases by 1 unit,
list the increases in output through n round,
compute the sum of them.
 Questions for review
11.Write the equation for equilibrium output in an open
economy with combined tax, call the names of
elements in it. How do you simplify this equation to get
the equation for equilibrium output in the closed
economy and lump-sum tax?
12.What is the fiscal policy, what is the goal of fiscal policy?
13.How many ways do government use to intervene in the
goods market?
14.What is the paradox of saving?
15.What are the automatic stabilizers?