INCOME EXPENDITURE MODEL: GOODS MARKET EQUILIBRIUM. Dongpeng Liu Department of Economics Nanjing University

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1 INCOME EXPENDITURE MODEL: GOODS MARKET EQUILIBRIUM Dongpeng Liu Department of Economics Nanjing University

2 ROADMAP INCOME EXPENDITURE LIQUIDITY PREFERENCE IS CURVE LM CURVE SHORT-RUN IS-LM MODEL AGGREGATE DEMAND AGGREGATE SUPPLY INTERMEDIATE-RUN AS-AD MODEL SOLOW MODEL LONG-RUN w/ CAPITAL ACCUMULATION LONG-RUN AS-AD MODEL LONG-RUN w/o CAPITAL ACCUMULATION LABOR MARKET PHILLIPS CURVE MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 2

3 TOTAL EXPENDITURE Total expenditure: Z = C + I + G + NX Expenditures are made by consumers, firms, governments and foreigners For the majority of the course, we focus on closed economy macroeconomics NX = 0 Z = C + I + G MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 3

4 CONSUMPTION Disposable income is the income after all taxes and transfer payments Y D = Y T Y is total income, T is the difference between taxes and transfer payment. For simplicity, throughout this course, T will be called taxes The tax discussed here is a lump-sum tax: a tax that is a fixed amount, no matter the change in circumstance of the taxed entity Note: Y, Z, C, I, G, NX, and T are real values, rather than nominal values Consumption function: C = c 0 + c 1 Y D c 0 : Autonomous consumption expenditure c 1 : Marginal propensity to consume MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 4

5 CONSUMPTION c 0 : Amount of consumptions when disposable income is 0 When Y D = 0, C = c 0 Normally, c 0 > 0 (Why?) Marginal propensity to consume: The additional consumption expenditure when disposable income increases by 1 unit 0 < c 1 < 1 Consumption increases as disposable income increases Only a part of the increase of disposable income is consumed Whose marginal propensity to consume is higher, the rich or the poor? MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 5

6 CONSUMPTION MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 6

7 INVESTMENT For simplicity, in this lecture, we assume that investment is exogenously given I = I Variables whose values are determined or explained by the model are endogenous variables Variables whose values are not determined nor explained by the model are exogenous variables MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 7

8 FISCAL POLICY Fiscal policies are governments choices of government purchase (G) and Taxes (T) Throughout this course, G and T are treated as exogenous variables One major task of macroeconomists is to propose fiscal policies. Hence, we want economic models to tell us what would be the consequences of a policy of interest. That is why G and T shall be treated as exogenous variables, rather than explained with the model. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 8

9 GOODS MARKET EQUILIBRIUM Goods market equilibrium means total output (Y) equals to total expenditures (Z) Y = Z Y = c 0 + c 1 Y T + I + G = c 0 c 1 T + I + G + c 1 Y Y = 1 (c 1 c 0 c 1 T + I + G) 1 c 0 c 1 T + I + G is the part of total expenditure not depending on total output, which is called autonomous spending Autonomous spending can only be negative when there is huge (government) budget surplus. For the purpose of this course, we ignore this possibility. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 9

10 GOODS MARKET EQUILIBRIUM The intersect of the total expenditure line and the 45 degree line shows the equilibrium level of total output (or total income/expenditures) MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 10

11 WHAT IF GOVERNMENT PURCHASE INCREASES BY $1 G increase s by $1 Consumption and total expenditure increases by c 1 Consumption and total expenditure increases by c 1 2 Output and income increases by $1 Output and income increase s by c 1 Output and income increases by c 1 2 MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 11

12 THE MULTIPLIER EFFECT This is an infinite decreasing geometric series The change of GDP caused by an $1 increase in G is Y = 1 + c 1 + c c = 1 1 c 1 > 1 1/(1 c 1 ) is the multiplier. for each $1 increase of c 0 c 1 T + (autonomous spending), GDP will increase by 1/(1 c 1 ) I + G MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 12

13 AN EXAMPLE OF CALCULATING GDP MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 13

14 EFFECTIVENESS OF EXPANSIONARY FISCAL POLICIES In the short-run, expansionary fiscal policies can raise total output In response to a recession, the government can hire some workers to dig a big hole, and then fill the it with dirt However, expansionary fiscal policy is not a panacea Income expenditure model relies on very restrictive assumptions Expansionary fiscal policies will raise interest rate and crowd out a part of investment (IS-LM model) Expansionary fiscal policies will cause inflation and change the expected price level of firms, making the expansion unsustainable (AS-AD model) MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 14

15 SAVINGS AND INVESTMENT Private savings (S) are the savings of S = Y D C = Y T C Public savings: T G IS relation S = C + I + G T C = I T G I = S + T G Investment = Private savings + Public savings Savings are the source of investment. IS relation and the income expenditure model are the two sides of the same coin. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 15

16 SUMMARY Income expenditure model Consumption function Goods market equilibrium Fiscal policies The multiplier effect IS relation MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 16