Chapter 3
Composition of GDP
The composition of GDP is of Consumption, Investment, Government spending, Net exports and Inventory systems.
Investment (also sometimes called fixed investment) is sum of non-residential investment (purchase by firms of new plants or
machines) and residential investment (purchase by people of new houses or apartments). In both residential and
nonresidential, the decision to buy them depends on the services they will yield in the future, therefore they are treated
together.
Government spending represents purchases of goods and services by the federal, state and local government. G doesn’t include
government transfers.
If exports exceed imports, there is trade surplus. If exports less than imports, there’s trade deficit.
The difference between goods produced and goods sold in a given year – the difference between production and sales is called
inventory system. Its positive when production exceeds sales.
Demand for goods
Z: total demand Z ≡C + I+ G+ X−ℑ
Assumptions:
- All firms produce same good with only one market
- Firms are willing to supply any amount of the good at a given price level (only valid in the short run)
- Economy is closed that doesn’t trade with the rest of the world so exports and imports are zero.
Modified Z Z ≡C + I + G+ ¿
Consumption
Consumption depends on disposable income YD Income after Consumer received transfer from G and paid T. When Y D goes up,
people buy more goods. The relation between consumption and disposable income is characterized by the parameters of C 0 and
C1
C1 is propensity to consume (additional dollar of disposable income has on consumption). C 1 has to be positive and less than 1.
Increase in disposable income increase in consumption.
C0 is what people would consume if their disposable income in the current year was equal to zero. This is always positive too. If
income is 0, consumers will either sell their assets or borrow. C = c0 + c1YD
Relationship between consumption and disposable income in a positive linear line, with slope C 1 and intercept of vertical axis C0
Disposable income is Y income minus T taxes. Replacing Yd gives C=c0 +c1(Y-T)
Investment
Endogenous variables: variables in the model (consumption previously)
Exogenous variables: variables outside the model (investment)
Investment is taken as given by line on top which shows it doesn’t respond to any changes in production I = I
Government Spending
G describes fiscal policy: choice of taxes and spending by the government. G and T are exogenous because governments don’t
behave same regularity as consumers or firm.
Determination of Equilibrium Output
Z=c0 +c1(Y-T)+I+G
Since production holds inventories, demand and production don’t need to be equal. Therefore Y=Z is the equilibrium condition.
By replacing Z by Y we get Y=c0 +c1(Y-T)+I+G where Y is used for production and income.
Using Algebra
Y = c0 +c1Y - c1T + I + G
(1-c1)Y= c0 + I + G - c1T
1
Y= (C 0+ I +G−c 1 T )
1−c 1
The part ( C 0+ I +G−c 1 T )is part of demand for goods that doesn’t depend on output, so it’s called autonomous spending
(not always positive but most likely positive).
1
Propensity to consume is between 0-1 and this equation is greater than 1, its multiples autonomous spending there it’s
1−c 1
called the multiplier. The closer C1 is to 1, the larger the multiplier.
Composition of GDP
The composition of GDP is of Consumption, Investment, Government spending, Net exports and Inventory systems.
Investment (also sometimes called fixed investment) is sum of non-residential investment (purchase by firms of new plants or
machines) and residential investment (purchase by people of new houses or apartments). In both residential and
nonresidential, the decision to buy them depends on the services they will yield in the future, therefore they are treated
together.
Government spending represents purchases of goods and services by the federal, state and local government. G doesn’t include
government transfers.
If exports exceed imports, there is trade surplus. If exports less than imports, there’s trade deficit.
The difference between goods produced and goods sold in a given year – the difference between production and sales is called
inventory system. Its positive when production exceeds sales.
Demand for goods
Z: total demand Z ≡C + I+ G+ X−ℑ
Assumptions:
- All firms produce same good with only one market
- Firms are willing to supply any amount of the good at a given price level (only valid in the short run)
- Economy is closed that doesn’t trade with the rest of the world so exports and imports are zero.
Modified Z Z ≡C + I + G+ ¿
Consumption
Consumption depends on disposable income YD Income after Consumer received transfer from G and paid T. When Y D goes up,
people buy more goods. The relation between consumption and disposable income is characterized by the parameters of C 0 and
C1
C1 is propensity to consume (additional dollar of disposable income has on consumption). C 1 has to be positive and less than 1.
Increase in disposable income increase in consumption.
C0 is what people would consume if their disposable income in the current year was equal to zero. This is always positive too. If
income is 0, consumers will either sell their assets or borrow. C = c0 + c1YD
Relationship between consumption and disposable income in a positive linear line, with slope C 1 and intercept of vertical axis C0
Disposable income is Y income minus T taxes. Replacing Yd gives C=c0 +c1(Y-T)
Investment
Endogenous variables: variables in the model (consumption previously)
Exogenous variables: variables outside the model (investment)
Investment is taken as given by line on top which shows it doesn’t respond to any changes in production I = I
Government Spending
G describes fiscal policy: choice of taxes and spending by the government. G and T are exogenous because governments don’t
behave same regularity as consumers or firm.
Determination of Equilibrium Output
Z=c0 +c1(Y-T)+I+G
Since production holds inventories, demand and production don’t need to be equal. Therefore Y=Z is the equilibrium condition.
By replacing Z by Y we get Y=c0 +c1(Y-T)+I+G where Y is used for production and income.
Using Algebra
Y = c0 +c1Y - c1T + I + G
(1-c1)Y= c0 + I + G - c1T
1
Y= (C 0+ I +G−c 1 T )
1−c 1
The part ( C 0+ I +G−c 1 T )is part of demand for goods that doesn’t depend on output, so it’s called autonomous spending
(not always positive but most likely positive).
1
Propensity to consume is between 0-1 and this equation is greater than 1, its multiples autonomous spending there it’s
1−c 1
called the multiplier. The closer C1 is to 1, the larger the multiplier.
