Chapter 3,The Product Market
Analysis
Gang Gong
March 4,2002
Copyright Notes:This electronic file is
only used as a lecture notes for the
student in this class,It is not allowed to be
used for presentation anywhere else
without the permission from the author,
Introduction
? The aim of this chapter is to study how
output is determined in Keynesian
framework,The analysis in this chapter is
often named multiplier analysis.
Introduction
? The key assumption of multiplier analysis is
on,the demand determined,” this is,output
is purely determined by demand.” There is
no restriction in the supply side of the
economy,The capacity to supply the output
as demanded is always available,The firms
are able and willing to supply any level of
output as demanded (at given price?).
Introduction
? In macroeconomics,aggregate demand (AD)
can be defined as the sum of consumption
(C),gross investment (I),government
expenditure (G) and net export (E-M).
AD = C+I+G+E-M
This is indeed the GDP minus inventory
change (V)
Introduction
? It is more difficult to define the aggregate
supply,Generally one simply believes that
aggregate supply is a function of economic
resources (labor,capital stock,technology
among others).
Output in a Private-Closed Economy
? In this case,the aggregate demand is equal
to consumption plus investment:
AD = C + I
Output in a Private-Closed Economy
? In the followed analysis,we simply assume
that V is equal to 0,indicating all output is
demanded,so that we should allow
GDP = C + I
Output in a Private-Closed Economy
? According to income approach,GDP is also
reflected as income (Y) so that we have
Y = C + I
Output in a Private-Closed Economy
? Consumption Determination,Consumption
can be divided into two parts,One is
income-related consumption and the other is
non-income related consumption (often
called autonomous consumption),Therefore
the consumption function can be written as
C = A + c·Y
Output in a Private-Closed Economy
? Consumption Determination:
C = A + c·Y
where A can be regarded as autonomous
consumption and c·Y as the income-related
consumption,Note that 1 > c > 0,This
indicates that when income increases,the
consumption will also increase,but with
less amount (see figure presented in class)
Output in a Private-Closed Economy
? Saving Determination,Saving (S) is the
income that is not used for consumption.
Therefore
S = Y - C
= Y - (A + cY)
= -A + (1-c)Y
(see the figure presented in class)
Output in a Private-Closed Economy
? Some Definitions,
– An autonomous demand is the demand that is
not related to income.
– Average propensity to consumption (APC)
APC = C/Y
– Average propensity to save (APS)
APS = S/Y
Output in a Private-Closed Economy
? Some Definitions:
– Marginal propensity to consumption (MPC)
MPC = ?C/?Y
– Marginal propensity to saving (MPS)
MPS = ?S/?Y
Output in a Private-Closed Economy
? Nonlinear and Linear Consumption
Function:
If the consumption function is linear as
presented before,then
APC = MPC = c
APS = MPS = 1-c.
Output in a Private-Closed Economy
? Nonlinear and Linear Consumption
Function,
Perhaps,a more reasonable consumption
function is nonlinear (see the figure
presented in class),In this case,MPC is
declining,This is indeed suggested by
Keynes in his General Theory,How about
APC and APS in this nonlinear case?
Output in a Private-Closed Economy
? Given the consumption function as
presented,the determination of output (Y) is
simply given by
(see the figure in class for the graphic
presentation of this determination)
)(
1
1 IA
c
Y ?
?
?
Output in a Private-Closed Economy
? Investment-Saving (IS) Relation,Note that
the above analysis indicates that investment
equals saving,Therefore the previous
equation is sometime also called IS curve,It
represents the equilibrium condition in
product market,given the autonomous
demand A and I.
Why multiplier?
? Consider now a change in investment
denoted as ?I,It will cause the output
increased by ? I/(1-c):
Therefore,a change in investment will cause
the change in output by a multiplier 1/(1-c).
I
c
Y ?
?
??
1
1
Why Multiplier?
? How can this Multiplier Occur?
Initial Change in Investment = ?I
First Change in Consumption = MPC × ?I
Second Change in Consumption = MPC2× ?I
:
?Y = (1+ MPC+ MPC2+ MPC3+...) × ?I
Why Multiplier?
? Assume MPC = c,We thus have
I
c
Y ?
?
??
1
1
Why Multiplier?
? Definition,The multiplier process is the
income and output generation process
starting with the injection of an autonomous
demand such as ?I with the total generated
output or income ?Y to be satisfied with
I
c
Y ?
?
??
1
1
Output in a Closed Economy
? In this case,the aggregate demand is equal
to consumption plus investment and
government expenditure:
AD = C + I + G
Output in a Closed Economy
? On the other hand,the income that the
household can use for consumption,
denoted as disposable income (Yd),can be
written as
where T is the tax.
TYY d ??
Output in a Closed Economy
? The consumption function should become
? Finally,assume that the tax is a proportion
of income
T = t ·Y
where t is the tax rate.
dYcAC ???
Output in a Closed Economy
? We thus have the model that includes
AD = C + I + G
Y = AD
T = t ·Y
dYcAC ???
TYY d ??
Output in a Closed Economy
? The solution of output Y is thus given by
(see the figure presented in class for the
graphic analysis)
? Is the multiplier process still applied here?
If it is,then what is the value of multiplier?
)(
)1(1
1 GIA
tc
Y ??
??
?
Output in an Open Economy
? In this case the model should include
AD = C + I + G + E-M
Y = AD
T = t ·Y
TYY d ??
dYcAC ???
Output in an Open Economy
? The solution of output Y is thus given by
(see the figure presented in class for the
graphic analysis)
)(
)1(1
1 MEGIA
tc
Y ????
??
?