Lecture 3: The Goods Market

okay let's uh let's start um so what you have there in that picture is U is the result of a survey to a bunch of Economist on which are asked to assess the probability that there is a recession within the next 12 months recession means essentially a decline in aggregate output um and well the first thing to notice here is that you know it's not very good news there is a very high chances at at least according to this expert that that the US enters a recession within the next 12 month or so pretty high

probability you can see that that number typically is very very low and it goes very high sort of real next to recessions and now we're not in a recession but but there's a sort of very high perceived probability that we may go into recession in the near future so how is that these people come up with this forecast well at some level either explicitly or implicitly they must have some Model H of the determination of equilibrium output you know they need to understand they need to see certain things that suggest once you go through a

model that output will decline um so that's what we're going to start doing today and uh and uh in fact that's what we're going to do throughout this course is we're going to try to find ever more complex perhaps or or richer modes of H output determination aggregate output determination so that's essentially what this course is about H and so in understanding sort of want to try to understand what is it that drives equilibrium output and how is that we get to one specific level of output that's what it means to find equilibrium level of

output um and we're going to do it sort of in three stages in the first part of the course that is up to quiz one H we're going to focus on on on the very short run how output is determined in the very short run say within a year or so well a little more even but but that type of frame time frame then we're going to focus on the medium run that's sort of at the beginning of of of the second part of the course ER and by the meum Run simply we're going to

mean by the time in which prices begin to adjust sufficiently okay before that is most of the action happens in in quantities there is little movement in Goods prices there's lots of movement in asset prices but little movement in Goods prices and in the last part of the course we're going to look at how output is determined over the long run which is quite different from how output is determined in the short run the the determination of output in the short run is what we mostly mean by business cycle analysis okay and short and medium

run the way we're going to find it here is what we mean by business cycle the countries in a recession is in a boom it's an expansion those are all terminologies of the short run or short to medium run the termination equilibrium in the long run is when we think about growth when we talk about why is a China grows faster than the us today well that's that's a question not about the business cycle it's a question about the longterm determinance of output growth okay and and there are even different class of models in more

advanced models if you were doing a PhD those things are a lot closer to each other and and and but but in this course they're going to be very different type of models it's easier to analyze these things with different type of moles than trying to integrate all in one big machine okay but let's start for the the simple part in the short run the key mechanism something that we will keep showing up in all the models and sub models we analyze in the first eight lectures or so or seven lectures the next seven lectures

or so is this mechanism in the very short run output that is equilibrium output the thing that these economies are forecasting that will decline in the next 12 within the next 12 month is determined primarily by what we call demand okay so demand will determine output that's so there a change in demand that will change production but when production changes that will also change income that you know from national accounts remember we said that we could measure output from the production side but we also measure the income sign and they're exactly the same more production

somebody has to receive the proceeds of that workers and owners Capital owners the government whatever but so changes in in in so the Second Step those changes in production that were brought about by the changes in demand will lead to a change in income but when income changes that will change theand again and so on so forth okay so that's essentially that's quential short run macro is to try to understand this aggregate demand because that's the main driver and then how it gets multiplied in the short run okay and we're in this lecture we're going

to talk just about that primarily about that okay but that's that's when so when I mean short run macro that's a structure I have in mind and that's the structure most people have in mind something where aggregate demand will determine that that's the reason why in the short run you worry a lot about whether consumer confidence is high or low that's demand if consumers are very depressed that tend to reduce demand if consumers are very bullish that will tend to increase demand and since in the short run output is ter demand the business cycle whether

we have have recession or not the depends a lot on how the man feels so if somebody's forecasting a recession within the next 12 month is forecasting really that demand will decline within the next 12 month okay why they're forecasting that that's something we're going to learn in a steps H as we go through the course what what are the kind of things they may be thinking about what are the drugs on aggregate demand that are likely to the Press demand H and so on so forth but that we'll we'll get there okay anyways first

let me tell you about the components of aggregate demand uh the first and one of the the largest component of aggregate demand is consumption okay and when I mean aggregate demand okay I'll be I'll pause for a for a slide let me let me go over the definition consumption we're going to note by C is the goods and service purchased by consumers okay households and so on investment which we're going to note by high is the sum of non-residential and residential Investments so equipment and and establish and and and you know factories on one side

and then residential investment is houses stuff like that apartment buildings and so on which is also these are goods and services as well there just capital goods and so on but they're also goods and services government expending that's we going to denote by G are purchase of goods and services by the federal state and local government government okay excluding and that's important government transfers what is a government transfer many of you may have received that during covid you know the government sent you a check for example okay well that check is not part of government

expenditure that check is like a m it's a negative tax and it's going to enter somewhere else when we mean government expenditure is is things the government purchases Services the government acquires and so on okay um then exports X which will play no role until seven lecture eight lectures from now or actually 10 lectures from now probably is purchase of us goods and services that is Goods produced by us factories er er by foreigners okay IM is the other side of the story Imports is the purchase of foreign Goods and services by us consumers us

firms US Government okay so when you buy something that is produced in Germany well that's an import when the Germans buy something that is produced in the US that's an export okay and then the last component is something we we're not going to play any attention whatsoever in this course which is inventory investment inventory investment is certainly is almost accidental there is some planning on it but but there is a lot of it's just when there difference between sales and production and over the very short run there's lots of differences I mean you're not producing

unless you're in a bakery you know you're not producing and selling immediately there's there's certain certain lags that's a small thing it it's volatile but it's a small thing so we're going to ignore it for this this course we're want to assume actually unless we explicitly say the contrary and that could show up in a pet it would never show in a quiz because it's not that important we're going to assume that this inventory investment is equal to zero also for this part of the course until further notice we're going to assume that exports and

imports are equal to zero as well that's not realistic but it's easier to analyze what we call a close economy okay an economy that is not interacting with the rest of the world in the in again 10 lecture from now we're going to open the economy to the rest of the world and then we're going to have to talk about things like import exports exchange rates things of that kind but for now let's keep it simple okay so now you so you get a sense this is for 2018 but I mean the totals change but

the composition doesn't change very much of GDP okay of of GDP output aggregate demand they're all the same in equilibrium but we'll get there ER in GDP you see that consumption accounts for a big chunk close to 70% of our great demand that's the reason people worry so much about consumer sentiment and so on University of Michigan has many claims to fame but one of them is they produce this index of consumer sentiment and everyone is watching that thing anybody that worries about macro or Finance is watching that thing because it tells you a lot

about one of the main drivers of output equilibrium output then you see investment is substantially smaller but it's large in particular non-residential investment government expenditure is a big component of aggregate demand h and then I'm not going to worry tooo much about for a country like the US the open openness part is is relatively small if you go to you know small a small economy typically we'll have sort of very large exports relative to GDP and so on but that's not the case of the US um and there you see why we're going to set

inventory investment to zero it's a small thing it moves a lot more than than its size so it kind of account for for fluctuations in in at sort of the monthly level of GDP but it's not that important in a slightly longer period of time okay so that's more or less the story so now this is the this is the mod please stop me say if you is there anything here you don't understand because any everything that we build from here to quiz one will build on understanding this what I'm about to say very simple

but if you miss a step here everything is going to be confusing in the next few lectures so and you're not supposed to understand it in the first run so so it's okay that you ask me but let's make sure that you understand what is going on here okay so that's aggregate demand first definition we're going to denote aggregate demand by this Z okay letter Z and aggregate demand is going to be when we say aggregate demand remember what what what is the exercise we're trying to do ultimately what we want to determine is the

output the production of the US economy say so when we me when we talk about aggregating demand we're trying to determine the demand for domestically produced goods for goods produced in the US that's what we're trying to pin down and so that's a reason aggregate demand looks like that is well consumers consumers are going to demand Goods investment G Plus exports if Foreigner demands us Goods that also increases us production minus Imports because Imports is goods and services that consumers firms and governments sort of buy from foreigners but they're not produced by by us companies

so they are not affect the determination of equilibrium output in the US okay that's the reason you subtracting now that distinction is not going to matter until 10 lectures from now because we're going to set X and IM am equal to zero from the point of view of modeling so all demand is demand for domestically produced Goods in the this part of the course okay so aggregate demand for us will be this C plus I plus G so we need to understand what the termes C plus I plus G and at least initially we're going

to keep it very very simple we're not going to think too much about what determines investment in fact we're going to assume there a constant is given so it's determined somewhere else not in the model I'm about to solve government expenditure the same I going to assume you know it'ser by some other priorities you know know Green agendas and stuff like that has very little to do with with with what we're doing here and then taxes is something that doesn't show up there but it will show up very shortly we're also going to assume that

they been determined somewhere else in pieces and later on in the course we're going to endogenize all that but not now let's assume I'm trying to come up with the simplest possible model of aggregate demand and I'm making two of these terms trivial just constants okay and I'm want to focus all my effort here in this component here which I already told you is the most important component of aggregate demand which is consumption okay so we're going to assume here we're going to have a function something has to move so for them all to be

interesting so this this this we're going to assume that consumption is an increasing function of disposable income I'm about to Define what disposable income is but you can imagine what it is it's something you can use to consume and so on so very naturally if you have a higher disposable in income you're going to consume more that's what this says okay in reality that consumption function is a lot more complex a lots of things that enter there that that we're not modeling for now but let's start from the basics okay so that's going to be

the only behavioral assumption we're going to make for a while that that the consumers consume more when they have more disposible income okay and I'm going to make it even simpler I'm going to assume that consumption is a linear function of this disposable income okay so there's going to be some constancy zero which captures lots of things that we're not modeling here for example the fact that for any given level of disposable income if you know if you if you if you're richer suppose you have some shares and now the shares double in value you

probably are going to consume more as well okay there are lots of other things that affect consumption which are different from aside from your disposable income but we're not going to mold that so that's we're going to call it autonomous autonomous in the sense that we're not going to determine it here we're going to take it as a parameter that comes from somewhere else we may do some experiments moving that variable around but it's not going to be part of what we model C1 is a more interesting parameter for this part of the course and

it's what we call the marginal propensity to consume out of disposable income in this case that is C1 tells you the Share if you get an extra dollar of disposable income how much of that do you spend in consumption okay so say you get an extra dollar of of income if you spend 60 cents in in the things you normally consume of that extra dollar well then your C1 is6 okay that's a marginal perent to consume and that's what gives us our increasing function if you get an extra dollar you're going to do you're going

to save part but some of it you're going to spend that part you're going to spend is one that we have there okay good H now let me tell you what how we define disposable income disposable income is just equal to income which is equal to production minus taxes that's disposable income okay it's whatever you earn as a either as a worker or as a capital owner H well then the government takes something out of it that's your disposable income and that's what you have to decide how much to save and how much to consume

okay that's so so that means that our consumption function is can be written that way after all these assumptions I made you know equal to this autonomous component plus C1 the marginal PR consume times income output minus taxes is it clear yes so all these are assumptions now they're not crazy assumptions in the sense that you know that we know that that there is a relationship between the two things again the consumption function in practice is much richer than that and there's lot of Randomness random terms around and so on but that's not what we

wor about here but that's if you're going to start with a consumption function this is a pretty reasonable one to start with okay okay so that's going to look in the space of disposable income or income I could put income there not disposable income it's going to look like that okay so c0 is that autonomous consumption is some something you're going to consume regardless of your level of disposable income and there is a minimum consumption you have to have you know say and then and then H the slope of that is is the marginal per

to consume which is C1 which is a number between zero and one okay so let's let's determine equilibrium output so we have aggregate demand which is C plus I plus G okay there we are that's that was our definition of agre demand ER I'm going to stick in now the functional forms well these guys are very boring they're constants and I'm plugging in here the the consum the consumption function okay so what we have here is that aggregate demand is an increasing function of output or income okay it's also function of taxes investment and so

on but but it's an increasing function of output and and this is important because remember the the goal of this is to find equilibrium output so here I have on the right hand side of my aggregate demand output that's good I have one equation in which output shows up okay now I cannot find equilibrium output just from this equation why is that so remember and we're trying to build a model to find equilibrium output that's our goal that's what will tell us whether we want recession or not output is low recession output is high in

a book obviously I cannot solve it from this I have two unknowns what are my two unknowns two unknown one equation what is my second unknown there aggregate demand of course we have to determine z and y okay so how we going to do that well using a second equation which is the equilibrium Condition it's not a function this is a function this is not a function this is an equilibrium condition it says in equilibrium not outside equilibrium in equilibrium output is equal to aggregate demand okay that's what this equilibrium condition tells us of equilibrium

this doesn't hold that's the reason this is not a function this holds everywhere it's a function this is an equilibrium condition it says at equilibrium aggregate demand is equal to Output so now we're done because we have two equations of two unknowns okay good and the reason I POS on this is that I see that mistake made often okay this is interpreted as a function it's not it's an equilibrium condition at equilibrium it holds and that you can see actually I'm going to illustrate the same point in in the diagram so this is the let

me let me keep going so this is clear no so this this is just a summary of what we had in the previous slides is and this is the new thing here which is in equilibrium output is equal to Aggregate theand and and and the and uh and again that's what makes this a really a short shortterm model you see I'm saying output in the shortterm is whatever demand wants it to be which is different from from from the long run you says no no hold on a second I mean but you how much output

you can produce is a function of the capital you have of the workers you have yeah yeah that's true in the long run but in the short run you have lots of flexibility because you have lots of unused capacity and so on okay so this is pretty it's a big assumption and there are schools of thoughts within microeconomic that split by this assumption whether you believe that that that in the short run output is aggre demand determined or not at MIT we tend to believe that in the short run the long run no but in

the short run that's what it does now sometimes the long run get gets to you very quickly and at this point we're in a situation like that that's the reason we're seeing inflation and so on but that's something you'll understand later on okay but but but for now so this is this is important we're going to we're saying here output I don't need another equation I could have done aggregate demand like this and then output a function of capital label lots of things I'm not going to even do that I'm going to say no no

output will be whatever the man wants it to be okay and that means in equilibrium they have to be equal good you had a question no they are the same for us that's our definition GDP for us is output so when they say agregate output I mean GDP remember real GDP we're talking all about real GDP okay uh and it's also equal to income not dispos but it's equal to income remember when we did those little tables where we look all the three different ways of doing it well the first two were output and the

last one was income and they had to be the same okay so why is real GDP for us that's real GDP what happens in the table I show you I already used the fact that real GDP is equal to aggregate demand and that's the reason I show you the different components of Z I show you that that and that okay but in equilibrium they're equal there's really a figure that that will clarify I think a lot of that but let's let me keep solving this so we have that and so when I'm going to do

next is just solve it so we have this equilibrium condition I'm going to plug in my aggregate demand function here and so I can solve out for equilibrium output and here we have the first for the first time in this course an equation for equilibrium output there you are that's your equilibrium output in this economy okay now this guy here is very famous and is very macro doesn't happen in micro it happens in macro only okay this guy here another guy there is called the multiplier okay and it's a very important macro concept it's a

huge concept macro now why do you think it's called a multiplier well obviously multiply something but a multiplier sounds like you know that multiplies that makes something bigger so what happen if C1 is H greater than zero if what happens if C1 is greater than zero remember it's between Z and one but what happens if it's greater than zero what happened with that number there one over 1 minus C1 it's greater than one this multiplies okay so a reason we call it a multiply it's not nothing deep there okay so this thing here is sort

of autonomous stuff you know is what the government spends what firms are spending Capital this is autonomous consumption and this actually this a typo there there should be a C1 in front of that type it comes from there see1 * so fix that type of place I'm want to upload the slides again with with the type of fix okay I'm just it comes from here see one * t Okay so that's what this does it multiplies so whatever it is that that is happening here whatever is that the government is spending or whatever this terms

multiply it and that's a huge thing there was a big debate H almost always when you're trying to get out of a recession and the government start spending a big question is well how big is the multiplier if the multiplier is small you're going to have to spend a lot to get the economy out of the recession if the multiplier is large then then H you you're going to have to spend very little and then the multiplier will take you away from from that recession so what is it that makes the multiplier large or small

well mechanically when is that multiplyer large um C1 is closer to one so when people spend more of their income on exactly when C1 is large and that that gives you the logic and that's very important in micro is why is that a big multiplier well because think what happens in micro the government spends now that increases output but now output increases income and if consumers spend a big share of their extra income and output and consumption again then that increases output again which increases income again and you keep going okay so that's a seet

on the contrary if consumers are very scared they don't want to spend any extra dollar they receive anything of the extra dollar they receive then you don't get any multiplier because this initial increase in output that comes from the government expansion that does lead to increasing income but if consumers don't spend it it doesn't recirculate into the economy and then you don't get a multiply okay so that's that's the reason we call it the multiplier so that diagram is is an important diagram I'm just ER doing this actually in that diagram I'm plotting the aggregate

demand function and then this equilibrium condition output equal to aggregate demand in the space of er aggregate demand and output production and income here but remember income is equal to production okay so there's your aggregate demand and that's your 45 degree line because this output equal to so whatever is in this axis equal to that axis that's the 45 de line okay that's your equilibrium condition is at equilibrium this guys here a great demand Z will have to be equal to Y those are that's Trace there this is aggregate demand why is this line flatter

than that why is AG demand flatter than uh because people don't spend their entire dollar exactly because C1 is less than one so the slope of the aggregate demand in this space is C1 it's a marginal prop to consume how much more they demand if they get an extra dollar well they don't get they don't demand one one extra unit they demand C1 unit and C1 is less than one okay that's the reason this so if C1 is very small this line is going to be very flat you see one is very large very high

PR consume this is going to be very steep the red line the other one doesn't change the 45 degree line okay and what I said is that at equili so you see if I take an off equilibrium level of output say this aggregate demand is different from output it's only at equilibrium that these two things will hold okay this function I can plot it everywhere but this one will hold only at equilibrium okay that's when these two things are equal so what I solve here here I just found this point okay so parameters here are

c0 H C1 * T and G the old shifters of this aggregate demand up and down okay and and that point here is exactly that and those all those things are parameters in my aggregate demand I really want you to internalize this diagram any questions about it just stare at it little it's going to show up repeatedly and and later on it's not going to show up but whenever you get confused the way to get yourself out of that confusion is going to be to go back to the diagram you'll see I'll remind you when

when when that's likely to happen Okay so so you better understand this diagram play with it move here the only thing you can move around is the ZZ the the the aggregate demand curve okay the other thing is a equilibrium condition you can move that 45 degree line but the Z you can move it around so let's do a a few exercises well one the most obvious suppose that c0 increases by 1 billion okay so autonomous consumption that is that level of consumption which is independent of income goes up by 1 billion and that could

be you know we're only in a better mood we know disposable income is whatever it is today but you know there is great expectation that that in the that the economy will enter a boom next year and so then you feel richer and so on and you may decide to consume not wait until next year you may decide to consume more today that kind of thought experiment can be captured by a czo type shift go up and that's when you I talk about consumer sentiment well consumer sentiment is about a lot about czo for any

given level of income well consumers are likely to to to consume more than they would otherwise or or less and that's what Theo captures so let's go everything in this model there's no Dynamics in this simple model so we immediately what we know is if you just were to solve the equation and I tell you what happens to C if output what happens to Output if c z goes up by 1 billion you know that output Will Rise by how much let's keep it simple I just staring at that equation if I tell you autonomous

consumption goes up by 1 billion what happens to equum Output goes up by more or less than 1 billion or or exactly 1 billion exactly and the multipli is greater than one so we know that the output will increase by more than 1 billion will increase by 1 billion times the multiplier if C1 is .5 then it will increase by two billion dollar equili output now I'm going to get you to from the 1 billion to the two billion in steps using the diagram that's what I intend to do next okay so this shift here

so we're starting from this equilibrium output here this shift here boom is increasing c z that's a 1 billion so distance A to B is 1 billion that's because what I did is for any given level of output I shift this aggregate demand up by 1 billion that's autonomous consumption up okay well because output is whatever the man wants that immediately increases output by 1 billion so B the distance between B and C is also 1 billion okay demand increase by 1 billion boom output IM catches up so output increases by 1 billion but if

output increases by 1 billion what has happened to income it also increased by 1 billion income is the same as output so income has increased by 1 billion well if income has increased by 1 billion and C1 is different from zero that means part of the extra billion is going to be spent in consumption second round so say see one.5 then now you get $500 million more of expenditure but if it's of consumption and if there $500 that's that's the C CD that's 500 million obviously this the one here is is less than 0.5 because

otherwise you know this would be half of that but but it's not anyway you get 500 million more but if you if now there's 500 million more of demand since output does whatever production does whatever demand wants then you get 500 more of production and if you have 500 more million dollar more of production then you have 500 million more of income and if you have 500 more of income and your C1 is greater than zero .5 you're want to spend 250 million more but 250 million more will generate 250 million of production which also

will generate $250 million more of income which will generate 125 million more of consumption and blah blah blah blah blah can okay so that's and that's what have is happening here yeah from C to D okay so this is initial shift in aggregate demand up 1 billion that lead to leads to a 1 billion more of production as well which means 1 billion more of income okay but now these consumers not only have this c 1 billion higher in C but they also have one billion more of income and since they have 1 B million

in and they're going to spend part of it C1 times that and I assume C1 was5 that's what giv me CD that's the the extra five 500 million and then this that thing there is also $500 million and then then when it's 250 million 250 million 125 125 62 and a half that's that's the way you get there's an alternative way of finding equilibrium output which is entirely equivalent and it's the way it was initially done by the way and and and you'll see later on a very important curve in this course will be the

is curve which is a curve that describes all the equilibrium in Goods markets we'll get there but but the reason it's called is is because of this alternative way of deriving the same I have derived which is through you you you can arrive to the same equilibrium by saying look equilibrium output is an output at which investment is equal to savings that's the reason that curve is going to be called is investment equal to saving s so let me very quickly do it for you and then make a point and connect the two things so

save Private saving is you know what consumers do and so on and firms is just disposable income minus consumption that's your saving okay so it's equal to Y minus t that's disposible income minus C government saving is taxes minus government expenditure so if the government has a deficit that thing is negative governments often have negative saving okay if he has a surplus then ta taxes are greater than G then you have a fiscal Surplus again rarely happens in the US or in the Americas in general okay it happens a lot in Asia but not doesn't

happen very much in this part of the world but there we are so in equilibrium investment I has to be equal to saving so that's what you are going to use the saving for to invest okay so investment is equal to the sum of savings I can replace all that in here and you see that I get exactly the same equilibrium condition I had before output equal to agregate demand okay so this is an entirely equivalent way of deriving this and I just want to show you this because is the way it was originally done

and and and and and you'll understand better the terminology we use later on if you see that this is an equivalent way this is also a nice way of illustrating something why macro can be counterintuitive sometimes microeconomics is very intuitive I mean things make sense it's like physics it make sense macro can be confusing for example there the well-known Paradox of saving in the short run not in the long run in the short run you have the Paradox of saving so you know we all think that you save more is a good thing our parents

teach us that it's a good thing to save more and so on and in general that is true you'll do better in life if you save a little more and so on but it's not true for the macro in the short run you know it's not good for macroeconomics in the short run unless you are in an overheated economy now it could help but otherwise it's not very good for equ equilibrium output and let me show you that very quickly with the expression I just show you remember they said equilibrium output is pinned down by

investment equal to saving and saving of the private saving here is an increasing is an increasing function of output okay is equal to actually one minus C the function has a slope of one minus C1 C1 is a share of income that you spend in consumption therefore 1 minus C1 is the share of your income that you spend in Saving Okay so this function is increasing with a slope of 1 minus C1 so suppose I tell you now that all we decided to to we learn the lessons of our parents and say okay we should

all save more so that means for any for any given level of income now we all decide to save more that means the S function shift up for any given level of income we save more but we have a problem there because now we have more saving than investment so how how do we restore equilibrium that's not an equilibrium how do we restore equilibrium so now we all decide to be more prudent and save a little more at the level of the economy as a whole now we have more saving than investment that can happen

can it's not an equilibrium what restores equilibrium well in this very simple mode how investment is fixed so I nothing can adjust on the investment side because it's fixed later on it's going to move but now it's fixed nothing can adjust in the public saving part because you know it can't move we assume that exogenous so something has to happen endogenously here that that reverses the increase in savings the only thing that can happen and the only thing can happen endogenously here is a decline in output output the client saving the client so here you

end up in a situation in which we all decided to be sort of you know better people save a little more and we end up sinking the economy in a recession output decline okay that's the reason it's called the Paradox of saving that's not going to happen to you individually but to an economy as a whole that's the reason I say it's count intuitive it it can happen I so look if you don't like this way of ER and it's not the main way we're going to use this if you don't like this way of

finding equilibrium output just ignore it I I just want you to know it go back to the thing you really need to understand is not this is is this that that that you need to understand so let me illustrate the Paradox of saving in in the model we're using in the one I want you to really remember well the par of saving I can capture by a decline in c0o okay for any given low of income now we decide to consume less if we consume less for any given level of income that means we're saving

more okay so I can capture in this diagram uh the fact that we all become sort of more prudent by a decline and aggregate demand but if aggregate demand decline so suppose we start at this equilibrium level of output and then all of a sudden say okay enough is enough we we need to start saving more then what Happ happens well agre demand declines I mean for any given level of income if you're going to save more that means you're going to consume less so agre demand de clients but what happens when aggregate demand de

clients output de clients what happens when when output declines income declines what happens when income declines well part of the income you consume so you're going to consume less see one times that so then and then you get the multiply working against you so not only if now we all decide to save more not only output Falls by the same amount that that we increase savings but actually declines by more than that because you get the multiplier working against against you okay that's the reason a big role of policy makers really in recession is to

try to maintain the Cal the you know because you can get into these kind of things is everybody gets a scared and and you know we all get a scared so the economy can implode just out of bad sentiment and so now we're on the opposite side of the cycle we would want output to decline a little because we are having other problems inflation and so on again something we'll discuss later so now you may want to scare consumers a little and in fact er er the the governance of the Federal Reserve and the same

is happening in other places in the world are doing just that I mean when they go out there says the economy is too hot we're going to have to mess up this economy a little they're telling us that and and and the first ones that listen to these things is the financial market so every time this come out and make a speech of that kind Equity markets decline Equity markets captured before the mood that consumers will have in the future they captures early but that's a message okay so they're trying to at this moment really

policy makers at least the the central banks are trying to do just that the press a little bit consumers so so so we can cool off the economy a bit any questions again very important lecture because we're going to build on on this and and later on this is going to be always in the background and uh of this until we actually go to the third part of the course the key model will be this this will be in the background more things will be happening on top but but whenever I ask you a question

for example later on ah one example what else would produce a a a a this a situation like this what else would what what could happen what kind of policy would generate that that movement well at this point we haven't introduced monetary policy so you cannot talk about monetary policy but we do we do have other kind of policy we could talk about remember here fiscal policy okay fiscal policy G and T those are fiscal parameters when when G goes down or t goes up we call that contractionary fiscal policy why contractionary because it contract

aggregate demand if if G goes down clearly a demand goes down immediately if T goes up well disposable income for any given low of income goes down and therefore consumption goes down so so we call an increase a decline in G or an increase in t a contractionary fiscal policy the opposite if G goes up and T goes down we call that an expansionary fiscal policy so I take you back to this diagram here and I asked you the question again what kind of fiscal policy will generate this type of this picture contractionary or expansionary

contraction contractionary I mean good nemonic the output decline you know so contraction so that is a decline a reduction in G and go on expenditure or an increase in taxes will shift that curve down and then the multiplier will make it even more contractionary than the initial fiscal impulse okay very good take see you on Wednesday