Lecture 3: The Goods Market

Summary

In this lecture, Ricardo J. Caballero discusses the concept of economic recession, highlighting a high probability of the US entering one within the next 12 months according to a survey of economists. He introduces models to determine aggregate output and equilibrium, emphasizing the role of aggregate demand in the short run. Caballero explains the components of aggregate demand, including consumption, investment, government spending, and exports, and delves into the multiplier effect, showing how changes in autonomous consumption, investment, or government spending can impact economic output. The lecture also touches on the paradox of thrift and the counterintuitive nature of macroeconomics, where increased saving can lead to decreased output.

Takeaways

• 📉 The script discusses a survey of economists indicating a high probability of a recession within the next 12 months, defined as a decline in aggregate output.
• 🔍 The course aims to understand the determinants of equilibrium output, focusing on models of aggregate output determination in the short, medium, and long run.
• 📚 The first part of the course will concentrate on the very short run, examining how output is determined within a year, while the medium run will consider price adjustments.
• 🌐 The long run will explore output determination in the context of economic growth, distinguishing it from business cycle analysis.
• 💡 Aggregate demand is identified as the key driver of output in the short run, with demand changes affecting production and income, which in turn influences further demand.
• 💼 The components of aggregate demand include consumption (C), investment (I), government spending (G), exports (X), and imports (IM), with consumption being the largest component.
• 🏦 The consumption function is modeled as an increasing function of disposable income, with autonomous consumption (C0) and a marginal propensity to consume (C1).
• 📉 Disposable income is defined as income minus taxes, and the consumption function is simplified to C = C0 + C1 * (Y - T), where Y is output and T is taxes.
• 🔗 The equilibrium condition states that in equilibrium, output is equal to aggregate demand, which is a critical assumption in short-run macroeconomic models.
• 🔄 The multiplier effect is introduced, showing how an initial increase in autonomous consumption or government spending can lead to a larger increase in equilibrium output through the multiplier mechanism.
• 💡 The paradox of thrift is discussed, illustrating how increased saving by individuals can lead to a decrease in aggregate demand and output, contrary to the individual benefit of saving more.

Q & A

What is the main topic of the lecture?

The main topic of the lecture is understanding aggregate output determination, focusing on the short run, medium run, and long run, and how these affect economic conditions such as recessions.

What does the term 'recession' mean in the context of this lecture?

In the context of this lecture, a recession is defined as a decline in aggregate output, which is a significant economic downturn.

Why is the probability of a recession within the next 12 months a concern?

The probability of a recession within the next 12 months is a concern because it indicates a high chance of a significant economic downturn, which can have negative impacts on various aspects of the economy.

What are the three stages in which the course will explore output determination?

The three stages are: the very short run (up to quiz 1), the medium run (beginning of the second part of the course), and the long run (last part of the course).

What is the primary factor that determines output in the short run according to the lecture?

In the short run, output is primarily determined by aggregate demand, which includes consumption, investment, government spending, and net exports.

What is the role of consumer confidence in the short-run macroeconomic model discussed in the lecture?

Consumer confidence plays a crucial role in the short-run macroeconomic model because it affects aggregate demand. High consumer confidence can increase demand, leading to higher output, while low consumer confidence can reduce demand and potentially lead to a recession.

What are the components of aggregate demand mentioned in the lecture?

The components of aggregate demand mentioned in the lecture are consumption (C), investment (I), government spending (G), exports (X), and imports (M). However, for simplicity in this course, imports and exports are initially assumed to be zero.

How does an increase in autonomous consumption (C0) affect equilibrium output?

An increase in autonomous consumption (C0) leads to an increase in aggregate demand, which, according to the equilibrium condition, results in a higher equilibrium output. The effect is magnified by the multiplier effect, where the total increase in output is greater than the initial increase in autonomous consumption.

What is the paradox of saving mentioned in the lecture?

The paradox of saving suggests that while saving more is generally considered good for an individual, in a macroeconomic context, if everyone tries to save more, it can lead to a decrease in aggregate demand, lower output, and potentially a recession. This is because increased saving reduces consumption, which is a major component of aggregate demand.

How does the marginal propensity to consume (C1) influence the multiplier effect?

The marginal propensity to consume (C1) determines the extent to which an increase in income leads to an increase in consumption. A higher C1 means that a larger portion of additional income is spent, which amplifies the multiplier effect. Conversely, a lower C1 means a weaker multiplier effect.

Outlines

00:00

📊 Economic Recession Forecasts and Aggregate Output

Ricardo J. Caballero begins by discussing the results of a survey among economists who assess the likelihood of a recession within the next 12 months. He highlights the high probability of a recession, as indicated by the experts, and emphasizes the importance of understanding the factors that drive equilibrium output. The course aims to explore models of output determination, focusing on the short, medium, and long-term perspectives. In the short run, business cycle analysis is crucial, while the long run is more about growth determinants. The lecture sets the stage for a deeper dive into economic models that predict output and the conditions that might lead to a recession.

05:04

💡 Understanding Aggregate Demand and Its Components

Caballero delves into the concept of aggregate demand, explaining its role as the primary driver of short-run macroeconomics. He outlines the components of aggregate demand, including consumption (C), investment (I), government spending (G), exports (X), and imports (IM). The lecture focuses on consumption as the largest component and discusses how changes in consumer confidence can significantly impact the economy. Investment and government spending are presented as constants for the time being, with taxes and transfers also playing a role. The simplicity of the model at this stage is intentional, aiming to build a foundation before introducing more complex dynamics.

10:09

🌐 The Role of Consumption in Aggregate Demand

The third paragraph emphasizes the importance of consumption in determining aggregate demand. Caballero introduces a simplified model where consumption is an increasing function of disposable income, represented by a linear function with an autonomous component (C0) and a marginal propensity to consume (C1). Disposable income is defined as income minus taxes. The model assumes that consumption is driven by both autonomous factors and the propensity to consume out of disposable income. This framework sets the stage for understanding how changes in consumption can affect overall demand and, consequently, economic output.

15:10

🔍 Equilibrium Output and the Aggregate Demand-Output Relationship

Caballero discusses the concept of equilibrium output, explaining that in the short run, output is determined by aggregate demand. He introduces the equilibrium condition that output must equal aggregate demand. Using a simple model, he derives an equation for equilibrium output, highlighting the role of autonomous consumption, taxes, and government spending. The lecture also introduces the multiplier effect, showing how an increase in autonomous demand can lead to a larger increase in output. The importance of understanding this relationship is emphasized for analyzing economic conditions such as recessions and booms.

20:11

📉 The Multiplier Effect and Its Impact on Economic Output

In this segment, Caballero explores the multiplier effect in more detail, explaining how it amplifies the impact of changes in autonomous demand on economic output. He illustrates that if the marginal propensity to consume (C1) is greater than zero, the multiplier effect is greater than one, leading to a larger increase in output than the initial change in demand. The lecture also discusses the implications of a large multiplier in the context of government spending and the debate over the effectiveness of fiscal policy in stimulating the economy.

25:12

📚 Aggregate Demand Function and Equilibrium Conditions

Caballero continues to dissect the aggregate demand function, explaining its slope and how it relates to the marginal propensity to consume. He uses a diagram to illustrate the relationship between aggregate demand and output, highlighting the equilibrium condition where output equals aggregate demand. The lecture also discusses the implications of shifts in the aggregate demand curve, such as those caused by changes in autonomous consumption, taxes, or government spending. The importance of understanding these shifts for predicting economic outcomes is emphasized.

30:12

💼 Fiscal Policy and Its Effects on Aggregate Demand

The lecture shifts focus to fiscal policy, discussing how changes in government spending (G) and taxes (T) can affect aggregate demand. Caballero explains that an increase in taxes or a decrease in government spending can lead to a contraction in aggregate demand, which in turn can reduce output. This is illustrated through the concept of the multiplier, where the initial effect of fiscal policy is amplified through its impact on consumption and income. The lecture also touches on the potential counterintuitive effects of increased saving in the context of macroeconomics.

35:15

🚨 The Paradox of Thrift and Its Macroeconomic Implications

Caballero introduces the paradox of thrift, a concept that illustrates how increased saving by individuals can lead to a decrease in aggregate demand and, consequently, a decline in output. He uses the model to show that if people decide to save more, consumption decreases, leading to a reduction in output and income. This, in turn, can cause a further decrease in consumption through the multiplier effect. The lecture highlights the counterintuitive nature of macroeconomics, where individual actions aimed at increasing saving can have negative consequences for the overall economy.

40:17

🌡️ Cooling the Economy: The Role of Policymakers

In the final paragraph, Caballero discusses the role of policymakers, particularly central banks, in managing the economy. He explains that policymakers sometimes need to dampen consumer sentiment to cool off an overheated economy, which can lead to a decline in equity markets. The lecture emphasizes the importance of fiscal policy in influencing aggregate demand and the need for policymakers to carefully manage economic sentiment to avoid economic implosions due to widespread fear and reduced consumption.

Keywords

💡Recession

A recession is defined as a decline in economic activity, typically characterized by a fall in GDP for two consecutive quarters. In the video, the concept is introduced as a period of decreased aggregate output, which is a central concern for economists surveyed. The script discusses the high probability of a recession within the next 12 months, indicating its relevance to the broader economic discussion.

💡Aggregate Output

Aggregate output refers to the total quantity of goods and services produced in an economy over a specific period. It is a key measure of economic performance. In the context of the video, the decline in aggregate output is used to define a recession, and the course aims to understand the factors driving equilibrium output, which is closely related to aggregate output.

💡Equilibrium Output

Equilibrium output is the level of production at which the total demand for goods and services in an economy equals the total supply, assuming all markets are in equilibrium. The video emphasizes understanding what drives equilibrium output and how it is determined, which is a fundamental concept in macroeconomic analysis.

💡Aggregate Demand

Aggregate demand is the total demand for final goods and services in an economy, comprising consumption, investment, government spending, and net exports. The script discusses how aggregate demand determines output in the short run, which is a core mechanism in macroeconomic models, especially in business cycle analysis.

💡Consumption

Consumption in economics refers to the use of goods and services by households. It is a major component of aggregate demand. The video script highlights consumption as a significant driver of output, with the marginal propensity to consume being a key factor in determining how changes in income affect consumption.

💡Investment

Investment in this context refers to the purchase of goods that are not consumed today but are used in the future to create wealth, such as machinery, equipment, and buildings. The script mentions investment as a component of aggregate demand, although it is initially assumed to be constant in the simple model presented.

💡Government Spending

Government spending is the expenditure by the government on goods and services, which is part of aggregate demand. The video discusses government spending as a component that can influence economic output, although it is also initially assumed to be exogenous in the model.

💡Exports and Imports

Exports are goods and services produced domestically and sold abroad, while imports are goods and services purchased from foreign countries. The script initially sets exports and imports to zero for simplicity, but later notes their importance in an open economy. These components of aggregate demand are crucial for understanding international trade and its impact on domestic output.

💡Inventory Investment

Inventory investment refers to the change in the total value of goods held in inventory by businesses. The video mentions that inventory investment is volatile but small in the context of aggregate demand, and it is initially ignored in the model for simplicity.

💡Multiplier Effect

The multiplier effect describes the phenomenon where an initial increase in spending leads to a larger increase in economic output. In the video, the multiplier is discussed in relation to the marginal propensity to consume, showing how an initial increase in autonomous consumption can lead to a larger increase in equilibrium output.

💡Fiscal Policy

Fiscal policy refers to government actions, such as changes in government spending and taxation, aimed at influencing the economy. The script discusses how changes in government spending (G) and taxes (T) can be used to either contract or expand aggregate demand, thereby affecting economic output.

Highlights

Economists surveyed predict a high probability of a US recession within the next 12 months.

Recession is defined as a decline in aggregate output.

Understanding models of output determination is crucial for forecasting economic conditions.

The course will explore models of output determination in three stages: very short run, medium run, and long run.

In the very short run, output is determined by aggregate demand.

Aggregate demand consists of consumption, investment, government spending, and net exports.

Consumption is a significant component of aggregate demand and is influenced by consumer sentiment.

Investment and government spending are assumed to be constants in the initial model.

Consumption is modeled as an increasing function of disposable income.

The marginal propensity to consume (C1) is a key parameter in determining consumption.

Disposable income is defined as income minus taxes.

Equilibrium output is determined where output equals aggregate demand.

The multiplier effect is a significant concept in macroeconomics, amplifying the impact of changes in autonomous consumption.

An increase in autonomous consumption (C0) leads to a larger increase in equilibrium output due to the multiplier effect.

The paradox of thrift suggests that increased saving by individuals can lead to a decrease in aggregate demand and output.

Fiscal policy, through government spending (G) and taxes (T), can be contractionary or expansionary, affecting aggregate demand.

Policymakers play a critical role in managing economic sentiment to prevent economic implosion during recessions.

Transcripts

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RICARDO J. CABALLERO: OK, let's start.

So what you have there in that picture

is the result of a survey to a bunch of economists 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.

And well, the first thing to notice here

is that it's not very good news.

There are very high chances that, at least

according to these experts, that the US enters

a recession within the next 12 months or so--

pretty high probability.

You can see that that number typically is very, very low,

and it goes very high sort of next to recessions.

And now we're not in a recession,

but there is a sort of very high perceived

probability that we may go into a recession in the near future.

So how is it that these people come up with this forecast?

Well, at some level, either explicitly or implicitly,

they must have some model of the termination of equilibrium

output.

And they need to understand--

they need to see certain things that

suggest, once you go through a model, that output will decline.

So that's what we're going to start doing today.

And in fact, that's what we're going

to do throughout this course.

We're going to try to find evermore complex, perhaps,

or richer models of output determination, aggregate output

determination.

So that's essentially what this course is about.

And so an understanding.

We're going to try to understand what

is it that drives equilibrium output,

and how is it that we get to one specific level of output.

That's what it means to find the equilibrium level of output.

And we're going to do it sort of in three stages.

In the first part of the course-- that is, up to quiz 1--

we're going to focus on the very short run, how output

is determined in the very short run, say within a year or so--

or a little more even, 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 the second part

of the course.

And by the medium run, simply we're

going to mean by the time in which prices begin

to adjust sufficiently, OK?

Before that, it's most of the action happens in quantities.

There is little movement in goods prices.

There's lots of movements 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 determination of output in the short run

is what we mostly mean by business cycle analysis.

And short or medium run, the way we're going to find it here,

is what we mean by business cycle-- the country's

in a recession, it's in a boom, is an expansion.

Those are all terminologies of the short run

or short or medium run.

The termination of equilibrium output in the long run

is when we think about growth.

When we talk about why China grows faster than the US today,

well, that's a question not about the business cycle.

It's a question about the long-run determinants

of output growth, OK?

And they 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.

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 models than trying to integrate

all in one big machine, OK?

But let's start with the simple part.

In the short run, the key mechanism,

something that will keep showing up in all the models

and submodels 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 economists are

forecasting that will decline in within the next 12 months--

is determined primarily by what we call demand.

So demand will determine output.

Thus, if there's 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 measured the income side.

And they're exactly the same.

More production, somebody has to receive the proceeds of that--

workers and owners, capital owners, the government,

whatever.

So changes in-- so the second step is 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 demand again and so

on and so forth, OK?

So that's essentially-- that's quintessential short-run macro,

to try to understand this aggregate demand,

because that's the main driver, and then

how it gets multiplied in the short run, OK?

In this lecture, we're going to talk just about that, primarily

about that.

But that's one-- so when I mean short-run macro, that's

a structure I have in mind.

And that's what 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, they tend to reduce demand.

If consumers are very bullish, that

will tend to increase demand.

And since, in the short run, output

is determined by demand, the business cycle,

whether we have a recession or not,

depends a lot on how demand feels.

So if somebody's forecasting a recession within the next 12

months, is forecasting really that demand will decline

within the next 12 months, OK?

Why they're forecasting that-- that's something

we're going to learn in steps as we go through the course.

What are the kind of things they may be thinking about?

What are the drags on aggregate demand

that are likely to depress demand and so on and so forth?

But we'll get there, OK?

Anyways, first, let me tell you about the components

of aggregate demand.

The first and one of--

the largest component of aggregate demand is consumption.

And what I mean aggregate demand--

OK, I'll be--

I'll pause for a slide.

Let me go over the definition.

Consumption-- we're going to denote by C--

is the goods and service purchased by consumers,

households, and so on.

Investment, which we're going to denote by I,

is the sum of nonresidential and residential investments--

so equipment and 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, capital goods and so on.

But they're are also goods and services.

Government spending-- that's what we're going to denote

by G-- are purchases of goods and services by the federal,

state, and local government, excluding--

that's important-- government transfers.

What is a government transfer?

Many of you may have received that during COVID.

The government sent you a check, for example, OK?

Well, that check is not part of government expenditure.

That check is like a-- is a negative tax

and is going to enter somewhere else.

When we mean government expenditure

is things the government purchases, services

the government acquires and so on, OK?

And then exports, X, which will play no role until seven

lectures, eight lectures from now,

or actually 10 lectures from now probably,

is purchases of US goods and services-- that is,

goods produced by US factories--

by foreigners.

IM is the other side of the story, inputs.

It's the purchase of foreign goods and services

by US consumers, US firms, US government.

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, OK?

And then the last component is something

we're not going to pay any attention whatsoever

in this course, which is inventory investment.

Inventory investment is certainly--

it's almost accidental.

There is some planning on it, but there is a lot of-- it's

just when there's 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're not producing and selling immediately.

There are certain lags.

That's a small thing.

It's volatile, but it's a small thing.

So we're going to ignore it for this course.

We're going to assume, actually, unless we explicitly

say the contrary, and that could show up in a pset.

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 0.

Also, for this part of the course, until further notice,

we're going to assume that exports and imports are

equal to 0 as well.

That's not realistic, but it's easier

to analyze what we call a closed economy, an economy that

is not interacting with the rest of the world.

In, again, 10 lectures 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, OK?

So now, 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--

of GDP output, aggregate demand.

They're are all the same in equilibrium,

but we'll get there.

In GDP, you see that consumption accounts for a big chunk, close

to 70% of aggregate 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 that they produce its 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, nonresidential investment.

Government expenditure is a big component of aggregate demand.

And then I'm not going to worry too much about--

for a country like the US, the openness part

is relatively small.

If you go to a--

a small economy typically will have sort of very large exports

relative to GDP and so on.

But that's not the case of the US.

And there you see why we're going to set

inventory investment to 0.

It's a small thing.

It moves a lot more than its size,

so it can account for fluctuations in sort

of the monthly level of GDP.

But it's not that important in a slightly longer period of time,

OK?

So that's more or less the story.

So now this is the model.

Please stop me.

Is there anything here you don't understand,

because everything that we build from here to quiz 1

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.

And you're not supposed to understand it in the first run,

so it's OK that you ask me.

But let's make sure that you understand

what is going on here.

OK, so that's aggregate demand.

First, definition-- so we're going to denote aggregate demand

by this Z, letter Z. And aggregate demand is going

to be--

when we say aggregate demand, remember

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 meet-- when we talk about aggregate 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 the reason aggregate demand looks

like that, is, well, consumers.

Consumers are going to demand goods.

Investment, G, plus exports.

If foreign 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 US companies.

So they do not affect the determination of equilibrium

output in the US, OK?

That's the reason you subtract it.

Now, that distinction is not going

to matter until 10 lectures from now, because we're

going to set X and IM equal to 0 from the point of view

of modeling.

So all demand is demand for domestically produced goods

in this part of the course, OK?

So aggregate demand for US will be this C plus I plus G.

So we need to understand what determines 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 that it's a constant, is given.

So it's determined somewhere else,

not in the model I'm about to solve.

Government expenditure, the same--

I'm going to assume it's determined

by some other priorities, green agendas and stuff like that.

It has very little to do 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 have

been determined somewhere else.

In psets 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,

OK?

And I'm going 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, OK?

So we're going to assume--

here we're going to have a function.

Something has to move for the model to be interesting.

So 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 income,

you're going to consume more.

That's what this says, OK?

In reality, that consumption function is a lot more complex.

There are lots of things that enter there that we're not

modeling for now.

But let's start from the basics, OK?

So that's going to be the only behavioral assumption we're

going to make for a while, that the consumers consume

more when they have more disposable income.

And then we're going to get even simpler.

I'm going to assume that consumption is a linear function

of this disposable income.

So there's going to be some constant C0 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--

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.

There are lots of other things that affect consumption

which are different from--

aside from your disposable income.

But we're not going to model that.

So thus, 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?

So say you get an extra dollar of income.

If you spend $0.60 in the things you normally consume of that

extra dollar, well, then your C1 is 0.6, OK?

That's the marginal propensity 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 the C1

that we have there, OK?

Good.

Now let me tell you how we define disposable income.

Disposable income is just equal to income,

which is equal to production, minus taxes.

That's disposable income.

It's whatever you earn as a worker or as a capital owner--

well, then the government takes some 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.

So that means that our consumption function

can be written that way after all these assumptions I've

made--

equal to its autonomous component plus C1,

the marginal propensity to 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 we know that there is a relationship between these two

things.

Again, the consumption function in practice

is much richer than that.

And there is lots of randomness, random terms around and so on.

But that's not what we're about here.

But that's-- if you want to start with a consumption

function, this is a pretty reasonable one to start with,

OK?

OK, so that's going to look in the space of disposable income,

or income--

I could have put income there, not disposable income--

so that it looks like that.

OK?

So C0 is that autonomous consumption.

It's something you're going to consume

regardless of your level of disposable income.

And there is a minimum consumption you have to have.

[CHUCKLES] And then the slope of that

is the marginal propensity to consume,

which is C1, which is a number between 0 and 1.

OK, so let's determine equilibrium output.

So we have aggregate demand, which is C plus I plus G, OK?

There we are.

That was our definition of aggregate demand.

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 consumption function.

So what we have here is that aggregate demand is

an increasing function of output, or income, OK?

It's also a function of taxes, investment, and so on.

But it's an increasing function of output.

And this is important because, remember, 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, [CHUCKLES] OK?

Now, I cannot find equilibrium output just from this equation.

Why is that?

So remember, we're trying to build a model

to find equilibrium output.

That's our goal.

That's what will tell us whether we're in a recession or not--

output is low, recession, output is high, we're in a boom.

Obviously, I cannot solve it from this.

I have two unknowns.

What are my two unknowns?

Two unknowns, one equation.

What is my second unknown there?

AUDIENCE: The aggregate demand.

RICARDO J. CABALLERO: Aggregate demand, of course.

We have to determine Z and Y. So how are 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.

OK?

That's what this equilibrium condition tells us.

Off 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, two

unknowns, OK?

Good.

And the reason I post on this is that I

see that mistake made often, that 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 the diagram.

So this is the--

let me keep going.

So this is clear, no?

So this is just a summary of what

we had in the previous slides.

And this is the new thing here, which is, in equilibrium, output

is equal to aggregate demand.

And again, that's what makes this really a short-term model.

You see, I'm saying output, in the short term,

is whatever demand wants it to be,

which is different from the long run that

says, no, no, hold on a second.

I mean, but 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, OK?

So this is pretty-- is a big assumption.

And there are schools of thought within macroeconomics

that are split by this assumption,

whether you believe that, in the short run,

output is aggregate demand-determined or not.

Ultimately, 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 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, OK?

But for now, so this is important.

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, labor, lots of things.

I'm not going to even do that.

I'm going to say, no, no, output will be whatever

demand wants it to be, OK?

And that means, in equilibrium, they have to be equal.

[CHUCKLES] Good.

You had a question.

AUDIENCE: [INAUDIBLE] can you [INAUDIBLE] output and GDP

[INAUDIBLE]?

RICARDO J. CABALLERO: No, they are the same for us.

AUDIENCE: They are [INAUDIBLE]?

RICARDO J. CABALLERO: That's our definition.

GDP, for us, is output.

So when they say aggregate output, I mean GDP.

Remember?

Real GDP-- we're talking all about real GDP, OK?

And it's also equal to income--

not disposable, but it's equal to income.

Remember when we did those little tables where we look

[INAUDIBLE], 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, OK?

So Y is real GDP for us?

That's real GDP.

What happens, in the table I showed you,

I already used the fact that real GDP

is equal to aggregate demand.

And that's the reason I showed you

the different components of Z I showed you

that, that, and that, [CHUCKLES] OK?

But in equilibrium, they are equal.

There's really a figure that will clarify,

I think, a lot of that.

But let me keep solving this.

So we have that--

so what 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, for the first time

in this course, an equation for equilibrium output.

There you are.

That's your equilibrium output in this economy.

OK?

Now, this guy here is very famous

and is very macro It doesn't happen in micro.

It happens in macro only, this guy here.

Another guy there is called the multiplier.

And it's a very important macro concept.

It's a huge concept in macro.

Now, why do you think it's called a multiplier?

Well, obviously, it multiplies something.

But a multiplier sounds like it multiplies--

that makes something bigger.

[CHUCKLES]

So what happens if C1 is greater than 0?

What happens if C1 is greater than 0.

Remember, it's between 0 and 1.

But what happens if it's greater than 0?

What happens with that number there, 1 over 1 minus C1?

AUDIENCE: Bigger than 1.

RICARDO J. CABALLERO: It's greater than 1.

It multiplies.

So the reason we call it a multiplier

is not nothing deep there.

So this thing here is sort of autonomous stuff.

It's what the government spends, what firms are spending,

capital.

This is autonomous consumption.

And this actually is a typo there.

There should be a C1 in front of that--

typo.

It comes from there, C1 times T. So fix that typo, please.

I'm going to upload the slides again with the typo fixed, OK?

I'm just-- it comes from here, C1 times T.

OK, so that's what this does.

It multiplies.

So whatever it is that is happening here,

whatever it is that the government is spending

or whatever, this term is multiplied.

And that's a huge thing.

There was a big debate--

almost always, when you're trying

to get out of a recession, and the government starts 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 you're

going to have to spend very little,

and then the multiplier will take you away

from that recession.

So what is it that makes a multiplier large or small?

Well, mechanically, when is it that multiplier large?

AUDIENCE: When C1 is closer to 1,

so when people are spending more of their income.

RICARDO J. CABALLERO: Exactly, when C1 is large.

And that gives you the logic.

And that's very important in macro,

is why is it a big multiplier?

Well, because think what happens in macro.

The government spends-- not increases output.

But now output increases income.

And if consumers spend a big share of their extra income,

an output, and consumption again,

then that increases output again,

which increases the income again, and you keep going, OK?

So that's the sequence.

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 increase in income.

But if consumers don't spend it, it

doesn't recirculate into the economy,

and then you don't get a multiplier.

So that's the reason we call it the multiplier.

So that diagram is an important diagram.

I'm just 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 aggregate demand and output, production, and income here.

But remember, income is equal to production, OK?

So there's your aggregate demand and, thus,

your 45-degree line because this output equal to-- so whatever is

in this axis equal to that axis, that's the 45-degree line, OK?

So that's your equilibrium conditions.

It's, at equilibrium, these guys here,

aggregate demand, Z, will have to be

equal to Y. Those are-- that's traced there.

This is aggregate demand.

Why is this line flatter than that?

Why is aggregate demand flatter than--

AUDIENCE: Because people don't spend their entire dollar.

RICARDO J. CABALLERO: Exactly, because C1 is less than 1.

So the slope of the aggregate demand in this space

is C1, is the marginal propensity to consume.

How much more they demand if they get an extra dollar?

Well, they don't get-- they don't demand one extra unit.

They demand C1 unit, and C1 is less than 1.

So that's the reason this.

So if C1 is very small, this line is going to be very flat.

If C1 is very large, very high propensity

to consume, this is going to be very steep, the red line.

The other one doesn't change, the 45-degree line.

And what I said is that, at--

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.

This function, I can plot it everywhere.

But this one will hold only at equilibrium, OK?

That's when these two things are equal.

So what I solve here--

here, I just found this point.

So parameters here are C0, C1 times T,

and G. They all shifters of this aggregate demand, up and down.

And that point here is exactly that.

And 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 a little because it's

going to show up repeatedly.

And later, 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 that's likely to happen.

So you better understand this diagram.

Play with it.

Move-- here, the only thing you can move around

is the ZZ, the aggregate demand curve, OK?

The other thing is an equilibrium condition.

[CHUCKLES] You can't move that 45-degree line.

But ZZ, you can move it around.

So let's do a few exercises.

One, the most obvious, suppose that C0 increases by $1 billion.

So autonomous consumption-- that is,

that level of consumption which is independent of income--

goes up by $1 billion.

And that could be we're only in a better mood.

Disposable income is whatever it is today.

But there is great expectation 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 C0 type

shift, go up.

And that's when I talk about consumer sentiment.

Well, consumer sentiment is a lot about C0--

for any given level of income, whether consumers

are likely to consume more than they would otherwise or less.

And that's what C0 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--

if output-- what happens to output if C0 goes up

by $1 billion, you know that output will rise by how much?

Let's keep it simple.

Just staring at that equation, if I tell you autonomous

consumption goes up by $1 billion,

what happens to equilibrium output?

Goes up by more or less than $1 billion?

Or exactly $1 billion?

AUDIENCE: [INAUDIBLE]

RICARDO J. CABALLERO: Exactly.

And the multiplier is greater than 1.

So we know that the output will increase by more than $1

billion, will increase by 1 billion times the multiplier.

If C1 is 0.5, then it will increase by $2 billion

equilibrium output.

Now, I'm going to get you from the $1 billion to the $2 billion

in steps using the diagram.

That's what I intend to do next.

OK?

So this shift here-- so we're starting from this equilibrium

output here.

This shift here, boom, is increasing C0.

That's at $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.

Thus, autonomous consumption, up, OK?

Well, because output is whatever demand wants,

that immediately increases output by $1 billion.

So the distance between B and C is also $1 billion.

Demand increased by $1 billion, boom, output

immediately 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 0, that means part of that extra billion

is going to be spent in consumption, second round.

So say C1 is 0.5, then now you get $500 million

more of expenditure.

But if it's-- of consumption.

And it's $500, that's the CD.

That's $500 million.

Obviously, this C1 here is less than 0.5

because otherwise this would be half of that, but it's not.

But anyway, you get $500 million more.

But 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 dollars

of more production, then you have $500 million

more of income.

And if you have $500 more of income,

and you have C1 is greater than 0--

say, 0.5-- you're going 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.

You [INAUDIBLE] OK?

So that's-- and that's what is happening here.

[WHISTLING] Boom.

Yeah?

AUDIENCE: [INAUDIBLE] the movement from C to D

[INAUDIBLE]?

RICARDO J. CABALLERO: From C to D. OK,

so this is the initial shift in aggregate demand up, $1 billion.

That leads to a $1 billion more of production

as well, which means $1 billion more of income, OK?

But now these consumers not only have this C0--

$1 billion higher in C0, but they also have $1 billion

more of income.

And since they have $1 billion more income,

and they're going to spend part of it--

C1 times that, and I assume C1 was 0.5--

that's what gives me CD.

That's the extra $500 million.

And then that thing there is also $500 million.

And there was $250 million, $250 million, $125, $125 $62.5.

That's the way you get there.

There is an alternative way of finding equilibrium output,

which is entirely equivalent.

And it's the way it was initially done, by the way.

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 the reason it's called IS because of this alternative way

of deriving the same I have derived, which is through--

you can arrive to the same equilibrium by saying,

look, equilibrium output is that output at which

investment is equal to savings.

That's the reason that curve is going to be called IS,

investment equal to savings, S.

So let me very quickly do it for you and then make a point

and connect the two things.

So private saving is what consumers do and so on,

and firms.

It's just disposable income minus consumption.

That's your saving, OK?

So it's equal to Y minus T. That's

disposable 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, OK?

If it has a surplus, then taxes are greater than G,

then you have a fiscal surplus.

Again, rarely happens in the US or in the Americas in general.

It happens a lot in Asia, but it 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,

OK?

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 aggregate demand.

So this is an entirely equivalent way of deriving this.

And I just want to show you this because it's

the way it was originally done.

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 makes sense.

Macro can be confusing.

For example, there is a well-known paradox of savings,

in the short run, not in the long run.

In the short run, you have the paradox of saving.

So we all think that you save more is a good thing.

Our parents teach us that is 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.

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 equilibrium output.

And let me show you that very quickly with the expression

I just showed you.

Remember I said, equilibrium output

is pinned down by investment equal to saving.

And saving-- the private saving here

is an increasing function of output, OK?

It's equal to, actually, 1 minus--

the function has a slope of 1 minus C1.

C1 is the share of income that you spend in consumption.

Therefore, 1 minus C1 is the share of your income

that you spend in saving, OK?

So this function is increasing with a slope of 1 minus C1.

So suppose I tell you now that all we

decided to learn the lessons of our parents

and say, OK, we should all save more.

So that means, for any given level of income,

now we all decide to save more.

That means the S function shifts up.

For any given level of income, we save more.

But we have a problem there because now we have more savings

than investment.

So how do we restore equilibrium?

That's not in equilibrium.

How do we restore equilibrium?

So now we all decided 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't happen.

It's not an equilibrium.

What restores equilibrium?

Well, in this very simple model, our investment is fixed.

So 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 savings part

because it can't move.

We assume that it's exogenous.

So something has to happen endogenously

here that the 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 declines, saving declines.

So here you end up in a situation

in which we all decided to be better people,

save a little more.

And we ended up sinking the economy in a recession--

output decline.

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 said it's counterintuitive.

It can happen.

So look, if you don't like this way of--

and it's not the main way we're going to use.

If you don't like this way of finding equilibrium output,

just ignore it.

I just wanted you to know it.

Go back to-- the thing you really need to understand

is not this.

It's this, that, that.

That you need to understand.

So let me illustrate the paradox of saving

in the model we're using, in the one

I want you to really remember.

Well, the paradox of saving I can capture by a decline in C0.

For any given level of income, now we decide to consume less.

If we consume less for any given level of income,

that means we're saving more.

So I can capture in this diagram the fact

that we have all become sort of more prudent

by a decline in aggregate demand.

But if aggregate demand declines-- so

suppose we start at this equilibrium level of output,

and then, all of a sudden, we say, OK, enough is enough.

We need to start saving more.

Then what happens?

Well, aggregate 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 aggregate demand declines.

But what happens when aggregate demand declines?

AUDIENCE: Output declines.

RICARDO J. CABALLERO: Output declines.

What happens when output declines?

AUDIENCE: [INAUDIBLE]

RICARDO J. CABALLERO: Income declines.

What happens when income declines?

Well, part of that income you consume.

So you're going to consume less.

C1 times that.

So then-- and then you get the multiplier working against you.

So not only-- if now we all decide to save more,

not only output falls by the same amount

that we increase savings, but actually

declines by more than that because you get the multiplier

working against you, OK?

That's the reason a big role of policymakers, really,

in recession is to try to maintain the calm because you

can get into these kinds of things.

It's everybody gets scared, and we all get scared.

So the economy can implode just out of bad sentiment and so on.

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, 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.

[CHUCKLES] They're telling us that.

And the first one is listen to these things

is the financial markets.

So every time they come out and make a speech of that kind,

equity markets decline.

Well, equity markets capture before the mood

that consumers will have in the future, captures it early.

But that's the message, OK?

So they're trying-- at this moment,

really, policymakers-- at least the central banks--

are trying to do just that, depress a little bit consumers

so we can cool off the economy a bit.

OK.

Any questions?

Again, very important lecture because we're

going to build on this and, later on, this

is going to be always in the background.

And 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 whenever I ask you a question--

for example, later-- ah, one example--

what else would produce a situation like this?

What else-- what could happen?

What kind of policy would generate that movement?

Well, at this point, we haven't introduced monetary policy.

So you cannot talk about monetary policy.

But we do have other kinds of policy we could talk about.

Remember?

Here, fiscal policy.

OK?

Fiscal policy.

G and T, those are fiscal parameters.

When G goes down or T goes up, we

call that contractionary fiscal policy.

Why contractionary?

Because it contracts aggregate demand.

If G goes down, clearly aggregate demand

goes down immediately.

If T goes up, well, disposable income

for any given level of income goes down,

and therefore, consumption goes down.

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 ask you the question again,

what kind of fiscal policy will generate this type of--

this picture?

Contractionary or expansionary?

AUDIENCE: Contractionary

RICARDO J. CABALLERO: Contractionary.

I mean, a good mnemonic, the output decline.

So contractionary-- so that is a decline-- a reduction in G,

in going 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.

OK?

Very good, see you on Wednesday.