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THE GOODS MARKET
Department of Economic Roadmap for Today ■ Aggregate demand and its compositions ■ Determinants of aggregate demand ■ Equilibrium in the goods market ■ Multiplier effect ■ Reading: Blanchard and Johnson, Chapter 3
Aggregate Demand ■ Aggregate demand () for goods and services: = + + + 1. Consumption (): Goods and services purchased by consumers 2. Government spending (): Goods and services purchased by governments (e.g., the federal, provincial, local governments) ■ Not including government transfers (e.g., employment insurance) 3. Net exports (): Exports – Imports, Positive = Trade surplus, Negative = Trade deficit 4. Investments (): Capital goods (e.g., houses, factories, machinery) ■ Not referring to financial investments (e.g., stocks, bonds) Aggregate Demand: An Example ■ Consider the following categories of aggregate demand: Consumption of goods, consumption of services, investment, government spending. Which category do the following items belong to? 1. A government transfer 2. A purchase of shares of a stock 3. A purchase of bread 4. A purchase of a 50-year old house 5. A purchase of a travel insurance 6. A construction of a new factory
Aggregate Demand: An Example ■ Consider the following categories of aggregate demand: Consumption of goods, consumption of services, investment, government spending. Which category do the following items belong to? 1. A government transfer (None) 2. A purchase of shares of a stock (None) 3. A purchase of bread (Consumption of goods) 4. A purchase of a 50-year old house (None) 5. A purchase of a travel insurance (Consumption of services) 6. A construction of a new factory (Investment)
Inventory Investment ■ Inventory investment () = Production – Sales – If > 0: Firms’ inventory accumulates – If < 0: Firms’ inventory decreases (production from previous years fulfills part of this year's demand)
Assumptions 1. Only one good in the economy 2. Inventories do not change ? Inventory investments, = 0: Assumed over the entire course 3. The economy is closed (no imports or exports, = = 0, and zero flow of funds across border): To be relaxed in Winter 2022 ■ Aggregate demand = + +
Determination of GDP in the Short Run ■ How is GDP (i.e., the level of output) determined in the short run in a closed economy? ■ Keynesian economics: Aggregate demand determines aggregate supply in the short run – Aggregate supply is perfectly elastic in the short run (price is constant) – In the long run, aggregate supply is determined by input factors and technology ■ Relationship between aggregate demand and supply:
DETERMINANTS OF AGGREGATE DEMAND
Relationship Between Income and Aggregate Demand ■ Government spending () not directly determined by income of a country? Take as exogenous (i.e., a given number) ■ Investment () is related to income, but also depends crucially on the financial markets ? Postpone the discussion to next week ? Focus on determinants of consumption ()
Determinants of Consumption ■ Consumption () is determined by 1. Disposable income: After-tax income, ≡ ? , where is gross income = GDP and is tax 2. Marginal propensity to consume (MPC), 1: When disposable income increases by 1 unit, by how many units consumption increases ■ Both factors positively affect the level of consumption ■ The simplest form: A linear relationship = 0 + 1 = 0 + 1( ? )
Consumption Function: Implications ■ Consumption increases with disposable income, but less than one for one ■ MPC is constant at all levels of income (implied by the linear relationship between and ) ■ Note: Alternatively, one can imagine that MPC decreases / increases with income ? Assuming linear relationship is a simplification ■ 0 > 0: The level of consumption for a household with zero disposable income – Example: Necessity expenditures (e.g., food) EQUILIBRIUM OUTPUT AND MULTIPLIER EFFECT
The Determination of Equilibrium Output ■ Equilibrium in the goods market occurs when Aggregate supply () = Aggregate demand () ■ Aggregate demand for goods: ≡ + + , where consumption: = 0 + 1 = 0 + 1( ? ), investment and government spending are taken as exogenous ■ Namely, = 0 + 1 ? + ? + ■ Solving for the equilibrium output, ?, we get ? = 11 ? 1 (0 + ? + ? 1)
Autonomous spending (i.e., spending that is independent of output or income) Illustration of Goods-Market Equilibrium
Summary ■ The goods market: – The production of goods and services within a period of time in a country (the definition of GDP) – Aggregate demand for goods and services: = + + (+ + ) ■ Determinants of consumption: Disposable income and marginal propensity of consume - = 0 + 1( ? ) ■ Equilibrium in the goods market (assuming perfectly elastic production): = 0 + 1 ? + ? + ■ Key to derive the IS curve ? Building block for the IS-LM model (Week 4)