Download The goods market Screen 1 In this presentation we take a closer

The goods market
Screen 1
In this presentation we take a closer look at the goods market and in particular how the
demand for goods determines the level of production and income in the goods market.
There are literally thousands of different producers of goods and services and millions of
different consumers of these goods and services in the economy. In macroeconomics all
these markets for goods and services, including producers and the consumers, are lumped
together under the heading of the goods market. In economics this Alumping together@ is
called aggregation. Because the goods market is concerned with real things, such as the
production and consumption of goods and services, it is also called the real sector.
The goods market is important because it is in this market that producers decide what and
how much to produce, and consumers decide what and how much to consume.
An important question that arises when dealing with the goods market is what determines
the level of production or output that producers are willing to undertake? In his book
The general theory of employment, interest and money published in 1936 John Maynard
Keynes tells us that the levels of production and income in the economy are determined
in the goods market by the demand for goods and services. This is the principle on which
our theoretical model is based and we will provide you with a goods market model that
captures some of the important variables that influence the demand for goods and
services. We will also show how this demand in turn determines the levels of production
and income in the economy.
Before we analyse demand and show how it influences production and income you must
understand why production and income are regarded as synonymous.
Assume the economy consists only of firms that are responsible for production, and
households who own the factors of production without which production cannot take
place. By making these factors of production available to firms, households receive an
income in the form of rent, wages, interest and profits from firms. What production
factors receive from producers equals total production, which means that income and
production are two sides of the same coin. Increased production calls for more factors of
production, which means that household’s income increases .
In a goods market diagram output and income are usually marked Y on the horizontal
axis. It is the determination of this variable that we are trying to explain in this goods
market model.
Besides the fact that total production and total income is related total production is also
related to employment and unemployment. Higher total production implies more
employment and less unemployment.
In our goods market model the demand for goods therefore not only determines the level
of output and income, but also the level of employment and unemployment.
Let’s take a closer look at the demand for goods.
Screen 2
In our goods market model the demand for goods drives production and income in the
economy and consists of the following components:
Consumption spending by households, which is indicated as C.
Investment spending by firms, which is indicated as I.
Government spending which is indicated as G .
Exports which is indicated as X.
and imports which is indicated as IM.
So our demand equation is therefore Z = C + I + G + (X - IM) which determines the level
of production and income.
A change in one or more of the demand components leads to a change in total production
and income. For instance, a higher demand for goods stimulates production and income
while a lower demand for goods effectively lowers production and income.
In this presentation we will assume a closed economy and ignore the impact of the
external sector on the goods market.
In our goods market diagram the demand for goods comprising C + I + G is indicated on
the vertical axis as Z.
Let’s examine these components starting with households’ consumption spending.
Screen 3
Since the consumption function predicts households’ behaviour it is a behavioural
equation.
According to this function households’ consumption spending is a function of
autonomous consumption, c0, and of disposable income, YD.
Autonomous consumption reflects the influence of non-income determinants of consumer
spending which are all the other factors, except the level of income, that influence
consumer spending, such as interest rates, expectations, wealth, income distribution,
access to credit, and so on . Autonomous consumption can also be regarded as
consumption that is financed from sources other than income, for example inheritances,
past savings, gifts or credit.
On a diagram disposable income YD is shown on the horizontal axis while autonomous
spending is shown on the vertical axis, as independent of disposable income.
Increased autonomous spending raises the vertical intercept.
Disposable income, shown as YD in the equation, equals income less income taxes.
Keynes had the following to say about the relationship between income and household
consumption:
"The fundamental psychological law, upon which we are entitled to depend with great
confidence both a priori from our knowledge of human nature and from the detailed facts
of experience, is that men are disposed to increase their consumption as income
increases, but not as much as the increase in income".
This indicates that between disposable income and consumption spending a positive
correlation exists and that the causality runs from a change in disposable income to a
change in consumption. Consumption expenditure rises and falls with disposable
income. Higher disposable income raises consumption expenditure while a decrease in
disposable income decreases consumption expenditure.
While an increase in households’ income causes an increase in their consumption
spending the increase in consumption spending is less than the increase in income. In
other words, if households’ income increases by R100 million we can expect consumer
spending to increase, but the increase will be less than R100 million. The fact that
consumption spending follows rising income at a lower rate is expressed as the marginal
propensity to consume c which has a value of less than 1.
Consumption that changes with income is referred to as induced consumption.
With disposable income on the horizontal axis and consumption spending on the vertical
axis the positive relationship between disposable income and consumption spending is
reflected as an upward trend indicating that as income increases consumption spending
increases as well.
The slope of the curve is determined by the marginal propensity to consume indicating as
less one meaning that the increase in consumption spending following an increase in
income is less than the increase in income . For example, if income rises by a 100 and
the marginal propensity to consume is 0.9, then consumption spending rises by 90.
Note that the vertical intercept is determined by autonomous consumption.
Households’ behaviour can now be described as follows: Households provide
firms with the factors of production, which are then used to produce goods
and services. In return for the factors of production households receive an
income from firms. Households use this income to buy the goods and services
that are produced by firms, but do not spend all their income on consumption.
What they don’t spend is saved.
There are two important things to remember about households’ consumption as reflected
in this model. The first is that whenever output and income rises it leads to an increase in
consumption spending by households . In other words, if you read in the newspaper that
output as measured by the gross domestic product has increased you can be sure that
households will be spending more.
Secondly, just as consumption spending follows output and income, output and income
follows spending which means that spending drives demand which determines output and
income. This feedback loop from income to spending and spending to income gives rise
to a multiplier process .
It is now time to consider the second component of the demand for goods, namely
investment spending.
Screen 4
Investment or real investment is spending by firms on additions to capital stock
(machinery, structures, inventories, etc) with a view to future profits. This is an
important definition that should not be confused with financial investment in existing
shares and other financial instruments. When people put money on deposit with a bank or
buy bonds or existing shares, they are making a financial investment, on which they earn
a return. Such investment is obviously very important in the economy, but it does not
directly create production capacity.
Real investment is important for two reasons. Firstly, it creates production capacity for
higher levels of production. The more machines, factories and tools we have, the more
goods and services we can produce.
In terms of our goods market model investment is important since it contributes directly
and indirectly to the demand for goods.
When a firm, decides to builds a new factory for instance the demand for goods, in this
case investment goods, initially rises in step with the investment. As these investment
goods are produced production increases, and so does the income of households since
they own the factors of production. In turn the higher income of households stimulate
consumption spending and therefore the demand for goods and in this way the multiplier
process is in operation.
But how do firms arrive at their investment decisions? Investment usually requires a
substantial capital outlay, and careful planning, mainly because the return on investment
lies in an uncertain future. On this issue Keynes wrote: AIf we speak frankly we have to
admit that our basis for knowledge for estimating the yield ten years hence of a railway, a
copper mine, a textile factory, the goodwill of patent medicine, an Atlantic liner, a
building in the City of London amounts to very little and sometimes to nothing@.
Factors such as the interest rate, expectations, business confidence and regulations all
play a part in the investment decision. In our goods market model these factors are
classified as exogenous and investment spending is regarded as an autonomous variable
since it is not related to the level of output.
In a diagram showing output on the horizontal axis and investment spending on the
vertical axis the investment curve appears as a horizontal line indicating that it is an
autonomous variable. A change in any of the exogenous factors will reflect as a shift in
the investment curve. For instance, a more investor friendly environment will stimulate
investment so that the investment curve shifts upwards.
With consumption spending and investment spending behind us we can present these two
components of the demand for goods in a single diagram.
Screen 5
In the following diagram output and income Y are measured on the horizontal and the
demand for goods Z on the vertical axis. The consumption function is presented by the
consumption curve and it is upward sloping indicating that it is a positive function of
output and income. The slope of the line is less than one indicating the marginal
propensity to consume. The vertical intercept of the consumption curve represents the
autonomous component of consumption spending.
The investment function appears as a horizontal line, indicating that it is an autonomous
variable.
The demand for goods is given by C + I, that is, consumption (C) and investment (I) are
added at each level of income . The vertical intercept of the demand for goods curve is
therefore equal to the autonomous consumption plus autonomous investment. The slope
of the demand for goods and consumption curves are the same and reflects the marginal
propensity to consume.
Lets look at an example: Assume that the consumption function is C = 100 + 0.8YD and
the investment function is I = 50. The vertical intercept of the demand for goods curve is
therefore 100 + 50 = 150 and the slope is equal to the slope of the consumption function
namely 0.8.
Let’s now consider the government sector.
Screen 6
The demand for goods are influenced by government spending and taxation.
Government spending is a component of the demand for goods and includes spending
school textbooks, medication for hospitals and services provided by government
employees, such as teachers and medical personnel.
In our goods market model government spending is not influenced by the level of output
and income and is regarded as an autonomous variable. In a diagram it appears as a
horizontal line.
Taxation influences disposable income in the economy and impacts households’
consumption spending. We conveniently assume it is an autonomous variable.
Using our previous demand for goods curve which consisted of C + I the inclusion of
government spending and taxation has the following impact. Government spending as an
autonomous variable shifts the demand for goods curve upwards. The vertical intercept
rises with an amount equal to government spending. In other words if government
spending is 100 the vertical intercept rises with 100.
The inclusion of taxation, which is also regarded as autonomous, also impacts on the
vertical intercept. Since taxation lowers disposable income the introduction of taxes
lowers consumption spending, the demand for goods curve shifts downwards, and the
vertical intercept is lower. The decrease in the vertical intercept, however, is less than the
amount of taxation because households do not spend all their disposable income but also
save part of it. If the marginal propensity is 0.8 and income taxation is 100 then the
decrease in autonomous spending is 0.8 x 100 = 80, that is, at each level of income
taxation reduces consumption spending by 80. Note that autonomous tax does not
influence the slope of the demand curve.
We have now constructed the demand for goods curve. You will notice that the vertical
intercept of this curve reflects the autonomous spending components namely autonomous
consumption + autonomous investment + autonomous government spending - the
marginal propensity to consume times income taxation. The upward slope of the curve
indicates that as output and income increases the demand for goods increases as well. By
how much the demand for goods increases depends on the marginal propensity to
consume.
Now let’s see how the demand for goods determines the equilibrium level of output and
income.
The equilibrium level of income occurs where the demand for goods equals the level of
output and income shown graphically as a 450 -line. At any point on this 450- line the
demand for goods, which is measured on the vertical axis, is equal to the level of output
and income, which is measured on the horizontal axis.
Given our demand for goods curve Z this equilibrium position is shown as point E and
the corresponding level of equilibrium output and income is Ye. At this point the
demand for goods Ze is equal to the level of output and income Ye.
At equilibrium position E the goods market is at rest. Households consume goods and
services in accordance with their autonomous consumption and disposable income and
will not change their spending unless there is a change in their disposable income or in
one or more of the factors that determine their autonomous consumption. Firms have
made and are implementing their investment decisions and do not intend to change their
behaviour unless one or more of the factors that determine their investment behaviour
changes, and the government has made and implemented its spending and taxation plans.
Given this spending pattern, the demand for goods determines the amount of goods and
services that producers produce and they will only change their production if the demand
for goods changes.
The equilibrium position can be explained by considering what happens when the
economy is in disequilibrium.
At a point such as A, the demand for goods is Z1, which exceeds the level of output and
income Y1 . Producers will increase their production and, on the horizontal axis, Y will
move closer to Ye. As Y increases, Z increases on the vertical axis and a move closer to
Ze occurs. This process continues until equilibrium is reached where Z = Y.
At a point such as point B the demand for goods Z2 is smaller than the level of output and
income Y3 and an excess supply of goods and services occurs. Producers will cut back on
their production and, on the horizontal axis, a move closer to Ye occurs. As the level of
production declines, the demand for goods Z also declines and on the vertical axis a move
closer to Ze occurs. This process continues until equilibrium is restored.
But what happens to this equilibrium position if one of the autonomous spending
components changes. Let’s see what happens if investment is stimulated by a favourable
investment climate.
Increased investment, which is part of autonomous spending, stimulates demand , shown
as an upwards shift in the demand for goods curve. The vertical intercept is higher, and
given the new demand for goods function Z1, the equilibrium level of income rises to Y1.
The increase in the equilibrium level from Ye to Y2, exceeds the increase in autonomous
investment because of the multiplier effect.
Screen 7
Behind the multiplier is the behaviour of households as captured by the consumption
function which tells us that whenever output and income Y increases households increase
their consumption spending .
Initially higher investment stimulates the demand for goods by an amount equal to the
increase in investment spending. If the initial increase is 100 the demand for goods Z also
increases with 100 with the result that firms produce more capital goods and production
and income increases by an amount equal to the initial increase in investment spending of
100. Households’ consumption spending now increases due to the increase in income to
an amount depending on the marginal propensity to consume . If the marginal propensity
to consume is 0.8 consumption spending increases by 80. This increase in consumption
spending means a further increase in the demand for goods, In this case the demand for
goods increases by 80 which effectively raises output and income by a further 80. The
increase of 80 in income increases consumption spending with a further 64 which is equal
to 0.8 times 80. This causes the demand for goods to increase by 64 which causes output
and income to increase by 64. Thus causing an increase in consumption spending of
51.2. The multiplier process is in operation.
Will this multiplier process continue indefinitely? The answer is Ano@ because the
increase in income diminishes after every round of spending, since households spend
only a proportion of their increase in income on consumption.
The end result of the multiplier, given a marginal propensity to consume of 0.8 and an
initial increase in investment spending of 100 is that the demand for goods and the level
of output increased with 500.
This is why the increase in equilibrium income is more than the increase in autonomous
spending.
Let’s summarise the main points of the goods market.
Screen 8
In the goods market the demand for goods determines the level of output and income, and
equilibrium is reached where the demand for goods equals output and income.
When demand for goods exceeds the level of output, there is an excess demand for goods
and producers will respond to this excess demand by increasing their level of production
thus employing more factors of production and consequently household income increases
and therefore consumer spending and the demand for goods increase . This process
continues until equilibrium is attained.
If demand for goods falls short of output and income , there is an excess supply of goods
and services, and firms will cut back on their production. As firms reduce their
production, they employ fewer factors of production and the income of households
decline, causing them to decrease their consumer spending and the demand for goods.
This process will continue until equilibrium is reached.
The demand for goods consists of consumption spending plus investment spending plus
government spending. Consumption spending by households equals autonomous
consumption plus the marginal propensity to consume times disposable income.
Disposable income equals income less taxes.
Investment spending, government spending and taxation are regarded as autonomous.
A change in any of the autonomous components causes a multiplier effect on the level of
output and income and a new equilibrium level of output and income is reached. Behind
the multiplier effect is the behaviour of households which indicates that as income
increases they respond by increasing their consumption spending which causes a further
increase in the demand for goods .
An increase in autonomous spending is reflected graphically as an upward shift of the
demand for goods curve and the equilibrium level of income increases. While a decrease
in autonomous spending shifts the demand for goods curve downwards and the
equilibrium level of output and income declines