WEEK 2 THE GOODS MARKET Yingnan Zhao Department of Economic University of Toronto Mississauga Fall 2021 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 2University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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) 3University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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 University of Toronto Mississauga, Department of Economics, Yingnan Zhao 4 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) University of Toronto Mississauga, Department of Economics, Yingnan Zhao 5 6University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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) 7University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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 = + + 8University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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 cons
tant) – In the long run, aggregate supply is determined by input factors and technology ■ Relationship between aggregate demand and supply: University of Toronto Mississauga, Department of Economics, Yingnan Zhao 9 DETERMINANTS OF AGGREGATE DEMAND 10University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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 () 11University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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( ) 12University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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) 13University of Toronto Mississauga, Department of Economics, Yingnan Zhao EQUILIBRIUM OUTPUT AND MULTIPLIER EFFECT 14University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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) 15University of Toronto Mississauga, Department of Economics, Yingnan Zhao Autonomous spending (i.e., spending that is independent of output or income) Illustration of Goods-Market Equilibrium 16University of Toronto Mississauga, Department of Economics, Yingnan Zhao 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) 23University of Toronto Mississauga, Department of Economics, Yingnan Zhao