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
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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)
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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
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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)
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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)
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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 = + +
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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:
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DETERMINANTS OF
AGGREGATE DEMAND
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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 ()
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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( ? )
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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)
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EQUILIBRIUM OUTPUT AND
MULTIPLIER EFFECT
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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)
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Autonomous spending (i.e., spending that is
independent of output or income)
Illustration of Goods-Market Equilibrium
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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)
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