Goods market

(G&S market)
Composition of GDP= Demand for G&S
• Y == C + I + G + NX (open economy)

• Consumption
• Investment
• Government purchase
• Net Exports

• Y == C + I + G (closed economy)
Consumption
C=f(YD) (+ve)

• YD = Personal Income -taxes= Disposable Income

• Consumption C is a function of disposable income YD
• Positive relation – as disposable income increases, consumption too
increases.
Savings
C=f(YD) (+ve)
YD - C =S (savings)
• Disposable Income -Consumption= private savings
YD = C + S
Consumption
• C = c 0 + c 1 YD
• Consumption and disposable income = Linear relation
• The relationship then depends on two parameters- c0 & c1
• Autonomous consumption= c0 (+ve)
• It is what people would consume if their disposable income in the current
year were equal to zero
• How can people have positive consumption if their income is equal to zero? =
They consume either by selling some of their assets or by borrowing=
dissavings
Autonomous consumption:
• Changes in c0 reflect changes in consumption for a given level of
disposable income.
• Increases in c0 reflect an increase in consumption given income,
decreases in c0 reflect a decrease in income.
• There are many reasons why people may decide to consume more or
less, given their disposable income.
• They may find it easier or more difficult to borrow; or may become more or
less optimistic about the future.
MPC
• Marginal Propensity to Consume (MPC) = c1
• It gives the effect an additional unit of disposable income (eg: 1 more rupee)
has on consumption.
• An assumption/restriction on c1 is that it be positive
• An increase in disposable income is likely to lead to an increase in
consumption.
• Another restriction is that c1 be less than 1
• People are likely to consume only part of any increase in disposable income
and save the rest
Consumption Function
Consumption function
C = c 0 + c 1 YD
• YD = Y-T
• T= taxes-transfer payments
C = c0 + c1 (Y-T)
• Consumption is a function of income (+ ve), taxes (- ve) and transfer
payments (+ ve)]
• Higher income increases consumption, but less than one for one.
Higher taxes decrease consumption, also less than one for one.
Higher transfer payments increases disposable income and hence
consumption rises.
Investment
• Both firms and households purchase investment goods.
• Firms buy investment goods to add to their stock of capital and to
replace existing capital as it wears out.
• Households also investment – in purchasing new house, car and other
assets
• The quantity of investment goods demanded depends on the interest
rate, which measures the cost of the funds used to finance
investment
Investment function

I=I(r) (-ve)
• Investment depends on the real interest rate because the interest
rate is the cost of borrowing.
• For an investment project to be profitable, its return (the revenue
from increased future production of goods and services) must exceed
its cost (the payments for borrowed funds).
• If the interest rate rises (cost of borrowed fund), fewer investment
projects are profitable, and the quantity of investment goods
demanded fall
Investment function

Investment function- slopes downward because as the interest rate rises, the quantity of
investment demanded falls.
Government Purchases
• The central government purchases defense goods and the services of
government employees.
• Local governments buy library books, build schools, and hire
teachers.
• Governments at all levels build roads and other public works.
• All these transactions make up government purchases of goods and
services
Government Purchases
• If 𝐺 = 𝑇 ; Balanced budget (where T= taxes-transfer)
• If 𝐺 > 𝑇 ; Budget deficit (deficit financing-Govt. borrows from the
financial market)
• If 𝐺 < 𝑇 ; Budget surplus
Exogeneous variables
𝐺 = 𝐺ҧ
T= 𝑇ത

• Government purchases and taxes are considered as exogenous

variables. To denote that these variables are fixed outside the model
of national income
• We are interested in examining the impact of fiscal policy on the
endogenous variables, which are determined within the model. The
endogenous variables here are consumption, investment, and the
interest rate.
Supply/Production of Goods & Services
• An economy’s supply of output (goods and services)—its GDP—depends on
(1) its quantity of inputs= the factors of production (determined by factor
price in factor market), and
(2) its ability to turn inputs into output=production function

• Factors of production
• Inputs used to produce goods and services.
• The two most important factors of production are capital (K) and labor (L)
• In this model we assume that the economy has fixed amounts of capital and labor.
ഥ &
K= 𝐾 L= 𝐿ത
• We also assume here that the factors of production (K & L) are fully
utilized/ full employed - no resources are wasted.
• In the real world, part of the labor force is unemployed, and some
capital lies idle.
Production function
• Production function: with the available technology how much output
is produced from given amounts of capital and labor.
Y=F(K,L)
Where Y= Output, K=capital and L=Labour
• The production function reflects the available technology for turning
capital and labor into output.
• If someone invents a better way to produce a good, the result is more
output from the same amounts of capital and labor. Thus,
technological change alters the production function
Characteristics of production function-
Constant Returns to Scale (CRS)
• CRS= desirable characteristics of production function
• A production function has CRS if an increase of an equal percentage
in all factors of production causes an increase in output of the same
percentage.
zY=F(zK, zL)
• Y=F(K, L) ; inputs increased by z%; F(zK,zL)=zF(K,L)=zY
• The assumption of constant returns to scale has an important
implication for how the income from production is distributed
Firm’s decision-profit maximisation
• We are assuming that households own the economy’s stock of capital.
• In this analysis, households rent out their capital, just as they sell
their labor.
• The firm obtains both factors of production from the households that
own them
Firm’s decision-profit maximisation
• The firm sells its output at a price ‘p’, hires workers at a wage ‘w’, and
rents capital at a rate ‘r’.
• The goal of the firm is to maximize profit.
• Profit is what the owners of the firm keep after paying for the costs of
production.
• Revenue equals p×Y, the selling price of the good ‘p’ multiplied by the
amount of the good the firm produces Y.
• Costs include labor and capital costs.
• Labor costs equal w×L, the wage ‘w’ times the amount of labor L.
• Capital costs equal r×K, the rental price of capital ‘r’ times the amount of
capital K
Profit maximisation
• Profit=Revenue−Labor Costs−Capital Costs
=pY −wL −rK
=p*F(K,L)-wL-rk
• This equation implies profit depends on the factors of production (L
and K), factor prices (w and r) and product price (p)
• Firm (competitive firm) takes the product price and factor prices as
given and chooses the amount of capital and labor that maximize
profit
Factor markets/ distribution of national income

• Factor prices
• Classical thought: prices are determined by supply and demand forces in a
free market economy
• Neo-classical theory of distribution: demand for each factor depends on the
marginal productivity of that factor
Factor prices
• The distribution of national income is determined by factor prices.
• Factor prices are the amounts paid to each unit of the factors of
production.
• The two factors of production are capital and labor
• The two factor prices are the rent the owners of capital collect and
the wage workers earn.
Marginal Product of factors
• The marginal product of labor (MPL) is the extra amount of output
the firm gets from one extra unit of labor, holding the amount of
capital fixed.
• MPL=F(K, L+1)−F(K, L)
• The marginal product of capital (MPK) is the amount of extra output
the firm gets from an extra unit of capital, holding the amount of
labor constant
• MPK=F(K+1, L)−F(K, L)
• Diminishing marginal product:holding the amount of capital (or
Labour) fixed, the marginal product of labor (or Capital) decreases as
the amount of labor (or capital) increases.
Marginal Product of Labour
Factor Price
Firms demand for factors
• What are the profit maximizing quantity of L and K
• MPL= W/P (real wage)
• MPK=R/P (real rent/real interest)
• The firm demands each factor of production until that factor’s
marginal product equals its real factor price as it is the profit
maximizing level of K and L
• Thus factors of production depends on firms profit maximization
behaviour
• In this national income model we consider output (Y) is determined
by production function and factors of production
ഥ , 𝐿ത )= 𝑌ത
Y=F(𝐾
Equilibrium in the market for G&S
• Equilibrium in G&S implies
supply of G&S= demand for G&S
• SS of G&S: Y
Output (Y) is determined by production function and factors of production
ഥ , 𝐿ത )= 𝑌ത
Y=F(𝐾
• Demand for G&S
• Consumption, investment, government purchase (closed economy)
• C,I,G and net exports (open economy)
Equilibrium in G&S
• Y=C+I+G.
• C = c0 + c1 (Y-T)
• I=I(r).
• 𝐺 = 𝐺ҧ
• T= 𝑇ത

• G and T are fixed by government policy

Equilibrium G&S-closed economy
𝑌ത =c0 + c1 (𝑌ത - 𝑇ത )+I(r)+ 𝐺ҧ
• This equation states that the supply of output equals its demand,
which is the sum of consumption, investment, and government
purchases
• Interest rate ‘r’ is the only variable not determined in this equation
• Hence interest rate ‘r’ must adjust to ensure that the demand for
goods & services equals the supply
Interest rate and equilibrium
• Case I: higher interest rate-lower investment-lower the demand
(C+I+G)
• Hence demand for G&S (C+I+G) < supply of G&S (𝑌ത )
• Case II: If the interest rate too low-investment too high-higher
demand
• Demand for G&S (C+I+G) > supply of G&S (𝑌ത )
• At the equilibrium interest rate, the demand for goods and services
equals the supply
Equilibrium in financial market: The supply
and demand for loanable funds
• Interest rate ‘r’= cost of borrowing
=return to lending in financial market
 Y= C+I+G
Y-C-G=I
(Y-T-C)+(T-G)=I
(Disposable Income-C)+ (Govt revenue-Govt. spending)=I
Private savings + Public savings = I
Savings=I
S=I
Flow into financial market(S)=flow out of financial market(I)
 Y=C+I(r)+G
Y-C-G=I(r)
𝑌ത − (c0 + c1 (𝑌ത - 𝑇ത ))- 𝐺ҧ =I(r)
𝑆ҧ =I(r)
Supply and demand of loanable funds

• Saving is the supply of loanable fund

Households lend their saving to
investors or deposit their saving in a
bank that then loans the funds out
• Investment is the demand for loanable
funds:
• investors borrow from the public
directly by selling bonds or
indirectly by borrowing from
banks.
Supply and demand of loanable funds
Supply and demand of loanable funds
• The interest rate adjusts until the amount that firms want to invest equals
the amount that households want to save.
• If the interest rate is too low, investors want more of the economy’s output
than households want to save. Equivalently, the quantity of loanable funds
demanded exceeds the quantity supplied. When this happens, the interest
rate rises.
• Conversely, if the interest rate is too high, households want to save more
than firms want to invest; because the quantity of loanable funds supplied
is greater than the quantity demanded, the interest rate falls.
• The equilibrium interest rate is found where the two curves intersect. At
the equilibrium interest rate, households’ desire to save balances firms’
desire to invest, and the quantity of loanable funds supplied equals the
quantity demanded