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.

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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.

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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.

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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.

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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