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Goods & Services Market

Aggregate Demand

Sign Component Symbol Meaning
+ Consumption \(C\) G&S purchased by consumers
+ Investment \(I\) Sum of residential and non-residential investment
+ Government spending \(G\) Purchases of G&S by federal, state, and local govts
(excluding Govt transfers)
+ Exports \(E\) Goods & services produced by country purchased by foreign countries
- Imports Foreign goods & services purchased by country
+ Inventory Investment Difference between production and sales

Behavioral Assumptions - Investment is exogenous of fiscal policy - Consumption is endogenous to disposable income

Consumption

Assuming Consumption \(\propto\) Income

\[ C = c_0 + c_1 (I-T) \]
  • \(C =\) total consumption
  • \(c_0 =\) base/autonomous consumption
    • \(c \ne 0\)
  • \(c_1 =\) MPC (Marginal Propensity to Consume)
  • \(I =\) Income
  • \(T=\) Taxes
  • \((I-T)=\) disposable income

IDk

Short-Run Medium-Run Long-Run
Equilibrium Output Factors - Aggregate Demand
- Production
- Income
Equilibrium Condition \(\text{Aggregate Demand} = \text{Aggregate Income}\)
\(\text{Aggregate Investment} = \text{Aggregate Savings}\)
Equilibrium Output \(\dfrac{1}{1-c_1} (c_0 - T + I + G)\)
Increase in autonomous consumption \(c_0\)

Output Multiplier

\(m = \dfrac{1}{1-c_1}\)

Implication - If \(m>1\): even small consumer spending will lead to increased output - If \(m \le 1\): lots of consumer spending required for growth

Short-Run

flowchart LR
d[Demand] -->
s[Supply] -->
i[Income] -->
d

Paradox of Saving

\[ \begin{aligned} \text{Investment} &= \bar S^G + S(Y) \\ S(Y) &= \dfrac{1}{1-c_1} Y & (\text{Output $Y$ = Income}) \end{aligned} \]

If savings \(S(Y)\) increase due to decrease in \(c_1\) - then savings > investment, ie consumption decreases - then \(Y\) reduces to restore equilibrium - this reduces income - this reduces consumption - this reduces output - vicious cycle

where \(Y =\) Real output

This is why drastic contractionary fiscal policy is detrimental - introducing high GST/VAT - decrease in govt expenditure

Last Updated: 2024-12-26 ; Contributors: AhmedThahir, web-flow

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