Goods & Services Market (A)

Aggregate Demand
 Aggregate demand refers to the total demand for all goods and services. In
other words, "it is the total value that consumers, investors, government, and
foreigners are willing to purchases."

Thus, aggregate demand or aggregate expenditure consists of the following

four components:

1. Household consumption demand:

 The total demand of goods and services for consumption purposes, by all
households of the country is the household consumption demand.
 The level of consumption demand depends on the level of disposable
income of household.
 If a households' disposable income increases, the total amount spent on
consumption also increases.
 But consumption does not increase as fast as income.
 Saving also increases as result of increase in income of the household.
 𝐶 = 𝑐0 + 𝑐1 𝑌𝑑
𝑌𝑑 = 𝑌 − 𝑇

2. Private investment demand:

 Investment is the money spent on the creation of new capital assets.
 Private investment depends upon rate of interest and marginal efficiency
of capital (expected rate of return of an additional unit of capital goods).
 An entrepreneur will continue to invest up to the point where rate of
interest is equal to marginal efficiency of capital (MEC).
 We assume that the economy is without money, then there is no interest
rate.
 This means that the investment function in such an economy becomes as
follows.
𝐼 = 𝐼0 + 𝐼1 𝑖 = 𝐼0

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3. Government demand for goods and services: (Government
spending)
 Today, government has become a prominent buyer of goods and services.
 Government demand these for meeting public needs such as roads,
schools, health, irrigation, power and infrastructure, maintenance of law
and order etc.
 We will assume that government spending is an exogenous variable, that
is, it is determined by the influence of factors not included in the model,
such as political considerations.
 This means that
𝐺 = 𝐺0

4. Net export demand:

 Net exports (exports minus imports) refer to foreign demand for goods
and services produced by an economy.
 It is affected by many factors such as trade policy of the trading partners,
relative prices of goods, incomes of the nations, foreign exchange rates
etc.

5. Net taxes:
 We pointed out that consumption directly depends on disposable income.
 We defined disposable income as nominal national income minus net
taxes (i.e., taxes minus government transfer payments).
 Here we will show the net tax function.
 The financial system of any country collects many different taxes.
 Some of these taxes impose on wealth, such as Properties, agricultural
land, and others impose on income, such as the wages and benefits tax
and the corporate profits tax.
 If the society's wealth is fixed, then the tax revenues are also fixed.
 As for the tax imposed on sources of income, it will change with income
change.
 Therefore, it can be assumed that net taxes (T) are a linear function of
income (Y), that is, they take the following formula:
𝑇 = 𝑡0 + 𝑡1 𝑌
 t1 in above equation is called the "marginal tax rate," while (t0) is a fixed
amount that represent the wealth tax minus transfer payments.

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  Both (to) and (t1) are determined by tax laws and policies, and its value
ranges between zero and one.
 This function is similar to the consumption function, where the vertical
intercept is determined by the constant amount (t0), and the slope of the
function is determined by the marginal tax rate (t1).

Aggregate demand/ total expenditure (E) is, thus, composed of consumption

expenditure/demand, investment expenditure/ demand, Government
expenditure/demand, and foreign expenditure/demand.
In short,
𝐸 = 𝐶 + 1 + 𝐺 + 𝑋 − 𝑀
Where,
 E = aggregate expenditure or total spending or aggregate demand;
 C = consumption
 | = investment
 G = Government spending
 X – M = net exports (exports, minus imports).

Model assumptions
 Assume that the economy is closed-that it does not trade with the rest of the
world:
Both exports and imports are zero.
This assumption clearly goes against the facts: Modern economies trade with
the rest of the world.
Later on, we will abandon this assumption as well and look at what happens
when the economy is open.
But, for the moment, this assumption will also simplify our discussion because
we won't have to think about what determines exports and imports.
 Assume that there are no retained earnings, depreciation, or taxes, transfer
payments and contributions for social security.
The importance of this assumption lies in its simplification of various income
concepts.
The gross national product becomes equal to the net national product,
national income, and disposable income, plus net taxes.
Therefore, we refer to them all with the symbol (Y).

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 Now let us rephrase the income concepts that we presented in the second
chapter.
Gross National Product = Net National Product + Depreciation
= National Income+ Depreciation +indirect taxes
= Disposable Income + Personal taxes +(direct taxes + retained earnings +
contributions for social security) - transfer payments + Depreciation indirect
taxes.
Under this assumption the gross national product becomes as follow:
Gross National Product = Net National Product = National Income
= Disposable Income + Personal taxes +direct taxes + contributions for social
security - transfer payments
As a result of this contributions for social security that is
𝐺𝑁𝑃 = 𝑁𝑁𝑃 = 𝑁𝐼 = 𝑌𝑑 = 𝑌
Under those assumptions the aggregate demand become aggregate demand
𝐸 = 𝐶+1 +𝐺

OR
= 𝑐0 + 𝐶1 𝑌 + 𝐼0 + 𝐺0
OR
= (𝐶0 + 𝐼0 + 𝐺0 ) + 𝐶1 𝑌
Level of Consumption Investment Government Aggregate
income (C) (I) (G) Expenditure
(E) (E=C+I+G)
0 10 10 10 30
10 15 10 10 35
20 20 10 10 40
30 25 10 10 45
40 30 10 10 50
50 35 10 10 55
60 40 10 10 60
70 45 10 10 65
80 50 10 10 70

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 Test your understanding
Multiple Choice Questions (MCQs):
1. A closed economy is one in which
a. imports exactly equal exports, so that trade is balanced
b. domestic firms invest in industries overseas
c. the home economy is isolated from foreign trade
d. savings exactly equal investment at full employment
2. An economy that has no interaction with the rest of the world is calle
a. an isolated economy.
b. a closed economy.
c. a parochial economy
d. a rogue nation.
3. In an economic model, an exogenous variable is
a. a stand-in for more complicated variable
b. determined by the model itself.
c. determined outside the model
d. a variable that has no effect on the workings of the model.
4. NNP means
a. GDP – depreciation
b. GDP + depreciation
c. NNP – depreciation
d. GNP – depreciation
5. In a three sector economy, Y equals
a. C+I
b. C+I+G
c. C+I+G+(X-M)
d. None of these
6. In a closed economy, aggregate demand is the sum of
a. consumer expenditure, actual investment spending, and government spending.
b. consumer expenditure, planned investment spending, and government spending
c. consumer expenditure, actual investment spending, government spending, and
net exports
d. consumer expenditure, planned investment spending, government spending, and
net exports

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7. Which of the following is the consumption sector?
a. Household
b. Firm
c. Government
d. Foreign
8. In a closed economy, -------------- is not included
a. Households
b. Firm
c. Government
d. Foreign sector
9. -----------is the net amount available to households for consumption and saving
a. national income
b. personal income
c. personal disposable income
d. government income
10. MEC curve slopes ______________________
a. Upward
b. Downward
c. remain constant
d. vertical

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