The Goods Market Equilibrium

Debajit Jha
Feb 26 and March 2, 2021

O. P. Jindal Global University Lecture 07 & 08

Jindal School of Government and Public Policy Fall 2021
 Graphical Method
• Steps to characterize the equilibrium graphically:
1. Plot production as a function of income. Because
production equals income, their relation is the 45-degree
line.
2. Plot demand as a function of income.

3. In equilibrium, production equals demand.

 Goods market equilibrium

Equilibrium output
is determined by
the condition that
production is equal
to demand.

Equilibrium in the Goods Market

 Goods market equilibrium

The effects of an increase in

autonomous spending on
output

An increase in autonomous
spending has a more than one-
for-one effect on equilibrium
output.
 Goods market equilibrium
• AB: first-round increase in production

• BC: first-round increase in income

• CD: second-round increase in demand

• DE: second-round increase in production and income

• The total increase in production after n+1 rounds:

1 + c 1 + c 12 + … + c 1 n
which is a geometric series with a limit of 1/(1-c1).
 Goods market equilibrium

• To summarize our findings using words:

– Production depends on demand, which depends on income, which is itself equal

to production.

– An increase in demand leads to an increase in production and income, which in

turn leads to a future increase in demand.

– The increase in output that is larger than the initial shift in demand, by a factor
equal to the multiplier.

– The multiplier depends on the propensity to consume, which can be estimated

using econometrics—the set of statistical methods used in economics.
 How long does it take for output to adjust?

• The adjustment of output over time is called the dynamics of

adjustment.

• How long the adjustment takes depends on how and when

firms revise their production schedule.
 The Lehman Bankruptcy, Fears of Another Great Depression,
and Shifts in the Consumption Function
Why would consumers decrease consumption if their disposable income has not changed?
Or, why might c0 decrease—leading in turn to a decrease in demand, output, and so on?

• When people start worrying about the future, they decide to save more even if their current
income has not changed.

Disposable Income, Consumption, and Consumption Of Durables In the United States,

2008:1 to 2009:3
• News about Lehman Brothers going bankrupt in September 2008 reminded
people of the Great Depression, as confirmed by the number of searches for “Great
Depression” in Google.

• Consumption fell even if disposable income had not yet changed.

Google Search Volume for “Great Depression,” January 2008 to September 2009
 Consumer Confidence Indices (15-Mar to 21-Jan)
Survey Details:
• Reserve Bank released the results of
the January 2021 round of its
Consumer Confidence Survey on
February 5th, 2021.
• Survey from January 02 to January
11, 2021
• 13 major cities, viz., Ahmedabad;
Bengaluru; Bhopal; Chennai; Delhi;
Guwahati; Hyderabad; Jaipur;
Kolkata; Lucknow; Mumbai; Patna;
and Thiruvananthapuram.
• N = 5,351 households.
Source: CCS: RBI, January 2021 release.

Highlights:
I. Consumers perceived that the current economic situation was significantly worse when
compared to a year ago, but it improved from November 2020 round of the survey.
II. The current situation index (CSI) continued to improve from its all-time low registered in
September 2020.
III. Going forward, consumers expect improvement in general economic situation and
employment conditions during the next one year.
IV. After reaching the historical low in May 2020 round around the peak of Covid-19 related
lockdown and restrictions, the future expectations index (FEI) increased for four
successive quarters and stood at 117.1 in January 2021.
 Perceptions and Expectations on Economic Situation, spending,
income, price level and employment (relative to 2020)

Source: CCS: RBI, January 2021 release.

Source: 114th and 115th round of NCAER’s Business Expectations Survey (BES)
Survey Details:
•The NCAER’s BES findings reported here are from 500 firms.
•6 cities to assess business sentiment in the four regions of India: Delhi NCR
representing the North; Mumbai and Pune, the West; Kolkata, the East; and Bengaluru
and Chennai, the South.
•All industries are adequately represented in terms of ownership type; industry sector and
firm size based on the annual turnover of the firms.
Highlights:
BCI:
•The proportion of respondents expecting that ‘overall economic conditions will improve in
the next six months’ increased by 4.8 percentage points, from 29.8 per
cent in 2020–21: Q2 to 34.6 per cent in 2020–21: Q3.
•The proportion of respondents expecting that the ‘financial position of firms will
improve in the next six months’ increased by 3.1 percentage points, from 27.7 per
cent in 2020–21: Q2 to 30.8 per cent in 2020–21: Q3.
•The share of positive responses for the statement, the ‘present investment climate
is positive compared with six months ago’ fell by (-) 27 percentage points from 40.7
per cent in Round 109 to 13.7 per cent in Round 114. It was the only component
which showed a decline in positive responses in the last quarter. A reversal was
seen in this round with the share of positive responses for this statement going up
to 29.8 per cent in Round 115.
•The proportion of respondents saying that ‘present capacity utilization is close to or
above the optimal level’ increased by 14.4 percentage points, from 58.4 per cent in
Round 114 to 72.8 per cent in Round 115.
•In Round 115, the components that relate to sentiments about the present, that is,
‘present investment climate is positive’ and ‘present capacity utilization is close to
or above the optimal level’, have shown larger q-o-q improvements than the ones
dealing with the future.
•The upturn in the PCI was driven by an improvement in business sentiments
for five of the eight components being studied, namely, ‘managing overall
economic growth’, ‘managing government finances’, ‘managing inflation’,
‘managing unemployment’ and ‘managing the exchange rate’.
 Investment Equals Saving: An Alternative
Way of Thinking about Goods-Market Equilibrium

• An alternative—but equivalent—way of thinking about equilibrium focuses instead on

investment and saving.

• This is how John Maynard Keynes first articulated this model in 1936, in The General
Theory of Employment, Interest and Money.

• Let’s start by looking at saving. Saving is the sum of private saving and public saving.

• By definition, private saving, S (i.e. saving by consumers), is equal to their disposable

income minus their consumption:

S = YD - C

• Using the definition of disposable income, we can rewrite private saving as income
minus taxes minus consumption:
S=Y-T-C
• By definition, public saving (T – G) is equal to taxes (net of transfers) minus
government spending.

• If taxes exceed government spending, the government is running a budget

surplus, so public saving is positive.

• If taxes are less than government spending, the government is running a budget
deficit, so public saving is negative.
• In equilibrium:
Y=C+I+G
• Subtract T from both sides and move C to the left side:
Y − T − C = I + G −T
• The left side of the equation is simply S, so
S = I + G −T
• Or equivalently
I = S + (T − G)
• On the left is investment. On the right is saving, the sum of private saving and public saving.

• This is the IS relation, which stands for “Investment equals Saving”.

• To summarize: There are two equivalent ways of stating the condition for
equilibrium in the goods market:

Production = Demand

Investment = Saving
 Are these two ways equivalent?
• Because consumption behavior implies that:
S=Y−T−C
= Y − T − c0 − c1(Y − T )
Rearranging terms, so

• (1−c1) is called the propensity to save, which is between zero and one.

• In equilibrium, I = S, so that equation (3.10) becomes:

I = −c0 + (1 − c1)(Y − T ) + (T − G )

• Solve for output:

which is the same as the equilibrium condition using earlier equation

 The Paradox of Saving
•We are told about the virtues of thrift as we grow up, but the model in this chapter
tells a different story.
•Suppose that consumers decide to save more, so c0 decreases.
•This implies that output decreases.
•Saving cannot change either, because equation implies that at equilibrium:
I = S + (T − G )
• S cannot change because I, T or G does not change by assumption.

•So should you forget the old wisdom? Should the government tell people to be
less thrifty? No.

•The results of this simple model are of much relevance in the short run.
•But when we look at the medium run and the long run— other mechanisms come
into play over time, and an increase in the saving rate is likely to lead over time to
higher saving and higher income.
•A warning remains, however:
Policies that encourage saving might be good in the medium run and in the long
run, but they can lead to a reduction in demand and in output, and perhaps even a
recession, in the short run.
 Is the Government Omnipotent? A Warning

• The discussion in this chapter suggests that the government can

choose the level of G or T to affect the level of output it wants.
• However, there are many aspects of reality that we have not
incorporated in our model:
– Changing G or T is not easy.
– Investment and imports may change, making it hard for governments to assess
the effects of their policies (Chapters 5, 9, and 18 to 20).
– Expectations are likely to matter (Chapters 14 to 16).
– The effects on output may be unsustainable in the medium run (Chapter 9).
– Cutting T or increasing G can lead to large budget deficits and public debt in
the long run (Chapters 9, 11, 16 and 22).