Equilibrium in The Goods Market

The circular flow of
income and the

Keynesian multiplier
Equilibrium in the goods market
The analysis of the goods market equilibrium is the
starting point of Macroeconomic analysis
(particularly from the Keynesian point of view)
All the goods and services are aggregated into a
single market 1 equation
The purpose is to find the equilibrium level of
output Y* on this market 1 unknown
A second issue is to describe how Y* varies as a
function of other macroeconomic variables

The circular flow of income
Aggregate demand and output
The multiplier and role of savings
Households Firms
Labour
Income
Goods
Expenditure
Households Firms
Labour
Goods
Real flows
Households Firms
Income
Expenditure
Monetary flows
The circular flow of income is what guarantees
the central accounting identities
Three definitions of GDP (output)
Sum of the expenditures Z
Sum of the value added produced Q
Sum of the incomes distributed Y
Accounting identities
Production = Aggregate demand / expenditure
Q = Z
Production = Incomes of factors of production
Q = Y
In the Keynesian model, the aggregate demand
(also called planned expenditure) in a closed
economy with no government is:

Z = C + I

with Z : Aggregate Demand
C : Consumption of households
I : Investment of firms
Consumption C is not fixed. Its level depends on
the level of income Y, and is given by the
consumption function.
C = C
0
+ cY
Where
C
0
is the autonomous level of consumption, i.e. the
level of consumption that does not depend on income
c is the marginal propensity to consume (mpc) : the
amount spent out of an extra unit of income.
The converse is the marginal propensity to save (mps)
s, such that
c + s = 1
For the moment, investment I is considered to
be exogenous.
Its level is pre-determined and does not depend
on output
This is a simplifying assumption that will be
relaxed later on (when interest rates are
introduced)
Aggregate demand Z is therefore a function of
output Y, of the marginal propensity to consume
c and of the exogenous level of investment I.
Z = C
0
+ cY + I

Income, output Y
Aggregate Demand (planned
expenditure)
Z = C
0
+ cY + I
mpc: 0<c<1
Aggregate demand as a function of income
Autonomous demand (not a function of Y)
C
0
+ I
Aggregate
Demand Z
Effective demand and equilibrium
For any level of planned expenditure Z (with a
slope < 1), There is only a single point for which
the planned expenditure is equal to the level of
income Y
This gives the equilibrium condition on the
goods market: Y = Z

There is no guarantee that this point is a full
employment equilibrium !!
This will be examined later.
45
Effective expenditure
Y = Z
Keynesian
Equilibrium Output
Y*
Income, output Y
expenditure)
Z = C
0
+ cY + I
Equilibrium on the goods market
Aggregate
Demand Z
For each aggregate demand curve Z there is
only a single point for which the planned
expenditure is equal to the level of income Y
But Z is determined by the plans of agents!

What happens if the level of planned
expenditure Z is not equal to Y ?
The goods market is not in equilibrium !!
Output will adjust so that the equilibrium is
reached
Y* Income, output Y
expenditure)
Disequilibrium with Z > Y
Z
Y
Unplanned reduction in
inventories
The firms are selling more than
they are producing. They have to
increase production in order to
meet the aggregate demand,
which brings the goods market
back to Y*
Y
Aggregate
Demand Z
45
Y
Z
Y* Income, output Y
expenditure)
Disequilibrium with Z < Y
Y
Unplanned increase in
inventories .
Firms are selling less than
they are producing. They
reduce output which brings
the goods market back to Y*
Aggregate
Demand Z
45
The multiplier and the role of savings
So aggregate demand is given by

Z = C + I

And the equilibrium condition is

Y = Z

So what happens to output Y if investment I
increases by an amount I ?
In fact, Y > I !!
Why is that?
45
Y = Z
Y
1
Income, output Y
Z
1
= C
0
+ cY + I
1

Multiplier effect on the goods market
Aggregate
Demand Z
Z
2
= C
0
+ cY + I
2

Y
Y
2
I
1. An increase in planned
investment
2. leads to a more than
proportional increase in income
Aggregate demand is given by : Z = C
0
+ cY + I
And Y = Z
Solving for the equilibrium level of output gives us :

There are 2 equivalent interpretations to this result

( )
( )
( ) I C
c
Y
I C c Y
I cY C Y
+
=
+ =
+ + =
0
0
0
1
1
1
( ) c I
Y
=
c
c
1
1
Multiplier
Autonomous
demand
(exogenous)
Why do we observe Y > I ?

Increase in planned
investment
I
Increase in income
Y
Increase in savings
Y mps
Increase in
consumption
Y mpc
First interpretation: a multiplier effect due
to the circular flow of income

Step 1 : output increases by I
Step 2 : output increases by c I
Step 3 : output increases by c
2
I
Step 4 : output increases by c
3
I
..... This continues forever ! The closer c is to 1, i.e.
the less people save, the larger the effect. (why ?)

The aggregate size of the increase is equal to:

c
c c c c
= + + + + +
1
1
... 1
4 3 2

Second interpretation: The economy is
increasing output in order to balance
investments and savings

This is because the equilibrium condition Y=Z is
equivalent to I=S (planned investment = savings)

These two equilibrium conditions are equivalent !
Aggregate demand can be decomposed into
consumption and investment
Z = C + I
Income can be decomposed into
consumption and savings
Y = Y(c+s) = C + S
So one can see that setting Y=Z is
equivalent to setting I=S !
S I Z Y = =

Starting from equilibrium, if investment increases
by I, then we are no longer in equilibrium:
I + I > S
To get back to equilibrium, we need savings to
increase by the same amount (S = I).

Given the savings function,

So we have
Y s S A = A
s S
Y 1
=
A
A
s I
Y 1
=
A
A

c I
Y
=
A
A
1
1

Both explanations (spending multiplier or
savings/investment balancing) are equally
valid.
The spending multiplier is usually easier to
understand, and is found in most manuals
The savings/investment balance, however,
often brings more interesting explanations
of the real-life economic phenomena.

Equilibrium in The Goods Market

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Equilibrium in The Goods Market

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The circular flow of

income and the

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