Chapter 4: National Income and Demand for Goods & Services

Chapter 1: Introduction

Chapter 4 continues the development of the basic classical model of national income.
Chapter 3 covered how the production function and the supplies of labor and capital determine the supply of goods and services, along with factor markets distributing income.
Chapter 4 focuses on the demand for goods and services.

Objectives:

Total Income Distribution: How much of a household's income is consumed versus saved.
Demand for Goods and Services: Demand by households, firms, and the government.
Equilibrium: How demand and supply of goods and services are balanced, with financial markets and interest rates playing a crucial role.

Determinants of Demand for Goods and Services:

In first year, we learned the identity of the four components of GDP: $Y = C + I + G + NX$ where:
- Y is total output (GDP)
- C is Consumption
- I is Investment
- G is Government Spending
- NX is Net Exports
Simplifying assumption for Chapter 4: closed economy. Net exports are ignored, assuming no trade with the rest of the world. (Open economy will be considered in Chapter 7).
Linking to Chapter 3 (supply side): Given factor supplies of capital and labor, total output is determined by the production function: $Y = F(K, L)$ . The real wage and real rental rate of capital are determined by the marginal product of labor and capital.

Components of GDP Defined:

Consumption (C): Household spending on final goods and services. The single largest component of GDP (over two-thirds in South Africa, according to the Reserve Bank).
- Durable Goods: Last a long time (generally > 3 years), e.g., cars, home appliances.
- Semi-Durable Goods: Last up to 3 years, e.g., T-shirts.
- Non-Durable Goods: Short time period, e.g., a loaf of bread.
- Services: Intangible, non-physical items or activities, e.g., music concerts, dry cleaning.
Investment (I): Spending on new capital (physical assets used in future production).
Government Spending (G): Spending by local, provincial, and national governments on goods and services.
- Excludes transfer payments (e.g., unemployment insurance) as these do not represent direct spending on goods and services and would lead to double counting.

Chapter 2: The Autonomous Consumption

Consumption is a decision between consuming now or saving for future consumption.
The consumption decision relies on expectations about future economic conditions and current circumstances.
Households receive income from labor and capital and pay taxes to the government.
Consumption is directly dependent on a household's income, but can also be financed by past or future income.

Key Definitions:

Disposable Income: Income left after paying taxes (T) to the government.
Relationship between Consumption (C) and Disposable Income: $C = C(Y - T)$ . Consumption depends on disposable income.
Consumption Function: Includes autonomous consumption: $C = \overline{C} + c(Y - T)$
- $C$ = Total consumption
- $\overline{C}$ = Autonomous consumption. (c with a bar on top.)
- $c$ = Marginal propensity to consume (MPC)
Marginal Propensity to Consume (MPC): The fraction of additional income spent on additional consumption.
- Formula: $MPC = \frac{\Delta C}{\Delta Y}$ (Change in Consumption / Change in Income).
Autonomous Consumption: The part of consumption not financed by current income, covered by past saving or future borrowing.

Marginal Propensity to Consume: Example

Someone with a high MPC (e.g., 0.99) spends 99¢ of every additional R1 (after tax deductions) on goods and services.
MPC describes how consumption responds to a change in income.
MPC is between 0 and 1.

Testing Understanding:

If income increases by R1,000 and spending increases by R600, then MPC = $\frac{600}{1000} = 0.6$
If income increases by another R1,000 and spending increases by R800, then MPC = $\frac{800}{1000} = 0.8$

Chapter 3: Entire Consumption Function

Marginal Propensity to Save (MPS): The relationship between changes in saving and income.
Since all income is either consumed or saved, any change in income equals the sum of the changes in consumption and saving.
Therefore: $MPC + MPS = 1$
To calculate MPS: $MPS = 1 - MPC$
If MPC = 0.8, then $MPS = 1 - 0.8 = 0.2$

Consumption Function Diagram

Characteristics:
1. Total consumption increases as income increases (positive relationship).
2. The consumption function starts above the origin, indicating positive consumption even if income is zero (autonomous consumption).
3. When income increases, total consumption increases, but by less than the increase in income (part of the additional income is saved).
Marginal propensity to consume (MPC) is the slope of the consumption function (rise over run).
If MPC increases, the consumption function pivots upwards.
The intercept of the function is determined by autonomous consumption, influenced by non-income factors (e.g., wealth, real interest rate, expected future income).
Wealth (net money value of assets) influences consumption. Higher wealth leads to more consumption at every level of income.
An increase in wealth causes the consumption function to shift upwards.
Lower real interest rates or increased expected future income would also shift the consumption function upward.

Chapter 4: Increasing Government Spending

The main determinant of investment is the real interest rate, representing the cost of borrowing money for investment projects.
Economists differentiate between nominal and real interest rates.
- Nominal = Stated rate.
- Real = Adjusted for inflation.
The real interest rate reflects the actual purchasing power a borrower has to give up to repay a loan.
The investment function slopes downward, showing an inverse relationship between the real interest rate and the quantity of investment.
Higher real interest rates result in less investment; lower real interest rates result in greater investment.
The real interest rate is both the cost of borrowing and the opportunity cost of using internal funds for investment.
For simplicity, assume a single interest rate in the economy.
Government spending includes purchases of goods and services by local, provincial, and national governments.
Excludes transfer payments, which contribute indirectly to demand through consumption.
Fiscal policy is determined by government spending and taxation (as outlined in the budget speech).
A measure of fiscal policy is the government budget deficit (Government Spending > Taxes).
Net taxes = Taxes - Transfer Payments
Government spending and taxation are considered exogenous (determined outside the model).
Expansionary fiscal policy: Increasing government spending or decreasing taxes to increase the deficit.
Contractionary fiscal policy: Decreasing government spending or increasing taxes.
Budget surplus: Taxes > Government Spending.
Balanced budget: Taxes - Transfers = Government Spending.
Governments finance deficits by issuing treasury bonds (borrowing).

Chapter 5: Conclusion

American Deficits Drivers:
- Early 1940s: World War Two.
- 1980's: Tax cuts, military spending and social programs.
- 1990's: Tax increases, spending cuts.
- February 2000's: tax cuts, wars, economic downturn. Reach record highs due to reduced tax revenue.
- Covid-19: Financial crisis and responses of the American government
The American government borrows to cover these annual shortfalls by issuing treasury bonds.
Deficits are annual shortfalls, while debt is the accumulation of past deficits over time.
Debt to GDP ratio: Indicates if the debt is growing faster than the economy's ability to repay it.
In South Africa since the 2021 budget, the budget deficit has fallen and is expected to continue decreasing.
Budget deficits are financed through borrowing on credit markets, where the government competes with the private sector for available savings.
Large budget deficits reduce savings in the economy.
Higher savings are needed to finance private investment to support faster economic growth.
South Africa's debt to GDP ratio has increased from 23.6% in 2009 to approximately 75% in 2024/2025.
The International Monetary Fund recommends South Africa reduce its debt to GDP ratio to approximately 60% of GDP.
Rising interest repayments have been crowding out critical expenditures on services like education, health, and infrastructure.