Learning Objectives
4.1 Discuss the factors that affect consumption and saving decisions.
4.2 Discuss the factors that affect the investment behavior of firms.
4.3 Explain the factors affecting goods market equilibrium.
In Chapter 3 we focused on some of the factors determining the amount of output produced, or supplied, in the economy. In this chapter we consider the factors that underlie the economywide demand for goods and services. In other words, we move from examining how much is produced to examining how that production is used.
Recall from Chapter 2 that aggregate demand (spending) in the economy has four components: the demand for consumer goods and services by households (consumption), the demand for new capital goods by firms and new homes by households (investment), government purchases of goods and services, and the net demand for domestic goods by foreigners (net exports). Because the level of government purchases is determined primarily by the political process, macroeconomic analysis usually treats that component of spending as given. For this chapter we also assume that the economy is closed so that net exports are zero (we drop the closed-economy assumption in Chapter 5). That leaves two major components of spending— consumption and investment—to be discussed in this chapter. In Section 4.1 we present the factors that determine how much households choose to consume, and in Section 4.2 we look at the decision by firms about how much to invest.
We have said that this chapter is about the aggregate demand for goods and services. However, we could just as easily say that it is about a seemingly very different (but equally important) topic: the determination of saving and capital formation. Studying the aggregate demand for goods and services is the same as studying the factors that determine saving and capital formation for the following reasons.
First, saving is simply what is left after an economic unit (say, a household) decides how much of its income to consume. Thus the decision about how much to consume is the same as the decision about how much to save. Second, investment spending is part of the aggregate demand for goods and services, but it also represents the acquisition of new capital goods by firms. In studying investment spending, we therefore are also looking at the factors that lead an economy to acquire new factories, machines, and housing. In effect, we do two things at once in this chapter:■ We explore the determinants of the aggregate demand for goods, which prepares you for future discussions of topics such as the role of spending fluctuations in business cycles.
■ While exploring aggregate demand we also examine the factors affecting saving and capital formation, which prepares you for future discussions of the sources of economic growth and other issues.
In making many economic decisions, including those we consider in this chapter, people must trade off the present against the future. In deciding how much to consume and save, for example, the people in a household must weigh the benefits of enjoying more consumption today against the benefits of putting aside some of its income as saving for the future. Similarly, in deciding how much to invest, a firm's manager must determine how much to spend today so as to increase the firm's productive capacity one, five, or even twenty years from now. In making these trade-offs, households and firms must take into account their expectations about the future of the economy, including expectations about government policy.
In Chapter 3 we asked, What forces act to bring the labor market into equilibrium? We close this chapter by asking the same question for the goods market. The goods market is in equilibrium when the quantity of goods and services that producers want to supply (discussed in Chapter 3) equals the quantity of goods and services demanded by households, firms, and the government (discussed in this chapter). Equivalently, the goods market is in equilibrium when desired saving in the economy equals desired investment. We show that the real interest rate plays a key role in bringing the goods market into equilibrium.
4.1