COMMODITY

MARKET
PROF. ASHUTOSH PANDEY
COMPOSITION OF GDP
• Y = C + I + G + (X-M)
• Where Y = GDP,
• C = Consumption Expenditure
• I = Investment (fixed capital formation)
• G = Government Expenditure
• X-M = Net Exports
WHAT WILL YOU DO WITH MONEY INCOME?

• What proportion will you consume?

• What proportion will you save?
• What if income becomes zero?
• What if the government imposes a tax on income?
WHAT WILL YOU DO WITH MONEY INCOME?

• Lessons:
1. People consume a proportion of money income (MPC) and
2. Save some proportion of money income (MPS)
3. MPC + MPS =1
4. People consume even when money income is zero (autonomous consumption)
5. Consumption made with disposable income is called induced consumption.
SUBMIT YOUR
RESPONSE
WHAT DETERMINES CONSUMPTION EXPENDITURE?

1. Disposable Income:
• The income left after paying taxes and receiving subsidies
• Higher disposable income higher spending and vice versa
2. Household Wealth:
• Wealth means assets minus liabilities
• Higher the wealth higher the consumption spending
3. Expected future income:
• Spending rises if income is expected to rise in future and vice versa
WHAT DETERMINES CONSUMPTION EXPENDITURE?
4. Price Level:
• An increase in price level will result in a decrease in the real income and hence
in consumption.
5. Interest Rate:
• Interest on financed consumer durables rises then less consumption
• Interest on savings rises then more saving and less consumption
6. Price Expectation:
• Rise in price in future, increase consumption
• Fall in price in future, reduce consumption
CONSUMPTION FUNCTION
Consumption depends on Income after taxes.
Thus, C = f (Yd)
But people also consume when there is no income. Hence,
𝐶 = 𝐶𝑎 + 𝑏𝑌𝑑
Where, C = Total Consumption Expenditure
𝐶𝑎 = Autonomous Consumption
𝑌𝑑 = Disposable Income
b = Marginal Propensity to Consume
CONSUMPTION FUNCTION

• Diagram
CONSUMPTION FUNCTION

• Marginal Propensity to Consume (MPC) = b = ∆C/∆Yd

• MPC is positive but less than one. Lies between 0 and 1.
• It remains constant irrespective of change in disposable
income.
• Average Propensity to Consume (APC) = C/Yd.
• APC decreases steadily with increase in disposable income.
APPLICATION 1
If C = 1000 + 0.80Yd then what is the value of
1. MPC and MPS
2. What is the slope of the equation?
3. What is autonomous consumption expenditure?
4. What is induced consumption?
5. If income is Rs 10 lakh per annum and government charges a tax @ 20% on income
then find the disposable income.
6. What would be the total consumption expenditure?
7. What proportion of disposable income is saved and what proportion is consumed?
SAVING FUNCTION

Saving function (S) = Yd – C

Or S = -Ca + (1-b)Yd
Or S = Sa + sYd
where
• Sa’ is autonomous component of savings. It is in negative
‘

• ‘sYd’ is induced component of savings which is dependent on disposable

income
• where 's' is marginal propensity to save and
• Yd is disposable income
SAVING FUNCTION

• Marginal Propensity to Save (MPS): s = ∆S/∆Y,

• MPS is positive but less than one.
• It remains constant irrespective of disposable
income.
• Average Propensity to Save (APS) = S/Yd
• APS increases steadily as disposable income rises.
APPLICATION 2
If S = -1000 + 0.20Yd then what is the value of
1. MPC
2. MPS
3. What is the slope of the equation?
4. What is autonomous saving (dissaving)?
5. If income is Rs 10 lakh per annum and the government charges a tax @ 20% on
income, then what is disposable income?
6. What is induced saving?
7. If income is Rs 10 lakh per annum and government charges a tax @ 20% on income
then what would be the total savings?
INVESTMENT
• Investment (I) is gross capital formation which includes Gross Fixed Capital
Formation (GFCF) and Change in Stock (CIS). Investment depends on:
1. Expectations of future profitability: High growth rate~ more demand~ more
profitability ~ more investment
2. Interest rate: Higher interest on borrowings lesser investment and vice versa
3. Taxes: There is an inverse relationship between corporate income tax and
investment spending
4. Cash Flow: The more profitable a firm is, the greater its cash flow and the greater
its ability to finance investment
GOVERNMENT EXPENDITURE (G)

Includes:
• Government Purchases of goods and services (G)
• Transfer payments (subsidies) are excluded while calculating
government expenditure on the goods and services produced
in the economy because it is added to consumption
expenditure.
NET EXPORTS

• NX=X-M
• Net exports depends on:
• Price level in the country (say India) relative to price levels in other
countries: If price level in India rises our goods become costlier, export falls.
Net export falls.
• Growth rate of GDP in the country (say India) relative to the growth rates of
GDP in other countries: When incomes rise faster in India than in other countries,
India consumers’ purchases of foreign goods and services will increase faster than foreign
consumers’ purchases of Indian goods and services. Net export falls.
NET EXPORTS

• Exchange rate between domestic currency (say INR)

and other currencies. If exchange rate falls (currency
depreciates) then imports fall, export rises. Net export rises
EQUILIBRIUM IN COMMODITY MARKET
• Commodity market is in Equilibrium when:
• Y = C + I + G + NX (Output or Production or Income = Aggregate Expenditure or Aggregate Demand)
• Where C is final consumption expenditure of households,
• I is investment expenditure,
• G is government purchases, and
• NX is net export (exports minus imports).
• Substitute Consumption function in the equilibrium equation:
• Y= 1
1−b
(Ca − bT + I + G + NX)
• (Ca − bT + I + G + NX) is autonomous in nature (independent of output OR Y).
EQUILIBRIUM IN COMMODITY MARKET

• The 45° line shows all the

points where expenditure
equals income.
• The vertical intercept of
the expenditure line shows
autonomous expenditure.
• The economy is in
equilibrium where the
expenditure line, cuts the
45° line
APPLICATION 3

• Suppose, C = 100 + 0.75Yd, I = 200, G = 100, T = 100,

X = 200, M = 100. Find the equilibrium level of income.
APPLICATION 4

• Suppose an economy is characterized by the following equations:

• 𝐶 = 160 + 0.6 𝑌𝐷 , I = 150, G = 150, T = 100
1. What is the equilibrium income?
2. What is the disposable income?
3. What is consumption spending?
4. What is MPC and MPS?
APPLICATION 5

• Consider an economy described by the following equations:

•Y = C + I + G
• Y = 5,000, G = 1,000, T = 1,000, C = 250 + 0.75(Y − T), I =
5000
• Compute GDP, Disposable income, Consumption Expenditure
DISEQUILIBRIUM IN THE COMMODITY MARKET

• Aggregate Expenditure = C + I + G + NX
• When Y ≠ C + I + G + NX then there is disequilibrium
1. When Y > AE:
• Firms experience an unplanned increase in inventories. They cut down production.
• As a result, aggregate output (Y) declines and may finally be equal to aggregate expenditure.
• It happens during a recession.

2. When Y < AE:

• Firms will experience an unplanned decrease in inventories and will increase production.
• As a result, aggregate output (Y) increases and may finally be equal to aggregate expenditure.
THE CONCEPT OF MULTIPLIER

• What happens to Y when I or G or Net Exports Rises?

• Change in equilibrium national output/income per unit
change in autonomous component of aggregate
expenditure is termed as multiplier
• Simulation
MULTIPLIER SIMULATION

1. Students decide their role: Household or Business

2. A company in some business decides to increase its investment invest by
Rs 100.
3. Transactions take place between businesses and households.
4. MPC = 0.8
INVESTMENT MULTIPLIER

• Y= 1
1−b
(Ca − bT + I + G + NX)
• Suppose, the Investment expenditure increases by ∆I, other things remaining constant.
• The ∆I causes an increase in the aggregate expenditure and, therefore, a rise in the equilibrium
level of income by, say, ∆Y.
• Thus,
• Y + ∆Y = 1
1−b
(Ca − bT + I + G + NX + ∆I)

• Y + ∆Y = 1
1−b
Ca − bT + I + G + NX + 1
1−b
(∆I)

• Y + ∆Y = 𝑌 + 1
1−b
(∆I)

• ∆Y = 1
1−b
(∆I)
INVESTMENT MULTIPLIER

• The investment multiplier can then be obtained as:

∆𝑌 1
• Im = =
∆𝐼 1−𝑏
∆𝑌 1 1
• Im = = =
∆𝐼 1−𝑀𝑃𝐶 𝑀𝑃𝑆

• E.g If MPC is 0.75 then an additional investment of 100

would cause an increase in Y by 4 times of 100. i.e. by 400.
INVESTMENT MULTIPLIER APPLICATION

• Suppose the consumption function for an economy is estimated

to be C = 100 + 0.75Yd, I = 200, G = 100, T = 100, X = 200, M
= 100.
• Find the equilibrium level of income.
• Suppose the businesses increase its investment by 100. What
would be the rise in the equilibrium level of income in the
economy?
GOVERNMENT EXPENDITURE MULTIPLIER

• Y= 1
1−b
(Ca − bT + I + G + NX)
• Suppose, the government expenditure increases by ∆G, other things remaining constant.
• The ∆G causes an increase in the aggregate demand (aggregate expenditure) and, therefore, a
rise in the equilibrium level of income by, say, ∆Y.
• Thus,
• Y + ∆Y = 1
1−b
(Ca − bT + I + G + NX + ∆G)
• Y + ∆Y = 1
1−b
(Ca − bT + I + G + NX) + 1−b
1
(∆G)

• ∆Y = 1
1−b
(∆G)
GOVERNMENT EXPENDITURE MULTIPLIER

• Government expenditure multiplier can then be obtained as:

∆𝑌 1
• Gm = =
∆𝐺 1−𝑏

• E.g If MPC is 0.75 then an additional government spending of

100 would cause an increase in Y by 4 times of 100. i.e. by 400.
GOVERNMENT SPENDING MULTIPLIER
APPLICATION

• Suppose the consumption function for an economy is estimated

to be C = 100 + 0.75Yd, I = 200, G = 100, T = 100, X = 200, M
= 100.
• Find the equilibrium level of income.
• Suppose the government spending rises by 100. What would be
the rise in the equilibrium level of income in the economy?
TAX MULTIPLIER

• Y= 1
1−b
(Ca − bT + I + G + NX)

• A change in tax (∆T) changes the national income by ∆Y

• Thus,

• Y + ∆Y = 1
1−b
Ca − b T + ∆T + I + G + NX

• Y + ∆Y = 1
1−b
Ca − bT − b∆T + I + G + NX

• Y + ∆Y = 1
1−b
Ca − bT + I + G + NX + 1
1−b
−b∆T

• ∆Y = 1
1−b
(−𝑏∆𝑇)
TAX MULTIPLIER

• Tax multiplier can then be obtained as:

∆𝑌 −𝑏
• Tm = =
∆𝑇 1−𝑏

• E.g If MPC is 0.75 then an additional tax of 100 would cause an

reduction in Y by 3 times of 100. i.e. by 300.
TAX MULTIPLIER APPLICATION

• Suppose the consumption function for an economy is estimated

to be C = 100 + 0.75Yd, I = 200, G = 100, T = 100, X = 200, M
= 100.
• Find the equilibrium level of income.
• Suppose the government raises the tax by 100. What would be
the change in the equilibrium level of income in the economy?
FOREIGN TRADE MULTIPLIER

• Y= 1
1−b
Ca − bT + I + G + NX
• Suppose, net exports increase by ∆NX, other factors remaining constant
• Y + ∆Y = 1
1−b
(Ca − bT + I + G + NX + ∆NX)
• Y + ∆Y = 1
1−b
(Ca − bT + I + G + NX) + 1−b
1
(∆𝑁𝑋)
• ∆Y = 1
1−b
(∆𝑁X)
• By rearranging, we get foreign trade multiplier as:
∆𝑌 1
• Fm = ∆𝑁𝑋 = 1−𝑏

• E.g If MPC is 0.75 then an increase in export of 100 would cause an increase in Y by 4 times
of 100. i.e. by 400.
FOREIGN TRADE MULTIPLIER APPLICATION

• Suppose the consumption function for an economy is estimated

to be C = 100 + 0.75Yd, I = 200, G = 100, T = 100, X = 200, M
= 100.
• Find the equilibrium level of income.
• Suppose export rises by 200. What would be the change in the
equilibrium level of income in the economy?
COMMODITY MARKET

• Y = C + G + I + NX. Graph
• C depends on Yd. As C rises Y rises.
• What happens to Y when G rises?
• What happens to Y when Govt increases/reduces tax?
• Reading
APPLICATION
• If MPC for an economy is 0.75 then predict the impact on
equilibrium GDP of the following:
1. An increase in government spending by 100.
2. An increase in taxes by 100.
3. Equal-sized increases in both government purchases and taxes
(both rise by 100).
BALANCED BUDGET MULTIPLIER

• When a government adopts a balanced budget policy it spends only as much as it collects through taxation,
i.e, T = G or ∆G = ∆T
• Balanced budget multiplier (BBm) can be obtained by adding government expenditure multiplier (Gm) and tax
multiplier (Tm)
• BBm = Gm + Tm
1 −𝑏
• BBm = 1−𝑏 + 1−𝑏
1−𝑏
• BBm = 1−𝑏 = 1

• Balanced budget theorem states that the balanced budget multiplier is always equal to one.
APPLICATION

• Assume that the consumption function is given by

C = 200 + 0.75 (Y − T ), I = 100, G = 100, T=100.
• What is the equilibrium level of income?
• If G increases to 125, what is the new equilibrium
income?
INVESTMENT FUNCTION

• What happens to Y when investment rises?

• What determines investment?
• Reading
INVESTMENT AND INTEREST RATE

•𝐼 = 𝑓 𝑟
• Induced Investment: Interest rate
• Autonomous Investment: Innovation, Invention, the
emergence of new entrepreneurs, among others.
• Diagram
INVESTMENT FUNCTION
• Investment (I) is linear and inverse function of rate of interest;
• I = Ia – hr
• where ‘Ia’ is autonomous investment and is independent of interest
rate;
• ‘hr’ is induced investment which is dependent on the rate of interest;
• ‘h’ is interest sensitivity of investment spending; it is the slope, h=
∆𝐼 Τ∆𝑟
• ‘r’ is rate of interest.
NATIONAL SAVING AND INVESTMENT
• Y = C+I+G
• Y-C-G = I
• Taxes are income for the government and it spends G after collecting T.
• Y-C-T+T-G = I
• Y-C-T = Private Savings
• T-G = Public Savings
• Thus National Savings = Y-C-G
• At the equilibrium level Savings = Investment
COMMODITY MARKET EQUILIBRIUM WITH
CHANGE IN INTEREST RATE

• DIAGRAM 1: Relation between interest and income

• DIAGRAM II: Income and Aggregate Expenditure
• DIAGRAM III: IS Curve
• IS Curve shows the combinations of the interest rate and the level of
output that are consistent with equilibrium in the goods market.
• An increase in interest rate leads to a decline in output. Consequently,
the IS curve is downward sloping.
COMMODITY MARKET EQUILIBRIUM WITH
CHANGE IN INTEREST RATE

• Suppose, C = 50 + 0.75Yd; I = 100 − 250r, G =

40, T = 40, X = 100, M = 60
• Y = 800 − 1000r is the IS equation.
APPLICATION

• Consider an economy having the following equations:

• C = 200 + .25Yd
• I = 150 + .25Y-1000i
• G=250
• T= 200
Derive the IS relation.