An Introduction to Basic Macroeconomic Markets

1. Chapter 9 An Introduction to Basic Macroeconomic Markets

2. 1. Understanding Macroeconomics: -- Our Game Plan

3. Understanding Macroeconomics: -- Our Game Plan • As a basic macroeconomic model is developed, we will assume that: • the money supply is constant, and that, • taxes and expenditures are constant. • There is a circular flow of output and income between these two key sectors: • businesses, and, • households.

4. 2. Four Key Markets Coordinate the Circular Flow of Income

5. Four Key Markets Coordinate the Circular Flow of Income • In this market, businesses supply goods&services in exchange for sales revenue. Households, investors, governments, and foreigners (net exports)demand goods. • Resource Market: • Highly aggregated market where business firms demand resources and households supply labor and other resources in exchange for income. • Loanable Funds Market: • Coordinates the actions of borrowers and lenders. • Foreign Exchange Market: • Coordinates the actions of Americans that demand foreign currency (in order to buy things abroad) and foreigners that supply foreign currencies in exchange for dollars (so they can buy things from Americans). • Goods and Services Market:

6. The Circular Flow Diagram • The circular-flow diagram presents a visual model of the economy as coordinated by the four key markets. • First, the resource market (bottom loop) coordinates the actions of businesses demanding resources and households supplying them in exchange for income. • Second, the goods & services market(top loop) coordinates the demand (consumption, investment, government purchases, and net-exports) for and supply of domestic production (GDP). • Third, the foreign exchange market (top right) brings the purchases (imports) from foreigners into balance with the sales (exports plus net inflow of capital) to them. • Fourth, the loanable funds market(lower center) brings the net saving of households plus the net inflow of foreign capital into balance with the borrowing of businesses and governments.

7. 3. Aggregate Demand for Goods & Services

8. Aggregate Demand for Goods & Services • Aggregate demand curve:-- indicates the various quantities of domestically produced goods & services that purchasers are willing to buy at different price levels . • The AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods & services demanded and the price level.

9. Price level A reduction in the price level will increase the quantity of goods &services demanded. P 1 P 2 AD Goods &Services(real GDP) Y Y 1 2 Aggregate Demand Curve • As illustrated here, the quantity of goods & services purchased will increase (to Y2from Y1) as the price level declines to P2(from P1). • Other things constant, the lower price level will increase the wealth of people holding the fixed quantity of money, lead to lower interest rates, and make domestically produced goods cheaper relative to foreign goods. • All these factors will tend to increase the quantity of goods & services purchased at the lower price level.

10. Why Does the Aggregate Demand Curve Slope Downward • A lower price level will increase the purchasing power of the fixed quantity of money. • The Interest Rate Effect: -- a lower price level will reduce the demand for money and lower the real interest rate, which will stimulate additional purchases during the current period. • Other things constant, a lower price level will make domestically produced goods less expensive relative to foreign goods.

11. 4. Aggregate Supply of Goods and Services

12. Aggregate Supply of Goods & Services • When considering the Aggregate Supply curve, it is important to distinguish between the short-run and the long-run. • Short-run:-- time period during which some prices, particularly those in resource markets, are set by prior contracts and agreements. Therefore, in the short-run, households and businesses are unable to adjust these prices when unexpected changes occur, including unexpected changes in the price level. • Long-run:-- a time period of sufficient duration that people have the opportunity to modify their behavior in response to price changes.

13. 5. Short-Run Aggregate Supply (SRAS)

14. Short-Run Aggregate Supply (SRAS) • SRAS indicates the various quantities of goods & services that domestic firms will supply in response to changing demand conditions that alter the level of prices in the goods & services market. • SRAS curve slopes upward to the right. • The upward slope reflects the fact that in the short run an unanticipated increase in the price level will improve the profitability of firms. • They will respond with an expansion in output.

15. Price level SRAS (P100) P 105 An increase in the price level will increase the quantity supplied in the short run. P 100 P 95 Goods &Services(real GDP) Y Y Y 1 2 3 Short-Run Aggregate Supply Curve • The short-run aggregate supply curve (SRAS) shows the relationship between the price level and the quantity supplied of goods & servicesby domestic producers. • In the short-run, firms will generally expand output as the price level increases because the higher prices will improve profit margins since many components of costs will be temporarily fixed as the result of prior long-term commitments.

16. 6. Long-Run Aggregate Supply (LRAS)

17. Long-Run Aggregate Supply (LRAS) • LRAS indicates the relationship between the price level and quantity of output after decision makers have had sufficient time to adjust their prior commitments where possible. • LRAS curve is vertical. • LRAS is related to the economy's production possibilities constraint. A higher price level does not loosen the constraints imposed by the economy's resource base, level of technology, and the efficiency of its institutional arrangements.

18. Price level LRAS Change in price level does not affect quantity supplied in the long run. Potential GDP Goods &Services(real GDP) Y (full employment rate of output) F Long-Run Aggregate Supply Curve • In the long-run, a higher price level will not expand an economy’s rate of input. Once people have time to adjust their long-term commitments, resource markets (and costs) will adjust to the higher levels of prices and thereby remove the incentive of firms to continue to supply a larger output. • An economy’s full employment rate of output (YF), the maximum output rate that is sustainable, is determined by the supply of resources, level of technology, and the structure of the institutions, factors that are insensitive to changes in the price level. Hence the vertical LRAS curve.

19. 1. What is the circular flow of income? What are the major markets that coordinate macroeconomic activities? Questions for Thought: 2. Why is the aggregate demand for goods & services inversely related to the price level? 3. What are the major factors that influence our ability to produce goods & services in the long run? Why is the long-run aggregate supply vertical? 4. Why does the short-run aggregate supply curve slope upward to the right? If the prices of both (a) resources, and, (b) goods & servicesincreased proportionally (by the same %), would business firms be willing to expand output? Why or why not?

20. 7. Equilibrium in the Goods & Services Market

21. Equilibrium in the Goods & Services Market • Short-run Equilibrium: • Short-run equilibrium is present in the goods & services market at the price level (P) where the aggregate quantity demanded is equal to the aggregate quantity supplied. • This occurs (graphically) at the output rate where the AD and SRAS curves intersect. • At this market clearing price (P), the amount that buyers want to purchase is just equal to the quantity that sellers are willing to supply during the current period.

22. Price level SRAS (P100) P Intersection of AD and SRAS determines output AD Goods &Services(real GDP) Y Short-Run Equilibrium in the Goods & Services Market • Short-run equilibrium in the goods & services market occurs at the price level (P) where AD and SRAS intersect. • If the price were lower than P, general excess demand in the goods & services markets would push prices upward. • Conversely, if the price level were higher than P, excess supply would result in falling prices.

23. Equilibrium in the Goods & Services Market • Long-run Equilibrium: • Long-run equilibrium requires that decision makers, who agreed to long-term contracts influencing current prices and costs, correctly anticipated the current price level at the time they arrived at the agreements. • If this is not the case, buyers and sellers will want to modify the agreements when the long-term contracts expire.

24. Equilibrium in the Goods & Services Market • When Long-run Equilibrium is Present: • Potential GDP is equal to the economy’s maximum sustainable output consistent with its resource base, current technology, and institutional structure. • The Economy is operating at full employment. • Actual Rate of Unemployment = Natural Rate of Unemployment. • Occurs (graphically) at the output rate where the AD,SRAS, and LRAS curves intersect.

25. Price level LRAS SRAS (P100) P 100 Note, at this point, the quantity demanded justequals quantity supplied. AD100 Y Goods &Services(real GDP) (full employment rate of output) F Long-Run Equilibrium in theGoods & Services Market • The subscripts on the SRAS and AD curves indicate that buyers and sellers alike anticipated the price level P100(where 100 represents an index of prices during an earlier base year). • When the anticipated price level is actually attained, current output (YF) will equal the economy’s potential GDP and full employmentwill be present.

26. Equilibrium in the Goods & Services Market • Disequilibrium:--Adjustments that occur when output differs from Long-Run potential. • An unexpected change in the price level (rate of inflation) will alter the rate of output in the short-run. • An unexpected increase in the price level will stimulate output and employment in the short-run. • An unexpected decline in the price level will cause output and employment to fall in the immediate future.

27. 1. If the price level in the current period is higher than what buyers and sellers anticipated, what will tend to happen to real wages and the level of employment? How will the profit margins of business firms be affected? How will the actual rate of unemployment compare with the natural rate of unemployment? Will the current rate of output be sustainable in the future? Questions for Thought: 2. Why is an increase in the price level likely to expand output in the short run, but not in the long run?

28. 8. Resource Market

29. Resource Market • The Demand for Resources:-- Business firms demand resources because they contribute to the production of goods the firm expects to sell at a profit. • The demand curvefor resources slopes downward and to the right. • The Supply of Resources:-- Households supply resources in exchange for income. • Higher wages increase the incentive to supply resources; thus, the supply curve slopes upward and to the right. • The equilibrium,or market clearing price, brings the amount demanded by firms into balance with the amount supplied by resource owners.

30. Resource Market Wage(Real Resource Price) Households supply resourcesin exchange for income S Pr Businesses demand resourcesto produce goods & services D Employment Q Equilibrium in the Resource Market • In general, as resource prices increase, the amount demanded by producers declines and the amount supplied by resource owners expands. • In equilibrium, the resource price brings the amount demanded into equality with the amount supplied in the aggregate-resource market. • The labor market is a major component of the resource market.

31. 9. Loanable Funds Market

32. Loanable Funds Market • The interest rate coordinates the actions of borrowers and lenders. • From the borrower's viewpoint, interest is the cost paid for earlier availability. • From the lender’s viewpoint, interest is a premium received for waiting, for delaying possible expenditures into the future.

33. - RealInterest Rate MoneyInterest Rate = Loanable Funds Market • The money and real interest rate: • When inflation is anticipated, lenders will demand (and borrowers will agree to pay) a higher money interest rate to compensate for the decline in the purchasing power of the dollar. • This premium for the expected decline in purchasing power of the dollar is called the inflation premium. InflationPremium

34. Loanable FundsMarket InterestRate S (3% inflation expected) Inflation premiumequals expectedrate of inflation S (stable prices expected) i .08 = r .05 = D (3% inflation expected) D (stable prices expected) Quantityof Funds Q Inflation and Interest Rates • Suppose that when people expect the general level of prices to be stable (zero inflation) in the future, a 5% interest rate brings quantity demanded into balance with quantity supplied. • Under these conditions, the money and realinterest rates will be equal. • When people expect prices to rise at a e% rate, the moneyinterest rate of interest (i) will rise to 8% even though the real interest rate (r) remains constant at 5%.

35. Real InterestRate Loanable FundsMarket Domesticsaving Supply ofloanablefunds CapitalInflow r 2 r 1 CapitalOutflow D 2 Quantityof Funds D D 0 1 Q2 Q1 Interest Rates and the Inflow and Outflow of Capital • The demand and supply in the loanable funds market will determine the interest rate. • When the demand for loanable funds is strong (like D2), the real interest rate will be high (r2) and there will be a net inflow of capital. • In contrast, weak demand (like D1) and low interest rates (like r2) will lead to net capital outflow.

36. 10. Foreign Exchange Market

37. Foreign Exchange Market • When Americans buy from foreigners and make investments abroad (an outflow of capital), their actions will generate a demand foreign currency in the foreign exchange market. • On the other hand, when Americans sell products and assets (including bonds) to foreigners, the transactions will generate a supply of foreign currency (in exchange for dollars) in the foreign exchange market. • The exchange rate will bring the quantity of foreign exchange demanded into equality with the quantity supplied.

38. Foreign ExchangeMarket Dollar Price(of foreign currency) S (Exports + capital inflow) P 1 D (Imports + capital outflow) Quantity of Currency Q Interest Rates and the Inflow and Outflow of Capital Depreciationof dollar Appreciationof dollar • Americans demand foreign currencies in order to import goods & services and make investments abroad. Foreigners supply their currency in exchange for dollars in order to purchase American exports and undertake investments in the United States. • The exchange rate will bring the quantity demanded into balance with the quantity supplied. This will bring (imports + capital outflow) into equality with (exports + capital inflow).

39. 11. Leakages and Injections from the Circular Flow of Income

40. + + Exports Imports - = Exports Imports + + Net Saving Investment - = + + Exports Imports Budget Deficit Net Saving Investment Leakages and Injections from the Circular Flow of Income • When the exchange marketis in equilibrium, the following relationship exists: = Capital Inflow Capital Outflow • As net capital inflow is (capital inflow–capital outflow)the above equation may be re-written as: Net Capital Inflow • Equilibrium in the Loanable Funds Market Implies: = Budget Deficit Net Capital Inflow • Substituting in for Net Capital Inflow from the above gives:

41. - + = + Budget Deficit Exports Imports Investment Net Saving GovernmentPurchases - - = + + Taxes Exports Imports Investment Net Saving GovernmentPurchases + = + + + Investment Imports Taxes Exports Net Saving Leakages Injections Leakages and Injections from the Circular Flow of Income • Because the budget deficit is (government purchases – taxes), the above equation may be re-written as: • The above equation may be re-written as: • Therefore, when the loanable funds and foreign exchange markets are in equilibrium, the leakages from the circular flow of income (savings + imports + taxes) and the injections into it (investment + government purchases + exports) will be equal.

42. This condition will be present when the injections(investment, government purchases, and exports) into the circular flow . . . injections equal the leakages(saving, taxes, and imports) from it. leakages The Circular Flow Diagram • Macro equilibrium will be present when the flow of expenditures on goods & services (top loop) is equal the flow of income to resources owners (bottom loop). • This will be the case when equilibrium is present in the loanable funds and foreign exchange markets.

43. 1. Suppose that you purchased a $5,000 bond that pays 6% interest annually and matures in five years. If the inflation rate in recent years has been steady at 3% annually, what is the estimated real rate of interest? If the inflation rate during the next five years rose to 8%, what real rate of return will you earn? Questions for Thought: 2. When equilibrium is present in the loanable funds and foreign exchange markets, how will the leakages from the circular flow of income compare with the injections into the circular flow. Explain.

44. EndChapter 9