Chapter 9 An Introduction to Basic Macroeconomic Markets

Chapter 9 An Introduction to Basic Macroeconomic Markets Slides to Accompany “Economics: Public and Private Choice 9 th ed. ” James Gwartney, Richard Stroup, and Russell Sobel Next page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

1. Understanding Macroeconomics: -- Our Game Plan Jump to first page Copyright (c) 2000

Understanding Macroeconomics: -- Our Game Plan n As a basic macroeconomic model is developed, we will assume that: n n n 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: n businesses, and, n households. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

2. Four Key Markets Coordinate the Circular Flow of Income Jump to first page

Four Key Markets Coordinate the Circular Flow of Income n Goods and Services Market: n n Resource Market: n n Highly aggregated market where business firms demand resources and households supply labor and other resources in exchange for income. Loanable Funds Market: n n In this market, businesses supply goods & services in exchange for sales revenue. Households, investors, governments, and foreigners (net exports) demand goods. Coordinates the actions of borrowers and lenders. Foreign Exchange Market: n 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). Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

3. Aggregate Demand for Goods & Services Jump to first page Copyright (c) 2000

Aggregate Demand for Goods & Services n n 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Aggregate Demand Curve Price level A reduction in the price level will increase the quantity of goods & services demanded. P 1 P 2 AD Y 1 n n n Y 2 Goods & Services (real GDP) As illustrated here, the quantity of goods & services purchased will increase (to Y 2 from Y 1) as the price level declines to P 2 (from P 1). 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Why Does the Aggregate Demand Curve Slope Downward n n n 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

4. Aggregate Supply of Goods and Services Jump to first page Copyright (c) 2000

Aggregate Supply of Goods & Services n n 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. n Long-run: -- a time period of sufficient duration that people have the opportunity to modify their behavior in response to price changes. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

5. Short-Run Aggregate Supply (SRAS) Jump to first page Copyright (c) 2000 by Harcourt

Short-Run Aggregate Supply (SRAS) n n n 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. n They will respond with an expansion in output. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Short-Run Aggregate Supply Curve Price level SRAS (P P 105 100) An increase in the price level will increase the quantity supplied in the short run. P 100 P 95 Y 1 n n Y 2 Y 3 Goods & Services (real GDP) The short-run aggregate supply curve (SRAS) shows the relationship between the price level and the quantity supplied of goods & services by 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

6. Long-Run Aggregate Supply (LRAS) Jump to first page Copyright (c) 2000 by Harcourt

Long-Run Aggregate Supply (LRAS) n n n 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Long-Run Aggregate Supply Curve Price level LRAS Change in price level does not affect quantity supplied in the long run. Potential GDP YF n n (full employment rate of output) Goods & Services (real GDP) 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Questions for Thought: 1. What is the circular flow of income? What are the major markets that coordinate macroeconomic activities? 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 & services increased proportionally (by the same %), would business firms be willing to expand output? Why or why not? Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

7. Equilibrium in the Goods & Services Market Jump to first page Copyright (c)

Equilibrium in the Goods & Services Market n Short-run Equilibrium: n n n 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Short-Run Equilibrium in the Goods & Services Market Price level SRAS (P Intersection of AD and SRAS determines output P AD Y n n n 100) Goods & Services (real GDP) 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Equilibrium in the Goods & Services Market n Long-run Equilibrium: n 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. n If this is not the case, buyers and sellers will want to modify the agreements when the long-term contracts expire. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Equilibrium in the Goods & Services Market n When Long-run Equilibrium is Present: n n 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Long-Run Equilibrium in the Goods & Services Market Price level LRAS SRAS (P Note, at this point, the quantity demanded just equals quantity supplied. P 100 YF n n 100) AD 100 Goods & Services (full employment rate of output) (real GDP) The subscripts on the SRAS and AD curves indicate that buyers and sellers alike anticipated the price level P 100 (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 employment will be present. Copyright (c) 2000 by Harcourt Inc. Jump to first page All rights reserved.

Equilibrium in the Goods & Services Market n Disequilibrium: -- Adjustments that occur when output differs from Long-Run potential. n n n 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Questions for Thought: 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? 2. Why is an increase in the price level likely to expand output in the short run, but not in the long run? Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

8. Resource Market Jump to first page Copyright (c) 2000 by Harcourt Inc. All

Resource Market n n n 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 curve for 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Equilibrium in the Resource Market Wage (Real Resource Price) Households supply resources in exchange for income S Businesses demand resources to produce goods & services Pr D Q n n n Employment 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

9. Loanable Funds Market Jump to first page Copyright (c) 2000 by Harcourt Inc.

Loanable Funds Market n The interest rate coordinates the actions of borrowers and lenders. n n 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Loanable Funds Market n The money and real interest rate: n n 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. Real Interest Rate = Money Interest Rate Jump to first page - Inflation Premium Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Inflation and Interest Rates Loanable Funds Market Interest Rate S(3% inflation expected) S(stable prices expected) Inflation premium equals expected rate of inflation i =. 08 r =. 05 D(3% inflation expected) D(stable prices expected) Q n n n Quantity of Funds 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 real interest rates will be equal. When people expect prices to rise at a e% rate, the money interest rate of interest ( i ) will rise to 8% even though the real interest rate ( r ) remains constant at 5%. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Interest Rates and the Inflow and Outflow of Capital Real Interest Rate Loanable Funds Market Domestic saving Supply of loanable funds Capital Inflow r 2 r 1 D 2 Capital Outflow D 1 Q 1 n n n D 0 Q 2 Quantity of Funds The demand supply in the loanable funds market will determine the interest rate. When the demand for loanable funds is strong (like D 2), the real interest rate will be high ( r 2 ) and there will be a net inflow of capital. In contrast, weak demand (like D 1) and low interest rates (like r 2) will lead to net capital outflow. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

10. Foreign Exchange Market Jump to first page Copyright (c) 2000 by Harcourt Inc.

Foreign Exchange Market n n n 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Interest Rates and the Inflow and Outflow of Capital Foreign Exchange Market Dollar Price (of foreign currency) S(Exports + capital inflow) Depreciation of dollar P 1 D(Imports + capital outflow) Appreciation of dollar Q n n Quantity of Currency 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). Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

11. Leakages and Injections from the Circular Flow of Income Jump to first page

Leakages and Injections from the Circular Flow of Income n n When the exchange market is in equilibrium, the following relationship exists: Imports + Capital Outflow = Exports + Capital Inflow As net capital inflow is (capital inflow – capital outflow) the above equation may be re-written as: Imports - Exports = Net Capital Inflow n Equilibrium in the Loanable Funds Market Implies: Net Saving + Net Capital Inflow = Investment + Budget Deficit n Substituting in for Net Capital Inflow from the above gives: Net Saving + Imports - Exports = Investment + Budget Deficit Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Leakages and Injections from the Circular Flow of Income Net Saving + Imports - Exports = Investment + Budget Deficit Because the budget deficit is (government purchases – taxes), the above equation may be re-written as: Government Net Saving + Imports - Exports = Investment + Purchases - Taxes n The above equation may be re-written as: Net Saving + Imports + Taxes = Investment + Government + Exports Purchases n Leakages n Injections 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

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 condition will be present when the injections (investment, government purchases, and exports) into the circular flow. . . equal the leakages (saving, taxes, and imports) from it. • This will be the case when equilibrium is present in the loanable funds and foreign exchange markets. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Questions for Thought: 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? 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. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.