Chapter 9: Macroeconomic Markets and Equilibrium

The Economic Way of Thinking

  • Tools of the Economist: Supply and Demand.
  • The Economic Approach.

Supply, Demand, and the Market Process

Climbing the Macroeconomic Mountain!

  • Core Macroeconomics.

Basic Macroeconomic Markets

  • Introduction to Basic Macroeconomic Markets.

Dynamic Change, Economic Fluctuations, and the AD-AS Model

Taking the Nation’s Economic Pulse

Economic Fluctuations, Unemployment, and Inflation

Classical vs. Keynesian Views

Fiscal Policy: The Keynesian View and the Historical Development of Macroeconomics

Fiscal Policy, Incentives, and Secondary Effects

Monetary Policy Options

Money and the Banking System

Modern Macroeconomics and Monetary Policy

Overview of Macroeconomic Markets

  • Resource market.
  • Loanable funds market (nominal and real interest rates).
  • Foreign exchange market (appreciation and depreciation of currency).
  • Aggregate goods/services market (short-run equilibrium and Long-run equilibrium).

Circular Flow Diagram

  • Depicts the flow of resources, goods, services, and money within an economy.
  • Includes:
    • Goods and services market: Households purchase goods and services from businesses; businesses supply goods and services.
    • Expenditures: Spending on national product.
    • Resource market: Households supply resources (labor, capital, land) to businesses; businesses pay resource payments (wages, rent, interest, profit).
    • National Income: Wages + Rents + Interest + Profits.
    • Loanable funds market: Coordinates borrowing and lending decisions; households save, and businesses and governments borrow.
    • Net Savings: Savings by households after taxes.
  • Foreign exchange market: Coordinates the exchange of currencies for international trade.
    • Exports: Goods and services sold to foreign countries.
    • Imports: Goods and services purchased from foreign countries.
    • Net Capital Flow: The difference between capital inflows and capital outflows.

The Labor Market

  • Price for labor is the wage (w).
  • Quantity of labor is employment (E).
  • Functions similarly to the goods market but with different names for price and quantity.

Labor Demand

  • Firms demand labor.
  • The labor demand curve is downward sloping because as wages decrease, firms want to employ more people.

Labor Supply

  • Workers supply labor.
  • The labor supply curve is upward sloping because as wages increase, people want to work more.

Loanable Funds Market

  • Coordinates the borrowing and lending decisions of firms and households.
  • The price of loanable funds is the real interest rate (rr).
  • The quantity of loanable funds is the amount saved or invested (QS,IQ_{S,I}).
  • Functions similarly to the goods/services market.

Demand for Loanable Funds

  • Firms demand loanable funds for investment.
  • Downward sloping because as the interest rate decreases, firms will want to borrow more money.
    • Increase in Investment: Demand curve shifts right.
    • Decrease in Investment: Demand curve shifts left.

Supply of Loanable Funds

  • Individuals supply loanable funds through savings.
    • Savings: After-tax income not spent on consumption.
  • Upward sloping because as the interest rate increases, people will want to save more.
    • Increase in Savings: Supply curve shifts right.
    • Decrease in Savings: Supply curve shifts left.

Market for Loanable Funds

  • Illustrates the supply and demand for loanable funds, determining the equilibrium interest rate (I<em>I^<em>) and quantity of loanable funds (Q</em>Q^</em>).

Impact of Interest Rate Changes

  • A drop in interest rates:
    • Causes AD to shift to the Right
    • Investment will increase.

Long-Run Aggregate Supply Curve

  • Long-Run Aggregate Supply (LRAS) curve: Vertical because in the long-run people have had time to adjust and so a higher price level will increase costs as much as it increases revenues
  • Firms have no incentive to change production at any price level
  • Indicates potential output (YfY_f) of the economy
  • Where SRAS intersects LRAS: actual price level = expected price level

Nominal vs. Real Interest Rate

  • Nominal interest rate: The percentage of the amount borrowed that must be paid to the lender in addition to the repayment of the principal.
  • Real interest rate: The interest rate adjusted for inflation (real cost of borrowing and lending money).

Impact of Inflation

  • When the actual rate of inflation is greater than anticipated: borrowers gain, lenders lose.
  • When the actual rate of inflation is less than anticipated: lenders gain, borrowers lose.
  • Inflation does not systematically benefit either borrowers or lenders.

Interest Rate and Bond Prices

  • The interest rate and bond prices are inversely related.
  • As interest rates rise (fall), the market value of previously issued bonds will fall (rise).

The Foreign Exchange Market

  • The market in which the currencies of different countries are bought and sold.
  • Price: The price of foreign currency.
  • Quantity: The amount of foreign currency.

Exchange Rate Changes

  • Appreciation: An increase in the value of a currency relative to foreign currencies (e.g., the dollar can buy more euros).
  • Depreciation: A reduction in the value of a currency relative to foreign currencies (e.g., the dollar can buy fewer euros).

Demand for Foreign Currency

  • Demand for foreign currency is: imports + capital outflows
    • Capital outflow: Domestic money invested abroad.
  • Downward sloping because as the dollar appreciates (foreign currency depreciates), people can import more and invest more in other countries.

Supply of Foreign Currency

  • Supply of foreign currency is: exports + capital inflows
    • Capital inflows: Foreign money invested domestically.
  • Upward sloping because as the dollar depreciates (foreign currency appreciates), foreign countries will demand more domestic exports and will invest more domestically.

Foreign Exchange Market Equilibrium

  • Trade Balance:
    • Deficit: Imports > Exports + Capital inflows > Capital outflows
    • Surplus: Exports > Imports + Capital outflows > Capital inflows

Aggregate Goods/Services Market

  • A market that includes all final goods and services (counts all items that enter into GDP).
    • Ex: Pizza, haircuts, office buildings, highways, national defense, etc.
  • Price: The price index (PI).
  • Quantity: Real GDP (Y).

The Aggregate Demand Curve

  • The Aggregate Demand (AD) curve: The relationship between the price level and the quantity of domestically produced goods and services all households, business firms, governments, and foreigners are willing to purchase
  • Downward sloping because as the price level goes down, the quantity demanded of all goods will increase.

Reasons for Downward Slope of AD Curve

  • A lower price level will:
    • Increase the purchasing power of money.
    • Lead to a lower real interest rate, which increases consumption and investment.
    • Make domestically produced goods less expensive relative to foreign goods.

Aggregate Supply Curve

  • The relationship between a nation's price level and the quantity of goods supplied by its producers.
  • Two types:
    • Short-run aggregate supply curve (SRAS).
    • Long-run aggregate supply curve (LRAS).

Short-Run Aggregate Supply Curve

  • Short-Run Aggregate Supply (SRAS) curve: Upward sloping because an increase in the price level will improve the profitability of the firms and cause them to increase output.
    • Many of the producers' costs are still fixed.

Long-Run Aggregate Supply Curve

  • Long-Run Aggregate Supply (LRAS) curve: Vertical because in the long-run people have had time to adjust and so a higher price level will increase costs as much as it increases revenues.
  • Firms have no incentive to change production at any price level.
  • Indicates potential output (YfY_f) of the economy.
  • Where SRAS intersects LRAS: Actual price level = expected price level.

Short-Run Equilibrium

  • Occurs at the intersection of the aggregate demand (AD) and short-run aggregate supply curve (SRAS).

Long-Run Equilibrium

  • Occurs where aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS) all intersect at a single point.
  • Occurs when we correctly anticipate the price level.
  • No expansion or recession (Y=YfY = Y_f).
  • Actual rate of unemployment = Natural rate of unemployment (U=U∗U = U^*).

Recession

  • Output below potential.

Market Coordination

  • Four key markets coordinate the circular flow of income:
    • The resource market coordinates the actions of businesses demanding resources and households supplying them in exchange for income.
    • The loanable funds market brings net household saving and the net inflow of foreign capital into balance with the borrowing of businesses and governments.
    • The foreign exchange market brings the purchases (imports) from foreigners into balance with the sales (exports plus net inflow of capital) to them.
    • The goods & services market coordinates the demand for and supply of domestic production (GDP).

Review

  • Know the resource, loanable funds, and foreign exchange markets (the axis labels, the reason curves are sloped the way they are, and how to shift each one).
  • Know the difference between the nominal and real interest rate and how inflation affects borrowers and lenders.
  • Know the relationship of imports/exports and capital inflows/capital outflows in foreign exchange market equilibrium (and how trade deficits and surpluses affect the relationship).
  • Know the Aggregate goods/services market:
    • The axis labels.
    • Why curves are sloped the way they are.
    • Short-run equilibrium.
    • Long-run equilibrium.