CHAPTER 9  
 Basic MacroEconomic Markets

BACK

UNIT THREE

NEXT

  I.         Understanding Macroeconomics: Our Game Plan

                A.    As a basic macroeconomic  model is developed, we will assume that:

                        1.        Money Supply is constant

                        2.        Taxes and expenditures are constant

                B.        Thus, there is a circular flow of output and income between these two key sectors: businesses and households.

II.       Four Key Markets—Resources, Goods and Services, Loanable Funds And Foreign Exchange Markets Coordinate the Circular Flow of Income

                A.        Goods and Services Market: In this market, businesses supply goods and services in exchange for sales revenue. Households, investors, governments, and foreigners (net exports) demand goods.

                B.        Resource Market: Highly aggregated market where business firms demand resources because of their contribution to the production of goods and services and households supply labor and other resources in exchange for income.

C.       Loanable Funds Market: Coordinates the actions of borrowers and

         lenders.

                D.        Foreign Exchange Market: Coordinates the actions of Americans demanding foreign currency in order to buy things from foreigners and foreigners supplying foreign currencies in exchange for dollars so they can buy things from Americans.

        III.   Aggregate Demand for Goods and Services

                A.        Aggregate demand curve indicates the various quantities of domestically produced goods and services that purchasers are willing to buy at different price levels.   

                B.    AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods and services demanded and the price level.

                C.  Why Does the Aggregate Demand Curve Slope Downward?

                        1.                A lower price level will increase the purchasing power of the fixed quantity of money.

                        2.                The Interest Rate Effect: a lower price level will reduce the demand for money and lower the real interest rate, which will stimulate addition purchases during the current period.

                        3.                Other things constant, a lower price level will make domestically produced goods less expensive relative to foreign goods.

        IV.   Aggregate Supply of Goods and Services

                A.        When considering the AS curve, it is important to distinguish between the short run and the long run.

                        1.                Short run: time period during which some prices, particularly those in labor 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.

                        2.                Long run: a time period of sufficient duration that people have the opportunity to modify their behavior in response to price changes.

        V.    Short-Run Aggregate Supply (SRAS)

                A.        Indicates the various quantities of goods and services that domestic firms will supply in response to changing demand conditions that alter the level of prices in the goods and services market.

                B.        SRAS curve slopes upward to the right.

                C.    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.

        VI. Long-Run Aggregate Supply (LRAS)

                A.        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.

                B.        LRAS curve is vertical.

                C.        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.

        VII. Equilibrium in the Goods and Services Market

                A. Short-run Equilibrium

                        1.                Short-run equilibrium is present in the goods and services market at the price level (P) where the aggregate quantity demanded is equal to the aggregate quantity supplied.

                        2.        Occurs at the output rate where the AD and SRAS curves intersect.

                        3.                At the market clearing price, the amount that buyers want to purchase is just equal the quantity that sellers are willing to supply during the current period.

                B.        Long-run Equilibrium

                        1.                A second condition is required for long-run equilibrium: the buyers and sellers must have correctly anticipated the consequences of their prior choices.

                        2.                Thus, long-run equilibrium requires that decision makers who agreed to long-term contracts influencing current prices and costs must have 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.

                C.        When Long-run Equilibrium is present:

                        1.                Potential GDP is equal to the economy s maximum sustainable output consistent with its resource base, current technology, and institutional structure.

                        2.        Economy is operating at full employment.

                        3.        Actual Rate of Unemployment = natural rate of unemployment

                D.         Disequilibrium: Adjustment When Output Differs from Long‑Run Potential

                        1.                An unexpected change in the price level (rate of inflation) will alter the   rate of  output in the short run.

                        2.                 An unexpected increase in the price level will stimulate output and employment during the next year or two.

                        3.                An  unexpected decline in the price level will cause output and employment to fall in the immediate future.

                VIII. Resource Market

                        A.                The demand for resources: Business firms demand resources because they contribute to the production of goods the firm expects to sell at a profit.

                        B.        The demand for resources slopes downward to the right.

                        C.                The supply of resources: Households supply resources in exchange for income.

                        D.                Higher wages increase the incentive to supply resources; thus, supply curve slopes upward to the right.

                        E.                The equilibrium or market clearing price brings the amount demanded by business firms into balance with the amount supplied by resource owners.

                IX.        Loanable Funds Market

                        A.        Interest rate coordinates the actions of borrowers and lenders.

                        B.                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.

                        C.  Money and real interest rate

                                1.        When inflation rate 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.

                                2.        This premium for the expected decline in purchasing power of the dollar is called the inflation premium.

                        D. Real interest rate = Money interest rate - Inflation premium

                X.         Foreign Exchange Market         

                        A.                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. 

                        B.                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.

                        C.                The exchange rate will bring the quantity of foreign exchange demanded into equality with the quantity supplied.

                XI.        Leakages and Injections From the Circular Flow of Income 

A.     When the exchange market is in equilibrium, the follow relationship exists:

1.                imports + capital outflow = exports + capital inflow                

B.      Because net capital inflow is capital inflow minus capital outflow, the above equation can be rewritten as:

1.                imports - exports = net capital inflow

                        C          Equilibrium in Loanable Funds Markets implies:

                                1.     net saving + net capital inflow = investment + budget deficit

                        D.                Substituting the left side of Equation in B above for net capital inflow in equation in C above yields:

                                1.     net saving + imports - exports = investment + budget deficit

                        E.                 Because the budget deficit is government purchases minus taxes, the Equation in D can be rewritten as:

                                1.                net saving + imports - exports = investment + government purchases - taxes

                        F.         The equation in E can be rewritten as:

                                1.     net savings + imports + taxes = investment + government                                                 purchases + exports

                        G.                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.