Four main markets in the economy: 1) market for final goods and services, 2) market for resources/inputs (labor mkt.), 3) market for financial assets (stocks, bonds, credit, loanable funds) and 4) foreign exchange.
In Ch 7 and 8, we looked at how to measure econ performance - GDP, real GDP, inflation, un rate, etc. We will now look closer at econ performance and study the factors that influence econ performance. We will develop a macro model of the economy using the concepts of Aggregate Demand and Aggregate Supply, the D and S conditions for the aggregate, or entire (macro) economy.
To start, let's define some basic concepts:
1. Fiscal policy - conducted by Congress and the President. Involves tax policy, spending policy, regulations, social security, Medicare, etc. Fiscal policy is the activity of Congress and President as they try to stabilize and regulate the economy, to promote national goals like economic growth, low un, etc.
2. Monetary Policy - conducted by the Federal Reserve or central bank of the country. The Fed controls the money supply and attempts to stabilize the price level. It can influence the money supply directly, and interest rates, ex-rates indirectly, price level, inflation, economic growth indirectly.
3. Money supply - most narrow definition of money is M1. Cash, checking accounts and traveler's checks, only counts money items that can be used to make final payment for goods and services. Doesn't count money in savings accounts for example, since those funds can't be used directly for final payment.
To simplify our Macro model of the economy, we will first
assume that fiscal policy and monetary policy are fixed or constant and
the MS is fixed. Simplifies the model, allows us to concentrate on the
economy without considering the influence of policy changes. After
setting up the basic model, we will come back and investigate fiscal policy
and monetary policy in later chapters.
4 KEY MARKETS: RESOURCES, LOANABLE FUNDS AND GOODS/SERVICES
Exhibit 8-1 on page 202 shows graphically the circular flow of income in the economy. There are four S/D diagrams representing the four key markets. We also assume that there are 3 units in the economy - households (Consume), businesses (Invest) and governments (Govt. Spending).
Resource markets - labor, land, inputs, natural materials, raw materials, physical capital, etc. Households supply all resources in the economy to businesses and governments - labor, land, and capital in the form of the supply of credit. All resource payments flow to households in the bottom of the graph in the form of wages, rents, interest and dividends.
Business spending is in three forms:
1) investment expenditures on final goods and services
(I in GDP),
2) taxes and
3) resource payments. Resource payments are equal to National Income.
The S/D at the top represents GDP - the market for goods and services. Notice that the four arrows leading into GDP are C + I + G + net X. This is also called the Aggregate Demand for final goods/services.
Also, notice that National Income to households can only go to: C + S + T. After taxes have been paid, we have disposable income. Disposable Income can only go to C and S. Savings = deferred consumption.
Household savings go into the Loanable Funds Market, Credit Market, Stock Markets, Banks, etc. Loanable funds go for Business Borrowing and Govt. Borrowing. The price of loanable funds is the interest rate. The interest rate coordinates borrowing and lending activities. Equilibrates S and D for loanable funds.
Notice: that the Govt. gets revenue from three sources: Taxes from Business, Taxes from Households, and Borrowed funds from the Credit Market. Remember: there is no such thing as government money.
The upper right hand side represents the international trade sector of the economy - Exports and Imports, which creates a demand for foreign currency. To buy German products, you first have to buy DM. Also, notice that funds flow between the Foreign Exchange Market and the Loanable Funds Market, reflecting that some of our savings gets invested overseas, and also some foreigners invest in the U.S., supply credit/loanable funds to the U.S. Investment capital flows into and out of the U.S. economy.
Remember from Chapter 7, GDP can be measured by spending
on final goods or by the income received to produce the final goods (GDI).
The top loop on p. 202 represents GDP measured by the Expenditure Approach,
and the bottom loop represents GDP measure by the Resource Cost-Income
AGGREGATE DEMAND FOR GOODS AND SERVICES -
We now focus on the market for aggregate goods and services. Probably the most important market - directly related to the health of the economy and our standard of living. We use standard S and D analysis, but now our quantity and price variables are different than before.
The Quantity variable is Real GDP on the horizontal axis (p. 204), which is the amount of domestically produced goods and services during a period. The Price variable is the Aggregate Price Level (vertical axis), the average price level for all goods and services using either the GDP Deflator or CPI.
Aggregate Demand (AD) is the total demand for domestic
goods and services by Consumers, Businesses, Governments and Foreigners
(GDP). AD (GDP) slopes downward and represents the different amounts of
real GDP that purchasers are willing to buy at different price levels.
Why does the AD curve slope downward? 3 reasons:
1. Real Balance Effect - as the price level increases, the purchasing power of money declines. When the price level decreases, the purchasing power of money increases. There is an inverse relation between real wealth and the price level. We assume that you are holding some of your wealth in the form of cash. If you have $20,000 under your mattress, or in the bank, and prices double, the value of your cash decreases by 1/2. You are worse off and would reduce your spending, a negative wealth effect. If all prices are cut in half, your cash is now worth twice as much. Because lower price levels increase the value of wealth in the form of cash holdings, you spend more when price levels fall because of the positive wealth effect. This contributes to an inverse relationship between the Price Level and Real GDP.
2. Interest Rate Effect - When the price level falls, people and businesses don't need as much cash to carry out transactions. Disposable income can only go to C + S. If C goes down because prices are falling, people will Save more. When the supply of savings goes up, there is downward pressure on int. rates.
Lower int. rate stimulate the economy - consumers will buy more interest-sensitive goods like cars and furniture, appliances, etc. that require financing. Businesses will increase spending on property, plant and equipment when int. rates are low. Int. rate effect contributes to the downward slope of the AD.
Sequence of events: Price level falls, savings increases, interest rates fall, real GDP increases. Result: inverse (neg.) relation between P and Q (real GDP).
3. International-Substitution Effect - If domestic prices fall, US goods will now be cheaper for Americans and foreigners. If U.S. prices are falling and other countries' prices are staying the same, it is as if their prices are rising, relative to ours. Imports (M) will decline and exports (X) will increase.
Americans will buy more domestic products and fewer foreign products (M falls). Foreigners will buy more U.S. products (X rises) and fewer of their own products. Real GDP will expand as Net Exports increases. X goes up, M goes down. (X-M) goes up. GDP goes up.
See Thumbnail Sketch on page 206 for a summary of the 3 effects.
AGGREGATE SUPPLY (AS) OF GOODS AND SERVICES
AS curve is the relationship between the Price Level (P) and Real Output (Q). For AS, we distinguish between two situations: the AS in short-run, SRAS; and the AS in the long-run, LRAS.
SRAS slopes upward because an unanticipated, or surprise increase in the general price level will generally increase the profitability of firms and they will expand output. See page 207. When the price level is expected to be P100, output will be at a normal level, Y0, and firms will earn a "normal" profit and "normal" rate of return.
At P105, why will output increase to Y1? Short-run profitability is enhanced. Profit per unit is equal to Price per unit - Cost per unit (Profit = Retail Price - Cost of Production). We assume that the firm's Retail Price is more flexible in the short run than its Cost of Production. Why?
Producer costs of production will be fixed in the short run by long-term contracts previously entered into - firm has fixed its interest rates on loans from banks for the next year, labor costs are pre-determined for years at a time, lease agreements for real estate and equipment are generally agreed upon for years, firm has negotiated contracts with its suppliers for parts, raw materials, etc. Those costs of production were set and pre-determined for a year or more, based on an Expected Price level of 100. If the firm can easily raise its Retail Price to the new higher price level of 105, and is locked into Costs of Production at the expected P of 100, Profits will increase and induce the firm to expand output.
An unexpected reduction in the price level to 95 would have just the opposite effect. Retail prices are more flexible than the costs of production and would adjust downward. Since firms' costs are fixed by long term contracts, profits will decrease and firm will contract output.
LRAS = Long-run AS (see p. 208). In the long-run (LR) after everyone has had sufficient time to adjust to unexpected increase (or decrease) in the price level, all contracts, loans, leases, wages, input prices, etc., would be renegotiated and profits will eventually return to normal. The incentive to temporarily expand (contract) output in the short run (SR) is gone in the long run.
For example, assume prices double, so that retail prices double (quickly), input prices double (slowly), rent doubles, etc.... In the long run, Retail Prices and Costs of Production both adjust to higher prices by the same amount, so unexpected price changes CANNOT expand output beyond YF (full employment rate of output) in the long run. YF = Potential GDP = Output at Full Employment = Full Capacity Output.
The economy's full output level in the LR is determined by real factors like the supply of resources, the level of technology, the size of the labor force, education level of labor force, demographics, institutional/legal/political arrangements, all factors that are unaffected by changes in the price level.
POINT: In the long run the price level (nominal variable) can't affect real output. Think of the PPF - it is not influenced by the price level. A higher or lower nominal price level can't help an economy expand permanently, since the Price Level is ultimately determined by the number of green pieces of paper (dollars) circulating in the economy. How could there be more jobs or more computers in the LR just because there was $1T of money instead of $.5T? Hint: the factors that shift out PPF are the same factors that shift out LRAS.
See Thumbnail Sketch, page 209.
EQUILIBRIUM IN THE GOODS AND SERVICES MARKET
Equilibrium = balance between S and D, resulting in Market Clearing at a price of P*, and AD=AS. See page 209, the macro market clears at P*, no shortages, no surpluses.
If Price Level (P) is below the equilibrium P*, then AD
> AS. Upward pressure on Price Level, to P*.
If Price level is above equilibrium P*, AS > AD. Downward pressure on Price Level, to P*.
Equilibrium in LR - Two conditions:
1. Price level adjusts to P* to bring AD=AS.
2. Buyers and sellers must be happy with their choices, which happens when the Actual Price Level (Pa) = Expected Price Level (Pe).
Example: suppose buyers and sellers, workers and employers, lenders and borrowers, etc. expect a Price Level of 100 and then enter into contracts and agreements based on that expected Price Level. As long as the actual price level turns out to be 100, there is no incentive to change or modify agreements. If the actual price level turns out to be higher (or lower) than expected, then some parties will be affected adversely and will want to renegotiate , modify or alter the contracts.
See page 210. P100 is expected. As long as Pa = 100, there will be full output at YF.
The only way to deviate from YF and have Y > YF or Y < YF is to have an actual price level other than 100.
At P>100, Y > YF.
If P<100, Y < YF.
YF = Full Output = Potential GDP = Maximum sustainable output consistent with resource base, current technology, institutional structure (prop rights, legal framework, regulations, etc.). Reflects the normal operation of markets. Full employment output, natural rate of un (frictional + structural). No cyclical unemployment. Actual un rate = natural rate.
For LR equilibrium, Output will at full potential
full employment is achieved at the natural rate of unemployment.
What happens when the actual Price Level is higher than expected? Pe = 100 and Pa = 105. Real wages fall (making workers worse off, retail prices rise unexpectedly by 5% and wages are the same), real interest rates fall, real input prices fall, so that profit margins increase and output expands, and actual Un Rate < Nat Rate, Y > YF. However, this increased output is not sustainable in the LR since no real factors (technology, productivity, etc.) have changed that would allow a permanent increase in output. As labor contracts, interest rates and resource prices adjust, profits return to normal, un rate returns to natural rate, output returns to normal, etc., LR equilibrium prevails eventually.
What if actual P < P expected? Deflation, or inflation
lower than expected. In that case, real wages are higher than expected
(retail prices fall and workers wages remain the same), profits fall, output
contracts, workers are laid off. Y < YF, Un Rate > Nat Rate.
Example: Recession of 1982 was caused because prices were lower than expected (Pa < Pe). Inflation was 13% in 1979 and 12% in 1980, then fell to 4 percent in 1982, so that actual inflation was less than people expected. Labor contracts had factored in 10-12% wage increases, assuming inflation was going to continue at the past rate. Since actual inflation was only 4%, real wages turned out to be much higher than expected, producers couldn't raise retail prices as fast as they thought. Profits fell, output fell, workers were laid off, economy went into a recession, Un Rate was almost 11%. Wages are "sticky" - take time to adjust.
Conclusions: 1) Economy operates at maximum
capacity/output (YF) as long as there is no unexpected inflation/deflation
2) Price level stability is critical for full output/full employment.
3) Unexpected increases in the Price Level temporarily expand output.
4) Unexpected decreases in the Price Level temporarily contract output.
In general, the resource market is the market for all inputs to production - labor, raw materials, machinery, etc. Firms demand resources to produce goods and services. Main resource market is labor market - 70 percent of production costs is labor. S and D for resources work like before - Law of Demand/Supply. See page 213. Households supply labor or other resources (land, capital) in exchange for income. Producers (businesses) demand resources to produce final products.
Demand for resources/labor/inputs is a DERIVED DEMAND, meaning that the real demand is the demand for final goods and services, and the demand for labor/resources is linked to the demand for final goods. If the demand increases for final goods, the demand will increase for resources to supply those goods. If the demand for college education increases, the demand for professors will increase.
Equilibrium in Resource Markets:
When the macroeconomy has settled into LR equilibrium, the Retail Prices
for final products relative to the Resource Prices will be such that Producers
will earn a normal rate of profit/return (in economic terms, economic profits
= 0) and will have no incentive to expand or contract output. If
resource prices are low relative to retail prices, output would expand.
If resource prices are high relative to retail prices, output would contract.
LOANABLE FUNDS MARKET -
Coordinates the actions of borrowers and lenders. Borrowers - Demanders of Credit. Lender/Savers - Suppliers of Credit. Diagram - page 215.
Households are net suppliers of credit/loanable funds, Households are savers and supply credit to the credit markets. Businesses and governments are net demanders of credit. Business borrowing and government borrowing. Financial intermediaries (banks/brokers) act as middlemen.
Borrowers demand credit to get control of resources/purchasing power now in return for repayment later, including interest. Interest = rental rate on money. We borrow against future income, as individuals or as a business. Borrowing allows us to escape the constraint of having to live within our current income. We can convert future income into purchasing power today. Allows us to transfer future wealth into a purchase today, so that we can spend future income today. We willingly agree to pay a rental charge for our impatience, the privilege of having access to our future income.
Savings allows us to transfer our current income/purchasing power into the future. Savings = deferred consumption. We get paid interest to defer consumption. Compensation for our frugality and thrift.
Credit markets give us a higher standard of living. We
can escape the constraints of time. Interest rates equilibrate the
market for loanable funds, bring about market clearing in the credit markets.
Interest Rates - Money/Nominal vs. Real Interest Rates
Nominal interest rate = Stated or quoted interest rate in paper.
Example - 30 year mortgage rate is 5.5%, the one year T-bill rate is 1.5%, the two year CD rate is 1.75%, the 3 year rate for car loans is 4%, etc., these are all nominal (money) interest rates (R). The nominal interest rate has two components: Real rate (r) + Inflation Premium (INFe).
Example: Inflation is expected to be 5% over the next year. You borrow $100 from the bank, pay it back in one year. All prices are 5% higher next year. If the interest rate charged by the bank was 5%, the bank would just break even, they wouldn't make any money on the loan and its real return would be zero.
If the nominal interest rate charged was 8% when expected inflation was 5%, then 5% would compensate the lender for inflation (loss of purchasing power) and the real rate of interest would be 3%.
Formula: Nominal Int. Rate (R) = Real Rate (r) + Inflation Premium (INFe) or
Real Interest Rate (r) = Nominal Rate (R) - Inflation (INFe).
Fixed nominal interest rates don't change, for example: 30 year fixed rate mortgage at 6%, based on expected inflation of 4%, real rate would be 2%. If actual inflation is greater than expected (5%), the real rate is lower than anticipated (1%). If actual inflation is less than expected (1%), the real rate is greater than expected (5%). Explains the trouble that S&Ls had in the 1970s and 1980s. They had given out millions of dollars of 30 year fixed rate mortgages at 6% in the 1960s expected inflation to remain at about 3-4% giving them a 2-3% real rate of return. Inflation started rising in the 1970s to 6%, giving them a real return of 0%, and then inflation reached almost 16%, given them a negative real return of -10% (6% - 16% = -10%). It was a great deal for the borrower, but a terrible deal for banks - over 1000 S&Ls failed in the 1980s because of this problem - falling and negative real rates of interest.
Summary (assumes fixed nominal rate, doesn't apply to variable, adjustable rates) :
1. When actual inflation is greater than expected, the real rate of interest falls, benefits debtors (borrowers), hurts lenders (savers).
2. When actual inflation is less than expected, the real rate of interest rises, hurts debtors (borrowers), helps lenders (savers).
3. When the actual rate of inflation is greater than the nominal interest rate, the real return is negative.
Inflation benefits debtors when: 1) debt has fixed nominal rate and 2) actual inflation is greater than expected, see p. 216.
Helps explain why unanticipated inflation expands output,
upward sloping SRAS. Higher than expected inflation lowers real interest rates,
helps producers, who are net borrowers. Lower real interest rates reduces the
real cost of borrowing, increases profits, expands output.
FOREIGN EXCHANGE MARKET
International transactions for foreign a) goods and b) financial assets creates a demand for foreign currency to buy those foreign goods and assets. When Americans buy foreign products or invest in foreign countries, that creates a demand for foreign currency. When foreigners buy American products or invest in U.S., that creates a demand for U.S. dollars and creates a supply of foreign currency. Based on the interactions of Supply and Demand in the foreign exchange market, the dollar will either appreciate (strengthen) or depreciate (weaken). When the dollar appreciates, the foreign currency depreciates.
If the demand for U.S. products (exports) increases, that will appreciate the $ and depreciate the foreign currency. If the demand for foreign products (imports) increases, that will appreciate the foreign currency and depreciate the $. The ex-rate will adjust to bring about equilibrium in the Foreign Exchange Market, see page 237.
Also, there is a link between the ex-rate, trade flows and capital flows. When the foreign exchange market is in equilibrium, then the following relationship exists:
IMPORTS (M) + CAPITAL OUTFLOW (Investments abroad) = EXPORTS (X) + CAPITAL INFLOW
IMPORTS (M) - EXPORTS (X) = CAPITAL INFLOW - CAPITAL OUTFLOW
When there is a TRADE DEFICIT (M > X), then there is a
Net Capital Inflow, and when there is a TRADE SURPLUS (X > M), then there
is a Net Capital Outflow. For the U.S., the Trade Deficit was about $500B (page 173) in
2002, meaning that there was a $500B Capital Inflow.
In essence, we bought $500B more of foreigners' products than they bought
of ours, and foreigners bought $500B more of our financial assets than
we bought of theirs. We had a trade deficit of $500B that was exactly
offset by a "capital surplus" of $500. The trade account and the
capital account together make up the Balance of Payments accounts, which
is always 0 (BP = -$500B trade deficit + $500B capital surplus = 0).
Equilibrium in Our 4 Market Macro Model
Four basic markets from our circular flow model - AD/AS (GDP), Resource Markets (National Income), Loanable Funds/Credit, and Foreign Exchange.
Long run equilibrium means that each of the four macro markets is in equilibrium. Means that there is a balance and that buyers and sellers are willing to continue with the present arrangements. Long run equilibrium is a point that the real economy may never get to, it is always moving towards equilibrium, but equilibrium is a moving target. Certain industries are expanding and others are contracting, reflecting the dynamic nature of the economy.
Equilibrium in the economy is like equilibrium in nature, a constant evolutionary process. Even if the economy never reaches static equilibrium or if it gets there but doesn't ever stay there very long, it is still very important to understand how the market forces of supply and demand are constantly moving and pushing the economy in the direction of equilibrium. Since the economy is always gravitating towards equilibrium, it is important and useful to understand the direction the economy is moving.
Questions 4, 5, and 8