Chapter 8 - Introduction to Basic Macroeconomic Markets

Quote - "Macro.... Those essentials lie in the interactions among the goods, labor and asset markets of the economy."

Three main markets in the economy: 1) goods and services, 2) labor/resources and 3) financial assets (stocks, bonds, credit, loanable funds, etc.).

In Ch 6 and 7, we look 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 S and D conditions for the aggregate, or Macro economy.

To start, let's define some basis concepts:

1. Fiscal policy - conducted by the Congress and President. Involves tax policy, spending policy, regulations, etc. Activity of Congress and President to try to stabilize and regulate the economy. Promote growth, low un.

2. Monetary Policy - conducted by the Federal Reserve or central bank. They control the money supply and attempt to stabilize the price level. They can influence the money supply directly, and int rates and ex-rates indirectly.

3. Money supply - narrow definition - M1. Cash, checking accounts and traveler's checks.

To simplify our model, we will first assume that fiscal policy and monetary policy are fixed or constant. MS is fixed. Simplifies the model, allows us to concentrate on the econ without the influence of policy changes.

3 KEY MKTS:RESOURCES,LOANABLE FUNDS AND GOODS/SERVICES

Exhibit 8-1 on page 193 shows graphically the circular flow of income in the economy. There are three S/D diagrams representing the three markets. There are also three units in the economy - households (C), businesses (I) and governments (G).

Resource markets - labor, land, physical capital. Households supply all resources in the economy to businesses and governments - labor, land, 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 can only go to: C + S + T. After taxes have been paid, we have disposable income. Disp Inc 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 int rate coordinates borrowing and lending activities. Equilibrates S and D for loanable funds.

Notice: that the Govt gets taxes from two sources: Business and Households. Remember: there is no such thing as government money!

The upper right hand side represents the trading sector of the economy - Exports and Imports.

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 - the amount of domestically produced goods and services during a period. The Price variable is the aggregate Price Level, or the average price level for all goods and services, like GDP Deflator or CPI.

Aggregate Demand (AD) is the total demand for domestic goods and services by Consumers, Businesses, Governments and Foreigners. AD slopes downward and represents the different amounts of real GDP that purchasers are willing to buy at different price levels.

The AD is different than a D curve for single good for two reasons:

1. Demand for McDonald's hamburgers slope down due to substitution - if the price of McDonald's hamburgers double, people buy less and substitute toward other goods - Burger King, Taco Bell, make your own, etc. If the ENTIRE price level falls, then the price of all goods falls equally, so there is no substitution in the AD model.

2. When the demand curve is derived for a single good, we assume that real income is held constant and look at the effect on demand of a price change. For the AD model, real income changes as we move along the curve.

Why does the AD curve slope downward? Three reasons:

1. Real Balance Effect - as 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 $2000 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. Neg 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 pos wealth effect.

2. Int 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. If the supply of savings goes up, there is downward pressure on int rates. See graph on board.

Price level goes down, savings goes up, int rates fall. 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.

3. International Substitution - If domestic prices fall, US goods will now be cheaper for Americans and foreigners. And if our prices are falling and other countries' prices are staying the same, it is as if their prices are rising, relative to ours. Imports will decline and exports will increase. Americans will buy more domestic products and fewer foreign 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 198 for a summary of the three effects.

AGGREGATE SUPPLY (AS) OF GOODS AND SERVICES

AS curve is the relationship between the price level and real output.

For AS, we have two situations: AS in short-run, SRAS; and the AS in the long-run, LRAS.

SRAS slopes upward, but again not for same reasons as for supply curve for an individual good. All prices rise and fall, so the relative prices are staying the same.

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 199. When the price level is expected to be P100, output will be at a normal level, Yo and firms will earn a normal profit.

At P=105, why will output be at Y1? Short-run profitability is enhanced. Profit per unit is equal to Price/unit - Cost/unit. We assume that the firm's price/unit is more flexible than its cost/unit.

Producer costs will be fixed in the short run - int rates on loans, labor costs/contracts, lease agreements for real estate and equipment, suppliers, etc. Those costs were set and pre-determined for a year, based on an expected Price level = 100. If the firm can easily raise its retail price to the new higher price level of 105 and is locked into costs at the expected P=100, profits will increase and firms will expand output.

An unexpected reduction in the price level would have just the opposite effect. Retail prices are more flexible and would adjust downward and firms would be locked into long term contracts.

Caution: SRAS relies somewhat on "money illusion." Confusion of nominal and real variables. Also: possible stagflation. Also: producers confuse a demand for all products for an increased demand for their product. Potential for malinvestment.

LRAS = long-run AS. In the long-run after everyone has had sufficient time to adjust to unexpected increases in the price level, all contracts, wages, input prices, etc., profits will return to normal. The incentive to temporarily expand output is gone in the long run.

For example, retail prices double, input prices double, rent doubles, etc.... In the long run, unexpected price changes cannot expand output beyond Y_f, potential GDP, or full production output, output produced when un is at the nat rate.

The economy's full output level 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 the factors that are insensitive to changes in the price level. In the long run the price level doesn't affect real output. Think of the PPF - it is not influenced by the price level. A higher price level can't help an economy expand permanently.

See Thumbnail Sketch, page 202.

Equilibrium = balance of S and D. Market Clearing. AD=AS. See page 203.

If Price Level is below equilibrium. AD > AS. Upward pressure on Prices.
If Price level is above equilibrium. AS > AD. Downward pressure on Prices.

Equilibrium in LR - Two conditions:
1. Price level adjusts to bring AD=AS.
2. Buyers and sellers must be happy with their choices. Expected Price Level = Actual Price Level.

If buyers and sellers expect a price level of 100 and the price level turns out to be 100, there is no incentive to change or modify agreements.

See page 204. P=100 is expected. As long as P=100, there will be full output at Y_f. Output is at LRAS and SRAS.

The only way to deviate from Y_f and have Y > Y_f or Y < Y_f is to have an actual price level other than 100.

At P>100, Y > Y_f.
If P<100, Y < Y_f.

Y_f = 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, nat rate of un (frictional + structural). No cyclical unemployment. Actual un rate = nat rate.

LR equilibrium, Output will at full potential, full employment achieved, nat rate of un. (4.5-6.5% estimated, page 206)

What happens when prices are higher than expected? Real wages fall, profit margins increase output expands and un < nat rate, Y > Y_f. As labor contracts, int rates and resource prices adjust, un returns to nat rate, output returns to normal.

What if actual P < P expected? Deflation, or inflation lower than expected. In that case, real wages are higher than expected, profits fall, people are laid off. Y < Y_f, un > nat rate.

Recession of 1982 - prices were lower than expected. Inflation was 13% in 1979 and 12% in 1980, then fell to 4 percent in 1982. This was less than expected. Labor contracts had factored in 10-12% wage increases, assuming inflation was going to continue at the past rate. Real wages turned out to be higher than expected, producers couldn't raise retail prices as fast as they thought. Profits fell, output fell, un rate was almost 11%. Wages are "sticky" - take time to adjust.

Conclusion: Economy operates at maximum capacity/output as long as their as there is no unexpected inflation/deflation. Point: price level stability is necessary for full output.

We have so far discussed the aggregate market for final goods/services. The two other macro markets that are important are: resource market and loanable funds market.

RESOURCE MARKET -

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. Substitutes.

See page 208 - diagram.

Demand for resources/labor 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.

LOANABLE FUNDS MARKET -

Coordinates the actions of borrowers and lenders. Borrowers - Demanders of Credit. Lender/Savers - Suppliers of Credit. Diagram - page 211.

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 act as middlemen/brokers.

Borrowers demand credit to get control of resources/purchasing power now in return for repayment later, including interest.

Interest = rental rate on money. 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. 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 Int Rate.

Nominal int rate = stated or quoted int rate in paper.

Example - 30 year mortgage rate is 9% or the one year Tbill rate is 5%. The nominal int rate has two components: real rate + inflation premium.

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. The real return would be zero.

If the nominal interest rate charged was 8%, then 5% would compensate the lender for inflation and the real rate would be 3%. If inflation was 0% then the nominal rate charged would be equal to the real rate.

Formula: Nominal Int Rate = Real Rate + Inflation Premium or

Real Interest Rate = Nominal Rate - Inflation.

Assume about a two percent real interest rate on average.

Nominal rates can't be changed, example: 30 year fixed rate mortgage at 6%. If actual inflation is greater than expected, the real rate is lower than anticipated. Inflation benefits debtors if: 1) fixed rate debt and 2) actual inflation is greater than expected. See Myths page 210 - "inflation benefits debtors."

Example: 1970s.

Helps explain why unanticipated inflation expands output, upward sloping SRAS. Higher than expected inflation lowers real int rates, helps producers, who are net borrowers. Lower real int rates reduces the real cost of borrowing, increases profits, expands output.

Equilibrium in Our 3 Market Macro Model

Three basic markets from our circular flow model - AD/AS (GDP), Resource Markets (National Income), and Loanable Funds/Credit. See page 213.

Long run equilibrium means that each of the three 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 never gets to. Moving towards, but it is a moving target. Certain industries are expanding and others are contracting, reflecting the dynamic nature of the economy.

Equilibrium in the economy would be like equilibrium in nature. Constant evolution.

Questions 4, 5, 8 and 9

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