CHAPTER 8. MACROECONOMIC SUPPLY AND DEMAND

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1 CHAPTER 8. MACROECONOMIC SUPPLY AND DEMAND There are four markets of primary interest to macroeconomics: Product, Credit, Labor, and Foreign Exchange. Each can be modeled using supply and demand. For each market we therefore need to: 1. define the quantity variable and how it is measured 2. define the price variable how it is measured 3. get a list of the Supply and Demand shifters Although all four of the markets will use standard supply and demand analysis, the concepts of price, quantity, demand and supply have names and interpretations that are specific to each market. What follows is a description of the particular details of each of the four markets. In the descriptions below, pay special attention to the notation and symbols that are introduced. MARKET PRODUCT (PrM) CREDIT (CrM) LABOR (LaM) FOREIGN EXCHANGE (FxM) Price Price Level (P) or Inflation Rate (p) Interest Rate (i) Wage Rate (W) Or Wage Growth (w) Exchange Rate (e) Quantity Real GDP (Q) or Real Growth Rate (q) Credit Used (Z) or Spending (AD,X) Employment (N) or Employment Growth (n) Dollars Traded ($) Demand Supply AD AS B L D L D $ S L S $ p p 0 The Product Market AS THE PRODUCT MARKET The quantity in the product market is the quantity of all goods and services bought and sold in the economy. This is measured by (the rate of change of) real gross domestic product. The price in the product market is the average price of all goods and services produced as measured by (the rate of change of) a price index, such as the consumer price index (CPI). q 0 AD q Demand Shifters -- Changes of Spending (x) due to: 1. money supply and interest rates 2. budget deficit 3. spending changes by households, businesses or foreigners. Supply Shifters -- Changes of Production Costs due to: 1. wages 2. energy (oil) costs 3. technology and worker productivity 4. other costs of production (business taxes, regulation) CHAPTER 8. Macro Supply and Demand Page 1 Macroeconomics, Kvaran

2 Demand Shifts and "Crowding Out". The term AD can be used to describe total spending. The equation AD or GDP or X = C + I + G + E is useful for summarizing that changes in spending by any sector of the economy will shift AD either forward or backward. An important possibility should be noted. If changes of the spending of one sector are precisely offset by changes in the spending of another sector, then total spending will not change, and AD does not shift. This scenario is frequently described with the name "crowding out." THE CREDIT MARKET i The Credit Market L The credit market exists to transfer spending power from those who have more than they currently want to those who have less than they currently want. i 0 z 0 z, AD The price in this market is the interest rate -- the price of credit. The quantity variable in the market will be given two interpretations. The most obvious is the quantity of credit transacted -- the number of dollars loaned and borrowed. The symbol Z will be used for this The second interpretation is to think of the quantity in the Credit Market as Total Spending (designated by AD or X). This works for two reasons. First, Z and AD should always rise and fall together. The reason people borrow money is to spend it, so total spending can be expected to always move in the same direction as the use of credit. Second, it makes sense to think of the interest rate as being a price of spending. If one borrows the funds in order to spend them, then the interest rate is clearly a part of the price paid to acquire the commodity purchased. Even if one's own funds are used, the interest rate still constitutes a price in the form of an opportunity cost. The reason for using AD as the quantity variable is that it links the Credit and Product Markets. It shows that changes in the Credit Market (shifts of L or B) will cause changes of total spending (AD). Those changes will then show up in the Product Market as shifts of the AD curve. A. Demand Shifters -- Changes of: 1. government deficit 2. private sector credit demand - investment B. Supply Shifters -- Changes of: 1. money supply 2. savings 3. foreign financial flows B CHAPTER 8. Macro Supply and Demand Page 2 Macroeconomics, Kvaran

3 K I CrM S Deficit MS Fed The Circular Flow diagram provides a convenient way to picture the Credit Market curve shifters. The arrows leading in to the market are the Supply (Lending) side, the arrows leading out of the market are the Demand (Borrowing) side. The Credit Market w 0 w n 0 S L D L The Labor Market n THE LABOR MARKET The price in the Labor Market is (the rate of change of) the wage rate (W). The quantity is (the rate of change of) employment (N) Note that businesses are the demand side of the market while households are the supply side -- precisely the reverse of the case in the product market. A. Demand Shifters -- Changes of: 1. Real GDP 2. labor productivity B. Supply Shifters -- Changes of: 1. willingness of the population to work 2. size of labor force 3. expected inflation THE FOREIGN EXCHANGE MARKET e 0 e S $ There is an extensive international market in which the currencies of different nations are traded -- the Foreign Exchange Market. We will describe the buying and selling of dollars. $ 0 D $ $ The price of the dollar in terms of another currency (e.g. "pesos per dollar") is known as the exchange rate. In this class, the exchange rate will always be thought of as the price of a Foreign Exchange Market dollar in terms of another currency (e.g. "yen per dollar"). Thus a high exchange rate corresponds to a "strong dollar". The quantity is the number of dollars traded. CHAPTER 8. Macro Supply and Demand Page 3 Macroeconomics, Kvaran

4 A. Demand Shifters -- Changes of: 1. demand for US exports (including tourism) 2. Foreign capital inflows, which depend on: 3. interest rates 4. demand for US physical capital; business profitability B. Supply Shifters -- Changes of: Demand for US imports E FxM F K The Circular Flow Diagram is again helpful for picturing the major curve shifters. The principle demands for dollars are the arrows leading out of the market -- to purchase our exports and to create capital inflows (largely influenced by interest rates). The principle supplier of dollars to the world is our imports. Foreign Exchange Market Important Curve shifters in the four macro markets PrM CrM Demand Supply Demand Supply Money Supply Wages (-) Budget Deficit Money Supply Budget Deficit Oil Prices (-) Investment Saving Technology/Productivity Kf LaM FxM Demand Supply Demand Supply Q (real GDP) Size of Labor Force Interest rates (Kf) Imports Worker Productivity Exports Note: the notation (-) means that an increase of that variable shifts the curve to the left and a decrease of the variable shifts the curve to the right. CHAPTER 8. Macro Supply and Demand Page 4 Macroeconomics, Kvaran

5 MONETARY AND FISCAL POLICY The workings of the macro markets can be demonstrated by showing the short-run responses of the system to changes of monetary or fiscal policy. This section will show how changes in the money supply and the government's budget deficit impact on the credit and product markets. This will produce predictions on the behavior of interest rates, credit used, aggregate demand, prices, and production. One point should be made explicitly. In the short run, both monetary and fiscal policy shift aggregate demand; neither policy affects aggregate supply. Monetary Policy The graphs below illustrate the credit market and product market responses to an increase of the money supply. Starting in the credit market, an increase of the money supply is shown as a rightward shift of L -- an increase of loanable funds. Interest rates fall and credit use increases. The inclusion of AD as the credit market quantity variable -- which has increased -- indicates that the rise in credit use, and lower interest rates, will cause a rise in spending. AD will shift up in the product market, causing both price and output to rise. An Increase of the Money Supply Credit Market Product Market i L 0 L 1 p AS p 1 i 0 p 0 i 1 AD 0 AD 1 B Z, AD q 0 q 1 AD 0 AD 1 q A decrease of the money supply can be depicted merely by interchanging the 0 and 1 subscripts and reversing the directions of all arrows in the graphs above. Fiscal Policy The graphs below illustrate the effects of an increase of the deficit. Increased borrowing is shown by raised demand in the credit market (B shifts to the right), which raises interest rates, credit use, and aggregate demand. Increased aggregate demand causes higher prices and greater output. CHAPTER 8. Macro Supply and Demand Page 5 Macroeconomics, Kvaran

6 Credit Market An Increase of the Deficit Product Market i L p AS i 1 p 1 i 0 p 0 AD 0 AD 1 B 0 B 1 Z, AD q 0 q 1 AD 0 AD 1 q A decrease of the deficit can be depicted by merely interchanging the 0 and 1 subscripts and reversing the directions of all arrows in the above graphs. Expansionary and Contractionary Policies It is useful to label a policy action as "expansionary" or "contractionary", depending on whether the action increases or decreases aggregate demand. Thus we may speak of "expansionary monetary policy" (an increase of the money supply) or of "contractionary" fiscal policy (a decrease of the deficit). Note that monetary and fiscal policies have basically the same effect in the product market, but have opposite effects on interest rates. Likewise, contractionary monetary and fiscal policies have the same effects in the product market but opposite effects in credit markets. THE FOREIGN EXCHANGE MARKET. Interest rates shift the demand for dollars Events in the economy are capable of having many effects in the foreign exchange market. For our purposes we can zero in on one specific effect. This is the manner in which the foreign exchange market is influenced by interest rates. The interest rate shifts the demand for dollars. That is: i D $ because higher interest rates make dollars more attractive to foreign purchasers of bonds. This would be seen as an increase of foreign financial capital inflows (Kf) as interest rates rise. Using this fact it is possible to trace effects of both monetary and fiscal policy to the foreign exchange market. Monetary Policy A decrease of the money supply will cause higher interest rates and therefore also cause an increase of the demand for dollars in the foreign exchange market. An increase of the money supply would have the opposite effect There is a second significant effect of monetary policy in the foreign exchange market. A decrease of the money supply will decrease the amount of dollars available in the foreign exchange market. This will reduce the dollar supply and raise exchange rates. Note that both the monetary policy effects outlined here have the same impact on exchange rates. CHAPTER 8. Macro Supply and Demand Page 6 Macroeconomics, Kvaran

7 Fiscal Policy An increase of the deficit will raise interest rates and therefore raise the demand for dollars in the foreign exchange market. A decrease of the deficit would have the opposite effect. THE LABOR MARKET. Output in the product market shifts the demand for labor. Greater output requires more workers. Using this fact we can trace the effects of monetary and fiscal policy into the labor market. To do so we first need to find the effect of the policy on output (q) in the product market. From this we can find the effect on the labor market. Monetary Policy MS AD q DL A decrease of the money supply would have the opposite effect. Fiscal Policy DEF AD q DL A decrease of the deficit would have the opposite effect. A shift of demand in the Product Market generally has the same effect on the demand for labor. That is, when the demand for products rises, so does the demand for the labor to make those products. CHAPTER 8. Macro Supply and Demand Page 7 Macroeconomics, Kvaran

8 MONETARY AND FISCAL POLICIES IN THE FOUR MACRO MARKETS PRODUCT MARKET 3. Real GDP (q) shifts the Demand for labor. FOREIGN EXCHANGE 2. CrM tells what happens to Spending (AD, X). Use that to shift Demand (AD) in PrM. CREDIT MARKET 1. Fiscal Policy Shifts Demand (B) in CrM TREASURY LABOR MARKET 4. Interest rates (i) change Demand in FxM. 1. Monetary Policy Shifts Supply (L) in CrM FEDERAL RESERVE Fiscal Policy POLICY Start in the Credit Market Monetary Policy Credit Product Labor Foreign Exchange Monetary Expansion MS Increase Supply i, AD, X X Increase Demand p, q q Increase Demand w, n i Decrease Demand e, $ Fiscal Expansion Deficit Increase Demand i, AD, X X Increase Demand p, q q Increase Demand w, n i Increase Demand e, $ Notice that the effects of both fiscal and monetary expansion are the same in the Product and Labor markets, but different in the Credit and Foreign Exchange Markets. CHAPTER 8. Macro Supply and Demand Page 8 Macroeconomics, Kvaran

2. Why is it important for the Fed to know the size and the rate of growth of the money supply?

2. Why is it important for the Fed to know the size and the rate of growth of the money supply? KOFA HIGH SCHOOL SOCIAL SCIENCES DEPARTMENT AP ECONOMICS EXAM PREP WORKSHOP # 4 > MONEY, MONETARY POLICY, AND ECONOMIC STABILITY NAME : DATE : All About The Ms : 1. What are the three basic functions of