4 pages Intermediate Macroeconomics Project for 5 days

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Models

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Use the loanable funds model to analyze the international capital market.

4.4

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Learning Objective

Different interest rates, different models

Last chapter we developed the money market model to explain short-run nominal interest rates.

In this section we will develop the loanable funds model in order to explain long-run real interest rates.

The latter is more relevant for firms and households making long-lived investments, such as in factories or houses.

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Savings in the loanable funds model

The supply of loanable funds come from savings from three sources: households, government, and the foreign sector:

SHouseholds = (Y + TR – T) – C

SGovernment = T – (G + TR)

SForeign = – NX

Adding these up, we get:

S = SHouseholds + SGovernment + SForeign

Note: Y = National income

C = Consumption expenditure

I = Investment expenditure

G = Government purchases

NX = Net exports

T = Household’s taxes

TR = Transfer payments

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Savings in the loanable funds model

S = SHouseholds + SGovernment + SForeign

As interest rates rise:

SHouseholds rises, as households delay consumption

Sforeign rises: capital flows into the U.S. due to the higher interest rates, increasing the demand for dollars; the $U.S. appreciates, causing exports to fall and imports rise; so NX falls.

Then overall, the supply of loanable funds goes up as the interest rate goes up—the supply of loanable funds is upward-sloping.

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Demand and the market for loanable funds

The demand for loanable funds derives from firms and households borrowing money.

They want to borrow more at lower interest rates; demand is downward sloping.

Demand (investment) and supply (saving) determine the equilibrium long-run real interest rate.

The market for loanable funds

Figure 4.4

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Changes in the demand for loanable funds

The demand for loanable funds will change if any of the following change:

Risk

Taxes on businesses

Expectations about the profitability of business projects

The figure shows the effect of expectations about profitability improving.

An increase in the demand of loanable funds

Figure 4.5

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Changes in the supply of loanable funds

The supply of loanable funds would change if any of the following changed:

Taxes on households

Government expenditure

The desire for households to consume today rather than in the future

National income

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Changes in the supply of loanable funds

A budget deficit, for example, crowds out some investment by decreasing the supply of loanable funds.

Crowding out The reduction in private investment that results from an increase in government purchases

The figure shows the effect of the budget deficit.

The effect of a budget deficit on the market for loanable funds

Figure 4.6

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Summary of the loanable funds model

Table 4.3

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Summary of the loanable funds model - continued

Summary of the loanable funds model

Table 4.3

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The international capital market and the interest rate

Most modern economies are relatively open; so borrowing and lending take place in the international capital market.

The world real interest rate, rW, is the corresponding interest rate.

Loanable funds can be supplied to fund projects in the domestic economy or abroad.

The size of the economy matters; so we will separately consider

Small open economies

Large open economies

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Small open economy

In a small open economy:

The quantity of domestic funds is small relative to foreign funds.

So the economy cannot affect the world real interest rate.

The difference between the domestic loanable funds demanded and supplied is made up by international lending or borrowing.

Determining the real interest rate in a small open economy

Figure 4.7

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For example, a small economy like Monaco or Fiji

Large open economy

Simplified model of a large open economy: let the world consist of two large economies, U.S. and “Rest of World”.

Excess lending (borrowing) by U.S. must equal excess borrowing (lending) by rest of world.

Determining the interest rate in a large open economy

Figure 4.8

(a) United States (b) Rest of the world

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Answering the key question

“What are the advantages and disadvantages of floating versus fixed exchange rates?”

Fixed exchange rates make it easier for firms to do business internationally, and easier for the central bank to avoid inflation. But they may require central banks to hold large foreign currency reserves, and hinder monetary policy.

Floating exchange rates require no government intervention, but can make planning difficult for firms.

Managed floating exchange rates allow for more flexibility than a fixed exchange system; but central bank purchases are still small compared with financial market demands.

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Explain how interest rates are determined in the money market and understand the risk structure and the term structure of interest rates

3.3

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Learning Objective

The money market

The interest rate is a key economic variable in the financial system.

Initial model for interest rates: the money market model (also called the liquidity preference model).

Money market model focuses on the interaction of the demand and supply of money to determine the short-term nominal interest rate.

Households have a choice between holding money and other assets like T-bills, which offer a return. The holding of paper currency offers a zero nominal return, while checking deposits offer a very low return.

When nominal interest rates on T-bills are higher, you are forgoing a higher amount of interest. Thus, at higher interest rates, you demand less cash.

Foregone interest is the opportunity cost of holding money.

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The demand for money

Lower nominal interest rates cause households and firms to switch from financial assets like T-bills to money.

As nominal interest rates on other assets declines from 4% to 3%, the quantity of money demanded rises from $900 to $950 billion in this example.

The demand for money

Figure 3.4

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Shifts in the money demand curve

Changes in GDP or the price level shift the money demand curve.

Increases in real GDP shift money demand to the right, while declining real GDP shifts money demand to the left.

Higher price levels shift money demand to the right, while falling price levels shift money demand to the left.

Shifts in the money demand curve

Figure 3.5

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Equilibrium in the money market

We assume that the Fed is able to perfectly control the supply of money (MS).

MS is therefore a vertical line.

Changes in the interest rate have no impact on the supply of money provided by the Fed.

The adjustment process:

The central bank increases the quantity of money available.

Households and firms are faced with additional money that they do not wish to hold.

They shift new money into other assets like Treasury bills.

The increased price of T-bills leads to a reduction in the interest rate.

The effect on the interest rate when the Fed increases the money supply

Figure 3.6

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Money market model summary

Summary of the money market model

Table 3.3

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Present value

Present value The value today of funds that will be received in the future.

The funds a person holds today are more valuable than prospective funds held in the future.

If you loaned $1,000 to a friend for a year, you would likely want more than $1,000 back. The amount over $1,000 is the interest you are charging.

Why would you charge interest?

Compensation for inflation

Compensation for default risk—the chance the borrower will not pay the loan back

Compensation for the opportunity cost of waiting to spend your money

The more impatient you are, the higher the interest rate you will charge

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Understand the effect of capital accumulation on labor productivity.

6.1

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Learning Objective

The Solow growth model

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Use the model of demand and supply for labor to explain how wages and employment are determined.

8.1

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Learning Objective

Nominal and real wages

Central banks like the Federal Reserve try to control the rate of inflation.

In the long run, the inflation rate is determined by the growth rate of the money supply.

Barter economies exist in the early stages of economic development.

Barter occurs where individuals trade goods directly with one another.

Problem occurs when a double coincidence of wants is lacking.

High transactions costs exist in barter economies.

Money reduces transactions costs and allows individuals to take advantage of specialization, yielding higher productivity, and higher incomes.

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The demand for labor services

Firms hire workers because they produce output. They hire workers as long as the marginal product of labor is at least as great as the cost of hiring.

Marginal product of labor (MPL) The extra output a firm receives from adding one more unit of labor, holding all other inputs and efficiency constant.

The labor demand curve

Figure 8.1

The labor demand curve is the same as the marginal product of labor curve.

It slopes downward, because of diminishing returns to adding an additional worker.

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Shifting the labor demand curve

The labor demand curve is a derived demand curve; the number of workers demanded derives from their profitability to firms.

If new technology allows workers to be more productive, firms will want to hire more of them at any given wage: an increase in labor demand.

Shifting the labor demand curve

Figure 8.2

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The supply of labor services

The real wage (w) can be thought of as the opportunity cost of leisure, since an additional hour of work means you forgo an hour of leisure.

The price of leisure rises as the wage increases, therefore you consume less of it via a substitution effect.

The income effect leads people to want to consume more leisure as their income rises, thus people work less.

In the short run, in the aggregate labor market the substitution effect tends to outweigh the income effect.

Implication is that at higher wages there is more labor provided.

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The labor supply curve

Higher real wages lead to an increased quantity of labor supplied due to substitution effects outweighing income effects in the short run.

Therefore, the labor supply curve slopes upward.

The labor supply curve

Figure 8.3

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A simple model of the natural rate of unemployment

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Deriving the natural rate of unemployment

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Use the aggregate demand and aggregate supply model to explain the business cycle.

9.4

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Learning Objective

A simple of model of the business cycle: AD & AS

We will develop more detailed models in the following chapters; but the aggregate demand and aggregate supply model, or AD-AS model, can help us understand some key facts about the business cycle.

The aggregate demand-aggregate supply model

Figure 9.6

Three components:

Aggregate demand (AD) curve: Shows the relationship between aggregate price level and total domestic expenditure.

Short-run aggregate supply (SRAS) curve: Shows the relationship between aggregate price level and firms’ intended production.

Long-run aggregate supply (LRAS) curve: Shows the long-run equilibrium (potential, full employment) level of GDP.

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Why does aggregate demand slope downward?

The AD curve resembles a regular demand curve; but it does not slope downward for the same reasons. It slopes downward because of:

The wealth effect: As the price level increases, the real value of household wealth declines, reducing consumption.

The interest rate effect: At higher price levels, the demand for money increases, causing an increase in the interest rate. At higher interest rates, firms and households invest less.

The international trade effect: High price levels in the U.S. relative to foreign countries make our exports expensive, and our imports cheap. So net exports fall. Also, higher interest rates might increase demand for the $U.S., again causing a decline in net exports.

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Aggregate supply shocks and the business cycle

An aggregate supply shock is a shock affecting firms’ costs of production.

Example: An increase in oil prices causes many firms’ costs of production to increase.

Negative aggregate supply shock

Figure 9.7

This is a negative aggregate supply shock, and it would cause the SRAS curve to shift up.

(A positive aggregate supply shock results in costs of production falling. The SRAS curve would shift down.)

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Aggregate supply shocks and the business cycle

As a result of the negative aggregate supply shock, the price level rises.

But real GDP decreases below potential GDP.

The cyclical unemployment rate rises, and downward pressure exists on wages.

Negative aggregate supply shock

Figure 9.7

Eventually, wages will fall in order to clear the labor market.

Thus the price level will fall, shifting the SRAS curve back down.

The economy has a automatic mechanism to return real GDP to potential GDP in the long run.

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Aggregate demand shocks and the business cycle

An aggregate demand shock is a shock affecting autonomous expenditure, like firm and household investment or autonomous consumer spending.

Example: Firms become pessimistic about the economy and decrease their investment spending.

Negative aggregate demand shock

Figure 9.8

This is a negative aggregate demand shock, and it would cause the AD curve to shift left.

(A positive aggregate demand shock results in costs of production falling. The AD curve would shift right.)

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Aggregate demand shocks and the business cycle

As a result of the negative aggregate demand shock, the economy is again producing below potential GDP; there is cyclical unemployment.

As with a negative aggregate supply shock, nominal wages will eventually decrease, shifting SRAS down.

Negative aggregate demand shock

Figure 9.8

The new long-run equilibrium is not the same as before. It occurs back at potential GDP, but at a lower price level.

Again, the automatic mechanism restores real GDP to its potential.

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Explain how the IS curve represents the relationship between the real interest rate and aggregate expenditure.

10.1

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Learning Objective

Initial IS-MP definitions

IS-MP model A macroeconomic model consisting of an IS curve, which represents equilibrium in the goods market; an MP curve, which represents monetary policy; and a Phillips curve, which represents the short-run relationship between the output gap (which is the percentage difference between actual and potential real GDP) and the inflation rate.

IS curve A curve in the IS–MP model that shows the combination of the real interest rate and aggregate output that represents equilibrium in the market for goods and services.

MP curve A curve in the IS–MP model that represents Federal Reserve monetary policy.

Phillips curve A curve that represents the short-run relationship between the output gap (or the unemployment rate) and the inflation rate.

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Equilibrium in the goods market

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Understand the role of the Phillips curve in the IS-MP model.

11.1

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Learning Objective

The IS-MP model and the Phillips curve

When output and employment are increasing, the inflation rate tends to rise.

A.W.H. Phillips first showed the relationship between the growth rate of nominal wages and the unemployment rate in the U.K.

Higher nominal wage growth was typically associated with lower rates of unemployment.

Higher nominal wages are generally passed along to consumers in the form of higher prices.

Interpretation was that higher inflation was associated with lower rates of unemployment.

The Phillips curve was initially viewed as a structural relationship.

A structural relationship depends on the basic behavior of households and firms and remains unchanged over long periods

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The traditional Phillips curve

If the Phillips curve is a structural relationship, the Fed could:

permanently reduce unemployment if they were willing to accept a higher inflation rate, or

permanently reduce inflation by raising the unemployment rate.

Operated under the assumption of constant expected inflation.

Milton Friedman and Edmund Phelps argued that expected inflation adjusts if current inflation differs from past inflation.

The Traditional Phillips curve

Figure 11.1

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