Macroeconomic Macroeconomic Fundamentals Fundamentals

1.1. Aggregate demand product Aggregate demand product market equilibriummarket equilibrium

2.2. Aggregate money marketAggregate money market3.3. General equilibriumGeneral equilibrium

Above average global GDP growth Above average global GDP growth rates in 6 of last 8 yearsrates in 6 of last 8 years

1988-97

Ave.

1998 1999 2000 2001 2002 2003 2004 2005 2006

World 3.4 2.8 3.7 4.9 2.6 3.1 4.1 5.3 4.9 5.1

Africa 2.3 2.8 2.7 3.1 4.2 3.6 4.6 5.5 5.4 5.4

Central and Eastern Europe

0.9 2.9 0.7 5.1 0.3 4.5 4.7 6.5 5.4 5.3

Middle East 4.0 3.7 1.8 5.3 3.0 4.1 6.4 5.5 5.7 5.8

China 9.9 7.8 7.1 8.4 8.3 9.1 10.0 10.1 10.2 10.0

India 6.0 5.9 6.9 5.3 4.1 4.3 7.2 8.0 8.5 8.3

Other emerging market and developing countries

4.1 3.0 4.1 6.1 4.4 5.1 6.7 7.7 7.4 7.3

United States 3.0 4.2 4.5 3.7 0.8 1.6 2.5 3.9 3.2 3.4

Sources: US Department of Commerce and International Monetary Fund.

Components of Aggregate Demand:Components of Aggregate Demand:

Aggregate demand is defined as the sum of consumption spending (C), investment spending (I), Government spending (G), and net exports (X-M); X represents exports and M represents imports.

Aggregate demand, referred to as Gross domestic product or GDP, is therefore given by:

AD = GDP = C + I + G + X – M

The economy is said to be in general equilibrium when the money, labor and product markets are all in equilibrium. Focus here is on the short run.

LMi3

i2

i1

Y1 Y2 Y3

Equilibrium in the Money MarketEquilibrium in the Money Market

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iE

MS

M

MD

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Inte

rest

Rat

e

Quantity of Money Gross Domestic Product

Definition of LM: Definition of LM: L L represents the demand for liquidity and MM represents the quantity of moneyAt all points along the LM curveLM curve, the demand for money equals supply.

Definition of LM: Definition of LM: L L represents the demand for liquidity and MM represents the quantity of moneyAt all points along the LM curveLM curve, the demand for money equals supply.

i3

i2

i1

Y3 Y2 Y1

IS

Product Market EquilibriumProduct Market Equilibrium

PE

ASAD

YE YPOT

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Gen

eral

Pric

e Le

vel

Gross Domestic Product Gross Domestic Product

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Definition of IS: Definition of IS: I I represents the investment spending and SS represents savings.At all points along the IS curveIS curve, investment equals savings.

Definition of IS: Definition of IS: I I represents the investment spending and SS represents savings.At all points along the IS curveIS curve, investment equals savings.

AS

YPOT

Gen

eral

Pric

e Le

vel

Gross Domestic Product

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Potential GDP in the current yearin the current year

Depressionrange

Normalrange

Classicalrange

Three Ranges of Aggregate SR Supply CurveThree Ranges of Aggregate SR Supply Curve

Note: The aggregate production aggregate production functionfunction for the general economy is:

Y = f(L,K) where L is the employed labor force, and K is the capital stock.

∆PE

ASAD

∆YE YPOT

Gen

eral

Pric

e Le

vel

Gross Domestic Product

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∆PE

ASAD

∆YE YPOT

Gross Domestic Product

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Elasticity of the short run aggregate supply curve in the normal range will help determine the rate of demand pull inflation in the economy, given by the percent change in the general price level or (∆PE/PE).

Elasticity of the short run aggregate supply curve in the normal range will help determine the rate of demand pull inflation in the economy, given by the percent change in the general price level or (∆PE/PE).

Elasticity of SR Aggregate Supply CurveElasticity of SR Aggregate Supply Curve

PE

ASAD

ISLM

YE YPOT

iE

YE

iE

MS

M

MD

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General Equilibrium General Equilibrium in the money and in the money and product marketsproduct markets

General Equilibrium General Equilibrium in the money and in the money and product marketsproduct markets

Inte

rest

Rat

e

Gen

eral

Pric

e Le

vel

Gross Domestic Product

Quantity of Money

∆WRE

∆LE LMAX

LD

LS

Equilibrium in Labor MarketEquilibrium in Labor Market

∆PE

AS

AD

∆YE YPOT

Product Market Labor Market

Gen

eral

Pric

e Le

vel

Gross Domestic Product EmploymentW

age

Rat

e

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The aggregate demand for goods and services in the product marketdrives the demand for labor in the nation’s labor market.

The aggregate demand for goods and services in the product marketdrives the demand for labor in the nation’s labor market.

UR

INF

Phillips Curve Tradeoff in Short RunPhillips Curve Tradeoff in Short Run

UR

INF

Expansionary Policy Impact Contractionary Policy Impact

Une

mpl

oym

ent

Rat

e

Inflation Rate Inflation Rate

This curve initially proposed by the English economist William Phillipstracks the short run tradeoffshort run tradeoff between unemployment and inflation.

This curve initially proposed by the English economist William Phillipstracks the short run tradeoffshort run tradeoff between unemployment and inflation.

ISLM

LM*

i

Y

ISLM

Y

IS*

i

Inte

rest

Rat

e

Gross Domestic Product

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Gross Domestic Product

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Hint: Contractionary monetary and fiscal policy actions have theexact opposite effects of expansionary policy actions.

Hint: Contractionary monetary and fiscal policy actions have theexact opposite effects of expansionary policy actions.

Expansionary Monetary policyAction: increase money supply

Expansionary Monetary policyAction: increase money supply

Expansionary Fiscal policyAction: cut tax rates and/or raise government spending

Expansionary Fiscal policyAction: cut tax rates and/or raise government spending

AD*

ISLM

LM*

i

YE

Expansionary Monetary policyAction: increase money supply

Expansionary Monetary policyAction: increase money supply

∆PE

ASAD

∆YE YPOT

∆WRE

∆LE LMAX

LD*LS

Inte

rest

Rat

e

Gen

eral

Pric

e Le

vel

Wag

e R

ate

Gross Domestic Product Employment

LD

Expansionary monetary policy lowers interest rates, stimulates investment spending, increases aggregate demand for goods and services, can increase the general price level, increases the need for additional labor to produce additional goods and services, and can increase the wage rates. Does not occur instantaneously.

Expansionary monetary policy lowers interest rates, stimulates investment spending, increases aggregate demand for goods and services, can increase the general price level, increases the need for additional labor to produce additional goods and services, and can increase the wage rates. Does not occur instantaneously.

ISLM

YE

Expansionary Fiscal policyAction: cut tax rates or raise

government spending

Expansionary Fiscal policyAction: cut tax rates or raise

government spending

IS*

∆PE

ASAD

∆YE YPOT

∆WRE

∆LE LMAX

LD

LS

i

Inte

rest

Rat

eG

ener

al P

rice

Leve

l

Wag

e R

ate

Gross Domestic Product Employment

Expansionary fiscal policy leads to government borrowing, raising interest rates, but stimulates aggregate demand for goods and services, can increase the general price level, increases the need for additional labor to produce additional goods and services, and can increase the wage rates. Does not occur instantaneously.

Expansionary fiscal policy leads to government borrowing, raising interest rates, but stimulates aggregate demand for goods and services, can increase the general price level, increases the need for additional labor to produce additional goods and services, and can increase the wage rates. Does not occur instantaneously.

Full Employment and GDP GapsFull Employment and GDP Gaps

PE

ASAD

YE YPOT

YFE

Recessionary GDP Gap

Use expansionary policy toUse expansionary policy toeliminate SR recessionary gap:eliminate SR recessionary gap:1. Lower interest rates2. Cut taxes3. Increase government spending

PE

ASAD

YE YPOT

Full Employment and GDP GapsFull Employment and GDP Gaps

PE

ASAD

YE YPOT

YFE

Recessionary GDP Gap Inflationary GDP Gap

YFE

Use expansionary policy toUse expansionary policy toeliminate SR recessionary gap:eliminate SR recessionary gap:1. Lower interest rates2. Cut taxes3. Increase government spending

Use contractionary policy toUse contractionary policy toeliminate SR inflationary gap:eliminate SR inflationary gap:1. Raise interest rates2. Raise taxes3. Decrease government spending

“Big 5” macroEconomicvariables

ExpansionaryExpansionaryMonetaryMonetary

PolicyPolicy

ContractionaryContractionaryMonetary PolicyMonetary Policy

ExpansionaryExpansionaryFiscalFiscalPolicyPolicy

ContractionaryContractionaryFiscalFiscalPolicyPolicy

Interest rate LowerLower HigherHigher HigherHigher LowerLower

GDP growth rate HigherHigher LowerLower HigherHigher LowerLower

Unemployment rate LowerLower HigherHigher LowerLower HigherHigher

Inflation rate HigherHigher LowerLower HigherHigher LowerLower

Exchange rate LowerLower HigherHigher HigherHigher LowerLower

Impact of macroeconomic policy on five variables important toImpact of macroeconomic policy on five variables important tothe nation’s food and fiber Industrythe nation’s food and fiber Industry

Impact of macroeconomic policy on five variables important toImpact of macroeconomic policy on five variables important tothe nation’s food and fiber Industrythe nation’s food and fiber Industry

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Policy Impacts on Macro EconomyPolicy Impacts on Macro Economy

Macro – Market – MicroMacro – Market – Micro

Page 102Note: This does not occur instantaneously.Note: This does not occur instantaneously.

Page 103Note: This does not occur instantaneously.Note: This does not occur instantaneously.

Farm sectorvariables

ExpansionaryExpansionaryMonetaryMonetary

PolicyPolicy

ContractionaryContractionaryMonetary PolicyMonetary Policy

ExpansionaryExpansionaryFiscalFiscalPolicyPolicy

ContractionaryContractionaryFiscalFiscalPolicyPolicy

Farm revenue Higher Lower Higher Lower

Farm expenses Higher Lower Higher Lower

Net farm income Higher Lower Higher Lower

Farm land values Higher Lower Higher Lower

Exports Higher Lower Lower Higher

Impact of macroeconomic policy on five variables important toImpact of macroeconomic policy on five variables important tothe nation’s farm sectorthe nation’s farm sector

Impact of macroeconomic policy on five variables important toImpact of macroeconomic policy on five variables important tothe nation’s farm sectorthe nation’s farm sector

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Policy Impacts on the Farm SectorPolicy Impacts on the Farm Sector

What is Next?What is Next? We have covered the

topic of market equilibrium for a specific commodity.

We have also covered the topic of general equilibrium and GDP gaps.

Let’s now look at policy actions we would expect from policymakers and their impact on individual markets at the economy level.

Any Questions?Any Questions?