Economics 311 Money and Income

Economics 311Money and Income Chapter 5-The Basic Market Clearing Model Department of Economics College of Business and Economics California State University-Northridge Professor Kenneth Ng nt. Monday, September 1, 2014

Administrative Details • Second Exam—Thursday, April 18th. • Homework-Due Tuesday April 16th.

The Basic Market Clearing Model • We have identified 3 markets in the economy: • Goods Market-production (Y) must equal consumption (c) • Bond Market-bonds sold must equal bonds bought. B=0 • Money Market-Amount of money supplied (fixed but controlled by FED) must equal the amount of money demanded. • On these three markets, the Interest Rate-R and the Price Level-P adjust so that supply and demand equalize in each of these markets. • When all three markets are in equilibrium, we say that General Market Clearing has occurred.

General Market Clearing or Walras' Law of Markets • The household's budget constraint in period 1 in real terms is: • If we sum up the budget constraint across all households, the Aggregate Budget Constraint is: • Because every dollar lent must equal a dollar borrowed, , we can rearrange the terms of the Aggregate Budget Constraint:

General Market Clearing or Walras' Law of Markets • In order for the economy to be in equilibrium, 3 conditions must be met: • But algebraically, if conditions 1 and 2 hold then by definition condition 3 must hold (Walras' Law of Markets-General Equilibrium Model). • Same as saying if you have a system of three equations in two unknowns, if a solution satisfies two of the equations, it must satisfy the third.

How the Commodity Market Clears: • The Interest Rate will change so that the supply of commodities (C) equals the production supply (Y): • Why does the supply of goods increase as the interest rate increases? • Inter-temporal substitution of labor. • An increase in interest rates causes people to work more now, save their extra earnings, and spend their savings plus interest in the future, i.e. an increase in the interest rate increases current work, current production, and the current supply of goods. • Why does the demand for consumption decrease as the interest rate increases? • Inter-temporal substitution of consumption. • An increase in interest rates causes people to spend less now, save the money not spent on current consumption, and spend their savings plus interest in the future, i.e. an increase in the interest rate decreases current consumption.

R Commodities Market: Supply Ys Why is the supply curve for commodities upward sloping? An increase in interest rates, causes an inter-temporal substitution of labor. Current labor effort increases causing current output to increase. Cd, Ys

Y Y Present Future B B A A Commodities Market: Supply In the present, workers will increase work effort, produce more (A to B), and save the extra output. l In the future, workers will increase work effort, reduce output, and consume their savings plus accrued interest. l

R Commodities Market: Demand Why is the demand curve for commodities downward sloping? As interest rates rise, an inter-temporal substitution effect is created. Households reduce current consumption and increase savings. Ys Cd Cd, Ys

C2 A B Commodities Market: Demand An increase in interest rates would cause a rotation of the inter-temporal budget constraint (blue to red). This would cause a decrease in current consumption and an increase in future consumption (A to B). Ys C1

R R1 Commodities Market Clearing Suppose the interest rate R1. How would the interest rate move to clear them market? At R1, there are more goods being demanded than are being supplied. If the interest rate were to rise, then there would be an inter-temporal substitution effect causing people to reduce current demand and raise current supply. Households would work more and produce more now (increase in supply). Households would reduce current consumption and save more (increase in demand). Ys Excess Demand Cd Cd, Ys

R R2 Commodities Market Clearing Suppose the interest rate is at R2. There are more goods being supplied than demanded. If the interest rate fell, there would be an inter-temporal substitution effect Current consumption would be increase because households would stop shifting consumption from the present to the future. Current work effort would decrease as households stopped producing a surplus of goods today that they save and consume in the future. Ys Excess Supply Cd Cd, Ys

Clearing the Money Market. • For the moment, assume that the supply of money is fixed. In point of fact it is controlled by the FED but assume a passive FED which keeps the money supply constant. • We know from previous discussions that the nominal money demand function can be written as:

P P1 The supply of money is controlled by the FED. For the moment assume that the FED keeps the money supply constant. Changes in Ms constitute monetary policy Money Market Ms When P1 increases we move along the money demand function. At P1 the demand for money is less than the supply. If the price were to rise then the nominal demand for money would increase. . Excess Supply M, Md

P P1 Money Market Ms Excess Demand At P2, the demand for money exceeds the supply. If the price were to fall, then the nominal demand for money would fall eventually equaling supply. Excess Supply M, Md

P P2 Money Market Ms Md At P2, the demand for money exceeds the supply. I f the price were to fall, then the nominal demand for money would fall. M, Md

General Market Clearing • We predict that the commodity market will clear and the amount of money demanded will equal the money supply. • The procedure for solving the model is to • First, figure out the interest rate (R*) which will clear the commodity market. This determines the interest rate R* and the amount of commodities supplied Y* • Second, we can substitute the R* and Y* from the commodity market into the money demand function and then find the P* that will clear the money market. • Example of analysis using the General Market Clearing model. Temporary shift of the production function, e.g. bad weather.

Permanent Proportional Improvement in the Production Function • A permanent proportional improvement in the production function effects two things. • Ys---The Supply of Commodities • Choice of work vs. leisure. • Wealth effect: Households are producing more goods with the same amount of work effort. • If leisure is normal, this will lead to a reduction in work effort. • Substitution effect: Given the amount of work effort, and additional hour worked produces more additional output (MPL or slope of PF has changed). • Inter-temporal substitution of labor. • Because the reward to labor is impacted equally in all periods, their is no incentive to work more in one period and less in another period and shift the consumption over time by borrowing and lending. • Cd ---The Demand for Commodities • Choice of consumption now vs.later. • Permanent Income Hypothesis • Households prefer even flows of consumption over time. • A permanent change creates no incentive to move consumption over time because both the present and future are impacted equally.

Y Y Present Future B B A A Commodities Market: Supply In the present, there will be a substitution effect causing households to work more and a wealth effect causing them to work less (if leisure is a normal good). The net effect is an increase in work effort and output (Ys). This is shown as the movement from A to B. o l The future will be the same as the present. There will be a Substitution and Wealth effect causing a net increase in work effort and output. l

R What effect will the permanent proportional improvement in the production function have on Ys—the supply of commodities? Commodities Market: Supply Ys At any given interest rate, more will be produced. Cd Cd, Ys

C2 A B Commodities Market: Demand What effect will the permanent proportional improvement in the production function have on future and present consumption and borrowing? Because the production function has improved and households are working more, the produce more in the present and future (Y1 and Y2 ) have increased. The inter-temporal budget constraint shifts out. Because the present and future are impacted equally there is no incentive to shift consumption over time. C2=Y2 C2=Y2 C1=Y1 C1=Y1 C1

R B A R1 Commodities Market: Supply Because income has increased in the present and the future, the household now demands more consumption. Cd shifts out. Because there improvement in the production function is permanent, there is no change in net borrowing and no change in the interest rate. The effect of the permanent proportional improvement in the production function is an increase in production and consumption with no change in the interest rate. Ys Cd Cd, Ys

P P1 P2 Money Market Ms Y has increased so money demand (Md) has increased. If the Fed keeps the money supply constant, the price level will fall from P1 to P2. M, Md

P P1 P2 Money Market Ms What monetary policy should the FED follow if it wants to keep prices stable? Increase money supply. M, Md

Temporary Proportional Improvement in the Production Function • A temporary proportional improvement in the production function effects two things. • Ys---The Supply of Commodities • Choice of work vs. leisure. • Wealth effect: Households are producing more goods with the same amount of work effort. • If leisure is normal, this will lead to a reduction in work effort. • Substitution effect: Given the amount of work effort, and additional hour worked produces more additional output (MPL or slope of PF has changed). • Inter-temporal substitution of labor. • Because the reward to labor is expected to be temporarily higher today, households have an incentive to work more today, save the extra income and work less in the future. • By saving they can shift the consumption over time. • Cd ---The Demand for Commodities • Choice of consumption now vs.later. • Permanent Income Hypothesis • Households prefer even flows of consumption over time. • Even though households earning more today, current consumption will not increase by as much as current income because households expect future income to be lower.

Y Y Present Future B B A A Commodities Market: Supply In the present, there will be a substitution effect causing households to work more and a wealth effect causing them to work less (if leisure is a normal good). The net effect is an increase in work effort and output (Ys). This is shown as the movement from A to B. The increase in work effort and output from a temporary proportional improvement in the production function is much greater than the increase from a permanent improvement. l In the future, households, will live off their savings. Future work effort and output will decrease. l

R Commodities Market: Supply Ys Ys The big increase in work effort will cause a large shift in the supply of commodities. Cd Cd, Ys

C2 A B C Commodities Market: Demand Households new pattern of earnings over time is represented by point B. Working and producing more today and less in the future. The permanent income hypothesis says households like to consume even patterns of consumption over time. Therefore, they use financial markets to consume consumption pattern C. Does this involve borrowing or lending? C2=Y2 Y2 C1=Y1 Y1 C1

R B A R1 R2 Commodities Market: Supply Although the supply of commodities has shifted out a lot, the demand for commodities shifts out only a little. This is because some of the increase in current production is being saved to be consumed in the future. At the new equilibrium, output has increased and the interest rate has fallen. If you were a bond speculator would you buy or sell bonds? Ys Cd Cd, Ys

P P1 P2 Money Market Ms Y has increased so money demand (Md) has increased. If the Fed keeps the money supply constant, the price level will fall from P1 to P2. M, Md

Temporary vs. Permanent shift in Production Function (1) • Compare and Contrast. • Wealth and Substitution Effects. • Position and slope of production function. • Inter-temporal substitution of labor and consumption. • When will there be an inter-temporal shift of labor? • Will the change in labor be greater if the change in the production function is temporary or permanent? • When will households use financial markets, i.e. buy and sell bonds, to shift consumption over time? • Movement along the inter-temporal budget constraint-permanent of temporary shift in production function. • Changes in Permanent Income. • Shift in position inter-temporal budget constraint-permanent of temporary change in production function.

Temporary vs. Permanent shift in Production Function (2) • Potential exam questions: • Which has a greater effect on bond prices, a temporary or permanent shift in the production function? Explain. • If you were a stock or bond speculator, which would offer a greater opportunity for short term profit a temporary or permanent shift in the production function? Explain. • If the Fed wished to maintain stable prices, what would the correct monetary policy be when there is a temporary or permanent improvement in the production function. Explain. • Would there be any difference? • If you wanted a bigger effect on current output would you make a tax cut temporary or permanent. Explain.

Pop Quiz • Suppose a proportional degradation of the production function in the future is expected. • Analyze the effects of such an expectation. • What effect would this have on current and future consumption and production, work effort, demand for money, interest rates and prices? • If the FED wanted to keep the price level constant, what should monetary policy (changes in the quantity of money) be?

Y Y Present Future B B A A Pop Quiz: Commodities Market: Supply In the present, households will increase their work effort. They will do this in anticipation of the wage rate being lower in the future. l In the future, households, the production function is expected to degrade (dotted line). Households will reduce their work effort and live off their savings. l

R Pop Quiz Commodities Market: Supply Ys Ys The big increase in current work effort will cause a large shift in the supply of commodities. Cd Cd, Ys

C2 A B C Pop Quiz Commodities Market: Demand Households start off at A. With the expected future degradation, the household will increase current work effort and reduce future work effort. The inter-temporal budget constraint will shift in because overall the production function has degraded. The household will save some of the extra output produced today and consume it in the future (B to C). C2=Y2 C2* Y2 C2* Y1 C1 C1=Y1

R B A R1 R2 Pop Quiz: Commodities Market: Supply Although the supply of commodities has shifted out a lot, the demand for commodities shifts in because at any given interest rate households want to save to maintain consumption in the future. At the new equilibrium, output will increase and interest rates will fall. If you were a bond speculator would you buy or sell bonds? Ys Cd Cd, Ys

P P1 P2 Pop Quiz: Money Market Ms Y has increased so money demand (Md) has increased. R has decreased so money demand (Md) has increased. If the Fed keeps the money supply constant, the price level will fall from P1 to P2. M, Md

Monetary Policy and the Basic Market Clearing Model • What is the effect of changes in the money supply on real variables (Cd and Ys)? • Stated another way, what is the link between FED policy and economic performance. • Can the Fed by changing the money supply effect work effort, output, nominal and real interest rates, and the price level. • This will be the main question addressed after the second exam.

Monetarism and the Neutrality of Money • Basic Market Clearing Model shows a property long studied by economists-Money Neutrality or Monetarism. • Permanent changes in the stock of money affect nominal variables but leave real variables unchanged. • A change in the money supply causes only an increase in the price level. • The increase in the price level causes an increase in nominal income and nominal output but real output and income remain the same. • In the Basic Market Clearing Model, P will increase but C and Y remain the same. • Nominal income (P*Y) and consumption (P*C) increase but real income (Y) and consumption (C) stay the same. • Monetarism posits that changes in the money supply are responsible for inflation in the long run. • Changes in the money supply can cause short term effects but they are unpredictable because they depend upon households expectations.

Exam: Study Guide • Be able to engage in economic analysis using the Basic Market Clearing Model. • Change in real world-----BMCM (handout)-----Y,C,R, and P. • Concentrate on the following graphs. • Work/Leisure Decision—Supply of Commodities. • Consumption now vs. later decision-Demand for Commodities. • Change in Interest Rates-Market for Commodities. • Change in Money Demand-Price Level. • Be able to solve stand alone problems involving the demand for money. • Formulas for V, M/D, and transaction interval. • Worth memorizing plus total cost of holding money formula. • Graph showing Total Cost of Holding Money and the optimal transaction interval.

Exam Study Guide • Changes in World. • Change in Production Function. • 4 Types: • Permanent Improvement/Degradation. • Temporary Improvement/Degradation. • Anticipated improvement/Degradation. • Change in expectations about the future. • Changes in technology of acquiring cash balances. • Transaction cost. • Change in Preferences. • Value of consumption now vs. later.

Economics 311 Money and Income