Supply and Demand

PricesSupplyDemandMovements along curvesShifts of curvesEquilibrium and disequilibriumPredictions of the S & D model

Supply and DemandSupply is the term we

assign to the description of the relationship between the quantity supplied of a good and its price, ceteris paribus.

Demand is the term we use to express the relationship between the quantity demanded of a good and its price , ceteris paribus.

Supply and Demand:movement along the curves:As the price of a good

increases, the quantity supplied increases, ceteris paribus.

The above effect is shown graphically as an upward movement along the Supply curve.

As the price of a good increases, the quantity demanded decreases, ceteris paribus.

The above effect is shown graphically as a downward movement along the Demand curve.

Supply and Demand:shifts of the curves

Supply depends on: Price of the good Number of Firms Capital Base Prices of the inputs Prices of substitutes Prices of complements Expectations about

future prices of all of the above

Firm Mission

Demand depends on: Price of the good Income Population Prices of substitutes Prices of complements Expectations about

future prices of all of the above, and income

Buyer preferences

Market in Equilibrium

The market price is referred to as the equilibrium price when the quantity demanded at such price = quantity supplied at such price.

Market out of equilibriumcomparative statics

When prices exceed the equilibrium price, market is in excess supply.

When prices are lower than the equilibrium price, market is in excess demand.

Summary of Macroeconomics

5 big questions8 fundamental ideas3 processes to understand the above

5 big questions

1. What to produce2. How to produce3. When to produce4. Where to produce5. Who consumes/produces

8 fundamental ideas1. Choices are tradeoffs because of

scarcity

2. Choices are made at the margin because of incentives

Diminishing marginal returns: “What have you done for me lately?” “It’s never as good as the last time”

8 fundamental ideas

3. Voluntary tradeoffs make transacting parties better off because of rationality

Markets are very efficient ways of organizing this sort of exchange

4. When incentives conflict with marginal choices, markets may fail and alternative mechanisms designed and employed (contracts, government, clubs).

8 fundamental ideas

5. Income = expenditure = gross value

6. Productivity gains enhance living standards

8 fundamental ideas (4)

7. inflation occurs when production grows at a slower rate than the quantity and use of money in the economy

8. unemployment is a necessary evil

3 processes used in 2 approaches Approaches

1. Positive How things are

2. Normative How things ought

to be

Tasks:1. Observing and

measuring

2. Modeling

3. Testing

Macroeconomic issues, by approach

Positive Issues Growth

tradeoff consumption today for more future consumption

Employment +/ -

Inflation +/ -

Budget Deficits +/ -

Normative IssuesFiscal PolicyMonetary Policy

Economics Measurements:Stocks versus flows

A stock is a measurement at a point in time.A flow is a measurement over time -per unit

of time.Example 1: Capital stock and InvestmentExample 2: Wealth and Saving

Expenditure=income=valueNational Income and Product Accounting

Y = C + I + G + X - MHouseholds are … Y - (C + S + T)Governments are … G - T + (T - G)Firms are (C+I+G+NX) + (S-G-I-(M-X)) - YRest of the world are (X-M) - (S-G-I)

Measuring GDPExpenditure Approach: C+I+G+NXIncome Approach:

Employee compensation + Net Interest + Rental Income + Corporate profits + Proprietor’s Income = net domestic income @ factor cost + adjustments from factor cost to market prices + adjustment to gross product = GDP

InflationCPI = % chg. in price index.

Tendency for upward bias in consumptionGDP Deflator = (GDP/realGDP) * 100

Bias injected via use of CPI in calculation of volume of goods produced.

SynthesisAggregate Supply (AS)Aggregate Demand (AD)General Economic Equilibrium“Positive” Effects of changes in AS and AD

on Economic Growth“Normative” Directions

Aggregate Supply (AS) is ...

The sum total of all production activity in an economy, expressed as a relation between:price levels (CPI on

vertical axis) and output (GDP on

horizontal axis)

CPI AS

Potential

GDP

GDP

Aggregate Demand (AD) is ...

The sum total of all expenditure activity in an economy, expressed as a relation between:price levels (CPI on

vertical axis) and output (GDP on

horizontal axis)

CPI

Potential

GDP

GDP

ADAS

General Equilibrium (GE) is ...The “consensus”

point between AD and AS, where production and consumption sectors find agreement in the general level of prices and output for the economy at a point in time.

CPI

Potential

GDP

GDP

ADAS

GE

Movements along the AS, in the short run

Short Run, real GDP increases when …

CPI rises but resource/factor prices rise at a slower rate, or

do not change.

Short Run, real GDP decreases when …

CPI falls but resource (factor) prices fall at a faster rate, or

do not change.

Shifts in short run ASSRAS shifts to the left when SRAS shifts to the right when

Prices of factors of production (resources) rise faster than the CPI (prices at which the goods sell in the economy)

Prices of factors of production (resources) fall faster than the CPI (prices at which the goods sell in the economy)

Amount (stock) of resources in the economy decreases (LF, K, Natural)

Amount (stock) of resources in the economy grows (LF, K, Natural)

Technological innovation occurs.

Protections of intellectual property are forgone globally.

Intellectual property becomes better protected globally.

Movements along the AD, in the short run

Quantity of real GDP demanded increases if …

The general level of prices (CPI) decreases, ceteris paribus … because of wealth and substitution effects

Quantity of real GDP demanded decreases if …

The general level of prices (CPI) increases, ceteris paribus … because of wealth and substitution effects

Shifts in AD

AD DECREASES IF AD INCREASES IF

Expected Y, inflation, or profits

Expected Y, inflation, or profits

Gov't Demand , Taxes , Transfers (Fiscal Policy changes)

Gov't Demand , Taxes , Transfers (Fiscal Policy changes)

Money , and/or Interest Rates (Monetary Policy changes)

Money , and/or Interest Rates (Monetary Policy changes)

Exchange rates Exchange Rates

Foreign income Foreign Income

Normative directions in policy

Is AD “flat” or “steep” --i.e., is demand responsive to changes in CPI or not in the short run?

Is AD “flat” or “steep” --i.e., is demand responsive to changes in CPI or not in the long run?

Which is more effective in the short run, Monetary or Fiscal policy?

Which is more effective in the long run, Monetary or Fiscal policy?

MoneyDefinitionUses

Medium of exchangeUnit of Account (“numeràire”)Store of value

Measuring money (M1, M2, …)

Financial intermediariesFirms that manage the flow of financial

funds from households and firms to other households and firms.Commercial banksS&L’sSavings Banks and Credit UnionsMoney Market Mutual Funds

Money and Banking Liabilities + Net worth = Assets(deposits + owner’s equity = loans

made)

deposits = reserves + loans madereserves = vault cash + FRB account

Economic functions of financial intermediaries

Create ‘liquidity’Minimize the ‘cost of obtaining funds’Minimize the ‘cost of lending funds’Pooling risks in order to maximize profits

RegulationDeposit insurance

FDICBalance sheet rules

capital requirementsreserve requirementsdeposit ruleslending rules

Money “creation”

The deposit-loan-reserve chain.International Effects:

Reverse Repurchase Agreements - Foreign Official and International Accounts

Repurchase

AgreementsA Repurchase Agreement is a contract to sell an asset and repurchase it in the future. It is a money-market instrument . For the party on the other end of the transaction , (buying the security and agreeing to sell in the future) it is a Reverse Repurchase Agreement. RRAs are usually used to raise short-term capital.

Reserve Balances11% of deposits at U.S. Banks

Balances are the sum total of all reserves held by the Fed for Banks in the Banking System

Liquidity SwapsA swap arrangement involves two

transactions. A foreign central bank draws on (obtains funding

under) the swap line, thus selling a certain amount of its currency to the Federal Reserve at the prevailing market exchange rate in exchange for dollars. This market rate becomes the swap exchange rate.

At the same time, the Federal Reserve and the foreign central bank enter into a binding agreement for a second transaction in which the foreign central bank is obligated to repurchase the foreign currency at a specified future date. The second transaction is done at the swap exchange rate—that is, the same exchange rate as in the first transaction

Short term AD - AS efffectsShifts AD right or left

Long term AD - AS effects

Shift of the SAS right of left