After reviewing all the various concepts we’ve covered in previous classes, we finally finished Chapter 6, and started with Chapter 7. To recapitulate: The important concepts from Chapter 6, are:
- Potential output
- Labor market equilibrium (using the marginal propensity of labor)
- The consumption function (and the marginal propensity to consume)
- The investment function (and the sensitivity of investment to interest rates)
- Government spending (particularly, transfer payments)
- Net exports (and their sensitivity to foreign GDP, domestic GDP and exchange rates)
There was one aspect of exchange rates that we yet had to cover: The relationship of exchange rates to interest rate differentials between domestic and foreign rates. To motivate the understanding of this relationship, consider the highly liquid and highly volatile foreign exchange market. You have speculators betting on all aspects of foreign exchange. They operate based on two conditions:
- rf > r: That is, the foreign (be it any country) real interest rate is greater than the one in the US. If this is the case, then bonds abroad pay a higher return than bonds at home. And that leads to these speculators taking their money out of the US and putting it into foreign currency-denominated bonds abroad. This, in turn, affects the exchange rate, because if they are taking their money out of the US and investing it abroad, they will be selling dollars to buy the foreign currency. And a selling of any commodity means a reduction in its price, so the price of dollars decreases, and the dollar depreciates (and the real exchange rate will rise).
- r > rf: That is, the US real interest rate is greater than the foreign (any country) rate. In this case, speculators will take their money out of bonds in other countries and sell those currencies to buy dollars, so that they can buy US, dollar-denominated bonds. Buying more dollars, means that the price of dollars increases, and so the dollar will appreciate (and the real exchange rate will fall).
The relationship between the real exchange rate and the differential of the foreign real interest rate and the domestic real interest rate, can be summed up by this equation: ε = ε0 – εr[r – rf]
Thus, an increase in the foreign rate will cause the exchange rate to increase which is a currency depreciation. And an increase in the domestic rate will cause the exchange rate to decrease which is a currency appreciation.
With this, we conclude our understanding of the building blocks of the flexible price model. Now let’s go on to Chapter 7, where we’ll see everything put together.
First off, there are two approaches to understanding how the economy gets into equilibrium:
- Flow-of-output approach: This has to do with looking at the aggregate demand, which is the sum of the components of total spending, or C + I + G + NX. When the aggregate demand equals the aggregate supply, which is nothing but our output, Y, the economy is in equilibrium. Remember though, that output is at its potential output level, so Y = Y*.
- Flow-of-funds approach: This has to do with looking at the market for loanable funds or the markets in which funds are borrowed and lent out. The funds that are lent out from lending institutions like banks, are put there by via savings from households, the government and foreign lenders. These funds are then borrowed by businesses to be invested into the economy, to increase production, and create profits. When the supply of funds that comes from savings, is equal to the demand for funds that comes from businesses wanting to invest, the economy is in equilibrium.
This approach has to do with aggregate demand: AD = C + I + G + NX.
The aggregate supply is nothing but the output or production, which is denoted by Y. But since we assume flexible-prices, the output is always at its potential output level and Y = Y*.
When the economy is in equilibrium, Y = Y* = AD = C + I + G + NX, or to put it simply: AD = Y*.
This is the flow-of-output approach and, as we will see shortly, it is the real interest rate, r that equilibrates aggregate demand with aggregate supply.
Savings have three components:
- Household savings, SH (is positive when Y – T – C > 0)
- Governmental savings, SG (is positive when T – G > 0)
- Foreign savings, SF (is positive when IM – GX > 0, or when -NX > 0)
When the economy is in equilibrium, SH + SG + SF = I, or investment.
In the market for loanable funds, the price of borrowing is the real interest rate r and that is what equilibrates savings with investment.
Common factor: Real Interest Rate
The common factor, r, can be seen more clearly if we do a little algebraic manipulation:
Assume that all markets are in equilibrium, so by the flow-of-output approach, we see that
Y* = C + I + G + NX
Now take everything on the left-hand side, but leave investment (I) on the right-hand side, to get:
Y* – C – G – NX = I
Now add and subtract taxes, T, on the left-hand-side:
Y* – T – C + T – G – NX = I
Now group the terms on the left-hand side:
(Y*-T-C) + (T-G) + (-NX) = I
But (Y*-T-C) is SH, T-G is SG and -NX is SF. So when the markets are in equilibrium via the Flow-of-Output approach, they are also in equilibrium via the Flow-of-Funds approach. The important result from all of this is: The two approaches are equivalent.
This is where we stopped. We’ll pick up again in the next class.