Chapter 10: Macroeconomic Equilibrium in the Short Run
1. Overview
To study the short run behaviour of the economy, we adopt a crucial Keynesian assumption
that prices are constant.
Macroeconomic price flexibility is a reasonable working assumption for the long run. Under
price flexibility, the monetary neutrality principle applies, and money and prices behave
independently of output. This long-run independence, or dichotomy, of the real and
monetary dimensions of the economy serves as an important anchor for analysis.
In the long run, prices are fully flexible and neatly separate out nominal and real sides of the
economy.
In the short run, prices do not move, or move rather slowly, the dichotomy fails and
everything becomes more complicated.
The Keynesian model focuses on two markets: (1) the market for goods and services (2) the
money market. We will add the foreign exchange market.
General equilibrium = the simple requirement that all markets achieve equilibrium at the
same time, and that these equilibrium conditions are mutually consistent with each other.
2. Aggregate Demand and the Goods Market
Y = C + I + G + PCA supply for goods and services = demand for goods and services
Public spending G and tax receipts T as exogenous. Wealth too.
Consumption function: C = C(wealth,Y,-T) (++)
Investment function: I = I(q,r) (+-)
Import function: Z = Z(A,ó) (++)
Export function: X = X(A*,ó) (+-)
A* = foreign asorption ó = real exchange rate
Primary current account function: PCA = X(A*,ó) - Z(A,ó) = PCA(A,A*,ó) = PCA(Y,Y*,ó)
The interest rate matters for investment for two reasons:
1. Because a higher interest rate reduces Tobin’s q
2. Because firms borrow from banks to finance investment. When borrowing costs rise,
firms invest less.
! For future reference, we note that it is the real interest rate r that matters for spending
decisions and the nominal interest rate i that is relevant when we look at monetary questions
Adding up the various demand functions according to the national income identify, we
obtain the planned or desired demand function (DD). DD increases with income.
DD = C(Ω,Y-Toverbar) + I(r,q) + G + PCA(Y,Y*, ó)
Desired demand rises with the GDP. But demand increases less than the GDP, which explains
why the DD schedule is flatter than the 45 line.
1. Overview
To study the short run behaviour of the economy, we adopt a crucial Keynesian assumption
that prices are constant.
Macroeconomic price flexibility is a reasonable working assumption for the long run. Under
price flexibility, the monetary neutrality principle applies, and money and prices behave
independently of output. This long-run independence, or dichotomy, of the real and
monetary dimensions of the economy serves as an important anchor for analysis.
In the long run, prices are fully flexible and neatly separate out nominal and real sides of the
economy.
In the short run, prices do not move, or move rather slowly, the dichotomy fails and
everything becomes more complicated.
The Keynesian model focuses on two markets: (1) the market for goods and services (2) the
money market. We will add the foreign exchange market.
General equilibrium = the simple requirement that all markets achieve equilibrium at the
same time, and that these equilibrium conditions are mutually consistent with each other.
2. Aggregate Demand and the Goods Market
Y = C + I + G + PCA supply for goods and services = demand for goods and services
Public spending G and tax receipts T as exogenous. Wealth too.
Consumption function: C = C(wealth,Y,-T) (++)
Investment function: I = I(q,r) (+-)
Import function: Z = Z(A,ó) (++)
Export function: X = X(A*,ó) (+-)
A* = foreign asorption ó = real exchange rate
Primary current account function: PCA = X(A*,ó) - Z(A,ó) = PCA(A,A*,ó) = PCA(Y,Y*,ó)
The interest rate matters for investment for two reasons:
1. Because a higher interest rate reduces Tobin’s q
2. Because firms borrow from banks to finance investment. When borrowing costs rise,
firms invest less.
! For future reference, we note that it is the real interest rate r that matters for spending
decisions and the nominal interest rate i that is relevant when we look at monetary questions
Adding up the various demand functions according to the national income identify, we
obtain the planned or desired demand function (DD). DD increases with income.
DD = C(Ω,Y-Toverbar) + I(r,q) + G + PCA(Y,Y*, ó)
Desired demand rises with the GDP. But demand increases less than the GDP, which explains
why the DD schedule is flatter than the 45 line.
