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Reconciling the Markets for Money and for Loanable Funds. Foreign Exchange Markets. Product and Factor Markets. Lesson: A Comparison of Graphs from Microeconomics and Macroeconomics.
About the Editor. About the Authors. 46 iii Introduction David A. Anderson and Paul G.
Blazer The goal of this special focus project is to support the proper labeling of economics graphs and reinforce the understanding of critical concepts that underlie these labels and graphs. When Richard Rankin suggested the development of materials for this purpose, I embraced the idea wholeheartedly, because disastrous economics free-response answers begin time and again with disastrous graphs. As a result of engagement with the assembled resources and activities, students will be able to construct and feel comfortable with many of the central graphs of introductory economics. In their approach to economic problem solving, it is naturally tempting for students to contemplate “punting” on graph mastery to focus on the intuitively appealing topical applications.
The trouble is that correct answers to important questions are gleaned quickly from accurate graphs, yet prove elusive for those who bypass graphical solutions. In other words, the seemingly hard path of struggling to learn the graphs is actually the easiest and most reliable line of attack. As a foundation for economic literacy, there is no alternative. The economics dream team of Eric Dodge, Woodrow Hughes, Pamela Schmitt, and Shaun Waldron has assembled these materials for the benefit of workshop leaders, instructors, and students.
Each of these authors is also a star teacher with years of experience teaching the principles of economics, and each has graded thousands of free-response AP® Economics questions. I think you will find their explanations to be thorough, insightful, and useful to anyone seeking greater comfort with the key graphs of economics. I would also like to thank James Chasey of the College of DuPage and Bruce Johnson of Centre College for their excellent comments on earlier drafts of this project; Richard Rankin of the Ioloni School for being the motivating force; and Lien Diaz and William Tinkler of the College Board for their kind and competent oversight. Special Focus: Markets Summary of Content These materials have been carefully composed so they can be used at different levels by workshop leaders, AP teachers, and students.
The following questions may be used to ascertain the reader’s grasp of important content concepts explored in these Special Focus materials: • Why is it appropriate to place the nominal interest rate rather than the real interest rate on the vertical axis of the money market graph? • What curves related to the foreign exchange market between Country A and Country B will shift if Country A falls into a recession and Country B does not? • Why is the short-run aggregate supply curve upward sloping? • What is the specific connection between the demand for goods and the demand for labor? Summaries of each specific content area follow. The Markets for Money and Loanable Funds In the first section, Eric Dodge walks users through the graphs for money and loanable funds markets. With the support of these materials, facilitators on any level will want to stress when to use the money market graph rather than the loanable funds graph, and emphasize that the nominal interest rate is determined in the money market whereas the real interest rate drives the loanable funds market. These are difficult concepts about which readers will relish clarity.
The exposition begins with a straightforward delivery of the most important distinctions. The remainder of this section explains the more rigorous side of these topics for those who want greater depth of knowledge. Readers are also treated to a refresher on a broad array of macroeconomic issues, as is necessary to tie the relevant content together without demanding uncomfortable leaps of faith. The Foreign Exchange Market Woodrow Hughes has written an easily digestible essay on the foreign exchange market, replete with real-world examples and user-friendly explanations.
This will help facilitators convey when to shift which line(s) for which country, and when multiple shifts are appropriate. Useful comparisons between the foreign exchange market and the standard market for a consumption good allow users to transfer their familiarity with goods markets to the less familiar markets for foreign currency. The included 2 Introduction exercise reinforces distinctions between the various types of curve shifts and tests for an understanding of how shifts affect currency appreciation or depreciation. Supply, Demand, Aggregate Supply, and Aggregate Demand Readers will appreciate Shaun Waldron’s side-by-side comparison of the macro and micro sides of supply and demand.
The piece demystifies axis labels and curves and juxtaposes them to emphasize similarities and differences between the two models. An exercise prompts users to consider whether specified changes affect supply, demand, aggregate supply, or aggregate demand. Factor Markets Pamela Schmitt’s piece focuses on factor market graphs, linkages between factor and product market graphs, and how and why to properly label these graphs. This section provides a numerical example of supply and demand in factor markets and allows users to follow changes in product demand through to see how they affect factor markets at the source of the product.
3 Reconciling the Markets for Money and for Loanable Funds Eric Dodge Hanover College Hanover, Indiana Most students of economics find the coverage of supply and demand, particularly in micro markets, both intuitive and useful. Teachers have very little trouble coming up with everyday examples that students can relate to, and the local newspaper is chock full of useful current events that demonstrate how the “real world” often supports the theory. When the students begin their macro studies with aggregate supply and demand, the intuition and tools learned with micro supply and demand become invaluable. As a result, students are usually pretty good at adapting micro supply and demand to the AD/AS model.
But when the course turns to more esoteric topics, even those that continue to rely on supply and demand analysis, many students hit the wall. For example, some economics teachers find it challenging to explain to their classes the difference between the money market and the market for loanable funds. In particular, it isn’t always clear why the vertical axes are labeled with different measures of the interest rate. When students find themselves confused about the money market and the market for loanable funds, it’s often difficult to articulate exactly what it is that creates the confusion.
I believe that much of the confusion can be traced to the textbook treatment of the different macroeconomic models (classical and Keynesian) and the foundations on which they are based. It might be helpful, then, to briefly summarize the underpinnings of these two schools of thought and to compare and contrast perspectives on how the macro economy works in the short run and in the long run.1 There are three key macroeconomic variables that play a role in the economy: the level of output, the price level, and the interest rate. The role of each variable in the 1. For coverage of these models at the introductory level, see Mankiw’s Principles of Economics (3rd) as well as Krugman and Wells’s Economics.
At the intermediate level, see Mankiw’s Macroeconomics (5th). Special Focus: Markets model depends upon whether the model assumes a long-run (classical) or a short-run (Keynesian) perspective. It is the long-run and short-run differences that provide for different treatments of the interest rate. A Brief Summary of the Classical View 1.
Output is determined by a production function that combines a nation’s capital stock, labor force, and technology to produce GDP. While nominal output might fluctuate in the short run, in the long run, real output will tend toward the natural level of output, or full-employment output. For any given level of output, savings must equal investment. Both savers and investors, each with a long-run horizon, respond to changes in the real interest rate.
If the real interest rate rises, savers (private and public) can expect a higher long-run return (after adjusting for inflation) on every dollar saved, so savings rises. But a higher real interest rate decreases the long- run profitability of every dollar invested. This is because most investment projects require the firm to borrow funds from a bank, and even if a firm does not have to borrow funds to finance projects, higher real interest rates impose a higher opportunity cost for the use of their own funds. Thus, private investors decrease their levels of investment at higher real interest rates.
There is only one real interest rate that equates the dollars saved with the dollars invested, and the market for loanable funds shows how this real interest rate is determined. The money market serves to balance the quantity of money demanded with the quantity of money supplied. The Quantity Theory of Money tells us that the value of money is simply the number of goods that can be bought with one dollar. If P is the price of a basket of goods and services measured in dollars, then the value of $1, or the “price” of money in the money market (the number of baskets that exchange for $1), is $1/P.
This school of thought, assuming a constant velocity of money and constant level of output, concludes that changes in the money supply will have a direct impact on the price level, and thus affect the value of each dollar. However, changes in the money supply will not impact the level of output because it has not changed the fundamental macroeconomic production function. In the long run, this is why the classical economists draw the AS curve as vertical. 6 Reconciling the Markets for Money and for Loanable Funds In the short run, many of the above assertions do not hold.
Output does fall below full employment and prices do not always quickly rise and fall with changes in the money supply. It is for the short-run view of the economy that the Keynesian model is used. A Brief Summary of the Keynesian View 1. The price level is assumed to be relatively fixed in the short run.
This is where the concept of “sticky prices” comes from. Because the price level is not changing, there is essentially no difference between the nominal and real rates of interest. For a given (and steady) price level, the nominal interest rate serves as the device to clear the money market.
