Y > C + I + G + NX(ε) => exchange rate decreases => NX increases until Y = C + I + G + NX(ε)
Y = C + I + G + NX(ε)
The left hand side of the goods market represents supply
The right hand side represents demand.
Y < C + I + G + NX(ε) => exchange rate increases => NX decreases until Y = C + I + G + NX(ε)
Change in Y
Change in L
Change in Y
Change in K
We begin with a production function.
For simplicity we assume K is fixed and allow L to vary.
The slope of this function is the marginal product of labour.
It tells us the change in output that results when we increase labour by one unit.
We might also assume L is fixed and allow K to vary.
We get a functional form that is increasing at a decreasing rate. This is consistent with the idea of diminishing marginal returns to labour.
Building the Goods Market Model: supply side
In this case a cross section of the surface would provide us with the two-dimensional production functions.
MPL is
labour
Demand
(W/P)*
L*
(R/P)*
K*
MPK is
Capital
Demand
The real wage W/P is the real price of labour. Where W (nominal wage) and P (price) are determined exogenously.
To determine the optimal amount of L, firms add L until the
MPL = W/P.
This is the profit maximization process that ultimately determines output.
The process is exactly the same for capital K. MPK = R/P (rental rate of capital divided by the price level).
S-I(r*),NX(ε)
ε
ε*
S-I(r*)
NX(ε)
ε
ε
Recall that S – I(r*) = NX(ε) is just a rearrangement of the goods market into net capital flow and trade balance components. This rearrangement is called the loanable funds market.
If the loanable funds market is out of equilibrium then the exchange rate adjusts to equilibrate it which in turn ensures that the goods market is in equilibrium.
Things that might shift S – I include changes in Y, T, G, or the mpc.
Things that might shift NX include changes in domestic and foreign trade policy policies such as tariffs or quotas.
S-I(r*),NX(ε)
ε
ε*
S-I(r*)
NX(ε)
ε*
ε*
NX(ε)
S-I(r*)
All these changes require a different real exchange rate to equilibrate the market.
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