SR+vs+LR - LECTURE 9-8 SUPPLEMENT The Economy in the Long...

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242 LECTURE SUPPLEMENT 9-8 The Economy in the Long Run and Very Long Run: Summary of Parts II and III and Introduction to Part IV Parts II and III of the textbook investigate the behavior of the economy in the long run and very long run; we summarize that analysis here. We first think about a large, closed economy. We wish to determine key macroeconomic variables—most notably the level of overall production of goods (that is, real GDP), the division of that production among alternative sources of demand (consumption, investment, government spending), and the determination of certain key prices (the rate of interest, the wage rate, the return to capital). Considering production first, and noting that goods are produced using capital and labor, we conclude that the overall supply of goods is determined by the existing stocks of capital and labor, together with the available technology. Equilibrium in the markets for capital and labor determines the price of capital ( R / P ) and the price of labor ( W / P ). These are real prices (in terms of goods). Turning to the various sources of demand, we take government behavior as exogenous ( G , T ) and posit simple behavioral relationships for consumption and investment. (The basic ideas underlying the consumption and investment functions are at this point simply taken as plausible; they are investigated more carefully in Part VI of the textbook.) Equilibrium in the market for goods determines the equilibrium real interest rate. Equally, this can be viewed as equilibrium in the market for loanable funds. Our analysis up to this point has therefore considered the markets for capital, labor, and goods. We have still not explained the determination of any nominal variables. We thus turn our attention to the market for money and assume that the demand for real money balances depends on income and the nominal interest rate. In equilibrium, this equals the real supply of money. This allows us to determine the price level. The Fisher equation reveals that the nominal interest rate equals the real interest rate plus the expected inflation rate. We also
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This note was uploaded on 10/04/2011 for the course ECON 101b taught by Professor Staff during the Spring '08 term at Berkeley.

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SR+vs+LR - LECTURE 9-8 SUPPLEMENT The Economy in the Long...

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