Economics 311
Money and Income
Chapter 5-The Basic Market Clearing Model
Department of Economics
College of Business and Economics
California State University-Northridge
Professor Kenneth Ng
nt.
Monday, July 31, 2017
Administrative Details
Second Exam—Thursday, April 18th.
Homework-Due Tuesday April 16th.
The Basic Market Clearing Model

We have identified 3 markets in the economy:
1. Goods Market-production (Y) must equal
consumption (c)
2. Bond Market-bonds sold must equal bonds
bought. B=0
3. Money Market-Amount of money supplied (fixed
but controlled by FED) must equal the amount of
money demanded.
 On these three markets, the Interest Rate-R and the
Price Level-P adjust so that supply and demand
equalize in each of these markets.
 When all three markets are in equilibrium, we say
that General Market Clearing has occurred.
General Market Clearing or Walras' Law of Markets
 The household's budget constraint in period 1 in real terms is:
d
b
(
1

R
)
m
m
s
d
0
0
y1 

 c1 
 1
P
P
P
P
b1d

If we sum up the budget constraint across all households, the
Aggregate Budget Constraint is:
d
d
B
(
1

R
)
M
B
M
Y1s  0
 0  C1d  1  1
P
P
P
P

Because every dollar lent must equal a dollar borrowed, , we can
rearrange the terms of the Aggregate Budget Constraint:
d

B
C1d  Y1s   1
 P
  M 1d M 0 
  
  0

P 
  P
General Market Clearing or Walras' Law of Markets
 In order for the economy to be in equilibrium, 3 conditions must
be met:
C1d  Y1s Demand for Commoditie s must equal Productio n
B1d  0 Bonds sold equals bonds bought,
or dollars lent equals dollars borrowed.
M 1d  M 0

People willingly hold the existing stock of money
But algebraically, if conditions 1 and 2 hold then by definition
condition 3 must hold (Walras' Law of Markets-General
Equilibrium Model).
 Same as saying if you have a system of three equations in
two unknowns, if a solution satisfies two of the equations, it
must satisfy the third.
How the Commodity Market Clears:
 The Interest Rate will change so that the supply of commodities
(C) equals the production supply (Y):
 Why does the supply of goods increase as the interest rate
increases?
 Inter-temporal substitution of labor.
• An increase in interest rates causes people to work more now,
save their extra earnings, and spend their savings plus interest in
the future, i.e. an increase in the interest rate increases current
work, current production, and the current supply of goods.
 Why does the demand for consumption decrease as the
interest rate increases?
 Inter-temporal substitution of consumption.
• An increase in interest rates causes people to spend less now,
save the money not spent on current consumption, and spend
their savings plus interest in the future, i.e. an increase in the
interest rate decreases current consumption.
Commodities Market: Supply
R
Ys
Why is the supply curve for
commodities upward
sloping?
An increase in interest rates,
causes an inter-temporal
substitution of labor.
Current labor effort increases
causing current output to
increase.
Cd, Ys
Commodities Market: Supply
Y
Present
A
In the present, workers will
increase work effort, produce
more (A to B), and save the
extra output.
B
Future
Y
A
B
l
In the future, workers will
increase work effort, reduce
output, and consume their
savings plus accrued interest.
l
Commodities Market: Demand
R
Why is the demand curve for
commodities downward
sloping? s
Y
As interest rates rise, an
inter-temporal substitution
effect is created.
Households reduce current
consumption and increase
savings.
Cd
Cd, Ys
Commodities Market: Demand
C2
B
An increase in interest rates
would cause a rotation of the
inter-temporal
budget
s
Y
constraint (blue to red).
This would cause a decrease
in current consumption and
an increase in future
consumption (A to B).
A
C1
Commodities Market Clearing
Suppose the interest rate R1.
How would the interest rate move
to clear them market?
R
At R1, there are
s more goods
Y
being demanded than are being
supplied.
If the interest rate were to rise,
then there would be an intertemporal substitution effect
causing people to reduce current
demand and raise current supply.
Households would work more and
produce more now (increase in
supply).
R1
Excess Demand
Households would reduce current
consumption
d and save more
C
(increase in demand).
Cd, Ys
Commodities Market Clearing
Suppose the interest rate
is at R2.
There are more goods
being supplied than
demanded.
Ys
R
Excess Supply
R2
If the interest rate fell,
there would be an intertemporal substitution
effect
Current consumption
would be increase
because households
would stop shifting
consumption from the
present to the future.
Current work effort would
decrease
as households
Cd
stopped producing a
surplus of goods today
that they
Cdsave
, Ys and
consume in the future.
Clearing the Money Market.
 For the moment, assume that the supply of money is fixed. In
point of fact it is controlled by the FED but assume a passive
FED which keeps the money supply constant.
 We know from previous discussions that the nominal money
demand function can be written as:
M


  R , Y ,.... 
 ( ) ( ) 
P
M  P   R , Y ,.... 
 ( ) ( ) 
The supply of money is
controlled by the FED.
Money Market
For the moment assume that
the FED keeps the money
supply constant.
Ms
P
Changes in Ms constitute
monetary policy
M d   R , Y ,.... 
 ( ) ( ) 
When P1 increases we move
along the money demand
function.
At P1 the demand for money
is less than the supply. If the
price were to rise then the
nominal demand for money
would increase. .
P1
Excess Supply
M, Md
Money Market
Ms
P
Excess
Demand
M d   R , Y ,.... 
 ( ) ( ) 
At P2, the demand for money
exceeds the supply.
If the price were to fall, then
the nominal demand for
money would fall eventually
equaling supply.
P1
Excess Supply
M, Md
Money Market
P
Ms
Md
P2
At P2, the demand for money
exceeds the supply. I f the
price were to fall, then the
nominal demand for money
would fall.
M, Md
General Market Clearing
 We predict that the commodity market will clear and the amount
of money demanded will equal the money supply.
 The procedure for solving the model is to
 First, figure out the interest rate (R*) which will clear the
commodity market. This determines the interest rate R* and
the amount of commodities supplied Y*
 Second, we can substitute the R* and Y* from the
commodity market into the money demand function and then
find the P* that will clear the money market.
 Example of analysis using the General Market Clearing model.
Temporary shift of the production function, e.g. bad weather.
Permanent Proportional Improvement in the Production
Function
 A permanent proportional improvement in the production function effects two
things.
 Ys---The Supply of Commodities
 Choice of work vs. leisure.
• Wealth effect: Households are producing more goods with the
same amount of work effort.
 If leisure is normal, this will lead to a reduction in work effort.
• Substitution effect: Given the amount of work effort, and additional
hour worked produces more additional output (MPL or slope of PF
has changed).
• Inter-temporal substitution of labor.
 Because the reward to labor is impacted equally in all
periods, their is no incentive to work more in one period and
less in another period and shift the consumption over time by
borrowing and lending.
 Cd ---The Demand for Commodities
 Choice of consumption now vs.later.
• Permanent Income Hypothesis
 Households prefer even flows of consumption over time.
• A permanent change creates no incentive to move consumption
over time because both the present and future are impacted
equally.
Commodities Market: Supply
Y
In the present, there will be a substitution effect
causing households to work more and a wealth
effect causing them to work less (if leisure is a
normal good).
Present
B
The net effect is an increase in work effort and
output (Ys).
A
This is shown as the movement from A to B.
Future
Y
o
l
B
A
The future will be the same as the
present.
There will be a Substitution and Wealth
effect causing a net increase in work
effort and output.
l
Commodities Market: Supply
R
What effect will the permanent
proportional improvement in the
production function have on Ys—
the supply of commodities?
Ys
At any given interest
rate, more will be
produced.
Cd
Cd, Ys
Commodities Market: Demand
What effect will the permanent
proportional improvement in the
production function have on future and
present consumption and borrowing?
C2
B
C2=Y
2
A
C2=Y
Because the production function has
improved and households are working
more, the produce more in the present
and future (Y1 and Y2 ) have increased.
The inter-temporal budget constraint
shifts out.
Because the present and future are
impacted equally there is no incentive
to shift consumption over time.
2
C1=Y1 C1=Y1
C1
Commodities Market: Supply
Because income has
increased in the present and
the future, the household
now demands more
s
Y
consumption.
Cd shifts out.
R
R1
A
B
Because there improvement
in the production function is
permanent, there is no
change in net borrowing and
no change in the interest rate.
The effect of the permanent
proportional improvement in
the production function is an
increase in production and
consumption with no change
in the interest rate.
Cd
Cd, Ys
Money Market
P
Ms
M d   R , Y ,.... 
 ( ) ( ) 
P1
P2
Y has increased so
money demand (Md) has
increased.
If the Fed keeps the
money supply constant,
the price level will fall
from P1 to P2.
M, Md
Money Market
P
Ms
M d   R , Y ,.... 
 ( ) ( ) 
P1
P2
What monetary policy
should the FED follow if
it wants to keep prices
stable?
Increase money supply.
M, Md
Temporary Proportional Improvement in the Production
Function
 A temporary proportional improvement in the production function effects two
things.
 Ys---The Supply of Commodities
 Choice of work vs. leisure.
• Wealth effect: Households are producing more goods with the
same amount of work effort.
 If leisure is normal, this will lead to a reduction in work effort.
• Substitution effect: Given the amount of work effort, and additional
hour worked produces more additional output (MPL or slope of PF
has changed).
• Inter-temporal substitution of labor.
 Because the reward to labor is expected to be temporarily
higher today, households have an incentive to work more
today, save the extra income and work less in the future.
 By saving they can shift the consumption over time.
 Cd ---The Demand for Commodities
 Choice of consumption now vs.later.
• Permanent Income Hypothesis
 Households prefer even flows of consumption over time.
• Even though households earning more today, current
consumption will not increase by as much as current income
because households expect future income to be lower.
Commodities Market: Supply
Y
In the present, there will be a substitution effect
causing households to work more and a wealth effect
causing them to work less (if leisure is a normal good).
Present
B
The net effect is an increase in work effort and output
(Ys). This is shown as the movement from A to B.
The increase in work effort and output from a
temporary proportional improvement in the production
function is much greater than the increase from a
permanent improvement.
A
Future
Y
l
In the future, households, will live off
their savings.
A
B
Future work effort and output will
decrease.
l
Commodities Market: Supply
R
Ys
Ys
The big increase in work
effort will cause a large shift
in the supply of
commodities.
Cd
Cd, Ys
Commodities Market: Demand
Households new pattern of earnings
over time is represented by point B.
Working and producing more today and
less in the future.
C2
The permanent income hypothesis says
households like to consume even
patterns of consumption over time.
C
Therefore, they use financial markets to
consume consumption pattern C.
A
Does this involve borrowing or lending?
C2=Y
2
B
Y2
C1=Y1
Y1
C1
Commodities Market: Supply
Although the supply of
commodities has shifted out
a lot, the demand for
commodities shifts out only a
little.
Ys
R
R1
R2
This is because some of the
increase in current
production is being saved to
be consumed in the future.
A
B
At the new equilibrium,
output has increased and the
interest rate has fallen.
If you were a bond
speculator would you buy or
sell bonds?
Cd
Cd, Ys
Money Market
P
Ms
M d   R , Y ,.... 
 ( ) ( ) 
P1
P2
Y has increased so
money demand (Md) has
increased.
If the Fed keeps the
money supply constant,
the price level will fall
from P1 to P2.
M, Md
Money Market
P
Ms
M d   R , Y ,.... 
 ( ) ( ) 
P1
P2
What monetary policy
should the FED follow if
it wants to keep prices
stable?
Increase money supply.
M, Md
Temporary vs. Permanent shift in
Production Function (1)
 Compare and Contrast.
 Wealth and Substitution Effects.
 Position and slope of production function.
 Inter-temporal substitution of labor and consumption.
 When will there be an inter-temporal shift of labor?
• Will the change in labor be greater if the change in the
production function is temporary or permanent?
 When will households use financial markets, i.e. buy and sell
bonds, to shift consumption over time?
• Movement along the inter-temporal budget constraintpermanent of temporary shift in production function.
 Changes in Permanent Income.
 Shift in position inter-temporal budget constraint-permanent of
temporary change in production function.
Temporary vs. Permanent shift in
Production Function (2)
 Potential exam questions:
 Which has a greater effect on bond prices, a temporary or permanent shift
in the production function? Explain.
 If you were a stock or bond speculator, which would offer a greater
opportunity for short term profit a temporary or permanent shift in the
production function? Explain.
 If the Fed wished to maintain stable prices, what would the correct
monetary policy be when there is a temporary or permanent improvement
in the production function. Explain.
 Would there be any difference?
 If you wanted a bigger effect on current output would you make a tax cut
temporary or permanent. Explain.
Pop Quiz
 Suppose a proportional degradation of the production
function in the future is expected.
 Analyze the effects of such an expectation.
What effect would this have on current and future
consumption and production, work effort, demand for
money, interest rates and prices?
If the FED wanted to keep the price level constant,
what should monetary policy (changes in the
quantity of money) be?
Pop Quiz: Commodities Market: Supply
Y
In the present, households will increase their work
effort. They will do this in anticipation of the wage rate
being lower in the future.
Present
B
A
Future
Y
A
l
In the future, households, the
production function is expected to
degrade (dotted line).
B
Households will reduce their work
effort and live off their savings.
l
Pop Quiz Commodities Market: Supply
R
Ys
Ys
The big increase in current
work effort will cause a large
shift in the supply of
commodities.
Cd
Cd, Ys
Pop Quiz Commodities Market: Demand
Households start off at A.
With the expected future degradation,
the household will increase current
work effort and reduce future work
effort.
C2
The inter-temporal budget constraint
will shift in because overall the
production function has degraded.
A
C2=Y
2
C2*
The household will save some of the
extra output produced today and
consume it in the future (B to C).
C
B
Y2
C2*
Y1
C1=Y1
C1
Pop Quiz: Commodities Market: SupplyAlthough the supply of
commodities has shifted out
a lot, the demand for
commodities shifts in
because
at any given interest
Ys
rate households want to save
to maintain consumption in
the future.
R
R1
A
B
At the new equilibrium,
output will increase and
interest rates will fall.
If you were a bond
speculator would you buy or
sell bonds?
R2
Cd
Cd, Ys
Pop Quiz: Money Market
P
Ms
M d   R , Y ,.... 
 ( ) ( ) 
P1
P2
Y has increased so
money demand (Md) has
increased.
R has decreased so
money demand (Md) has
increased.
If the Fed keeps the
money supply constant,
the price level will fall
from P1 to P2.
M, Md
Money Market
P
Ms
M d   R , Y ,.... 
 ( ) ( ) 
P1
P2
What monetary policy
should the FED follow if
it wants to keep prices
stable?
Increase money supply.
M, Md
Monetary Policy and the Basic
Market Clearing Model
 What is the effect of changes in the money supply on real variables
(Cd and Ys)?
 Stated another way, what is the link between FED policy and
economic performance.
 Can the Fed by changing the money supply effect work effort,
output, nominal and real interest rates, and the price level.
 This will be the main question addressed after the second exam.
Monetarism and the Neutrality of Money
 Basic Market Clearing Model shows a property long studied by
economists-Money Neutrality or Monetarism.
 Permanent changes in the stock of money affect nominal variables but
leave real variables unchanged.
 A change in the money supply causes only an increase in the price level.
 The increase in the price level causes an increase in nominal income
and nominal output but real output and income remain the same.
 In the Basic Market Clearing Model, P will increase but C and Y
remain the same.
 Nominal income (P*Y) and consumption (P*C) increase but real
income (Y) and consumption (C) stay the same.
 Monetarism posits that changes in the money supply are responsible for
inflation in the long run.
 Changes in the money supply can cause short term effects but they
are unpredictable because they depend upon households
expectations.
Exam: Study Guide
 Be able to engage in economic analysis using the Basic Market
Clearing Model.
 Change in real world-----BMCM (handout)-----Y,C,R, and P.
 Concentrate on the following graphs.
 Work/Leisure Decision—Supply of Commodities.
 Consumption now vs. later decision-Demand for Commodities.
 Change in Interest Rates-Market for Commodities.
 Change in Money Demand-Price Level.
 Be able to solve stand alone problems involving the demand for
money.
 Formulas for V, M/D, and transaction interval.
 Worth memorizing plus total cost of holding money formula.
 Graph showing Total Cost of Holding Money and the optimal
transaction interval.
Exam Study Guide
Changes in World.
Change in Production Function.
4 Types:
• Permanent Improvement/Degradation.
• Temporary Improvement/Degradation.
• Anticipated improvement/Degradation.
Change in expectations about the future.
Changes in technology of acquiring cash
balances.
Transaction cost.
Change in Preferences.
Value of consumption now vs. later.