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Chapter 6: Markets, Prices, Supply, and
Demand
Chapter Summary:
This is the first chapter of a new unit on the nature of economic
fluctuations. Up to this point, the text has focused on the relatively steady
increase of production over long periods of time based entirely on supply side
factors. In this unit, the role of the demand side is developed, short term
In the chapter, the market process is modeled using the familiar supply
and demand approach in 4 important markets: the market for goods, the market
for labor services, the market for capital services, and the market for bonds. In
each case the factors that determine the supply and demand are described and
Chapter Outline:
I. Introduction: Markets, Prices, Supply and Demand
II. Four Key Markets in the Macroeconomy
A. The Goods Market
III. Household Income and Spending
A. Sources of Income
IV. Market Clearing for Labor and Capital Services
A. Profit Motive and the Demand for Resources
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B. The Market for Labor Services
1. Demand for Labor
C. The Market for Capital Services
1. Demand for Capital Services
a. equilibrium interest rate
D. Profit in Equilibrium
Teaching Tips:
1. As we have seen before, the introduction of so many new symbols is likely to
lead to confusion among the students. Teachers should consider posting a
2. The discussion of the bond market provides an opportunity to introduce
students to one of the truly useful economic indicators. The “markets lineup”
3. Although students may be aware of the concept of zero economic profit as a
condition for long run equilibrium, it is worth explaining the relation of zero
Answers to review questions, pg. 147
1. Money and prices are a convenient unit of measurement, but they are not
fixed units like feet or inches. Ignoring changes in the value of money would be
similar to ignoring changes between kilometers and miles per hour when
establishing acceptable speed limits. In Canada, where speed is measured in
kilometers, 100 is associated with a particular level of safety. A speed limit of 100
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2. A change in a household’s net asset position during the period is a flow
variable, the accumulated effects of these changes is a stock variable. For
3. The household budget constraint is given by equation (6.12)
C+(1/P)* B + K= /P +(w/P)*L + i*(B/P + K)
This shows that real consumption plus real saving= real household income.
4. An increase in the real wage rate, w/P reduces the quantity of labor
demanded. This conclusion is based on the shape of the demand curve shown in
5. The answer to this question is analogous to question 4, as shown in figure 6.6
on page 142.
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Answers to Problems for discussion, pg. 147
6a. The rate of interest on the bond will be given by the formula:
i= (principal-PB)/ PB
7a. Purchasing the two year bond is equivalent to purchasing the one year bond
and reinvesting the proceeds at maturity in another one year bond. So our
investor has a choice of either investing in an asset that yields (per $1 invested)
(1+it)(1+it+1) or he can invest in the 2 year bond in which case he will earn
(1+i2t)(1+i2t) per dollar invested. (Remember the 2 in the superscript is to denote a
7b. If short term rates are expected to rise as in the previous example, then the
long term rate will by higher than the short term rate. This is because the long
term rate must take into account next years short term rates in order to be
attractive to today’s lenders. This may explain why, in a growing economy, the
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7c. If future short term rates are not known with certainty, then the decision to
hold long term bonds entails some risk. Unexpected movements in short term
rates could leave long term bond holders with lower rates of return. This could
cause prices of long term bonds to fall below the average of the expected short
term rates, which would result in higher rates for long term bonds.
8c. The intermediary has experience and information that borrowers and
lenders lack. The ability to evaluate the creditworthiness of potential borrowers
and arrange terms which fit the unique needs of both borrowers and lenders is
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Handout: Symbols Used in Chapter 6
Symbol:
Concept:
Definition:
Y
Real Goods
Produced
The quantity of goods and services produced during the period.
Xd
quantity of “x”
demanded
The superscript “d” refers to the demand side of the market for
“X”.
M
The nominal
quantity of money
The quantity of money circulating in the economy
expressed in dollars
M/P
The real quantity of
money
The quantity of money circulating in the economy expressed in
terms of its real purchasing power
w
The nominal wage
rate
The amount paid for one unit of labor services, expressed in
dollars.
The real wage rate
The amount paid for one unit of labor services expressed in
terms of its real purchasing power
The nominal rental
rate for capital
The amount paid for one unit of capital services, expressed in
dollars.
The real rental rate
for capital
The amount paid for one unit of capital services, in terms of its
real purchasing power
P
The Price Level
A price index which expresses the cost of a basket of all goods
and services in the economy. It is the price paid for one unit of
Y.
i
The nominal rate of
interest
The rate of return on money loaned out (in our model, the rate
of return on bonds) expressed as a percentage of the principal.
r
The real rate of
interest
The rate of return on money loaned out (in our model, the rate
of return on bonds) adjusted for inflation. r=i-inflation.
The nominal value of
Bonds
dollars.
Nominal Profit
Income from sales- wage and rental payments, expressed in
dollars.
State of Technology
A technological “multiplier” that makes capital and labor
services more productive.
Real Capital
Assets such as buildings, equipment, materials, employed in the
production process.
Real Labor
The amount of labor services employed in the production
process.
capital and labor input to a particular value of output.
supplied