Download Rate of interest

Slide Show #10
AGEC 430
Macroeconomics of Agriculture
Spring 2010
Handout #18
The Big 5 Macro Variables
 There are 5 key variables linking the food
and fiber system with the general
economy.
 They are:
1. Rate of inflation
2. Rate of interest
3. Rate of unemployment
4. Rate of growth in GDP
5. Rate of foreign exchange
The Big 5 Macro Variables
1. Rate of inflation – affects prices for farm inputs in the
short run and interest rates in the longer run.
2. Rate of interest – affects farm interest expenses and
farm land values.
3. Rate of unemployment – affects off-farm income of
farm operator families, an important source of internal
equity capital for many farmers and ranchers.
4. Rate of growth in GDP – affects domestic demand for
agricultural products (remember the income elasticity of
demand.
5. Rate of foreign exchange – reflects the value of the
dollar relative to client nation currencies and hence the
export demand for agricultural products.
Handout #19
MD
MS
ie
QM
Substituting equations 1 and
2 into equation 3 and solving
for the interest rate “i”
A partial equilibrium focusing
on the money market. As “Y”
changes, it affects the rate of
interest or “i”.
AD
AS
Pe
Ye
Substituting equations
6, 7 and 8 into equation 9 and solving for
“Y”…
Savings, measured by
S in this equation 13, is
the “S” in the IS curve.
A partial equilibrium
focusing on the
product market. As
the rate of interest “I”
changes, aggregate
demand “Y” changes.
A general equilibrium
for both the money
and product market.
This captures the only
interest rate and level
of GDP that satisfies
both markets.
Expansionary
Monetary
Policy
Given Y and i, you can solve for investment and consumption expenditures
Expansionary
Fiscal
Policy
The intersection of the IS
and LM curves not only
gives us the general
equilibrium in the money
and aggregate product
markets, but it also gives
us the general price level
in the economy (i.e., CPI).
Expansionary monetary
policy, for example,
would shift the LM curve
to the right. Lower interest
rates would stimulate
investment and shift the
aggregate demand curve
to the right. We saw this
presented earlier in
Handout #16, but not in
this general equilibrium
context.
Macro-Market-Micro
LS
LD
wr
LE LMAX
Macro-Market-Micro
Overview
UR
YPOT
%∆P
Implications for a Commodity Market and Individual Producer
Wheat Market
Dw
Sw
Qwe
MC
MC
MR
AC
Pwe
Pwe
Profit Analysis
Wheat Producer
qwe
Pwe
MR
AC
qwe
Average profit = MR – AC at qwe (distance between red and blue dots)
Total profit = average profit times qwe (shaded area)
Expansionary
Monetary Policy
LS
LD
wr
LE LMAX
Macro-Market-Micro
Overview
UR
YPOT
%∆P
LS
LD
1
wr
LE
UR
%∆P
Step 1: Increase in
the money supply
shifts the LM curve to
the right. Interest
rates fall, suggesting
an increase in investment expenditures.
LS
LD
wr
LE
2
Step 2: Aggregate demand
increases, pulling up the
general price level, and
thus requires addition
production.
UR
%∆P
LS
LD
3
wr
LE
Step 3: The increased
production requires
additional labor,
shifting the labor
demand curve to the
right and pushing up
wages rates.
UR
%∆P
LS
LD
wr
LE
Step 4: The decline in
unemployment rate
and presence of both
demand pull and cost
push inflation results
in a movement down
the Phillips curve.
4
UR
%∆P
Wheat Market
5
Dw
Sw
PWe
QWe
One of the factors that shifts the demand curve for a commodity
is disposable income. This not only shifts the aggregate demand
curve for all goods and services but intermediate goods like
wheat (step 5). This increases the price of the commodity.
Wheat Market
5
Dw
Sw
Wheat Producer
6
MC
MR
PWe
PWe
QWe
AC
qwe
The increase in the price of the commodity means that the price
that price takers like our wheat producer rises (step 6). Average
profit rises (spread between green dots now instead of yellow
dots). And more is supplied, increasing revenue and profit since
qwe is greater.
Wheat Producer
Farm Income Statement:
Farm revenue
Farm expenses
Farm taxable income
Income taxes 3/
Net farm income
6
Up
Up slightly
Up
No change
Up
MC
MR
PWe
AC
qwe
Farm Balance Sheet: 1/
Current assets
Up
Land values 2/
Up
Fixed assets
No change
Total assets
Up
Current liabilities
Fixed liabilities
Net worth or equity
Total debt and equity
Up (accrued taxes)
No change
Up
Up
1/ Assumes a current market value balance sheet.
2/ Capitalized land values rise due to higher farm income.
3/ Reflects assumption that taxes paid on last year’s income.
The annual change in equity = retained earnings + net asset appreciation
Expansionary
Fiscal Policy
LS
LD
wr
LE LMAX
Macro-Market-Micro
Overview
UR
YPOT
%∆P
LS
LD
1
wr
LE
UR
%∆P
Step 1: A cut in the
income tax rate shifts
the IS curve to the
right. Interest rates
rise, but the tax cut
suggests an increase
in consumption
expenditures.
LS
LD
wr
LE
Step 2: Aggregate demand
increases, pulling up the
general price level, and
thus requires addition
production.
2
UR
%∆P
LS
LD
3
wr
LE
Step 3: The increased
production requires
additional labor,
shifting the labor
demand curve to the
right and pushing up
wages rates.
UR
%∆P
LS
LD
wr
LE
4
UR
%∆P
Step 4: The decline in
unemployment rate
and presence of both
demand pull and cost
push inflation results
in a movement down
the Phillips curve.
Wheat Market
5
Dw
Sw
PWe
QWe
One of the factors that shifts the demand curve for a commodity
is disposable income. This not only shifts the aggregate demand
curve for all goods and services but intermediate goods like
wheat (step 5). This increases the price of the commodity.
Wheat Market
5
Dw
Sw
Wheat Producer
6
MC
MR
PWe
PWe
QWe
AC
qwe
The increase in the price of the commodity means that the price
that price takers like our wheat producer rises (step 6). Average
profit rises (spread between green dots now instead of yellow
dots). And more is supplied, increasing revenue and profit since
qwe is greater.
Wheat Producer
Farm Income Statement:
Farm revenue
Farm expenses
Farm taxable income
Income taxes 3/
Net farm income
6
Up
Up slightly
Up
No change
Up
MC
MR
PWe
AC
qwe
Farm Balance Sheet: 1/
Current assets
Up
Land values 2/
Up
Fixed assets
No change
Total assets
Up
Current liabilities
Fixed liabilities
Net worth or equity
Total debt and equity
Up (accrued taxes)
No change
Up
Up
1/ Assumes a current market value balance sheet.
2/ Capitalized land values rise due to higher farm income.
3/ Reflects assumption that taxes paid on last year’s income.
The annual change in equity = retained earnings + net asset appreciation
Summary Comments
 Contractionary policy actions will reverse the
conclusions shown in this slide show.
 Know the four combinations of gaps and macro
policy in Handouts #16 and #17 (also see Slide
Show #9). One will be on exam #2, being worth
20 points.
 Be able to extend your analysis to the market
and producer level illustrated in this slide show.
This follow up may be on exam #2, and maybe
worth another 5-10 points.