[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

chapter will be used in Chapter 25 to understand the implications of the large
budget deficits that the U.S. government is currently running. Chapter 26 will explore
the role of international financial markets, the economy’s trade balance, and
exchange rates, while Chapter 27 will focus on the factors that account for longrun
economic growth. But to organize our discussion of these important economic
topics, we will need a model that explains how the adjustment of real wages
and the real interest rate help ensure that the economy is able, on average, to
achieve and maintain full employment. There is another reason for beginning with
a study of the long run: often, policies are proposed that may seem sensible at first
sight but that over time have undesirable consequences. To fully evaluate macroeconomic
policies, we must not neglect their long-run impact on employment,
interest rates, and economic growth.
Macroeconomic Equilibrium
The model we employ here is the basic competitive model described in Chapters
2 and 9. In it, large numbers of households and firms interact in the labor, product,
and capital markets. Households supply labor to firms that use it to produce goods
and services. Firms compensate workers by paying wages. Households use their
income to purchase the goods and services that firms produce. Households also
save, and their savings finance firms’ investments in the plant and equipment
needed to undertake production. For the use of their funds, households earn interest
and dividends from firms.
Two key lessons emerge from a study of macroeconomics. First, all markets are
interrelated. What happens in one market will have an impact on other markets.
The demand for labor, for instance, depends on the level of output in the product
market. Second, wages, interest rates, and prices adjust to ensure that demand
equals supply in each market. One of our major assumptions in this part of the book
will be that wages, interest rates, and prices adjust so that the labor, product, and
capital markets are in equilibrium. That is, they all clear, with the quantity demanded
equal to the quantity supplied. 1
While assuming that markets clear would be inappropriate if we were studying
the year-to-year behavior of the economy, it is a useful simplification for helping
us understand how the aggregate economy behaves over decades. The
assumption that prices, wages, and interest rates adjust to balance supply and
demand throughout the economy gives us powerful insights into some of the basic
issues of macroeconomics.
1 What happens when markets do not clear is the topic of Part Seven and will be important for understanding
short-run fluctuations in the economy. In this and the next few chapters, however, our assumption is that there
has been enough time for wages, interest rates, and prices to adjust to clear all markets. Some markets, such
as financial markets, adjust very quickly to clear every day; others, such as the labor market, may take many
months to clear if there are shifts in demand or supply.
526 ∂ CHAPTER 24 THE FULL-EMPLOYMENT MODEL