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Theories of Equilibrating Variables

Overview

In a standard model of supply and demand for a good, the price of the good is taken to be the equilibrating variable that adjusts to achieve equilibrium where supply equals demand.  In a setting with two goods X and Y and two prices PX and PY, the path to equilibrium is not so obvious.  If external factors cause a shift in the supply curve for X (food), then the prices of both X (food) and Y (clothing) may well change as agents adjust their demand for clothing in light of the new situation in the market for food.  In a sense, the price of clothing is adjusting to help achieve equilibrium in response to a change in the supply of food.  In microeconomics, this complication is not generally important because the price of food is held to do most of the adjusting when the supply of food shifts and the price of clothing is thought to respond rather passively.

In macroeconomics, an economy includes a variety of equilibrating variables, including prices, wage rates, interest rates, and exchange rates.  Sharp disagreements about the role of equilibrating variables at the center of many debates.  Two examples illustrate the nature of this issue.  (i) If prices are fixed in the short run, then the interest rate might adjust to achieve equilibrium in the goods market.  (ii) Unemployment might be interpreted as a failure to achieve equilibrium in the labor market.

Macroeconomics thus faces a number of questions.  (a) Which equilibrating variables respond to the largest extent for a given shock?  (b) Can the equilibrating variables adjust fast enough to achieve equilibrium?  (c) What happens if the government fixes or otherwise manipulates the equilibrating variables?
 

Comments?  Questions?  macro-at-econmodel-dot-com  Copyright 2006 William R. Parke