LONG-RUN ADJUSTMENT: The combined adjustment of an industry and of each firm in the industry to an equilibrium condition that based on (1) profit maximization when all inputs are variable and (2) the entry and exit of firms. The complete adjustment is undertaken by both perfect competition and monopolistic competition. There are two parts of this adjustment process. One is the adjustment of each firm to the appropriate factory size that maximizes long-run profit. The other is the entry of firms into the industry or exit of firms out of the industry, to eliminated economic profits or economic losses. The end result of this long-run adjustment is different for the two market structures based on the fact that perfect competition has equality between price and marginal revenue, while monopolistic competition does not.
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Markets that exchange financial instruments, or the legal claims to the ownership of physical assets. All four sectors--household, business, government, and foreign operate on both the demand and supply sides of financial markets. The household sector is generally a net buyer of legal claims as it saves a portion of income. The business and government sector tend to be net sellers as they borrow the funds used to pay for expenditures. The study of macroeconomics is concerned with how the flow of income through financial markets affects short-run business-cycle instability and long-run economic growth. The financial markets are one of three primary sets of macroeconomic markets. The other two are product markets and resource markets. Financial markets are important to the macroeconomic analysis of interest rates and their influence on saving and investment. While product markets usually take center stage in macroeconomics, activity in the financial markets are closely connected.
In particular, financial markets provide a means of generating the revenue that the business sector uses to pay for investment expenditures. Short-run changes in investment expenditures can cause business-cycle instability. The flow of funds through financial markets also affects the purchase of capital goods, which then affects production capabilities and long-run economic growth.
Legal ClaimsFinancial markets exchange legal claims that represent ownership of physical assets. Common examples of legal claims are corporate stocks and bonds, government securities, bank accounts, and money. These legal claims are traded through financial markets such as stock markets, bond markets, commodity exchanges, the open market (which trades government securities), and markets that trade futures and options.
The exchange of legal claims also occurs with the lending and borrowing that consumers, business, and banks do through the banking system. Insurance is another legal claim, a claim on an uncertain future, that is also traded through financial markets. Foreign exchange markets trade the currency of different nations, which is essential to foreign trade.
Legal claims provide the mechanism for accumulating the funds used for capital investment. In fact, without legal claims and financial markets the economy would find it nearly impossible to invest in large scale capital projects.
Buyers and SellersAll four macroeconomic sectors--household, business, government, and foreign--participate on both sides of financial markets. Some members of the household sector buy legal claims as they save a portion of their income and other members sell legal claims as they borrow to pay for purchases. Some businesses buy legal claims when they have extra revenue and others sell legal claims to raise the funds needed to finance investment expenditures.
However, the household sector is generally a net buyer of legal claims and thus a net saver, while the business and government sectors are usually net sellers and borrowers. In other words, the household sector diverts a portion of income to the financial markets which is then used by the business and government sectors to finance their spending.
- Household Saving: The household sector both buys and sells legal claims through the financial markets. When it buys legal claims, it diverts income to the financial markets, which is saving. When it sells legal claims, it obtains funds from the financial markets, which is borrowing.
By virtue of its ownership of all factors of production, the household sector lays claim to all income generated from the production of goods and services. A portion of this income is necessarily used to finance investment expenditures and government purchases through saving. As such, the household sector is necessarily a net buyer of legal claims. The legal claims commonly purchased in the course of saving are bank accounts, corporate stocks, and government securities.
- Business Borrowing: The business sector also both buys and sells legal claims through the financial markets. While it often buys legal claims with extra revenue not immediately claimed by the factors of production, it is primarily a seller. The business sector sells legal claims to finance investment expenditures for capital goods.
In that the business sector has no ownership of productive factors, it has no direct claim on income. It must ultimately obtain any income used for investment expenditures from the household sector. It does this by selling legal claims such as corporate stock, corporate bonds, and bank promissory notes (loans).
- Government Borrowing: Legal claims are also both bought and sold by the government sector. Like the business sector, the government sector frequently buys legal claims with extra tax revenue not immediately needed for expenditures. However, it is also a major seller of legal claims.
In that the government sector, like the business sector, also has no ownership of productive factors, it must obtain the income used for government purchases from the household sector. The majority of this income is acquired through taxes. However, when the tax revenue needed to finance expenditures comes up short, it sells legal claims through the financial markets. A couple of the more popular legal claims used to obtain this extra revenue are government securities and municipal bonds.
One of ThreeThe financial markets are one of three groups of macroeconomic markets. The other two are product and resource.
- Product Markets: The production of final goods and services, what is formally termed gross domestic product, is exchanged through product markets. The buyers of this production are the four macroeconomic sectors--household, business, government, and foreign. The seller of this production is primarily the business sector. A substantial part of macroeconomics is devoted to explaining how and why gross domestic product exchanged through the product markets rises or falls.
- Resource Markets: The services of the four factors of production--labor, capital, land, and entrepreneurship--are traded through resource markets. Resource markets, also termed factor markets, are used by the business sector to acquire the factor services needed for production. Payment for these factor services then generate income received by the household sector, which owns the resources. Note that only factor services are exchanged through resource markets, not the actual factors.
The Circular Flow
Financial markets are a key component of the circular flow model of the economy. The circular flow captures the continuous movement of production, income, and factor services that move between producers and consumers.
|The Circular Flow
The four main components of this simple model are: household sector, business sector, product markets, and resource markets. The household sector contains the consuming population of the economy. The business sector includes all of the producers.
The product markets direct production from the business sector to the household sector in exchange for payment flowing in the opposite direction. The resource markets direct factor services from the household sector to the business sector in exchange for payment flowing in the opposite direction.
The financial markets enter the circular flow as a means of temporarily diverting household saving away from the product markets. This diverted income is acquired by the business sector to finance investment expenditures and the government sector to finance government purchases.It is often convenient to combine the thousands of individual microeconomic financial markets used to exchange assorted legal claims into an abstract aggregation. Demand in this aggregate financial market reflects the net savings of the household sector as people purchase assorted legal claims through individual markets. And supply in the aggregate financial market reflects the net borrowing by the business and government sectors as they sell legal claims through individual markets.
Equilibrium in the aggregate financial market is an essential aspect of macroeconomic analysis. In particular, overall macroeconomic equilibrium, both short-run equilibrium and long-run equilibrium, requires aggregate financial market equilibrium. This exists if the total quantity of legal claims supplied is equal to the total quantity demanded. In other words, saving equals borrowing.
However, this does not mean every individual financial market is in equilibrium. One might have a bit of a shortage and another a bit of a surplus. As long as the shortages and surpluses balance out, meaning total quantity demanded is equal to total quantity supplied, then the aggregate financial market is in equilibrium.
FINANCIAL MARKETS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 28, 2024].
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