In an earlier post, I discussed the application of mrts in economics of Japan during the early 1990s. In this article, I will discuss how the same analysis can be applied to other countries and even to different time periods. The focus will be on supply-side shocks and demand-side shocks to the economy. The analysis highlights two contrasting theoretical lenses which are necessary in order for the analysis to proceed: the Phillips curve and the IS curve.
The first step in testing the impact of changes in the rate of interest is to observe the response of the aggregate demand curve to changes in the level of the prime rate. By conducting a series of fixed-rate bench tests, we can approximate the effects of any changes in the base rate on the aggregate demand curve over the period. Importantly, we should remember that changes in the base rate will not necessarily affect mrts in economics directly. For instance, changes in the inflation index may have a significant impact on both the level of mrts in economics and the inflationary index, but the impact on the aggregate demand curve will be much less than on the prime rate.
After setting up a number of potential models for unobservable inputs, we next need to establish the theoretical framework in which to analyze the relationship between demand, supply, and market prices. One important constraint in this regard is the fact that the relationship between marginal changes in the level of prime rates and changes in aggregate demand are actually functionaries of demand and supply elasticities rather than directly affecting output prices. This is because changes in the level of nominal spending relative to output tradeoffs between investment and capacity utilization are themselves economic indicators of the quality of the input, not of the value of the output. To overcome this problem, we must adopt a notion of perfect substitutes. An ideal substitute is a pricing mechanism on which demand is effectively regulated by supply. Perfect substitutes are necessary because traditional economic models lead to errors when estimating the effects of changes in the variables of interest on the variables of output.
The concept of the marginal rate of substitution suggests that changes in the price level of good can diverge in equilibrium from equilibrium as long as the elasticity of substitution remains high. A simple example of this occurs when the price of oil is expected to increase slightly above the present price, while its price in the actual market stays constant or falls only slightly. If the demand for the good increases linearly with time, the corresponding elasticity of substitution increases linearly as well. The result is that demand for oil will exceed the supply due to the perfect elasticity of supply and price will fall below the equilibrium value. This form of demand disturbance is called "perfect substitution" for a particular good and is a fundamental aspect of modern economic theory known as imperfect competition.
By itself, this assumption is not a satisfactory assumption. The assumption becomes more satisfactory when the definition of marginal rates of substitution is expanded. Specifically, we denote the change in the price of any good X from zero to one by the amount of money spent on Y minus the amount of money saved in X. Under these conditions, any change in the level of output relative to demand in the economy is referred to as a marginal rate of substitution.
Critics of modern economics argue that marginal rates of substitution are overly simple and that they fail to take into account important microeconomics such as information technology and the impact of international trade on domestic production. They argue that the assumption is wrong in almost all cases, leading to an inflation of demand and prices that do not contribute to economic welfare. According to these critics, modern economics uses economic tools such as mrts in economics and square to solve the problem instead of following the traditional approach of analyzing the effects of changes in production on demand. While the use of technical substitutes in the context of MRTSs in economics is considered by many as an acceptable means of describing real-world economics, many in the mainstream view it as inappropriate because it reduces the relevance of microeconomics to the analysis of economic problems.
An MPL formula a part of the MRTS in economics, you can read about in detail on thekeepitsimple a blogging website for management students.
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