The macroeconomic factors of an economy usually adjust themselves to form a Macroeconomic Coordination Process. This chapter focuses on such factors and their behaviors to observe conditions under which an economy's production output (GDP), output's demand (APE) and money supply funding (ASF) are equalize through changes in interest rates, employment level, price level and output level. Among various factors of economic health, GDP is the main indicator which reflects a country's output level. GDP is not affected by price or interest rate fluctuations since GDP is simply measured on a price index which changes along with output level and therefore, the value of GDP remains same. However, there is an indirect effect of change in price and interest level, which is in the form of change in output leading to change in employment level and thus, income level. Gross Domestic Income level (GDY) of a nation is directly and equally linked to GDP, i.e. GDY increase or decreases with the same amount as GDP increases or decreases. This implies that the income generated will always be sufficient for the output produced by a nation. The Gross Domestic Income of a nation further distributes that income to three main classes and a fourth category: Income to Household (HY), Income to Businesses (BY), Income to Government (GY) and Income to Foreigners (FY). The level of income generated in an economy does not guarantee purchase of all output produced since income is a different concept from money supply and it is money supply in market which provides the purchasing power. The money supply is provided by financial institutions, both banks and non-banks. The second important component of MCP is Aggregate Planned Expenditure (APE) which represents demand of output generated from household, businesses, government and foreigners in the form of exports. The component of imports is also a part of nation's demand for goods and is therefore, excluded from APE. Any change in GDP will result in equal yet delayed change in APE since it takes time to adjust demand. The impact of interest rate on APE is not significant since mostly mild fluctuations are observed and even if the fluctuations are large, the demand is backed by savings of nation.
The third important factor is the money supply funding, which represents paper money, coins and checking accounts that let a consumer actually make purchases in market. The continuous purchases with money generate velocity which is further enhanced by increased lending. The product of money and velocity is the maximum amount that can be spent on output and any increase in price level will reduce the money supply. This money supply is brought in market through banks that take deposits from customers and use those deposits to generate income. For each deposit that bank takes, a reserve has to be formed with the Federal Reserve Bank to guarantee against any default on customer deposits. Another form of reserve formed by banks is known as working reserve which is created to support the institute in contingency situations. This reserve is created on cost of forgoing earnings that can be generated on that deposit. As interest rate rises, the cost of keeping working reserve increase since the amount could be lent in market at higher rates. When banks transfer the amount from working reserve and lend in market, it increases money supply. Therefore, it can be concluded that increase in interest rate increases money supply. Another concept of MCP is Aggregate Demand for Funding (ADF) which represents a specific amount of demand for funding before the supply. However, under conditions where demand for goods and services is equal to output level of nation, ADF is incorporated in ASF since required funding is already available in market. When APE is less than GDP, the producers of output face a shortfall of monetary resources to finance their operations and employees since sales are reduced. At such time, demand is created for extra funding (ADF) which is then provided by financial institutions.
This Chapter presents graphical arrangement of macroeconomic variables. It starts with a single diagram with interest rate or “I” on the Y axis and magnitudes for different variables on X axis. The first table explains the relationship between Interest Rates, GDP, APE and ASF. The table explains that the GDP has no direct impact on interest rate. The graphical representation of this relationship results in a straight vertical parallel to the interest rate on the vertical axis. The Vertical GDP line will move forward or backward on the horizontal axis with the change in magnitude.
In the next step APE which may be represented by the equation “a+b (GDY)-ci” is added to the graph. The relationship of APE to interest rate is negative which means a rise in the magnitude of APE will result in a reduction in interest rates and vice versa. The plotting of APE equation results in an upward sloping line to the left. Along with APE another line is drawn on the graph which is labeled as IS. IS does not measure the magnitude of anything it is just a line representing the point where GDP=APE. As explained earlier any change in GDP will shift the vertical line representing the magnitude of GDP to left or right depending on the increase or decrease. The APE line will also move in the direction respective to the GDP line. The distance however will be measured by the equation a + b (GDP), where “a” in the APE equation represents any changes in the variables other than GDP and interest rates and “b” represents additional portion of domestic income that would be used to purchase the additional output. The change in GDP will not result in any movement for the IS curve.
Any increase or decrease in “a” will result in the shift of APE line with respect to direction of the IS curve which will move along with it in order to maintain a common intersection point between GDP line and APE line and with GDP line remaining stationary. As the magnitude of GDP increases, the GDP line will shift to the right and the APE line will move along to the right but with a different magnitude. The point at which GDP and APE line interests (GDP=APE) if plotted leftward to the interest rate at the vertical axis tells us about the interest rates. It is evident that the interest rate declines slowly with every level of increasing GDP. If all the intersection points where GDP=APE at different levels of GDP are connected together with a line, it results in creation of IS Curve. Therefore, it can be said that the IS curve passes through all the intersection points of GDP and APE and at different levels of GDP, the IS line does not move. If the APE line moves for factors other than the change in GDP, the IS line will also shift parallel to APE to new point where GDP and APE intersect. Aggregate supply of funding refers to a particular amount of money that is provided in an economy to make actual purchases of output. Spending in an economy cannot exceed the product of money supply and its velocity since ASF is the maximum limit to a nation. As interest rate increases, the financial institutions increase lending in market to certain extent till the interest rates reach at levels when lending stop yielding positive results. Given the factors prevailing in market, other than interest rate effect, money supply can also be presented as sum of factors affected by interest rates (e) and factors, other than interest rates (m), affecting money supply. The supply of funding increases with increase in interest rate, thereby, depicting a positive slope. As interest rate increases and has increased impact on money supply, factors affected by interest rate (e) also increase. Increased price level also makes the supply curve steeper. The ASF curve will keep moving along the curve in response to any change in money circulated or its velocity. When APE is less than the output produced in the economy, demand for more funds is generated which is represented by ADF. As shown in figure below, Aggregate demand for funding is a reducing line when output is greater than aggregate demand for goods since at such point, ADF is included in the ASF. However, when aggregate planned expenditure is less than the output produced, demand for funding is generated, mainly by producers, and ADF increases.
This chapter intends to study the market's reaction to two important factors: demand and cost structure. In order to study this behavior normal assumptions are considered regarding markets, for instance, the demand curve is downward sloping for products in a market where entry and exit barriers are low. For a normal market, profit margins are usually low that makes that market less attractive for investors. Firms with low cost infrastructure cannot stop the costs per unit from increasing when output rate varies from its original rate. The main goal of firms is to maximize their profits; however, the cost levels cannot be maintained below the minimum level where cost of suppliers and basic infrastructure is incurred. The average cost of a firm usually shows a U-shaped curve due to its declining nature with expansion of output in beginning, while as the output continue to increase, AC starts to increase again. Figure 1 shows average cost curve along with marginal cost (MC), where MC increases with each unit added to output level.
When average cost is declining due to increase in output level, marginal cost also remain below AC since average cost is the total of marginal costs for all units. However, at certain level, the cost of increasing output starts to rise but this increase is less than the increase in marginal cost for each unit.
Since firms operate to maximize their profits, the demand generated for firm's goods and service also indicate its revenues. The firms will be determined to charge maximum prices for its products till the level where demand exists. As the output of firm increases, its Average Revenue (AR) also decreases; however, the decrease will be greater than decrease in Marginal Revenue (MR) which is the revenue per additional unit a firm produces. Firms will operate under conditions where Marginal Revenue for each unit is at least equal to Marginal cost for producing additional units since below that point the firm will be incurring additional costs on each additional unit produced. When MR is more than MC, it means that for each additional unit that a firm produces, economic profit has been made.
The economic profits shown in figure 2 provide incentives for new firms to enter the market. However, after entrance of various producers, the output availability increases in market and demand for each producer reduces. This shrinkage results in reduced economic profits, as indicated in figure 3, and after further reduction, the economic profits will reach a phase where firms will be barely surviving at cost level and those levels will impede entry of new firms.
Under such conditions when demand for existing firms increase, the output increases along with prices leading to rightward shift in average revenue. Increase in AR means increased average revenue against average cost and therefore, attractive economic profits for new firms. Under assumed conditions, new entrants will again push the output outwards increasing supply in market which will eventually pull the prices to their previous position where economic profits are minimal. Nevertheless, there are several hurdles that in reality firms might face such as entry restrictions, infrastructure expansion constraints, increase in suppliers' cost, and overall increase in firm's cost structure. Occurrence of any of these conditions will keep the economic profits and prices positively up for existing players. For firms with sufficient level of economic profits, a decrease in cost structure will again increase average revenues due to more difference in AR and AC. Increased economic profits will again result in new entries in the market, thereby, distributing the revenues among all players and reducing profit margins for each producer. Figure 4 shows that increased players will increase the output level while reducing prices and therefore, bringing economic profits near to zero. Such conditions might be hindered by entry barriers or suppliers' utilization of cost benefits.
When economic profits are sufficient for firms and the demand for output decreases, the firms will decrease output level and prices to attract sales. This will result in negative economic profits for existing firms and therefore, their exit. However, with time, reduced competition will bring sales to prevailing producers which will increase their profits while keeping output low.
An increase in cost for a market, with economic profits at bearable level, the first reaction of firms is to increase prices. Such increased costs incur due to many reasons including high wages, increased cost of raw material, and governmental regulations. Such increase in prices will be an attempt by firms to minimize their losses while the economic profits will remain negative due to higher MC than MR. This will result in shrinkage of industry size and so, the output. Decrease in output and increase in prices will pull up the MR - MC curve leaving sufficient economic profits for remaining firms.
This chapter studies the behavior of economy in response to change in level of money supply and planned expenditures of nation. Whenever demand and supply of money is involved financial institutions play their role for increase or decrease lending in market while demand and supply of output involves expenditure level of consumers which forces producers to adjust their prices and output levels. There are three main groups of consumers: people with sufficient money, people with less than sufficient money and people with more than sufficient money. Group of consumers with sufficient amount of money does not require any adjustments in funding process and therefore, financial institutions keep their lending process at regular rate, thereby, resulting in stable interest rates. When consumers have insufficient funds for purchases, a demand for money supply is generated which is facilitated by banks and financial institutions through increased lending in market. People with more than sufficient funds will be attracted by higher interest returns from banks and will therefore, increase deposits which in turn will be used for lending by banks, on higher interest rates, to consumers with insufficient funds. The incurrence of higher interest rates will eventually reduce demand for funding forcing lenders to offer funding at lower rates. The interest rates will eventually settle down at level where demand and supply of funding is equal. When there is less demand for funding, the consumer group with more than sufficient funds will be larger in number than consumer who need funds. The banks and financial institutions will have more deposits than their earnings and therefore, will offer loans at low interest rates to attract borrowers. At low interest rates, the consumers with more than sufficient funds will be less willing to lend, leading to shortage of funds in market. This will result in increased interest rate and final settlement on level where demand and supply for funds is equal.
Under conditions where adequate funding is available in market, different firms face different levels of demand from consumers for their output. There are three main categories of firms: firms with production level equal to demand level, firms with insufficient production level and firms with more than sufficient production level. The direct impact of output level is on factors like prices, employment and interest rates. When aggregate demand for output is equal to output level of producer, no adjustment is made in price or interest rate levels. When aggregate demand exceeds output of a firm, the firms respond by increasing their output level as well as prices. This expansion in output level puts upward pressure on employment level. At the same time, some firms will have insufficient demand for their output and therefore, they will decrease their output level and, to attract customers, decrease price levels to an extent. Where increase in output and demand for money by producers will increase interest rates, firms with insufficient demand will encounter losses due to decreased output and increased demand in market. On the other hand, firms with more than sufficient demand will have enough economic profits to attract new entrants in market while some players facing losses will leave the industry. The exit of few firms and entrance of more firms in the industry will generate enough output in the industry which will limit the increase in prices and supply to avoid reduced demand. In the process of matching output level with aggregate demand results in increased output, increased employment and interest rate level. Conversely, when output produced by firms exceed the demand, firms with insufficient demand will continue reducing output level and prices while firms with increased demand will not reduce output by equal level. The overall reduction in output level and prices will bring employment and interest rate level downwards. Reduced interest rate levels will increase money supply in market. Reduced demand will cut down economic profits that will result in exit of various firms, bringing down the output level and therefore, upward shift in price and demand of output. The final settlement of output and prices will be at the level where demand and output match each other.
This chapter discusses three main macroeconomic shocks that stimulate the macroeconomic coordination process (MCP): increase in APE, ASF and decrease in GDP. Observation of these factors requires consideration of economy in long run equilibrium state where all macroeconomic factors are stable.
Increase in APE occurs due to high demand from household, businesses and government sector when economy is improving. This leads to increase in demand of money supply which further raises interest rates to an extent that demand and supply come at same level. When demand for funding is met through financial institutions, consumers demand more output from producers since purchasing power also increases. This leads to increased employment level as well as increased prices. The increasing rate of interest ceases at point where GDP equals the demand level (APE). The producers make economic profits through high prices and increased interest rates until funding becomes less attractive for borrowers and demand is sufficiently met. This leads to decline in prices and eventual settlement at original level in the long run, whereas the employment and output level increase.
In order to improve economic conditions or in anticipation of better economic conditions, financial institutions including banks and non-banks, under government policies, increase money circulation in market. Since money supply increases without its demand in market, interest rates are kept low in order to attract demand for funding. Increased funding in the market results in generated demand for funds and when demand for funds is met through lending, the output level becomes insufficient for market demand.
When demand for output increases in market, producers increases the output level which again generates employment level and increases price level since supply is less and demand is more. The output level continues to expand until aggregate demand meets funding in the market. However, output continues to increase until supply exceeds demand and prices are pushed down to their original level.
GDP and factors related to it like employment, price and interest rate levels also vary according to cost structure of firms in an industry. Since the main purpose of firms is to maximize profits, they try to keep profit margins as large as possible through cost reduction or price increase. In order to expand, firms increase their output levels while maintaining reduced costs. However, employment has to increase in order to keep output increasing while the decreased prices will increase funding shortage for firms. This situation leads to demand for increased funding by producers. Under circumstances where interest rates are reduced, funding process will increase in the market but the decreased prices will have a negative impact on the economic profits resulting in deflation.
Another macroeconomic shock is the shortage of supply by firms which causes inflation in an economy. Natural and worldly disasters like earthquake, wars, floods and other disasters disrupt the availability of various resources and raw materials for producers including human resource that badly affects its operations since inputs needed for generating output are unavailable or scarcely available. Such instances reduces the level of output from producers resulting in scarcity of output, employment level, and reduced prices which pushes interest rates further lower since demand for funding is reduced. Since the firms cannot increase output levels due to unavailability of resources, firms will face economic losses which will covered by increased prices to bring output level equal to aggregate demand. The increased level of prices will decrease the demand for output while interest rates will remain high resulting in inflation. Any betterment in economic situation will pull economy out of inflation; otherwise inflation will prevail in economy until resources are widely available.
The chapter discusses three external macroeconomic shocks which affect the Macroeconomic Coordination Process (MCP): decrease in APE and ASF and increase in GDP.
Decrease in APE or aggregate demand occurs when several factors like tax costs or anticipation of bad economic conditions prevails which leads to increased inclination towards saving. The reduced demand for output results in decreased purchases and demand for funding. This process does not affect funding demand since firms, in order to cover up their costs, will borrow from financial institutions while reducing their output accordingly. Reduction in output will slash employment while decreased demand will push back prices as well as interest rates. Net result will be reduction in GDP level and deflation due to negative economic profits. In order to cope up with negative profits, firms will again pull up the prices to keep economic profits equal to zero in order to sustain in market. However, the output level will keep reducing until demand is met with supply. Overall employment and output will reduce in long run.
A decrease in ASF results from decrease in availability of funding in market due to governmental regulation or increased reserve requirement from Federal Reserve Bank. Such requirements induce banks to separate money for reserves instead of lending, thereby, reducing supply of funding. Reduced availability of funds in market leads to increased demand for funds which further increases the interest rate. An increase in interest rate then decreases the demand for funds, causing APE to decrease.
The decreased aggregate demand in turn results in losses for producers with excess output. As a consequence, producers demand for more funding to cover up their costs. ASF increases in response to demand and continues to rise along with rise interest rate while producers keep reducing their output levels. The situation's outcome is reduced output, employment and price levels which eventually push back the interest rate up to level where funding is availed by consumers and output levels are met by purchases and economic profits reach level of zero. A decline in ASF results in reduced GDP, employment level and increased interest rates.
Increase in cost of production greatly affects employment and output level since producers try to reduce their costs through layoffs and decreased output level. In order to keep their profit margins positive, producers increase prices for output which further reduces demand for output and therefore, GDP and APE decline. Negative economic profits cause some firms to leave the industry while remaining companies keep prices high to maintain minimum possible economic profits. After exit of few firms, the output decreases further while sales are divided among few players thereby, increasing economic profits to zero or above. At such point, firms will reduce the layoff of employees and hold the prices at current levels. Therefore, increase in cost structure of firms results in increased prices and interest rates while reduces output and employment level.
Growth of firms is another important concept in macroeconomic which studies factors that affect growth of industries. There exists a mismatch between increasing GDP and stagnant ASF and APE. In order to increase purchases and expansion plans, both consumers and producers require funding. Increased demand for funding increase interest rates which in later stages of growth declines due to less demand for expensive funding. As supply of funding equals aggregate demand, APE will not be able to reach level of output which will lead to creation of insufficient demand. With decreased level of APE, firms will decrease their prices as well as output to cope up with increased costs. This will result in negative profits and zero growth pushing few firms to leave the industry. Exit of firms will decrease output further making APE equal to GDP. However, the costs incurred by firms in terms of capacity expansion and infrastructure cost will remain as a loss leading to decreased output and employment level as well as stagnant growth. In order to maintain growth in economy, governmental institutes should formulate proper policies facilitating producers in times of economic losses and provide a separate means for their funding process.
This chapter discusses the macroeconomic policies and structures during 1900s when Great Depression hit the world and shaped the macroeconomic study we know today.
Since money circulation was dependent on gold submitted with Government Treasury, there was no concept of money and its velocity creating inflation in economy. For analysis of macroeconomics in 1900s, it is important to assume that ASF was independent of interest rates and the study of APE in response to GDP was not studied yet.
Figure 1 elaborates macroeconomic process in 1900s where the output produced is equal to aggregate demand and sufficient funding is available in market. As demand for output increases and consumers requires excess funding, ASF does not increase since it is independent of interest rate and therefore, interest rate will keep rising due to increase in demand (Figure 2).
The interest rate will rise up to the level where demand for output ceases. Since demand has no impact on interest rates, therefore, supply of funding is independent of demand and output produces do not get information regarding increasing demand and therefore, keep their prices and output level intact.
When aggregate demand for a product declines, the funding in market exceeds the demand and lenders keep interest rates low to lend money. However, lower interest rates does not affect borrowing rate, except for firms that have interest rate sensitive equipment. The declining interest rate eventually settles down when demand is brought back to level to output.
Decreased prices by producers lead to increased funding at all interest rates due to increased demand for purchases. There is an inverse relationship between interest rates and aggregate funding. Also excess supply of money decreases interest rates and pulls up demand which together with ASF exceed the output level in an economy. To cope up with excess demand, according to classical model, the producers will simply increase prices which will then increase interest rates. This trend will continue until prices are so high that pushes down the ASF and APE and inflation is created in economy. Conversely, when ASF is increased, a decrease in available funding increases interest rates which push demand down. Producers in such situation react by decreasing prices and adjusting other costs of business to increase demand.
When GDP of a nation decreases, it decreases the demand for funding since prices are raised by producers. Decreasing ASF results in increasing interest rates which reduces the level of aggregate demand till it meets the output level. On the other hand, an increase in level of GDP increases the demand for funding which reduces interest rate level and thus, increase APE to match the output level. Therefore, in classical macroeconomic situation, GDP will strive to remain at levels where full employment can be provided to nation while, interest rates and prices are moved in either direction to keep APE in line with ASF and GDP.
However, it is also observed from studies that whatever action producers and consumers take to adjust price and interest rate level, there is some time lag in these adjustments which has resulted in temporary recessions in economies where employees have been laid off and output has been adjusted (decreased) to fill the gap till APE and ASF are brought to optimal level of GDP. Before the Great Depression came in 1900s, minor adjustments were made in monetary policies to keep economies away from inflation and deflation. However, the Great Depression resulted in severe changes in macroeconomic policies with ASF becoming responsive to interest rates and adjustments of demand for product and money supply through financial institutions to cater to demand of consumers and producers. The extreme behavior of interest rates and prices observed during classical economic era became unobservable in today's economics since the interest rates can never become negative in an economy. Similarly, producers can never run into negative profits since a minimum cost level is maintained no matter what economic condition is.
In response to various financial crises, Congress formed Federal Reserve to manage money supply of their economy. The members of Federal Reserve include banks that gain substantially from revenue generated from Fed. Federal Reserve formulates several strategies like open market operations, reserve requirements for banks and adjustment of discount rates to stabilize the financial sector of nation. The main objectives of Federal Reserve include keeping stable levels of employment, price levels and interest rate levels. The Fed controls money supply in market along with interest rates which leads to change in demand for money supply. Any change in level of money supply alters GDP, employment and price levels accordingly. Money supply as explained earlier comprises of paper money and coins as well as checking account. In order to guarantee liquidity of banks, Fed requires banks to keep reserves with the Fed as a guarantee against their deposits. The banks keep required reserves as well as working reserve which is the extra reserve that banks keep to maintain their liquidity. The monetary base for banks includes paper money and coins a well as reserves that bank keeps. The cash to checking account ratio as well as time deposit to checking account deposit ratio is also expected to be calculated by banks in order to calculate the money supply in market. The supply of money calculated is the ratio of currency to deposit ratio and sum of all required and working reserves as well as time deposit to checking account ratio. Using these values money multiplier can be calculated which shows impact of monetary base on money supply.
Among these variables bank can control the interest rates it provides on deposits as well as the working capital which can be used in investment instead of reserves. On the other hand Fed has direct control over required reserves as well as monetary base while indirect control on interest rate can be exercised. Given the importance of interest rates on monetary policies, Fed can exercise its influence on money supply through its policies regarding discount rates.
Open Market Operations (OMO) are one of the main tools that Fed uses to control money supply in market. In OMO securities issued by US Treasury and other government agencies is sold and purchased to increase or decrease money supply in market through changes in monetary base. Another tool used by Federal Bank is the reserve requirements that are placed with banks operating in an economy. These reserve requirements are restricted to non personal savings accounts and checking accounts. Increased reserve requirements lead to decreased lending by banks since the cost incurred on reserves is higher to maintain reasonable profits. Decrease in loan amounts will reduce money supply in market. Banks also react to increased money supply by utilizing some of their working reserve as lending amount to enhance their earnings. Third tool used by Fed is discount rate where increase in discount rate relative to bank lending rate increases the penalties on borrowed reserves of banks which forces banks to increase working reserve and therefore, decrease lending and money supply. Fed eases as well as tighten its policies to achieve required level of output and interest rate in an economy. Shifts in APE and ASF are made to create or reduce funding in the market, subsequently changing output level (GDP) of economy. The effectiveness of monetary policy depends on banks as well since an ease in policy might prove less effective if banks adjust their reserves to counter Fed's policies. Tightening policy of Fed is often criticized for its negative impact on output and employment since decreased prices reduce profit margins. However, this policy is often used in nations where hyper inflation is observed due to weakening economic conditions.
As studied in previous chapters, the output level of a nation equals its aggregate demand if the sum of budget surpluses of household, businesses and government and foreigners are equal to zero. However, if the sum of these surpluses exceeds zero, this implies that income of nation exceeds its aggregate demand. Conversely, a negative number for sum of surpluses mean that income is insufficient to meet aggregate demand. Since a nation's income equals its output level, the concept of saving does not prevail in economy because savings will result in decreased purchasing thereby, reducing sales that might lead to unemployment and reduced output. Excess of income results in inflation while shortage of income results in recession, therefore, requiring maintenance of balance between deficit and surplus between different sectors.
Fiscal policy is an instrument used by Congress to keep income budgets under control to avoid recessions or inflation. There are two main forms of fiscal policy: automatic stabilizers and discretionary fiscal policy where automatic stabilizers, in form of tax and other laws as well as various developmental programs, control the macroeconomic coordination process (MCP) while discretionary fiscal policy is used to interfere with output levels to adjust employment, interest rate and price levels. The figure below represents Congress's use of automatic stabilizers to control decline in APE while controlling GDP from falling or rising substantially.
The figure indicates actions taken by Congress to control the aggregate demand level in an economy. The automatic stabilizers affect the IS line where GDP is supported to instigate a rise in output and as a result aggregate demand starts to fall. The automatic stabilizers then restrict the output level by adjusting funding and thereby, increasing the aggregate demand.
On the hand, discretionary fiscal policy is exercised by changing the level of government spending, changing tax revenues for households and businesses. These changes will result in difference in various macroeconomic factors like employment, interest rates and prices. The fiscal policy implementation can be understood by studying impact of change in tax laws over various sectors. In order to increase GDP of a nation, the fiscal policy makers will use expansionary fiscal policy while to decrease GDP, restrictive policy will be used. Change in APE is equal to sum of changes in household income, business income and government income.
To increase APE, policy makers can increase government purchases while keeping taxes for businesses and household intact or increase taxes for household while increasing government expenditure to avoid national debt increments. Similarly, various alternatives among different sectors and tax laws can be used to achieve targeted output level. For restrictive fiscal policy, i.e. to decrease APE, different targets for various sectors' outcome can be planned to achieve desired output. When tax revenues are reduced, it increases the demand for purchase in households and businesses due to surplus of disposable income and therefore, increases APE.
However, when government purchases are decreased and focus is shifted to increasing tax revenues, it leads to reduced demand for goods and services by sectors and thereby, reduces APE. Drafting of fiscal policy is a long procedure given extensive processes for bill's approval. Also there are various complications regarding political implications of decisions taken in the Congress related to fiscal policy. Congress holds major control over Federal budget that allows it to exercise changes in federal tax revenues which is better for economy. There is a need for coordination of Congress with Federal Reserve to find collaboration between monetary and fiscal policy and find better and biases-free solution to economical problems.
Monetary and Fiscal policy affect aggregate demand in different ways, having indirect and direct impact respectively. This chapter focuses on several issues that fiscal and monetary policies face while trying to use expansionary and restrictive policies towards aggregate demand (APE). In cases where it is impossible to generate output levels such as in case of natural disasters, increasing demand will not have any fruitful impact since there will not be enough resources to increase GDP and therefore, producers will only increase prices. Whereas in cases where there are decreased funding in market, monetary policies can accelerate ASF through Open market operations or reduced reserve requirements. Monetary and Fiscal policies can increase the demand level through these options by increasing funding in market along with government support through development programs and tax cuts however, each policy works differently under different circumstances. Figure 1 represents a situation where APE has fallen well below GDP and in order to increase demand, monetary policy tries to decrease the interest rates in order to increase funding in market and support APE to rise. However, it is clear that even with 0% interest rate, which is impossible to achieve, the demand cannot reach its original level.However, the similar problem can be eliminated with fiscal policy by using tax cuts to further support demand curve and move it to the right to equate with GDP level.
Extreme recession state also leads to failing monetary and fiscal policies since no level of interest rate is attractive for investors or household to invest or purchase, thereby, decreasing demand and output. Extremely illiquid markets are an example of such recessions where policies become ineffective. When economy is pushed towards expansion by monetary and fiscal policies, aggregate demand is increased without a proper increase in funding supply. This can result in increase in interest rates due to high demand and therefore, negative impact on investors and thereby, the demand will soon start to decline again unless an aggressive funding is supplied in market. An increase in APE often results in government budget deficit which is covered through additional tax collection on redemption of government securities. Tax payers aware of this situation will save more to become able to pay off the additional taxes and therefore, more saving will lead to fewer purchases and less demand. The conclusion can be that if tax payers are knowledgeable and the government does not manage its deficit outside tax premises, then the expansionary policies will not be able to achieve goal of increase in APE.
Like expansionary policies, restrictive policies, too have some issues when applied in different situations. For instance when restrictive policy is used to increase demand and funding in market, the output level is also restricted which further restricts growth of employment rate and therefore, hinders growth process. When cost structures in an economy increase, it reduces output levels and therefore, funding in market for which attempt is made by producers to cover up costs with increased prices. Even if funding is made available in market, producers can increase their output to a certain level but inflation cannot be controlled after prices go up. The monetary policies need serious considerations to avoid excess money supply in market due to borrowing from Fed instead of utilizing existing money supply, resulting in hyper inflation.
The monetary and fiscal policies can be used along with separate tax based policies to cater to different problems at same time. The tax based policies provide incentives for producers to inflation at low levels and wages at reasonable level to avail tax benefits provided by government. The differing impacts of monetary and fiscal policies on employment and interest rates forces a cyclical fluctuation in policies and its effects since the Fed and Congress will keep switching between monetary and fiscal policies to keep both unemployment and price increases under control. Separate implementation of monetary and fiscal policies produces conflicting results for each process in reduction of unemployment since these lower interest rates as well that is against fiscal policy's goal. To resolve this problem, the monetary and fiscal policies should be handled by Federal Reserve System to coordinate between both policies. Other restrictions regarding policy implementation include lack of relevant data, delays in understanding, implementation and impact of policy measures which can be reduced by providing Fed with rights to process policy implementation.
This chapter emphasizes on the importance of monetary policy in shaping the currencies and monetary framework around the world. Exchange rate markets and foreign investments have utilized monetary policies in determining a nation's currency policies. Balance of Payments (BOP) is an account maintained by countries to record all cross border transactions by its residents as well as government. Where all details regarding imports and exports, and other means of payments in return for services is recorded in current account, foreign account records details regarding investments of capital or technology or transfer of assets in or out of foreign countries. Figure 1 represents demand for dollar by Europeans in both current and financial accounts. Addition of dollar to European account is referred to as Df and Dc while U.S. demand for Euro is represented as Sc and Sf.
To keep balance demand for dollar is kept equal to supply for dollar. An increase in dollar value results in lower U.S. exports while cheaper imports. In order to study pegged currency system, it is assumed that U.S dollar is pegged with Euro at certain period of time as shown in Figure 2.
An increase in GDP will result in rising income for nation which will be attracted to spend domestically as well as to import from other countries. As a result the current account of U.S. will rise to include imports. Attractive U.S. dollar due to increase in GDP will move the supply curve to left due to its increased interest rates. Under pegging system, the interest rate will keep adjusting to keep U.S. dollar and other currencies at specific pegged amount.
The balance of payment account also constantly adjusts itself to keep the U.S. dollar at level where pegging exchange rate has been fixed by other economies. The pegged exchange rate system does not allow Federal Reserve System of a country to interfere with interest rates and output level of nation since the macroeconomic coordination process will work towards keeping interest rates and money supply in line with balance of payment adjustments. However, liberty of altering the APE resides with fiscal policy makers since it does not affect GDP. The use of pegged system restricts the flexibility of fiscal and monetary policy makers which has more liberty under flexible exchange rate. If government wants to expand the economy, it will have to use combination of both monetary and fiscal policies to move aggregate demand and supply of funds to new output level. Under pegged exchange rate, a drop in interest rates will make US dollar less attractive to foreign investors making it less attractive in exchange rate market. However, increase in interest rate will cause an expansion in US economy as exports will rise and domestic demand will pull the output to upper level. Whereas, under pegged exchange rate, the devaluation cannot exceed a specific percentage. Therefore, it can be concluded that under different circumstances, the change in dollar value can be capitalized by domestic fiscal and monetary policies to shift the GDP of nation towards new equilibrium while pegged exchange system makes economy stagnant. However, in some cases, expansion policies often lead to increased interest rates which further increases cost of its exports and reduce them. However, such changes can be avoided by carefully formulating policies for increased interest rates and keeping a balance between GDP and interest rates. There is a need for strong coordination between monetary and fiscal policies to take expansionary plans forward for economies and therefore, instead of involvement of political bodies like Congress, it is important that independent bodies like Federal Reserve should have the responsibility of formulating both monetary and fiscal policies to avoid any clashes and delays in economy's expansion and growth.
Average annual income per capita of a nation is the sole indicator of a nation's economic conditions. The distribution of income among business sectors versus non business sector and distribution among rich and poor is very difficult to classify. Where GDP per capita of developed nations reach around $50,000 per capita, most of nations around the world barely reach $750 per capita. Economists around the world have been trying to develop economic models that enhance the income level in under developed nations. In order to raise income level and reduce gap between developed and under developed nations, developed nations are assumed to have around 3% growth rate for next 24 years while middle-income and low-income economies have assumed to have 9% and 12% growth rate respectively to achieve that goal.
The population growth in low income nations is usually high than high income nations because of the fact that poverty leads poor families to have as many children as possible to keep their income level increasing. Conversely, high income families are less bothered by increase in number of children since they have sufficient income to support themselves. Another factor that needs attention for increasing income is increase of production factors. A country's resources are needed to be optimally utilized to generate income elements for the nation. Although high income nations have contributed significantly towards improvements in poor nations however, use of natural resources of a nation requires more sophisticated technology and knowledge which is achievable through high investment in human capital. Since poor economies have not sufficient funds to save for their economy, middle range and high range income economies bring capital investment in nations. However, there are several barriers to improvements in poor nations. These barriers include political unrest, corruption, poor foreign investment policies and other unstable factors that hinder investors from entering poor nations. After World War II, establishment of IBRD to support Europe and Asia, in 1960s establishment of IDA for interest free loans to African states and eventually merger of two to form World Bank is an example of efforts on part of developed nations.
The monetary help itself cannot support a whole economy to enter different phases of development since increasing capital per capita itself will eventually result in diminishing gains. The model created by Solow (Figure 1) suggests that the capital provided eventually starts to diminish due to increase in population.
Even with constant capital injections, the population growth with consume all savings and investments due to increase in population and depreciating labor capital. Even after keeping population in control for some time, the growth cannot be sustained since savings and investments both cannot continue till end. The lending process will have to be ceased by lenders eventually leading to declining growth of nation. The solution to this situation can be provided by constantly updating and innovating new technology to refresh the per capita income. Governments should provide incentives for firms that make investment in high tech projects and research for long term growth. Policies regarding foreign investment and allowing various research projects in a nation should be formulated in a way to preserve unique knowledge within nation. Another restriction that poor nations face includes lack of access to legal mechanisms that their brilliant entrepreneurs could utilize for economic gains. The real estate owned and constructed by third world countries can be one of the few steps that, if legal stature provided, can take poor economies from under developed to developing state. There are several social and economic barriers that restrict third world economies from uplifting their economies from the poor nation category to entrepreneurial category.
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