The Objective of Macroeconomics - Essay Example

? Chapter Macroeconomics Macroeconomics is the subset of economics whereby changes in the level of output, price, interest rates, employment and others is studied at large. The entire macroeconomics dynamics is composed of GDP, APE, ASF and ADF. The objective of macroeconomics is to establish coordination and equality amongst first three components and the process is termed Macroeconomic Coordination Process (Ashby 2011). GDP (Gross Domestic Product) GDP is the measure of total production of goods and services within a country in a given year. It basically measures output and thus is a totally different concept from GDY (Gross Domestic Income) because the latter measures incomes. Also, only domestic production is counted in GDP and no foreign or abroad output. The calculation of GDP is facilitated by the use of price indices whereby current prices are measured against the price of a base year and thus, changes in the level of output are measured every year. Output and GDP changes are positively correlated. GDP is not directly impacted by a change in the level of prices and interest rates but indirectly, they bring about changes in employment levels and therefore, GDP is indirectly affected by these variables. APE (Aggregate Planned Expenditure) APE is the measure of total goods and services demanded by all the sectors in a country. Because it is the demand which creates GDP in domestic market, APE in reality also includes foreign imports which tend to increase the APE. In order to arrive at the actual APE, all imports (F) are subtracted from the sum total of household consumption (C), business investment (I), government purchases (G) and exports (X). Mathematically, it is denoted by the following formula: APE= C + I + G + X –F Variables affecting the APE are GDP and the interest rate levels. For GDP, the change is positive, strong and quick while for interest rates, it is slow, negative and weak. However, APE is not directly affected by price level changes. ASF (Aggregate Supply of Funding) To measure and define ASF, it is first essential to understand the meaning of velocity of money (V). V is the number of time a dollar is used to purchase goods or services within a year. Also, funds in a country can be categorized in currency and coins (CC) and checking account balances (CA), the sum of which gives us the money supply (M). While M increases with the increase in bank lending, V increases with the increase in non-bank lending. As such, ASF comes out to be: ASF= (M * V) / p where p= price index Consequently, change in ASF is directly proportional to a change in interest rates while it is inversely proportional to change in price levels. ADF (Aggregate Demand for Funding) Concept of ADF creeps in when we establish equality between APE and GDP. In case of APE almost equal to GDP, ASF supports the funding of production as well as sales. However, when APE is less than GDP, producers and businessmen need additional revenues to compensate their bills and costs. It thus follows that ADF equals APE when APE equals GDP. However, ADF equals GDP when APE < GDP. Chapter 2 Plotting GDP on a graph When plotting the macroeconomics variables of GDP, APE, ASF and ADF, the vertical axis is the interest rate level (i) and the other three are shown on the horizontal axis. Since interest rate level has no direct impact upon GDP level, the GDP line goes vertical unaffected. It just moves right or left by the amount of change in GDP. Adding APE to the graph To plot APE line on the graph, use of the following formula is done which has already been discussed above: APE= a + b (GDY) – ci. The slope of the APE line is always to the left and upwards because rise in interest rates signifies fall in APE. Another line called IS which is not a measuring unit, depicts all the combination of interest rate levels and GDP at which GDP equals APE. The Macroeconomic Coordination Process tends the three lines to intersect at common points whether they shift to the right or left (Appendix 1). Graphical IS Line derivation The GDP line shifts to the left or right depending upon the change in the amount of GDP. The IS line remains stationary while the APE line shifts itself to maintain the common intersection point of coordination. The only thing is that IS line shifts only when APE line moves as a result of change in any other factor than GDP. Adding ASF to the graph Because ASF shares positive correlation with interest rate levels, the ASF line has positive slope and shifts to left or right depending upon a change in the interest rate. Also, factors affecting M and P will also affect the slope and position of the ASF line. For example, ASF line shifts to the left horizontally with a rise in price level or a fall in M or V. Likewise, ASF line shifts to the right with a fall in price level or a rise in M or V. Mapping ADF on the graph As mentioned above, ADF is equal to APE or GDP, whichever is larger. Therefore, the ADF line takes a kinked form when plotted. It lies above the IS line when APE is less than GDP and lies below the IS line when APE is greater than GDP (Appendix 2). Chapter 3 Microeconomics explains the demand and cost functions which ultimately help to understand the Macroeconomic Coordination Process. Before heading on to understand the effect of demand and cost changes on macroeconomic dynamics, we need to get hold of some basic concepts first. Assumptions made here are that a firm has a demand curve depicted as straight line, entry and exit of firms is not hindered, the profits are enough to just let the firms stick but not adequate to attract new firms, firms are behaving in the normal profit maximizing role and the firms have such production facilities which enables them to produce at lowest costs. While determining the equilibrium level of an individual firm, it is to be noted that the average revenue is always equal to the marginal revenue in perfect competition because the price at which the goods are sold remains constant whether quantity demanded is more or less. As the average revenue remains constant, the marginal revenue which implies the additional revenue derived by selling an additional unit of a commodity also remains constant (Appendix 3). If demand increases When demand increases, the average and marginal revenue curves shift to the right because of increased output and consequently increased average revenues. The two curves return back to their original positions but in the meanwhile, the output level and the price level has already changed due to the entry of new players in the industry. Some externalities might limit the entry of new players which will cut short the level of output demanded and also increases the cost per supplier. As such, anticipated economic profits and industry growth is limited due to increase in the costs. Thus, conclusion follows that increase in demand results in increase in prices but very less amount of rise in the level of output (Appendix 4). If costs decrease Decrease in costs brings about changes in both micro and macro cost and demand structures. Individual firm earns more economic profits due to fallen costs and reduced average revenue. But this also calls for entry of new players and increased demand in the market. Because of the entry of new firms, the industry output level increases but the price is lowered by the amount of fall in the cost level (Appendix 5). If demand decreases With decrease in demand, firms will have to reduce their output and prices which will let the average revenue and marginal revenue curves to shift to the left. Because of reduced output and prices, firms will suffer negative economic profits which will compel the firms in the industry to leave. At a point when lesser number of firms is left in the industry, the two curves will get back to their original positions. Consequently, both the industry size and the output level will decline and profitability will also diminish (Appendix 6). If costs increase Increase in costs is supplemented by increase in prices, cuts in wages and use of lesser quality materials. To compensate for increase costs, firms will reduce the output level but increase the prices. Some firms might also have to leave the industry because of the risen costs. As a result, the total industrial output will decline but price will go up by the amount of rise in the cost level (Appendix 7). Appendices Appendix 1 Appendix 2 Appendix 3 Appendix 4 Appendix 5 Appendix 6 Appendix 7 Work Cited Ashby, D.B. Winter 2011. 30 January 2011 . Read More