Intermediate Macro Mechanics: Macroeconomic Coordination - Essay Example

? here) (Your here) (Type of assignment e.g. Test assignment) (Due INTERMEDIATE MACRO MECHANICS Chapter 4 - MACROECONOMIC COORDINATION Funding Adjustments Funding Adjustment is the interaction of reactions by money users and money suppliers to draw the magnitudes of ASF and ADF together when they become unequal. Funding adjustments can be made quickly and their effect can be immediate. The purchasers of GDP are divided into three groups which are: Group 1 - those with just sufficient available money balances to fund their current planned purchases; Group 2 – those with insufficient available money balances to fund their current planned purchases; and Group 3 – those with more than sufficient available money balances to fund their current planned purchases. The members in each group are not always ensconced in their respective groups permanently. They can be shifted in other groups. There are three scenarios of funding adjustments. Funding Adjustment if ADF = ASF In this case, the members of each group are not aware of the equality of ADF and ASF. They are aware of their own financial positions and act according to them. The members of Group 2 need to borrow funds to finance their demand. The members of Group 3 look to lend their excess funds. The lender’s and borrower’s needs are met by financial intermediaries1. As ADF = ASF, the excess funds are just enough to fulfill the borrowing needs of members of Group 2. The financial intermediaries do not need to alter the rates of interest as there is no need to encourage or discourage the lending or borrowing. Funding Adjustment if ADF > ASF In this case, the members of Group 2 and 3 are unaware of this inequality but are fully aware of their own needs. The members of Group 2 borrow funds from financial intermediaries but the funds available are inadequate to satisfy their demand completely. Financial intermediaries raise the interest rates. This raises the ASF and lowers the ADF. The process of raising interest rate continues until the ASF matches the ADF. Funding Adjustment if ADF < ASF Again, the purchasers of GDP are unaware of this inequality but make decisions according to their own needs. The members of Group 3 lend to financial intermediaries but the demand for their funds is insufficient. The financial intermediaries lower the interest rates. This raises the ADF and lowers the ASF and the process continues until both become equal. The completion of funding adjustment makes the economy ready to step in output-price adjustment phase after giving any one of the three following scenarios: GDP = APE = ASF; GDP < APE = ASF; or APE < GDP =ASF. Output-Price Adjustments The producers of each domestic output lie in one of the following groups: Group A – firms facing demand at average annual rates that just equal their current average annual production rates; Group B – firms with excess demand; and Group C – firms facing insufficient demand. Output-Price Adjustments if GDP = APE = ASF The members of Group B and C are unaware on this equality and make decisions according to their own circumstances. The producers of Group B raise their prices and increase their output level. The producers of Group C lower their prices and output. As APE = GDP, the excess demand for the producers of Group B almost off-sets the demand deficit for the output of producers of Group C. Therefore, this equality has no significant impact on levels of employment, output, interest rates, and prices. Output-Price Adjustments if GDP < APE = ASF The producers of domestic output are unaware of this inequality and act according to their own requirements. The excess demand faced by the producers of Group B is higher than the shortage of demand by the producers of Group C by exact amount that APE exceeds GDP. The price rise from Group B is higher than the price cut by Group C. The overall price and GDP rise. This raises the income level resulting in increased demand and interest rates. The economic profits earned by Group B encourage entry in their industry while Group C’s loss induces exits. The total entries are higher than the total exits causing net positive economic profits. The new entries increase the total output and the prices are lowered. Therefore, the price level comes back almost to its original level but the level of output, employment and interest rates are higher than before. Output-Price Adjustments if APE < GDP = ASF The members of all the groups are unaware of this inequality but are aware of their own individual situations. The producers of Group B raise prices and increase output while the producers of Group C lower the prices and reduce their output. As GDP > APE, the net effect is lower prices and reduced output. The fall in GDP causes GDY to fall and overall demand also falls. The economic profits earned by producers of Group 2 encourage entries into their industries while Group 3’s loss induces exits. The total exits are greater than total entries and there are net negative economic profits. The output continues to fall until the price level gets back to its original level. Therefore, the economy faces no change in the price level but a significant cut in GDP, employment level and interest rates. Therefore, the adjustments are made automatically and unknowingly by individual reaction to their own needs. The gaps between GDP, APE and ASF, if any, are filled automatically without any supervision by a higher authority. Chapter 5- MACROECONOMIC SHOCKS: EXCESS DEMAND CASES There are six shocks that can trigger the MCP. These shocks involve a rise or a fall in GDP, APE or ASF and can occur singly or in a combination. The economy is assumed to be in long run equilibrium. They are discussed in the following. Case #1 – Demand-Caused Expansion This happens due to any increase in APE that can come from any source. This increase causes the interest rates to rise in the phase of funding adjustment to equalize APE and ASF. To meet the excess demand, the producers increase the level of output, increase employment and their funding requirements need the interest rates to go on increasing in the output-price adjustment phase. The positive economic profits of their industries encourage entries into the industry and the resulting competition contributes in bringing the price level down. By the end of output-price adjustment phase, the prices fall down to their original level while employment and output level rise and interest rates go down. Case #2m – Money-and-Credit-Caused Expansion Whenever ASF increases, it involves an increase of M x V relative to the price index (p). ASF increases when there is a desire by lenders to loan more funds even before there is an actual increased demand for more funds. The expanded loans increase the velocity of money (V). In the phase of funding adjustment, the availability of excess funds causes a fall in interest rates. This raises APE and decreases ASF but APE exceeds the current GDP level i.e. GDP < APE = ASF, hence making the circumstances same as in the previous case. Therefore, by the end of output-price adjustment phase, the prices fall down to their original level while employment and output level rise and interest rates go down. Case #2c - Cost-Induced Expansion/Deflation When the cost structures of a large number of industries fall, they start to expand their output and cut their prices. This increases employment too. Therefore, GDP, APE and ASF increase and prices go on falling resulting in interest rates to fall too. The industries continue to expand until reach the point where they have lowered their prices to the same level to which their average costs fell. The scenario hence created is almost identical to that of the previous case but in this case, the level of prices stays down. This shows that there is deflation. The economy stays at this position until another shock hits it. Case #3 – Supply-Caused Inflation GDP of a country can fall due to natural calamities or internal chaos. When it happens, there is a fall in income and employment also. If GDP, APE and ASF were equal initially, the fall in GDP makes this situation: GDP < APE < ASF. The lenders have excess funds than the APE so the interest rates are lowered down to the level where ASF = APE. The producers facing excess demand are not able to increase the output level; their only recourse is increasing the prices. This causes the rates of interest to shoot up. The process continues until GDP = APE = ASF. When the economy overcomes the reasons of fallen GDP, the whole process is reversed and GDP, APE and ASF increase to their original level. Chapter 6 - MACROECONOMIC SHOCKS: INSUFFICIENT DEMAND CASES The remaining three external shocks have one thing in common: After the initial funding adjustment, all three have insufficient demand for the currently available domestic supply of goods and services (APE < GDP = ASF). Case #4 – Demand-Caused Recession This case is generated by fall in APE. The decline in demand of funds is off-set by increased demand of funds by producers to finance the unused surplus of inventory. Therefore, no funding adjustment is required. The situation at the start of output-price adjustment phase is APE < GDP = ASF. The producers start to decrease employment to cut the supply level and also reduce the price level. The rates of interest also fall. The process continues until the economy gets a temporary situation of GDP = APE = ASF. This practice generates net negative economic profits: the exits of firms declines GDP further. It continues until the prices rise to a level where net negative economic profits are diminished. At the end of output-price adjustment process, the economy has a fallen level of employment, output and rates of interest while the prices are unaltered. Case #5m – Money-and-Credit-Caused Recession When the lenders of funds decide to cut the supply of loanable funds, there is a fall in M x V which results in fall of ASF. If initial situation was GDP = APE = ASF, the new situation is GDP = APE > ASF. The shortage of funds causes the interest rates to rise which decrease APE and ASF rises. It continues until APE = ASF but there level stays the level of GDP. The producers’ demand for funds to finance their unused inventory pushes causes the interest rates to rise even higher which reduce APE even lower. The resulting situation becomes APE < GDP = ASF which is the same as previous case. At the end of output-price adjustment process, the economy has a fallen level of employment and output, increased rates of interest and unchanged prices. Case #5c - Cost-Push Inflation When the cost structures of large number of industries rise, they raise the prices and cut their output level. GDP, APE and ASF start to decline with the rates of interest going up with the price level. The process goes on until the price level reaches the point where it matches the rise of variable cost of the industries. The newly attained position is lower level of employment and output and higher level of rates of interest and prices. In this case, the level of prices stays up depicting inflation. The economy stays in inflationary recession2 until another shock hits it. Case #6 – The Growth Problem Additional investment by producers generates more output: increases GDP. The corresponding rise in income increases APE but this rise is lesser than that of GDP. This is one half of growth problem. The other half is accompanied funding problem i.e. ASF stays stagnant. The situation attained, therefore, is ASF < APE < GDP. A great need of funding arises which pushes the rates of interest of scarce funds upwards. This causes APE to fall. ASF and APE finally equalize each other but at the point where GDP is higher. The resulting situation is GDP > APE = ASF. ASF continues to rise due to producer’s demand for funds and equalizes GDP eventually bringing the economy to a position where APE < GDP = ASF. Insufficient demand causes producers to lower the prices and they continue until a significant amount of producers leave the industry and GDP= ASF = APE. This is also a temporary situation as producers have now no demand for their expanded output capacity. They start to de-invest which lowers APE causing a demand-caused recession. Therefore, the economy faces lowered level of employment, output, rates of interest and unchanged prices. Endnotes 1. Financial Intermediaries obtain funds from members of Group 3 and lend them to members of Group 2 at a certain rate of interest. 2. As there is a price hike with low level of employment and output, the situation is of inflationary recession. Works Cited Ashby, David B. Intermediate Macro Mechanics. Lake Oswego, Oregon: EconAnalytics, 2009. Web. Read More