Classical Analysis and Policy - Essay Example

? ical Analysis and Policy The following discussion pertains to the new macroeconomic policy as developed by economists of the world keeping in mind the possibility of a shock in output and employment levels such as those seen in the Great Depression of 1929. The depression caused the world’s macroeconomists to alter their theories in order to make allowances for paradigm shifts resulting from changes in interest rates and money supply. The original macroeconomic equilibrium takes place when Aggregate Supply of Funding = Aggregate Planned Expenditure = Gross Domestic Product. The ASF line was a vertical line with interest rates measured along the y axis. Thus, the ASF line was unresponsive to changing interest rates at a given level of output (GDP). Both Money and Supply are unresponsive to interest rate changes as well. It is assumed that the GDP is at a profit-maximizing level. Hence, any change in the level of APE will not be complemented by a similar rise in ASF. This is because when APE increases, and the buyers hunt for cash through funding, the ASF remains the same as money supply and the velocity of money are taken to be unresponsive to any changes in interest rates. In order to cope with this excess demand, the banks will offer higher interest rates, and keep going higher till it overshadows the excess demand. Even though demand was high, there was no real increase in expenditure because APE was unresponsive, and thus businesses never had any incentive to raise prices or output; hence, GDP remained the same too. The APE curve will shift back to its position eventually owing to increased interest rates which curb demand. Same is the case when APE falls; price and output are unaffected. It is only when the ASF, being a vertical line still in classical macroeconomic theory, shifts to the right or left is the price and output of product (GDP) affected. When funding (ASF) increases, interest rates fall which in turn raises APE. The economy will find a new equilibrium ahead of the current GDP, giving an incentive to producers to increase prices (producers in this version of the macroeconomic theory are taken to be satisfied at current level of output). Once prices are increased, it curbs funding (ASF), which in turn increases interest rates. When rates are increased, the APE falls until all three, interest, ASF, and APE are back at the initial equilibrium. Hence, it could be concluded that a rise in ASF would only cause inflation without any chance in output or employment. As such, a fall in ASF would result in a loss of APE, causing loss of demand and higher interest rates. Businesses will counter with lower prices, causing ASF to rise again and APE to go back to its original level, without any change in output or employment. This was the same case with any fall in GDP, so that if output fell, and prices rose, resulting in less ASF, all businesses had to do was readjust their costs and consequently prices of goods in order to increase expenditure (APE) back up again and with the help of lower interest rates, ASF to rise up back to its original level. Output would remain unaffected. According to classical macroeconomic coordination, all these changes were to take place over a period of time. However, the Great Depression of 1929 saw unparalleled levels of unemployment and loss of GDP which brought a change in theories since. The first change was on the control of expenditure. It was seen that when APE rose, the corresponding change in interest rates would not be able to fully engulf the new rise in demand. Some demand would be funded affecting the conditions of the market, causing temporary rise in output and inflation. On the contrary, if APE fell, interest rates would also remain unchanged until manufacturers responded by cutting costs and prices. However, the macroeconomic coordination’s tendency to find the equilibrium by altering the prices to reach GDP at full-employment is faced with two problems. Firstly, APE can fall to such low levels that it cuts the GDP line (which is vertical) in the negative. Businesses necessarily have to cut prices in order to raise APE back to full-employment levels of GDP, consequently lowering interest rates as well. However, interest rates can only be lowered so far, and can obviously never reach zero, such that to reach full-employment GDP, businesses would have to cut employment as well as output. Secondly, in order for businesses to be able to reduce prices, they should be able to reduce proportionately their costs as well. If the percentage of cost cutting is less than percentage cut of prices, it is apparently disadvantageous to the business as profits plunge drastically. Moreover, competition in today’s world is fierce, and businesses already have a tendency to run efficiently with minimal cost requirements, such that bargaining for raw materials may be their only resort to cost cutting. That in itself is a tough job in today’s corporate environments. The result of these two problems is that businesses end up producing low levels of output at low levels of employment. Monetary Policy Monetary Policy purports to controlling the money supply by the Federal Reserve by adjusting the reserve requirement and discount rates in order to affect the levels of interest rates, prices, employment and output. This change is brought about by altering the supply in three steps; first is adjustments in reserve requirements for banks, open market operations and discount rates which in turn affects the money supply. Second is the adjustment in ASF which is caused by adjustments in the money supply. Third is the consequent changes in employment, output, prices and interest rates. The measurement of aspects of money supply is done by mechanical formulas. Money supply is given by M= CC + CA where CC equates to the two types of measurements of money that exist in the U.S, coins and currency, and CA equates to the checking account. Bank reserves are given by R = (r' x CA) + (r" x TD) + (w x CA), where r' denotes average number of dollars required by law for banks to keep, CA is the checking account, r" is the average number of dollars banks are required to uphold for timed deposits, TD denotes timed deposits, and w is the amount of working reserves (actual reserves that banks keep over and above their lowest requirement). The third measure is that of Monetary Base, which is denoted by B = CC + R, followed by the cash to checking account ratio, denoted by d = CC/CA. The fifth and final element is that of the ratio of timed deposits to checking account, as denoted by t. Using substitution, the money supply M = (d + 1 / d + r’ + r” x t + w) x B. The alterations in each of these variables will have a corresponding effect on the Money Supply. The general public controls d and t, where t may be influenced by banks through change in interest rates of timed deposits. The bank obviously controls w, subject to legal requirements, and the Federal Reserve is responsible for r’, r” and B. These three variables influence the money supply in order to benefit the four elements mentioned in the introduction. B is influenced by open market operations, r’ and r” by altering the minimum reserve requirements, and by adjusting the discount rate in order to influence the values of the working reserves (w). The policy measures that may be adopted by the Federal Reserve are restrictive in nature of the money supply and the Aggregate Supply of Funding, hence the corresponding policy measures are defined by the words tightening or Easing the restrictions. By controlling the money supply in this way, the policy makers can work towards achieving a higher GDP or a lower GDP at full employment depending on the prevailing output. A tight measure of monetary policy is usually reserved for controlling inflation. Fiscal Policy This measure of GDP and price control employs two control measures; Automatic stabilization and discretionary fiscal policy. The automatic stabilizers, as the name suggest, automatically minimize adjustments in the levels of employment and output that occur in the macroeconomic coordination process. This is accomplished by minimizing the aggregate planned expenditure’s changes effected by changes in the gross domestic income. In order to minimize the responsiveness of APE to income, the reservoir principle is used to support the stabilizers of welfare funds and unemployment compensation insurance programs. This principle allows a certain portion of income to be reserved when incomes are on the rise for tough times in order to supplement the people’s ability to purchase. They are designed to work in unison with the economy without government intervention, being run with taxes and supporting low-income eligibility criteria fulfilling individuals. An important contribution to the automatic stabilizers is the use of a progressive tax management system. This allows for the percentage of tax to rise as the income (GDY) rises, dissuading the buyers from engaging in purchases because there is less of a change in APE. The same is the case when GDY is falling, as the progressive system takes away progressively lesser amounts of the taxpayer’s income, resulting in fewer upsets to the taxpayer’s purchasing power. This also controls the number of people claiming income support and military retirement benefits as the outgoing benefits of these programs correlate with the incoming tax receipts. Consequently, the automatic stabilizers enable the IS line to edge towards vertical, reducing the responsiveness of the APE to GDP. The discretionary fiscal policy, on the other hand, employs measures to control domestic output purchases, tax receipts from businesses and tax receipts from homes, consequently altering the APE positions which in turn adjust employment, output, interest rates and prices as the market forces enforce the macroeconomic equilibrium. The fiscal policy mechanics are given by: ?APE = ?G - 0.65?HT - 0.35?BT, where G denotes government domestic output purchases, HT denotes household taxes and BT denotes business taxes. These three variables can be altered in order to effect a change in the APE through the macroeconomic coordination process. When governments aim to increase the APE through a change in the fiscal measures mentioned above, the move is known as an expansionary policy measure. For e.g, in order to increase APE, the government may favor an increase in federal purchases while at the same time altering tax receipts in the same direction. This procedure is known as the balanced budget approach which realizes a minimal rise in national debt. However, for this to happen, there must be a substantial increase in tax receipts and more government expenditure (as opposed to private expenditure), which is politically unfavorable. The opposite of this procedure is the use of Restrictive Fiscal Policies, designed to reduce aggregate demand and create budget surpluses. For the benefit of the public at large and to attain simultaneously the goals of reduced unemployment and inflation, discretionary fiscal policy is used in conjunction with monetary policy addressing mainly the government’s collection of tax revenue. Works Cited Ashby, David B. “Classical Analysis and Policy” Intermediate Macromechanics. 2009 ch. 7 p. 121 – 134. Ashby, David B. “Monetary Policy” Intermediate Macromechanics. 2009 ch. 8 p. 121 – 134. Ashby, David B. “Fiscal Policy” Intermediate Macromechanics. 2009 ch. 9, p. 163 – 200. Read More