Aggregate Demand of the Economy - Essay Example

? Macro & Micro economics Table of Contents Summary of chapter 10 3 Summary of chapter 11 7 Summary of chapter 12 11 Reference 15 Summary of chapter 10 The chapter reveals some of the expansionary fiscal and monetary policies which impacts on the aggregate demand of the economy. The effectiveness of the two policies is derived from the way the combination of both policies affects the aggregate demand in the economy (APE). The monetary policies affects the supply function (ASF), thereby shifting the supply curve towards the right or left. This causes the rate of interest to fall or rise respectively. On the other hand the fiscal policies alter the aggregate demand in the economy through the increase or decrease of government purchase components and the after tax share of the GDY which is held by the private sector. The following diagrams would portray a graphical analysis of some of the policy measures that are undertaken and their impacts in the economy (Ashby, 2011, “Expansionary policies”). In the above diagram the general equilibrium exists at the point if intersection of GDP, ASF and APE. Monetary policies would shift the ASF line to the right. However, it is seen from the diagram that this point cannot be reached as it is impossible for the economy to reach that point. This would consequently require a negative rate of interest but the interest rate cannot fall below zero. This shows that monetary policies independently cannot allow the economy to attain the former GDP. This requires the need for fiscal policies in the economy (Ashby, 2011, “Inconsistency Problem”). Fiscal policies in the form of government purchases and tax cuts would be able to move the APE line to the right far enough so that the IS curve would be able to intersect the GDP line at a point of low interest level which would be attainable. Thus the monetary policy would shift the ASF line towards the right and this would pass through the point which is now attainable. To summarize it, monetary policy can be effective only with the assistance of fiscal policies in order to help the economy recover from the effects of recession. The picture also reflects the potential problems related with monetary policies. The faint response of APE after changes in the rates of interest coupled with the low level of interest makes it unable to fall enough to provide enough impetus to the APE to revert back to the original level (Ashby, 2011, “Some Fiscal Policy is needed”). A major problem associated with monetary policies can be explained in terms of the liquidity traps. This is a situation in which the economy enters into a severe depression which dramatic fall in prices, reduction in profits, businesses making losses which causes them to draw back from making investments in new projects. However, the problem is likely to arise only at extreme situations. Another concern associated with the economy is the crowding out effect which arises out of expansionary fiscal policies which increases aggregate demand, APE significantly without a corresponding rise in aggregate demand or APE. The main concern about the phenomenon is that the resulting loss of funds causes a rise in interest levels and this consequently crowds out the rise in APE. According to the views of Ricardo (1772 - 1823), fiscal policies also result in budget deficit in the government that is financed by treasury borrowing. Ricardo has put forth the fact that the tax payers would be able to recognize the fact the government will be required to redeem the bonds at the time of maturity and would then levy taxes to compensate for the principle amount of the outstanding debt and also any amount of accrued interest. A number of restrictive policies can be undertaken in order to curb inflation arising out of expansionary fiscal policies. Short term measures would include the intervention of government and implementing direct control over wages, prices, rather than the implementation of restrictive fiscal and monetary policies. In case of the cost push effects of inflation, the obvious measures would be to release the monetary policies in order to restore the ASF to its original position. This would allow the economy to enter into a recession (Ashby, 2011, “Restrictive Policies”). Summary of chapter 11 The chapter explores the powers of monetary policies which are generally confronted with numerous obstacles in the way of yielding the desired results. However, recently there have been a number of international financial arrangements which has enhanced the potential powers of monetary policies significantly. Since the early 1970s, the American currency and the other major currencies freely fluctuated responding to the changes of the demand and supply of the foreign exchange markets. The market responsive rates of exchange and the increase in international mobility of the financial capital have been able to strengthen the monetary policies and allowed the international monetary authorities towards emphasizing on the domestic policy objectives and goals. It is important to explain the concept of balance of payments, which is done using the following diagram (Ashby, 2009, “Balance of Payments”). The diagram depicts the American balance of payments with that of the European Union (EU) nations using the euro as monetary unit. In the figure it is assumed that the Df is larger in comparison to Sf, which reflects the fact that America has been more efficient in terms of attracting financial investments than the European Union countries. The high rate of Df to Sf is responsible for holding the value of dollar at such a high level that it has been running out of deficits in its current account with that of EU. The balance in current accounts has been consequently affecting the level of aggregate demand, APE for products and services in the US. Rise in the global exchange value of the dollar leads to an upward movement along the Sc and Dc lines. The upward movement of Sc means contraction of the US exports. Rise in the exchange rate causes the APE to decline. Likewise, fall in the exchange rate causes a rise in the APE (Ashby, 2009, “Balance of Payments”). If it is considered that the GDP in the United States was to rise, this would consequently lead to the rise of GDY out of which a small part would be used for spending on the imports coming from Europe. As apparent from the diagram below, the S$ line would shift rightwards as the Sc line would move to the right. This would lead to the fall in the exchange value of dollar, as shown in the figure. However, raising the rates of interest would be able to curtail the fall in the exchange value of dollar. This rise would make America more attractive for foreign financial investors from the Europe. This would consequently move the D$ line towards the right which reflects the rightward movement of the Df line which demonstrates the demand for dollars by Europe for the financial account exports. This would cause the S$ line to move leftwards. Thus there must be a particular level of rise in the interest rates in USA which would move the D$ and the S$ lines to the exact extent to close the existing gap. Otherwise the dollar would be depreciated or there would be fall in the exchange rate. This is shown in the figure below. Given the fact that there are huge financial capital all across the world and that they easily respond to the smallest of changes in interest, the BP line is expected to have very shallow slope. However for the attainment of equilibrium, all the lines must intersect at a common point (Ashby, 2009, “Pegged Rates and Domestic Policies”). Summary of chapter 12 The chapter seeks to explore the effectiveness of GDY as an indicator of the well being of the population. The question is to realize the importance of the same in considering the food, housing, healthcare, education and other well being factors as opposed to the luxury factors meant for the riches and the upper class of society. Also the dispersing of GDY among the entire population plays an important role in deciding its effectiveness. Among the highly developed nations of the world, United States has a GDY of $50,000. However, on the contrary nations along the tropical latitudes have an annual per capital income of less than $750. These nations account for holding one third of the entire population of the world. It is also expected that in the next five years the largest population growth in the world would take place in these regions also. The conditions in these regions are already dreadful with high mortality rates, low life expectancy and conditions are expected to worsen over the years. The removal of poverty from these nations has been the main role of economists for long. This requires raising the GDY substantially such that people living below the poverty level are considered to be exceptional cases and majority of the population survives above the level. Consequently this would require the GDY to grow at a rate above the growth of the population (Ashby, 2009, “Reducing Population Growth”). The reason for low birth rates of countries with high incomes and high birth rates of countries with low incomes is that high birth rates are commonly associated with poverty which leads to families giving birth to children who would eventually provide financial support for the family. Thus it is to be realized that it is poverty which acts as driving factor for high rates of birth and not vice versa. People living below the subsistence level are not able to save much and most of the poor nations of the world are unable to provide their citizens with after retirement benefits. This causes them to depend mostly on their children for taking care of them and thus is considerably against birth control. Enhancing the GDY necessarily requires increasing the products and services of the nation. This additionally requires the proper and optimum allocation of resources and productive factors. At this stage the main requirement has been identified as investments in physical capital, i.e. equipments and plants. However, capital investments are generally brought about through savings. With the major income lying below the level of subsistence countries find it difficult to save. This requires outside sources to finance the technology and capital goods. However, very little capital investments are made from the high income countries to the low income countries. To resolve the issue the Bretton Woods Conference tried to establish IBRD or the International Bank for Reconstruction and Development. The main purpose of the bank was to generate funds through the sale of bonds across the global financial markets for financing the reconstruction of the Asian and the European nations which were devastated after the Second World War (Ashby, 2009, “Accelerating Growth in the GDY”). From the above figure it apparent that increasing Kpc or the capital per capita would lead to generation of diminishing marginal returns. This would lead to the GDP and the GDPpc or the output per capita to rise at a diminishing rate. The way to increase Kpc or push it to the right would be through the increase of investments and savings. This would rotate the Spc line upwards which is not feasible for attaining sustainable increase of average per capita income. The idea behind attainment of high income has been identified as the attainment of sustained growth in the average per capita income over a period of time. Innovation and technological changes would play critical roles in these conditions in making the factors of production more productive. This would be effective in rotating the GDPpc line upwards. In order to facilitate innovation and changes in technology, governments in the poor nations are required to subsidize technological research and development and also subsidize the adoption of technology from the industrialized nations. One of the main problems with the poor nations is that they lack proper entrepreneurship. Although they have accumulated huge amounts of dollars on real estates, they lack access to the proper property mechanism which could realize the economic potential of their assets. It is important that governments of the third world nations try to get their real assets properly accounted on books. Only then would the ownerships be clearly established and entrepreneurs would be able to tap real value of their assets for business loans (Ashby, 2009, “Investment in Not Enough”). Reference Ashby, D. B. Expansionary Policies. 2011. Policy Issues. July 20, 2011. < http://home.earthlink.net/~econanalytics/09intermediate10.pdf>. Ashby, D. B. Balance of Payments. 2009. International Issues. July 20, 2011. < http://home.earthlink.net/~econanalytics/09intermediate11.pdf>. Ashby, D. B. Reducing Population Growth. 2009. Development Issues. July 20, 2011. < http://home.earthlink.net/~econanalytics/09intermediate12.pdf>. Read More