The Business Cycle and Macroeconomic Objectives - Term Paper Example

Submitted by: XXXXXXX Number: XXXXXXX XXXXXX XXXXXXX XXXXXX of XXXXXXX Submission: XX – XX – 2009 The Business Cycle and Macroeconomic Objectives Abstract The business cycle and the circular flow of income in the markets has been an essential element of economies for years. An economy runs based on the funds that are available in the markets at all times. The paper has dealt with some essential concepts of economics like the circular flow of income and the inner flow of income. Various elements like injections into the markets and the leakages of the market have also been discussed. Recognition of the relationship of withdrawals and injections has also been made which allows better overview of the markets. The relationship of withdrawal and injections has shown an indirect link similar to the savings and investments, taxation and government expenditures. The last and most essentials element of this paper is the discussion of the circular flow of income and the four macroeconomic objectives i.e. a) Economic Growth, b) Reduced Unemployment, c) Rise of Inflation, and d) Deterioration of Balance of Payments. Introduction: The figure below provides a view on the relationship of the four main objectives of macroeconomics. The figure shows how in a short term the four objectives, i.e. faster growth of output, lower unemployment, lower inflation and the avoidance of balance of payments deficits are related to each other (Sloman and Sutcliffe). The relationship depends on the aggregate demand which is influenced by each phase of the business. a) Expansionary Phase: In this phase (phase 2), the aggregate demand grows very rapidly and the gap between the potential output and actual output is relatively narrower. Here the growth in the output will be relatively rapid and the levels of unemployment will be faced with a drop as well. This provides a solution for two issues however it leads to the other two sectors to be faced with issues (Sloman and Sutcliffe). With the higher levels of shortages the inflation is also affected and this leads to the deteriorating balance of payments which in turn leads to the domestic goods being less competitive in the international markets. b) Peak: At phase three of the cycle i.e. the peak phase, the level of unemployment is at the lowest and the output of the company is at the highest level. At this level that company’s growth is slowed down and the in some cases even ceased (Sloman and Sutcliffe). Here the balance of payments and the inflation issues are very high and acute. c) Phase4: At this stage, under the assumption that it is an actual recession with the output being faced with high levels of decline. Here the result will be opposite to that in phase 2. The falling demand will lead to negative growth which will lead to a higher demand – deficit unemployment. However here the inflation will tend to reduce and a clear improvement will be seen in the balance of payments (Sloman and Sutcliffe). This leads to a dilemma within the government. In case the economy is deflated, the balance of payments and the inflation will face a high level of growth however the unemployment will also be faced with high rise and growth and the output will be faced with a steep decline. Figure: The business cycle and the four macroeconomic objectives (Sloman and Sutcliffe) The Circular Flow of Income: Apart from the above mentioned method of understanding the relationship between the four macroeconomic objectives, another simpler method is to understand the economy as well. In the diagram below, it is clear that the economy has been divided into two major groups, i.e. households and the businesses. In any economy, the two divisions play a major role in the development of the economy. The businesses are the producers of the goods and services while they also play a major role as employers. The households on the other hand are consumers of the goods and services and they also form the suppliers in terms of human resources and the various other factors of production as well. Figure: Circular Flow of Income (Sloman and Sutcliffe) a) Definition and Meaning of Circular Flow of Income: “The circular flow of income is a simple model of the economy showing flows of goods and services and factors of production between firms and households. In the absence of government and international trade this simple model shows that households provide the factors of production for firms who produce goods and services. In return the factors of production receive factor payments, such as wages, which in turn are spent on the output of firms” (Bized). b) Inner Flow of Money: The inner flow of money is referred to the money that firms pay to households in terms of the salaries, wages, dividends, rent and interest. These payments are mostly provided as a return for the services provided by the households like labor, land and capital. These payments are referred to as the ‘factor payments’ (see above image) (Bized). The payments received by the households are in turn used to pay the domestic firms for purchasing the ‘consumption of domestically produced goods and services’. It is also essential to note that in the real world economy, not all the money that is received by the households is used to buy domestic products. The various terms that are involved in this process have been explained as below: i. Consumption of Domestically produced Goods and Services: This refers to the direct flow of money in terms of payments from households to the firms (Solman and Sutcliffe). If the households, i.e. individuals spend all of the money that is received from the businesses as factor payments, there will not be a change in the markets as the money will continue to rotate in the market indefinitely over time. ii. Withdrawals / Leakages: This refers to the incomes of the households or the firms and factories that do not pass through the inner flow. Withdrawals can be expressed as Net Savings (S) + Net Taxes (T) + Import Expenditure (M). iii. Injections: This refers to the inflow of money into the firms from sources outside the inner flow of income. This can be expressed as Investments (I) + Government Expenditure (G) + Expenditure on Exports (X) (Sloman and Sutcliffe). c) Relationship between Withdrawals and Injections: The link between the savings of the households and the investments, taxation and government expenditures, and imports and exports are indirect. For instance, if the amount of taxes that are received is higher, the government will be able to spend a lot more for the expenses. Similarly, if the savings are high, the amount of funds available to the banks and financial institutions is much higher and this allows more funds that are available for circulation within the market. The relationship between the two is indirect and this cannot be set down to be constant (Bized). The main reason for this is the levels of savings and investments for every household are different and the plans of each household are also very different. Macroeconomic Objectives and the Circular Flow of Income: As seen in the previous discussion, it is clear that there is a strong relationship between the level of injection and the level of withdrawals. It is important to understand, if the level of injections exceed the levels of withdrawals, then the economy will be faced with a higher level of expenditures. This extra aggregate demand has an influence on the increase of the extra incomes, i.e. there will be a rise in the actual national income of the economy (Sloman and Sutcliffe). Also, it is essential to understand that, if the rise in the actual income is higher than that in the potential income, then the four macroeconomic objectives of the economy will be affected as follows: i) Economic Growth: When there is a higher injection of funds into the markets and the level of withdrawal is low, there is an instant rise in the national income of the country as well. Hence this leads to higher economic growth. ii) Reduced Unemployment: When the demand increases, the need for higher employment is also present in the markets. Hence the firms will recruit higher number of employees to be able to meet the demand and this in turn will lead to reduced unemployment within the economy. iii) Rise of Inflation: If the economy is faced with a big gap between the actual income and the potential income, the demand goes high, and in order to meet this, the firms need to increase their prices. This will lead to increased inflation within the economy. iv) Deterioration of Balance of Payments: As discussed earlier, the increased gap between the injection and the withdrawals will lead to higher demand and higher inflation. When a situation like this arises, the imports tend to become higher, in order to meet the demands and the exports start to reduce due to the high prices. This increase in imports and decrease of exports will lead to a deterioration of the balance of payments. Thus it is clear that the impact of the relationship of injection and withdrawals is vast and can have a major impact on the macroeconomic environment. Conclusions: The economy works based on a circular flow of income. There is a high need for this flow to be balanced to eliminate risk of any kind. An imbalance in the economy can have a major affect on the four macroeconomic objectives and can lead to a complete imbalance in the economy as a whole. Available References: There are a few good books and references that are available for any further research that might be conducted on this topic. The following are the available books: Bized. The National Income Accounts: Measuring the Circular Flow of Income. 2009. 25 October 2009 . Carlin, W. (2006). Macroeconomics: Imperfections, Institutions and Policies. USA: Oxford University Press. Davis, M. A. (2009). Macroeconomics for MBAs and Masters of Finance. Cambridge University Press. Hoover, K. D. (2001). Causality in Macroeconomics, 1st Edition. Cambridge University Press. Mankiw, N. G. (2008). Principles of Macroeconomics, 5th Edition. South-Western College Pub. Sloman, Jack and Mark Sutcliffe. Ecnomics for Business, Third Edition. London: Pearson Education Limited, 2004. Swanenberg, A. (2005). Macroeconomics Demystified, 1st edition. McGraw-Hill. Tucker, I. B. (2008). Macroeconomics for Today, 6th Edition. South-Western College Pub. Tutor2u. Circular Flow of Income and Spending. 2009. 26 October 2009 . References Bized. The National Income Accounts: Measuring the Circular Flow of Income. 2009. 25 October 2009 . Sloman, Jack and Mark Sutcliffe. Ecnomics for Business, Third Edition. London: Pearson Education Limited, 2004. Tutor2u. Circular Flow of Income and Spending. 2009. 26 October 2009 . Read More