The Role of Economic Models - Report Example

Topic: Macroeconomics Introduction This paper seeks to discuss a published economic event or issue in order to explain how they relate totheories in macroeconomics. The result of this paper will help the reader to realize and explain the economics that exist all around us. The paper includes a graph used as an explanatory tool of the economic principle. 2. Analysis and discussion 2.1 Published current economic events or issues The current issue that will be analyzed and discussed here is the case of the effect of the rise of the US interest by the Federal Reserve the US on investments US stocks as reported in Sydney, Australia. Rodrigues (2006) filed a news report with a head line: “US stocks fall on fear of higher rates, slow growth, 23/6/2006 Sydney, Australia.” This news report is an issue or event that has macroeconomic consequences and applications and therefore chosen in this paper to be analyzed and discussed. 2.2. Explain how they relate to theories in macroeconomics. Rise in interest rate is an economic reality that affects the lives of people not only in US but also in the whole world. It is an issue that felt and debated by every right thinking decision makers. Interest rates have different meaning for decision makers. Interest, which is conceptually the price of money, may be bad or good depending on one’s point of view. To start the analysis, let as assume that one has $100,000. That amount of money may be just kept at home or in the bank. The owner would most like want that at home if in the short period of time, he will use the money to buy or pay something. However, if he does not need the money, he might just as well keep the money in the bank due to the lure in interest income that may be earned plus the riskier to loss decision if he keeps the money at home. Interest rate therefore motivates a holder of money to invest his money at the bank. 2.3. Realize and explain the economics that exist all around us. Economics which is the study of the limited resources trying to satisfy unlimited need and wants have their daily or every moment effects on the lives of the people. The fact that information on interest rate is monitored and reacted upon to is a proof of its influence in the lives of people. 2.4 Monetary policy and its effects on economy and people. Monetary policy is a choice that may be implemented by the Monetary Authorities around the World. In the US, it is the Federal Reserve that implements monetary policies. The Federal Reserve has the power to increase of decrease monetary supply. Through the price of money, which is interest? Hence, demand for money is high if the interest rate is high and vice versa. The Federal Reserve, therefore, has the power to increase to influence the level of interest rate with the macroeconomic objectives of full employment, economic growth and stability. If the Federal Reserve decreases interest rate, it is actually encouraging investment and the if investment is increased, aggregate demand (Slavin, 1996) will increase and therefore GNP or GDP will grow. GNP or GDP measures output in the economy. The greater, the growth the better will be the lives of the US people. This reality is illustrated by the following graph: Figure I. Illustration of the relationship of interest rate, supply and demand of money The supply curves are represented by S1 and S2 while the demand curve is are represented by D1. D1 meets S1 at E1, this is the equilibrium before the shift to S2, when the Federal Reserve increases interest. This E1 equilibrium illustrates the balance between availability of money in circulation before the Federal Reserve raised interest rate at i2.The graph clearly illustrates the increase in demand from S1 to S2, and it resulted to an increase in prices of goods and/or interest rate required to arrive at a new equilibrium point in E2 along the same curve (D1). Take note a separate graph could be presented separately to illustrate that increase in investment will increase aggregate demand. But since Output is a function of investment, government spending and consumption, this paper opted to assume the reader will understand that the relationship is direct and hence an increase or decrease in investment is also an increase and decrease of investment. Observe that the decrease in output or GNP growth was actually caused by the decision to increase interest rate by the Federal Reserve, based on the premise that the decrease in money supply decreased the amount of private investment. It must also be noted that the demand curve which is downward sloping also represents the relationship of interest and investment, that is the greater the investment, the lower the interest rate and vice versa, which is feared by investors of stock in Sydney, Australia. Hence, the next question is: “Why would investors of US stocks in Sydney, Australia get affected by the increase of interest rate in the US?” The phenomenon may be explained by the fact that the higher interest being decided by the Federal Reserve would attract investors from said stock to sell their stock and instead buy treasury bills or bonds that may be floated by the Federal Reserve. This is one of the characteristics of a market economy. If for example an investor faces a choice of investment in stocks generating a return of 6% per annum and a choice to earn on treasury for the same rate of 6%, the would investor would normally choose the treasury sold by the US Federal Reserve. Why? The reason of course is that by investing in Treasury bill that is government guaranteed, the investor is actually reducing risk and increasing his liquidity. Although stock possession allows the investor to easily dispose the same, the investor is better off in heaving Treasury bill since it is almost equivalent to money; the only restriction is if selling the same prematurely would have to give in to some discount. In the nature of things , the function of the Federal Reserve is always there hovering over the economic decision makers since its function is to promote public welfare by attaining full employment, stability and zero or low inflation. The next question is: “Is there any other way of increasing interest rate by the Federal Reserve without selling treasury or treasury bills?” The answer of course is yes, and that is through the reserve requirement by the Federal Reserve. How? By increasing the reserve requirement for banks, the Federal Reserve is actually tightening money supply and hence interest rate will also increase. By doing the reverse, the Federal Reserve may increase money supply? The next logical question then is: “Why would the Federal Reserve increase interest rates when it will result to lower economic growth?” Well, the Federal Reserve is also mandated to maintain stability in the economy by slowing down the economy or by merely reducing inflation. In other words, the Federal Reserve must balance the attainment of its objectives. 3. Conclusion We have seen how the Federal Reserve exercises its power to influence the rise and fall of interest rate pursuant to the accomplishment of its objectives. By so exercising the its prerogative to increase interest rate to slow down the economy or reduce inflation, it sees the greater good of having a lower yet stable growth than allow uncontrolled increase in prices should the economy turn out to ‘overheating’ or does not allow growth because of the possibility of higher prices. Making such decision may affect investors of stocks in many part of the world who may have the opportunity to buy US treasury bills or notes or necessarily get affected by the Federal Reserve’s decision in the matter. Such reactions of investors are expected and rational since nobody wants to lose every opportunity for increasing wealth for allowing such to a happen would actually be a financial loss in the real sense of the word. Economic models that explain economic principles have their roles for easier assimilation of the concepts. Though the Federal Reserve’s people understand the same, businessmen in order to survive the rigors of doing business have no choice but also need to understand the same to properly react accordingly to their best interests. Bibliography: 1. Rodrigues, V. (2006), US stocks fall on fear of higher rates, slow growth, 23/6/2006 Sydney, Australia, ninemsn Pty Ltd, {www document} URL http://investor.ninemsn.com.au/investor/osshares/usreview/story_detail.asp?index=19746, Accessed June 25,2006. 2. Sameulson P. and Nordhaus W. (1992), Economics, , McGraw-Hill, Inc, New York, USA 3. Slavin, S. (1996) Economics, Fourth Edition, IRWIN, Chicago, USA Read More