Gross Domestic Product, Aggregate Planned Expenditure, and Aggregate Supply of Funding - Coursework Example

CHAPTER 1 Macroeconomics takes a holistic approach to study the economy using variables such as inflation, unemployment, output and interest rates. It also examines the policies and strategies used to manipulate those variables. The book elucidates the behavior of macroeconomics in terms of coordination between three key variables; Gross Domestic Product (GDP), Aggregate Planned Expenditure (APE), and Aggregate Supply of Funding (ASF). At the beginning, these three variables might be unequal therefore the Government uses different policies and tools(Macroeconomic coordination process) such as interest rates and tax to influence and bridge the gap between these variables. GDP GDP measures a nation’s total expenditure on goods and services produced in a single year. Since, the expenditures on goods and services are based on the price level during that period therefore the GDP is adjusted through the price level. The adjusted GDP is called Real GDP. Interest rate is one of the tool which helps in influencing GDP. Although, interest rate is not directly linked with GDP since increasing or decreasing the interest rate doesn’t affect GDP but it can affect the employment level which in turn changes the output level (GDP). One of the concepts that reside in the horizon of GDP pertains to Gross Domestic Income (GDY) which represents the total income of the nation in a year. For an economy as a whole, the income (GDY) equals expenditure (GDP). It is so because every dollar of spending by a buyer is a dollar of income for some seller. APE The second component APE relates to the economy’s total demand for goods and services in the country’s output. Technically, it is the sum of consumption, investment, government expenditures and net export. Consumption is the demand of current output by household sector incorporating both demand of domestic and foreign goods & services. Investments are the business sector demand while government purchases are expenditures made by the government. GDP and APE are strongly correlated and APE shows a quick response to a change in GDP. As for the manipulation tools are concerned, research proves that interest rate is not linked with consumption derived by household sector because there is an offsetting behavior in the household sector due to interest rate. However, there is a close relationship between interest rate and net exports in the equation. Overall, the interest rates & APE are negatively interlinked and APE responds slowly with the impact of interest rate. ASF Aggregate supply of funding (ASF) is the source which finances the domestic demand or alternately APE. By definition, the money supply includes all the country issued coins and paper currency except the money in bank vaults & Federal Reserves. In addition to that it comprises of all checking account balances except that which are owned by domestic banks & Federal Treasury Department. Typically, the quantity of money supply can be understood by asking oneself a question that how many times a typical dollar bill is used to buy a good or service. Generally, this concept leads us to the notion of velocity of money. Total money (M) times the velocity of money (V) equals the total output produced by an economy in a particular year. This M times V is further deflated to discard the impact of inflation. This deflated measure is called Aggregate supply of funding. An increase in quantity of money or velocity increases the GDP and thus APE. Whereas, an increase in price level will cause the ASF to decrease. Whenever a customer makes a deposit to a bank it increases the bank reserves. There are regulations which require banks to hold a certain proportion of their reserves in the Central Reserve System. Excess Reserves over statutory requirements are lent to the borrowers because we know that the opportunity cost of idle reserve is zero. ASF increases when the interest rates increase because money supplier will not want to lose the opportunity of placing their funds at a higher rate. CHAPTER 2 This chapter provides a graphical illustration of the concepts learned in the previous chapter. The first equation relates to Aggregate Planned Expenditures which is equal to APE = a + b(GDY) – ci Where “a” measures the influences on APE by all variables other than GDY and I (interest rate) as their impact are described in the other parts. “b” represents the impact of Gross domestic income on APE. The positive sign shows that they are positively correlated. “c” represents the impact of interest rate on APE. The negative sign connotes the negative relationship between the variables as an increase in interest rate causes the APE to go down slightly. The above graph shows three lines; GDP, APE & IS. The GDP line is vertical as there is no direct relationship between interest rate & GDP. The APE equation is already described and its horizontal intercept is (a + b(GDP) – c(0))= a + b(GDP). The IS equation shows all the combination of interest rate & GDP where GDP=APE In the above scenario, the APE line increases (shifts to the right) or decreases (shifts to the left) and the IS line reacts to the change in APE by intersecting at a common point at GDP. The IS line responds to change in APE because both of them are directly related since IS line shows all the value of i for which APE=GDP. Derivation of IS Graph The graph shows how the IS line is derived from GDP & APE lines. When GDP decreases it causes the APE line to shift leftward by the amount b(GDP). Since in United States, the “b” is approximately equal to 0.5 therefore the APE line decreases by half the amount. Furthermore, the interest rates at which APE=GDP declines. All the points are connected together to derive the IS line. Graphical representation of ASF As we found out in the previous chapter that Aggregate supply of funding is dependent on three factors, namely; Amount of Money (M), Velocity of Money (V) & Price Level (P). We know that M and V are positively related with interest rate M x V = m + ie Here m represents the combined effect on M x V other than interest rates “i” represents the impact of interest rate on M x V. The positive sign shows a positive relationship between the variables. Dividing the above equation by price level will generate the ASF equation. (M x V)/P = m/P + ie/P The above equation has a horizontal intercept of m/P and a slope of (e/P) which implies that for a one unit change in interest rate the Aggregate supply of funding changes by e/P. CHAPTER 3 Microeconomics is the branch of economics that the studies how households and firms make decisions and how they interact in markets. The individual demand that the firms face in the economy is always downward sloping because when the price is increased, individuals shift to other products or firm. The firms face a U-shaped average cost curve in their businesses because at the initial level of outputs the cost decreases, however, once a certain output is reached the costs start to increasing due to law of marginal diminishing productivity. Another concept which is associated with the above topic is Marginal Cost (MC). MC is the increase in total cost for a single unit of output. Technically, it can be deduced that when average cost curve is decreasing then Marginal cost curve is also decreasing or vice versa. The diagram below explains how it works. A concept similar to MC is the Marginal Revenue which is defined as the increase in total revenue by increasing one unit of output. A firm maximizes its total profit when MR = MC because at higher level of outputs Marginal cost would be greater than marginal revenue which means that your costs are increasing at a greater rate than your revenues. When an industry has significant economic profits, it attracts new firms to grasp those opportunities of earning profits. The original firms experience a shift in their demand curve due to the entry of new firms. This phenomenon continues until the profit making process extinguishes in the industry. Increase in Demand When an industry experiences an increase in its demand, the individuals firms in the industry observe a shift in their MR and AR curve. With their original output at x, the firms face an excessive demand. In turn, they increase their price to AR which causes them to earn positive profits. The opportunity of positive profit entices the new firms to join the industry. This brings the competition in the industry to an intense level and pushes back the level of individual demand and prices to the original level. However, there are certain limitations to this phenomenon. If there are certain barriers to entry, then the firms can manipulate their demand and price to earn maximum profits. Decrease in Costs An organization can also experience a decrease in its cost structure due to several reasons. A technological advance increases the efficiency and reduces the time so it ultimately causes the average cost to fall down. We will see how the firms respond to a decrease in costs. When the costs decrease the AC curve shifts down and MC curve shifts to the right. This causes profit maximizing output level to shift to the right thus increasing the output & decreasing the price (AR). The existing firms start to earn economic profits, attracting the prospective firms to join the industry. When the firms join the industry, the MR and AR curve of the existing firms shift to the left causing them to come to their original level. Decrease in Demand If the industry experiences a decrease in its demand, than its price reduces & output is also reduced to a certain level. The level of profitability shrinks in the industry and causes the unprofitable firms to leave the industry. The individual demand of the firms increases which restores the price and output to come to their original level. Read More