The Important Notions of Income - Assignment Example

Income Chapter 3) Though GDP which measures production and GDI which measures income are two different concepts but their magnitudes are always equal. The change in GDI will always reflect a similar change in GDP as it’s caused by change in GDP only. Three important notions 1) Any changes in the value of the products which would be reflected as change in GDP will also be reflected as a change in GDI as depreciation, a reduction in production, will correspond to a loss thus reducing income and appreciation vice versa. 2) Money and income are distinct concepts. People earn income through money and they spend this income through money. Money is the medium through which income is transferred. 3) Credit acts as lubricant in the economic process due to which transactions are smooth. Lack of credit may result in the slowing down of the economy. GDI receivers are divided in to three sectors, Households, Business and the government represented as HY, BY and GY with respective share of 74%, 10-12 %, 14 % in the US. GDI of household is called disposable income which includes wages, profits distributed, interest, rent and royalties by the businesses and transfer payments by govt. less taxes, social contributions and transfer to foreigners. Business sector’s share is called as business saving which comprises of depreciation allowances, undistributed profits, and inventory revaluation, if any. Government income comes through tax receipts, fines, and license fees, but not from borrowed funds, but it passes back a substantial proportion of its income back to house holds and business as transfer payments. Albeit very small, just 1 %, but a part of Household, Businesses and Government incomes goes to foreigners also which is represented by TF. Thus, GDP ≡ GDY ………………….(1) GDY ≡ HY + BY + GY + TF……..(2) which shows that current domestic production generates current incomes that are just equal to the amount needed to buy the production. Though price level changes do not impact GDY but they may redistribute the income among HY, BY and GY Income levels and expenditures need not necessary be equal. People may choose to spend less than their income thus saving the remaining part or spending more than their current income by dissaving past savings or borrowing. Though GDY and GDP are equal, the level of aggregate demand represented by APE aggregate planned expenditure for current domestic output by recipients of the GDY need not be equal GDY. APE ≡ C + I + G + X – F……………….(3) Consumption (C) is household sector’s demand for current output from both domestic and foreign countries. Investment (I) the business sector’s demand for current output, both domestic and foreign countries. G – Government Purchases, X – Exports and F – Imports. Subtracting F in the above equation ensures that purchases by Household, Businesses and Government from foreign countries are excluded. If F increases at the cost of C, B G then only it decreases APE other wise having higher F will not impact APE level. From equation 1, 2 and 3 for APE and GDP to equal the following equation must hold (HY - C) + (BY - I) + (GY - G) + (TF + F - X) = 0 (HY - C) measures the house hold budget surplus. Similarly (BY - I), (GY - G) and (TF + F - X) measure the surpluses in respective sectors. If all the sectors budget surpluses, when added, give out a positive number then GDY > APE or GDP > APE, which would mean that some output will not sell which may lead to recession while if the all surpluses when added result in a negative number then there will be inflation as demand will be higher than the current output i.e. GDP < APE. Thus GDY or GDP has to be maintained equal to APE. As there can’t be net saving or dissaving for GDP = APE to hold. Thus, if there is surplus in any sector it has to be offset by a deficit in other sector(s). The Federal Debt When the government finds it has to spend more that it receives as tax revenues then it runs a budget deficit. There are two ways to arrange money to spend more than tax income. One is to print dollars, which it does not usually resort to, and the other one is to borrow. The government borrows by issuing treasury securities to household, businesses, local governments, foreigners and international organizations. The federal debt or national debt is sum total of all yet to mature treasury securities. In March 2010 the Federal debt in US was $ 12.7 trillion which is 88% of US GDP. Such a big proportion of debt, though may seem fiscally irresponsible, is actually good as it is what saves an economy from the recession and going forward also the government’s first priority should be sustaining demand and thus GDP and not reducing the quantum of fiscal deficit. Demand ( chapter 4 ) The impact of Employment and output changes on APE can better be understood by their indirect impact through the impact of income on the different parts of APE i.e. C, I, G and X. The changes in the price level may directly impact the level of APE but they don’t do so right now. The indirect impact of price level change son the level of APE comes through the macroeconomic coordination process (the MCP). Income and Consumption C which is the household sector’s annual demand for currently-produced goods and services (both domestic and foreign) and HY i.e. house hold income need not necessarily be equal. Household may spend less than they earn thus saving, by investing in bonds, land (produced earlier etc). Alternatively they may choose to spend more than they earn either, by dissaving or borrowing. In the U.S. household saving is more than its borrowing. On an average 90% + increase in C has coincided with change in HY. This does not mean that the change is solely caused by the change in HY only. There are other factors to it. But the impact of HY change on change in C has been around 65% Interest rate and Consumption ( C) There is no considerable impact of changes in Interest rate on change in C in the U.S. economy. The reason could be though some house hold start saving more when interest are higher and vice versa but some house hold may behave exactly oppositely thus spending more when interest rates rise this set of household are those who save for a fixed goal thus rising interest rates mean they have to set aside a smaller amount to reach their future financial goal. In other economies this however may different due to the relative composition of the households. Income and Investment (I) Investment (I) is the business sector’s purchase of the current output which reflects. BY, the income by the business sectors has stood at 10-12 % of UD GDY. But this BY has been less than I thus, business sector in the U.S. has been running a net deficit. The change in BY positively impacts the (I) i.e. increase in BY would motivate businesses to invests more and vice versa but the impact is delayed by more than a year because of planning and execution delays. Interest rate sand investment Changes in the interest rates are negatively correlated with changes in I specifically with plant and equipment investment and housing component. Inventory component does not show any relationship with changes in interest rates. G, accounting for about 14% of the U.S. GDY, is the annual combined demand of the nation’s various governmental units for current output. Government sector’s decisions to run surplus or deficit are determined by political, social and other noneconomic considerations. G is not particularly sensitive to changes in income, interest rates or price levels. Foreign Trade – This is relatively a small part of the U.S. economy. In the US we are running a trade deficit as our imports F are much higher than our exports X, while other countries are running trade surplus with the U.S. Income and Trade F relates with income and wealth changes for the U.S. citizens positively. The strength of relation is around 10 to 15 % with change in GDY. Interest rate and Trade Interest rate in the U.S. if is less as compared to other countries then the U.S. will lose investments as it will not be able to offer good returns while other countries with higher rates will attract foreign investments which would result in depreciation of the U.S. dollar in the international market, this cooling down of dollar would make exports from the U.S. to other countries cheaper and imports from other countries dearer. As a a result our net exports would increase. Thus we find that there will be increase in the production and APE will rise in response to reduction in interest rates and vice versa. Income and APE The impact of GDP and thus GDY will be around 50 % upon APE i.e. if GDP and thus GDY change by $1 billion, it will result in to $500 million change in APE in a quick that is within a year manner. Interest rates and APE The impact of change in interest rate up on APE is negative, delayed and rather small. However the reverse relationship i.e. of APE upon interest rates will be positive. Money and Banking ( Chapter 5) Anything that can be commonly used as medium of exchange is called money. Money supply is one of the most important considerations in an economy, as a sharp increase in money supply make bring in inflation and shortage of it may result in recession, deflation etc. Federal Reserve has been entrusted by the congress to manage the money supply on its behalf. The power to create money resides with public’s banks, treasury and Federal Reserve banks only. Treasury does not resort to money creation; it simply borrows whatever it may need. Majorly money is created by banks which are privately owned and operated. Fed’s share is one third only. Federal Reserve keeps observing these banks through regulatory powers and all. The major types of money in the US are coins, paper currency and checking accounts offered by banks. As per official definition Money supply includes all coins and currencies circulated in the market i.e. available to the public plus all checking accounts by entities other than banks and the US treasury. Money supply can be expressed as M = CC + CA The current money supply stands at $1700 billion divided among CC and CA in a proportion of 51 and 49 %. The latter is the major source of new money and is thus instrumental in controlling the money supply in the economy. Though M is fixed by the Federal Reserve but the breakup of it in CC and CA is determined by us individuals. The treasury operates the US mint and prints money and sends it to the 12 federal banks. These banks then further send it to other banks as and when they need which in turn is determined by us individuals. The US dollar being the international currency is actually held by many foreigners’ governments, foreigners and foreign banks. Thus out of the $ 870 million two third is circulated outside the US. The Banking Business Banks like any other for profit organization deal in products to generate profit. The products could be selling and renting checking accounts, loans, cash, saving accounts etc. You may get an account opened in bank with either cash or a cheque drawn on another bank or alternatively you may request a loan and get account credited. Bank has to maintain a reserve with it to meet daily operational expenses and more importantly to honor the claims by those who deposited their money. Since banking is a highly regulated industry the Congress guarantees all the deposits in a bank in case a bank fails. Money creation by banks Banks create money by the process of increasing the amount of their checking accounts and not reducing anybody else’ accounts balance. Banks do so as a step by step process. Suppose person X deposits $ 10000 in a bank. Now the bank will take currency from the person and open a checking account with a balance of $1000. Let’s also consider that the reserve ratio requirement is 10 % only. Thus bank has to keep $1000 with it and rest $9000 which is excess reserve, can be loaned out to somebody else. Now let’s say bank offers a loan of $9000 to Mr. Y who keeps $4500 with him and deposits $4500 in to his account with the bank. Now the bank has increased the money supply by increasing the checking balance of person by $4500 and circulating $ 4500 in to the market. Bank will have to keep 10% of this $4500 as a reserve requirement for the deposit of $4500 and can loan the excess reserve i.e. $4150 to person Z. This process may continue till the bank has any excess reserve than what it is required to maintain. Once the excess reserve is dried out, the bank will not be able to create any money as it will have only as much reserve as it is required by the regulatory authority to maintain. The ratio of amount, that a person deposits back in the bank, is called as feedback ratio. The reserve ratio and the feedback ratio together determine the money created. The lower the reserve ratio and higher the feedback ratio the higher will be the money creation by a bank and vice versa. Read More