Principles of Economics: Global Financial Crisis - Example

Macro & Micro Economics The development of the of Economics as a branch of social science has been developed on the assumptions of rationality as one of its fundamentals. And stressing upon this assumption coupled with the evidences of the behavior of the agents (rational human beings engaged in the domain of social interaction), economics has been able to develop various stylized theoretical models for analyzing those interacting patterns and generating optimal solutions for the attainment of general welfare of the people. One of the significant areas of economics especially is macroeconomics which is a branch of economics that deals with the problems of a particular country or economic region comprised of several economic agents acting with their individual economic behaviors and the evaluation of the policies taken by the government of these countries in order to tackle those problems (Adams, 2002, p. 16). Within the vast arena of macroeconomics, the development of the model of Aggregate Demand and Aggregate Supply generally known as AD-AS model is of immense importance as it has been developed and applied for determining and evaluating the factors that are very useful in realizing the effects of Real Gross Domestic Product which is i.e, GDP deflated by the general price level. As a consequence the model also acts as a useful indicator for the determination of the inflation level of the economy (Taylor & Weerapana, 2009, p.695). The AD-AS model also incorporates the notion of micro economic concepts like demand and supply framework including equilibrium analysis (Karl, E, 2007, p. 409) and thus setting up a platform in accordance with the demand of the paper. Focus of the paper The paper will focus on the underlying mechanism of the aggregate demand (especially) and aggregate supply along with the concepts of volume of money demand and supply and its application and importance in the economy of the United States of America (US) with its recent financial crisis within the backdrop of the article, “It’s the Aggregate Demand, Stupid” written by Bruce Bartlett who has held senior policy roles in the administration of Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Pau. Crux of AD-AS model Before entering into the AD-AS model a short purview of the notion of law of demand and law of supply requires to be mentioned. The law of demand has been developed by the economists out of several criticisms (various exceptions like Giffen goods, Veblen effect) and the law basically states that for a normal commodity, there is an inverse relationship between the price of a particular commodity and the quantity demanded keeping all other things constant. The demand function can be stated as,signifying the inverse relation between price and quantity. A short mathematical and graphical explanation will make it clearer (Maurice & Thomas, p.43). Let, , (where a, b>0) be a linear demand curve which is taken for our purpose. Differentiating the above function with respect to Q we get, Therefore the slope of the curve is negative. The graphical representation is as follows: Fig.1 The law of demand (Maurice & Thomas, p.43) In the above diagram, at the price level P2, the quantity demanded was at the level Q2 when the price fell down to the level of P1, the quantity demanded rose to the level Q1. Thus the inverse relationship between the price and quantity as given by the law of demand is represented. The demand comes from the consumer’s angle in an economy that purchase goods and services in an economy for the maximization of their utility (Bhidé, 2010, p. 313). The theory of supply on the other hand represents the positive relationship between the quantity and the price keeping all other things constant (Hussain, 2010, p. 214). It comes from the producer’s angle. More the commodity the producer sells more the price will it charge. Let a linear supply curve be considered as, . Now differentiating the above equation with respect to Q we get, Thus the slope of the supply curve is positively sloped representing the positive relationship between the price and the quantity supplied. The following diagram represents the following: Fig.2 The law of Supply (Wessels, 2006, p. 35). In the above diagram, at the price level P1 the quantity supplied was Q1. When the price rose to the level of P2, the quantity supplied increases to the level of Q2, thus representing the positive relationship between the price and the quantity supplied and it maximizes the revenue and minimizes the cost structure of the producers (Wessels, 2006, p. 35). The market equilibrium for the particular commodity occurs with the intersection of the demand and the supply curve. Now the aggregate demand the aggregate supply can be thought to be the aggregation of the individual demand and the supply schedule of the individuals and every commodity in an economy. Aggregate demand (AD) basically represents the accumulated spending of the economy at alterative price levels and on the other hand the Aggregate supply (AS) curve can be represented as the total output of the economy at alternative price levels. The intersection between the aggregate demand curve and the aggregate supply curve determines the equilibrium price level as well as the equilibrium level of real GDP. Once the equilibrium is reached, then there will be no adjustments of the prices and the outputs in deviating from the equilibrium. This is depicted in the following diagram: Fig.3 The interaction of the AD-AS curve (Boyes & Melvin, 2012,p. 155) In the above diagram, E represents the equilibrium and corresponding to it, the equilibrium price level of the economy is P and the equilibrium quantity is Q. The equilibrium quantity and price changes with economic shocks like (population outburst, increase in demand for any good, rise of expectation and oil price volatility and so on, basically regarded as the demand and the supply shocks) which shifts the AD and AS curve and accordingly results in the shift of the equilibrium price and quantity levels (Boyes & Melvin, 2012, p. 155). Aggregate demand and supply and the quantity theory of money The quantity theory of money is very important in the discussion of the understanding of the aggregate demand curve. The basic quantity theory of money shows the equality between the product of velocity of money (V) and supply of money (M) and the product of the price level (P) and the amount of output. The equation is given as follows: Now if the velocity of the money is kept constant, then the above equation depicts that the money supply leads to the determination of the nominal value of the output which in turn affects the price level as well as the output level. Now the quantity equation can be reframed in the following structure of demand and supply for real money balances as follows: In this case, and it is a parameter incorporated in determining the amount of money people want to hold for each dollar of income. Stated in this form, the quantity theory directs that the supply of the real money balances is equal to the demand and the demand is proportional to the output Y. The velocity of money V is the inverse of the money demand parameter k. With any fixed amount of money supply and velocity, the equation reveals a negative relationship between the price level P and the output Y which suffices the downward sloping pattern of the AD curve. The money supply and M and the velocity of the money V determines the nominal value of output PY. When PY is fixed, if P rises, then Y must decrease (Mankiw, 2005, pp. 242-243). In the short run, the firms supply goods and services and have sticky prices in the short run and in the long run the output level is generally determined by the amounts of capital, labor and technology and is generally independent of the changes of the price level. In the long run, the AS curve is vertical and the intersection between the long run AS curve and the AD curve determines the equilibrium output and the price levels of the economy which is shown in the diagram below: In the above diagram, the long run AS curve is vertical and the intersection between the AD curves and the LRAS curve determines the equilibrium output and price. Q is the full employment output of the economy which is always the target of the economy. In the diagram a shift of AD curve from AD1 to AD2 is shown and it occurs due to the reduction in the money supply in the economy and decrease in the velocity of money. In the face of vertical long run AS curve, any change in the money supply shifts the AD curve and changes occur on the price level and not on the real GDP (Arnold, 2008, p. 309). The housing bubble in the US and the application of AD-AS model In the first half of the last decade, the prices of the houses in USA experienced a significant rise in the real rate of appreciation (Poterba & Noguchi, 1994, p. 5). The significant increase in the prices of the houses led the economists forecast that there was an existence of speculative bubble in the housing market of United States. Within the time span of 2000-2005, the prices of the houses in the United States enhanced nominally by 8.9% per annum or 6.5% in real terms per year. From the supply side analysis, the department of agriculture reported that the average price of the agricultural land increased at a rate of 9.7% per year with doubling of the construction costs. With the increase in the supply price of any commodity, a rational consumer will always purchase less of that good but in the interval of 2000-2005, with the appreciation in the supply prices in real terms, the aggregate demand for the owner-occupied housing also increased dramatically and US housing consumers purchased more, not less, owner-occupied housing (Goodman & Thibodeau, 2008, pp. 117-119). In the US banks, there was large expansion in the home loans and the expansions were made in the mortgages to the low-income workers and there were huge rates of default in the US real estate market and the bubble started to explode in 2006 with acceleration in 2007 and 2008 (Lundblad & Brown, 2009). The price decline meant that the house owners were no longer able to refinance in a time when their mortgage rates was reset and resulted in the delinquencies and defaults of the mortgages increasing sharply. The dreams of millions of Americans turned into nightmare and the economy staggered and resulted in financial crisis of several financial institutions and tremendous job losses (Moseley, 2009). In this article, Bruce Bartlett states that increase in the aggregate demand will be the solution for the stabilization of the economy rather than only on increasing on the employment scenario. The federal government also had the provision of increasing the AD by directly employing the workers for undertaking of the public works project but the political constraint was regarded as a loophole. The above stated policy led to the creation of the avenue for increased spending and will be difficult as long as the unemployment was high and with the reduction in the AD, the households were still saving heavily for the restructuring of the wealth which was devastated by the fall collapse in the housing prices. Savings is regarded as a negative spending (Kurihara, 2003, p.371). Changes in the wealth will affect the spending behavior as people will spend a percentage of their increased wealth and the spending will increase when the perception is more or less permanent. The perception was that the people viewed the rise in the home equity as permanent as compared to the increase in stock. The people came to believe that they had no reason to save which led to the fall in the personal savings rate from 3.5 percent in the early 2000s to just 1.4 percent in 2005 at the peak of the housing bubble. Another way for the explanation of the rise and the fall of the spending was visualized from the point of view of the velocity of money which determines the speed of the turnover of the economy. When there is a rise in the velocity, there will be more GDP generated per dollar of the money supply. Shrinking in the velocity will lead to the fall in the economic impact the same way as if the money supply shrank by the same percentage. The Federal Reserve Bank of St. Louis stated that the velocity as the ratio of the money supply (M2) to nominal G.D.P. increased from 1.85 in 2003 to 1.96 in 2006 and in 2011 was at the level of 1.66. Since 2006, the Federal Reserve increased the money supply by around $2 trillion but the velocity fell at a rate faster than the money supply increase as households conjectured on the reduced spending and enhanced spending and the banks and businesses hoarded cash. Injections through fiscal policies could be directed towards the raising economic growth in the economy but it was not feasible at that point of time as the government was resorting on the tightening of the monetary policies. The optimal policy which was suggested for the policy makers was in the cessation of the obsessing about debt and instead relying on the augmentation of the aggregate demand. In USA, Bill Gross of the investment firm Pimco stated that, “While our debt crisis is real and promises to grow to Frankenstein proportions in future years, debt is not the disease — it is a symptom. Lack of aggregate demand or, to put it simply, insufficient consumption and investment is the disease” (Bartlett, 2011). Conclusion The paper circumscribed around the basic theories of macro economics relating the economic structure and operations in a country and policies for obtaining a dynamic stabilization. The stylized model of AD-AS has been put forwarded with the underlying economic interpretations and mechanics with special emphasis on the quantity theory of money. Focus has been highlighted on the financial crisis which USA faced due to the crumbling down of the real estate sector and policies for strengthening the aggregate demand of the economy has been put forwarded which is absolutely necessary for attaining long run growth. Reference 1. 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