Effect of Level of Consumption Within the Country - Essay Example

Macro Economics Table of Contents Macro Economics 3 2. a. Affect of Level of Consumption within the Country 3 2 b. Affect on the Level of Investment by Firms 7 2. c. Affect the Demand for Real Money Balances 9 2. d. Monetary Policy Affects the Level of Aggregate Demand 11 References 12 Bibliography 14 Macro Economics Economics is the study that deals with allocation of limited resource to meet the unlimited demands or wants of human beings. Macroeconomics deals with the collective performance of the whole economic system. Monetary policy is one of the significant components of the macro-economy of a country (Dilts, 2006). 2. a. Affect of Level of Consumption within the Country When the UK Government monetary policy committee will increase the interest rate, the demand for credit will be higher and the consumption pattern will decline as the consumers will be moving toward savings rather than consumption spending. It also has an affect upon the macro economics as it is the tool to attract more consumers towards the banking instruments, not only from the domestic investors but also from the foreign investors.            (a) (Thammasat University, n.d.). At interest rates r0 and r1, investment levels in (a) will be i0 and i1. To produce equilibrium in the item for consumption market, level of income must be at y0 and y1 respectively. Therefore, interest rate income combines r0, y0 and r1, y1, which are the equilibrium points along the IS schedule, slopes downward towards right. The more responsive is investment to change in interest rate, the flatter is the IS curve       (a) (d) (b) (c) (Thammasat University, n.d.). With investment being responsive to alterations in the interest rates, the investment plan i (r) on (a) is moderately flat. A decrease in interest rate will raise investment by a huge amount. Therefore, a large increase in income, y0y2, is necessary to re-establish the product market equilibrium. Consequently, the IS schedule in part (d) will be flat. Points off ISLM Curves: (Thammasat University, n.d.). (EconModel, n.d.). The Effects of a fall in Consumer Confidence The rise in the interest rate will decrease the consumer confidence level. 2 b. Affect on the Level of Investment by Firms The Capital Investment Spending in the UK Economy The gross investment in 2000 was £167.5 billion and the GDP rate was 16.9%. This had increased to £195.1billion in 2005 with 16.8% GDP rate (Riley, 2006). The level of investments by firms is highly affected through the monetary policy of the government. The raise in the interest rate will force the investment level to increase by firms. To increase the investment level by different firms the monetary policy was implemented by the UK government. When the consumer confidence index falls, there is an increase in the level of savings and many firms decide to reschedule or push back the capital investment spending projects because of uncertainties over a shortcoming of demand and there is a fall in the expected rate of profit on investment. This affect is upturned down through the monetary policy of the government by implementation of the interest rate policy. The increase in the interest rate will increase the confidence index of investment and the expectation level of investing firms will be higher as there is more return through the financial instruments. This rise in the confidence index and investment increases the investment in capital projects that helps the economy to grow. 2. c. Affect the Demand for Real Money Balances The real money balances represent the actual purchasing power in terms of commodities by consumers (Encyclo, n.d.). In application with the Fisher’s equation it is know that, as the income increases the demand for real money rises and as the interest rate raises the demand for the money falls. Money, price and interest rate are related to each other. The Quantity theory of money illustrates that the price is determined by money demand and supply. The inflation rate gets affected due to the changes in the price level. And this inflation influences the nominal rate of interest according to Fishers equation effect. The nominal interest rate affects the real money demand. This is the overall affect of the demand for real money balances. (Economics Network, n.d.). From the Fisher’s effect it is illustrated that inflation affects the nominal interest rate and consequently the nominal interest rate influences the demand for real money. Assuming all the motives of holding the money, the price level and the level of income is directly related to demand for money. With the level of interest rate the demand for money varies inversely. The money income will fall till the demand for money is equivalent to the supply of money and this is caused due to the increase in the interest rate. The equilibrium in the market related to money will take place when the quantity of real money that an individual holds is equal to quantity of money they are willing to keep. Let, M (d) is demand for money in real terms and M(s) is supply of money in real terms and P is overall price level. Then the status will be, M (d) / P = M(s) / P (Pailwar, 2009). 2. d. Monetary Policy Affects the Level of Aggregate Demand The rise in the interest rate increases the cost of borrowing that is likely to reduce the capital investment and as a consequence the whole aggregate demand decreases. Changes in the interest rate have effect on the consumers spending. The rise in interest rate increases the cost of purchasing or prices that are for financing such as house, cars; and reduces the amount of such finance and spending. The aggregative demand comprises of all the elements of GDP. The interest rate is essentially the price of financing. When the interest rate rises it leads to decrease the investment. Since the interest rate determines the actual amount of money in circulation, the higher interest rate will lessen the consumption that will affect all the elements of GDP. Therefore the interest rate policy is an important tool in the monetary policy in controlling the economy. References Dilts, D. A., 2006. Introduction to Macroeconomics. Indiana-Purdue University. [Online] Available at: http://www.ipfw.edu/econ/courseschedule/Books/E202book.pdf [Accessed December 13, 2010]. EconModel, No Date. Classic Economic Model. IS Curves. [Online] Available at: http://www.econmodel.com/classic/short_run_fluc_figs.pdf [Accessed December 13, 2010]. Encyclo, No Date. Real Money Balances. ONB. [Online] Available at: http://www.encyclo.co.uk/define/Real%20money%20balances [Accessed December 13, 2010]. Economics Network, No Date. Money & Inflation. Macro Economics. [Online] Available at: http://docs.google.com/viewer?a=v&q=cache:WZGePqCeUsYJ:www.economicsnetwork.ac.uk/slides/Macro11_Money_and_Inflation.ppt+relationship+between+increase+in+interest+rate+and+demand+for+real+money+balances&hl=en&gl=in&pid=bl&srcid=ADGEESh2aQT4BSDxLlpWbw9qqvBYXPBm1mgmLrlmR2YPRJ2bWaWXZQkDcnUfCTTs1kgmRL7WouEq1f0HStPfpNWFuO75AYTz0xnlnNPVEJnLxqxP4C6jZZDCokiFBq3pmoYDiNV2cAuq&sig=AHIEtbTmS6UsyOkO38ixOtJL0C2HXY-OLQ [Accessed December 13, 2010]. Harvey Mudd College, No Date. The Aggregate Supply - Aggregate Demand Model. Model. [Online] Available at: http://www2.hmc.edu/~evans/chap2.pdf [Accessed December 13, 2010]. Pailwar. 2009. Economic Environment of Business. PHI Learning Pvt. Ltd. Riley, G., 2006. Capital Investment & Spending. Macroeconomics / International Economy. [Online] Available at: http://tutor2u.net/economics/revision-notes/a2-macro-capital-investment.html [Accessed December 13, 2010]. Thammasat University, No Date. Graphical Derivation of IS Curves. Economics. [Online] Available at: http://econ.tu.ac.th/ee312/islm/islmgrph.htm [Accessed December 13, 2010]. Bibliography Sloman, G., 2007. Essentials of Economics. Financial Times Prentice Hall. Read More