Nasser Al-Rayes and Keynesian Cross Model - Essay Example

Nasser Al-Rayes Macroeconomics Fall Econ 201-004 Dr. Martin H. Sabo Macroeconomics is the branch of economics that deals with the economy as a whole. There are different kind of economic indicators that reflect the wellbeing of the people which include the gross domestic product, the rate of employment in the economy and the existing levels of the prices. There are several macroeconomic variables like the rate of interest, the national income, the savings and spending rates and the existence of trade in the country, that are have their effect on these indicators. These indicators and their relationship with the macroeconomic variables are best captured in the various macroeconomic models that have been proposed by eminent economists over the years. Introduction The outcome of these models is a comprehensive understanding of the business cycles and the economic growth in the long run and the short run respectively. These results in turn help the government and the central bank of the economy to determine the policies that would be ideal for an economy in a particular scenario. The government of a country and the central bank act as the major policy making bodies in an economy and thus their roles in the molding of the economic system of a country are quite significant. This essay analyses some of the popular macroeconomic models that have been widely discussed over a long period of time. The analyses have been supported by the relevant figures, graphs and mathematical representations. However, before discussing the macroeconomic models it is essential to enumerate the basic concepts that would come up in any macroeconomic discussion. Macroeconomic Variables The most important macroeconomic variable is the national income of a country. It is the value added of the total goods and services produced in the specific duration of time. The total output translates to the income and therefore the national income is identified with the Gross Domestic Product of the economy (Arnold 113). The progress of an economy depends on the growth rate of this GDP. But there may not be a consistent level of growth in an economy. The variation in the growth rates are caused by the changes in the business cycles. The fall in the national product during any such cycle can be termed as recession. The other important variables include the rate of unemployment. This is the number of people in the economy who have the potential to get employed but have remained unemployed. On the other hand the increase in the price level of the economy is termed as inflation (Rossi 121). The monetary policy of an economy is a measure to control this variable. Keynesian Cross Model The relationship between aggregate demand and aggregate supply has been represented by John Maynard Keynes in his Cross Model. In the horizontal axis the output of the economy has been measured and in the vertical axis the aggregate demand or aggregate expenditure has been plotted. The 45 degree line represents the planned expenditure or the spending that the economy plans to undertake. On the other hand the actual expenditure of the economy includes the consumption expenditure, the investment expenditure and the government expenditure that the country has actually undertaken. The lines are positively sloped because with an increase in the income of the individuals their expenses will increase. Again when the income of the government increases more money would be spent on the developmental projects. The equilibrium is reached at the point of intersection of the two curves where the aggregate demand of the economy equals the total national product of the economy. This means that at the point of intersection of the two curves, AD=Y. The equilibrium output has been shown with the help of the dotted lines. If the output exceeds the aggregate demand, the inventories stock up in the warehouse and the production goes down. This has an effect on the output and the economy moves back to the equilibrium. On the other hand if the demand exceeds the output the inventories would exhaust and the firms would engage more in the process of production. As a result of this output would increase and the economy reaches the equilibrium where AD= AS or the output of the economy. The Keynesian cross model acts as the stepping stone of many of the future macroeconomic models including the IS-LM model that has been discussed in the next section. IS-LM Model The Investment Savings and Liquidity Preference Money Supply Model constitute one of the backbones of macroeconomic thoughts on which the present day studies of macroeconomics are conducted by the economists. The Keynesian theory of macroeconomics has been summarized by the Hicks and Meade using this model. The model can be better represented using the graphs as follows. The basic graph of the IS-LM model depicts the IS and LM curves. On the horizontal axis the national income of the country has been plotted and on the vertical graph the rates of interests are calculated. The IS curve is a downward sloping curve as shown in the figure it determines the point where the total amount of investments in the economy is equal to the total amount of savings in the economy. Therefore it is the locus of the points at which the commodity market would be in equilibrium. Thus it depicts the equilibrium in the real economy by the interactions of the real variables. For a particular level of interest rate, there would be a level of investment. This in turn would have an effect on the national product which would affect the consumption and the net exports of the country. The relation of the IS curve can be represented with the help of the following equation. In the equation it can be seen that the investment of an economy depends on the rate of interest. The consumption and the net export on the other hand depend on the national income of the country. The sum of these components constitutes the national income of a country. On the other hand the LM curve in the figure is an upward rising curve that depicts the relation of the nominal variables in the economy. Thus in case of LM curve, interest rate is the dependent variable and income is the independent variable. The LM curve depicts the locus of the points for which the money market is in equilibrium. The LM curve is an upward rising curve. The LM curve represents the locus of the equilibrium combinations between money supply and liquidity preference. The LM curve can be represented in the following equation. The amount of liquidity in the economy is determined by the rate of interest and the money supply in the economy. The LM curve is an upward rising curve because the relationship between the rate of the interest and national income is positive in the money market. Shifts in the IS and LM curves The shifts in the curves have been expressed with the help of the following diagram. Suppose the government faces a deficit in the spending. The initial IS curve was IS1. The IS curve would face a rightward shift due to this. The rate of interest would rise from r2 to r1. On the other hand the national income of the economy would also increase from Y1 to YF. Thus the aggregate demand of the economy would be at the point of interaction of the IS and LM curves as shown in the figure. The economic explanation for this is that deficit spending is a way of stimulating the economy. The increase in the rate of interest would lead to a crowding out effect which in turn which would dampen the investments. Thus the growth of the supply side would be hampered (Colander 245). The IS curve also encounter a rightward shift due to a number of reasons. If the investment spending increases exogenously it would shift the IS curve to the right because the commodity market would experience a boost. If on the other hand the investment spending decreases the IS curve would move towards the left and the rate of interest and the national income of the country would go down. On the other hand the LM curve can also experience shifts. Suppose the initial LM curve is at LM1. The central bank wants to reduce the amount of liquidity from the economy. This would result in the increase in the rate of interest. As a result the LM curve would shift towards the left and the new equilibrium would provide a national income of Y1. Thus the shift in the LM curve towards the left would reduce the aggregate demand in the economy. It is important to mention the functions of government and the central bank in the context of the formulation of the policies. The fiscal policies of a country are controlled by the respective governments in the economy. On the other hand the monetary policy is framed by the central bank. Though independent entities, these two bodies work in tandem with each other to enable the proper working of the economy. By implementation of the fiscal policies the government manipulates the government expenditure and the tax rate of the economy. An expansionary fiscal policy would be the one in which the spending of the government would exceed the taxes that the government would collect from the general public. On the other hand a contractionary fiscal policy would involve the tax collected to exceed the government expenditure. This entire exercise is controlled by the government and the central bank practically has no role to play here (Hubbard and O’Brien 471). The central bank of a country on the other hand is generally the apex financial institution that determines the monetary policy of the country. The monetary policy can be implemented using several tools. However, the major tool for the control of liquidity and money supply in the economy is the rate of interest. When the amount of liquidity in the economy increases the central bank increases the rate of interest. These rates are determined by the prices of bonds in the bond market. When the bonds provide greater amount of return the people cut down their spending and park more money with the banks. Thus the demand for the consumption of goods and services decreases. This in turn results in the reduction of the aggregate demand in the economy and the production of the firms reduce. Therefore the total output of the economy decreases and the national income falls. This is a contractionary monetary policy of the central bank. On the other had when the money supply in the economy decreases the central bank would want to implement an expansionary monetary policy. By this policy the central bank would reduce the rate of interest. The opportunity cost of keeping money in the banks would increase for the common people and they would get involved in spending rather than use the money for buying the bonds. This increase in the aggregate demand would lead to an increase in the consumer demand and the firms would start producing more amounts of the goods. Therefore the total production would increase which in turn would result in an increase in the national income of the economy. Therefore the central bank has a significant role in the determination of the economic condition of the country. The depiction of the changes in the monetary and the fiscal policy can be nets represented in the ISLM framework. The monetary policies are more preferred compared to the fiscal policies chiefly because of the ease of implementation of the policies in a shorter span of time. Aggregate demand and Aggregate Supply This is another widely accepted model of macroeconomics. The model summarizes the equilibrium demand and supply in the economy on a price and output plane. The relationship has been explained with the help of the following diagram. The aggregate demand curve represents the total demand made by all the individuals in the economy for the various types of goods and services. On the other hand aggregate supply is the total supply of the goods and services provided by all the producers of the economy. The aggregate demand aggregate supply curves have been plotted on the P-Y plane where P is the price level of the economy and Y is the national income or the gross domestic product of the economy (Mankiw 430). The equilibrium in the economy would be reached at the point A where the two curves intersect at price level P* and GDP of Q*. When the aggregate demand of the economy increases at the same level of aggregate supply, there is an increase in the price level as well as the national income of the country. The reverse is true when there is decreases in the aggregate demand in the economy. While the left hand panel of the diagram shows the AD-AS curves the right hand panel shows the relationship between the rate of inflation and the unemployment level in the economy. When the price level rises there is an increase in the rate of inflation in the economy. The national product rises as the aggregate demand increases. This in turn increases the participation of the labor force in the production process and the rate of unemployment decreases. On the other hand, when the price level falls, the rate of inflation goes down and there is less aggregate demand which in turn increases the rate of unemployment in the economy. Hence there exists a negative relationship between inflation and the level of unemployment and it is represented by the Philips Curve. The right hand panel shows the Philips curve which is a downward sloping curve. The derivation of the equation of the Philips curve is done from the aggregate supply function. The equation has been represented below. The above equation is the expectation augmented Philips curve where an inverse relationship has been shown with the growth rate of wages and the rate of unemployment in the economy. Thus the actual inflation would cause a pressure on the expectation of the people and would give rise to further inflation. Conclusion Thus in this essay looked into the basic models of macroeconomics and analyzed the scope of each of the model. Though all of these models have their limitations, they are the basic foundations on which the modern day macroeconomic theories of business cycles, interest rate and unemployment are based on. The present day macroeconomic problems like Great Depression could be explained by Keynes and his followers which the classical school of thought failed to justify. The concepts of multiplier effect and the consequences were explained by Keynes which has its significance even in the present day. The later day theories of consumption, investment and the other theories on money demand and supply were based on these theories that Keynes had put forward. The economic explanations from the macroeconomic point of view are essential for any government to formulate policies rationally. Therefore it is important to analyze an economy in the light of this macroeconomic framework so that the problems existing in the present day could be addressed with the implementation of feasible solutions. Works cited Blanchard, Olivier. Macroeconomics. Englewood Cliffs: Prentice Hall. 2000. Print. Rossi, Sergio. Money and Payments in Theory and Practice. New York: Routledge. 2007. Print. Mankiw, N. Gregory. Principles of Macroeconomics. Mason: Cengage Learning. 2012. Hubbard, R. Glenn and O’Brien, Anthony Patrick. Macroeconomics. New Delhi: Pearson Education. 2006. Print. Arnold, Roger A. Macroeconomics. Mason: South Western Cengage Learning. 2008. Print. Colander, David C. and Gamber, Edward. Macroeconomics. Cape Town: Prentice Hall. 2006. Print. Read More