Framework to Demonstrate the Macroeconomic Coordination Procedure Graphically - Essay Example

?Chapter 8 This chapter presents a framework to demonstrate the macroeconomic coordination procedure graphically. It develops a graphical set up to analyse how Gross Domestic Product (GDP), Aggregate Planned Expenditure (APE) and Aggregate Supply of Funds (ASF) interact and how these interactions are related to and affected by changes in employment and output levels, prices and interest rates. The first aspect introduced is that of the relationship between GDP and interest rates. Changes in the interest rate have no direct impact on the GDP. Consequentially, the GDP remains stationary at its given level (GDP0 in the diagram below) for all levels of the interest rate. Therefore, a vertical line represents the GDP in the graph. Note that a change in employment or output implies a direct positive impact on the GDP and thus there will be a horizontal shift in the vertical line representing GDP in such cases. However, like the level of interest rate, changes in the price level also has no direct impact on the GDP and thus, the GDP line would remain stationary if there was a change in the price level. Figure 1: Graphical representation of GDP The next step is to add the APE into this set up. Assuming a simple linear form under typical assumptions, we can have the following expression:  Note that a, b and c are all positive fractions. ‘a’ represents the autonomous part of planned expenditure, while b represents the marginal propensity to expend out of income and c represents the marginal expenses induced by interest rate changes. Figure 2: Adding in the APE – the horizontal intercept of the APE line is a+b(GDP0) as i=0 along the horizontal axis by definition. To graph this relationship into the set up introduced previously, first note that the interest rate has an inverse relationship with APE implying that the graph will slope upwards to the left, i.e., the APE wil fall (rise) following an increase (decrease) in the interest rate. Further, at the GDP fixed at GDP0, the horizontal intercept of the APE curve will be a+b(GDP0). The next step is to add in the IS relationship. Recall that the IS curve is the locus of all combinations of I and GDP for which APE=GDP. Suppose . Again, since along the IS line GDP = APE, we also have:  The last expression clearly implies that the IS relationship can be plotted as a straight line which has a horizontal intercept equal to  which lies to the right of a+b(GDP0) and rises upwards to the left with a flatter incline compared to the APE line (since the coefficient on I is c for the APE line while it is c/(1-b) for the IS line. This is shown in the diagram below (figure 3) Figure 3: Adding in the IS line Observe that due to the particular specifications of each of these lines, there will always be an intersection or a common point were the lines cross. Suppose that if there is a change in GDP, the GDP line will move horizontally to the right in case of an increase or to the left in case of a decrease and the APE line will also shift in the same direction but by a smaller magnitude. The shift will be b times the shift in the GDP line. The IS line will remain unchanged. Alternatively if there is a change in the APE line, then the GDP line will remain stationary but the IS line will shift upwards or downwards in accordance to the direction of the change in the APE line. However, the crucial point to note here is that due to these coordinated movements, that these lines will intersect is necessarily ensured. Since by definition the IS line is the locus of combinations of the interest rate and the GDP such that APE=GDP, we can trace the IS line by allowing the GDP to change, letting the APE curve shift in accordance and connecting the new intersection points. The final point to note in this context is that if the GDP shifts first, then the APE will also shift in response and the IS line shall remain stationary. However, if the APE line shifts by itself (say due to a change in a), then the GDP line remains stationary, while the IS line shifts. ASF which is defined as the upper limit on real aggregate expenditures for current domestic output imposed by the money supply in real terms can be expressed as: ASF = (M x V)/P where M stands for the nominal money supply, V depicts the average number of times per year a dollar is used to fund current domestic purchases and P denotes the price level. Again, since M and V both are positively influenced by the rate of interest, we assume the following linear form: (M x V) = m + e.i Thus, represents the equation for the ASF line. Evidently, the first part is the horizontal intercept and the coefficient of I is the slope which is positive under the assumption that m and e are positive constants. The slope measures the responsiveness of the ASF to changes in interest rates. Figure 4: Adding in the ASF In the diagram above (figure 4) we have drawn only the ASF that corresponds to the intersection point for all the three lines. All other ASF lines given the m/p ratio lie to the left or right of this particular ASF line. The final element in the set up is the Aggregate Demand for Funding which is simply the larger of the GDP and the APE. Thus graphically it takes the form of the red heavy line in the diagram below (figure 5). Figure 5: Mapping in the ADF which is simply the larger of the APE and the GDP Observe, this line moves and shifts equivalently to the GDP line when GDP>APE and equivalently to the APE line when APE>GDP. Chapter 9 The objective of this chapter is to enhance perceptions regarding the mechanics of the output price adjustment process. For this, it is pertinent to first comprehend the mechanics of how demand and cost structures influence aggregate business behavior and thus, to comprehend how behavior of individual firms are affected by changes in demands and costs. We consider a particular business firm operating in an industry that satisfies the assumptions of i) facing a downward sloping demand curve, ii) no insurmountable barriers to entering the industry, iii)the firms operate at a profit level that is just enough to keep them operating but not substantial to draw in new firms, iv) the average cost structure of the firm is U shaped implying there is a particular level of output that uniquely minimizes the average cost of production while moving away from that level of output in either direction leads to increasing costs that increase at an increasing rate, and finally v)the firms objective is to maximize its long term sustainable profits. Now, assumption i) additionally implies that to sell an additional unit the firm has to lower its price which in turn implies that the Marginal Revenue (MR) curve lies below the demand curve which is also the Average Revenue (AR) curve. Assumption iv)implies that the marginal cost (MC)curve will lie below the average cost (AC) curve when AC is falling, will lie above it when AC is rising and will intersect the AC curve when AC is at its minimum. All this is shown in the diagram below (figure 6). Figure 6: Graphical implications of assumptions i and iv Now, a firm’s profit maximization condition is given by the equality of its MR and MC since if MR>MC then the firm gains in terms of profits at the margin by increasing output while if MC>MR then the firm is making losses at the margin and can increase profitability if it reduces its output. In the diagram below the firm’s profit maximization is demonstrated. Figure 7: Profit maximization However, note that if the firm makes such high profits then new firms will be attracted into the industry and consequentially the demand curves of the individual firms will start shifting leftwards since the share of the market falls. Consequently, the market will stabilize when each individual firm earns a profit that is just enough to keep it operational but not enough to attract new firms. This implies a situation similar to the situation depicted in figure 8. P* and Q* are the equilibrium price and output level. To elaborate upon the impacts changes in costs or demands have on the firm’s behavior the situation depicted below shall always be the starting point. Figure 8: Long term equilibrium: observe at output level Q* MC=MR as well as AC=AR. Read More