Day 36 Summary chapter 7-12

Principles of macroeconomics

Summary chapter 7-12

Chapter 7 

The Keynesian model introduces the idea that a decline in aggregated spending may cause an output gap. It assumes that in the short-run, firms set a particular price to meet the demand during that period, instead of responding to every change in demand by adjusting their prices. Because of  this, the planned aggregate expenditure in an economy can be different with the actual aggregate expenditure. The major reason behind the difference is the investment spending were varied by the inventory investment. Firms may or may not be able to sell the expected quantities of products. In order to perform further analysis, the Keynesian model also provides a consumption function, which defines the total consumption is determined by the exogenous factor such as wealth effect, consumer's faith, and other variables that are independent of output. Plus the disposable income times the marginal propensity to consume. As we studied before, the output gap exists when the actual out put is large or less than the potential output. So as to identify the short-term actual output, we need to find the short-run equilibrium output. This value shall be obtained with two approaches, the first one is with the 45-degree diagram(Keynesian cross)’s interception with the PAE curve. Which means at this point, the PAE equals to the actual short-run output, in other words, the actual aggregate spending. If the output lies lower than the PAE, it indicates that the planned investment is larger than actual investment spending. Therefore, the inventory stock must be lower than planned, the firm is selling more than expected. At first, the firm will meet the demands by run down inventories, but eventually it will boost productions. Which is a up-ward movement along the PAE curve until reaches the equilibrium. This is the market self-correction power. In addition, the circular flow of income explained the economy's equilibrium can be reached when the total injections( all exogenous expenditure, investment, government spending and net export) can be exactly offset by the total withdrawals(part of income not used for consumption purposes, savings, tax, and imports). Similar to the application of the Keynesian cross diagrams, when injection is larger than withdrawal, the demand domestically increases, which leads an increase in production. In a more concise explanation, the S(WD)=Y’-CY’Y’<Ip(Inj), therefore, Y’<C+Ip. In this equation, we can observe that the demand exceed the output,so the increase in production will be carried out to meet that demand.In a four sector model, we can draw a conclusive equation for planned aggregate expenditure at . Where (c-m)(1-t) is the income multiplier factor x, in the function 1/(1-x) The multiplier indicates the effect of a one-unit change in exogenous expenditure on short-run equilibrium out put. Due to the change in the exogenous factor will affect other people’s income and spending as well. Hence the multiplier is used to calculate the overall aggregated effect on the economy. With the equilibrium output, we can check the economy is experiencing an expansionary gap and contractionary gap, so the government and reserve bank will take procedures to eliminate these gaps.

Chapter 8

The fiscal policy is the economic policy imposed by government focus on the economy's stabilization. Generally, it aims to pull the country out of recession. It can be done with two methods. Firstly, the government can increase in its aggregate expenditure. Under the assumption o Keynesian model, it will pull the PAE cure up-ward vertically, so the planned aggregate expenditure will match the potential output quantities. In addition, the government can vary the tax rate, which indirectly affect the aggregate spending. As we learned in chapter 7, the induced factor of the PAE is expressed as(c-m)(1-t), therefore, the change in t will vary the slope of PAE, which is straight-forward, since the less tax charged on income, the more income can be spent. The transfer payment such as baby bonus is a balanced budget multiplier and will actually reduce the output. Because the reduction on exogenous components in tax is financed through the reduction in government spending, but the increased amount is combined with the savings plus additional spending.()The fiscal policy can affect the potential output by investing in public capital, which will raise the economy's productivity. However, the prolong legislative process reduces the flexibility for fiscal police to react timely as a stabilization tool. Furthermore, the fiscal policy creates budget deficits that decrease national savings to benefit the economy in the future. Although with these shortages, it is still an important stabilizing force, due to the automatic stabilization function. When there is a recessionary gap, the tax collection falls automatically, while other welfare transfer payments rise without explicit actions by government. Moreover, the fiscal policy can be used to against the deferred long-term contraction. Income inequalization has been a problem to industrial countries over many years, and the specific fiscal policy such as the progressive tax system will help to redistribute wealth. We should use the Gini coefficient and the Lorenze curve to gain a visualized idea of a society’s inequality. The lower the Gini coefficient the more equal we would say is the distribution of income. Related to the fiscal policy, the tax smoothing theory states that the government should run a budget surplus to save for the future anticipated high spending. The government spending has to be financed either through raising taxes or by government borrowings. With the same equation, we can conclude that if the government keeps running a budget surplus( where tax collected can cover the spending and transfer payments), the public debt will eventually be fully paid off. That is crucial to the concept of inter-generational equity. In conclusion, conclusion, the fiscal policy acts as the stabilizer of economy and society, it has to deal on the problems corresponding to the demo-graphical changes, as well as, the economy's recessions.

Chapter 9

Money carries three functions: the medium of exchange, store of value and unit of account. For concise distinction, economists measure money in four different categories: the currency also called M0, which is the notes and coins floating on the market; the M1, which is the currency plus current deposits; M2, which is the general definition of the money supply, is the M1 plus other less liquid money such as savings on both long-term and short-term. M3 is M1 plus all bank deposits of the private non-bank sector, for instance, the commercial notes or debentures. The integrated amount is the broad money. In an economy, the money supply is the currency held by public plus the deposits. The money deposited in the bank will generate a circulation effect, that allows the bank to supply money to the market corresponding to its desired reserve ratio. The main reason for this is people will re-deposit the loan money into the bank. Hence the money supply from the bank can be calculated as Bank reserves divided by the desired reserve/deposit ratio. Thereby the total money supply in the market will be the currency plus the bank deposits. The money stock is directly linked to the inflation in the long-run. The velocity measure the amount of expenditure can be financed from a given amount of money over a particular time period. With the same equation, we find out the price level is based on the money stock, while holding the velocity and output quantity constant, As a further implication of this connection, the reserve bank(central bank) maintains the inflation rate through the overnight cash rate. The overnight cash market is a special financial market where commercial banks borrow and lend money, in order to maintain the exchange settlement account balances The reserve bank lowers the cash rate by open-market purchase activities, so the financial assets in the commercial bank are purchased by the government. As a consequence, the commercial banks have more money in their exchange settlement account, thus they are willing to supply more funds in the overnight market, then the cash rate will drop. On the contrary, the reserve bank raises the interest by open-market sales. The long-term interest rate is linked to the cash rate, thus the reserve bank can adjust the interest rate corresponding to the inflation level during the period.

Chapter 10

When an individual develops the portfolio allocation decision, he/she determined the individual demand of money. However, there is an opportunity cost of holding money on hand, the nominal interest rate determines that returns can be gained by investing the money into financial assets. According to the cost-benefit principle, people will choose to hold money only if the benefit exceeds the cost. In this case, the benefit for holding money is affected by the real income which increases the incentive to consume, and the price level due to more money is required to settle transactions for higher price. Therefore, individuals will choose to maintain more money on hand when the nominal interest is low, or the price and real income are high. On the other hand, the supply of money is determined by the reserve bank’s open-market operations, so the curve is vertical since its not affected by the nominal rate. Like other demand-supply curves, the interception indicates the equilibrium level in the money market. In order to explain the process of reserve bank adjusting nominal interest rate, it is critical to comprehend the bond price identification factors The essential part is, when the nominal interest is high, the bond price drops. That is because the buyer will rather to invest on other financial assets if the nominal rate is higher than the coupon rate. So the price of the bond needs to be lower to compensate the opportunity cost for buyers. Therefore, when the money market is at disequilibrium, individuals are not happy with the proportion to their wealth held as money, then they will purchase/sale bonds. These actions will increase/decrease the price of bonds, so the nominal interest rate will decrease/increase in the contrary of bonds price. The variation in nominal interest rate will affect people’s behavior to hold money until the equilibrium is reached.The borrowers and lenders in financial markets are considered rational. Hence if the reserve bank lowers the cash rate in the overnight market, it is reasonable the suppler of the bonds will seek to borrow at that market for the lower rate. In addition, the lender in the overnight cash market will become the demander in the bond's market, pursuing the higher rate of return. As a result, the demand of bonds will increase and the supply of bonds will decline. The rise in bond price will lead the reduction in nominal interest rate. Consequently, the aim of the reserve bank, which is to reduce the overall nominal rate is achieved. That is how central banks influence the demand of money by adjusting nominal interest rate. Although the reserve cannot control the supply of money and targeting an interest rate at the same time, the monetary policy enables it to adjust real interest rate in the short-run, since the inflation is slow to adjust. Because the higher interest rate will encourage saving and therefore, reduce spending, the reserve bank can reduce interest to stimulate aggregate expenditure. The contractionary gap can be eliminated as well as the expansionary gap.

Chapter 11

The aggregate demand curve is used to describe the relation between the output(aggregate spending) and the inflation rate. It is downward sloping due to the higher inflation rate will create uncertainties for expenditure, reduce the wealth holding and enormously reduce the export value. Changes in exogenous factors that are independent from output or real interest rate will shift the aggregate demand curve. In addition, addition, the tighter monetary policy which set interest higher for each given rate of inflation will reduce the aggregate demand and shift it to the left. The aggregate supply is based on the short/long-run inflation rate. In short-term, we assume that firms do not adjust their price corresponding to the demand, so the SRAS is a horizontal line. The long-run aggregate supply indicates the economy potential output. The short-run equilibrium indicates the actual output level under the current inflation rate, the economy tends to correct itself when there is an output gap. Thus, if there is an expansionary gap, firms will raise the price to match the excess demand. It there is a contractionary gap, firms will cut the price as to sell more. As a result, a result, giving enough period of time, the economy itself will eliminate the output gap and achieve long-run equilibrium. By studying the AD-AS model, the source of inflation is clear. It can be caused by the increase in exogenous components that shift the AD curve to the right. That will create an expansionary gap, so the inflation will rise as stated before. Another source of inflation change is the inflation shock, which adverse inflation shock raises the current inflation rate, and favorable inflation shock reduces the inflation rate. The adverse inflation shock will bring the inflation rate up, therefore the reserve bank may choose to ease its monetary policy to eliminate the recessionary output gap. There is another type of shock to potential output, that will decrease the long-run aggregate supply, hence create an expansionary gap. As a consequence, the inflation rate will increase till the new long-run equilibrium. Both of the adverse shock in inflation and the shock to potential output are the aggregate supply shock, which will reduce output and increase inflation. For the purpose of inflation control, the central may choose to tighter their monetary police before an anticipated rise in inflation. This will deliberately create a recessionary gap with shifting the AD curve to the left, thereby the inflation rate can be expected to fall. The public’s expectation and the inflation rate are mutually affected. The higher the predicted inflation, the more proportion of wages people will ask to rise. This will make the firm to raise the price to cover the cost, so the inflation will increase. And vice versa.

Chapter 12

Economists use the growth in GDP per capita to measure the economic growth in the long-run. The potential output will affect the economic growth on a larger scale, and the essential factor that influences the output is the labor productivity. The GDP per capita can be rewritten into the function average labor productivity times the share of population employed. So the quantity of goods and services that each person can consume is based on: how much each worker can produce, and how many people are working. The human capital and physical capital will determine the average labor productivity. The human capital is the skills, education, inborn talent and other features that affect an individual’s ability to produce. The physical capital is the equipment, technology, resources, political environment and entrepreneurship that increase the labors’ efficiency. The marginal return on an additional unit of capital tends to diminish beyond some point, hence the firm will use each piece of capital at maximum productivity. Since the amount of labor and other inputs are held constant according to the demand of labor in chapter 5, the easiest way to explain the diminishing return on capital is there may not be enough workers to operate the new added capital. The scarcity principle states that there must be something to be sacrificed at present to exchange for the future growth. Consequently, the economic growth is associated with cost at present Which is the cost to acquire new capital and the workers’ health/safety. These cost reduced the current living standard as to obtain benefits in the long-run. In conclusion, the economic growth can be promoted by any polices that improve the human capital and physical capital. To illustrate, policies that encourage savings that supply the funds for new capital investment; the policies that support research on new technologies, because new technology will stimulate the investment spending, and the legal framework to maintain the stability.