Macroeconomics

Chapter 11 of Wholly Macro starts off by explaining the different cases of insufficient demand. The writer starts off by explaining that aggregate demand (APE) may drop because of three reasons; less household expenditure, less government purchase of domestic produce and reduction in demand of U.S products outside.

Next the writer explains how recession is caused by demand. When the APE decreases and becomes less than the GDP, there is excess produce. This means supply or ASF is now more and hence funding goes towards financing the excess produce. This funding will always be equal to the supply and hence, no price adjustment is requires. This situation will ultimately force producers to reduce the people employed as well as the output. This move will again increase ASF and reduce the GDP and APE and will then affect the interest rate as well which will decrease. All this will make the three components (i.e. APE, GDP and the ASF) equal but on the other hand will generate negative economic profit. Once the prices rise and eliminate the negative profit, the prices will then become stable until the next shock change.

The writer then moves on to the second cause of recession. When the ASF will fall it will cause the M x V to fall as well. This could be due to a fall in V, M or both. If the above 3 components are equal and then ASF falls, this means buyers are now short of funds and will resort to credit funding, to meet current demand. This will then cause the ASF to rise. ASF and interest rates will continue rising until ASF= APE. With demand now less than the produce, producers will need funding for excess. This will give rise to increase in ASF and interest rates until ASF equals the GDP. However, interest rates have kept on rising, and this will cause APE to become lower than the GDP. The same effects of unemployment, price adjustment etc will take effect and ultimately all three components will become equal, resulting in less employment and output, high interest rate and unchanged price.

Next the writer explains how cost-push inflation causes recession. When the cost of production rises, the firms pass it on to their customers by reducing output and employment and increasing prices. Rise in prices will decrease the ASF and a fall in employment and output will reduce the GDP as a whole. As a result the demand (APE) will fall as well. During this time interest rates will start increasing causing APE to fall so that ASF and GDP can become equal. All companies cannot bear the rise in cost and some will exit the market causing equal increase in cost and prices until the cost and price are equal. This means there is no more negative profit. Now there is no need of reducing employment and output. Hence there will be no decrease causing ASF, GDP and APE to become equal. Ultimately the employment is now stable at a lower level and so is the output. Prices too are stable, but at a higher level. In other words, inflation has hit the economy.

Lastly the writer says that, another problem is the growth problem. This problem occurs when GDP increases due to increased production capacity, But APE increase less than it (i.e. there is insufficient demand). The second part of the problem is funding problems. When GDP rises it does not increase the ASF (funding), however, it does increase the need of funding. APE will rise, but there is no increase in ASF, hence, credit funding will come into play. Now ASF will rise. But with this, interest rates have increased and some demand is lost. Now ASF and interest rate will rise until they equal GDP while APE will fall and continue to fall below original level of GDP. With less demand, prices will fall, some firms, not being able to bear this, will leave due to negative profit. Their leaving will reduce output and prices will rise up again to same level as before and ultimately all GDP growth will come to nothing. No demand means, cut it production and this means all the money invested in expansion is a waste and expansion has to stop. GDP levels can no longer be maintained and the economy will go into recession.

MONETARY POLICY

In Chapter 12 the writer has focused on how people can manipulate the levels of employment, GDP etc by use of monetary policy. In the U.S, this is the work of the Federal Reserve System, which is independent but under authority by the Congress. The Fed’s have a number of banks under them, though owned privately. The Fed’s functions range from, regulating the money supply, to generating revenue as well as being the bank of the Federal government.

The writer, then explains how monetary policy influences employment, interest rates etc. Using their policy tools the Fed’s influence the money supply and interest rates. This change in money supply causes a change in the ASF. Once the ASF is affected it alters employment, interest rate and output. In other words, change in money supply will cause all the changes and this is in the hands of the Fed’s.

The writer now goes on to link the Fed’s control variables to the magnitude of money supply. By combining the formulas for money supply (M), total reserves of banks (R), monetary base (B), the cash to checking account deposit ratio (d) and the time deposit to checking account deposit ratio (t) the ultimate formula for money supply can be written as M={ (d + 1)/(d + r’ + r” x t + w) } x B. In this formula the main thing is the B. The B is the money multiplier and hence, it will determine how much money supply is generated. Similarly the d, r’, r” and t are also controllable by the Fed’s and hence effect money supply.

The d and t are controlled by public, but the banks, using interest can influence it. The Fed’s have control over r’, r” and B. The Fed’s can increase and decrease the multiplier directly by directly changing the r’ and r”. For example if Fed’s decrease r’ and r”, the multipliers value will increase and hence the money supply will increase too. This means the Fed’s can control the ASF .However, since all variable are not under the control of the Fed’s, and any change in them can cause ASF to change, therefore many times the Fed’s have to change their variable to correct anything they feel is not right, but was not under their control.

Moving further the writers explains the three policies, via which the monetary policy is controlled by the Fed’s. The first policy is to conduct open market operations. This means they buy and sell securities. These securities are bought by the special securities dealers, who then sell them ahead. What this buying and selling does is that, it alters the magnitude of B and since B and M are related it ultimately affects M or the money supply.

The next policy is to alter the reserve requirement. By altering, the checking account and time deposits requirements (i.e.  r’ and r”) the Fed’s can dictate the money supply. However they are dependant to certain extent on the willingness of the banks. If banks don’t mind reducing the working reserve (w) this is easy, otherwise the Fed’s can increase r’ and r” to such level that banks will be forced, because they cannot in any circumstance allow (w) to go below zero. The opposite is the case with decreasing reserve requirements. Again bank need to be willing to increase the (w).

Similarly discount rate adjustment can also be used to control monetary policy. Working reserves (w) come into play here. The banks need to determine their optimum level of w, so that ultimately their interest penalty on borrowed funds does not exceed the interest earnings on extra funds. If discount rate was to rise resulting in expected interest earning loss less than penalty, banks would start to hold working reserves and this will decrease M. This tells us that discount rate does not directly affect M, but it is actually w which does.

The Fed’s refer to their policy changes as tightening or easing the monetary policy. Monetary policy can be eased to increase the ASF which has fallen due to money and-credit recession, thereby saving the employment and output from going down. Similarly it can also be eased when GDP growth needs to be sustained by increasing funding. Easing of monetary policy will be effective if firstly, banks do not increase too much of their working reserve and secondly if there is a strong reaction on the demand side to reduced interest rate.

The Fed’s can tighten the monetary policy to control inflation. But the problem is that this is temporary and causes output to reduce and then employment as well. Tightening policy would mean that, banks will be forced to minimize lending. The banks will then increase the interest rates. Ultimately it depends on how demand reacts to high interest rate.

FISCAL POLICY

After explaining the monetary policy the writers now moves on to fiscal policy in chapter 13. Fiscal policy, according to the writers consists of, firstly, automatic stabilizers. These stabilizers reduce the APE’s responsiveness to changes in the level of income or GDY, thereby reducing the drop in GDP. Among the different stabilizers are nation’s welfare programs which are run under the reservoir principle. When the income increases, taxes increase and hence the money goes in the fund and when incomes decrease these funds are then used to facilitate the low income people.

Besides this, the government can also use progressive income taxes, as a method towards automatic stabilization. When income rises, people go into higher tax slabs, as a result more income in the form of taxes comes to the government. If the government does not increase its purchase and allows a surplus to build up, the growth in demand will reduce. Similarly a decrease in income will have a vice versa effect. Thus these programs are automatically being affected by level of income. In other words with less income and government grants during these times to families, the purchasing power is not hit by heavy impact and hence stabilization takes place.

The next form of fiscal policy is the discretionary one. In this the Federal government alters levels of three things; current domestic output purchases and tax receipts from households and businesses. This will affect APE and thus employment levels, prices etc.

To show how the federal purchases and federal tax receipts affect APE, the writer has come up with a formula for fiscal policy. Starting with the formula for APE and using symbols for change in tax receipts etc. The final formula after assuming a few figures (for explanation purpose) come to be, ?APE = ?G – 0.65?HT – 0.35?BT.

Next the writer explains what measures the government can take if it wants to set a certain level for the GDP. In other words, what the government can do to keep the change in APE equal to the excess GDP over current APE. For this purpose the government can do two things. The first is expansionary fiscal policy, which is used when, excess GDP – APE >0. In this case the government could either reduce taxes of households or businesses or increase purchase of domestic products. Whatever they do, to increase the APE, ultimately the government will have to borrow, thus increasing the national debt. To avoid this, government can make a large increase in tax and at the same time direct demand away from the private sector. The government will have to consider the pros and cons of both.

Next the writer tells us what restrictive fiscal policies are. In this policy federal purchases will need to be reduced as compared to tax receipts. As a result there will be a positive effect on the budget.

Discretionary fiscal policy has the purpose to reduce unemployment and lower inflation etc. It does this by impacting the APE directly. In other words, it is important that the fiscal policy is carefully drafted, so that the desired effects are achieved without any problems and complications.

POLICY ISSUES

The fourteenth chapter is all about policy issue. The writer starts off by explaining; firstly, what problems are associated with boosting APE when expansionary monetary policy is being practiced? The first problem is inconsistency. For example, if the APE has dropped, the Fed’s can use any method to drop the interest rate as that would boost the APE back to original level. However, this will not guaranteed to work always. It is possible that the initial interest level is so low that even if it becomes zero, the corresponding increase in APE will not be enough to get it back to the original level. This would cause the need for additional measures. Hence the writer is telling us that, every time the government will have to use a combination of different measure and therefore there is no consistency.

The second problem is liquidity trap. This trap is created when, the economy is facing recession. During this time, interest rates fall, unemployment increases and people lose the capacity to purchase. During this time banks struggle to give loans as businesses are not launching new projects. Those that are able to, do so at very low rates. When economy recovers those who gave loans on low rates will suffer loss. All this will bring the ASF down. However, the Fed’s cannot do anything to increase it because the fall in ASF is fast and large and is increasing all the time. All they can do during this time is to try and stop the ASF from falling. In other words the depression is reducing the effectiveness of the monetary policy.

Besides this, expansionary fiscal policy can be affected by crowding out. Crowding out occurs when APE>ASF. If APE rises and ASF doesn’t then interest rates will go up and this will crowd out the increase. However, if ASF rises a little in response then, little bit of the increase will crowd out but not all. This means crowding out doesn’t destroy fiscal policy measures, but it does reduce its efficiency.

Next the writer explains how the fiscal policy can fail by using the Ricardian Equivalence. According to it, people know that government has borrowed and in future when treasury bonds are redeemed, government will increase taxes. People, to prepare for this, will save more and purchase less and hence goal of fiscal policy to increase aggregate demand will fail. However, the writer also states that this is not the case in U.S.A. People are not increasing saving too much hence coupled with other factors fiscal policy will not fail, but will definitely lose some efficiency.

Now the writer moves towards restrictive policies and how they are used to offset inflationary effects. Firstly, when the APE or ASF increase and can increase inflation, government can use restrictive policy to stop it. But that also means there will be no growth. However, when GDP goes down, government should not use restrictive policy as this is short term and hence short term solutions should be used. Next the writer says that, in case of inflation due to rise in prices, no policy should be used as it would have no effect on the inflation. If we interfere then unemployment will rise.

However, the writer says, the government can control the prices; by using a tax based income policy. Using this policy the government can reduce inflation and at the same time use a demand based policy to increase employment. In the tax based income policy the government sets certain limits of average wages and price. Anyone who gets more wages or increase the price more than the official target will be required to pay a tax penalty (i.e. more tax) and similarly vice versa. This will deter people from increasing beyond official level. This way the government can control prices.

Next the writer explains that if the government continues with demand based policy it will cause the economy to go through policy-induced business cycles. This means that, if that, the different economic shocks that hit the economy cause random movements in employment level, interest rates, output etc. The severity and timing of these cycles is not known and this is the danger. Moreover, once the process of cycle’s starts, it will continue and the economy will keep on getting these cycles from time to time.

Next the writer explains that, the Fed’s constant switching between tightening and easing the monetary policy, which they do to counteract the effects of their previous policy change, instead of stabilizing, it destabilizes the economy because it reinforces the cycles occurring due to other sources. What they can do is that, they should use the demand based policy to reduce unemployment and use any policy, like the tax-based income policy to reduce inflation.

Further the writer explains that, in order to get the right and desired interest rate there has to be a balance between monetary and fiscal policy. This can be achieved easily if one organization (for example the Fed’s), handle it. But they control only the monetary part and the fiscal policy is in the hand of the government. Hence striking the right balance and the right changes becomes a problem.

Moreover, another problem is availability of the correct data and that too on time. The economy is very sensitive. Policy decisions have effects on it. If data is incorrect or late this can cause wrong decisions to be made and can result in a disaster for the economy. There is a lot of problem in the available data of the GDP, APE, ASF etc and this is causing a problem.

This problem is compounded by the fact that time is wasted, before the problem is recognized. After recognizing, then they design and implement it. Hence its effects take time. Meanwhile the MCP is doing its process. Lastly the writer says that, though monetary and fiscal policies are good, but the data problems, policy lags and inability to predict the effects of economic shocks accurately are making it ineffective.