Macroeconomics analysis gives insight on the economys current institutional structure and hence classical macroeconomics aptly forms the basis that M V remain indifferent to any varying changes in interest rates, which keep the ASF vertical as it greatly impacts the macroeconomic coordination process. In the scenario where the APE shows a rightward shift, increasing APE, it will exceed ASF.
The above diagram explains the correlation between GDP, APE, ASF and interest rates.
ASF will remain unchanged as M V are indifferent to any change in the interest rate. However if APE falls or a leftward shift occurs than interest rates will fall and excessive funding will take place which will surpass ASF as compared to APE. Fund holders will have excess funds and will have difficulty finding borrowers and therefore interest rates will drop. Decrease in interest rate do not affect ASF, but will give rise to interest sensitive demand while interest rate will continue to decline until APE is back to its original point where ASF and GDP are constant.
Classical economy and economist underlying notion believed that interest rates are elastic enough to repel any significant changes that occur in APE and restore it equilibrium with ASF and GDP. In cases where APE experiences a leftward or rightward shift, funds will be in excess and will not be needed. Funds holders or banks that will hold these excess funds will offer it on lowest interest rates. While interest rates will fall, APE will rise until it equals ASF and exceed GDP where funds demanded surpasses output. As a result, businesses experiencing increase in demand will increase their prices.
The diagram illustrates the shift in APE. When APE increases, interest rates rise to i1. Also ASF increases funds, which in turn depresses interest rates and it falls, subsequently funds demands exceed GDP and prices increases which restore the ASF line back to its original point.
The classical economist point of view states that businesses are happy with their current levels of output of production and sales, that is selling at constant profit maximizing output levels. However the increase in prices will make the ASF line shift leftwards and in turn will increase the interest rates which make APE fall showing a downward movement along the APE line.
Prices continue to increase until interest rates, ASF and APE return to their original point. Rise in ASF only indicates an increase in price and has no affect on output and employment while interest rates drop initially but eventually restore to their original levels. However if ASF drops, prices decrease, and interest rates will again rise but will decrease to their initial levels. A drop in ASF also indicates shortage of funds, which in turn increase interest rates, while dropping APE. Drop in ASF will result in businesses cutting prices, which will increase ASF, decrease interest rates and will enable APE to restore to its initial point. Hence businesses will adjust that product prices according to demand and variation in sales.
If GDP drops, prices will increase, and will make ASF drop to the GDP level, simultaneously interest rates will raise enabling APE to drop to ASF and GDP level. Similarly if GDP rises, businesses will give prices cuts and will lower costs to increase ASF up to GDPs level, in turn interest rates will fall to bring APE back to ASF and GDP levels. All scenarios indicate that ASF, GDP, APE, interest rates and prices are correlated, as interest rates fluctuations keep APEASF, flexible prices keeps ASFGDP and GDP indicates the economys full employment cycle.
Until great depression there had been no changes in employment and output levels to have doubt on the market abilitys to continue operating at high output levels. Interest rates do not fall until businesses cut prices and output. Leaning ASF line, indicating shifts in demand brought into view changes in output and price elasticity which was earlier unheard in classical economy. Macroeconomists were hopeful that businesses should only rely on price changes to adjust sales fluctuations, so as to restore demand ASF and APE to its original levels of GDP. Hence implying that equilibrium point ASFAPEGDP does not necessarily requires full employment level of output.
Chapter 8 Monetary Policy
There are twelve Federal Reserve Banks and each is privately-owned corporation having stock owners who are members of the Federal Reserve System that are banks in their respective districts. Federal Reserve Banks are created by the federal government and operate under their jurisdiction. Monetary policy is regulated by Federal Reserve Act to purposely have open market operations, adjustments in reserve requirements, and changes in interest rates to apply intended control on interest rates levels, prices, employment and levels of outputs through a three step process.
First the Federal Reserve systems use its either of its three policy tools i.e. open market operations, changes in bank reserve requirements and changes in discount rates to bring about a change in nations money supply M and interest rates. This alters the scale of ASF, which in turn affects employment, output, interest rates and prices as per the macroeconomic coordination process.
Money supply is expressed as M CC CA. r is the average of dollars that banks must keep on reserve per dollar of each checking deposits (CA), and r represent reserves per dollar of time deposits (TD). r x CA measures the total of required reserves of nations banks corresponding to checking deposits. While w x CA indicates total working reserves which are voluntarily held by banks in excess and addition of legally required reserves. The total reserves of banks are given by R (r x CA) (r x TD) (w x CA). B indicates the coins and currency portion of money supply and all reserves of the banks and hence is given by B CC R.
Feds direct monetary control variables are B, r, and r. If banks have negative working reserves it implies they have lesser reserves than the current requirement. Fed can increase ASF by asking banks to decrease w, increasing B and decreasing r, and r. Any reverse changes will decline ASF. Fed uses three tools to control monetary policy, open market operations require the alteration in B which is the monetary base and affect the level of M and ASF. Open market purchases boost B by the extent of purchases, and open market sales lessens B by amount of sales. Any cash withdrawals will increase CC and reduce R, while any cash deposits will have the reverse affect.
Second tool is through reserve requirement adjustment. To keep higher level of reserves while unchanging the working reserves, banks reduce their outstanding loans. Every dollar of bank deposit that is used to pay off bank loans in turn frees the reserve that was holding that dollar, and is used to increase reserves being held on deposits. If feds cut r or r, w will involuntarily increase until banks release loans to absorb required reserves that were accumulated to fill the reduction in reserve requirements. Furthermore any resulting increase in money supply must be utilized in lending and not become part of the working reserves.
Thirdly feds use the discount rate adjustments to control monetary regulations. Whenever a dollar is deposited in a bank, its reserves increase by that dollar, and its withdrawal diffuses its reserves. Banks are required to maintain a certain percent of reserves against its account balances. Hence voluntarily keeping working reserves ensures that the bank does not have insufficient reserves in the event of net withdrawals.
Working reserves also can be used in interest based income yielding loans. If working reserves are low, it will enable banks to have lower interest penalties on borrowed reserves, however higher reserves will limit the scope of banks earnings on consumer loans. If the discount rate level rises relative to bank lending rates it will increase the penalty on borrowed reserves as compared to its interest income that was being sacrificed while keeping this working reserve. In addition it also encourages banks to keep higher working reserves.
Hence Fed maneuvers the situation to its advantage to pressurize the money supply of the nation and changes B by altering (r and r) and the level of discount rate in relation to banks lending interest rates, in response to which banks change and alter their working reserves. An open market purchase increase B, lower required reserves, and hence lowers the discount rates in relation to bank lending interest rates. This triggers the money multiplier, and in turn increases ASF. B decreases as a result of open market sales. A higher reserve requirement and higher discount rate in relation to bank lending of interest rates will decrease the money multiplier and in turn decreases the ASF.
The diagram above illustrates the use of monetary policy to bring GDP to the desired output level expansion. It reduces interest rates for more borrowing of funds by businesses, increasing demand and facilitates in increasing output.
Monetary policy is used to restrain the logic of managing the growth of money supply and ASF. And hence the Federal Reserve uses two policies to either ease or tighten the money supply restraint. To bring about an increase in M i.e. money supply, fed may use one or more open market purchases, slash in reserve requirements and a cutback in discount rates. Ease of monetary policy can be used to offset the significant drop in APE, as it creates more funding chances, lowering the interest rate levels.
A steep ASF line indicates ASFs weak response to any changes in the levels of interest rates and supports the likely impact of monetary policy. The influence of easing of monetary policy depends largely on banks sensitivity to their rise in excess reserves and subsequent expansion in lending. Furthermore this will lower interest rates and APE demand response will reflect how effective easing policy has been.
Tight monetary policy is used by the Federal Reserve to attain its goal of price stability. It is used to curb inflation and has short-term effect on prices and interest rates. Tightening of monetary policy helps in increasing the interest rates and decreases demand. This cost push price increases will shift the ASF line to left, which in turn will lower GDP and APE also shifting the APE line to left. In this scenario easing monetary policy will help in restoring the ASF line to its initial point.
Hence tight monetary policy is not an effective tool to control money supply, as it requires banks to reduce their lending forcing a decrease in M and ASF, which in turn leaves the bank with reserves lower than the minimum requirement. Subsequently this reduction in lending will require banks to offer a higher rate of interest on lending, which will deject borrowers. The impact of tight monetary policy will strongly reflect on how APE demand responds to higher interest rates.
Chapter 9 Fiscal Policy
Following are equations from preceding chapters
GDP a GDY 1-1
GDY a HY BY GY TF 1-2
APE a C I G X F
Hence it can be implied that APEGDP in the case when (HY-C) gauges increase in income relative to output demanded and reflects the household s surplus income. In the same way businesses budget surplus is given by (BY-I) and governments by (GY-G). Sum of sector budget surplus will equal zero only when APEGDP, and any sector budget surplus will be counteract other sectors deficits to retain the equilibrium.
Congress formulates the fiscal policy and can have two basic forms of automatic stabilization or discretionary fiscal policy. Automatic stabilization policy refers to progressive net tax structure and welfare and employment reforms, which are applied to lessen the sensitivity of APE to GDP changes. They are beneficial to gauge the degree of likely changes in employment and output during the macroeconomic coordination cycle. Discretionary fiscal policy helps in maneuvering the net federal tax revenues and controlling federal government requirement of current domestic output. It influences the nations cumulative demand for domestic output (APE) as per the intended objective of demanding the preferred levels of interest rates, employment, prices and output through macroeconomic coordination process operations.
Governments exploitation of progressive income taxes can greatly contribute to automatic stabilization if it does not change the current national output while tax receipts fluctuate. When GDP is on the rise, a progressive income tax takes new income away from the tax payers, and hence limits their after-tax income levels and in turn minimizes any likely increase in their purchases. However if the government reacts slowly to decline in tax receipts and takes no action what so ever it will result in a decrease of APE in reaction to this change in GDY. Tax receipts greatly impact GDY and it may rise or fall respectively, however it has no influence on benefits of these programs. Under proportional tax reform, no change is visible on the households tax rate however it falls under the progressive tax reform if income falls.
Discretionary fiscal policy is applied in a two step process. First the federal government modifies its current output purchases which change G, bring a change in tax receipts from household altering C and from business altering I. this will in turn change APE likely to affect output, employment, prices and interest rates as per the macroeconomic coordination process. Hence from this scenario one can easily infer the fiscal policy formula that reflects the how APE enhances or lowers when any changes are made to the federal taxes and federal purchases of current domestic output.
HT is the change in government tax receipts and HT denotes household s taxes
BT is the change in government tax receipts and BT denotes business taxes
G is the change in government demand for current domestic output
Hence the fiscal policy formula can be given by APE G - 0.65HT - 0.35BT. if the government is able to set a targeted GDP level, where GDP reflects highest employment level in absence of inflation then fiscal policy s objective is to keep APE GDP. APE (GDP - APE) where APE reflects the existing cumulative demand. If (GDP - APE) 0 it will require the use of expansionary fiscal policy. (GDP - APE) 0 it will require the use of restrictive fiscal policy.
Fiscal policy helps government to take calculated steps to bring variation in the APE line simultaneously changing the levels of government purchases and tax revenues. If tax revenues decrease as compared to government purchases, APE will increase experiencing a rightward shift. Subsequently if tax revenues increase in relation to government purchases, it will decrease APE, resulting in a leftward shift.
The diagram below shows the use of expansionary fiscal policy by usage of automatic stabilizers. Though the fiscal policy helps in increasing APE, the steeper IS line indicates less effectiveness of the policy and possibility of better GDP if GDP lines shifts to the right.
Use of automatic stabilizers results in a steeper IS line, and lessens the impact of expansionary fiscal policy effectiveness. In the same way steeper APE indicates the cumulative demand reaction and their relative impact on interest rates. Hence to lessen APE the government requires good use of variables changes in G, HT, and BT.