Classical analysis and policy
This chapter evaluates macroeconomics as it was before the advent of the Great Depression that forced alterations in the advancement of the fiscal policy measures. Initially, the use of gold in determining the domestic money supply made the supply independent of the interest rate alterations. Owing to this, the money supply (M) and the velocity of money (V) were assumed to be independent of the interest changes. A vertical line would thus represent the ASF appropriately. The IS line is left out as the economists did not envision how alterations in GDY would affect the APE level. Therefore, a classical economy in equilibrium has the following attributes:
- GDP=APE=ASF is at a certain interest rate, io.
- ASF and GDP are represented by vertical lines.
- The APE line has a relatively large negative gradient and cuts the ASF line at io.
Implications of the vertical ASF line to the economy
Case#1: Increase in the APE (line shifts to the right).
APE exceeds ASF. This increases the interest rates until all the demand increase due to differences between APE and ASF has been wiped out. However, the price of commodities and the level of output remain constant.
Case#4: APE decreases (line shifts to the right).
ASF exceeds APE. The interest rates decrease due to excess funding until the difference between ASF and APE is offset.
Case#2: ASF increases (a shift to the right)
Commodity prices increase, but employment and the output levels remain unaltered due to the temporary decrease in the interest rates. The change is due to excess funding in the market.
Case#5: A decrease in ASF (a shift to the left)
This results in a decrease in the price of commodities due to the temporary increase in the interest rates as a result of a shortage of funds. Employment and output levels are unaltered.
Case#3: A decrease in the GDP
Both the prices and the interest rates increase as ASF and APE move to the GDP level.
Case#6: An increase in the GDP
Both prices and interest rates drop as ASF and APE shift to the level of GDP.
In all the above cases, interest rates changes ensure APE to be equal to ASF while the elastic prices ensure ASF= GDP. GDP, on the other hand, is assumed to be at the full-employment level.
Since the macroeconomic coordination process was not instant, it was marked by recessions, in which production reduced, and retrenchment occurred, and brief booms in which more people were employed and the output increased. These were, however, very temporary occurrences. When the Great Depression set in, M and V became dependent on the interest rates causing the ASF line to become a positive slope. This made demand changes to cause lasting output alterations and impermanent price level adjustments.
Dependence on the price changes influenced businesses to restore the full-employment level of GDP through demand APE while ASF was marred by two problems. First, there was a likelihood of the APE becoming erratic with the full-employment output. Secondly, a lesser percentage cut in costs than in the profit could result in losses for the business, assuming the fact that the output level is held constant.
Monetary policy
This refers to the control of the interest rates, commodity prices, employment levels, and output by employing open market operations, alterations in the reserve requirements, and changes in the discount rates by the Federal Reserve System. The policy achieves these goals through a three-step process.
- Step #1:The Federal Reserve System uses the above policy tools to cause changes in the money supply (M) and prevailing interest rates in the market.
- Step#2: Changes in M cause alterations in the size of ASF since ASF= (M x V)/p
- Step #3: Changes in ASF, in turn, alter the levels of employment, output, interest rates, and the commodity prices through the macroeconomic coordination process described earlier.
A Money-Supply Formula
A formula to indicate how the different components are manipulated to alter the money supply is:
- M = {(d +1)/ (d + r’ + r” x t + w)} X B
Where
- d- denotes the desired cash to checking account deposit ratio that is CC/CA
- r’- denotes the Federal Reserve’s reserve requirement for every dollar of checking account deposits (CA).
- r”– denotes the Federal Reserve’s reserve requirement for every dollar of time deposits (TD).
- t- denotes the desired public time deposit to checking account ratio (TD/CA).
- w- denotes the number of working reserves per dollar of checking account balances that the banks are willing to save for the above-required reserves.
- B- refers to the monetary base, (CC + R)
- M- denotes the supply of money, (CC+ CA)
The realistic values for the above quantities are:
d = 1, r’= 0.07, r”=0, t= 6.0, and w= 0.003, while, B (money multiplier) can be denoted by (d + 1)/ (d + r’ + r” x t + w) = 1.8.
Among these factors, the public influences the value of d and t; banks t and w while the Federal reserve controls B by raising or lowering the open market purchases, determining the range of r’ and r” as stipulated by the Congress. Adjusting the discount rates also offers them a means of controlling w.
Rewriting the value of ASF in terms of B gives
- ASF = {(d + 1)/ (d + r’ + r’ x t + w)} x (B x V)/ p.
Therefore, efforts by Fed to increase the value of B, decrease r’ and r”, or motivate banks to lower w would consequently increase the value of ASF.
Monetary policy methods
The Federal Reserve utilizes three methods to alter the money supply. They include:
Open Market Operations
The Federal Reserve System sells government securities to dealers in New York City who in turn resell them to the households, businesses, and other interested institutions. Open market purchases increase the value of B, while sales reduce its value. Subsequently, the ASF is altered.
Reserve Requirement Alterations
Increasing either one or both of the reserve necessities causes a forced reduction in the monetary supply, while a decrease only facilitates the upward change of the monetary supply.
Discount Rate alterations
Maintaining voluntary reserves by banks reduces the chances of net withdrawals resulting in inadequate reserve positions that can cause the imposition of penalties by the Federal Reserve. Increasing the discount rate relative to the bank lending rates encourages the banks to raise the value of w and thus reduce the money supply, M. Conversely, a reduction in these discount rates discourages the holding of optional reserves, w, which in turn inflates the value of M. The effect of discount rates is, therefore, indirect.
Monetary policy restrictiveness in altering the money supply, and ASF can be divided into two: tightening and easing.
Monetary Policy- Easing
This refers to a decreasing in restrictiveness. Induction of an upsurge in the money supply through the policy tools above increases ASF, causing its line to shift to the right in the graph. This drives interest rates down and thus counteracts the effect of an autonomous drop in APE. The power of easing monetary policy is dependent on the aggressiveness of the banks in response to the increase in the value of w and the strength of APE’s reaction to lower interest rates.
Monetary Policy –Tight
It is used by the Federal Reserve to ensure the stability of prices. However, its efforts of reducing inflation result in a reduction in output and unemployment besides causing a temporary effect upon the prices. It attempts to raise interest rates, thereby reducing the demand level. The businesses are compelled to cut down their prices. It is not a reliable method of altering the money supply due to its adverse effects.
However, it is powerful since it can force banks to cut down their lending rate and thus reduce the money supply while ease can only expedite but not ascertain an increase in bank lending.
Fiscal policy
Fiscal policy refers to the measures taken by the government in ensuring that the total of all the surpluses or deficits from all sectors of the economy is equal to zero. Unlike in the case of monetary policy, Congress comes up with a design of the fiscal policies besides enacting the measures to ensure these policies are in place. It basically assumes two forms, automatic stabilization and discretionary fiscal policy.
Automatic Stabilization
It is dependent on the features of the economy, such as the tax structure, to alter the potential changes in the GDP and the employment levels during the macroeconomic process. This is on APE to the changes in the income level (GDY). An increase in the GDY has the effect of restricting the rise in the taxpayers’ after-tax income and consequently reduces their purchases. An increase in the GDY slows down the decrease in after-tax incomes. Thus, it encourages more purchases by the taxpayers.
The automatic stabilizers, which include the tax structure, welfare, and compensation programs, increase the steepness of the IS line. Whatever the outcome of these forces, the government does not interfere but simply allows the forces to reduce the GDP by causing a fall in the APE. Alternatively, raising the APE has an eventual effect of reducing the GDP.
Discretionary Fiscal Policy
This process assumes two steps.
- Step #1: The government adjusts the levels of the present domestic output, tax receipts from the households and businesses.
- Step#2: Due to the above adjustments, changes in APE results consequently affect the levels of employment and vary the interest rates through the macroeconomic coordination process described earlier.
A Fiscal Policy Formula
- Since APE = C + I + G + X – F
We can have the fiscal formula as
ΔAPE = ΔG – 0.65 ΔHT – 0.35 ΔBT
Where ΔAPE is representative of the initial alteration in APE that is prompted by:
- ΔHT, an alteration in the form of the government tax receipts emanates from the households.
- ΔBT is an alteration in the number of business tax receipts to the government.
- ΔG is an alteration in the present output demand by the government.
For this to hold, it is assumed that the tax and government demands do not affect the level of exports or imports directly. An expansionary fiscal policy is employed so as to regulate the aggregate demand when the ΔAPE > 0. Alternatively, when it is less than zero, a restrictive fiscal policy is employed.
Expansionary Fiscal Policies
In order to increase the APE, the government has the option of increasing the purchases of the domestic output and holding the business and household business receipts constant. Alternatively, it can alter the household or business receipts and hold the purchases constant. However, all the above adjustments have a common effect of increasing national debt in different proportions, with the adjustment of the business tax receipts having the largest effect. To avoid this, a balanced budget approach that alters the purchases in the same direction as the amount is applied.
Under the discretionary fiscal policy, the government changes the relative levels of its purchases and tax returns, causing the APE line to shift. Decreasing taxes relative to purchases cause a rise in the APE, causing its line to shift towards the right of the graph. This amounts to expansionary fiscal policy. On the other hand, increasing taxes relative to purchases cause a drop in APE. Its line then shifts to the left. This, in turn, amounts to restrictive fiscal policy.
For more responsiveness of the lenders to the alteration in the interest rates, the potential effect of the discretionary fiscal policy measures should be higher. The responsiveness of the APE to the alterations in the interest rates is indicated by the steepness of the APE line, that is, the value of ‘c’ in the equation below.
- APE = a + b (GDY) – ci
As the value of ‘c’ reduces, the IS line becomes steeper and boosts the strength of the discretionary fiscal policy measures.
Restrictive Fiscal policies
Under this, the government employs the combined effect of the alteration in its purchases, business tax receipts, and household tax receipts to alter the APE.
Discretionary Fiscal Policies: Final comments.
- The government can exercise a combination of adjustments on the household tax receipts, business receipts, and purchases to alter the amount of expenditure and revenue while ensuring there is no net alteration in the APE.
- The reason for the government’s purchase of present domestic output is to provide for national defense, fire, and other public demands.
- The common goals between the monetary policy and the discretionary fiscal policy are low unemployment and low inflation. In addition, the operation of the two is based on the manipulation of the APE. While the discretionary fiscal policy manipulates the APE directly, the monetary policy uses the influence of the ASF on the APE.
- There are infinite combinations of the alterations of the household and business receipts or purchases that can give a particular change in the APE.
Appendix
The Federal Debt
This is also denoted as the national debt. When the government runs a budget deficit, it has the option of printing money to finance this gap. However, it prefers to borrow money from another state. Unlike the individual debt, this money has neither a particular repayment date nor collateral attached. It is simply transferred from generation to generation with no critical consequences on payment default. To finance the interest on the debt, the government issues securities to the general public and institutions rather than increasing their taxes. In such a way, the government avoids the risk of a recession that can cause huge retrenchment of its citizens.
Works Cited
Ashby, David. Intermediate Macro Mechanics. Western Oregon University, 2009.