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Economy plays a major role of coordinating the amount and type of goods and services to produce in line with the needs of buyers. Besides, it involves ensuring that there is an efficient money supply to allow the production and purchase of goods and services.
Different societies organize their economies in different ways. For instance, the Soviet Union ensured that the government was the most instrumental institution in determining the nature, type and quantities of goods produced.
In a liberal economy like the US, the government plays the peripheral role in dictating the nature, type and quantity of goods produced. Indeed, the Federal government concerns itself with the production of goods and services only in the public sector.
In addition, there is a substantial difference between the microeconomic and macroeconomic processes. While the latter processes are systemic, the former are intentional and are driven by intent and consumer behavior.
Macroeconomic processes concern with the ‘economy of aggregates’ that is dependent on the total output of an economy in addition to the rate of unemployment.
While many people argue that the government interference in the economy is counterproductive, it is important for government to respond to situations of high unemployment, low output and high prices of goods and services it produces.
Besides, government’s intervention is important in countries whose economies are not effective.
Macroeconomics is a sub discipline of economics that focuses on the determinants of employment (or lack of it), output, prices of goods and services and policies that enhance effective money supply. It dwells on gross domestic product (GDP), aggregate planned expenditures (APE) and aggregate supply for funding (ASF).
The interplay of the above three parameters reveals the macroeconomic coordination process (MCP). The study of macroeconomics allows the policy makers to erect measures that allow effective running of the economy and provides insights to the future of an economy.
It also allows the learners to have a glimpse on the way the economy operates within and without the microeconomic environment.
Every country has specific factors of production that include land (resources), labor and capital. In order to create goods and services, a country combines the factors of production using the available technology. The process of combining the factors of production is referred to as the production process.
This implies that a country can measure the amount of goods and services produced within a specific year using the factors of production. Apparently, the most feasible way to calculate the volume of goods and services produced is through the Gross Domestic Product (GDP).
The reason is that GDP allows a country to calculate the amount of goods and services produced by relying on the market value. Initially, it was difficult to calculate the aggregate amount of goods and services produced owing to the fact that services and some goods are unquantifiable.
In fact, GDP measures the current values (selling prices) of goods and services produced within a country annually. Due to the difficulty in quantifying services, it is important to calculate the value of services at the cost of production. This way, the services will have established market value.
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Moreover, Commerce Department emphasizes on the need to deduct the total payments paid to other governments and avoid multiple counting. This is through calculating the final products rather than counting goods sold as raw materials to other producers within the country.
Owing to the fact that GDP measures the market value of goods and services produced within a country, it is critical to enhance its accuracy and consistency. The reason is that market values keep changing. As such, GDP changes overtime. This is despite lack of change in the total output and factors of production in an economy.
To enhance the accuracy of GDP, Commerce Department uses Prices Level Indexes. The price level index measures the changes in prices overtime. To comprehend the manner in which the prices have changed over a specific period it is important to establish the base year, which will provide the starting point.
For instance, Commerce Department uses 2005 as the base year and makes a list of all goods and services produced and their corresponding market values. The list of all goods and services produced makes up the market basket of a country.
It is apparent that the prices of goods and services increased by 3.231% according to the Commerce Department from 2005 to 2006. This implies that the cost of goods increased by 1.03231times in 2006.
Consequently, the prices increased by 1.02902, 1.02217, 1.00873 and 1.011335 times in 2007, 2008, 2009 and 2010 respectively. These figures indicate the average changes in prices and are referred to as the price indexes.
To get the actual changes in prices from 2005 to 2010, Commerce Department multiplies the indexes for the five years. In other words, the prices changed by 1.03231×1.02902×1.02217×1.00873×1.011335, which amounts to approximately 1.10992.
This insinuates that the prices have increased by 10.992% since 2005 through 2010. It is important to point out that a new price index joins the level of prices yearly.
GDP of a country therefore represents the amount of goods and services produced in a country. However, it is important to adjust the GDP value in line with the prevalent price indexes in order to get the actual value of the GDP. This is possible by dividing the GDP value by the subsequent price index of the same year.
Besides, GDP changes with any change in the quantity of goods produced. However, GDP’s adjusted value rarely changes when there are changes in the interest rates. As such, GDP has to put into account the changes in prices for it to be accurate and conclusive.
The concept of GDP allows us to understand the gross domestic income (GDY). While the two concepts are distinctive, their values are similar. In other words, it is possible to measure the amount of change that will occur to GDY when GDP increases.
The rationale is that GDP and GDY are directly related in the sense that a change in one concept will lead an equal change in the other. As such, production process is the main source of income for governments, businesses and households.
GDY is the total amount of all income claims by all workers and institutions within an economy due to their roles in the production process. In an attempt to understand the concept of GDY, it is imperative to analyze various prevalent notions about the idea.
First, GDP is the aggregate amount of products that a country produces annually. These products are expected to fetch incomes in future. However, their prices change and it is important to make adjustments that capture those dynamics.
Second, it is essential to distinguish the concept of income and money. The two are not synonymous contrary to many notions and usages. As such, the amount of money available in an economy is much less than the actual income.
Third, producers and buyers should access credit in anticipation of sales revenues and incomes respectively. However, producers ought to use credit in a responsibly to avoid a recurrence of recession that engulfed USA and the rest of the world in 2008.
Households, businesses and governments are the major recipients of GDY. The amount of income that individuals receive from their participation in the production process is known as disposable income. It includes the wages, royalties and transfers.
However, the actual figure of disposable income is derived at when personal taxes and contributions are deducted from the gross income. Household incomes are the largest representing 74% of the US GDY. Business savings are major sources of business incomes.
They include allowances on depreciation, retained earnings and revaluations on inventories. The business incomes are approximately 12% of the entire gross domestic income. Finally, government revenues are used in making transfer payments to both business and household sectors.
The net revenues for the government represent total government revenues minus transfer of payments and interest paid on government debt. Due to the importance of stimulating the economy through households and businesses, the government net income has continued to diminish overtime.
Besides, the government has transferred payments to people and institutions abroad. This leads to the diminished net income for the government.
As aforementioned, it is always true that GDP is equal to gross domestic income (GDY). Besides, it is also true that GDY is equal to disposable income of the household plus business income plus the government income plus the foreign transfers.
Hence, there exists enough income to purchase the entire output implying that a change in price will not result to a consequent change in the GDY. In cases of an increase in prices of goods and constant incomes, people are unable to afford similar quantity of goods, as was the case with the previous prices.
Consequently, rise in incomes without subsequent changes in prices will always imply that one group of the society is better of than another. As such, it is impossible to increase incomes for one group without affecting another in a negative/positive way.
Although GDP is always equal to GDY, it does not imply that all income purchases of goods and services. Some of the income goes to savings for future expenditure and some may go to borrowing. In addition, the total output of a country may not be sold or may not be enough for the country.
To that extent, there is the need to understand the demand for output given that it might surpass the output or it may be below it. Aggregate Planned Expenditure (APE) of a specific country refers to the amount of consumption (C) plus investment (I) plus government purchases (G) plus exports (X) minus imports (F). Subtracting the exports does not necessarily imply that APE will reduce.
The rationale is that all parameters used to calculate APE takes into consideration the imports. Finally, it is important to note that government debt has been typical of numerous government transactions across the world. In the US, the debt continues to rise.
Government debt refers to the ability of government to spend more than its revenues. In other words, the government spends more than its revenues by issuing treasury securities that allows it to adjust their maturity.
In essence, the government cannot print amount of money that equal its budget in order to increase its spending. As a remedy, the government borrows money from the public by issuing bonds. Currently, the US has huge ability to borrow money to increase its spending which in turn stimulates the economy and GDP.
In the previous chapter, it is clear that changes in prices have no direct effects on the aggregate planned expenditure (APE). In other words, changes in prices receive equal changes in incomes. To that end, changes in prices of goods will be compensated fully by the incomes.
In other words, GDP will be equal to APE. However, it is important to evaluate the changes in unemployment levels, output, interest rates and their direct or indirect effect on APE and GDP. At the outset, consumption (C) reflects the amount of disposable income that goes to spending.
Despite the income accruing the household amounting to 74%, it is evident that the current spending by household is 90%. This implies that any amount of income that is not consumed or spent in buying goods and services is saved. From the numbers, it is clear that US households spend more than their incomes.
Where does the income to spend on goods and services come from? The US households may spend more than their incomes owing to accumulated savings and borrowings in terms of credit. Nonetheless, the households save more than they borrow explaining the discrepancy in incomes and consumption.
It is imperative to notice that changes in income ought to influence the trends in consumption. However, the personal wealth and savings may not reveal the changes. It is therefore critical to analyze the changes separately.
Another critical factor is that American households will save more when the interest rates are low and save less when they are high. This is ironic, or is it? The rationale is that an individual who would like to save a fixed amount of money will have to contribute less when the interest rates are high than when they fall.
In other words, the Americans have a culture of making a fixed-goal savings in terms of contributions towards social security and medical insurance among many other ways of saving.
In the case of businesses, it is important to point out that a rise in interest rates will ultimately diminish the level of investment (I) and vice versa. Further, government purchases (G) remain unaffected by various factors including the interest rate.
This is dissimilar to transfers made to foreigners. When the US makes more exports than imports, it runs a trade surplus. When the reverse is the case, the country makes a trade deficit.
Further, it is critical to highlight that an increase in interest rates will ultimately cause the businesses to increase their imports. In other words, businesses will import more than they export. This implies that an increase in GDP will ultimately result to APE and the vice versa is true.
It is therefore true to suppose that the impact of GDP on APE is quick and positive. This implies that the change in GDP will cause the APE to go along the same direction as GDP. In addition, the impact of changes in GDP is equally strong for APE.
However, interest rates affect the APE in an inverse way in that a rise in the rate of interestS will cause a consequent fall in APE and a decrease in the interest rates will cause a rise in APE.
However, the changes in APE because of changes in interest rates are marginal. It is important to note that this chapter assumes that changes in prices of goods and services produced will not lead to changes in APE.
Money and Banking
It is important for government to regulate money supply in the economy. When the amount of money is in excess, inflation is the outcome. On the other hand, when the supply of money is too little, the economy may experience a recession, high rates of unemployment and deflation.
In the US, it is responsibility of the Congress, Federal Reserve System (FRS) and the banks to regulate money supply. Privately owned financial institutions and enterprises that economists refer to as the banks are solely responsible in the creation of money.
While the FRS has the power to create money, it only ploughs back the profits made when it mints money in terms of seigniorage. The amount of the money that the FRS puts back into the economy is negligible. In addition, it has an oversight authority to regulate the money supply according to economists.
In US, banks refer to financial institutions that have checking accounts. In the entire world, money exists in terms of coins and notes and checking balances. It is important to demystify that ‘plastic money’ in terms of debit and credit cards serve the purposes of enhancing money transfers. They are not kinds of money.
Money supply (M) therefore is an aggregate of coins and currency (CC) plus the checking accounts (CA). As such, any activity that leads to the reduction of money (CA or CC) impacts on the supply of money in a negative way.
Since various authorities regulate money supply, it is therefore logical to suppose that it excludes all kinds of money that belong the regulators. For instance, it is absurd to refer to money owned by Federal Reserve System or The Treasury as money.
Apparently, 48% of money supply is in coins and notes while the rest is held by banks in terms of checking balances. Hence, it is important for the regulators to control the amount of money that is available to banks for lending or credit purposes. When does the created cash become money?
As aforementioned, Federal Banks creates money and store it into its vaults. The banks checking accounts reflect money that is in the banks for various purposes. To this end, the populace withdraws money from the bank accounts creating the need for the bank to ask for money from the Federal Reserve.
When the banks receive these amounts of money, they become money in supply and constitute M. Thus, it is upon withdrawal of money that created cash becomes money. It is important to note that various countries and people use dollars across the world.
As such, it is absurd to think that CA only refers to domestically available dollars. The rationale is that there exists a myriad of checking accounts outside the US.
The banks are referred as such because of their ability to rent and sell check accounts and balances. Customer purchases of checking accounts are the major activity of banks. Besides, a bank must hold a specific proportion of the amount that a customer deposit into a bank account to be profitable.
In addition, a bank may opt to lend money to the customers due to the lucrative nature of the business. As such, it is important to mention that banks ought to engage in the processes of providing cash to customers through loans and other means. This way, the bank remains profitable like any other business.
Financial Intermediation and Funding
Forgery or counterfeiting currencies is an illegal practice. Members of public must therefore attempt to tap money from the legal money supply channels. The banks play an intermediation role that entails ensuring that people with more than sufficient amount of money balance off with people with insufficient amount of money.
Those with insufficient money may be forced to cut down their purchases while those with excess amount of money may lend, increase their purchases or hold onto their money. The banks lure those with excess amount of money to deposit the excess in bank accounts with the promise of earning an interest.
As such, the banks play the role of ensuring that there is sufficient amount of money to allow transactions within an economy. The deposited excess amount of money allows the banks the ability to issue loans to the people with insufficient amount of money.
It is important to note that interest rates are essential in the entire intermediation process in the sense that they offer low interests to those who deposit their money and charge high interests on the loaners. This makes the demand for loans to be modest.
The banks are not the only financial institutions that can absorb the excess amount of money from the citizens. The government can also borrow money from the public by issuing treasury bonds. Other institutions sell shares and stock with the same aim of ensuring that excess money in supply is absorbed.
As such, there is competition for people to deposit their excess amounts of money to various channels. When there is high competition among the lenders, it is likely that the interests charged on loans increase while the interests paid to the owners of excess cash also increase.
Hence, the market forces play a crucial role in setting the interests paid to depositors and investors and the interests charged on the loaners. It is worth mentioning that the Federal Reserve play a crucial role of instituting measures to reduce or increase the bank reserves.
When the Federal Reserve takes such measures, banks respond to them by adjusting the interests charged on loans. This makes loan attractive or less so according to the measures adopted by the Federal Reserve.
The lowest rate of interest that a bank can lend is called the prime interest rate and is determined by various financial institutions.
Another important aspect of intermediation is the velocity of money (V). This is the amount of times that a single dollar is used to buy goods and services within the country’s output. Currently, the velocity of the dollar is six. In other words, when the banks increase their lending, the velocity of money decreases.
However, it increases every time non-banking institutions offer loans to the population. Apparently, the amount of money used to purchase goods and services in an economy can never exceed the amount of money supply (M) multiplied by the velocity of money (V).
Thus, it is possible to define the Aggregate Supply of Funding (ASF), which is upper limit that people can purchase given the prevalent velocity of money and the prices of goods and services.