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Concepts and Relationships
The major role of any economy is to ensure that it coordinates the changes in the level of goods produced and the changes in the demand for the goods. Besides, it ought to ensure that there is sufficient money supply to facilitate the process through which the producers and consumers interact. In an economy where the government plays an integral role in the coordination process, the central government plays the planning role. In a liberal and market-oriented economy, other factors such as unemployment, interest rates, and prices guide the coordination process. This is despite the prevalent notion that the government’s decisions do not give a free economy any direction. However, the macroeconomic coordination process involves various parameters. They include Gross Domestic Product (GDP), Aggregate Planned Expenditures (APE), and Aggregate Supply of Funding (ASF).
Ideally, the three parameters ought to be equal. The rationale is that any imbalances lead to changes in the rates of unemployment, prices, production, and other factors that are pertinent to the economy. GDP helps in measuring the changes in the volume of goods produced within a year. However, it is imperative to emphasize that during the macroeconomic coordination process, GDP refers to price-adjusted values of the volumes produced within a period that utilizes the same base year. It takes into account the changes that might occur within the period due to inflationary influences.
As such, GDP is calculated by dividing the current value of output by the price index. It is important to point out that interest rates do not have a direct impact on the value of GDP although they affect it indirectly. Many people confuse GDP with Gross National Income (GNY) since their values are similar. However, the former measures output or production while the latter measures incomes that accrue all sectors of an economy. As such, an economy generates income for households, businesses, and the government. The income is enough to purchase the entire output of the economy. However, the money supply is an important factor that may impede the ability of the GNY to purchase all the output that an economy produces. To that end, banks and other lending institutions control the availability of money by dictating the interest rates on loans.
As aforementioned, APE is another important factor that is an integral component of the macroeconomic coordination process. It represents the total demand for goods produced within an economy and abroad. In other words, APE equals consumption (C) plus investment (I) plus government purchase (G) plus exports (X) minus the total imports (F).
APE affects the GDP and GNY positively. As such, the APE has a positive correlation with the parameters, which is quick. However, it has a negative correlation with the levels of interest rates. For instance, APE will fall when the interest rates are high and vice versa. However, the correlation is not as quick as is with other factors. It is imperative to pinpoint that the impact of interest rates on the APE is the focus as opposed to the impact of APE on interest rates. Further, changes in the prices of goods and services in an economy do not influence the level of APE whatsoever.
Further, Aggregate Supply of Funding (ASF) is an important aspect of the macroeconomic coordination process. It focuses mainly on the availability of money (both in currency and in checking accounts). As such, money in supply is the combination of currency and notes (CC) and checking account balance (CA). It is important to highlight that the velocity of money (V) helps to put an upper limit on the amount of money that the government and households use to purchase goods within a year. Logically, (M × V) is the upper limit that the economy can use to purchase goods and services. To calculate the actual ASF hence, the upper limit is divided by the price index. Such factors as interest rates negatively affect the ASF. Finally, the Aggregate Demand for Funding (ADF) is an important component of the macroeconomic coordination process. It is equal to either APE or GDP (whichever is larger). The rationale is that not all goods produced are sold to the demanders. To this end, the macroeconomic coordination process enhances a balanced interplay among APE, GDP, and ASF.
It is important to portray the macroeconomic coordination process (MPC) graphically. At the outset, the main components of the graph include the interest rate (i), GDP, ASF as well as the APE. The vertical axis represents (i) while the horizontal axis of the graph will represent the other three parameters. To comprehend the graphical representation, it is important to highlight the impact of interest rates, unemployment, and prices on GDP, ASF, and APE. First, it is agreeable from the previous section that the levels of employment and output affect the level of GDP and APE positively. However, the level of unemployment and output has no direct impact on the ASF. Second, the level of interest rates has no direct effect on the GDP but it has a negative correlation on the APE. The level of interest rates has a negative correlation with the level of ASF. Third, the prices of goods and commodities do not directly affect GDP and APE. However, price levels have a negative correlation with the level of ASF in an economy.
When plotting the graph, GDP should reflect a line that is parallel to the vertical axis (interest rate). This implies that the line depicting GDP can move along the horizontal axis with changes in the volume of output. Since the rate of interest (i) has no direct impact on the GDP, the line is vertical. To that end, we have a graph that has two vertical lines. Therefore, it is important to add APE to the graphical representation. The APE is a component of both endogenous and exogenous variables. In this case, APE is determined by GDY, which is an independent variable while the rest of the factors are dependent variables. For the sake of the graph, a will represent all factors other than GDY and (i). b on the other hand represents the extra portion of a dollar that will be used to purchase the output. c represents the responsiveness (quick or slow) of APE to the fluctuations of (i). To this end, the aggregate planned expenditure (APE) will resemble the following equation.
APE = a + b (GDY) – ci
This implies that the APE line in the graph will replicate a diagonal line that intersects with the horizontal axis. The line slopes upwards to indicate that APE will reduce when there is an increase in the levels of interest rate and vice versa.
Further, it is important to include the IS line that shows all combinations of the graph when APE is equal to GDP. In other words, various IS lines will have different equations reflecting the levels at which the two parameters are equal. This implies any fluctuation in the level of GDP will result in a shift in the position of the IS line within the graph. Ideally, the line will shift to the left or right. The distance that the IS line moves is equivalent to b. This is equal to the distance that the line moves on the vertical axis. This distance is a. This ensures that the APE, GDP and IS lines will intersect at a point within the graph. This common point shifts when there is an apparent shift in APE and GDP. Finally, it is imperative to represent the ASF line in the graph. The line will slope downwards given the fact that an increase in (i) will cause a consequent rise in APE. The equation of ASF is derived from an equation that recognizes that:
ASF = (M×V)/p.
It is important to revisit the fundamentals of output-price adjustments. At the outset, various assumptions are pertinent to this process. First, economists ought to assume that sales will be high in the events of low prices and vice versa. Second, all firms experience no barriers when they decide to enter a specific market or exit it. Third, all firms in the market aim to attain a specific profit margin that keeps them stable. Below this minimum, many firms will exit the market and the reverse is true. Fourthly, it is important to assume that every firm has an average cost (AC) curve that is u-shaped. Finally, firms act as though their sole intention is to maximize profits. For instance, Marginal cost (MC) depicts the increase in the total cost for an extra unit of goods produced. To this end, if the cost of production is increasing, it implies that the MC ought to be lower than the average cost of production. The reverse is true. The demand curve (D) ought to represent a firm’s average revenues (AR). However, the highest price that a company can sell an equal amount of goods represents its average revenue that it reaps from one unit of goods sold.
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Another important concept of the output-price adjustment process is marginal revenues (MR). It refers to the rise in revenues due to one unit of goods. For a firm to maximize profits, therefore, it has to produce a way that the MR equals the MC. This implies that MC will be less than the MR during the periods of low output. Conversely, firms have a marginal cost that is higher than the marginal revenues when many units of goods. As such, a firm that seeks to maximize profits should be able to adjust its prices and output to achieve economic profits. A company that sells its products at high prices during a period of low demand risks exiting the market. Since the firm can hypothetically focus on increasing its output to become profitable, it is imperative to note that such a high output level is impossible owing to low demand. As such, the firm will prioritize making economic profits as opposed to increasing its level of output.
Assuming that a firm will produce at a point where the output equals the sales, the firm may face excessive demand as it increases. This will prompt the firm to increase its output and price. At such a point, the firm is assured of economic profits. Many firms will subsequently seek to enter the market. However, this will not be as quick as it sounds. The rationale is that some firms will face barriers of entry but the industry will ultimately enlarge. This may imply that the price of the goods will not go back to the original position in the short term but in the long term. If the costs associated with the production of goods decrease, the industry will ultimately enlarge while at the same time decreasing the prices of goods produced. If the demand for goods decreases, the industry will reduce in size as firms seek to exit the market. Finally, an increase in the cost of production will insinuate that the industry will shrink while the prices will rise.
It is important to pinpoint that when the aggregate demand for funding is unequal to the aggregate supply of funding, the money suppliers (lending and financial institutions) and money users will not notice it. The rationale is that they will react normally. These normal actions will equalize the ADF and ASF. This is a funding adjustment. On the other hand, the suppliers of goods will react in a normal way to equalize GDP and APE when they are unequal. However, they will not notice the disparities. This is called output-price adjustments. To this end, it is essential to assume that funding adjustments will always precede output-price funding.
As explained earlier, money users will always fall into one of the following categories. The categories include the money users with a sufficient amount of money to purchase goods and services, money users with more than sufficient money, and those with an inadequate amount of money to make purchases of goods and services. Those with extra money may decide to lend or make extra purchases while those with an inadequate amount of money may seek alternative ways to access the money supply. If the aforementioned two categories of money users opt to lend or borrow money respectively, the ASF and APE curves will not shift during the process of funding adjustments. In cases where ASF and ADF are equal, the money users with extra money, and those with insufficient money will not be aware of the situation. However, the latter will seek alternative sources of money from the banking institutions that will ultimately prompt the lending institutions to raise their interest rates (i).
On the other hand, the money users with surplus money will lend it to those with insufficient at a lower rate of interest than the interest charged by the banks. This implies that the users with extra money will lower the interest rate with the same margin that the banks will raise their lending rates. This way, ADF and ASF will attain a balance without the knowledge of the money users. Finally, when the aggregate demand for funding exceeds the aggregate supply of funding, the interest rates will rise as the lending institutions step in to rectify the situation. When the aggregate supply of funding exceeds the aggregate demand for funding, it follows that the banks will lower the interest rates to enhance accessibility and availability. The rationale is that the number of money users with excess money will be larger than the category of people with inadequate money.