Understanding Macroeconomics: Measurement and Fiscal Policy
Measurement and Fiscal Policy
Aggregate Supply and Demand Models
This section discusses the relevance of aggregate supply and demand models in classical and Keynesian economics.
Classical Model
The classical model places minimal importance on aggregate demand in determining equilibrium output. The supply curve (with price on the x-axis and GDP on the y-axis) is vertical, indicating that demand has no influence on production levels.
Keynesian Model
The Keynesian model considers aggregate demand as fundamental. In its short-term form, the supply curve is horizontal (price on the x-axis and GDP on the y-axis), implying that variations in aggregate demand have a direct impact on equilibrium output.
Keynesian Model in the Very Short Term
In the very short term, the Keynesian model represents aggregate supply as a horizontal line, indicating that prices remain constant and output (GDP) can vary along the x-axis.
The 45-Degree Line
The 45-degree line represents the points of possible equilibrium between aggregate supply and demand.
Savings and Investment
In equilibrium, savings and investment are generally equal. However, if investment is zero, savings will also be zero.
Relationship Between Savings, Income, and Consumption
The equation Y = C + S represents the relationship between income (Y), consumption (C), and savings (S).
Graphical Representation
The relationship between savings, income, and consumption can be graphically represented using two approaches:
- Consumption on the y-axis and income on the x-axis
- Savings on the y-axis and income on the x-axis
The Spending Multiplier
The spending multiplier explains how an initial increase in investment spending can lead to a larger increase in equilibrium income (GDP). This occurs through a chain reaction of secondary consumer spending, with the magnitude of the effect determined by the marginal propensity to consume (MPC).
Examples and Applications
The document provides several examples and applications of the Keynesian model, including calculations of equilibrium output, savings, and the multiplier effect under different scenarios, such as changes in autonomous consumption, investment, government spending, and taxes.
Monetary Policy
Financial Assets
A financial asset represents a claim on future payments, such as loans, stocks, bonds, and bank deposits.
Investment Spending vs. Investment in Assets
Investment spending (I) in GDP calculations refers specifically to new buildings and equipment, while investment in assets can include purchases of both new and used physical or financial assets.
Bonds
Bonds are promises of payment issued by borrowers to lenders, typically involving fixed interest payments and a principal repayment at a future date.
Transaction Costs and Bonds
Bonds can reduce transaction costs for large companies by standardizing the borrowing process, providing public information about the borrower’s creditworthiness, and offering liquidity through secondary markets.
Demand for Loans
The demand for business loans increases as interest rates decrease, as more investment projects become profitable.
Supply of Loans
The supply of loans from families increases as interest rates increase, as the potential for future consumption rises.
Role of Banks
Banks act as intermediaries, providing financial assets in the form of deposits to lenders and using those funds to finance borrowers.
Bank Runs
Bank runs occur when a large number of depositors attempt to withdraw their funds simultaneously, often due to concerns about the bank’s solvency.
Money and Trade
Money facilitates trade by solving the problem of double coincidence of wants, allowing for indirect exchange and increasing overall economic welfare.
Functions of Money
Money serves three primary functions:
- Medium of exchange
- Store of value
- Unit of account
Types of Currency
Historically, there have been three main types of currency:
- Commodity currency (e.g., gold, silver)
- Currency with backing (e.g., gold-backed paper money)
- Fiat currency (e.g., modern paper money)
Money Supply (M1)
M1 is a measure of the money supply that includes currency in circulation and demand deposits.
Central Bank and Money Creation
While the central bank is the sole issuer of paper currency, commercial banks also contribute to money creation through the process of lending and deposit creation.
The Banking Multiplier
The banking multiplier explains how an initial increase in reserves can lead to a larger increase in the money supply through a process of lending and deposit creation.
Factors Influencing the Banking Multiplier
The size of the banking multiplier is determined by the reserve requirement set by the central bank and the amount of money held by the public as currency.
Monetary Base vs. Money Supply
The monetary base includes paper currency and bank reserves, while the money supply (M1) includes paper currency and demand deposits.
Monetary Control Instruments
The central bank uses three main instruments to control the money supply:
- Reserve requirements
- Discount rate
- Open market operations (most commonly used)
Indirect Control of Money Supply
The central bank’s control over the money supply is indirect and imperfect, as it depends on the behavior of individuals and banks.
Demand for Money
The demand for money is influenced by the opportunity cost of holding money (interest rates) and the level of economic activity (GDP).
Money Demand Curve
The money demand curve has a negative slope, indicating that as interest rates rise, the quantity of money demanded decreases.
Shifts in Money Demand
Factors such as inflation and changes in real GDP can shift the money demand curve.
Adjustment Mechanism in the Money Market
If the demand for money exceeds the supply, interest rates will rise to restore equilibrium.
Central Bank and Interest Rate Targets
The central bank can use its monetary policy instruments to influence interest rates and achieve its target rate.