The book “Intermediate Macro Mechanics, by David B. Ashby” is an useful read for all students of Economics. Here, I am reproducing a summary of the book prepared during my student days. I hope students of economics find this summary useful. The book was supplied to us as a PDF document by our class teacher. I do not possess the soft copy right now. But one may download the book by clicking on the links on the respective chapters.
David Ashby is one of my most favourite all time teachers of economics. No, I have never been his student. But as a teacher, the way he seeks to make his students understand the difficult topics in economics, especially “MACROECONOMICS”, is something which is quite unusual and innovative, I always try to imitate this great teacher.
Photo Source: Official Webpage of David Ashbay
Page of Contents
Basic Concepts and Relations
Chapter one deals with basic conceptual issues such as scope of macroeconomics, Gross Domestic Product (GDP), Aggregate Planned Expenditure (APE), Aggregate Supply for Funding (ASF), Aggregate Demand for Funding (ADF).
Macro economics deals with broader and larger issues related to the economy such as; employment, prices, output and interest rate. It also deals with policies undertaken towards stabilisation of the economy.
The chapter starts with the concept of macroeconomic coordination process in which, the above mentioned variables interplay among each other to ensure stability in the economy, in the form of an equilibrium situation where GDP, APE and ASF are equal.
The Gross Domestic Product or GDP of a country for a particular year, as described by the author is the total volume of goods and services produced in a country during that year. However, a country produces numerous commodities which are measured differently. For example, cotton is measured in bales, gas is measured in gallon and grains are measured in tonnes. Therefore, instead of the quantity, the market value of out put produced in a year is considered as GDP. Again, since market value is not truly reflected in market price because of inflation of different degree for different products, the Department of Commerce makes a discount for the price changes and prepares the GDP figure for the country. Once such a discount is made for price changes, what a GDP measures is only the output produced and any change in the level of production changes the GDP figure as well. However, since the effect of price change is already taken into consideration, any change in the level of prices does not affect GDP directly. Similarly, the rate of interest does not directly affect the level of GDP. However, they may influence GDP indirectly through their influence on the level of employment and output during the macroeconomic coordination process. Since the value of output is a summation of all the factor incomes to economic agents such as households, government, businesses and foreigners working in the country associated in the production process, the level of GDP and gross domestic income is same.
Aggregate Planned Expenditure or APE is the total demand for all goods and services that are part of the GDP. This does not include import demand. So, APE is the sum of all household consumption expenditure, investment demand, government demand and the net exports (i.e., exports minus imports). Since all the expenses on the domestic output also factor in total factor income in the economy (i.e. GDY or GDP), the value of APE is also equal to the market value of GDP. APE moves in the same direction as the GDP. APE responds inversely to the rate of interest, but only according to the level of responsiveness the business and trade sectors to the changes in the interest rate.
Aggregate supply of funding or ASF is the aggregate money supply in the economy. The total money supply (M) is the sum of all currency in circulation and the total checking amount component used for transaction of goods and services. In this contest, it is also necessary to understand the concept of the velocity of money (V), which is the average number of times that a unit of money is used in a year's time to fund purchases of current domestic output. The actual purchases that happen in an economy can not be more than the magnitude of the product of M times V. However, this figure does not mean that the same level of goods and services are transacted in the economy. Therefore, when one is actually interested to know the level of money supply available to support all the transactions in the economy, one needs to deflate the value of MV by the level of prices (price index) in the economy. Such a deflated MV represented by MV/P is called the aggregate supply of funding. While GDP shows the total volume of goods and serviced produced in an economy, the ASF shows the amount of money required to support transaction of the goods and services represented by the GDP depending on the number of times the money changes hands. For example, is a 100$ note is earned by a barber by serving a haircut and the same note is spent by the barber to purchase a visit to the doctor in a year, the 100$ note is sufficient to support transaction of $ 200 worth of services produced in the year.
The next set of terms used in the chapter relate to the banking sector. Given the fact that depending on the velocity of money a $ 100 note is able to generate transactions worth more than $100, the banks also need to operate with a reserve which is less than the actual needs of money (needs of withdrawal) they would expect. At times, banks hold a small amount of extra reserves as well. This is called working reserve. But maintaining a reserve would mean that the same amount of money can not be used for giving loan and making profits. In order to offset this foregone profit, banks make arrangement with the central bank to borrow the reserves by paying a penalty interest rate to the central bank. This is called the federal fund rate or the discount rate.
The final discussion in the chapter is on the aggregate demand for funding. The businesses survive on the sales which depend on the demand of the goods and services. Demands fluctuate but the production process has to continue at a pace compatible with the existing capacity in use. When demands are less (or APE<GDP), the businesses may not have sufficient revenue to pay for the production. They require an additional dollar worth of ASF to meet this situation. This is called the aggregate demand for funds or the ADF. In other words, ADF = APE+ (GDP-APE*) whenever APE* is less than the GDP. And whenever APE* =GDP, ADF is also equal to APE*. Therefore, ADF can never be less than GDP or APE.
Basic Concepts and Relationships: Graphical Portrayal
Chapter two presents different concepts in Macroeconomics, such as GDP, IS curve, ASF and ADF in terms of graphs.
As we know, a graph is a curve between two variables. Here in the horizontal axis we take dependant variables such as GDP, APE, ASF etc and plot the impact on these variables of the changes in the level of employment, output, interest rate, prices and so on. As we learnt from the previous chapter, prices do not impact on GDP. So, a price change will leave GDP unaffected. If we plot a relationship between GDP and price change or interest rate, the line representing GDP will be a vertical straight line for all levels of prices. If we plot the relationship between APE and the interest rate, when interest rate changes, it will have a negative impact on the APE. However, GDY will have a positive impact on APE. Apart from GDY and interest rate also, there are other factors which might exert an impact on the APE. This impact of other factors can be considered as constant in a relationship and represented in the graph as an intercept. Therefore, the level to which APE will change would depend on the combined impact of GDY, interest rate and all other factors in the economy. So the APE line has an intercept on the horizontal axis and slopes upward from right to left indicating a decline in APE as the interest rate increases.
The chapter introduces the concept of an IS which indicate all combinations of interest rate and GDP for which APE and GDP are equal. So, it is not any variable. Rather, it is the name of a locus that represent equilibrium points between GDP and APE. Since, IS represents the point of intersection between the GDP and the APE points, the coordinated movement of the GDP, IS and APE lines always cross at a common point.
The equation of APE is represented by;
When APE=GDP, we get;
Which is the equation of the IS curve. In the IS curve, 1/(1-b) represents the autonomous expenditure multiplier that indicated the change in GDP that would restore equality between APE and GDP at all levels of interest rate.
Now, if we introduce the aggregate supply of funding to the discussion, we have to bring in the concept of money supply, velocity and price to the discussion. As we know, ASF is the maximum of aggregate expenditures for current domestic output that is imposed by the existing money supply at the current prices and prevailing velocity. Here, we introduce the equation, MV=m+ei, where m is the combined impact upon the magnitude of MV that results from all influences other than the level of interest rates. And e is the influence of the interest rate. Here we assume that both m and e have positive values.
Thus ASF will be equal to;
ASF=(m/p) + (e/p)i as ASF=MV/P
ASF line shall have a positive slope of value e/p and a horizontal intercept equal to m/p.
In the chapter we also learnt about mapping of Aggregate Demand for Funding or (ADF). The ADF line is a kinked line that consists of the portion of GDP line that lies above the IS curve and the portion of APE line that lies below the IS curve. Therefore, it is a line with two different sections; first a portion where APEGDP.
Chapter three discussed the micro economic foundations of macroeconomics by incorporating issues related to demand and cost changes. Or in other words, there is a need to understand the influences of demand and cost on macroeconomic coordination process through their influence on business behaviour.
In order to move ahead, the author makes the same assumptions of straight line downward sloping demand curve, free entry and exit in the industry, U-shaped average cost curves and normal profit conditions with the primary goal of the firms to maximise profits in the long run. Two different situations such as a demand increase or a cost decline are important issues for consideration here.
If there is an increase in the demand, the average and marginal revenue curves will shift rightward. With the increased demand for its product, the firm will try to maximise profits by increasing its output to match its supply with the increased demand and would earn positive economic profits. Such a situation would attract new firms into industry and the AR and MR curves will be pushed back to their original levels. However, there are other factors such as entry barriers as well as cost factors that can potentially limit such optimism of higher growth and employment. Cost factors also include the demand by the workers to increase wages.
On a different note, suppose there is a downward shift in costs. Such a situation would eventually result from technological advances, increase in labour productivity, lower priced raw materials arising out of exchange rate fluctuation and so on. With the fall in costs, output that maximises profit is determined at a level when MR is equal to MC. At this level, firm will enjoy substantial economic profit as the average cost will be settled at a much lower level. Such a situation will also result in the entry of new firms to increase the industry size and output. However, this might also be curbed due to presence of entry barriers, and other factors as discussed in the demand increase case that might push the revenue down through price reduction.
In a situation where demand decreases, the AR and MR curves will shift leftward. The profit maximising firm would respond to this situation by cutting down the output and minimising the total loss. That is the best a firm can do. When the industry as a whole makes losses, many firms would leave the industry and this exodus would continue till the AR and MR curve are back to their original levels. However, under such demand constrained situation, nothing much can be done to alter the situation. This is because, input costs are less flexible at moving downwards than they are at moving upwards. So under a demand fall situation, the most significant choice before the industry is to reduce out put than doing anything else.
There are also situations when the cost increases. When costs increase, the producers try to pass it on to their consumers by increasing the price level. Costs increase through an increase in the wage bill, increase in the prices of raw materials due to scarcity, exchange rate fluctuations affecting the price of the raw materials and so on. The industry tries to cope with the situation by decreasing the level of production and reducing the output size at one hand and by increasing the prices on the other hand so that the initial rise in costs is managed by increased revenues from the price rise. When costs rise the output level that equate MR and MC shifts leftward and price upward. However, under such situation of low profits or losses, many firms in the industry would leave the sector and the exodus will continue till the Average revenue curve becomes tangent to the new higher average cost curve where normal profit can be ensured. The total industry output will be down as many firms exit and therefore,with the decline in supply, prices go up to match the increased cost conditions.
Chapter-4 deals with the macroeconomic coordination related to adjustments in funding and adjustments in output and prices. In the section on adjustments in funding the chapter deals with different relations between ADF and ASF. In the output price adjustments, the relationship between GDP, APE and ASF are discussed.
Funding adjustments: Depending on the sufficiency of the available money balances with the consumers to fund their current planned expenditure, the consumers would fall in three different categories such as those with just sufficient money balance, those with less than sufficient money balances and those with more than sufficient money balances. For those with less money balances, the best possible solution that has institutional support from banks is to borrow and those with more balances, the solution is to lend through banks. The chapter describes those with less money balances as Group-2 and those with more balances as group-3. With this background, the discussion is continued on different relations between ADF and ASF.
When ADF=ASF, the total amount of funds with members of Group-3 want to lend will be exactly equal to the total amount needed to be borrowed by Group-2. There will be no need on part of the financial intermediaries to influence the inflow or outflow through interest rate. So, interest rate will not change.
When ADF >ASF, the borrowing requirements are more than the lending capacities. The deposits with the banks will be less than the loan applications. So the financial intermediaries like banks will seek to respond to this situation by increasing the interest rate and thereby increasing the incentive to deposit in the bank and increasing the disincentive to borrow.
When ADF<ASF, the lending capacities will be more than the borrowing requirements. Under such situations, there will be enough deposits with the banks, but not too many takers of loans. This would be dealt with by lowering the interest rate and thereby increasing the incentives to borrow and increasing the disincentives to keep deposits.
So it can be drawn that notwithstanding their knowledge about the existing ADF and ASF situations, the combined action of all the individuals in an economy would result in a process that ultimately lead to equality between ADF and ASF. Or in other words, the combined effort of individuals might result in making ASF equal to either GDP or APE. So after the end of this adjustment process, one of the three situations such as (1) GDP=APE=ASF or (2) GDP<APE+ASF or (3) APE<GDP+ASF would prevail in the economy.
Output-Price Adjustments: Similar analysis can be undertaken to understand the process of output-price adjustments by classifying the firms or businesses into three categories such as (1) Group-A: Firms facing normal demand (2) Group-B: Firms facing excess demand and (3) Group-C : Firms facing insufficient demand.
Under the conditions when GDP=APE=ASF, output price adjustments will take place by group-B firms increasing the price and expanding the output and by Group-C firms reducing the product price and cutting down the output. Since GDP=APE the reduction in production by firms in Group C will be exactly sufficient to be compensated through the increase in output by Group-B and the average change in price level will have no effect on the general prices. So the situation will have no significant changes in the levels of employment, output, interest rate and prices.
Under situations of GDP<APE=ASF, the producers face a combined level of fully funded demand which is greater than the combined current output. However, the total combined excess demand faced by Group-B firms will exceed the total combined demand deficit faced by the Group-C firms. Thus, the total increase in output and prices made by group B will outweigh the total cut in prices and output by Group-C. As a result the overall prices and GDP will increase. However, the growth in GDP will be more than the original gap between GDP and APE and this will ultimately bring down the increase in prices to its original level. Thus, the adjustment process will lead to and settle at a level with more GDP, more employment, higher interest rate and no change in the price level.
Similarly, output-price adjustment processes in situations where APE<GDP=ASF will lead to a situation in which the adjustment process would bring in a shrinking in employment, output and interest rate, but no significant change in the price level.
It can be finally asserted that whenever there are gaps among APE, ASF and GDP; the macroeconomic coordination process sets in motion automatically to eliminate those gaps. All price changes that happen would be temporary in the nature of creeping inflation and the MCP response to the gaps will ultimately be in the form of output.
Macroeconomic Shocks: Excess Demand Cases
Chapter five deals with macroeconomic shocks arising out of excess demand and explains the situations through cases of (a) Demand caused Expansion, (b) Money and Credit caused Expansion, (c ) Cost induced Expansion/ deflation and (d) Supply caused inflation.
Shocks can be for good or bad, but they are necessarily external in nature which trigger the macroeconomic coordination process. The shocks as mentioned above can occur independently or they may occur in combinations. The present chapter is based on these shocks and how they impact on the equilibrium between GDP, APE or ASF.
Demand caused expansion occurs when there is an increase in the APE. The causes for this increase may originate from many sources such as domestic, foreign or change in policies. Immediately after the increase in APE, the result will be a situation where ASF<APE. This will result in an adjustment in MCP that will lead to an increase in the interest rate.
A part of the excess demand would crowd out with the increase in the interest rate. But with the remaining excess demand, there will be an incentive for the producers to increase the employment, output and prices. With this, the interest rate will continue to increase as long as GDP=APE=ASF is achieved again. However, the process will end when the prices are pushed back down to its original level. So, with the excess demand shock; employment, output, interest rate will be up at new levels but the price and this level will continue till a new shock attacks the new equilibrium.
The money and credit caused expansion takes place when there is an increase in the ASF. Any increase in ASF will lead to an increase in MV compared to price (either M or V or both increase with a less than corresponding increase in P; or MV falls less than proportionately than a fall in P), and the new disequilibrium condition is set at a level GDP=APE<ASF. Under such a situation, it becomes difficult to find borrowers without reducing the interest rate. A fall in the interest rate will result in the expansion on APE via rises in employment, output and prices leading to an increase in the interest rate again till the GDP=APE=ASF is achieved. Prices will ultimately be pushed down through entry of new firms into the business. Finally, the MCP will come to a rest at a new level with increased employment, output and a lower interest rate with price level unchanged.
Cost induces expansion occurs when there is a fall in the cost structure. Employment and output will rise while the prices will fall resulting in a shift in the GDP, APE and ASF lines to the right. This will result in a downward shift in the interest rate as well. So, a drop in production costs would result in a drop in the interest rate and prices while the employment and output will be on the increase.
Disasters caused by war and natural calamities severely affect the production capacities and depress the country's output and put pressure on prices. As the GDP falls, it will lead to a situation where GDP<APE<ASF. In this situation, the lenders will face a shortage of borrowers and the interest rate will also fall leading to an expansion of APE and once again we are in a situation where GDP<APE=ASF. As discusser earlier, such a disequilibrium will be continued in the MCP until the levels of APE and ASF are brought down to the lower level of GDP. However this new equlibrium will also be temporary as the GDP will be able to regain its earlier level once the impact of the disaster subsides. The the MCP will reverse itself and all the indicators such as employment, output, interest rates and prices return to their original levels.
The first three cases such as excess demand, money-credit expansion and cost expansion creates growth in the economy where as the supply caused inflation makes the economy struggle to retain its position. So, it is not necessary that inflation is always growth inducing. If the inflation is because of the fact that too many dollars are chasing too few goods, then it is of temporary nature. If the inflation is caused due to a push in the costs then it sustains itself. In this chapter we discussed an increase in APE and ASF. The subsequent chapter will discuss the decline in APE, ASF and GDP.
Macroeconomic Shocks: Insufficient Demand Cases
Shocks might result in creating insufficient demands in the economy. In chapter six we shall discuss some of these cases in the form of demand caused recession, money and credit caused recession, cost push inflation ans the problems in growth.
Demand caused recession is a case followed by a fall in the aggregate demand or APE, due to several reasons such as an increase in tax, reduced government consumption, decline in exports or an apprehension about future market failure. APE line shifts to left. ASF remains equal to GDP but APE <GDP. Such a situation will be critical as the producers will not respond immediately and shall wait whether the demand will revert back or not. If the demand does not come up, the output price adjustment will happen with lower employment, output, interest rate and prices as long as GDP=APE=ASF is achieved and price rises back to eliminate losses to the producers.
If on the other hand, ASF declines involving a fall of MV relative to prices. MV will decline if lenders reduce their outstanding volume of loans in response to a tight monetary policy or due to a heavy cash outflow from the country resulting in a decline in V. This is a situation where GDP=APE>ASF and the economy lacks sufficient funding to support APE and GDP. The increased demand for funds will put pressure on the interest rate and subsequently some demand will crowd out in response to an increase in the interest rate. APE will decline along with an increase in ASF as well as interest rate as long as APE=ASF is achieved. But this will lead to the new situation where GDP>APE=ASF. This would require a further increase in interest rate and ASF will continue to rise compared to APE. The resulting situation will be APE<GDP=ASF as discussed in the precious situation of demand caused recession and settled accordingly as discussed above. In this situation, employment and output will decline, interest rate will increase and prices will remain unchanged in the final settling down of the MCP.
Cost push inflation occurs when producers try to pass on the increased cost to the customers through the vehicle of prices. In those segments of the economy where costs increase, prices will increase while output and employment will fall. This will shift the ASF towards left (due to rise in prices) and the GDP and APE lines will shift to the left (due to a fall in output and employment). With this, due to an exodus of the firms from the industry, the level of zero profit will be maintained and the trend of shift of the GDP, APE and ASF will halt. The final result is the same as discussed in the earlier case of money credit caused recession, but with a significant difference as in this case, the prices will be up unlike the previous case. In this strange situation, output and employment will fall, interest rate and prices will rise. This is called the condition of stagflation or inflationary recession or stagnation plus inflation.
Growth problem occurs when the increase in GDP is not accompanied by a corresponding increase in APE and a corresponding finding problem. When GDP rises it increased a demand for funding but it does not automatically generate more funding. So, ADF increases but not the ASF. However, the higher level of GDP can not be sustained without an increase in the ASF. In a situation where ASF<APE<GDP, consumers will demand more funding and succeed through an increase in the interest rate resulting in a crowding out of demand but an increase in ASF and a decline in APE. This will continue till GDP >APE=ASF. The efforts to get more funding will result in a rise in the interest rate and the ASF will increase pushing down the APE further leading to a situation where APE<GDP=ASF. This is a situation of insufficient demand. The produces will now try to cut down prices and output to match insufficient demand. So, this will again lead to a situation where GDP and APE will fall further along with a rise in ASF.
The author argues that in order to maintain the increased GDP, a monetary intervention is necessary. If the ASF can be raised to accommodate the increased GDP in the first place, then the GDP can be sustained. Otherwise, any other form of effort would lead to a situation where the level of employment, output and interest rates will be below their original levels following an initial growth in GDP and the price level will remain unchanged.
Classical analysis and Policy
The Chapter seven deals with classical macroeconomics as it was analysed and practised before the Great Depression in 1930s.
The predominant practice of gold standard during early 1990s left little scope of adjustments of money supply with the changes in interest rates. Classical economists assumed that both M and V were not linked with interest rate. So the ASF line was vertical. There was no IS line as APE was not linked with GDY. The GDP and ASF line coincided with each other as a vertical line crossed by a negatively sloped APE line. If there was a shock due to excess demand, then APE would shift to right without any corresponding increase in the ASF line as M and V were non responsive to interest rates, the continuous increase in interest rate due to shift of APE would subside after all the excess demands crowded out. So, a rise in APE caused only higher interest without affecting prices, output or employment; and vice versa.
Similarly, an increase in ASF creates excess funding and depresses the interest rate. This will create a new demand to exceed the GDP and subsequent rise in prices. With the increase in prices, the ASF would revert back to its original level. Therefore, a rise in ASF can only increase the price and no effect is seen in terms of employment and output. Although the interest rate drops initially, it returns to its original level. Similarly, a drop in ASF will depress the prices without impacting employment and output and interest rate in its final equilibrium although the interest rate would increase temporarily.
Similar cases are experienced when there are drops or expansions in GDP. When GDP drops, prices would rise until the ASF is brought down to the level of GDP. In caseof a rise in GDP, prices are cut down to boost ASF level and interest rate would fall till the level of APE is pulled down to the level of GDP.
In all cases of shocks as describes in earlier chapters, adjustments in the interest rates would keep the APE level equal to ASF and price adjustments would keep the ASF level equal to GDP. GDP will be maintained at a full employment level.
There also is another argument in the analysis of classical macroeconomics that deals with MCP and business cycles during those days. That is the eventuality of the process of adjustment over a long period of time.
If APE or ASF falls it would take time for interest rate and price to sufficiently fall to restore APE and ASF back at their original level. In the mean time, in the absence of any other mechanisms, businesses would cut production temporarily which might lead to temporary recessions. Similarly, if APE and ASF rises, it will come down to their original level through action of MCP over time by a sufficient increase in price as well as prices. In the mean time, the increase in demand would be reacted by the businesses through an increase in the output and employment temporarily.
The Great Depression that started in 1929 and lasted for a decade, necessitated an update in the classical understanding of macroeconomics. The ASF line was made with a positive slope as M and V were made responsive to the interest rates. However, there still were problems in classical understanding as far as the level of APE was concerned. The classical economists believed that the changes in price would bring back the full employment level of GDP at which APE=ASF could be restored. There were two genuine problems to prevent such a situation. Firstly, the possibility of APE becoming inconsistent with full employment output. Whatever change could happen was believed through the business sector which was relatively small compared to the overall GDY. Secondly, the ability of the business sector alone to influence prices was also under question mark. If the price cut is more than the cut in costs then there was high possibility of the businesses getting into losses as the profit margins are very small given the increasing competition. Cost cutting is not possible beyond a limit for significant limitations on the part of the firms because of the long term contracts in the supply chain of raw materials and labour as well as limitations in changing the input mix or technology as that might involve a huge risk of sunk cost.
Chapter eight deals with the issues related to the monetary policy. The history of systematic monetary policy dates back to 1907 with the formation of the National Monetary Commission that was entrusted with the responsibility of looking at the issues relating to stabilisation and control of the nation's money and banking system. The monetary policy involves the judicious use of instruments like open market operations, reserve requirements and discount rate adjustments in a manner that may exert desired influence on the levels of interest rate, prices employment and output.
Monetary policy involved three major steps such as (a) use of any of the three major instruments of monetary policy as mentioned above either in isolated manner or in combinations; (b) Changing the M for altering the magnitude of ASF and (c ) affecting the employment, output, interest and prices through changing of ASF in the Macroeconomic coordination process. In the chapter, the focus is on the first step only. The chapter begins the analysis by presenting the money supply formula that involves money supply (M), the total reserves of the banks (R ), the money base (B), the cash to checking account deposit ratio (d) and time deposit to checking account deposit ratio (t). The formula for money supply is,
M=[(d+1)/(d+r*+r**t+W)] B or M=mB
Where, r* is the reserve requirement per dollar of checking account deposits (CA).
.r** is the reserve requirement per dollar of time deposits (TD), t is the public's desired time deposit to checking account deposit ratio (TD/CA), w is the bank's desired amount of working reserves per dollar of checking account balances.
Where the whole term [(d+1)/(d+r*+r**t+W)] is known as the money multiplier, in which the general public controls only two variables such as d and t. Banks can influence t by adjusting the rate of interest they pay on time deposits. The estimates presented by the author on the current great recession (2010) the magnitude of w increased manifold by 46,000 % to reduce the money multiplier to half of its previous level. Banks also control d as well as w. The monetary authority directly controls the money base B (throughopen market operations), r* and r** (through reserve requirements) and indirectly controls w (through discount rate policy).
At the policy level, the effort of the monetary authorities are to control the money supply and ASF either by easing or by tightening them. By easing policy, we mean efforts to induce money supply or ASF. Easing monetary policy would initiate the MCP by shifting the ASF curve to the right. Tight monetary policy is undertaken when there is a need to restrict the money supply. Easing policy is adopted conveniently when the ASF line has already shifted to the left because of an autonomous decline in MV. When there is an expansion of GDP in comparison to APE or ASF, then also easing monetary policy is adopted along with some stimulus fiscal policy. Easing counteracts the impact of an autonomous drop in the APE. By increasing the ASF and letting the interest rate down, an interest sensitive demand for business investment can be generated. However, problems arise when interest rates are not high enough at the initiation of the policy and /or if the demand for investment is not responsive to changes in the interest rate, any further decline in interest rate could lead the economy into a liquidity trap and makes the monetary policy ineffective. The effectiveness of monetary policy depends significantly on the aggressiveness of the banks to respond to the increase in their excess reserves. If banks are able and interested to convert a part of the excess reserve into a working reserve, then the effectiveness of the policy is reduced. Secondly if the aggregate demand (APE) is not strong enough in reacting to an increased supply of funding, then the policy is not very effective. On the other hand, tight monetary policy is a dangerous tool from the policy perspective, unless it is meant for abating a sustained inflation caused from a series of shocks of money and credit origin. However,it has serious negative effects for the economy. A tight monetary policy can potentially worsen the recession situation by shifting the ASF curve further to the left.
Chapter nine deals with various tenets of a fiscal policy. The major issues covered in this chapter are automatic stabilisation, discretionary fiscal policy, expansionary and restrictive fiscal policy and their uses.
In an economy, GDP=APE is achieved only when combined budget surplus of households, businesses, government and the foreign trade sector are equal to zero. There can be situations when the combined budget surpluses are positive or negative.
If the sum of sector surpluses are positive then APE will be less than the GDP and a part of the GDP will remain as unused. This will lead the economy into a recession. If the sum of sector surpluses are negative then APE will be greater than the GDP meaning the current GDP is less to satisfy the demand of the buyers. This would result in inflation. It is therefore necessary that the four sector surpluses must add to zero in order to avoid inflation or recession. If all the sectors can be monitored and a corresponding fiscal policy of whether deficit or surplus can be initiated, then it is called a counter cyclical fiscal policy in the Keynesian tradition. Any policy that is meant towards equalisation of APE and GDP by utilising tools of government like tax, expenditure, and borrowing are called the fiscal policy, that generally takes two forms (a) automatic stabilisation and (b) discretionary fiscal policy.
Automatic stabilisers are meant to reduce the responsiveness of GDP and APE to the changes in the MCP. Discretionary fiscal policy on the other hand is a deliberate attempt to influence the APE to achieve the desired goals of influencing interest rates, prices, employment and output. Automatic stabilisers are attempted through welfare and unemployment compensation programmes that operate through a reservoir principle. Reservoir principle means an effort to cut away some current consumption out of increased income and channelise the funds into a reservoir that can be used in a situation when incomes are be falling. Many other mechanisms like progressive taxation, pension, disability benefits and other social security measures are examples of automatic stabilisation fiscal policy instruments.
The other three Chapters can be downloaded from;
Chapter 10: Policy Issues
Chapter 11: International Issues
Chapter 12: Development Issues