Correcting an Economic That is in Recessionary Gap - Assignment Example

Running head: MACROECONOMICS Correcting an Economic that is in Recessionary Gap Name Course Information Professor Information Date Due The aggregate demand/ aggregate supply model In a study by Lloyd (2006), Federal Reserve or any other Central Bank in the world has mandate to influence level of economic activity by manipulating interest rate and money supply. By changing the level of interest rate and money supply, aggregate demand for goods and services in an economy is affected. Apart from actions taken by the Federal Reserve, there are additional factors that determine aggregate demand. The basic model of aggregate demand and aggregate supply is illustrated in figure 1 below. Figure 1: Aggregate demand and aggregate supply model Aggregate demand curve, marked as AD, gives the quantity of goods and services demanded by households and firms at varied price levels. Conversely, aggregate supply curve, AS, demonstrates goods and services supplied by firms at varied prices. In figure 1, price and output are plotted on vertical and horizontal axis respectively. The intersection of aggregate demand and supply curve yields equilibrium price and real output. Any shift in AD or AS curve would result in a different equilibrium price and output. An example is a rightward shift in AD curve, which leads to a rise in price as well as real output. Similarly, a rightward shift in supply curve causes equilibrium output to rise accompanied by a reduction in equilibrium price as illustrated in figure 1 above. According to Lloyd (2006, p. 453), aggregate demand curve slopes downwards because of the effect of price on components of aggregate demand. The components of aggregate demand comprise are visible in aggregate expenditure function given by for an open economy. It is important to note that consumption demand, investment demand and net exports have contrariwise relationship with price. To prove this fact, a low price level increase real money supply. Consequently, real interest rate declines resulting in consumption and investment demand. In the case of aggregate supply, the curve is upward sloping since higher price stimulates suppliers to produce more goods and services. Rates of wage and cost of equipment and raw materials tend be fixed in the short-run but vary over a longer period. Adjustment process from below full employment equilibrium When the economy is operating below full employment, it implies that some resources are not being placed under productive use (Lipsey & Chrystal, 2011). It further infers that plants are not being fully utilized, willing workers are not employed, and that raw materials are not being fully utilized for production. Under this condition, the distressed and willing workers are forced to take up jobs for lower pay. At the same time, cost of manufacturing would decline because of excess availability of raw materials and capacity. The reduction in wages and cost of manufacturing is a motivation to supply more goods in the market. However, the producers are forced to sell at a lower price in order to clear the expanded production. In response to the declining prices, households and business demand for more goods and services. This process will stop at full employment where there are no excess resources and no motivation for wages and prices to fall. Figure 2 is an illustration of an economy that is operating below full employment i.e. where short-run equilibrium output is below potentials of the economy. Figure 2: Below full employment equilibrium The graph is an image of deflationary gap where demand in an economy is not sufficient to take up output of an economy at full employment. This is also termed as an output or recessionary gap. In order to correct this situation, the government can employ discretionary fiscal policy. Discretionary fiscal policy The policy is a revenue expenditure policy intended to influence purchasing power in an economy. Jain and Ohri (2006) held that operation of fiscal policy requires the increment of public expenditure through programs such as public health, education, and defence. The government can also raise private expenditure by lowering the rates of taxation or introducing transfer payments. When government spending is increased, aggregate demand shifts rightward consequently bridging recessionary gap (McEachern, 2011). Expansionary monetary policy The government can opt to stimulate demand in an economy through credit creation or encourage supply of money. This is a form of monetary policy where monetary authority adjusts interest rate eventually affecting the supply of money. Tools such as open market operations, the discount rate, and reserve requirements are used to adjust supply of money. In a research by Tragakes (2011), change in interest rate caused by changes in money supply affects two components of aggregate demand namely investment and consumption. It is important to note that part of consumer spending is paid through borrowing thus change in interest rate will affect level of consumption spending. In the same manner, investors borrow money for their investment needs. The relationship between money supply and interest rate is explained by figure 3. Figure 3: interest rate and money supply. The money market is such that demand for money is inversely related to interest rate. When interest rate moves down due to an incremental money supply, a lower equilibrium is attained at point in figure 3. Low interest rate motivates to investors to borrow for investment. When investment rises, output level as well as employment will increase. Rising demand, however, is accompanied by inflationary pressure. In order to determine the variable that the government will influence strongly, it is necessary to look at position held by Keynes. Keynes maintained a view that recessionary gap was most likely to be caused by inadequate spending. Concisely, recession occurred due to a leftward shift in aggregate demand curve caused by pessimism about the future. To move from pessimism to optimism, Keynes proposed a boost in spending without raising tax rates. Similarly, the government could cut taxes without affecting spending (Arnold, 2010). The impact would be an increase in aggregate spending and real GDP. From this study, it can be concluded that consumption and investment are variables that will influence strongly a government’s action to reduce recessionary gap. References Arnold, R. A. (2010). Macroeconomics. Mason, OH: Cengage Learning Jain, T. R., & Ohri, V. K. (2006). Introductory Microeconomics and Macroeconomics. New Delhi: V.K Publications. Lipsey, R., & Chrystal, A. (2011). Economics. Oxford: Oxford University Press. Lloyd, T. (2006). Money, Banking and Financial Markets. Mason, OH: Cengage Learning. McEachern, W. A. (2011). ECON Macro 3. Mason, OH: Cengage Learning. Tragakes, E. (2011). Economics for the IB Diploma with CD-ROM. Cambridge: Cambridge University Press. Read More