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Price index

In the long-run, the potential GDP is equal to the actual GDP. Here aggregate supply is vertical which intersects with the aggregate demand. Aggregate supply is the total volume of goods and services produced within an economy at a general given price (Defining Aggregate Supply, http://www. tutor2u. net/economics/content/topics/ad_as/aggregate_supply. htm). Prices of goods and services are indexed into what economists call “price index. ” This is the determinant of the aggregate supply schedule. Outward shift of the demand curve indicates an increase of spending among the three components of the expenditure equation: Y = C + I + G.

C stands for consumption, I for investment, and G for government spending (The Market System, http://www. bized. co. uk/learn/economics/markets/mechanism/interactive/part1. htm). This equation can be expanded to Y = C(Y-T) + I(r) + G (T). Consumption is the difference between the income and the taxes deducted. Hence it is equal to disposable income. Investment is determined by interest rate (r) – nominal interest rate (inflation rate adjusted). Lower interest rates will induce firms to invest more. Higher interest rates will do otherwise. Public spending (G) is the expenditure of the government derived from revenues and taxes.

Induced expenditure is the amount of goods and services bought by consumers in a given period. It is tantamount to the GDP minus government spending and investment. Increasing the C, I, and G components will naturally increase the country’s income, measure by GDP (expenditure approach). Suppose we let I and G constant, and lower or higher the consumption component of the equation. Since C is the disposable income, we have a consumption coefficient and a savings coefficient. For example if the income is 100 000, the consumption coefficient is 0. 70, and the savings coefficient is 0.

30, we expect an expenditure of 70, 000 and a savings of 30, 000. If the consumption coefficient increases to . 80 and the savings coefficient to decrease to 0. 20, we expect an expenditure of 80, 000 and a savings of 20, 000. In effect, the economy increased its income (Y) or the GDP (via expenditure approach). Increases in savings therefore coupled with low interest rates will induce consumers to spend less (since induced expenditure is the amount of goods and services bought by consumers – excluding the government- in a given period), and more importantly for firms to less invest.

This will naturally shift the equilibrium GDP to the left, as firms cut labor and production costs. Thus, an increase in S will naturally decrease level of I and henceforth the economy’s GDP Q. Since GDP is tantamount to the overall expenditure in the economy, then Y also decreases. Added to that, the overall unemployment rate tends to increase as wage proves to be inflexible in the short-run. Actual expenditure is the amount of goods and services that are actually bought in a given economy.

Planned expenditure is the volume of goods and services that the economy produced to accommodate the aggregate demand schedule of the consumers. A 45-degree curve is used as a tool for determining the level of goods and services when the actual expenditure is equal, more than, or less than the planned expenditure (Keynes, 1936). This curve is derived from the savings and investment functions, and hence indicates the increase or decrease of an economy’s output. When the actual expenditure is greater than the planned expenditure, we expect a fall of inventories.

When the actual expenditure is below the level of planned expenditure, we expect an increase in the inventories of firms. Here the level of savings increased; hence we expect a decrease in investment, and therefore an increase in the firm’s inventories. In the 45-degree graph, savings is derived from the overall expenditure of the economy. The initial point of the actual expenditure on the Y-axis is the expenditure when income is zero. As you can see in diagram 1 (appendix), the amount of expenditure tends to increase when income increases. Savings is constant since the marginal to save is constant.

When the MPS increases, we can expect a decrease in the MPC, leading to an overall decrease in consumption. When savings increase, we can expect a general decrease in the output of the economy (see diagram 2 in appendix). Since output is generally GDP and that GDP is at its point of potentiality, it will drive the economy to a downward stage. Decrease in quantity is a manifestation that the economy produces more than what consumers want. Planned expenditure is above the actual expenditure (see diagram 3 in the appendix). 2) Answers to Question 2

The United States is treated in the world of trade and economics as an economic power, a source of investment and technology. On the fiscal side, a relative decrease in the propensity of the firms in the United States to invest in other countries will cause a relative decrease of the GDP of both the United States and the countries which its firms invested. Again, the effects of an induced decrease in aggregate demand will shift the equilibrium points of the economies involved to the left, causing widespread unemployment. Lower interest rates will stimulate firms to increase their investment schedule.

Higher interest rates will do otherwise. Although there may be a sufficient amount of potential capital from an increase of savings in the economy, which would not necessarily be translated to capital. Lower interest rates will have to be provided. To increase the country’s GDP the government will increase the money circulating in the economy. This will induce consumers to increase their spending. The firms will react, and increase the supply available. The market however adjusts the prices of goods and services in the economy, driving the inflation rate upward.

Thus an increase in the volume of money circulating in the country will cause the inflation rate to increase (see Diagram 4). In the case of the United States, since it provides a sufficient amount of capital and investment to countries (which usually belong to the Third World), it controls the amount of investment floating in the “benefactor” country. When the capital is withhold from the fiscal side, the economies of the countries involved suffer from high interest rates and lower GDP, causing widespread unemployment.

This was the situation of the United States and Western Europe during the time of the Great Depression. The unregulated increase of the United States GDP was met by a very low actual expenditure. This caused the inventories of firms to bloat, driving the firms to cut costs. Instead of cutting the wages of laborers, it was more practical to cut labor. However, the situation of the United States and Western Europe at that time was not only caused by fiscal mismanagement (wrong assumption of the classical economists – Keynes differentiated actual expenditure from planned expenditure to explain the Great Depression).

Monetary economists also argued that the Great Depression was caused by unexpected increase of volume of money circulating in the economies of the United States and Western Europe, driving interest rates to go up. Investment climate became a gloom atmosphere of economic policies of most nations. Nevertheless, because the United States at that time provides countries with long-term loans and investment, the actual value of the stocks was reduced to almost 1000 % of its value.

In the same way, monetary economists argued that since the Federal Reserve Board of the United States controls the world standard interest rate (since the United States is the primary source of investment), all other economies adjust their interest rates based from the interest rate dictated by the Federal Reserve Board. Australia for example, owes 11% of its current GDP output from American companies. If American companies reduced their production schedule to half, due to some economic disruptions in the United States, we can expect a general reduction of Australia’s GDP.

The same is true on the fiscal side, unintended reduction of output will cause a general labor cut, and hence an increase in the unemployment rate of, say, Australia. When some American companies abandoned their investment in Australia some time in the recession of 1983, the Australian government was forced to increase spending. The government wanted to maintain the level of output of the economy. As we had said, increased government spending will increase GDP (Y in terms of expenditure). But the side effect of the policy was felt in the money sector of the economy.

As the government increased spending, they were forced to increase the circulation of money in the economy to induced consumers to increase their spending. The net effects: inflation rate began to increase and interest rates skyrocket. Firms who wanted to invest in Australia did not like the rising interest rates in the country. Hence, the policy was of no avail. The cause of the recession was the recession in the US in 1983. The US government was forced to increase the volume of money circulating in the economy. Interest rates increased, and general output decreased (recession – 3 consecutive periods of low economic output).