Keynesians argue that supply is determined by the level of aggregate demand. The higher the price, the lower is the purchasing power, therefore the quantity of goods and services that can be acquired with a certain income falls. As soon as the aggregate demand decreases the aggregate supply must also decrease.
The Monetarists follow Say's Law which argues that the government should stimulate production rather than consumption and that aggregate supply is determined by supply-side factors.
The theory of the multiplier process developed to be an important tool when Keynes proposed it to help governments in order to achieve full employment. This demand management approach was designed to overcome the shortage of capital investment in business, measure government spending that was needed in order to realise a National Income level that could avoid unemployment.
In the diagram below we see the effects on an inward shift in aggregate demand in the economy.
The result of the inward shift of AD is a contraction along the short run aggregate supply curve and a fall in the real level of national output. This causes downward pressure on the general price level.
If aggregate demand shifts we expect to see both a rise in the price level and higher National Output.
Q1C
Business cycles are alternating periods of economic growth and contraction.
Economies and business cycles are where various changes in economic and business activity in period of time. The activity of an economy is measured by Real Income Gross Domestic Product (GDP).
These cycles quite often occur when spending within an economy varies from the economy’s ability to produce services and goods. A longer lasting era of spending growth that exceeds output growth will develop to constricted factor markets. A period of recession may occur in the economy because the rate of spending can’t continue.
The cycle of the thriving economic market is known as the multiplier effect. It will occur when business employment increases, thus generating more service jobs. A higher populace formed will in turn require filling of the support services. When market becomes saturated with services and goods or when the market will decline this cycle can.
According to J. M. Keynes ‘A trade cycle is composed of periods of good trade characterised by rising prices & low unemployment percentages with periods of bad trade characterised by falling prices & high unemployment rate.’
Business cycles are recurring but irregular fluctuations in economic activity and occur one after another, the time span of the period & phases may vary
The Economics cycles phases are:
- Expansion - Prosperity, upswing or boom.
- Peak - Upper Turning Point, where economic activity starts to slow down.
- Contraction - Depression, downswing or Recession.
- Trough -Lower Turning Point, where economic activities start to rise.
Features of Economic cycles:
- Economic cycles are in nature irregular.
- Fluctuations can occur in a number of variables simultaneously apart from production.
- Investment & Consumption of durable goods are more affected.
- Investment & Consumption of non-durable goods are less affected.
- Immediate effect on the level of inventory stock.
- Profits fluctuate more than any other incomes.
Booms/recessions can be generated by rise/fall in government expenditure, fiscal policy.
Similarly, a wave of optimism/pessimism can cause consumers to spend more/less than usual.
Similarly, businesses may invest more (build up new capacities)/disinvest.
Fiscal Policy Governments can choose to use fiscal policy in times of recession or a general downturn in economic activity, the government use Fiscal Policy to get out of Recession and to look to give a the economy a boost.
This can be helped by decreasing taxes and increasing the level of government expenditure.
This will look to encourage more spending. If indirect taxes are lower, then this will decrease the taxed goods price and therefore encourage more demand. If direct taxes are lowered then this will increase disposable income and hopefully encourage more spending. With either process this should look to encourage demand in the economy and economic growth.
Fiscal policies could therefore include:
- Cutting the lower, basic or higher rates of tax
- Increasing the level of personal allowances (Wages)
- Increasing the level of government expenditure
Another possible cause of recessions and booms is monetary policy. A firm faced with high interest rates may decide to postpone building a new factory. Households may be lured by cheap housing loans, and construction activities may boom.
The Government can use the monetary policy for the aim to control the actions of the central bank, the currency board or any other regulatory committee, that can determine the rate of growth and size of the money supply, which can affect interest rates. The monetary policy is sustained by actions like increasing interest rates, or changing the amount of money banks need to keep in the reserve.
Classical
- Growth Theory
- Monetary Theory
- The Bullionist Controversy
- The General Glut Controversy
- The Business Cycle Theory
Neoclassical
- The Neoclassical Marco-model
- Monetarism
- Rational Expectations
- Neoclassical Growth Theory
- Capital and Investment Theory
Keynesian
- On Keynes’s General Theory
- The Neo-Keynesian world
- Keynesian Business Cycle Theory
- Keynesian Growth Theory
- Disequilibrium Keynesian
Ceilings and Floors
The theory is often combined with the idea that there are natural upper and lower limits to levels of production and income.
Inventory Cycle Theory
Inventories refer to stocks of unsold goods or material inputs to make those goods. This theory is similar to the multiplier–accelerator model except that it focuses on investment in these inventories.
Random Events and Lags
The inventory cycle theory rests on the existence of time lags in economic decision making.
Policy Induced Cycles
Attempts by government to operate a counter-cyclical stabilisation policy may misfire and generate a cycle which is more volatile than the normal business cycle. Again this is because of lags in decision making.
Exogenously Determined Cycles
Cycles in the domestic economic activity of a country may be generated by policy changes or by changes in economic behaviour elsewhere in the world economy.
Q2A
Money creation by a government can be created through the banking system or by printing more money, by printing more money it is spent within the economy then the real value of money that is in the economy will fall. This is known as inflation. When governments print money to fund a war, then hyper-inflation can occur.
In the current period a unit of money will be worth considerably less in the future by creating money by this method for an economy it is not seen to be a good way.
Quantitative easing monetary policy is unconventional but used by central banks in order to stimulate the economy once conventional monetary policy becomes ineffective. This is where a central bank will buy monetary assets to introduce a pre-determined amount of money into an economy.
The standard policy of selling or buying government bonds in order to maintain interest rates within a target level. A central bank will implement quantitative easing by obtaining financial assets from private sector businesses and banks with newly created money.
This will increase the excess bank reserves, while also raising the price of financial assets bought, which will lower the yield.
Quantitative easing can assist and ensure that inflation doesn’t fall below the target levels. The risks include any policy becoming more effective than it was intended in acting against deflation – leading to higher inflation, or of not being effective enough – if banks do not lend out the additional reserves.
Another way to create money in an economy is by use of the banking system, where the banking system has to maintain reserves. When a loan is made by a bank, money is created. That money is generated since the bank had put the takings (of the loan) into an account for the loanee. This therefore increases the bank’s balance sheet as well as increasing the money supply.
As the lending bank has to maintain a necessary reserve, then the full amount doesn’t enter into the money supply.
The growth in money supply isn’t limited to a lending bank. As the reserve amount is left out and the ratio is controlled. The money the borrower then spends increases the accounts of sellers of services and goods that were purchased by the loanee with the loan takings. The effect of the original loan is compounded by this process. The real amount of produced money is mutual to the essential reserve rate (M=1/r, r = the reserve rate). As long as reserve requirements are met then banks are able to continue to create money.
Q2B
The money supply and inflation relate with each other. The money supply can be defined as notes and coins circulating outside the central bank. As money supply circulating around the economy increases inflation and balance of payments in turn also increases, however, this has very little effect on employment. Inflation in economics terms is used to describe a decline in the value of money with what it will buy in relation to & services and goods. It is normally measured by the Retail Price Index known as the RPI.
It is the persistent and continued rise in the level of prices that is measured by indexes of cost of services and goods. Repetitive increases in price erode purchasing power of money and fixed value financial assets, producing severe economic alterations and insecurity. When real economic pressures and future development anticipation for the basis of demand for services and goods, is to surpass the available supply at current prices or where available output is constrained by wavering production and market constraints. Continuous price rises were traditionally linked to political upheavals, poor harvests, wars, or further unique events.
Causes
When aggregate demand surpasses existing supplies then demand-pull inflation occurs, driving price increases, increasing materials, wages, and financing and operating costs. When prices increase to cover expenses and maintain profit margins then cost-push inflation occurs. A persistent cost price spiral will develop eventually as institutions and groups react to every increase.
Economists have proposed three functional theories to explain why supply and demand elements change: aggregate level of incomes; available quantity of money; and supply side production and cost variables. Supporters of monetarism have belief that price levels changes reflect shifting money volumes available. They claim that, to create steady prices the increase of money supply, should be at a steady rate equal with an economy's actual output capability. This theories critics claim that changes in the money supply are responses, rather than causes of, price level adjustments.
The aggregate level of income theory is based on Keynesianism. This approach believes changes within the national income govern consumption and investment rates thus the government’s taxation policies and fiscal spending ought to be used to preserve full employment and outputs levels. The money supply should be change to finance economic growth at a desired level whilst avoiding a financial crisis as higher interest rates will discourage investment and consumption. Government tax and spending policies may be used to offset inflation by adjusting supply and demand according to this theory.
The supply-side elements theory is related to the significant productivity erosion. The elements include changes in the composition and age of the labour force, the long term pace of capital investment and technological development, the move away from business activities, the hurried creation of government guidelines. These supply-side issues may be important in developing monetary and fiscal policies.
Effects
Wealth redistribution: the income is redistributed to those with negotiating power to achieve more rent, profit increase or pay, those with assets from those with less power, fixed incomes and people paying rates of interest below the rate of inflation.
Economic growth: higher levels of inflation can create uncertainty within the business sector as it becomes more difficult for organisations to predict revenue and costs, by having a high or fluctuating level of inflation cause organisations to become discouraged and the lack of investments which leads to a downturn in economic growth. Monetary policies may have a negative effect upon economic growth whilst trying to curb inflation.
Balance of payment: levels of inflation can affect exported goods prices, by becoming less competitive and with imported goods becoming cheaper. This will put the balance of trade in deficit with exports falling and imports rising, effects such as higher interest rates and fall in exchange rate will be noticed.
Q3
With regard to whether it is cheaper to produce goods domestically to avoid costs of transportation and costs to the environment then we must look at the advantages and disadvantages if International trade.
There are various theories behind international trade, these are:
Mercantilist Theory
- Theory developed - 1500 to 1800 AD
- Country’s wealth measured in terms of gold holdings
- Encouraged exports and discouraged imports
- Imports were taxed and thus restricted
- Exports were encouraged to gain maximum gold
- During colonial rule, colony masters imported raw material from colonies and exported finished goods
- The theory ignores the fact that imports are necessary at times
- If the imports are restricted too much, the country’s population has to do without some of the commodities
Theory of Absolute Advantage.
- Put forward by Adam Smith
- Believes that every country has an absolute advantage in supplying certain products
- Hence, the country must specialise in export of those products only
- It should import goods from countries, which have an absolute advantage in exporting the products, and hence get them at a cheaper rate
- E.g. Japan has an advantage in production of high quality steel while India has huge reserves of iron and coal mines. This advantage can be used to complement each other
- In practicality, it is not possible for only one country to have absolute advantage in terms of cost or otherwise for a particular product
Theory of Country Size
- It says that the size of the country decides how much and what type of products to trade in
- Larger countries have varied climates and natural resources
- It makes them self-sufficient, due to which they import and export less
- In these countries, transportation is costlier to larger expanse of land, compared to smaller countries
- Since transport cost is less in smaller countries (due to less distance in production units and end markets), they have an advantage in international trade
Theory of Comparative Advantage
- Improved version of absolute advantage theory, by David Ricardo
- In case a country has an absolute advantage or absolute disadvantage in production of all the goods it consumes, it cannot export or import each product
- Hence, it needs to trade in goods in which it has a comparative advantage
- It involves redirecting the resources to more efficient uses
- When two countries need to consume a product, the country which produces it in lowest cost/using least resources will have a comparative advantage over the other country
Factors Proportion Theory
- It says that factors of production that are in abundance are cheaper than those in relative scarcity
- In capital abundant countries, cost of capital is low, while in labour abundant countries, manpower is available at a low cost
- Hence, a country can trade in factors which are found in abundance
- India exports software professionals to US of A due to cheap labour availability
- Australia and Canada have abundance land and hence concentrate on agriculture
Product Life Cycle Theory
- Introduction
- Growth
- Maturity
- Decline
Advantages
- Faster growth: Economies that have operate internationally tend to develop at a much quicker pace than those operating locally
- Access to cheaper inputs: Operating internationally may enable the firm to source raw materials or labour at lower prices
- Increased quality and efficiency: Exposure to foreign competition will encourage increased efficiency. Doing business in the international market allows improvement to the quality of their product in order to gain a competitive advantage.
- New market opportunities: International business presents new market opportunities. These new markets provide more opportunities for expansion, growth, and income. A bigger market means more customers, increased revenue, a larger profit margin, and allows the business to realize economies of scale.
- Diversification: As the economy diversifies its market, it becomes less vulnerable to changes in local demand.
Disadvantages
- Increased costs: There are increased operating expenses including the establishment of facilities abroad, the hiring of additional staff, traveling of personnel, specialised transport networks, information and communication technology.
- Foreign regulations and standards: The firm may need to conform to new standards. This may require changes such as in the production process, inputs and packaging, incurring additional costs.
- Delays in payments: International trade may cause delays in payments, adversely affecting the firm's cash flow.
- Complex organisational structure: International business usually requires changes to an operating structure. Training/retraining of management may be necessary to facilitate restructuring.
- Countries cannot live in isolation. They have to mutually share their prosperity, technical know-how and undertake trade in order to sell their surplus products. The world economy is inter-dependent. Economic progress of a nation would depend upon its ties with other countries.
Bibliography
CEM (2002) ‘The level of economic activity’, Paper 0492. Reading; The College of Estate Management.
CEM (2009) ‘Growth and Cycles’, Paper 0493. Reading; The College of Estate Management.
CEM (2009) ‘Inflation and property, Paper 0498. Reading; The College of Estate Management.
CEM (2010) ‘Measuring the economy’, Paper 3408. Reading; The College of Estate Management.
www.businessballs.com (Last accessed 4 June 2012).
http://www.econguru.com/ (Last accessed 4 Jun 2012).
http://www.investopedia.com/ (Last accessed 4 June 2012).
http://tutor2u.net/economics (Last accessed 4 June 2012).
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