In a democratic country based on a consumer economy it is uncertain what role the government should play in setting financial ground rules. However, in the light of recession macroeconomists often take a extra look at the patterns, policies and practices which have led the country into hard times in the past.
Chapter 10 deals primarily with three principles which can lead to recession. These principles include a decrease in the demand for aggregate (Aggregate Demand for Funding or ADF), a decrease in ASF (Aggregate Supply for Funding or ASF) and an increase in Gross Domestic Product or GDP. These principles are illustrated in four case studies which follow how they impact the economy as a whole.
Case four, the first case within this study, illustrates how the decreased demand for aggregate can ultimately shrink the entire industry. The decreased demand for APE (Aggregate Planned Expenditure or APE) or aggregate products could be related to several different factors including tax increases, reduced government supplementation of domestic output and a decreased value on American resources in the foreign market. As this happens a string of economic consequences take place. Industries tend to shrink in response to negative demand for goods and services. “The situation is APE < GDP = ASF. Producers will eventually respond by decreasing output and prices. To the extent that producers cut employment and output ASF will fall. The level of interest rates will be falling, as ASF rises relative to GDP. These changes will achieve GDP = APE = ASF but will also create net negative economic profit, (Ashby, p. 185).” This represents a demand caused recession. The lack of demand for aggregate planned expenditures caused shrinkage of the industry as a whole and ultimately a recession.
Case five however, represents a recession caused by the lack of funding as opposed to a decline in demand. This generally occurs when banks or non-bank lenders scale back on their value of outstanding loans. “In the case of banks, this might be in response to Federal Reserve actions to tighten monetary policy, (Ashby, p. 186).”
When this occurs buyers begin to put pressure on the nation’s resources for funding and therefore the ASF will rise. However, interest rates will also increase taking out some of the demand from consumers who either can not or will not pay the increased rate. In addition to the demand wan associated with increased interest rates, prices will fall due to the resulting drop in sales. This means that as fewer consumers find access to reasonable funding the prices of goods will fall. However, after a large rise in production costs both output and employment will fall causing prices and interest rates to increase.
Case 6 outlines a situation in which any output increases initially increase interest rates. As producers react to lacking demands the interest rates will fall again as well as employment and output levels. Most often once the market resumes its original point the economy will fall below the original level of production.
The model cases illustrate how inflation is not the only factor triggering recession. Instead employment rates, interest rates and funding availability may be a primary part of the factors influencing recession. “The macroeconomic coordination process is driven by the independent and uncoordinated decisions of an immense number of households, businesses and governments – with would-be purchasers of the nation’s current output individually responding to their own surpluses or shortages of funding and suppliers individually reacting to any excess or insufficient demands for their own output, (Ashby, p. 199)
Chapter 11 defines the Federal Reserve System as well as the National Monetary Commission, established in response to a series of financial sector crises during the early part of the twentieth century. This commission was designed to study the implications associated with those market crashes as well as develop a solution to prevent future instances. The Commission recommended establishing a stabilizing and controlling institution that would oversea the nations money and banking systems. This institution became known as the Federal Reserve System. The goal of the Federal Reserve is to “promote effectively the goals of maximum employment, stable prices and moderate long term interest rates, (Ashby, p. 204).” In addition the reserve has several functions including the regulation of the nation’s monetary supplies, act as a bank for the Federal government, serve as US bankers to several foreign governments, ensures financially sound banking practices and serve as a banker’s bank providing specialized services to banking institutions across the nation.
These goals effect employment, output and interest rates by initiating a three step process in which the reserve first initiates change within the economy through manipulation of open market accounts, changes in bank reserve requirements and discount rates. This alters the overall ASF, which in-turn changes the levels of employment, output, interest rates and prices.
Money supply is derived from five definitions including the actual supply of coin and currency, reserve requirements, which are composed of the average number of dollars banks must keep on reserve, monetary base, and cash to checking account ratio as well as time deposits to checking account ratio. Using these definitions a money supply formula can be derived. Using this formula the Federal Reserve is able to achieve and maintain control over the nation’s money supplies as well as observe changes and initiate policies.
The Federal Reserve has three primary tools for conducting policy these include open market operations, reserve requirement adjustments and discount rate adjustments. Monetary policy in itself is generally limiting in its capacity to control financial growth. To ease the restrictiveness of the market the Federal Reserve can “use one or more of open market purchases, reserve requirement cuts and a discount rate reduction to induce a rise in the money supply, (Ashby, p. 217).” Easing the restrictions on the market has a positive influence on increasing revenue. However, tightening restrictions can temporarily stabilize the economy but has no long term effects.
All financial policies are set by the Board of Governors, located in Washington, DC. The seven members of the board are appointed by the US President to serve a 14 year term. Appointment is suspended on a staggering two year rotation meaning one member’s term expires bi-annually. Working in conjunction with the Board is the Federal Open Market Committee, Federal Advisory Council and Federal Advisory Council. These organizations make up the Federal Reserve Structure.
Chapter 12 outlines fiscal policy. Congress took on the responsibility to use taxation and its spending powers for the greater good of the nation. In 1946, members of Congress drafted the Employment Act and later in 1978 the Humphrey-Hawkins Act, both of which are used to allow government entities access to the nations finances and help them to prevent recession, inflation and other financial crisis. To do this there are two primary forms of policy, automatic stabilization and discretionary fiscal policy.
Automatic Stabilizers, such as the nation’s welfare program and unemployment compensation, function on a reservoir principle. This means a portion of all incomes that may have otherwise gone toward funding domestic output projects is funneled into reservoirs that can be used for these programs instead. “The progressive income tax structure and the presence of transfer programs to help families when their incomes fall enable families to suffer income declines with minimal impact upon their level of purchases. That is the goal of the automatic stabilizers (the progressive income tax structure and income-based government transfer programs), (Ashby, p. 230).”
Discretionary fiscal policy is a two step process in which the government alters current levels of domestic output purchases, tax receipt from households and businesses. In addition, levels of employment, output, interest rates and prices will change.
Chapter 13 outlines various policy issues including tax based incomes policies, business cycles and interest rate policies. Both monetary and fiscal policies have an impact on APE, aggregate demand. However, manipulating APE can cause many issues.
Expansionary policies are policies designed to increase APE demand. Other policies such as an inconsistency program used to boost funding for increased APE and liquidity traps are primarily part of a sever recession or depression. These control methods and others have benefits but are risky in that they have significant short-comings as well. More stable methods of controlling prices fall under tax-based income policies in which the government would set official targets for average wage and price increases. This policy is currently not in use.
Business cycles are a normal part of the economy. The unstable nature of business cycles often conflict with the overall goals of the Federal Reserve. Other issues include data problems, policy delays and interest rates.
Chapter 14 provides an overview of internal trading. Although trading impacts differ by region they are universally beneficial. “The law of comparative languages addresses the case of trade between nations when one produces everything more efficiently than does the others. The surprising result is that this case too, both nations stand to gain from trade, (Ashby, p. 270).” However, each country must protect their internal industries from congestion, pollution and social friction. In order to do so tariffs and quotas are put in place. Tariffs are essentially taxes imposed on imported goods. The tax increase raises the overall price of imported goods giving domestic items an advantage. Quotas directly limit the number of imported goods that can be imported into the country. Other issues defined in chapter 14 include absolute and comparative advantages. Ultimately what the country imports and exports as well as its overall effect on the country is largely dependant on trade policies, as outlined in chapter 15. Trade policies include trade impacts, which will always be both positive and negative. “Both imports and export yield benefits to society as a whole, but because imports harm producers and exports harm consumers all countries impede trade with various restrictions. The primary restrictions are tariffs and quotas on imports. Less common are restrictions on exports, (Ashby, p. 307).”
Tariffs and quotas help nation industries that are competing against imported goods. But they hurt the domestic consumer who ends up paying more for a product because it was made outside of the nation. It also hurts the foreign producer who may retaliate against the nation in terms of increased pricing, national boycott of imported goods. Restricting trade in the form of quotas is also detrimental to trade potential. Currently the only retribution comes in the form of subsidies or negative taxes.
Chapter 16 addresses international finance. Because specialization and trade are best served by a common medium of exchange but there is no common form of currency. So the foreign exchange market has evolved. For each type of currency there is a foreign exchange market. These markets are influenced significantly by increase and decreases with the countries market internally. In addition, each country maintains a balance of payment record which illustrates all foreign trade accounts between household, businesses and government entities. At one point all countries switched over to the International Gold Standard. This means that the country defines its currency in the form of gold as well as the country allows gold to be moved in and out of the country and uses the countries funds to buy gold. This ensures two avenues of trading currencies between countries, within the foreign exchange and in gold. Generally gold is bought or sold when currency price rise above an economical rate between countries. In this way gold often flows from one country to another as the rate of the nation’s currency changes. However, the international gold standard ended in 1914 and was replaced with The International change Standard. The Bretton Woods System was developed to address the negative effects the International Gold Standard had on the country that was shelling out gold. This meant that country had no choice but to endure a recession. Under this system rates of exchange are continually changing. “As economic, political and other conditions change that affect countries’ balance of payments, the average levels that a freely-fluctuating exchange market would set for exchange rates will vary over time. Consequently, it was recognized that most exchange rates would need to be adjusted every five to ten years or so. Whenever the market dictated such a change on the official pegged exchange rate between two currencies, the countries involved were expected to come before the IMF and ask for a suitable adjustment in the official rate, (Ashby, p. 349).”
Ashby, D. (1979 – 2008 ). Macroeconomics Re-engineered. Message posted to home.teleport.com, archived at home.teleport.com