Macroeconomics: A European Perspective, Coursework Example

According to the fundamental identity of national income accounting, income and output are identical. Output is measured using Gross Domestic Product, which is the value of all goods produced within a given country’s borders. Income is measured using national income. Gross domestic product fails to take into consideration the existence of generated cash flows for the economy outside of its borders.

However, national income takes into account the fact that some of the country’s national work and live outside the country’s borders. National income is derived from deducting the consumption of fixed capital, i.e. depreciation, from the Gross National Product (GNP). GNP takes into account all of a country’s citizens making it ownership based. However, GDP is place based as it only takes into account the geographical boundaries. GDP will therefore not be equal to national income as they measure different aspects (place and ownership) of output and income.

Government spending has a similar effect on the equilibrium output that investments have. This is because when government expenditure increases, the amount of capital available for investment by businesses within the economy also increases by a similar amount. This means that aggregate expenditure is also going to increase. This is known as the government spending multiplier effect.

On the other hand, an increase in taxes has a much smaller effect on equilibrium output as compared to government spending. The tax multiplier is much smaller than the government spending multiplier for one main reason, the actual amount of money invested into the economy. When government chooses to reduce taxes, it chooses to not make money through the economy. This reduces the amount of money that individuals have to pay to government in the form of taxes. However, this new available income will not be completely invested in economic activity. However, some of this money would be directed into household expenditure. When government increases expenditure, all of the money is directed to investment. For this reason, the effect of the government spending multiplier on equilibrium output is much larger than the tax multiplier.

An economy at equilibrium is at the point where amount of goods or commodities demanded by the economy is matched by the suppliers (. When interest rates increase, the cost of production increases, raising the general prices of commodities within the market. Thus causes a shift in the IS curve. This increase in interest rates may be attributed to an increase in government borrowing, a situation known as crowding out.

To respond to this shift, government will reduce expenditure effectively reducing the interest rates. This can be done through the reduction in government borrowing. When government reduces the need for foreign liabilities, there is a general reduction in the need for credit within the market. This effectively reduced interest rates within the market.

Alternatively, the government can achieve this through the reduction of government expenditure. When government expenditure reduces, the amount of private investments increases, effectively lowering the prevailing interest rates.

Interest rates usually determine the profitability of saving by adjusting the interest payment paid to saver by financial institutions. When interest rates increase, individuals with enough disposable income to surpass their basic consumption will be encouraged to engage in saving. This is because saving is largely perceived as delayed consumption. An individual would therefore be willing to postpone consumption of given enough incentive, in the form if interest payments. The rewards associated with savings are directly related to the prevailing interest rate. Assuming a closed model, an increase in interest rates is expected to depict an increase in savings.

However, this is based on the assumption that in this model, savings is only affected or influenced by interest rates. In real world models, savings is affected and influenced by a myriad of elements within the economy such as inflation. Some of the most important players within the financial sectors are banks. Banks manipulate interest rates relative to the central interest rates so as to achieve optimal profitability. As such, an increase in interest rates depicts an increasing need by financial institutions for its customers to save. The money saved is directed into investments as savings is a prerequisite to investing.

Furthermore, taking into consideration the assumption of a closed model, countries with negative rate of deposit should be experiencing little to no savings. This would stem from the fact that there is not enough incentive to postpone consumption. However, this is not the case. In countries with negative deposit rates like China, household have been found to save more. Despite the fact that China has had negative deposit rates for a number of years, households maintain a high savings rate.

Savings are crucial to the growth and development of any economy. It is the prerequisite to creating and developing capital required to spur economic growth and development. As such, savings are crucial to future capital investments. As such, an increase in savings as a result of an increase in interest rates would increase investments made by financial institutions holding their customers’ deposits. This assumption is generally held in a closed economy.

As such, a decrease in interest rates is expected to cause a general decline in savings resulting in reduced investments. However, a decline in interest rates encourages individuals to spend as opposed to saving. This new disposable income is not usually completely directed into consumption. Instead, individuals engage in personal investments. This causes a general increase in investment despite the reduction in interest rates.

Furthermore, a reduction in interest rates indicates growth in stock and real-estate markets. This means financial institutions have lesser demand for savings deposits and would wish customers to borrow instead. As such, they would encourage borrowing, thus increasing investments made through borrowing.

For a country with a high savings rate like China, its balance of trade is pivoted on the levels and rates of savings. Owing to the fact that China continually depicts characters of a closed economy, a decrease in savings would lead to resulting decrease in domestic investment. This is because savings is a prerequisite of domestic investment. Despite that China depicts negative interest rates in most financial institutions, the levels of savings is still considerably high. As such, a decrease in the savings rate would effectively lead to an increase in interest rates.

China’s high rate of production and positive net export position has been achieved as a result of the high savings rate. A reduction in savings rates would effectively lead to reduction in investments and therefore reducing China’s net export position and balance of payments. This would lead to a reduction in the levels of savings and investments made by both the public and the private sector.

New and developing economies avail a new frontier for growing and developing multinationals. As a result these multinationals inject a considerable inflow of capital into the developing economy. A developing economy is usually growing from one stage of economic growth to another. As such, there is great need for the growth and development of a number of crucial new industries. This entails importation of technology and other factors of production required for execution of production. This creates a situation where imports surpass exports.

An increase in capital inflow tend to increase an economy’s net foreign liabilities. Increasing net foreign liabilities considerably reduces a country’s bargaining power. Owing to reduce bargaining power, the economy is opened up its market to goods and services from their foreign debtors. This creates a general reduced or negative net exports. This is because imports from foreign markets become cheaper than products and services existing within the economy. When the capital account depicts a negative or reducing value, i.e. the financial capital inflows surpass financial capital outflow, the balance of payments is skewed in the form of negative net exports.

In an open economy, an increase in investments is largely associated with a relative increase in savings. However, this may not always be the case. There are instances when an increase leads to no increase in investments. This is because the element of saving in an economy is defined by two components, (1) Investment, and (2) Current Account. When savings increases it can either be used to increase capital stock. However, an increase in savings can also be used to improve the current account by ensuring a current account surplus. This directly increases the economy’s net foreign assets which is crucial in determining its financial position relative to its financial obligations to foreign debtors.

Furthermore, an economy’s distance to the technology frontier relative to savings determines whether revenue saved would be directed to investment. For a country that is not close to technology frontier like most third world economies, an increase in savings would work to induce foreign entrepreneurial efforts on behalf of the local entrepreneur by the government. This would instigate foreign investment as opposed to domestic investments.

There are two techniques of ensuring increasing wealth. Increasing investments is the surest way of a country increasing wealth for their citizens. It is largely accepted that wealth can be effectively increased by an increase in current and/or future consumption. By investing the excess of disposable income after deduction of basic consumption, the country engages domestic income in economic activities, growing existing capital wealth. However, there is an underlying opportunity cost to investing net disposable income. By investing one’s own resources, they reduce their current consumption, effectively reducing their wealth position.

It is largely accepted that wealth can be increased by increasing either current or future consumption. Future consumption is guaranteed through savings. As such, increasing savings is the optimal way to increase national wealth. In an open economy, savings can be used to induce foreign investors by guaranteeing returns and profitability. This would instigate foreign investments. Such investments can generate income to pay off foreign liability. This effectively maintains the country’s savings position and increases foreign investments growing the country’s wealth. This increases both current and future spending.

Monetary policy is an essential tool to control and manipulate aggregate demand. However, aggregate demand is only equal to aggregate production as stated in Say’s Law. In the case of Japan as depicted in the figure below, the low level of aggregate demand necessitated reaction through monetary policy. In order for Say’s law to be maintained, i.e. aggregate demand is equivalent to aggregate production, interest rates have to be reduced. This serves to increase investor confidence and boost consumption (aggregate demand). However, the liquidity trap dictates that as interest rates move towards zero, they cannot fall any further.

This situation is defined by the central bank increasing currency into the private banking sector so as to reduce interest rates and increase aggregate demand through consumption. This monetary policy however becomes ineffective as interest rates approach zero. In anticipation of insufficient aggregate demand, units within the economy hoard cash creating a general liquidity problem. This situation is characterized by erratic fluctuations within the money supply and demand market (LM Curve) that do not transform in to changes in prices.

When government expenditure increases, the IS curve shifts outwards increasing aggregate demand and therefore increasing the gross domestic product or output. This in turn increases interest rates. An increase in government expenditure would raise interest rates but fail to increase aggregate demand.