Macroeconomic Concepts: From Paradox of Thrift to Mundell-Fleming Model
The paradox of thrift, a key concept in Keynesian economics, illustrates a scenario where increased individual saving, while rational and beneficial on a personal level, can have adverse effects on the overall economy if practiced widely, especially during a recession. When many people start saving more and spending less, aggregate demand for goods and services decreases. This reduced consumption leads businesses to lower production, which results in layoffs and higher unemployment.
Consequently, the overall income in the economy declines, further reducing consumption and savings, thereby creating a self-reinforcing cycle of economic contraction. For example, during a recession, if households collectively decide to save more and cut back on spending, it can deepen the economic downturn by reducing business revenues and increasing unemployment. Therefore, the paradox of thrift highlights the conflict between individual financial prudence and macroeconomic stability, emphasizing the need for a balanced approach to saving and spending to avoid exacerbating economic recessions.
Functions of money
1. A medium of exchange:
Money served as a medium of exchange for all kinds of goods and services to avoid the problem of double coincidence of wants under barter system, the money was introduced to act as an ideal medium of exchange
2. A measure of value.; money act as a medium of exchange. This means that money is a common denominator through which the exchange value of all goods and service can take place without any difficulty.
3. Store of value.: money also serve as a store of value. It is a repository of purchasing power overtime. That means it can be used for savings being the most liquid asset. It facilitates transaction of all goods and services.
4. Standard of deferred payment.: with the introduction of money, borrowing and lending have become easier, defer payments are those which are postponed for the future money enable current transaction to be discharged in future
Measures of money supply
M1= currency+ demand deposit+ other deposit with RBI. M2.= M1.+ post office saving deposit. M3= M1.+ time, deposit of public with banks. M4= M3+ total post office deposit. M1 INCLUDES THE MONEY SUPPLIED BY THE RBI, GOVERNMENT OF INDIA AND OTHER COMMERCIAL BANK. IT EMPHASISES MONEY ONLY AS A MEDIUM OF ACTION. SO IT IS KNOWN AS NARROW MONEY ON THE OTHER HAND. M3 EMPHASISES BOTH ON MEDIUM OF EXCHANGE FUNCTION AND STORE OF VALUE, THAT’S WHY M3 IS KNOWN AS BROAD M.
High powered money is the sum of commercial bank reserve and currency held by public. It is the base for the expansion of bank, deposit and creation of money, supply, high power money.=C+RR+ER
Money supply(M) consist of commercial bank(D) and currency(C) held by public does Manish supply M=D+C
Dividing equation
And dividing numerator and denominator of both side by D
Causes of Inflationary Gap
Increased Consumer Spending
When consumers spend more, aggregate demand rises.Government Spending
Increased government expenditures can boost aggregate demand.Investment
Higher levels of business investment in capital goods.Net Exports
An increase in exports relative to imports.
Removing the Inflationary Gap
To reduce or eliminate the inflationary gap, policies typically aim to decrease aggregate demand. Here are some common methods:
1.
Contractionary Fiscal Policy
Decrease Government Spending
Reducing government expenditures can directly lower aggregate demand.
Increase Taxes
Raising taxes decreases disposable income, which reduces consumer spending and aggregate demand.
2.
Contractionary Monetary Policy– Increase Interest Rates
Higher interest rates make borrowing more expensive, which reduces consumer spending and business investment.
Reduce Money Supply
Central banks can use open market operations to sell government securities, thereby reducing the money supply and increasing interest rates.
3.
Supply-Side Policies-
While not directly targeting demand, improving supply-side conditions can help mitigate inflationary pressures by increasing potential output:
Improving Productivity
Investing in technology, education, and infrastructure can increase the economy’s productive capacity.
Labor Market Reforms
Policies aimed at increasing labor market flexibility and efficiency.
The short-run Phillips Curve (SRPC) demonstrates the inverse relationship between inflation and unemployment, suggesting that lower unemployment comes with higher inflation and vice versa. Graphically, the SRPC is downward-sloping, with the unemployment rate on the x-axis and the inflation rate on the y-axis. This inverse relationship arises because increased aggregate demand boosts production and employment, reducing unemployment but also driving up prices and inflation. Policymakers can temporarily reduce unemployment by accepting higher inflation or curb inflation by tolerating higher unemployment, although this trade-off is influenced by inflation expectations and supply shocks.
The long-run Phillips Curve (LRPC) is vertical, indicating no trade-off between inflation and unemployment in the long term. This curve is positioned at the natural rate of unemployment, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU). In the long run, inflation expectations adjust, and any attempt to reduce unemployment below the natural rate only leads to higher inflation without reducing unemployment. This adjustment process means that policies aimed at lowering unemployment through increased inflation are ineffective in the long run, emphasizing that the economy returns to the natural rate of unemployment regardless of the inflation rate.
Saving-Investment Equality
Saving-investment equality is a fundamental concept in macroeconomics that refers to the idea that, in an economy, the total amount of saving is equal to the total amount of investment. This equality is crucial for understanding how financial markets and the overall economy function.
1. **Closed Economy**: In a closed economy (one without international trade), saving (S) must equal investment (I). This is expressed in the national income identity: Y = C + I + G. where \( Y \) is the national income, \( C \) is consumption, \( I \) is investment, and \( G \) is government spending. Rearranging, we get:
Y – C – G = I. Here, Y – C – G represents total saving (S), so \( S = I \).
2. **Open Economy**: In an open economy, the relationship includes net exports (NX):
Y = C + I + G + NX Rearranging, we get: S = I + NX. Here, \( S \) includes both domestic saving and net capital outflow.
3. **Role in Financial Markets**: Saving represents funds available in the financial system for lending, while investment represents borrowing for capital expenditures. The equality ensures that every dollar saved is channeled into investment, balancing the supply and demand for funds.
4. **Equilibrium Mechanism**: Interest rates adjust to maintain the equality. If saving exceeds investment, interest rates fall, encouraging more investment and less saving until equilibrium is restored. Conversely, if investment exceeds saving, interest rates rise, encouraging more saving and less investment.
Mundel flaming model
Here we consider the mobility of financial asset. It is an open economy model V. Assume there are only two asset number one domestic bond with a rate of return ‘r’and foreign bond with rate of return ‘r*’ they are comparable in the sense that there is no difference between risk between them show the investor choice will be government by their return only under perfect capital mobility assets can be purchased at zero transaction cost without any time. Difference in case in perfect capital mobility. There are restriction on movement of fund across national boundaries so that interest rate may not be equal.
i) policy under profit, capital mobility
In this case, the rate of return on domestic and foreign bond are equal that is r=r* the foreign rate of interest is uninfluenced by domestic policy
Dirty float
Under a managed exchange rate regime, expansionary monetary policy involves increasing the money supply and lowering interest rates to stimulate economic growth. This reduction in interest rates makes borrowing cheaper, encouraging investment and consumption, but also leads to capital outflows as foreign investors seek higher returns elsewhere. These outflows put downward pressure on the domestic currency, causing it to depreciate. In a managed float system, the central bank may intervene in the foreign exchange market to prevent excessive depreciation or volatility by buying or selling foreign currencies. This intervention helps to stabilize the currency while allowing some market-driven adjustments, thereby supporting the domestic economy’s growth objectives without allowing extreme fluctuations in the exchange rate.
Assumption:
– demand create its own supply. – the aggregate price level remains fixed. This means all variables are real variables.
– the economy has excess production capacity. – the economy is closed economy. – all profits are shared
In the SKM model, the equilibrium condition can be expressed as y= E (i) y= total output, E= aggregate expenditure/ desired expenditure
Three sector closed economy y= E= C+ I+ G (2)
Since national output(y) also measures national income, we can write y= C+ S+ T (3)
Moreover, y is national output, so we can write y= C+Ir+g (4)
Where Ir= realised investment. It is the permitted investment which has been sold or disposed. It is the sum of plant and unplanned investment.
Comparing equation 3 and 4. C+ S+ T=y= C+Ir+ G. S+ T=Ir+G. S+T=I+G (since Ir=I)
Comparing equation 2 and 4. Y= C+ I+ G. Y= C+ Ir+ G. C+ I+ G= C+Ir+ G I+Ir
Show that three condition are: 1.Y= E= C+ I+ G. 2. S+ T=I+G. 3. I=Ir
Simple keynesian model Desire expenditure, Y = C+ I+ G
Actual output, Y=C+S+T
In Equilibrium I= Ir
Where I= desired investment. Ir= actual investment
Desired= actual + inventory. Change in inventory=TRIAN inv. If,IR>I =. TRIAN inv>0. Unintended inventory accumulation if, I<Ir =TRIANinv<0. = inventory storage.
Explain the effectiveness of fiscal and monetary policy under perfect capital mobility and fixed exchange rate under mundel Flemming model
We assume two countries, India and USA
There are two fiscal asset domestic bond with rate of return ‘r’and foreign bond with rate of return ‘r*’
Under perfect capital capital mobility, there is no transaction cost and time lag so r=r* that is written from domestic bond equals to written from foreign bonds
i) fixed exchange, fiscal policy
The initial equilibrium is achieved at point E1 the I S and LM curve intersect on the horizontal BB line, which shows due to perfect capital mobility, domestic rate of interest cannot go out with the fixed the foreign interest rate, expansionary, fiscal policy shifts IS1 to IS2 as the rate of interest goes up to r1 there is massive capital inflow investors purchase, huge amount of domestic bond. The exchange rate can be kept only if the reserve bank by dollar from the market in exchange of rupees. This action will increase domestic money supply, LM curve shift to LM2 domestic and foreign rate of return becomes equal once again, and creates maximum positive impact on output
ii) fixed exchange monetary policy
And increase in domestic money supply shift the LM1 curve to the right to LM2 the domestic rate of return ‘r1’ shifts below ‘r*’this will create outflow of capital. Investors will sell their Indian bonds and demand for dollars to keep exchange rate. Fixed. RBI will sell dollars from eight stock. This will cause domestic money supply to fall, and the process will continue until LM shifts to original position under perfect capital mobility, and fixed exchange. Monetary policy loses its effectiveness complete.