This part of the paper mainly concentrates on the graphical representation of the macroeconomic process of coordination using a single diagram with the level of interest plotted on the vertical axis and the GDP, ADP and ASF values plotted on the horizontal axis. A vertical line is mapped out when GDP is plotted on a graph because it does not have a direct relationship with the change in the level of interest rates (Ashby 2009). The line will move to the right or the left if the level of GDP increases or decreases respectively. The line will however remain vertical regardless of the change that may be experienced in the price levels.
When APE is added to the GDP graph by plotting the equation APE ≡ a + b (GDY) – ci, the line will have a horizontal intercept that is equal to a + b (GDP0) which will slope upwards and to the left which indicates a reduction in APE as interest increases. The horizontal intervals created by the interested axis at any interest level of APE and GDP indicate their respective magnitudes. On the same graph there is another line, IS, which unlike the others does not represent any value or magnitude. Therefore, under no circumstance can the line be equal to anything. Its lines only represent the combination of interest and GDP for which GPS is equal to APE. The different combinations of these three lines (APE, GDP and IS) ensure that the lines will always cross each other at some point.
As mentioned earlier, the IS line is a representation of various combinations of GDP and interest at levels in which the APE is equal to the GDP. The figure below has various levels of GDP and corresponding values of APE with different levels of interest. From the graph one can easily note that the horizontal movement of APE is half the horizontal movement of the GDP line. The point at which they intersect is the level of interest, which declines steadily as GDP shifts to the right. The IS line is therefore plotted by joining the different levels of interest.
It should however be noted that the levels of interest shown by the IS line in which GDP is equal to APE have no relationship with the level of GDP. It will therefore be wrong to say that the level of interest reduces as GDP increases. This is because the rates of interest are determined by ADF and ASF.
The aggregate supply of funding (ASF) is the upper limit of expenditure of domestic output. It is determined by the existing money output at a specific point (M) and time given the average prices of commodities and the annual number of times the dollar has been used to make purchases in the market (V). It has a positive slope and its equation is ASF = (m/p) + (e/p) i. Any changes to the responsiveness of its values (M and V) affect the interest rates. If the values of M and V become more responsive then the interest increases and if these same values become less responsive, the interest rates decrease.
The aggregate demand for funding (ADF) is the sum of ADP and GDP at any given level. In the graph, it is represented by the kinked line consisting of a portion of a GDP and ADP line that lies above and below the IS line respectively.
It is necessary to understand the theory of costs and demand as they play a critical role in the determination of business behavior. To have a proper understanding of this theory, we should assume that a business firm is facing a demand curve that is sloping downwards for its products. There are also no barriers that would prevent other businesses from entering the market (it is an open market). The firms in the market are enjoying normal profits, just enough to sustain them in the market but not attractive to attract new firms into the market. All the firms in the market product using the same mechanisms hence they have the same average cost per unit which increases as the level of output increases. Lastly, the firms work hard to ensure that they make sustainable profits that will enable them to survive in the market in the long run.
Another factor that has to be considered is the marginal cost (MC) of the firm. This is the cost required to produce an extra unit of a commodity. A decline in the average cost (AC) results in the MC being lower than the average cost while an increase in the AC results in the MC being greater than AC at any level of production. This is because the marginal cost curve cuts the average cost curve upwards from below as shown in figure 6 below.
Thus for a firm to enjoy maximum profits, it must operate at the point where MC=MR and MC cut MR from below. At low levels of output, MR>MC, therefore, the profits are in the excess of MR over MC per unit while at higher levels MC>MR reduces the profits by the difference between the revenue and costs. In the figure below the shaded region represents the economic profits which are earned for the period.
Firms that are in such markets enjoy super-normal profits, a condition that attracts new firms into the market. However, with the entry of new firms into the market, the average revenue earned by each firm reduces making the average revenue curve (AR curve) shift towards the left. Therefore, the economic profits earned are zero inferring that the maximum profits have been reduced to the minimum level. These profits are only capable of sustaining the firms to survive in the market. They cannot, therefore, attract new firms into the market.
In some situations, the market demand may increase shifting the MR and AR to the right. This will lead to an increase in the level of output and the price per unit making the firm earn positive economic profits. this condition attracts new firms into the market. This entry may take some time due to barriers such as patents and license requirements but eventually, new firms will join the market making the AR and MR curves return to their original positions hence the firms will earn profits that will just sustain them to survive in the market.
The cost of production might also decrease. This will result in the point at which MC=MR move to the right leading to a reduction in price and an increase in the output. The firm will therefore enjoy positive economic profits attracting new firms into the market leading to a situation similar to that of an increase in demand.
The market demand may also decrease. The firms will therefore be forced to reduce their level of output and price of the commodity. This will have an overall effect of reducing the average revenue (AR). The firm will therefore earn negative economic profits. This situation will force firms to leave the industry reducing competition. The AR will thus return to its original level hence the firms will earn zero economic profits.
The costs of production may also increase leading to an increase in price. This situation moves the point at which MR=MC to the left hence the firms will be earning negative economic profits. This situation prompts firms to leave the industry hence competition reduces. The remaining firms will enjoy zero economic profits which will just be enough to sustain them to survive in the market.
Whenever ADF and ASF deviate from each other, market forces interact to bring them back together through funding adjustments. Output-price adjustments have the same effect on GDP and APE. Funding adjustments have three different groups; the members of the first group have sufficient money balances to fund their current planned projects while the second and the third groups have insufficient and more than sufficient money balances respectively. Banks and other financial institutions encourage group 2 and three members to borrow or lend money thus these individuals are unaware when ADF=ASF. Group 2 members will seek to borrow more and group 3 members will seek to lend more. At this level the amount of money borrowed will be equal to the amount of money lent thus financial institutions will not require to manipulate borrowing and lending rates.
When ADF>ASF group 2 and 3 members will be unaware that the supply of money does not meet its demand. They will, however, be aware of the financial status and group 2 members will borrow more and at the same time group 3 members will lend more since they have more than enough. Financial institutions will respond to this situation by raising interest rates. When ADF
At any one time, a supplier will find himself either in group A composed of firms facing an average demand, group B facing an excess demand or group C facing an insufficient demand. The figure below shows the initial situation where GDP, APE, ASF and IS intersect one point at the prevailing levels of interest. When APE=GDP firms in group B will face a high demand thus they will increase their output and prices. On the other hand group C firms will face a reduced demand thus they will reduce their level of output and reduce their prices.
As discussed earlier, an increase or decrease in demand does not have a lot of influence on price. Therefore, the overall effects of output levels and price between groups B and C will be synchronized thus there will be no adverse changes in price or output when GDP=ADP=ASF.
When GDP<ADP=ASF the firms will not be aware of the change in equilibrium. Group B firms will be facing high demand thus will increase their output and price while Group C firms will be facing low demand thus will reduce output and price.
When APE>GDP then the overall increase in demand experienced in group B will exceed the decline in demand of group C therefore the output levels and the price will increase. This will eventually make the GDP also increase. Income and demand levels will also increase resulting in positive economic profits.
Excess Demand Cases
Demand-caused expansion may occur as a result of an increase in APE resulting in domestic and foreign increases in demand coupled with improvements in the economies of households and businesses. An increase in APE will shift the APE line to the right and reposition the IS line. The resultant increase in demand will not be funded since APE>ASF hence the interest rates will go up to increase funding. This will result in a decline in demand until APE=ASF creates new demand and price which will prevail until when another shock hits the market.
Money and credit caused expansion occurs when ASF increases. This makes the level of interest reduce during the initial stages of funding. However, during the output-price adjustments, the interest rates together with demand, price and employment levels will also rise. This will increase the amount of income and also the level of output. This will continue until the prices return to their original levels. Fig. 13
A cost-induced expansion or deflation may occur as a result of reduced business costs which may affect the rates of interest, employment and output level. Such firms, therefore, increase employment levels, expand their output and reduce their prices to maximize their profit. This will make the ASF, GDP and APE lines shift to the right. The IS line will thus move downwards reducing the interest rates. This will continue up to the point where the further expansion of these industries is impossible due to a reduction in profits. This will make the prices and the level of output return to their original points of output.
The GDP of a country can decline as a result of it losing its factors of production such as labor, capital, and land. Because at equilibrium GDP=APE=ASF, a decline in GDP will lead to a decline in APE and ASF will decline in turn. Therefore the new situation will be GDP<APE
Ashby, David. Macroeconomic Coordination. Money Mechanics, 1(1) 2009: 164-240.