ADF is called the aggregate demand for funding. GDP is generally measured in dollars and represents the supply of goods and services within a country. Private firms do not produce goods that do not sell. Goods that do not sell have low levels of demand. APE represents the actual demand for these types of goods. APE is usually less than the GDP. Part of GDP will not sell. Here, the concept of ASF comes into mind.
The ASF measures how much GDP are purchased with respect to the existing monetary supply. Buyers need to way in $1 of ASF per dollar of APE. Suppose that the APE is as large as the GDP, the demand for ASF is not included in the ADF. When there is adequate funding of APE, then there is also the adequate funding of GDP.
When the APE is less than current GDP, buyers should buy an amount of ASF equal to APE. Producers provide additional secondary funds. This is so since producers are usually used to fluctuations in sales. Suppose that sales are below production. Firms do not necessarily reduce employment and production levels. During periods of slow sales, firms would have to cover variable costs such as payroll and other operating bills. Firms will need an additional dollar of ASF for every dollar (when APE is less than GDP).
Funding Adjustments First
Suppose that GDP, APE, and ASF are not equal, a coordinating process is needed to bring a balance to the equation. When ADF and ASF are unequal, both money suppliers and user engage in complex economic behavior. The behavior will continue until the gap between ADF and ASF are at its minimum. This engagement is called ‘funding adjustment.’ The net effect: if GDP and ASF are unequal, then suppliers will embark output-price adjustments. This closes the gap between APE and GDP.
While output-price adjustments eliminate the gap between GDP and APE, the participants in the process have no consciousness of the gap between GDP and APE and have no intention of removing the gap. Both GDP and APE represent the supply of goods and services and the demand for all products in an economy. GDP represents the aggregate product produced in an economy while APE is the aggregate demand for such goods. The participants in the adjustment process are conscious of their own individual supply and demand imbalances.
These adjustments involve decisions and arrangements that are implemented rapidly. The output-price adjustments will involve risky decisions that producers will build after some deliberations. The coordination process re-establishes the ge3neral equality GDP = APE = ASF. There are three groups in the adjustment process: Group 1 are persons with sufficient money balances to finance current expenditures; Group 2 are persons with insufficient money balances to finance their current planned expenditures; Group 3 are persons with more than sufficient money balances to fund their current expenditure. Members of the second group face the following choices: beg, borrow, steal additional money, reduce non-GDP expenditure, and reduce GDP purchases. Members of the third group face the opposite choices: give away, lend, hold surplus money, and increase GDP and non-GDP purchases.
ADF = ASF
Suppose that ADF = ASF, members of Group 2 and 3 are generally unaware of the equality. Both groups do not know that the total supply of funding is sufficient to meet its current demand. Members of Group 3 will be inclined to lend excess funds. Members of Group 2 will be inclined to increase its borrowing initiative.
ADF > ASF
Suppose that ADF > ASF, members of Groups 2 and 3 will also be unaware of the inequality. In this case, total supply of funding is insufficient to support its current demand. Members of Group 2 are generally inclined to borrow more. Members of Group 3 will lend excess funds less than the demand of Group 2. The higher is the rate of lending interest; the lower is the incentive to lend. As the interest rate rises, ASF will rise, APE will decline, and ADF will fall.
ADF < ASF
In this case, members of Group 3 have sufficient funding to meet borrowing needs of Group 1 and 2. Group 3 will be inclined to increase its lending initiative while Group 2 will be inclined to borrow more.
Chapter 8 Summary
To fully understand the dynamics of the output-price adjustment process, there is essentially a need to understand the influences of demand and cost structures on economic behavior. Economic behavior is defined as ‘behavior’ arising from economic expectations. The ruling assumptions are as follows:
1) Usually, a firm faces a downward-sloping demand curve for its good. In short, as the price of such good falls, quantity demanded increases. As the price of the good increases, quantity-demanded falls;
2) There is an absence of barriers which would prevent firms from entering or exiting the industry (this is a characteristic/quality of perfect competition);
3) There is sufficient profit to keep existing firms in an industry but too low to attract new producers to enter the industry. Each output level is determined by prevailing price differentials or variable costs;
4) Firms own facilities that are particularly engineered to produce a specific output at a particular rate. Firms produce goods where average unit cost is at the minimum and where average unit cost rises as output also rises;
5) Firms maximize profit. In perfectly competitive markets, maximum profit is achieved by setting the price equal to both to the MR and MC.
In order to understand the given assumptions, there is a need to define and explain some essential economic concepts. The firm’s demand curve is also called the average revenue curve. The AR curve shows the highest uniform price that the firm can charge for its units of output. The slope of the profit curve is called ‘marginal revenue.’ Marginal revenue is the increase in aggregate revenue as sales increase by one additional unit of a good.
The marginal revenue curve is located between the AR curve and the vertical axis. In order for a firm to maximize its profits, it must operate at the output level where marginal revenue is equal to marginal cost. If MR > MC, then profit is equal to the excess of MR over MC. If MR < MC, then profit is equal to the excess of MC over MR. In short, the first inequality indicates that the firm is enjoying higher profits while the second inequality indicates that the firm is enjoying lower profits (or even losing profits).
Positive profits usually attract entry of new firms. As the industry expands, there is an incentive for new firms to enter the market. At some point, firms will find their demand curves shifting to the left as individual market share falls. So long as there is positive economic profit, firms will continue to enter the market (until the saturation point).
If demand increases, the firm will increase its output and raise the good’s prevailing price. The firm is therefore earning positive economic profits. The implication: this attracts new firms to enter the industry, and to some extent decreases demand.
If demand falls, the firm will decrease both its output and the prevailing price for the good. The firm is therefore earning negative or close to zero economic profits. This encourages firms to exit the market.
The growth of an industry may be cut short by a rising cost level. The rise in costs is due perhaps to the rising demands for particular commodities. Suppliers will set their prices higher than the prevailing prices. As average costs increases, the product price falls because of increased output. The effect: economic profits will decrease indefinitely.
Chapter 9 Summary
Producers of domestic goods are grouped into one of the following groups:
Group A – these are firms with sales that match current production;
Group B – these are firms with excess demand (in short, current production is insufficient to match current demand);
Group C – these are firms which face insufficient demand (sales are insufficient to fund current production).
GDP = APE = ASF
When GDP equals APE, the firms in Group B and C will be unaware of the equality. Members of Group B will face an excess demand (and thus raises both its output and its associated price). Members of Group C will face insufficient demand (and thus reduces both its output and its associated price).
The total combined shortage in demand face by firms of Group C will equal the total combined excess demand faced by Group B. Output and price impacts from Group B will offset effects from Group C.
Suppose that there exist negative profits in an industry. These decreases will push total output downward. This drives the price level to rise and shrink the negative economic profits. Suppose that there is the absence of significant cost-level reductions, output will shrink until the price is restored to its original level. The economy achieves long-run sustainable equilibrium.
If APE < GDP = ASF, then the economy respond by decreasing GDP. This results to lower employment, output, and interest rates. Prices will gradually fall but eventually will return to its original level. If APE = GDP = ASF, then the levels of employment, output, prices, and interest rates will remain at their prevailing levels until future shocks causes the three elements to become unequal. For example, suppose that there is an unexpected increase in money supply. An increase in money supply drives prices up and lowers prevailing interest rates. Consumers will have to face a rising cost initiative. For the economy as a whole, a rising inflation rate (single digit) is a sign that it has achieved short-term sustainability.
Suppose that there is an unexpected increase in interest rates. Firms will have to decrease their borrowing initiative. Consumers, on the other hand, will tend to keep their money as deposits to achieve significant returns. The effect: output and employment fall as firms revaluate their liquid capital.
ADF > ASF
There is no change in output and employment levels. Interest rates increase while prices remain to its original levels.
ADF < ASF
Again, there is no change in output and employment levels. Interest rates decrease while prices remain to its original levels.
APE > GDP
There is an expected increase in output and employment levels. Interest rates tend to increase while prices temporarily increase.
APE < GDP
There is an expected decrease in output and employment levels. Interest rates tend to fall while prices temporarily decrease.
GDP = APE = ASF
There is no expected change in output, employment, interest rates, and price levels.
Chapter 10 Summary
There are generally six shocks which can trigger the so-called macroeconomic coordination process. Each of the six shocks is external to MCP and involves either a rise or fall in GDP, ASF, and APE. The six shocks may occur in combination or sequence. For the sake of simplicity, only three shocks will be discussed – an increase in APE, an increase in ASF, and a decrease in GDP. These shocks have one thing in common. After some initial funding adjustment, the three will have a level of funded demand that exceeds the current supply of goods and services within an economy.
An Increase in APE or Demand-Caused Expansion
An increase in aggregate demand may result from widespread involvement in the economic outlook of households and businesses. This may also be the result of a federal fiscal policy. The objective of this federal policy is to stimulate the economy by raising the level of federal expenditure from the GDP relative to tax revenues and total reserves. An increase in aggregate demand may be the result of increased foreign demand for domestic goods. Suppose that APE rises. The level of interest rate will rise during the initial funding adjustment. This is accompanied by a rise in employment, output, and price levels until GDP = APE = ASF.
An Increase in ASF or Money and Credit-Caused Expansion
As ASF rises, interest rates will fall. During the output-price adjustment, interest rates will temporarily increase, accompanied by a general rise in employment, output, and price levels. Both employment and output will increase until prices return to its original levels. The effect: employment and output will be higher, interest rates lower, and prices unchanged.
A Decrease in GDP or Supply –Caused Inflation
A fall in GDP reflects a decrease in interest rates. Prices and interest rates rise until APE and ASF decrease. However, this is temporary. Output, employment, and interest rates return to its original levels. As a result, GDP returns to its former level.
Ashby, David. Wholly Macro! Macroeconomics Re-Engineered.