Financial Cycle And Comparative Macroeconomics Essay

Question:

Discuss about the Financial Cycle and Comparative Macroeconomics.

Answer:

Introduction:

As stated by Panizza, U. and Presbitero (2013), GDP is the monetary value of the products and services produced within a geographical region of an economy and within a financial year. Real GDP is the measure of inflation adjusted economic output. Real GDP is calculated by dividing nominal GDP with GDP deflator. In the view of Filis and Chatziantoniou (2014), when GDP of an economy rises, per capita income hikes upward. Increase in per capita income cannot improve the standard of living completely. Increase in GDP indicates growth of the economy. However, economic growth does not ensure the development of the economy. As opined by Del Negro, Giannoni and Schorfheide (2014), growth of real GDP reflects only the increase in total money value of the output. It does not indicate the improvement of every section of people. In the view of Filis and Chatziantoniou (2014), growth of one sector may happen with the contraction of other sector as the growing sector may use the resources of contracting sector.

During the phase of industrialisation in an economy, air and water pollution rises to affect the health of people. Growth of an economy does not ensure healthy life of human being within a polluted environment. Diseases in the society may increase in the absence of proper awareness and may reduce life expectancy. Standard of living depends on the development of other aspects of life such as education, health. GDP growth rate fails to measure income disparities and thus extent of poverty among people belong to different income group. For example, China has the second highest GDP among all the countries next to United States, although it stands at 84nd rank in the social progress index (Porter, Stern and Green 2016). Therefore, it can be stated that real GDP is not a good measure of standard of living.

Unemployment rate is the total number of unemployed workers in an economy among the entire labour force. Unemployment rate is the percentage of unemployed people of the total labour force, who are seeking job. Unemployment arises in the economy when production of total goods and services are less than total demand. Elsby, Hobijn and ?ahin (2013) cited that full employment in an economy is achieved when a country utilises all resources efficiently in the production of goods and services. Different types of unemployment arise in an economy such as seasonal, frictional, structural and cyclical. Frictional unemployment arises when a person switches between jobs. Unemployment arises during the recession and depression stage, when aggregate demand in the economy is not sufficient to create jobs in the economy. Unemployment rate rises, when the minimum wage is set above the market clearing level. Firms are unwilling to employ more workers as the cost of production rises. According to Okun’s Law, there is negative relationship between growth rate of real GDP and the cyclical unemployment (Bernal-Verdugo, Furceri and Guillaume 2012). It indicates that when real GDP falls, unemployment rate rises. In the words of Cho and Newhouse (2013), a natural rate of unemployment always observed in an economy.

As stated by Pissarides (2013), structural and seasonal unemployment are unavoidable in the economy. Seasonal unemployment is seen mainly in the agriculture sector, which is mostly dependent on the nature. A farmer becomes unemployed when weather is not in favour of producing crops. A person without having required skills cannot be recruited at a different sector in short run. Structural unemployment is unavoidable in the short run. This kind of unemployment occurs in the economy, when an economy transits from one phase to another such as change from agricultural base to the industrial base. This type of unemployment is unavoidable.

Price of goods and services falls in an economy, when there is a gap in demand and supply of goods. Consumer price index is the weighted average of the prices of all consumer goods (Mankiw 2014). CPI inflation occurs in the economy with the increase in the price index. Inflation captures changes in the price level of the products used by households in the economy.

Year

Annual

Inflation rate

2005

83

-

2006

85.9

3%

2007

87.9

2%

2008

91.8

4%

2009

93.4

2%

2010

96.1

3%

2011

99.3

3%

2012

101

2%

2013

103.5

2%

2014

106

2%

2015

107.6

2%

Table 1: CPI index ad inflation rate in Australia

(Source: abs.gov.au, 2016)

It is agreed that inflation rises with increase in price of goods and services. During government expenditure in the economy rises, aggregate consumption demand rises due to increase in per capita income. CPI includes all the goods demanded by households. Therefore, increasing per capita income raises the aggregate demand. However, in short run, it is not possible for the suppliers to increase production at the level of demand. Hence, a gap arises in the economy (Borio 2014). In order to meet the demand, sellers raise the price of goods and thus consumer price index rises. Inflation occurs in the economy due to upward movement of CPI. Figure 1 shows that inflation rate in Australia has a falling trend and remains at 2% from 2012.

Aggregate demand is the sum of total demand for goods and services in an economy at a stated price level. Aggregate demand curve slopes downward as the demand for goods and services move in the opposite direction of price level (Mankiw 2014). Aggregate demand curve shows the relationship between the aggregate price level and the real output of the economy. Equation of aggregate demand is stated as follows:

AD = C + I + G + NX, where C is consumption expenditure, I represents investment expenditure, G shows government expenditure and NX is the net export demand.

One of the reasons for negatively slope of AD curve is fall in real income. When price level rises or inflation occurs in the economy, real money value falls. Hence, purchasing power of individual falls and this affects aggregate demand. Furthermore, when import rises and export falls due to fall in price of foreign goods, export sector contracts and there is fall in AD. Another reason is effect of interest rate. Nominal interest rate rises when inflation occurs in the economy (Borio 2014). When interest rate in the economy is high, investment level falls and real output level falls as well. Per capita income falls with the decrease in real output. AD curve is downward sloping for these reasons.

In the view of Mankiw (2014), changes in resources can be adjusted with the demand. It is believed that after a point output reaches at the optimal level by using all the resources such as labour, capital and technology optimally. Long run supply curve is vertical as it shows that supply become static in the long run for a given level of resources, when real output is fixed. Movement occurs along the LRAS curve only due to change in aggregate demand.

Short run aggregate supply curve shifts due to change in wage rate, technology, and increase in interest rate. Short run supply curve is upward sloping as suppliers get incentive to produce more output, when price level rises. There is a positive relationship between the aggregate price level and the real output of the economy. Hence, the SRAS curve upward sloping.

References

Bernal-Verdugo, L.E., Furceri, D. and Guillaume, D., 2012. Labor market flexibility and unemployment: new empirical evidence of static and dynamic effects. Comparative Economic Studies, 54(2), pp.251-273.

Borio, C., 2014. The financial cycle and macroeconomics: What have we learnt?. Journal of Banking & Finance, 45, pp.182-198.

Cho, Y. and Newhouse, D., 2013. How did the great recession affect different types of workers? Evidence from 17 middle-income countries. World Development, 41, pp.31-50.

Del Negro, M., Giannoni, M.P. and Schorfheide, F., 2014. Inflation in the great recession and new keynesian models (No. w20055). National Bureau of Economic Research.

Elsby, M.W., Hobijn, B. and ?ahin, A., 2013. Unemployment dynamics in the OECD. Review of Economics and Statistics, 95(2), pp.530-548.

Filis, G. and Chatziantoniou, I., 2014. Financial and monetary policy responses to oil price shocks: evidence from oil-importing and oil-exporting countries. Review of Quantitative Finance and Accounting, 42(4), pp.709-729.

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Panizza, U. and Presbitero, A.F., 2013. Public debt and economic growth in advanced economies: A survey. Swiss Journal of Economics and Statistics, 149(2), pp.175-204.

Pissarides, C.A., 2013. Unemployment in the great recession. Economica, 80(319), pp.385-403.

Porter, M., Stern, S. and Green, M. 2016. Social progress index 2016. [online] socialprogressimperative.org. Available at: [Accessed 4 Jan. 2017].

How to cite this essay: