Business Activities, Employment and Inflation - Term Paper Example

XXXXXXXX XXXXXXXX XXXXXXX XXXXXXX XX – XX – 2009 Macroeconomics – Business Activities, Employment and Inflation Abstract The relationship between money and the GDP of a country is an essential factor that needs to be understood. This paper deals with the effects of the business activities on inflation and employment. To do so, the paper has dealt with some essential aspects like the Equation of Exachange, Multiplier effect, and Keynesian Model. The paper provides a surface level explanation of these theories and concepts and deals more on the Keynesian model and concepts like the ‘Full Employment GDP’, ‘The Deflationary Gap’, and ‘The Inflationary Gap’. This will give an overall view of the relationship between the unemployment and inflation. Further research recommendations have also been included at the end of this paper, along with some of the best readings for further research and understanding of the topic. Introduction: Business activities are a major part of every economy. This paper will deal with the various factors that determine the business activities and reasons why they fluctuate. Also included in this paper are the effects of the business activities on the levels of employment and inflation within a country. To begin with, it is essential to consider the determinants of GDP and mainly the role of demand on the level of business production. The first section will deal with the determination of business activities following which, a brief explanation of the relationship between GDP and money will also be explained. This will be followed by the relationship of unemployment and inflation with the aggregate demand. Business Activity Determination: To understand the determinants of a business activity, it is essential to know the simple income flow diagram. This is the simple relationship between the Households (individuals) and the firms. Figure: The Circular Flow of Income If the injections of an economy (J) are not equal to the withdrawals (W), then there is a clear disequilibrium in the economy. The only factors that bring this equilibrium back into line is the change in the national income (GDP) and the levels of employments (Sloman and Sutcliffe). To understand the above figure better, lets consider that the economy is faced with a state of equilibrium, i.e. the levels of withdrawals and the level of injections is the same. If there is an increase in the injections, and the firms aim at investing more into the company, then the aggregate demand, i.e. Cd will also be higher. Hence to meet up with this demand, the firms will also need to increase the labor and other resources which would in turn lead to higher levels of incomes for the households (Y) (Sloman and Sutcliffe). With an increase in the income of the households, there will be an increase in the expenses as well, which in turn will lead the firms to also sell higher. Higher sales will mean the firms need to produce higher which again would mean more labor, and other resources (Mankiw). This is a multiplied affect that will continue to go on within the economy. This effect is referred to as, ‘Multiplier Effect’ and is defined as, ‘an initial increase in aggregate demand of $Xm leads to an eventual rise in national income that is greater than $Xm’ (Sloman and Sutcliffe). This follows the principle of ‘Cumulative Causation’, which can be defined as, ‘An initial event can cause an ultimate effect which is much larger’ (Sloman and Sutcliffe). The above mentioned process however is not a never – ending cycle and this will balance out when the injections and withdrawals meet at a certain point. It is important to note that every time the household incomes rise, there is also a rise in the savings, levels of taxes and also import purchases. This will lead to a rise in the withdrawals (Mankiw). Once the two, i.e. withdrawals and injections reach a standard level, and this will lead to an equilibrium being restored which in turn will lead to the national income and the employment to stop rising as well (Sloman and Sutcliffe). This process can be summarized by the following formula: J > W → Y ↑ → W ↑ until J = W (Sloman and Sutcliffe) Similarly, in case of an initial fall in the injection levels the scenario would compute as below: J < W → Y ↓→ W ↓ until J = W (Sloman and Sutcliffe) Thus it is clear that the circular flow of income can exist at any level of GDP and employment. Relationship between GDP and Money: This section will provide a clear relationship between money and GDP. The best and most effective manner to understand this is by using ‘The equation of exchange’. Before moving into the equation for this, it is essential to understand the following. Considering the supply of money to be represented as ‘M’, ‘P’ represents the level of prices and the velocity of money are represented as ‘V’. Velocity of money is defined as, ‘The number of times annually that money on average is spent on goods and services that make up GDP’ (Sloman and Sutcliffe). The price is expressed in terms of an index, and the index 1 is recognized to be the base year. The nominal national income is referred to as ‘PY’. Then the equation of exchange can be represented as MV = PY. The equation of exchange is defined as, ‘the total level of spending on GDP (MV) equals the total value of goods and services produced (PQ) that go to make up GDP’ (Sloman and Sutcliffe). There is however an essential theory that also required to be understood, i.e. Quantity Theory of money. This theory states that the price is directly related to the quantity of money in an economy. This theory has been set down way back in the past during the period of the Roman and it was explained that with an increase in the supply, there will also be an increase in the prices (McConnell, et.al). The theory also explains, in order to control inflation, it is essential to control the supply of money as well. The ‘Monetarists’ – a group of economists in the 1970s and 1980s introduced this concept when the world economy was facing an inflation. Keynesian Model – Unemployment and Inflation: A few of the essential elements and concepts of the Keynesian theory are: a) An assumption has been made that there is a maximum level of GDP that is possible to be obtained at any given point in time (McConnell, et.al). Hence this implies, that if the equilibrium is at that level, then there is no deficiency in terms of the aggregate demand and this in turn implies that there is no disequilibrium in terms of unemployment. This level of GDP is referred to as the ‘Full – Employment GDP’ and is denoted by GDPF. b) In another assumption, if the level of equilibrium if GDP (GDPe) is lesser or below the full – employment GDP (GDPF), then, it is considered that there is an excess capacity which in turn leads to deficient unemployment within an economy. The deficit of the aggregate expenditure in respect to the full – employment GDP is referred to as a ‘Deflationary GDP’. It is also essential to note that the size of a deflationary gap can be less than the level by which the GDPe falls short of the GDPF. This is again a similar situation as that discussed earlier, of a multiplier (Sloman and Sutcliffe). Here if an example of an aggregate expenditure has been chosen as a – b, then the multiplier is equated as: [GDPF – GDPe] / [a-b] (Sloman and Sutcliffe). c) Also, in case at the full – employment GDP, the aggregate expenditure is more than the GDP, then this will lead to excess demand. The GDPe, in this case will be over the GDPF. This situation is referred to as an ‘Inflationary Gap’ (Sloman and Sutcliffe). Hence it is recommended by numerous economists to incorporate the policy if a demand management. This will raise the aggregate demand and will help reduce or close the deflationary gap (McConnell, et.al). Also the reducing of the aggregate demand will help close or reduce the inflationary gap. Conclusions: In conclusion, it is clear that the business activities have a major impact on the levels of inflation and unemployment within an economy. However after all the arguments by several authors and economists, there has been an agreement that has been reached upon (McConnell, et.al). This however considers several other factors as well, which have not been discussed in the paper. The agreement was that, ‘in the short run, changes in aggregate demand will have a major effect on output and employment’ (Sloman and Sutcliffe). Also, ‘in the long run, changes in aggregate demand will have a much less effect on the output and employment and much more effect on prices’ (Sloman and Sutcliffe) and lastly, ‘Expectations have important effects on the economy’ (Sloman and Sutcliffe). Hence it is essential that the Governments of every economy, is able to create a balance among the businesses and the consumers equally, as they form a major part of the economy (Mankiw). Further Research Recommendations: This paper has dealt with the relationship in a simple and superficial manner. However to gain a complete understanding of these concepts and the relationships, it is recommended to also gain a clear and concise perspective on the business cycles as well. This will allow a better understanding of the relationship of the business cycles and the aggregate demand and supply. A few of the best books that can be used for any further research on this topic are as follows. These books provide a deep insight into the topic and are simple to read and understand. a) Davis, M. A. (2009). Macroeconomics for MBAs and Masters of Finance. Cambridge University Press. b) Hoover, K. D. (2001). Causality in Macroeconomics, 1st Edition. Cambridge University Press. c) Mankiw, N. Gregory. Macroeconomics. Worth Publishers, 2006. d) McConnell, Campbell and Stanley Bruce. Macroeconomics - 17th Edition. McGraw-Hill/Irwin, 2006. e) McConnell, Campbell, Stanley Bruce and Sean Flynn. Macroeconomics - 18th Edition. McGraw-Hill/Irwin, 2008. f) Sloman, Jack and Mark Sutcliffe. Ecnomics for Business, Third Edition. London: Pearson Education Limited, 2004. g) Swanenberg, A. (2005). Macroeconomics Demystified, 1st edition. McGraw-Hill. h) Tucker, I. B. (2008). Macroeconomics for Today, 6th Edition. South-Western College Pub. Works Cited Mankiw, N. Gregory. Macroeconomics. Worth Publishers, 2006. McConnell, Campbell and Stanley Bruce. Macroeconomics - 17th Edition. McGraw-Hill/Irwin, 2006. Sloman, Jack and Mark Sutcliffe. Ecnomics for Business, Third Edition. London: Pearson Education Limited, 2004. Read More