The Decrease in the APE, a Decrease in the ASF and a Sudden Rise in Essay

The Decrease in the APE, a Decrease in the ASF and a Sudden Rise in GDP Demonstrated Graphically - Essay Example A demand shock - fall in APE In the diagram above, we consider the effect of a fall in APE. The immediate response from businesses is to wait to see if the APE returns to its initial height. When it does not, the output-price adjustment process is initiated which leads to falling prices, output, employment and profits until the equality between GDP, ASF and APE is restored. The fall in output and employment however will continue until prices and profits return to their initial levels. Next consider the impact of a decline in ASF. The initial funding adjustment will manifest in the form of a sharp rise in interest rates. Figure 2: Impact of fall in ASF - money and credit caused recession The following output-price adjustment process like the earlier case will involve drops in output, employment, interest rates, prices and profits until GDP=ASF=APE. Output and employment will continue to fall until profit and prices rise back up to their initial levels. At the end of the coordination procedure, output and employment will be down while interest rates will be up but prices and profits will be restored to their initial levels. Finally, consider the impact of a rise in GDP. The initial impact will be a rise in interest rates. Then, as the producers react to insufficient demands, output and employment will fall back to the initial levels. But this situation wi ll lead to a demand caused recessionary scenario which stimulates the coordination procedure described in the first case in this chapter. ... The APE line shifts out leading to excess demand which in turn leads to a rise in interest rates. However, since ASF is unresponsive to interest rate changes, this rise in interest rates will have no impact on ASF and i continues to rise until it reaches i1 which signifies the new equilibrium interest rate since at this rate, the entire rise in APE is crowded out and we once more have the equality. The opposite mechanism would have been triggered in case of a negative shock to APE hitting the system. This is shown in the diagram below. Figure 5 Thus, we see that a shock to APE only leads to a movement in the interest rate in the same direction while GDP, employment and prices are left unchanged. Thus, the classical doctrine implies that interest rates are flexible enough to accommodate for any shocks to APE such that movements in the interest rate absorbs the full brunt of the shock and GDP, employment and prices are left unchanged. Next, consider the impact of a shock to ASF. This i s shown in the diagram below. Figure 6 In this case it is actually the price level that responds while all other aspects remain the same. Interest rates change initially but they are restored back to the initial levels as price adjustments take place and the ASF line is restored to its original state. It is pertinent to note that imbalances between the aggregate demand and supply of output was assumed to be cured entirely through price adjustments since the classical economists believed that businesses maintained a particular level of output and profits which remained fixed so that whenever this level of output exceeded or fell short of funded demand, price adjustments would take place which increased or curtailed the