Macro Theory and Policy

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The national income output and expenditure of a country is what constitutes the relationship between two major sectors in any economy, the household and firms. Households provide the services that firms require while firms produce the goods that households need. Moreover, the household sector provides the capital that fund the creation of firms while firms employ the capital with the aim of acquiring profits.

This give-and-take relationship comprises economic activity and it is typically measured through the national product – the aggregate amount of goods and services that an economy creates at a given time expressed in terms of money (Suranovic).A more common form of the national product is GDP and is used by economists to measure that flow and ebb of money – a measuring stick for economic activity (“GDP”). This economic indicator can be computed using three methods: income, output and expenditure (“GDP”). The income method sums up the income of the household sector in providing factor services to the firms that require their services.

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The output method is simply the aggregated output of all economic sectors. Lastly, the expenditure method is the sum of purchases made by consumers. The three methods are not expected to come up with the same value, i.e.

the expenditure method is likely to be less than the output method unless all goods are purchased.Whatever method is employed and despite the disparity among measurements, GDP remains to be a good measure of an economy’s growth. Suranovic, however, points out that it is still not a measure of welfare. In the early 90’s, Japan was hit by a major earthquake and its implication was a significant loss in economic value.

At this time, Japan’s GDP increased but it was only because many households and businesses were forced to spend on repairs and restoration work. As we can see from this moment in history, GDP reliably measured the increase in economic activity but failed to convey the reality that the earthquake resulted in significant economic losses.The United Nations recently estimated that 2007 was going to be a major slack in terms of economic growth in general (UN News Centre). What is of some concern is that the global slowdown, according to the UN, is mainly due to a weakening housing market in the United States.

The dire picture that the news item brings is that it predicts that the United States’ economic growth would end up less than 1 percent in the current year. Even more alarming in the report is the possibility of a collapse in house prices which could set about a deflationary economic environment.Housing has always played a vital role in human history. Everyone would like to have some artificial construct to shelter one from the harsh environment.

People want to have a place of their own and call it home. The news item from the UN is troubling because an economic slowdown could mean individuals losing their homes. Most home owners and prospective home buyers have savings for a down payment and use their income to service the amortized cost of property. Taking out a loan means a undertaking a contractual agreement and the borrower repays the cost of the house plus interest through monthly payments while the property serves as collateral.

Interest payments are based on the size of the borrowed amount, the term of the loan, and the interest rate.However, some mortgages do not have a fixed interest rate and instead are re-assessed from time to time according to economic conditions and the prevailing interest rate. This is the problem faced by subprime mortgage holders (Bajaj 1). According to the New York Times writer, the past six year boom in the housing market has seen subprime mortgages- or mortgage arrangements for individuals with bad credit history, rise from about 719,000 outstanding loan arrangements to about 5.

7 million by June of 2006. At first, subprime loans constituted no more than 2.4 percent of all mortgages but that number has risen to 13.4 percent.

Subprime loans, according to Bajaj, are mainly extended to minority groups like Hispanics and African Americans.The two news reports appear to be invariably linked despite the fact that the problem faced by subprime loans is limited to minority groups. The dramatic increase in the subprime mortgages appears to be at least one factor which contributed greatly to the housing market boom that the country experienced for the better part of the past decade. According to Bajaj, the subprime market is becoming worrisome as more and more of the loans outstanding end up defaulting on payments.

By June of 2006, there were about 350,000 delinquent loans that have been left unpaid from the subprime mortgage market and this number is 6 times what it was when the boom began. The creation of the subprime market is an obvious boon because it provided housing to people who, prior, had no access to credit and created demand a big demand on housing.But how will the government maintain this demand for housing? According to Bajaj, federal laws were put into place in order to weed out potential borrower that would, otherwise, be unable to pay the monthly dues should the variable interest rate reach the highest contracted amount (the assumption is that subprime mortgages agreements place a ceiling amount on the variable interest rate.) The Federal Reserve Bank of San Francisco published an article on the Federal Reserve’s (Fed) functions.

According to the article, a major consideration when purchasing a large asset is inflation. Inflation is the rate of increase of the general price level of all goods and services (“U.S. Monetary Policy”).

But at this point, the more likely condition to watch is the rate of economic growth and the following discussion highlights the danger that lurks behind a slow down with respect to the housing market and the economy, in general.According to Hernandez, all economies go through “booms” and “busts” (Hernandez). When GDP is plotted out in a time-series graph, it appears to be (somewhat jagged) waves. These waves have about 3 major points with the first (A), representing peaks or plateaus.

The economy can also go through (B) troughs, which constitute the lowest level of economic activity and, quite likely employment. Lastly, (C), represents either a downward or upward movements that are respectively economic recoveries and recessionary periods. Recessionary periods are characterized as a continual decline of real output, employment and trade lasting at least 6 months (Hernandez).Figure 1 (Hernandez – Please see reference list)This recurring pattern of upward and downward movements is what is termed as the business cycle.

The business cycle has significant effects on the households and firms sectors because it can dictate the amount of employment available and the amount of goods and services that an economy consumes (de la Dehesa 2). According to de la Dehesa, recessionary periods also mean that government revenues dramatically decrease from both progressive and fixed taxes. This lowers the ability of the government to impose fiscal policy measures to counteract the effects of recessionary periods without resolving to incur more national debts. Lowered economic activity can result from a number of causes, but it always results in hardship for both households and firms.

Lowered economic activity means job losses or involuntary separation (Wall & Zoëga 26). These periods means that goods in services in the economy are left unsold and firms have to scale operations down according to the environment. According to Wall, recession during the 80’s and  90’s have resulted in increases in the unemployment rate (Wall). Because more and more households during these periods find a sudden cut in income, they are forced to default on payments, which leads back to the topic on housing.

It is likely that members of the minority sector who contract subprime mortgage arrangements will be the first to be hit by recessionary periods. The arguable consequences are that the subprime mortgage markets which now accounts for a significant amount of the mortgage market and have, in the past 6 years, accounted for a major portion of growth in the housing market is in dire straights.Fiscal policy is one of the tools of macroeconomic policy and is tantamount to government control over its spending and its inherent power to collect taxes (“Fiscal Policy”). Government spending can be increased in order to, likewise, increase the aggregate demand in the economy.

Tax measures, on the other hand, can be to reduce fixed or progressive taxes so that people have more disposable income with which to raise the level of aggregate demand. The second instrument of macroeconomic policy is monetary policy (“Monetary Policy”). Monetary policy in the United States is controlled by the U.S.

Monetary Board (U.S. Monetary Policy 2). The Fed can control the amount of money in the economy through several measures.

Increasing the supply of money can, in the short-run, increase demand because people have more money to spend but would likely result in an increase in inflation. According to the FAQ released by the Fed, it cannot directly stimulate or hinder economic demand, instead it can control certain factors. The Fed can control the reserve requirement of banks, buy or sell government securities like T-bills in the “open market”, and control the interest rate for extremely short-term loans (U.S Monetary Policy 10).

As described in the foregoing section and through class discussions, the government has a plethora of tools with which to enhance economic growth and stem recessionary spells. However, according to the Fed, a lag is apparent between the time policy is implemented and the time it takes effect over the economy. This is an obvious vote against the Keynesian view that the government should maximize the use of monetary and fiscal policy in the management of the economy. Because of the lag time, fiscal and monetary policy could conceivably have dire effects causing either to prolong recessionary periods or cut short periods of economy recovery and growth.

In the case of the subprime mortgages, it should be argued that the government should react quickly to stem the possibility of a lowered economic activity. As aforementioned, these periods mean job losses and the first to be hit are precisely the same market which caused significant growth in the properties market. Job losses mean more defaults on these loans and a decrease in the demand for housing. The result, as the UN predicts, is a deflationary environment where property values drop.

According to the latest press release by the Fed, interest rates remain the same and the board sees that inflation remains stable (Federal Reserve Board). Since the Fed is an independent body which holds its own views, the only measure which remains is fiscal in nature. Perhaps the government should, as Bajaj reports, do more than simply offer to restructure the loan of subprime mortgagors and offer to channel more State funds into housing for the mean time. Reference List:Bajaj, Vikas and Nixon, R.

“Subprime Loans Going From Boon to Housing Bane.” The New York Times. December 6, 2006 [Online]. 25 Feb 07<http://www.> De la Dehesa, Guillermo. “Fiscal Policy as a Stabilizer of Business Cycle Fluctuations in the Euro-Area.

” 2001. 25 Feb. 2007<www.europarl.> Federal Reserve Board. “Press Release”.

January 31, 2007. 25 Feb 2007.<http://www.federalreserve.

gov/Boarddocs/Press/Monetary/2007/20070131/default.htm> Hernandez Ignacio. “Business Cycles.” Online posting.

28 Apr. 2006. Worldbank. 25 Feb.

2007<> Suranovic, Stephen. “The National Income & Product Accounts.

” International Finance Theory & Policy Analysis. 2001. 25 Feb. 2007<http://internationalecon.

com/v1.0/Finance/ch5/5c010.html> UN News Centre. “Slower economic growth forecast for this year, mainly due to US housing market: UN.

” 2007. UN News Service. Jan 10, 2007 [Online]. 25 Feb.

07<> “U.

S. Monetary Policy: An Introduction.” 2004. Federal Reserve Bank of San Francisco.

25 Feb. 2007<

pdf> Wall, Howard and Zoëga, G. “U.S. Regional Business Cycles and the Natural Rate of Unemployment.

” Federal Reserve Bank of St. Louis Review. January/February 2004, 86(1), pp. 23-31.

 “Business Cycle”. 2007.

The Economist Newspaper Limited. 25 Feb. 2007<http://www.economist.

com/research/Economics/alphabetic.cfm?letter=B#businesscycle> “GDP”.

2007. The Economist Newspaper Limited. 25 Feb. 2007<http://www.> “GNP”. Economist.

com. 2007. The Economist Newspaper Limited. 25 Feb.

2007<> “Fiscal Policy”. 2007. The Economist Newspaper Limited.

25 Feb. 2007<

cfm?term=fiscalpolicy#fiscalpolicy> “Monetary Policy”. 2007.

The Economist Newspaper Limited. 25 Feb. 2007<>   

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