It is true that the long-term is more important than the short term in the economy, but there are variables that it is important to analyze in the short term such as the internal consumption of people, investment, the trade balance, the exchange rate, and others. When people are analyzing the short term, it can be concluded why an economy is behaving in a certain way since variables that are constantly changing are analyzed. Even fiscal and monetary policies are based more on the short term because they have to correct the failures that exist in economic cycles so that the crises are not so deep and that the booms do not turn out to be negative, as in some cases it has been presented euphoria in the stock market.
In an economy there are different agents such as companies, consumers or the state and each of them makes their decisions in different ways. Therefore, if someone wants to understand how the demand for goods behaves it is necessary to decompose the aggregate production (gross domestic product) from the point of view of the different goods produced and the different buyers. When GDP is decomposed several important components can be seen.
The first component of the gross domestic product is consumption. It represents the goods and services purchased by consumers ranging from food to luxury goods. In all countries, this is the most predominant component of the gross domestic product. The second component is the investment which considers the investment in capital and the residential investment. The third component is public expenditure which represents the goods and services purchased by the state, but this component does not consider the transfers made by the state nor the interest paid by the public debt. In the chart below, you can see the spending of three countries as a percentage of the gross domestic product.
Graph 11. Expense. Data taken from the World Bank
To find the purchase of domestic goods and services should be subtracted imports and added exports. The subtraction between exports and imports is called the trade balance. If exports are higher than imports, it is said that the country has a trade surplus. If exports are lower than imports, the country is said to have a trade deficit. With what has been mentioned so far, we have analyzed some sources of purchases or sales of goods and services. To analyze the production, it must be considered that companies may have inventories from previous years or that they do not sell all their products in the current year. The difference between goods produced and goods sold in a year is called inventory investment. This investment is usually small and can be positive or negative. The following two graphs show exports and imports respectively from four countries.
Graph 12. Exports of goods and services. Data taken from the World Bank
Graph 13. Imports of goods and services Data taken from the World Bank
Consumption decisions depend on many factors, but the main one is available disposable income after paying taxes and other compulsory expenses. It is normal that, if disposable income increases over a long period of time, the demand for goods increases. The effect of income on consumption is called the marginal propensity to consume and this effect may be different between countries. In conclusion, consumption depends on income and taxes.
As for public expenditure is determined by the fiscal policy of each state. It is directly affected by taxes since these are the main source of income for a state. As states do not behave as companies or consumers cannot establish rules about this component since it involves policy, so it is not easy to analyze how the fiscal policy of countries
The production depends on the demand which depends on the rent. So, an increase in public spending causes an increase in production and this leads to an increase in income-generating an impact on demand and this again affects production and so on. Given the above, it is important to analyze what effects each component of GDP has since all variables are related to each other. But despite the models that indicate how each variable affects production is impossible for governments to reach the level of production they want because there will always be external shocks, or the expectations of agents will not respond as expected.
In the next part of the article, we analyze the determinants of the demand for money. In the economy, there are several types of instruments such as bonds, shares and bank deposits. Also, people could decide to have all their wealth of money which would be more comfortable since they would not have to make transactions nor go to the bank, but that also means that they will not receive any interest in this so the decision to have cash or does not depend on the yields of the various instruments. The determinants of the demand for money will be our number of transactions and the interest rate. The interest rate serves to intervene in the economy by the central bank affecting consumer decisions.
The demand for money from the economy is no more than the sum of everyone’s money demands. For everyone, the demand for money increases in proportion as income increases and the demand for money has an inverse relationship with the interest rate. The higher the interest rate set by the central bank the higher the opportunity cost of having money in the pocket and the better it would be to have bonds or deposits in the bank.
The money supply will now be analyzed. In economies, there are two sources of supply. The first, bank deposits that are offered to the public and the second source is the cash offered by the central bank. When there is an increase in the national income this leads to the demand for money increases, but not the supply, which generates an increase in the interest rate to balance supply and demand. So, when the central bank increases the money supply generates a decrease in the interest rate to reach equilibrium in the money market by increasing the demand for money. It is important to keep in mind that these interest rates that are modified are in the short term.
In current economies, central banks change the money supply by buying or selling bonds in open market operations. If a central bank wants more liquidity in the economy, it buys bonds and pays them by creating money and if it wants to remove liquidity it sells bonds to collect money from the economy. With these open market operations, the economies succeeded in modifying the short-term interest rate. This short-term, as well as long-term rate, affects the investment of the economy as consumers and companies take these rates into account in their decisions. The higher the interest rate both short and long term will be more expensive for the company to borrow and will postpone this decision. In the equilibrium of the goods market, a rise in the interest rate will cause a decrease in production.
In current economies, governments and central banks combine fiscal and monetary policies to have deeper effects on the economy and take it along the path they believe is right, but they do not always agree on their policies. When there are recessions in the countries is when the banks and governments agree to get the economy out of this state. At other times when the bank takes an expansive monetary policy the government may have a contractive fiscal policy this depends on the expectations of each and what the objective of each agent.
After the implementation of these policies the adjustment in the economy is not immediately and each agent takes time to adjust their decisions, so when taxes rise consumption takes time to show the effects or the same when the monetary policy is changing when the central bank lowers its interest rates consumption does not respond immediately because the economy has transmission channels that are not updated in a quick way. In addition, in each country, the transmission time of the policies can vary because each consumer or company in each country acts differently so it cannot take an estimated transmission time globally.
Now we will discuss the trade balance issue. Nowadays the world is totally globalized and so is the economy. Globalization brought with it greater competition for local companies and specialization of economies, taking advantage of their competitive advantages thanks to their geographical location or climate. Exports represent important percentages in the domestic production of a country. Imports are also positive if consumer welfare is analyzed as they will have more variety of products and will be able to choose better goods. This decision of consumers and companies sometimes buying foreign and non-local goods obviously affect local production.
In the decision to buy inland or foreign goods is fundamental the price of goods in the choice of which to buy. The comparison of foreign and local prices is a relative price and is called the real exchange rate. This rate is the important one to know because the agents prefer local or foreign goods as it indicates the relative terms of exchange, but in goods not in currency. The real exchange rate is an index number i.e. it does not transmit direct information, but it can indicate whether in a country with the passing of time the goods became more expensive or not with respect to other countries what matters is the variation of this exchange rate.
A rise in the real exchange rate means a real appreciation and a reduction in the rate is called real depreciation. But globalization consists not only in the exchange of goods and services but also the opening of financial markets. This opening also affects the trade surplus or deficit of countries. If a country is in a trade deficit, it means that a country is buying more from the rest of the world than it sells to them and therefore must borrow from international agencies to balance its accounts. The investment decision of the financial markets will depend on the differential of the interest rate between countries, the political risk and the growth prospects of the regions among other risks. In the following chart, you can see the net inflow of capital at current prices in dollars.
Graph 14. Foreign direct investment, net inflows. Data taken from the World Bank
In conclusion, the real rate affects the composition of consumer spending on domestic and foreign goods, although in the first instance it should not affect the total level of consumption. The same can happen with investment, the real exchange rate can influence the decision of companies to buy local or foreign capital, and for the financial markets enter other variables that will decide which is preferred by the investors like the difference of interest rate.