Financial System According to Basic

Financial System

According to basic macroeconomic theory, Gross Domestic Product within a country is the function of total consumption in the economy, namely, consumption of households, government expenditure, investment, tax receipts and net export, or export minus import rates. Each of these variables has its' own sources that affect its' movements either positively or negatively. For example, consumption of households is dependant on wages in the economy, output levels, overall price levels and inflation rates, interest rates in the financial markets which motivate households to consume more if they are low, or on the contrary, to save more if they are high. Government expenditure is one of the measures to trigger GDP growth if the expenditure is targeted at investment rather than spending money with no long-term perspective. Thus, construction of roads or redevelopment and innovations to improve productivity are the examples of the former. Investment by the companies is dependant on the interest rates in the economy. Lower interest rates motivate firms to borrow as the cost of capital is low for them and to fund growth and expansion of the company. Households are better off to consume when the interest rates are low as they also borrow and can afford durable goods. Furthermore, all these variables together are interlinked and the shift in one of them leads to the shift in another.

Interest rate movements is one of the most frequently used aggregate to very fast influence the development of the economy. If the interest rate is increased, it becomes expensive for companies and households to borrow and the inflationary pressure becomes less and production volumes remain at their previous levels. If the government finds it optimal to boost the economy and there are internal or external resources for this, the interest rate is decreased which has positive affect on all the elements of GDP.

Empirical test is carried out in order to estimate whether the interest rate is significantly correlated with GDP movements during the last 26 years in the U.S.A. economy. This era was known as Greenspan years when he was in charge of country monetary policy. The data was obtained from Federal Bank of Reserve of Saint Louis. Monthly values from 01/01/1980 until 01/06/2006 for the fundamentals of GDP rate, Federal Reserve Effective Funds Rate as interest rate, influence of disposable personal income, personal savings rate and personal expenditure on durables and nondurables as two fundamentals were selected. The regression analysis was employed and GDP values were regressed against the mentioned above factors. This is referred to as multi-factor regression when the dependence of variation of one variable is dependant on variations of other theoretically grounded variables. The R. square for the regression output is 0.99, which means that 99% of the variation of GDP is explained by the chosen factors and thus the model is statistically correct. The number of observations was in the model 317. Standard error was at the order of 75.

The model theoretically looks as follows: Y = a + ?1*X1 + ?2*X2 +...+ ?, where Y is the dependant variable, or GDP within this model, a is autonomous level of Y when all the explanatory variables are equal to zero, ?1 and ?2 are coefficients of explanatory variables and the last variable in the equation is the error, or the difference between predicted by the linear dependency model value of Y at specific observation time and its' actual observed value. Coefficients reflect to a rate of change in the dependant variable which leads to one point change in dependant variable. For example, coefficient of -0,05 infers small negative influence of this explanatory variable on the dependant variable, while coefficient of 1.5 implies that 1.5 rate growth of this variable will lead to positive growth by one point of the explanatory variable.

The results of the regression model are as follows:

GDP ($, billions)= 568.04 + 16.07*Interest_Rate + 1.19*Disposable_Personal_Income -64.75*Personal_Savings_Rate + 0.5*Personal_Expenditure_On_Nondurables - 0.26*Personal_Expenditure_On_Durables.

Coefficients

Standard Error

Stat

P-value

Intercept

1.384E-16

Interest rate

4.089E-13

Disposable Personal Income

2.327E-88

Personal Savings Rate

5.196E-34

Personal Expenditure Nondurables

1.085E-05

Personal Exp Durables

The result suggest, that autonomous value of the GDP is rather high, or that explanatory variable that has big negative affect on GDP was not included in the model. Interest rate has the biggest positive affect on the GDP, while simple calculation of correlation between these two variables reflect large statistically significant negative correlation of -0.77.But the P. value of this variable is large negative which implies that the probability of not finding influence of this variable on GDP while there is influence, is very small. The results thus are misleading and not reliable.