SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM AND THE ECONOMY (part 6)

Maximization: Plans, Revisions, and Actions

by

Charles Lamson

Each spending unit in the economy is presumed to pursue some objective or set of objectives. Understanding the goals is important for our purposes because they are what guide an economic unit's spending, saving, and financing decisions.

For households, we assume they wish to maximize utility or satisfaction over time. But what does this mean? If, as seems sensible, more is better than less, then people will desire to increase their holdings of goods and financial assets, and when faced with a choice, people will first select those items that provide the most utility or satisfaction. Imagine trying to choose between two identically priced goods you want---say a new color television set and a new couch. Of course, you would prefer to have both, but if you can have only one you will choose whatever is most useful to you now---that is, the one that yields the most utility or satisfaction.

For business firms, we assume that their decisions are guided by the desire to maximize profits. Logically, this means that firms will try to maximize the difference between their revenues from sales and their costs of production. After all, profits equal revenues minus costs. In general, firms will make production, hiring, investment, and pricing decisions by assessing the impact of alternative courses of action on costs and revenues and thus ultimately on their profits.

To sum up, each spending unit in the economy is attempting to maximize something. This maximization process is nothing more than the attempt of economic units to do the best they can, given their objectives and the circumstances they face. Such maximization plans are depicted in Exhibit 1.

1. Goals of Various Spending Units

As we all know, there are limits to what economic units can attain. The practical world does not allow us to achieve unlimited utility or unlimited profits. The fundamental economic problem is that we have infinite wants, while our means or resources are limited. Put more directly,`   there are constraints that limit the maximum degree of satisfaction profits and the like that economic units can attain. the existence of such constraints forces economic units to choose among alternative courses of action. for example, as mentioned previously you might prefer to purchase both a new television set and a new couch however if you can afford only one---if you are constrained by your available funds---you must make a choice between the two alternatives. Thus, every economic unit will chose the course of action that is most consistent with its objectives subject to the constraints it faces. The formal term for this process is constrained maximization.

But what are these constraints? It has often been said that the first rule of economics is "there is no such thing as a free lunch." All purchases of goods or financial assets must somehow be financed. More specifically, you must part with money to consummate transactions. This being the case, the constraint on an economic unit's spending can be defined in terms of its access to means of payment. In this regard, an individual economic unit can choose among several financing possibilities: (1) the unit can use its existing holdings of money; (2) the unit can earn income by selling its labor (households) or its products (firms); (3) the unit can sell some of its holdings of financial or real assets accumulated from past saving; and/or (4) the unit can borrow.

Households will make plans to work, spend, and save. These plans will be based, for the most part, on the households'  current economic and financial situations; their expectations about prices, interest rates, and profits. Is there any reason to expect that the plans of households to work, spend, and save will mesh exactly with the plans of firms to hire, produce, and borrow? Of course, the answer is no; this would occur only by accident. So what happens if the plans do not mesh? The answer is that the plans will have to be revised. To see how and why, an example will help.

Assume we have a simplified economy of firms and households. Suppose the current interest rate is 6 percent and households in the aggregate, given the factors and objectives discussed above, plan to lend $300 billion while firms plan to borrow $400 billion. In this case, the planned quantity demanded of funds by firms would exceed the planned quantity supplied of funds by households. This excess quantity demanded of funds would tend to raise the interest rate, and here comes the main point. As the interest rate rises, we would expect households and firms to revise their plans. In particular, the rise in the interest rate to say 8 percent will discourage some firms from investing, and thus, borrowing. The higher cost of borrowing will make certain projects unprofitable. Given the profit-maximization objective, firms will reduce their planned investment spending. At the same time, the rise in the interest rate may well encourage our utility-maximizing households to save more.

With such actions by firms reducing the quantity of funds demanded and such actions by households increasing the quantity supplied, the excess quantity demanded of funds shrinks. In general the interest rate will continue to rise and plans will continue to be revised until the excess quantity demanded. in analytical terms, an equilibrium is reached when the plans mesh; at this point the plans and the resulting supplying and demanding actions of households and firms in the various markets are consistent.

By outlining the analytical basis for action by economic units, we have identified, at least in a general way, the forces and processes that produce the "motion" we observe in the economy. To nail down the relevant set of points, it is only necessary to see that if the economy is in equilibrium and the Fed, for example, increases the supply of funds, the resulting fall in the interest rate will lead to a revision of plans by households and firms regarding the quantities supplied and demanded in the financial system, output market, and factor market. In effect, the size of the circular flow will grow, and the "motion" of the economy will quicken.

Recap

Given their constraints, households maximize utility and business firms maximize profits. The economy is in equilibrium when the spending plans of all economic units mesh, and all markets are in equilibrium. If any factor affecting the supply and demand decisions of households or firms changes, an adjustment process will be set in motion. Prices and quantities will change until the spending plans of all economic units again match.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD EDITION, 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 74-75*

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