Major Principle of Macroeconomics - Assignment Example

PRINCIPLE OF MACRO ECONOMICS Name Institution Date Table of Contents Table of Contents 2 Question One 3 Determinants of Investment 3 Explain theories of interest 4 Question Two 5 Inflation 5 Causes of inflation 5 Question Three 6 Business cycle 6 Phases of business cycle 6 Four theories of business cycles 7 Question Four 8 Jobs of financial intermediaries 8 Functions of financial markets 9 Question Five 9 The functions of money 9 Tools of monetary control 9 Functions of Central Bank of UAE 10 Question One Determinants of Investment Revenue Business cycle and economic growth encourage people to invest as they anticipate reaping more from their investment. Economic growth favor higher returns and hence people will invest. Growth in revenue therefore will lead to increased investment. The reserve is also true. Cost Taxes and interest rates are some of the costs of doing business. If the interest rates increase, people will be discouraged to invest because they will pay more if they borrow money for investment from banks. When interest rate go down more people try to invest. Taxes make investors to shy away from investing in certain area (Elton et al, 2003). Expectation Stable political and economic conditions of a country will attract investment. Where there is war, there are a few people who will dare risk investing in such a country. Peace and stability provide a good environment for investing. Consumer demand If there is substantial consumer demand, investment can be easily be directed in the given area. Explain theories of interest Marginal productivity theory In accordance to this theory, there is a gain of interest on capital due to productivity. The lender who gives money for investment is paid interest which can only be determined with the degree of productivity. Where marginal productivity is less the interest paid, there is no need to invest. Abstinence or waiting theory Capital is the result of savings. There more an individual saves, the more the capital he has. Present needs have to be put aside in order to keep money for future investment. The interest rate is paid for abstinence due to cancellation of needs of consumption (Merton, 1992). Time preference theory Present satisfaction is generally preferred as compared to future satisfaction. The interest rate is inversely correlated to the expectation of income in future. Rate of interest is tagged on the time preference. Income flow is changed until it equals rate of interest. Classical theory of the rate of interest The interest rate is determined by interaction of forces of supply and demand for capital. Choice of theories of interest Marginal productivity theory will be most preferred since it relates the returns that will be obtained in the investment to the interest reset. Consequently one can decide quickly if a business venture is viable or not. In this way, one can take advantage of small windows of opportunities. A business can be profitable for a while but reap a lot of profits. Question Two Inflation Inflation is the drop of value in currency so that more funds are needed to buy the same product which had cost less previously. Inflation causes increased cost of living as prices of basic commodities go up. Money decreases in its value. Anticipated inflation happens when groups or people can predict any future changes in inflation and consider it in their future decision making such as contracts, discussions, and wage negotiations. Unanticipated inflation is where uncertainties cloud the future and resources have to be set aside for dealing with any unexpected changes in the standard of living expressed through the cost of commodities and services (Hall & Taylor, 1993). Causes of inflation Demand pull-when the demand of products is higher that the supply, it is obvious that supplies will raise their prices to benefit more from the increased demand. When there is an acute shortage of some product or a resource to manufacture a certain product, the price of the final product will go up to cater for the increased demand (Sullivan & Sheffrin, 2003). Cost push-this is where wages are increased rapidly as compared to productivity. In this sense, there will be more disposable income relative to the commodities to be purchased in the market. Hence, increased demand of commodities will push prices up as individuals will have more money to spend due to increase in wages. Profit push: This are cases where there is a deliberate attempt to increase the profits through raising prices. Increase in prices due to increase in costs of production will push prices up and hence more money will be required to buy the same product which had cost less previously. Question Three Business cycle A business cycle is variations that bring about falling and rising in the degree of activities in business for unspecified period of time and magnitude. Business cycle is determined by looking at decreases and increases in business activity. Phases of business cycle A business cycle is comprised of an expansion, a recession, and then an expansion. During expansion, there are increased economic activities that lead to job creation and economic growth. The level of unemployment goes down. This happens particularly for seasonal economic activities such as tourism. When tourists come in large number, there are increased economic activities in that country or area (Baro, 1997). Where the tourists leave a recession is witnessed. The expansion climaxes at the peak which is followed by a downturn to the trough of the recession. The trough is at the very worst of the recession period. From there, the economy goes through upturn towards expansion. Recessions and expansion cannot be anticipated how long they will take. Four theories of business cycles War theory In many circumstances it has been noted that war stimulates the economy where as peace lead to recession. In times of war there more demand for food and other products as people anticipate crisis in future. Government spent more money on military equipment. People do not save but release their money into the economy. The Second World War led to increased economy activities. Moreover, the Gulf war of the 1990s led to increased economic activities in the gulf region as countries anticipates attacks from anywhere (Merton, 1992). Allies traded in weapons and food supplies were increased to the fighting soldiers. Many black markets for scarce commodities come up during the times of war. The price shock theory Price of essential commodities like oil determines the economic activity of a region since many activities are facilitated by availability of oil. Changes in prices of oil alter the economic activities in many parts of the world. Increase in prices slows down economic activities particularly in oil non-producing countries. The coast of living and production goes up in oil nonproducing when the prices of oil go up. Innovation theory Increased innovation leads over-production of commodities. Where there is saturation in the market, economic activities in that market will go down. Saturation pins down economic activities from taking place. In this case, there would be very few avenues of investment. Monetary theory The central back is responsible for controlling the amount of money in circulation. If the central bank demands that banks should raise their minimum reserves, there would less money in circulation which leads to decreased economic activities (Groz, 2009). The government also through its treasury bills can sell them to the public leading to increase in money circulation. Question Four Financial system Financial system shows the flow of money from lenders to borrowers through financial intermediaries in the financial market by observing necessary regulation and use of financial instruments like stocks and bonds. Jobs of financial intermediaries Financial intermediaries link the lender and the borrower for a complete transaction to happen. The intermediaries bring down the cost of transactions through liquidity of services and economies of scale. Financial intermediaries are also involved in reduction of risks. Risk reduction is accomplished through diversification and risk sharing like in the case of insurance companies. Financial intermediaries remove difficulties that exist between the lenders and borrowers. Intermediaries ensure elimination of moral hazard through provision of monitoring expertise and also joint ownership (Pilbeam, 2010) Functions of financial markets Financial markets provide money flows from the lender to the borrower, and then bank to the lender when the borrower pays back. Financial markets facilitate business. Various plays in the market can effect their transaction through the financial market. Through financial market, money can circulate through the economy (Groz, 2009). Question Five The functions of money Money is a means or medium of exchange. It is acceptable as payment. Money can be used to perform different functions in many circumstances since it is readily acceptable. Money is also a unit of account. Money is a determination of worthiness of a product. Money has been used to compare relative values of goods (Sullivan & Sheffrin, 2003). Money is a store of value. Apart from the fact that money is used for measuring value of commodities, money can also be used as a means of storing wealth for future spending. Someone can sell land and put money in the bank before he buys a car or house. Tools of monetary control Open-Market Operations (OMO) The central bank will sell bond to the public in order withdrew money from circulation. The public will use money to buy bonds will anticipation of increase in interest rates. On the other hand when the central bank to increase money in circulation it will buy the bonds from the public and get the money to the public to be spend in the economy. Reserve Ratio The reserve ratio is the minimum amount that a commercial bank is allowed to have. The central bank can decrease money in circulation by increasing the reserve ratio so that banks only lend money to a few people. Reduction in the reserve ratio will increase money in circulation as more people will be given loans (Blanchard, 2000). Discount rate This is the rate that the other banks are charged by the central bank for money that they borrow. If the discount rate increases, banks will borrow less leading to decrease in circulation of money. When the discount rate decreases, more banks can afford to borrow leading to increased money in the economy. Functions of Central Bank of UAE The Central Bank of UAE is in charge of issuing of printed currency for circulation. It decides the AED notes that are required in circulation. The Central Bank also lends to other banks in the country if they are unable to borrow from anywhere else. At times banks are caught in financial crisis and imminence of collapsing, the Central bank of UAE can lend to that bank in such circumstances (Sullivan & Sheffrin, 2003). The Central Bank is considered as the lender of last resort. The Central bank comes up with the appropriate monetary policy that will help in combating such things like inflation and unemployment. The government has to ensure that there is job creation and favorable balance of payment. There is normal a balance that has to be struck between the two for a healthy economy. The UAE’s Central Bank can also invest foreign exchange for instance, buying the dollar from the American for easy trade with the American dollar which is accepted in many places. The Central bank fixes the interest rates for banks in case of lending. The central bank of UAE keeps money for the government of UAE as it goes ahead to accomplish its budget allocation activities. The reserves kept at the central bank by commercial bank act as securities to investors who are saving theory money in those banks. The central bank of UAE performs the role of a financial agent (Andrew & Bernanke, 2005). The government uses the Central bank in doing some business for it such dealing in foreign exchange. The central bank regulates the activities of commercial bank to ensure that they are engaging in lawful activities (Siklos, 2001). Central bank has a supervisory role over the other commercial banks to ensure that they meet all requirement in the legislation of the banking Act. The central bank ensures that interest rtes are not exorbitant. The UAE Central Bank is bank to the other commercial banks. The other banks deposit cash with the UAE Central bank. References Groz M.M. (2009). Forbes Guide to the Markets, John Wiley & Sons, Inc., New York. Elton, E.J., Gruber, M.J., Brown, S.J., Goetzmann, W.N. (2003): Modern Portfolio Theory and Investment Analysis, John Wiley & Sons, New York. Merton, R.C. (1992). Continuous-Time Finance, Blackwell Publishers Inc Pilbeam, K. (2010) Finance and Financial Markets, Melbourne: Palgrave Andrew A. & Bernanke, B. (2005). Macroeconomics (5th ed.). London: Pearson Baro, R. J. (1997). Macroeconomics. Cambridge, Mass: MIT Press Blanchard, O. (2000). Macroeconomics (2nd ed.). Englewood Cliffs, N.J: Prentice Hall Hall, R. E. & Taylor, J.B. (1993). Macroeconomics. New York: W.W. Norton Siklos, P. (2001). Money, Banking, and Financial Institutions: Canada in the Global Environment. Toronto: McGraw-Hill Ryerson. Sullivan, A. & Sheffrin SM. (2003). Economics: Principles in action. Upper Saddle River, New Jersey Read More