Three components of the transmission mechanism,through which the expansionary policy works - Essay Example

?Q1. Explain in detail how expansionary monetary policy controls a recessionary gap. Explain the three components of the transmission mechanism, through which the expansionary policy works. Use a set of diagrams to illustrate your answer clearly? An expansionary monetary policy works by increasing the supply of money available in the economy. The recessionary gap is handled by the corresponding increase in demand which tends to create employment in the shorter run. As soon as the economy is supplied with money, the aggregate demand level rises from its previous state as shown in Figure 1 below. The demand level tends to rise from the existing AD1 level to a new AD2 level. In turn this increase in demand triggers an increase in the price level which tends to rise from an existing level of P1 to P2 which can be seen as inflation (Mankiw, Kneebone and McKenzie 503). As a consequence of price hikes, the inflation rate tends to increase as shown in Figure 2 and Figure 3 below. The short term Phillips Curve shows a linear increase as the amount of inflation rises but the long term Phillips Curve shows a vertical increase as the aggregate demand rises. If money is supplied to the economy at a fast rate, the outcome would be a small change in the overall employment rate since inflationary pressure would curb the economic growth. In contrast, if money is supplied to the economy relatively slowly, there would be a smaller increase in overall inflation and hence the net employment gain would be greater. In order to control a recessionary gap, the government has to offer the economy greater liquidity by increasing the supply of money. However, it must be kept in mind that the rate of supply of money has to be relatively low so that long term inflationary pressures do not set in. Figure 1 - The model of aggregate demand and aggregate supply Figure 2 - The short term Phillips Curve Figure 3 - The long term Phillips Curve Q2. Explain what are the tools of fiscal policy? Explain in detail how does a contractionary fiscal policy combat inflation? Explain in detail the crowding out effect and how it weakens or cancels the stimulus of fiscal policy? Draw the flow chart and the graph to illustrate your answer. The tools of fiscal policy are government spending and tax cuts. Fiscal policy can be controlled by increasing or decreasing government spending as well as by manipulating the taxation levels of ordinary households. A contractionary fiscal policy reduces the supply of money to the economy. When the supply of money to the economy decreases, the aggregate demand reduces from its existing level to a lower level. This leads to a contraction of the aggregate demand which in turn reduces the overall output levels in the economy. Consequently, the contractionary fiscal policy moves the economy along the short run Phillips curve as shown in Figure 4 below. In the longer run, the economy shifts vertically along the Phillips curve which leads to a reduction in the overall inflation rate with a minimal effect on the overall employment levels (Mankiw, Kneebone and McKenzie 512). Figure 4 - Disinflationary monetary policy in the short run and long run When the amount of government spending tends to increase, it increases the overall money supply in the economy. As a result, the demand for money in the economy tends to rise from MD1 to MD2 as shown in Figure 5. Consequently, the interest rate tends to rise which leads to a net reduction in the investment levels and puts reduction pressure on aggregate demand. The aggregate demand level tends to rise though it fails to meet its expected level of increase. While the expected level of increase in the aggregate demand curve should be from AD1 to AD2 but it actually increases only to aggregate demand levels between actual level and expected level to AD3 as shown in Figure 6. The reduction of the aggregate demand as soon as a fiscal expansion takes place is better known as the crowding out effect (Mankiw, Kneebone and McKenzie 487). Figure 5 - The money market Figure 6 - Changes in Aggregate Demand Figure 7 - Flowchart for Crowding Out effect Q3. What are the key determinants of Aggregate Supply? Explain at least 5 of them in some detail and clearly how does the changes in these factors shift the aggregate supply curve. Draw graphs to illustrate your answer. Aggregate supply is affected by changes in the supply of labour, capital, natural resources, technology as well as expected price levels. If the labour supply is increased, the aggregate supply curve shifts to the right side. On the other hand, if the labour supply decreases, the aggregate supply curve shifts to the left side. When the capital increases in an economy (either due to an increase in physical capital or human capital), the aggregate supply curve tends to shift to the right side. In contrast, if the supply of capital decreases in the economy, the aggregate supply curve shifts to the left side. In a similar manner, when the natural resources available to an economy increase, their supply increases leading to a right hand side shift in the aggregate supply curve. However, if the amount of natural resources available to an economy decreases, the aggregate supply curve tends to shift to the left side. Similarly, when the technological gains in an economy tend to increase, they bolster the supply levels so that the aggregate supply curve shifts to the right hand side. However, if the available technology levels tend to decrease for any reason, the supply levels decrease triggering the aggregate supply curve to shift to the left hand side. In contrast to the factors above, a decrease in the expected price levels tends to move the aggregate supply curve to the right hand side. However, an increase in the expected price levels tends to shift the aggregate supply curve to the left hand side. Figure 8 - Aggregate Supply Curve sourced from (Amos Web) Q4. Explain the multiplier effect of an increase in Gross Private investment (lg) on the equilibrium GDP. What is the relationship and bearing of MPS and MPC on the size of the multiplier. Calculate the multiplier when MPS is 0.4, 0.6, and 0.75. Explain the difference and contrast between the closed economy and open economy multiplier in detail. Use a numerical example to illustrate your answer. When Gross Private Investment (Ig) is increased, the output levels of the workers’ pays increase accordingly. The spending of the workers increases outputs in other areas where they consume. Consequently, the net increase in the economy is greater than the Ig increase leading to an increase in the equilibrium GDP. The amount of increase triggered by the Ig is better known as the multiplier. The multiplier can be expressed in terms of the marginal propensity to save (MPS) and the marginal propensity to consume (MPC) as shown below: MPS and MPC denote the total increase in the disposable income of the average worker in the economy. The amount saved is denoted by MPS and the amount consumed is denoted by MPC. The sum of MPC and MPS leads to the total increase in the worker’s overall disposable income. The open economy multiplier is smaller than the closed economy multiplier since the open economy allows the import of foreign goods that must be taken into account as the marginal propensity to import (MIM). In the case of the open economy, the multiplier can be expressed as: In contrast, the closed economy does not allow imports so its multiplier is devoid of the import term altogether. For example, if two neighbouring countries had similar demographics, spending habits and disposable incomes then suppose that their MPC was 0.5. One of these countries, A, allows imports with a MIM of 0.25 while the other country, B, does not allow imports. In this case, their multipliers would be as shown below: Works Cited Amos Web. AGGREGATE SUPPLY DETERMINANTS. 2012. 20 September 2012 . Mankiw, N. Gregory, Ronald D. Kneebone and Kenneth J. McKenzie. Principles of Macroeconomics (5th Canadian Edition). Nelson College Indigenous, 2010. Read More