Economics for the Global Manager - Assignment Example

Economics for the global manager What are the key elements that allow transactions to occur in the market The key elements that allow transactionsare, first of all, a market that exists either physically (like the stock or commodities exchange or a flea market) in a location or building, or virtually (for bond trading or derivatives) in a computer system; goods that are exchanged in this market; buyers and sellers who either buy or sell the goods; and money that is used as the medium of exchange. A market transaction is therefore where buyers acquire from sellers certain goods in exchange for money at an agreed price. 2. Explain the logic behind the following statement: "there is no such thing as a free lunch" If by the word free we mean that one gets something for nothing and enjoys a benefit at no cost, then it means that in the world nothing is free, because someone is always paying for it. All benefits have a corresponding cost. The air we breathe, kept clean through laws costing millions of dollars to enforce, is not free. If your friend treats you for lunch, it is not free for you either, because the time you spent with your friend has an opportunity cost that may probably be more than the price of the lunch. 3. Why might the government want to influence transactions The government wants to influence transactions for many reasons. First, as in nations with free market economies, the government wants to make sure the market's rules are fair as part of its mandate to keep the people happy. One danger of a free market economy is explained by what is called asymmetric information: sellers may hide vital information from buyers that does not allow a fair price to be paid for a good (think second-hand car dealers). Otherwise, people cheated all the time will be aggravated and may move to change the government. Second, the government wants to control the supply and flow of money in the economy, because if they do not, there will be trouble in the form of inflation that can lead to social unrest (Solomon 1972 cited in Samuelson 1992, p. 712). Third, the government wants to influence transactions, like the Fed setting interest rates, Congress cutting budget deficits, or the Commerce Department negotiating trade agreements, because of the add-on effects that these actions (all are forms of market intervention) have on the nation's macroeconomic conditions. And fourth, government wants to ensure the country's patrimony is safe, for example to prevent some scam artist from selling the Statue of Liberty to foreigners. 4. What does the spillover or externality principle measure Use examples. This principle measures the costs or benefits of externalities, activities that affect others, without meaning to, either positively in the form of benefits not paid for or negatively in the form of inconvenience or costs for which they are not compensated. An example of the first (called external economies) is having a wife who is a doctor (you can consult her for "free" or, at least, you don't have to pay someone else to prescribe the right medicine). An example of the second (called external diseconomies) is driving recklessly on the freeway, which makes many other drivers nervous and increases their consumption of tranquilizers. 5. Currently our demand for gasoline is rising as our economy is expanding. However, we expect OPEC to keep the supply stable. Use a graph to show what your prediction is for the price of gasoline. USE A GRAPH INDICATING WHEN THE DEMAND INCREASES. I predict the price will increase, because as shown in the graph on Figure 1, with the supply constant and the demand increasing, the demand curve shifts to the right, moving the equilibrium point to the right, with the effect of increasing the equilibrium price, or the point at which the current supply curve intersects the increased demand curve, from p to p'. At price p, the gasoline market is in equilibrium, that is, supply equals demand. OPEC's move holds the supply curve steady, but an expanding/growing economy needs more fuel, so demand increases and the equilibrium point e moves to e' as the demand curve moves to the right (representing the increase in demand), pushing the equilibrium price to p', which is the new (higher) price of gasoline at the new equilibrium point. 6. Why do people expect inflation to heat up when the unemployment rate reaches 4% USE AGGREGATE DEMAND AND AGGREGATE SUPPLY CURVE. The figure of 4% is the so-called natural rate of unemployment, the level of unemployment at which forces acting on wages and prices are in balance. Below that rate, inflation generally tends to rise, while above it, inflation tends to subside (Samuelson 1992, p. 611). The figure changes depending on the actual state of the economy as measured using a variety of statistical techniques. In the early 1990s, it was 6% (Samuelson 1992, p. 609) and in 1997 it was 3.75% (Kramer and Li 1997, p. 31). As shown in the graph of the aggregate supply and demand of labor in Figure 2, the equilibrium point e is when, at a natural unemployment rate of 4%, the wage p is the price of labor. When the natural rate of unemployment is breached, that is, the unemployment rate starts to go down (say, to 3.9%) because of an increasing demand for jobs, a tight labor situation results: the aggregate supply of workers is fixed but the aggregate demand shifts to the right, signifying an increase. The result is higher cost of labor and an increase in wages. When wages rise, the costs of producing goods will rise. If business owners want to keep their profit margins, they will pass these added costs of higher wages to the consumer by raising prices, a phenomenon known as inflation. 7. How might the aggregate supply and demand curves have been affected by September 11- 2001 terrorist attacks Explain the changes and use a graph to illustrate your answer. EXPLAIN EQUILIBRIUM ECONOMY WITH A GRAPH. The equilibrium economy is the level of GNP at which intended aggregate demand equals intended aggregate supply. At this equilibrium point, the desired consumption, government expenditures, investment, and net exports just equal the quantity that businesses wish to sell at the going price level (Samuelson 1992, p.736). This is shown in Figure 3.1, where aggregate demand (AD) and supply (AS) curves intersect at the equilibrium point e, a situation where total spending in terms of GNP is in balance with the over-all price level p which is, in effect, the country's inflation rate. The terrorist attacks of 9/11 can be considered as a shock to the U.S. economy, and two of the short-term effects can be shown in Figure 3. We can take, for example, the effects of increasing oil prices due to a leftward shift of oil supplies due to the stoppage of deliveries of Mid-East oil and a tightening of monetary policy to counter the inflationary effects. Delayed oil deliveries reduce the oil supply, shifting the AS curve to the left and raising gasoline prices. Businesses then increase the prices of their goods, causing inflation and raising over-all price levels from p to p' as in Figure 3.1 The Fed, foreseeing the rise in inflation, tightens the money supply by raising interest rates, slowing down economic activity and reducing aggregate demand for goods. This shifts the demand curve to the left shown in Figure 3.2 to bring down price levels back to p. In reality, the phenomenon is not as simple as this because the whole GNP consists of several sectors, some like the security and food industries experiencing demand increases (with inflationary effects) but other sectors like the airline and tourism industries experiencing demand decreases (with deflationary effects). Different sectors of the economy behave in different ways, and with several AD-AS curves shifting, it is possible that in the end price levels remain the same, and it takes only a few Fed pronouncements on the government's monetary policy (tightening by increasing interest rates by a few tenths of a percent or loosening by doing the opposite) to keep it there. This is one of the reasons why, despite the many shocks to the U.S. economy after 9/11, the inflation rate has not budged much. Other reasons (Economist 2005a) are cheap goods from China and their purchase of U.S. bonds to defend the Yuan, China's currency. 8. Is it possible to balance the government's budget every year Is it desirable INDICATE WHY CONGRESS CANNOT BALANCE THE BUDGET. Yes, it is theoretically possible to balance the government's budget every year. In fact in 1998, Heniff and Keith (2004, p. 3) pointed out, the government budget was in surplus, the first time it happened in thirty years. This was the result, they claim, of several years of fiscal discipline following years of deficits. In fact, after the budget surplus, lawmakers and every guy next door discussed the problem of what to do with the surplus (pay foreign debts, increase pensions, or as what eventually happened, to give out tax refunds, a move that somehow helped Bush win the presidency in 2000). In reality, budgets are very difficult to balance because many budget assumptions are almost perfectly impossible to quantify (Kogan 1997). On the receipts side, it is difficult to know how much companies and individuals will pay in taxes, because several factors affect it like the performance of the world economy (if it booms, sales of U.S. goods boom too), investment decisions of corporate boards (if many decide to put profits in tax-deductible investments, tax revenues go down), and natural disasters (like hurricanes that can wipe out a company). On the expenses side, it is difficult to predict how much government will spend because sectors of the economy can go through a recession (leading to higher unemployment benefits), a flu epidemic downs millions (increasing health care costs), or a hurricane hits (increasing reconstruction expenses). Should budgets be always balanced No. There will be cases, for example in a recession, when government can and should step in to prime the economy by increasing spending to generate employment and production of goods. Over the years, there have been moves to pass a balanced budget act where revenues should equal expenses, or a line item veto act (which passed in 1996 but which the U.S. Supreme Court ruled as unconstitutional in 1998) (Heniff and Keith 2004, p. 6), but because recessions can still happen and the government cannot afford the luxury of amending the constitution before it steps in to intervene in the market, most people think it is better to leave things as they are: Congress tries its best to balance the budget even if it knows it is difficult, almost impossible to do so, every year; get people to pay the right amount of taxes on time; and ask everyone to be more understanding of the situation and get involved in their own way to help the country by starting businesses or being more productive. The advantage of being in a free market is that, at least once every thirty years, it is possible to have a surplus. 9. What is the burden of the national debt As of end-2004, America's net external debt position - the difference between the value of America's foreign assets and its foreign liabilities - was $2.6 trillion (Economist 2005b, p. 20). This national debt, equivalent to around 24% of America's GDP, has to be repaid at some future time, and as the government piles one budget deficit on top of another (by third quarter 2005, the year's deficit stood at $700 billion), the debt burden just keeps growing. Should this be a cause for worry No, according to the same article, for several reasons. One is that American households are worth $30 trillion, so a debt repayment of $700 billion is less than 2% of total wealth, just like someone with $1,000 in assets having around $100 of debt continuing to borrow $20 a year for personal expenses including debt principal and interest payments. Although given its present levels the debt looks manageable, many fear that it is not sustainable, and some changes in the behavior of American consumers, for example saving more money and using credit cards less often, would be needed. Not everyone agree, and each side presents convincing arguments to support their positions. 10. What monetary and fiscal policies would you recommend for the current economy Explain and support your answer. INDICATE WHAT MONETARY AND FISCAL POLICY WOULD YOU USE. A recent Fortune article (Fox 2005, pp. 68-71) explains the economic challenges facing new Fed Chairman, the one in charge of monetary policy, and the team of President Bush and Congress, in charge of fiscal policy. What are needed when the economy is booming, inflation is down, and standard of living is rising, while at the same time the real estate bubble expands, national debt rises, job uncertainty fills the air, a pension system crisis looms in the horizon, and the health care system continues in its dysfunctional ways A lot and nothing much (p. 68), except to keep the free market system vibrantly humming. As Fox proposed (p. 71), these problems do not necessarily call for a massive government solution. There are, however, priority monetary and fiscal policy issues that need to be addressed. A key monetary policy I would use if I were the Fed Chairman is to push for a tiny interest rate hike to signal to the world (especially Americans) that the government is keeping inflation under control. As for fiscal policy, I would ask Congress for spending cuts by looking for solutions to three problems: how to bring down health care costs, how to pay for baby boomers' retirements without bankrupting corporations, and finding a way to stop borrowing too much money from foreigners. And I'll keep my hands off the free market economy that has kept business cycles in different sectors of the economy in balance, keeping inflation under control, stimulating wealth creation and growth, and maintaining interest rates at reasonably low levels (Fox 2005, p. 70-71). The worst thing government can do now is to legislate the U.S. into a recession. References Economist. (2005a). China and the world economy. The Economist, July 30-August 5, 2005, pp. 65-67. Economist. (2005b). A survey of the world economy. The Economist. September 24-30, 2005, p. 20. Fox, J. (2005). It's his economy now-and yours. Fortune Magazine. November 28, 2005, pp. 68-71. Heniff, B. Jr. and Keith, R. (July 8, 2004). Federal budget process reform: a brief overview. Congressional Research Service. Washington: Library of Congress, pp. 3, and 6. Retrieved December 3, 2005, from http://www.fas.org/sgp/crs/RS21752.pdf. Kogan, R. (January 6, 1997). Enforcement of a constitutional balanced budget amendment: questions without answers. Center for Budget and Policy Priorities website. Retrieved December 3, 2005, from http://www.cbpp.org/BBAENFRC.htm. Kramer, C. F. and Li, Y. (1997). Job Uncertainty, Unemployment, and Inflation in the United States. IMF Country Report 97/97, United States. Finance and Development, December 1997. pp. 30-32. Retrieved December 3, 2005, from http://www.imf.org/external/pubs/ft/fandd/1997/12/pdf/kramerli.pdf. Samuelson, P. A. and Nordhaus, W. D. (1992). Economics. New York: McGraw-Hill. Solomon, R. (1977) The International Monetary System, 1945-1976. An Insider's View. New York: Harper & Row, pp. 1 and 7. Figure Captions Figure 1. Graph for Question no. 5 showing the effects of OPEC policy on gasoline prices. Figure 2. Graph for Question no. 6 showing inflationary effects of lower unemployment rates. Figure 3. Graph for Question no. 7 showing the effects of 9/11 on the economy. Figure 1 Quantity of Gasoline, Q [1] Effect of Increase in Demand for gasoline: prices go up as oil demand increases with constant Supply. Figure 2 [2] Effect of Increase in Aggregate Demand in a tightening labor market: prices go up as goods become more expensive with higher wages. Figure 3 [3.1] Effect of Decrease in Aggregate Supply on an Economy in Equilibrium: prices go up [3.2] Effect of Decrease in Demand: prices go down as GNP contracts from Q2 to Q1 Read More