Macroeconomics in Finance: Investment and Economy Models - Assignment Example

Macroeconomics in Finance Question one A) A Closed -economy is the one that limits trade with the outside world thus relying wholly on its own resource. In a model under a closed -economy macroeconomic, some of the assets are taxed and there is an evaluation of the long run and short run implication of a change in the expected inflation. Any increase in the inflation rate will shift the aggregate demand composition since the assets bearers will shift their case from the assets that are taxed to the untaxed one. We shall construct an IS-LM model in a closed economy (Obstfeld and Kenneth, 1996) The model is taken to be equally influential as the Keynesian model that which was originally formulated by John Keynes in the 20th century. The model relates employment and aggregate demand to three exogenous quantities namely; the government spending, business expectations by the state and the total amount of money in circulation. The model can be understood in the general equilibrium theory. The model can be used in line with the Phillips curve to make prediction for example an increase in the general employment level would lead to increased inflation rate (the general price rise) the resultant increase in money supply would hence increase employment and the output level (Obstfeld, M. and Kenneth, R.(1996) Under the model a sustained fail in general prices (deflation) will be caused by a shift in the supply curve and more importantly the demand curve for goods and interest. This means a fall in how the prices of goods compared to how much the economy is willing to buy of. b) The importance of consumption smoothing effect of investment It helps in the general understanding that private consumption represents aggregate demand component in the largest share. (Obstfeld and Kenneth, 1996) Private consumption is very essential in determining the domestic investment that is being financed by the domestic savings in any given country. The consumption behaviour is a key element to the external process of adjustment because the deficit in current account is given by as the domestic investment less domestic savings. It helps household in maximizing utility as long as there is separable utility without uncertainty. It determines the investment and therefore the general growth rate level It helps residents of those countries experiencing high per-capital income growth in exhibiting high levels of savings. It helps in the determination of physical capital accumulation rate. It therefore becomes a key factor in productive capacity development. It acts as an impulsive aggregate demand component. It helps in understanding the important role played by aggregate demand in steering private investment. It helps in foreseeing the short-run real money holdings behaviour thus providing more clear specifications to the dynamics in the short run. It brings the idea of benefit of unemployment, insurance and fluctuations costs. i.e. the unemployed exhibit significant heterogeneity in marginal propensity to consume the available income and in holding of wealth. (Obstfeld, and Kenneth, 1996) c) The IS-LM model in the closed-economy is similar to the IS model in various Aspects for example it has all the variables that are contained in the IS-LM model i.e. consumption interest rate, expected inflation, the gross domestic product, investment and government spending. (Uzawa, 1969) However, the two models have some differences in their basic setup. The IS curve is given as Y=C+I+G+NX Where NX= net exports While the LM curve is given as M/P=L (I, Y) Where M= money supply P= average price L= liquidity I= interest rate U=GDP Question Two IS -LM-FE Mundell Fleming model in comparing effect of an increase in public spending under fixed exchange rates Under a flexible exchange rate an increase in public spending will translate into an increase in the money supply in any given country. According to this model an increase in money supply will shift the LM curve to the right. The resultant effect will be reduced local interest rate thus placing them below the global interest rate. There will be a capital outflow leading to the depreciation in exchange rate of the local currency. This will in return increase the net exports since the local goods will be cheaper when compared to those goods in the foreign markets. The IS curve will shift to the right as a result of the increase in the net export to a level where the global rate will be equal to the local interest rate. Thus increasing the general income level of the local economy. Under a fixed exchange rate regime the model asserts is that the monetary authority and the local central bank will be responsible in altering the money supply so as to come up with an equalized exchange level. Any increase in public spending will mean a proportionate increase in the money supply since the public will be releasing more money in circulation thus increased money supply. (Phelps, 1972) Incase the local interest rate is below the global interest rate (depreciation) the local authority will appreciate the exchange rate by purchasing more foreign currency without the local currency a thing that will increase its foreign reserve thus treating depreciation. The exchange rate will thereby be returned to its normal level. However, in a case where global interest rate (appreciation) and there is pressure on the part of the local authority to treat the impending appreciation the local authority decrease its foreign reserve by purchasing its own currency using the foreign reserve. This will return the currency in its normal level. A devaluation will occur when there is a permanent decline in the exchange rate and hence an increase in money supply (Phelps, 1972) Applying monetary policy in alleviating crowding out effect Crowding effect will partially be determined by how expenditure generating the impending deficit is spent. However the crowding out can be nullified if the deficit from the public investment balancing the private investment. (Hendry, 1999) Local authorities can introduce low rates of interest without affecting inflation to alleviate the crowding out effect. Monetary policing effects will stimulate growth leading to poverty reduction. The monetary policing rules out any link between inflation and growth rates. The policy can treat serious and distorted interest rats in the exchange rate behaviour. This scenario of distorted interest rates leads to appreciation thus massive trade deficits in concerned countries. This culminates into large commercial capital inflows and a price boom in the export commodity. (Hendry, 1999) According to Hendry (1999) monetary policy will help disconnecting the exchange rate from the competitiveness in exports to the fall or rise in financial flows. It will help averting the large trade deficits, which undermines the export performance through discouraging new producer entries and rendering marginal producers unprofitable. The policy will intervene and maintain the exchange rates thus locating the crowding out effect. By increasing investment monetary policy will increase the LRAS curve. The greater long-term impact on monetary supply increase will depend on sensitivity of investment to its changes. Monetary policy will increase the gross domestic product. The supply of loanable funds will be increased by any increment in the money supply. This will in return increase investment, reduce the rate of interest, and increase prices, GDP and aggregate demand Expansionary monetary policy would lead to reduced interest rates the net effect being a little change in interest rate and increased gross domestic product level. (Hendry, 1999) Monetary policy is therefore very effective because of the demand for money remains constant with the increase in money supply, any extra cash will be directed to the loanable funds market. The overall effect will be a reduction in interest rate an increase in both output and investment levels. (Hendry, 1999) References Fitoussi, J and Phelps S. (1988): The Slump in Europe: Open Economy Theory Reconstructed, Oxford, Basil Blackwell Hendry, D. (1999): Does Money determines UK Inflation in the Longrun Oxford, Nuffied College Obstfeld, M. and Kenneth, R. (1996): Foundation of International Macroeconomics, Cambridge, MIT Press Phelps, E (1972): Inflation Policy and Unemployment Theory, London, Macmillan. Phelps, E. (1970): Microeconomic Foundations of Employment and Inflation, New York, Norton Uzawa, H (1969): Readings in the Theory of Economic Growth, Cambridge, M.I.T. Press Read More