Assignment on Macroeconomics - Essay Example

?QUESTION Assume the federal government runs huge budget deficits today to finance, say, Social Security, Medicare, and other programs for elderly,and finances these deficits by selling bonds that raises interest rate. Since business often borrows money to invest, and interest is the cost of borrowing, these higher interest rates will reduce investment. Describe why this scenario is likely to be bad for the macro economy. This scenario runs counter to a sound fiscal policy. Financing deficit by borrowing in the futures through bonds with a premium interest is not a good prescription to finance additional expenditures. Running a budget deficit places upward pressure on interest rates (Arestis & Sawyer, 2010, pg.328) When a government has to raise money, which in this case is to finance Social Security, Medicare or other programs for the elderly, one of the tools it can use to sell bonds or promissory notes which the buyer or investor can cash in at a maturity date which the government guarantees. Raising money for such laudable programs is not a problem, only the method it is being raised in this case because it has a contagion or ripple effect in the other sectors of the economy. We all know that business needs capital either to start or to expand. Business is essential in a given economy as it does not only pays taxes for the government to spend on its programs but it also provides jobs which in turn yields more taxes to the government through the income tax of the employees. Also, it produces goods and services which other entities may utilize to create value and in the process also yields tax to the government. Suffice to say, business is important in the over-all health of any given economy. Business also incurs costs; either for its operation or the overhead of maintaining itself to be a going concern as a business. One of the expenses it has to pay is interest expense or the cost of money. It is necessary for business needs additional capital for it to expand and respond to competition, changing technology or to simply adapt with the times to remain competitive. So when interest rates are jacked up to invite investors to avail the bonds for the government to finance the spending on Social Security, Medicare, and other similar programs, it inadvertently harms other components of the economy such as business. Plainly, what the government is doing in this case is to make the cost of money more expensive so that there will be more buyer of its promissory notes or bonds. When cost of money becomes high, it will precipitate a vicious cycle in the economy. If we may recall the recent crisis both in Asia July of 1997 and United States in 2009, interest rates became so high that nobody can afford to loan it or banks were just hesitant to lend money due to the high prevailing interest rates thinking that they will not be repaid or that borrowers will default on it. So when interest rates or cost of money is high, business will freeze their expansion programs or whatever projects they have on the table. This will result in the freeze hiring of additional workers, business becoming less competitive resulting in the over-all contraction of the economy. So while there will be money that will be raised for financing the government social programs such as Social Security, Medicare, etch, it will eventually back fire in the future. Not only that the economy will contract, but there will also be lesser jobs available. Business will implement cost-saving measures and this will precipitate a recession as business are interconnected, one supplies the other or dependent with the other. When there are lesser jobs available or when companies are refusing to give its employee a salary raise, there will be less money available in the pockets of the consumer. When there is less money in the pockets of the consumer, they will tend to spend less. When there is less spending in the economy, there will be less incentive for the industry to produce. For one man’s spending is another man’s earning. And when nobody is spending or spending less, the others will also not be earning. This is the typical vicious cycle of a recession when left on its own, will consume itself to a downward spiral until it will hit depression. Such that government has to intervene and make difficult decision just like what President Obama did with his bailout package to save the US economy. QUESTION 2 Exchange rates and purchasing power parity should be the same between countries. If it costs $300 to purchase and iPod in the US and 400 Australian dollars in Sydney, then the exchange rate between Australia and the US should be 4:3. Why might purchasing power parity be different from the exchange rate? Ideally, exchange rates and purchasing power parity should be the same between countries and economies. That if an iPod costs $300 in the US then it should also cost the same in Australia. This is what the Purchasing power parity theory suggests that the value of the exchange rate between one currency compared to another is equal or in equilibrium when their domestic purchasing powers are equal in that rate of exchange. According to purchasing power theory, relative prices across countries determine exchange rates (Mitchell et al, 2009, pg 155) and price difference between countries and economies will eventually be corrected by the market forces. That any price differential is unsustainable in the long-run as market will equalize any inequality in price. To illustrate; say for example, borrowing from the case above that the price of buying an iPod in Sydney, Australia is also 300 Australian dollars while the same is being sold in the United States for $300. So if the exchange rate between Australia and United States is 4:3, then iPod actually costs only US $225 in Sydney (3/4 = .75 x 300). That is $75 cheaper to buy the same iPod in Sydney compared to the US which is $75 more expensive. The PPP hypothesis implies that the real exchange rate should be constant such that any deviations from equilibrium should be transitory (Pappel, 2006, pg 78) According to this Purchasing Power Parity theory, market forces will set in to correct this difference in prices. Inferring to the law of Supply and Demand, since it is cheaper to buy iPod in Australia, US dollars preference will eventually shift to Australia as it is cheaper. What will happen is that they will sell their US dollars to buy Australian dollars to make the purchase of the iPod. Such that in the long-run, since there is now a greater demand for the Australian dollar, its price will eventually rise. And since US dollars were made unattractive due to the cheaper iPod in Australia, demand for the currency will drop resulting in the depreciation of the US dollars. Market correction will continue until such time that their price will equal which in this case, the equilibrium is US $300 and 400 Australian dollars. Why might purchasing power parity be different from the exchange rate? In practice however, Purchasing Power Parity is difficult if not impossible to achieve due to several factors such that it will really differ from exchange rate. One thing that should be considered is inflation and other inputs of production. Let’s take for example the popular Big Mac which is often used by economist to illustrate differences in Purchasing Power Parity with countries above United States and Australia as countries of reference. If the ratio of the rate of exchange between these two countries is 4:3, then a Big Mac in US should cost .75 Australian dollars. But we know that it is not the case. We have to consider that these two countries has different inflation rate (rising of price). If US have a higher inflation rate than Australia, then Big Mac will definitely be more expensive in US. Other inputs in production and items also affect the differences in price. Its inputs like wheat, meat, vegetables vary from one place to another considering the transportation cost and this will reflect in the price difference of Big Mac from one country to another. Even location costs differently from one place to another. Trade restrictions also play a significant part in determining the price of one good from one country to another. Taking the example of Big Mac, if one its main component like wheat has to be imported and the tariff imposed on it is high, say for example, 200% of its price, that will definitely contribute to the difference of purchasing power relative to exchange rates from one country to another. One of the main reasons PPP fails is the existence of nontradable goods. The inability to arbitrage nontradable goods causes exchange rates to deviate from PPP (Mitchell et al, 2009, pg 157). Efforts put into the creation of Big Mac from country to another cannot be traded and as such, contributes to the difference in prices from one country to another. REFERENCES Arestis, Philip; Sawyer, Malcolm. The return of fiscal policy.. Journal of Post Keynesian Economics, Spring2010, Vol. 32 Issue 3, p327-346, 20p, 1 Chart; DOI: 10.2753/PKE0160-3477320301 Mitchell, David T.; Rebelein, Robert P.; Schneider, Patricia H.; Simpson, Nicole B.; Fisher, Eric. A Classroom Experiment on Exchange Rate Determination with Purchasing Power Parity. Journal of Economic Education, Spring2009, Vol. 40 Issue 2, p150-165, 16p, 3 Charts PAPELL, DAVID H . The Panel Purchasing Power Parity Puzzle.. . Journal of Money, Credit & Banking (Ohio State University Press), Mar2006, Vol. 38 Issue 2, p447-467, 21p Read More