Major Macroeconomics Problems - Essay Example

Macroeconomics SECTION ONE: a) Wanda, in America, wants to buy a bottle of French wine. The wine costs 1000 euro’s. Pierre, a Frenchman, wants to buy an American computer that costs $2000. The exchange rate is ‘1 euro=$1.08’. Showing all work, how many dollars does Wanda spend to buy the wine, and how many Euro’s does Pierre spend to buy the computer? Given that ‘1 euro=$1.08,’ therefore Wanda will spend (1000*1.08) 1080 dollars when purchasing a bottle of French wine. In the case of Pierre, ‘$1.08=1 euro’ and will have to pay (2000/1.08) 1,851.85 Euros for the purchase of computer. b) Assume the exchange rate changes. Now, ‘1 euro=$1.20’. Showing all work, what does Wanda pay for the wine? What does Pierre pay for the computer? In this case, there is a change in the individual rates of exchange between the euro and the dollar. Currently, ‘1 euro=$1.20’ hence Wanda will spend (1000*1.20) 1200 dollars on a bottle of French wine. On the other hand, Pierre will spend (2000/1.20) 1,666.67 Euros on the purchase of an American computer. c) Which currency appreciated? Explain. Taking a closer look at the two currencies, it is evident that the Euro appreciated against the dollar. According to macroeconomic theory, appreciation of a currency refers to the increase in the value of one international currency against the other in the sense that the appreciating currency is able to purchase more of the other currency (Krugman & Wells 100). In the above mentioned case, the dollar and the Euro are international currency that had an initial exchange rate of ‘1 euro=$1.08.’ However, there was a change in the exchange rates and the current rate stands at ‘1 euro=1.20.’ This means that the dollar has to fetch more additional units to purchase a single unit of a Euro. This is evident in the case of an American purchasing a bottle of wine and has to pay an initial price of 1080 dollars. Since the euro has appreciated, the American will have to pay a higher price of 1200 for the same bottle of French wine. Consumers using the Euro have a higher purchasing power compared to those using the dollar. SECTION TWO: a) In this section, you will set up a balance of payments table. Please read chapter 26. A BOP has three accounts. You will need to place each item in its proper account and have a dollar value for the total of each account. The table will be in billions. Please indicate, plus or minus, for each number. Credits ‘000,000 ($) Debits ‘000,000 ($) A. Current Account (1) Exports (2) Imports (3) Net Transfers (4) Net Interest Income Balance B. Capital Account (5) Foreign Investments in the U.S. (6) U.S. Investments Abroad Balance (7) Statistical Discrepancies Overall Balance C. Official Reserve Account +2,421 +150 +220 +1150 +250 +30 -2,971 -180 -900 -40 -30 b) What does the official settlements number indicate? Be precise in explaining this. Based on the above table, the official settlements number is -30 and this indicates that the US has an increase in its foreign reserves and that there is also a decrease in the dollar reserves held by foreign central banks (Krugman & Wells 113). The decrease in dollar reserves among foreign central banks count as debits in the Balance Of Payments account. SECTION THREE: a) Under what conditions would the Fed sell government securities? The Fed would sell government securities under conditions such as inflation, employment and national output. Under such cases, the Fed does not have control but can only influence such conditions to its favor. The Fed can create an effect on such conditions by increasing or reducing the short term rate interest especially through open market operations. Some of the government securities used during open market operations includes treasury bills, bonds and notes (Krugman & Wells 119). The control of money supply offers tangible solutions to the conditions mentioned above. When the Fed is targeting to increase the supply of money in the economy, there will be the purchase of securities. On the other hand, a decrease in the supply of money will involve the sell of securities. In the case of increasing the supply of money in the economy, the Fed will purchase securities from banks and banks will use the money from such transactions by offering loans to individuals and businesses. The fact that there is a lot of money available for lending results in a decrease in the rates of lending hence more borrowers will have access to cheaper capital (Krugman & Wells 121). Consequently, there will be high levels of investments that will eventually stimulate the economy. Selling securities to banks results in the transfer of money from banks to the federal reserve. The economy will experience a decrease in the levels of money available for investment hence the available capital will be very expensive to obtain due to high interest rates. Eventually, the reduced amount of capital available for investment will lead to a slow growth of the economy. b) What is the key rate the Fed is targeting? The key rate that the Fed is targeting is commonly referred to as the Feds funds rate. The Fed funds rate refers to the short term rate of interest that U.S. depository institutions lend each other in a short time period within the systems of the Federal Reserve. According to macroeconomic theory, the federal funds rate is synonymous to the Fed Funds Rate Target. The target rate is maintained by the Fed’s open market operations. Economists and business analysts concur that the Fed Rate is the most influential benchmark tool used in the determination of interest rates in the US. The fed uses the target rate in the regulation of the economy. For instance, whenever the economy needs a boost, the target rate will be lowered and whenever there are high levels of inflation the target rate will be increased. c) What would happen to that rate when the Fed sells the securities? When the Fed sells the securities, banks will have a reduced level of money and there will be little capital for loans to individuals and businesses. This will eventually result in an increase in the rate in an effort to reduce the demand for money in the economy. This is especially evident in cases where there are very high levels of inflation in the economy. d) What would happen to real GDP? When the government sells securities, the GDP for the country will reduce. The sell of securities results in the transfer of money from banks to the Federal Reserve. Banks will have little capital to offer business and individual who engage in investment activities. People and businesses will engage in little investment activities because of the high cost of obtaining capital for investment. Eventually, the economy will grow at a slow pace characterized by low levels of GDP. e) What type gap would the Fed be closing? The Fed would be closing the inflationary gap which may arise as a result of instability in business cycles. Unstable business cycles often result in the problem of inflation in an economy. The gap exists when the aggregate level of production is higher that the level of production achieved at full employment resources (Krugman & Wells 140). The business cycle expands and there is an increase in the rates of inflation. The inflationary gap is illustrated using the aggregate market gap presented below: GDP Price Deflator LRAS SRAS Inflationary Gap AD 0 Real GDP The full time level of real production is marked by the Long Run Aggregate Supply curve (LRAS). In the short run, the equilibrium point is achieved when there is an intersection between the demand curve and the SRAS curve. However, whenever the SRAS curve grows higher that the LRAS there results in an inflationary gap. Once there is an inflationary gap, the Fed responds by introducing contractionary fiscal policies that aid in closing the gap by introducing changes in the aggregate expenditures which eventually shift the aggregate demand curve (AD) to the left as illustrated by the figure below: GDP Price Deflator LRAS SRAS AD AD’ Real GDP SECTION FOUR: a) On a PPF, where does one find production efficiency? What is true of allocative efficiency on the PPF? On a PPF, one can find production efficiency at the point where output is equal to the average total cost. This means that producers are in a good position to minimize wastage of resources during the process of production. The truth about the allocative efficiency on the PPF is that it is achieved when price equals the marginal cost. According to Pareto, allocative efficiency arises when no one can become better off without making someone else worth off (Krugman & Wells 199). The allocative efficiency is best illustrated in the figure below: Production of Good A A B Production of other goods In the diagram illustrated above, allocative efficiency is demonstrated by point A. At point B, the producer is in a position to increase the production capacity of both goods by making full utilization of existing resources hence increasing the efficiency of production. b) How does technology impact the PPF? The introduction of new technology has the effect of shifting the PPF. The PPF will shift outwards resulting in an increase in the output possibilities. This means that the provision of the good improves consumer satisfaction hence an improvement in economic welfare (Krugman & Wells 210). This is illustrated in the diagram below: Production of Good A C A B PPF1 PPF2 0 Production of Other Goods Technological improvements have the effect of reducing the market prices for products. This means that consumers are able to afford most of the products in the market at their prevailing prices (Krugman & Wells 210). This is evident in the market for computers and digital products whereby technology has improved the economies of scale among producers resulting in lower prices for computers and digital gadgets. c) What does the income effect tell us regarding a demand curve? The income effect tells us that an increase in the price of goods would result in a decrease in the quantity of goods demanded by consumers. This is simply because an increase in the price of goods is assumed to reduce the income of the consumer. The consumer will be able to purchase fewer units given the fact that he/she has a constant income. d) What happens to a supply curve when the price of a factor of production rises? An increase in the price of a factor of production has the effect of reducing the quantity supplied at any given time. Producers will result in producers reducing the quantity produced in order to supply the product at a given price. Although there is an option of increasing the price of the product relative to the increase in the cost of production, it is highly possible that consumers will resist the higher prices. Consumers may eventually move to the use of substitute products that will be relatively cheaper, abandon the use of the product or even move to another producer who is more efficient. e) See the data below: Depreciation is $1775, Investment= $2000, net exports=$720,net interest=$915,consumption =$10,000, and government=$2,800. All numbers are in billions. Show and find the value of GDP using the expenditure approach. According to the expenditure approach, GDP is calculated by the formula C(Consumption) + Ig(Investment) + G(Government) + Xn(Net Exports). The formula can be substituted by the following values 10,000+2,000+2,800+720= $15,520. f) Assume 100 people unemployed, 1,500 people employed, 1,600 people in the labor force, and 2,000 people in the working age population. Find the unemployment rate. Show all steps. Unemployment Rate = (Unemployed Workers / Total Labor Force) * 100 = (100/1600)*100 = 6.25% g) The number of people unemployed is 100. The number of people employed is 1,000. The working age population is 1,400. Find and show the employment to population ratio. Employment to Population ratio = Labor Force Employed/Total Population = 1,000/1,400 = 1:1.4 h) Assume real GDP per person is $50,000 in year one. In year two, real GDP per person is $49,000. Find the real GDP per person growth rate and comment on it. Show all work. Real GDP per person growth rate = [Change in GDP per person/ Initial GDP per person]*100 = [(49,000 - 50,000)/(50,000)]*100 = -2% The real GDP per person has decreased by 2 percent from the previous value. This shows that there is a decrease in the living standards of the people within the selected economy. i) In terms of the production function, what happens when labor hours increase? When technology increases? Increase in labor hours while holding all the other factors of production constant results in a reduction in the total output. The same will apply in the case of increasing technology. According to the law of diminishing returns, adding one input while maintaining other inputs at constant levels eventually leads to smaller and smaller additional output. J) What two things make a production function shift? The production function may shift under two conditions including supply shocks and changes in the scale of operations. Supply shocks refer to supply changes that have an effect on the overall production process of a firm. For instance, there may be changes in the supply of energy or management practices (Krugman & Wells 230). In the case of changes in the scale of operations, a firm may decide to change factors of production that were fixed in the short run hence shifting the production function upwards. k) If the nominal interest rate is 7% and inflation is 2%, what is the real interest rate? Show formula and answer. According to the Fisher equation, Real Interest = [(1 + Interest)/ (1+ Inflation)] – 1 Therefore, Real interest = [(1 + 7)/ (1 + 2)] – 1 = 1.67% l) ABC company starts the year with $30,000 of equipment. It buys $10,000 of new equipment and $5,000 of equipment wears out. What is gross investment for the year? Net investment for the year? Gross Investment = Purchases = $10,000 Net Investment = Purchases – Depreciation = $10,000 - $5,000= $5,000 m) Let’s imagine that the government has a debt of $100b. Over the next 5 years, the budget is as follows: $10b, $15b, $22b, all deficits, but has two surpluses of $5b and $8b. What is the government’s debt at the end of the fifth year? Show all work. Credits($) Debits($) Opening Balance -100b Year 1 -10b Year 2 -15b Year 3 -22b Year 4 +5b Year 5 +8b Overall total -134b The government debt at the end of the fifth year is 134 billion dollars as shown in the workings above. n) What has the Fed chosen as its target instrument? The Fed has chosen short term interest rates as its target instrument in the market. o) How does the Fed get this instrument to its desired rate? The Fed gets the short term interest rates to its desired rates through market operations. It is able to sell or purchase securities depending on the desired outcome hence controlling the supply of money in the economy. Higher rates are achieved through the sell of securities whereas lower rates are achieved through the purchase of securities. p) What is the largest source of revenue for the Federal government? Tax is the largest source of revenue for the Federal government since 1950s. As of 2010, tax accounted for 91 percent of government revenue with individual income taxes and payroll taxes forming the largest bulk. q) What is the difference between gross and net debt? Gross debt sums all the debt obligations whereas net debt includes the sum of all debt obligations less cash and cash equivalents. r) What concept did Edward Prescott use to compare three nations, and which nations did he compare? What is the value of this concept? Edward Prescott uses the concept of labor supply question in comparing three countries including France, Japan and the U.S. He cites that there are huge differences in working hours among the three countries because of the issue of taxation as opposed to cultural differences. This concept is valuable because it analyses the effect of taxes on the supply of labor in any economy in the world. He notes that individuals are less willing to supply labor when there are higher taxes hence the sought to spend most of their time on leisure activities. s)What is the difference between discretionary and non-discretionary fiscal policy? Discretionary policies are imposed by the government in response to specific economic conditions and may include policies such as tax rate cuts. On the other hand, non-discretionary policies take place automatically without any influences. For instance, a progressive income tax increases aggregate demand during recessions and reduces aggregate demand during inflation. t) What is meant by a structural surplus or deficit? A structural deficit refers to a situation whereby a country records a deficit despite the fact that the economy is operating at its full potential. The deficit is recorded despite the performance of the economy. This means that a country spends more that its revenue. u) If France raised interest rates relative to the U.S., what would happen to the exchange rate (what would the $ do)? The value of the dollar is likely to drop because investors will want to hold most of their assets in a French currency because they attract higher rates of interests. There will be an increase in the demand for the Euro hence the dollar will depreciate in the market for foreign currencies. v) What are the four main determinants of the quantity of U.S. dollars demanded in the foreign exchange (FX) market? They include: 1. Exchange rate 2. Global demand for U.S. Exports 3. Interest rates in the United States and other countries 4. The expected future exchange rate w) What are the four main determinants of the quantity of U.S. dollars supplied in the foreign exchange market? They include: 1. The exchange rate 2. U.S. demand for imports 3. Interest rates in the United States and other countries 4. The expected future exchange rate x) If the expected future exchange rate rises, which curve in FX market shifts, in which direction, and what happens to the exchange rate? The demand curve for U.S. dollars will shift rightward and the exchange rate will increase. y) Why is the current account balance so large and so negative? The amount of imports is far higher than the amount of exports hence resulting in more investments within the country than what the country invests outside the country (Krugman & Wells 100). Works Cited Krugman, Paul and Wells, Robin. Macroeconomics. Chicago: Worth Publishers, 2009. 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