Macroeconomics Theory - Term Paper Example

Foreign exchange rate is the price of one currency in terms of another currency. BOP has direct relation with the foreign exchange market as the spending of the consumer depends on the value of currency in other countries. Under the free-floating currency regime (McGregor) the balance of payment depends highly on the forces of supply and demand. In this free-floating regime, the price of the currency automatically adjusts according to the requirement which equals the supply and demand of the currency.

This shows that in this market conditions, price automatically is in equilibrium in the balance of payment. There is no intervention by the government due to which the outcomes are automatically achieved by counteracting between both the current account and the capital account. This market is also termed as “self-correcting market” which fluctuates continuously based on the changing market conditions. Under the fixed-rate currency regime (Bized), intervention by the government is mostly seen to regulate the exchange rate.

The price in this exchange rate is not automatically adjustable as compared to the floating exchange rate. The government has to intervene to adjust the value of foreign currency to the country’s currency. . It is an essential tool to analyze the macro-economic policy. The relation between the unemployment and income is that falling unemployment might give rise to inflation and on the other hand rising unemployment would lead to fall in the inflation. To reduce the unemployment rate, average demand must be increased which would increase the employment for short-period (Baumol and Blinder).

Supposing that the economy is stable at Y. Increase in the government spending will shift the AD curve from AD to AD1 which would lead to the increase in income and reduction in the unemployment in the short term. The outward shift of the AD curve to AD1 takes the equilibrium to Y1 which creates a positive gap which is thought as the cause of rise in inflation. Due to such shift the price changes from P to P1 but due to the inward shift of the AS curve the price again shifts from P1 to P2 which shows increase of the P but the shift brought back the equilibrium at Y at P2.

The major reason for the rejection of Keynesian theory was the weakness regarding the stagflation in 1970’s. Keynesian theory was focused on increasing the government spending when the unemployment was high and when the inflation becomes a problem the government should reduce its spending. This shows that Keynesian theory was addressed to stabilize the economy through government creating cash flows (Dornbusch, Fischer, and Startz). After the rejection of Keynesian theory regarding stagflation, New classical became the new standard.

The reason behind the selection of New Classical theory as a standard was the price system which efficiently adjusted the supply and demand in all market. This theory was focused on simple basis that the equilibrium point is achieved when the quantity supplied