Solutions to Major Economic Questions - Assignment Example

? Solutions to economics questions First Last Net Exports and Net Capital Outflow Net exports refers to the differencebetween a country’s total value of exports and the total value of imports within a given period of time (Lukes, 1959). When the difference is negative, the country is said to be having a trade deficit and when the difference is positive it is said to have a trade surplus. The term net capital outflow refers to the net flow of funds being invested by a country in other countries within a certain period of time (Lukes, 1959). Flow of capital is determined by real interest rates. When domestic real interest rates rise, the domestic assets become more attractive to foreign investors. These investors buy this country’s assets assets resulting in capital inflow. Higher interest rates also induces domestic investors to buy home assets instead of foreign ones. This significantly reduces the amount of capital outflow. This leads to a decline in the net capital outflow. A decrease in the domestic real interest rate will substantially reduce investors returns from their investments. This will discourage foreign investors from investing locally hence reducing capital inflow. Domestic investors will shift their investments to countries with rising real interest rates thus increasing capital outflow. This will ultimately lead to increased net capital outflow. Relationship among saving, investment, and net capital outflow. According to Lukes (1959), disposable income is used for consumption and investment. The amount of money saved is the one used for investments and therefore investment is equal to savings. The total amount of a country’s savings is used for domestic investment and purchase of capital goods abroad. As explained above, net capital outflow is the net flow of funds being invested in other countries by a country during a certain period of time. Therefore savings are equal to domestic investments plus the net capital outflow. Supply and demand in the market for loanable funds and the market for foreign-currency exchange The term loanable funds refer to the amount of money used for savings and investments in an economy (John, 1936) . In the loanable market, demand refers to the total investment in an economy while supply refers to total savings in an economy. In economics, the term investment refers to purchase of new capital and other factors of production often through the use of loans. As shown in the graph below, the demand curve in the loanable market is downward sloping from left to right while the supply curve in the same market is downward sloping from right to left. According to John ( 1936), when the real interest rate increases, the cost of taking loans increases. This leads to low investment as investors shy away from acquiring loans to fund investments due to the increased costs. On the other hand, when the real interest rates are low, the cost of taking loans reduces hence loans becomes more attractive to investors. This translates to increased investments. When the real interest rate rises, people save more in order to take advantage of the increased returns on their savings. Therefore, there will be increased money saved in the economy. On the other hand, when the real interest rate decreases, people will be discouraged from saving by the low returns they get due to lower real interest rates, leading to low savings. The foreign exchange market is a market for trading of currency. In this market, one party exchanges one country’s currency with an equivalent quantity of another currency. The exchange rate is the price of one currency in terms of another currency. The major role of foreign exchange market is to facilitate the loanable funds market. Foreign goods are usually priced in foreign currency and therefore an investor will need foreign currency to buy foreign assets. The rate at which a currency is exchanged for another is determined by the demand and supply of that currency. The higher the demand for financial assets in a certain country the higher the demand for that country’s currency hence the higher its exchange rate. Reasons why the aggregate-demand curve is downward sloping. 1. Wealth effect . The aggregate demand curve assumes that the government holds the supply of money constant. The amount of money supply determines the wealth of a nation and therefore the wealth of a nation at a given time is equivalent to the amount of money supply at that time. When the price level rises, the wealth of the nation decreases. Consequently, the purchasing power of money also reduces. Therefore, buyers reduce their demand for goods and services. On the other hand, the purchasing power of money rises as the price level falls. Buyers become wealthier and are able to buy more products in the market. Therefore, the wealth effect leads to the inverse relationship. 2. Interest rate effect. When the price level rises, firms and households are forced to look for more money to support their operations. This increased demand for money against a fixed supply, pushes the interest rate upwards. As the interest rate rises, the level of spending reduces. Therefore, the interest rate effect leads to an inverse relationship between demand for real GDP and the price level. 3. Net exports effect. When the price level rises, foreign made products become relatively cheaper compared to domestic products. This leads to increased demand for foreign goods hence increased imports. Also, as the domestic price level rises, demand for domestic goods by foreigners decreases hence decreased exports. The observed decrease in exports and an increase in imports, leads to decrease in net exports. As explained above, net exports is the difference between total exports and total imports. As net export is a key part of the real GDP, its reduction leads to a decline in the real GDP. This clearly shows an inverse relationship between demand for real GDP and the price levels. Why the long-run aggregate-supply curve is vertical. The long run supply curve is vertical because it is not affected by changes in the price level in the long run. Supplies of labour, capital, technology and land are the only factors that affect production in the long run, however they are fixed in the long run. Five arguments often given to support trade restrictions. Trade barriers are policies put in place by the government to discourage imports from the foreign sector e.g tariffs and import quotas. 1. Protect infant industries against foreign competition A country may have a comparative advantage in a product once an industry is fully established. This country may find it useful to protect the firm producing such product until it can successfully compete internationally. Economists feel that this argument is subject to misuse. It is difficult to forecast which industry will actually be able to compete successfully in the future hence many unnecessary policies will be put in place out of speculations. It may also be difficult to repeal such laws later. 2. Domestic employment A country can protect its domestic production against foreign competition to safeguard local firms. Foreign imports provide competition for domestic production. Increased consumption of foreign products rather than domestic products leads to less domestic production and so does the domestic employment. Trade restrictions reduces the reduction in domestic production and domestic employment. Economists justify this point by arguing that production is provided by citizens of the domestic economy who pay taxes and vote rather than foreign workers. 3. Low foreign wages Some countries enjoy comparative advantage due to the low wages they pay their Workers. The low wages prevents domestic producers and their workers from competing on a level playing ground. Low wages might be as a result of the natural comparative advantage, subsidies or other policies. Trade barriers restrict imports from low wage countries from unfairly negatively affecting domestic production. 4. Unfair trade Foreign firms often engage in unfair trade practices resulting in undue advantage.Some foreign goods are sold in domestic market at a price below production cost. This practice is referred to as dumping and it is aimed at driving domestic businesses out of business (Thomas, 2000). Consequently, this lessens competition and increase the market share of the foreign producers. Trade barriers prevent foreign producers from unfairly gaining a competitive advantage in the domestic economy and help to level the playing ground. 5. An adverse effect on the host nation's balance of payments.  A country may find it useful to to use trade barriers to limit the amount of imports. Excessive importation compared to exports leads to an unfavorable balance of payment. This leads to a country working on a budget deficit which consequently negatively affects the economic performance. References John M. K. (1936). The General Theory of Employment, Interest, and Money. London. Prometheus Books Lutes, J. (2001). Balance of payment and economic growth: New York: Herper and Brothers. Thomas. S. P. (2000). Basic Economics: A Citizen's Guide to the Economy. New York, NY: Basic Books Read More