Macroeconomic in Finance - Assignment Example

Running Header: MACROECONOMIC IN FINANCE Macroeconomic in Finance in APA Style by University Question 1 (i) Construct a simple two-period model of intertemporal trade. The basic form of a two-period model of intertemporal trade can be mathematically expressed as: Ap + Af / (1 + R) = Yp + Yf / (1 + R) Where: Ap denotes present production abroad Af denotes future production abroad Yp denotes present domestic production Yf denotes future domestic production R denotes domestic interest rate. We will build a simple model by assuming that the country has a production function of: Yf = Kf0.5Nf0.5 Where: K denotes capital stock in the present + investment in the present N denotes labor endowment Plugging in, we have a simple model of intertemporal trade as: Ap + Af / (1 + R ) = Kp0.5Np0.5 + (Kp + Ip)0.5 (Np)0.5 / (1+ R) (ii) Show how investment has both a consumption augmenting and a consumption smoothing effect in your model. In the model above, present consumption is equal to Ap + Yp while future consumption is equal to Af + Yf. Suppose that the in the present, the country invests 100. This will then an effect of lessening consumption by the amount of investment. Mathematically speaking, it is expressed as: Cp - 100 = Ap + Yp -100 This highlights the smoothing effect of investment in consumption. In period 2 however, the investment has a consumption augmenting effect. Since Cf = Af + Yf, then consumption will increase by the increase in production due to the investment in period 1. Cf = Af + (Kp + Ip)0.5 (Np)0.5 Cf = Af + (Kp + 100) 0.5 (Np)0.5 Thus, consumption will increase by 1000.5 or 10. (iii) Critically assess the contribution of such micro-foundations models to our understanding of contemporary macroeconomics. The model of intertemporal trade is one of the simplest models which make up the foundations of contemporary economics. In its simplicity, this model gives significant information about the functioning of the entire economy. Micro-foundation models help us understand larger more complicated economic situations by starting at the basic. These models also highlight the interrelatedness of variables in the economy, which is one of the core concepts in contemporary macroeconomics. Question 2 Explain how the effectiveness of both fiscal and monetary policy is dependent on the sensitivity of money demand to the interest rate in the closed-economy. Explain how other factors may also impact on policy effectiveness. The effectiveness of fiscal and monetary policies is dependent on the different variables in the economy. This section will look at the monetary and fiscal policy effectiveness in a closed economy. Monetary policy is "the government or central bank process of managing the money supply to achieve specific goals such as constraining inflation, maintaining an exchange rate, achieving full employment, or economic growth." The monetary policy tools refer to the policy tools of the central bank used to affect the money supply and interest rates such as open market operations, changes in the discount rates, and changes in the reserve requirements (Mishkin 2004). It should be noted that the effectiveness of all these policies rests on the relationship between money supply and interest rate. Accordingly, an increase in the money supply tends to bring a reduction in the interest rate while a decrease in money supply brings about a rise in interest rates. It is notable that without affecting the interest rate, monetary policy renders no effect on the economy. For example, a government wishing to eliminate unemployment pursues an expansionary monetary policy lowering the reserve ratio. This in effect will lead to excess reserve rates and encourages bank lending while increasing the money supply. Since interest rate is inversely related with money supply, interest rate falls which encourages investment. Aggregate demand increases and unemployment is reduced or eliminated through the creation of jobs in the economy. In this example, it can be seen that without the reaction of interest rate in the increase in money supply, the monetary policy is useless and the economy will remain in its current position. It should be noted that the decrease in interest rate encourage investors to borrow funds in order to finance their projects. Without this, job creation will not be facilitated. Fiscal policy on the other hand, aims to correct the economy by increasing or decreasing tax levels and public spending. For example, if the economy is down and the government wishes to fuel the economy, it will reduce tax levels. This will give consumers more disposable income and encourage spending. With the increase in demand, businesses will then turn to higher production. It can be seen that in fiscal policy, the sensitivity of interest rate is not significant for the policy to be effective. In this type of macroeconomic tool, the economy is corrected without influencing the level of interest rate in the economy. The policy directly targets consumer spending and business production. In the case of monetary policy, its effectiveness is solely based on the sensitivity of the interest rate. Without the reaction of interest rate to the change in money supply, the monetary policy is rendered useless. Meanwhile, the effectiveness of fiscal policy is dependent on the reaction of other economic participants such as the households and investors. For example, the decrease in tax level cannot improve the economy if the consumers prefer to save the increase in disposable income. In summary, monetary policies affect the economy by affecting output through changes in interest rate and investment while fiscal policy directly works by directly affecting the values of consumer spending through taxes and government spending. Question 3 Show in depth the importance of the interest elasticity of investment in policy effectiveness, using a closed-economy Keynesian model to structure your exposition. Is this the only parameter to have such a profound effect on policy efficacy Interest elasticity of investment refers to the sensitivity of investment to the level of interest rates. It is discussed above that interest sensitivity is very much important in the efficacy of monetary policies but is not significant in fiscal policies. This section will further elaborate by using a closed-economy Keynesian model. The Keynesian closed economy model can be best exemplified by the IS-LM model where the LM shows the money market and the IS shows the goods market. The LM schedule is an upward sloping curve representing the role of finance and money and is denoted as "the equilibrium of the demand to hold money as an asset and the supply of money by banks and the central bank" (IS-LM 2006). The slope of the LM curve shows the change in interest rate in response to the change in output. The IS curve is the downward sloping schedule which shows the equilibrium in the goods market. The slope of the IS curve denotes the interest elasticity of investment demand and the marginal propensity to save. Therefore, the slope of the IS curve will be steeper the lower the interest elasticity of investment demand while gentler the higher the interest elasticity of investment. Figure 1. Effects of Increase in Money Supply with Different Interest Elasticity of Investment With this, we will evaluate the policy effectiveness of monetary and fiscal policies in terms of different interest elasticity of investment. Figure 1 shows the effects of increase in the money supply with a high and low elasticity of demand. An increase in the money supply will shift the LM curve to the right, from LM1 to LM2. It should be noted that lower interest elasticity of investment demand will yield into a lower level of r2 than one with the higher interest elasticity. Finally, higher interest elasticity will yield a higher level of Y2. Thus, expansionary monetary policy is more effective in increasing productivity when interest elasticity is high. Figure 2. Effects of Increase in Government Spending with Different Interest Elasticity of Investment Figure 2 shows the effects of the increase in government spending on output and interest rates. This will consequently shift the IS curve to the right, increasing productivity and interest rate. It should be noted that in both cases, since the increase in government spending is the same, both output and interest rate levels mount by the same proportion. We conclude that fiscal policy is not sensitive to the interest elasticity of the investment. Question 4 Discussion advantages and disadvantages of direct foreign investment Define and discuss how to avoid exchange rate risks. Direct foreign investments can be defined as "international capital flows in which a firm in one country creates or expands a subsidiary in another" (Krugman and Obstfeld 2003). As opposed to other growth strategies pursued by business organizations, this move signifies a high level of involvement in the host country's economy. Direct foreign investment involves not only a transfer of resources but also acquisition of control as the subsidiary does not simply have a financial obligation to the parent company, it is a part of same organizational structure. The advantages and disadvantages of direct foreign investment can be clearly summarized by looking at the case of the two parties involved namely, the multinational company and the host country. A multinational company is often created as a vehicle of international lending and borrowing where the parent company lends money to their foreign subsidiaries. Since direct foreign investment involves the extension of a business organization, it also implies an extension of power and control. The main advantages in the formation of multinational can be explained by location motive and internalization motive. Location motive stresses the gains that the parent company can gain due to the host country's lower labor costs, easier access to less costly and readily available natural resources, fiscal incentives, and the elimination of the barriers to trade. On the other hand, internalization motive stresses the fact that a parent company can easily transfer its expertise and technology on its subsidiary. However, multinational firm also faces the risk of exchange rate risks when operating in a foreign country. In the case of a host country, direct foreign investment is almost always encouraged and justified because they generate employment, additional government revenue from taxes, technological spillover, more choices for the domestic costumer, and inflow of foreign currency. In fact, direct foreign investment is always seen as an indispensable tool in the pursuing economic growth. However, real world examples have shown how multinationals have contributed to the wider income distribution gap and environmental degradation in their host countries. Exchange rate risk is the risk that the value of investment will change over time because of the change of exchange rate fluctuations. Exchange rate risk is very common in the current world economy because of the prevalence of floating exchanged rates as opposed to the traditional fixed or managed exchange rate regimes. Business entities and individuals who conduct international transactions as much as possible wants to avoid the detrimental effect of exchange rate risks. Some measures are being undertaken in order to preserve the value of investments or capital. In the case of low cost airlines, they usually employ aggressive hedging which allows them to purchase fuel in advance with the current exchange rate. Transactions with businesses and individuals abroad are insulated from exchange rate risk through predetermined exchange rate for their future dealings. Nowadays, foreign exchange rate risk is also eliminated through the employment of technological breakthroughs like the internet which helps investors to see the movement of exchange rates and allow them to exchange their foreign currency on foreign exchange markets where rates are higher. References IS-LM 2006, Wikipedia, the Free Encyclopedia. Retrieved 13 January 2007, from http://en.wikipedia.org/wiki/IS/LM_model Krugman P & Obstfeld, M 2003, International Economics: Theory and Policy. Addison-Wesley (6th ed) Mishkin, F 2004, The Economics of Money, Banking, and Financial Markets. Addison-Wesley, (7th ed.) Read More