Money Market and the Commodity Market - Essay Example

The task involves two different scenarios. Scenario I In an economy without an external sector, both the money market and the commodity market behave according to the principles of the classical model. QUESTIONS Explain, with the help of appropriate diagrams(s) what happens when 1. the government increases its expenditure and finances it by selling bonds to the non-banking private sector If the government increases its expenditure, the aggregate demand will increase, as given by the equation: Where, Y is the aggregate demand, C is the consumption and G is government expenditure. An increase in government expenditure will result in government expenses increasing above taxes. Thus this extra expenditure needs to be financed with either bonds or an increase in money supply. In this case it has been financed with bonds. This results in private investments being crowded out. Since the demand for money rises above money supply the interest rate rises. This results in increases savings and decreased private investment. Since people can either save or consume their income, in order to increase savings the consumption will decrease. As G will increase, this will be impacted in the short run by a decrease in consumption, since many people will be there to give loans. This will effectively increase interest rates. Along with this there will be an impact on aggregate output as output will increase with the increase in government spending. In the long run, there will be a price adjustment and there will be an increase in prices to cater for the higher demand. Both Classical and Keynesian economists agree to this, yet, according to the classical model this adjustment is made very quickly and according to the Keynesian model this change will occur over time. Thus according to the classical model there will be an immediate increase in price as the “invisible hand” will be there at work and balance the forces of supply and demand. 2. the government increases its expenditure and finances it by selling bonds to the banking system If the government increases its expenditure, the aggregate demand will increase, as given by the equation: Where, Y is the aggregate demand, C is the consumption and G is government expenditure. As G will increase, this will be impacted in the short run by a decrease in investment, as supply of money in the banking sector will decrease. This will effectively increase interest rates. Along with this there will be an impact on aggregate output as output will increase with the increase in government spending. Thus the aggregate demand will go up. This does increase private income and creates a multiplier effect to increase the output. In the long run, there will be a price adjustment and there will be an increase in prices to cater for the higher demand. In the money market, the money supply will reduce from the banking system; on the other hand there will be money creation due to increased government spending. A money multiplier effect will take place and the money supply will increase. If the effect of money supply increase by increased government spending is higher than the decrease caused by the reduction in the banking sector then interest rates will fall. On the other hand if the impact of the increased government spending is higher than the impact of decreased money supply in the banking system then the interest rate will rise. In the commodity market, since the government expenditure will increase the demand for goods will rise. Thus the aggregate output will rise. Both Classical and Keynesian economists agree to this, yet, according to the classical model this adjustment is made very quickly and according to the Keynesian model this change will occur over time. Thus according to the classical model there will be an immediate increase in price as the “invisible hand” will be there at work and balance the forces of supply and demand. Interest rates will go up due to the reduction in money supply in the banking sector. On the other hand there will be a factor pushing the money supply up. Thus a balance will be created between money supply and money demand. Effectively the money that was kept in banks will be circulated to the public, thus creating the money multiplier effect, or creating secondary forms of money. Regarding employment, employment will remain constant in the classical model as the adjustment will be on prices and not on aggregate demand and supply. 3. large amounts of banknotes are dropped off from a helicopter In this scenario the aggregate supply will increase. This will exist due to the fact that the money supply is increased. The money multiplier effect will come into place. This will thus result in a shift of the aggregate supply curve to the right. This will result in higher employment and a decrease in prices. In the money market, the money supply has increase over money demand. Thus the interest rates will fall. This will result in greater consumption and lesser savings. This will increase the aggregate demand by increasing the Consumption(C) factor in the equation. In the commodity market, the increased money supply will result in lower prices. As given in the IS-LM curve. The LM curve will shift thus increasing consumption and decreasing investment. Thus the prices of commodities will fall. Finally the aggregate output will increase. Thus is due to the increase in the LRAS ( long run aggregate supply) curve. As can be seen from the figure, Y1 shows the new output level and Y0 the initial output level. According to the classical model this adjustment will be made immediately so as to decrease prices and increase the aggregate output. Scenario II In the same economy the money market adheres to the principles of the classical model but the commodity market displays a substantial amount of Keynesian unemployment with stable prices. According to the Keynesian model the effects of all the three situations will be the same, the difference will be there in the effect of the time frame. According to the classical model the effect is immediate and the adjustment takes place right away. According to the Keynesian model all these effects take place over a longer period of time and this can be 10 years , 20 years or even more. Answer the same set of questions as thosein Scenario I, namely, explain with the help of appropriate diagrams(s) what happens when 4. the government increases its expenditure and finances it by selling bonds to the non-banking private sector If the government increases its expenditure, the aggregate demand will increase, as given by the equation: Where, Y is the aggregate demand, C is the consumption and G is government expenditure. As G will increase, this will be impacted in the short run by a decrease in consumption, since many people will be there to give loans. This will effectively increase interest rates. Along with this there will be an impact on aggregate output as output will increase with the increase in government spending. An increase in government expenditure will result in government expenses increasing above taxes. Thus this extra expenditure needs to be financed with either bonds or an increase in money supply. In this case it has been financed with bonds. This results in private investments being crowded out. Since the demand for money rises above money supply the interest rate rises. This results in increases savings and decreased private investment. Since people can either save or consume their income, in order to increase savings the consumption will decrease. In the long run, there will be a price adjustment and there will be an increase in prices to cater for the higher demand. Both Classical and Keynesian economists agree to this, yet, according to the classical model this adjustment is made very quickly and according to the Keynesian model this change will occur over time. Thus according the Keynesian model the aggregate output will increase. The price impact will come up, but that will take a long time to occur. Thus according to the Keynesian model this effect will be in terms of increased employment and increased aggregate output. 5. the government increases its expenditure and finances it by selling bonds to the banking system If the government increases its expenditure, the aggregate demand will increase, as given by the equation: Where, Y is the aggregate demand, C is the consumption and G is government expenditure. As G will increase, this will be impacted in the short run by a decrease in investment, as supply of money in the banking sector will decrease. This will effectively increase interest rates. Along with this there will be an impact on aggregate output as output will increase with the increase in government spending. Thus the aggregate demand will go up. This does increase private income and creates a multiplier effect to increase the output. In the long run, there will be a price adjustment and there will be an increase in prices to cater for the higher demand. Both Classical and Keynesian economists agree to this, yet, according to the classical model this adjustment is made very quickly and according to the Keynesian model this change will occur over time. Thus according the Keynesian model the aggregate output will increase. The price impact will come up, but that will take a long time to occur. Thus according to the Keynesian model this effect will be in terms of increased employment and increased aggregate output. Regarding employment, employment will increase due to the fact that aggregate demand has increased and this will have a positive impact on employment. According to the Keynesian model the prices do not increase. Thus the major impact will be an increase in employment and an increase in aggregate output. 6. large amounts of banknotes are dropped off from a helicopter In this scenario the aggregate supply will increase. This will exist due to the fact that the money supply is increased. The money multiplier effect will come into place. This will thus result in a shift of the aggregate supply curve to the right. This will result in higher employment and a decrease in prices. In the money market, the money supply has increased over money demand. Thus the interest rates will fall. This will result in greater consumption and lesser savings. This will increase the aggregate demand by increasing the Consumption(C) factor in the equation. In the commodity market, the increased money supply will result in lower prices. As given in the IS-LM curve. The LM curve will shift thus increasing consumption and decreasing investment. Thus the prices of commodities will fall. Finally the aggregate output will increase. Thus is due to the increase in the LRAS ( long run aggregate supply) curve. As can be seen from the figure, Y1 shows the new output level and Y0 the initial output level. According to the Keynesian model the economy will take time to adjust to the changes in demand structure. Over time the aggregate demand will slowly increase. References: 1. Burda, M. & Wyplosz, C. (2005), Macroeconomics: A European Text, Oxford Univeristy Press. 2. Cameron, G. (2003), Economic Growth, Open University Worldwide. 3. Crafts, N. & Woodward, N. (1991), The British economy since 1945, Clarendon Press, Oxford. 4. Jones, C. I. (1999), ‘Growth with or without scale effects’, The American Economic Review 89(2). 5. Jones, C. I. (2002), ‘Sources of u.s. economic growth in a world of ideas’, The American Economic Review 92(1). 6. Mankiw, N. G. (2002), Macroeconomics, Worth Publishers. 7. Mankiw, N. G., Phelps, E. S. & Romer, P. M. (1995), ‘The growth of nations’, Brookings Papers on Economic Activity 1995(1). 8. Romer, D. (1996), Advanced Macroeconomics: Third Edition, McGraw-Hill. 9. Romer, P. M. 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