Economical Strategy of the Government - Assignment Example

Scenario I In an economy without an external sector, both the money market and the commodity market behave according to the principles of the ical model. A few assumption for classical model: prices & wages are perfectly flexible equilibrium level of income/output at any time is at full employment labour market clears perfect information 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 Answer: In the classical model, total supply of loanable funds (S) is equivalent to household saving. The funds supplied are loan out and the household receive payment from the interest. Meantime, business demand of loan (I) is their planned investment spending. The government expenditure is represented by G while T is the net taxes. When government purchases of goods and services (G) are greater than net taxes (T), budget deficit equal to G - T, as in the diagram. On the other hand, when government purchases of goods and services (G) are less than net taxes (T), it runs a budget surplus equal to T - G. From the diagram, the demand of the loanable sum is inversely related to the interest rate (r). Firms generally will compare the expected profitability of investments with the interest rate. At lower interest rates, projects are profitable, and there will be a higher demand for loanable funds. When the government finance the fund from the private pool, the demand increase by the government expenditure minus the tax income (G - T ). The increase in the government financing reduces the availability of loanable sum in the market. Equilibrium of the supply and demand curve is disturbed and shifted to a higher interest rate. Both national saving and investment would be lower. The government loan forces the investor to compete for real interest rate make investment less attractive, assuring that investment will decrease (I shift to I' in diagram) along with the national saving. This is called crowding out. It causes a lower economic growth. Economist generally advises to reduce deficit. 2. the government increases its expenditure and finances it by selling bonds to the banking system Answer: When the government switched from public to bank for credit, the supply of loanable fund to the market reduced. This thus causes a shift of the supply line to the left as in the diagram. The result of the reduction of loanable fund is the increase in the interest rates of loan. Private sector or firm will try to reduce their loan due to the high interest. There will not be a lot of projects going on and as a consequence the investment in the country will drop. Both situation 1 and 2 would result in inflation as interest rate increased. 3. large amounts of banknotes are dropped off from a helicopter Answer: When money falls from a helicopter, the supply of money or the saving hold by the public in the market increases. In the diagram, this is illustrated by the shift of supply curve (S) to the right (S'). The household expenditure might increase due to the increase in saving. Thus, the interest rate reduces (from r to r') and the demand of loanable funds increases (from I to I'). From the reduction of interest rate, more loan will be taken out to construct development projects. This is a situation where the money in the market increase without causing inflation. 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. A few assumption for Keynesian model prices & wages are fixed at a given level at these price & wage levels there is involuntary unemployment (there are workers without a job who would like to work at the going market real wage) Answer the same set of questions as those in 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. Answer: The Keynesian model is saying that the labor market is driven by demand conditions so that the 'equilibrium' in the labor market is not an equilibrium in the sense that demand need not equal supply all the time. In fact, labor market conditions are determined by labor demand rather than labor supply because of which we observe the phenomenon of 'involuntary unemployment' (i.e., people look for jobs but can't find them). When Price is stable, the employment rate would depend on the money wages. Meaning when the money wages is high, the employment will be low. The Keynesian labour supply function is: Ns = t(W/Pe) where W is the money wage and Pe is the expected price level. In effect, this amounts to the labour supply depending on the real wage but the real wage defined as money wage divided by the expected price level. Assuming that a relatively fixed expectation of the aggregate price levels, labour supply and demand varies with the money wage. Meanwhile, the private firms' labour demand would be based on the real wage which is the function of the marginal productivity of labour (MPN), the money wage and price level as in the figure below. The increase in the demand of labour will not be reflected in the loanable fund market. But it could be observed from a IS-LM Model. IS = Investment / Saving quilibrium. LM = Liquidity / Money Supply equilibrium. Overall output Y = C + I + G. In business, firms are looking for profit. When government increase expenditure, the IS1 curve shifted up to IS2, meaning an increase in the saving as well as the investment due to the accelerator increase. The increase in Y, due to increase in G let the business see rising profit, increase sales and cash flow. Accelerator effect works well when the unemployment is high. When the employment is low, the money wage labour tended to be 'sticky' rather than flexible which meant that if interest rose the money wage did not. This meant that a interest increase would lead to higher profits for firms and higher output. The stickiness of money wages meant that there was no automatic adjustment to return the economy to full employment. 5. the government increases its expenditure and finances it by selling bonds to the banking system Answer: When the government turns to banking system for financing, the supply of money to the market decreases. The LM curve thus shifts to the left. The excess money at Y0 pushes the interest up. The increasing interest rate causes investment spending to drop. While investment spending is dropping, income, Y, is dropping as such that S drops. A new equilibrium is achieved when the interest rise is reducing the demand of the money. Unemployment rate might increase due to the decrease of saving. 6. large amounts of banknotes are dropped off from a helicopter Answer: When free money flow into the market, the people's saving increase. In the meantime, the demand for money will decrease. The LM curve shift to right giving a drop to the interest rate. The free money contributed to the expenditure, C and investment, I. Thus the output, Y increase (shift from Y0 to Y1). Such increase is favourable to the output of the nation. However, this is only short term and there will be no effect at all to the employment at all. References: Elemental Economy. 2006. Macroeconomy: The classical model. Macro +3.1 - Elemental Economy. Information retrieved on 20th Nov 2006. http://members.shaw.ca/h-chartrand/Macro%20+%203.1c.htm University of Sussex. 2006. Keynes and the Classics. University of Sussex. Information retrieve on 21st Nov 2006. http://www.sussex.ac.uk/Units/economics/ma_macro/topic2.doc UNC. Lecture Twelve: Dynamics in the IS-LM Curve Model. University of North Carolina Information retrieved on 21st Nov 2006 http://www.unc.edu/kellchan/Lecture%20Twelve_IS-LM%20Equilibrium%20I.doc Wikipedia. 2006. IS-LM Curve. Wikipedia Online Encyclopedia. Information retrieved on 21st Nov 2006. http://en.wikipedia.org/wiki/IS-LM Read More