Econ Assessment - Assignment Example

CHAPTER 7 Macroeconomic analysis has taken various forms and one of the most prominent among them is ical analysis of macroeconomics. During the1900’s, the money supply was bonded up with the amount of gold an economy possessed therefore this prevented the money supply to respond with respect to interest rate changes. The classical macroeconomists based on there period assumptions viewed the Velocity (V) & Money Supply (M) as unresponsive to any changes in interest rates. Figure 1: Vertical ASF Line The assumptions of classical macroeconomists have various implications on our comprehension. Firstly, the ASF (Aggregate Supply of Funding) will remain constant with respect to any interest rate changes therefore we will depict it as a vertical line as shown in the above graph. Suppose that due to certain shocks in the economy, the APE line shifts to the right. The increase in APE will require funding to support it but the ASF will remain unresponsive to the change. As consumers move to gain funding, the lenders will drive up the interest rates. Increase in interest rates will crowd out the demand and the output and price levels will remain unchanged. What if the amount of gold in an economy increased or decreased. Based on the quantity of gold the ASF line would shift to either left or right. If ASF had a rightward shift than it implies that there will be an excess of funding in the economy. Thus the lenders will be willing to provide their money at lower level of interest rates. This lower level of interest rates will induce the consumers to spend more therefore increasing ADF. Now ADF will cross ASF at a decreased interest rate level and both will exceed the GDP level. Increase in a funded demand will cause the firms to increase their prices. This increase in Price Level brings a fall in ASF which will also decrease APE. Prices will continue to move in upward direction until & unless interest rate, APE & ASF return to their original level. Prior to the Great Depression of 1929, the classical macroeconomics functioned as it was required. There were no economic slumps and employment and GDP’s were stable throughout the period. The assumption of classical macroeconomists regarding the invisible hand was proved to be almost true. There was no need for government policies or intervention to control the economy and macroeconomics was taking care of itself. Suddenly, the Great Depression of 1929 made its way in the economy and plunged economies in state of chaos. Some faltering economies almost experienced a decline of 30% in their GDP and as much as 25% of the workforce was unemployed. This made it evident that the assumptions held by classical macroeconomists were erroneous and they need to be revised in order to manage the economies. CHAPTER 8 Monetary policy deals with Federal Reserve System (a central system) actions to influence the availability and cost of money and credit in terms of using policies such as open market operations, changing reserve requirements and discount rate which are indispensable tools to promote high employment, economic growth, price stability, and a sustainable pattern of international transactions. The monetary policy brings changes in employment level, output, and interest rates via a step by step process. At the first step, Federal Reserve System uses one of its three policy tools described earlier to have an impact on money supply and interest rates. The change in money supply as we know that brings a change in ASF line. Finally, this ASF line causes a change in the level of employment, prices, and output. The above equation depicts the money supply as a function of several variables. Among these variables the general public only controls two of them namely; d (desired currency to deposit ratio) and t (time deposit to checking account deposit ratio). Banks have their control on one variable, w, which is the desired amount of working reserves per dollar of checking account balances. Finally, the Fed controls B (Total Monetary Base), r’ (Fed’s reserve requirement per dollar of checking account balances and r’’ (Fed reserve requirement per dollar of time deposits). Open Market Operations are classified as Sales or Purchases. In an open market sale, the Fed market its securities to dealers who than sell those securities to households, businesses and other institutions who are willing to buy them. Whereas in an open market sale, the general institutions or households market securities to dealers who than sell those securities to government. These operations have an impact on monetary base by an amount equal to S times Money Multiplier. For instance, open market purchase increases the amount of monetary base which brings an excess of reserves. After that, there is an excess of reserves which are utilized by lending those money. The cycle continues until those excess reserves have exhausted. Hence, an open market purchase increases the money supply thus increasing ASF. The required reserve ratio is the minimum amount of reserves which is kept at Fed as a percentage of deposits. If the Fed increases the required reserve ratio, banks will have to keep a higher amount of reserve at Fed. This will cause the banks to reduce their outstanding loans and keep that money at Fed without any return. As a result of this, the money supply in the economy shrinks and ASF shifts to the left. The Feds third tool is the discount rate, or we can say that it is the interest rate that banks pay to borrow funds from Federal Reserve Bank. In general, if the discount rate is decreased by the Fed then it encourages banks to borrow, which increases the amount of available reserves held by the banking system and results in an increase in the money supply. Monetary policy’s restrictiveness can be classified either as easing or tightening. An easing monetary policy occurs when the Fed tries to increase money supply by in order to stimulate the economy. The Fed in case of a easing monetary policy will buy securities through open market operations; it may reduce the required reserve ratio and the discount rate. In a tightening monetary policy, the Fed will decrease money supply in order to slow down spending in the economy due to inflation (increase in APE). To reduce money supply, the Fed will sell securities or it can increase the required reserve ratio and discount rate. CHAPTER 9 Fiscal Policy deals with the federal government’s decisions regarding the amount of money it spends and collects in taxes to achieve full employment and bring price stability. Fiscal policy most of the time takes two forms; automatic stabilization and discretionary fiscal policy. Automatic stabilization works as an automatic tool which reduces fluctuations in real GDP without any policy action taken by the government. A discretionary fiscal policy uses policies such as tax cut or increasing government expenditures which are basically initiated by the government in order to change aggregate demand as opposed to automatic stabilizers. Basically, Automatic stabilizers are supposed to automatically promote a budget deficit during recession and budget surplus during an expansion. This means that Government Expenditures will be greater during the period of recession in order to spur the Aggregate Demand and bring the economy to equilibrium. We can illustrate the automatic stabilizers with the help of an example. For instance, if an economy is in recession, workers are laid off from the organizations. Government will start to provide social security benefits to those unemployed workers which means than Government Spending has increased. In addition to that, tax receipts also decrease during recessionary phase as organizations with lower incomes will pay fewer taxes to the government. Secondly, progressive income tax system also provides an automatic stabilizer. Under Progressive income tax system, if incomes are increasing than tax rate moves in upward direction. Similarly if they are decreasing, the tax rate is reduced and consumers & firms pay lesser taxes which again pushes the economy into a budget deficit during contraction and budget surplus during expansion. Discretionary fiscal policy comprises of two steps. At the first step, the government itself intervenes and manipulates the levels of different variables. It can alter its level of expenditures or either it can change the tax rate in an economy. This will cause the level of APE to change thus changing the level of output, prices, employment & interest rates via the macroeconomic coordination process. A formula for fiscal policy can be formed on the basis of mathematical analysis. Since, we know that when government increases its expenditures, it has to achieve this through either borrowing or increasing tax rates as it is the sole source of government revenue. When government increases the tax rate, it’s actually trying to increase its expenditures. Simultaneously, the increase in tax rate is compensated equally by a decrease in consumption as household will have lesser amount of disposable income to consume. Similarly, the businesses will be reluctant to make investment as their real rate of return decreases with an increase in tax rate. If we assume that the levels of import and export are not affected by the tax rate, then following equation can be derived. ΔAPE ≡ ΔC + ΔI + ΔG However since the ΔC and ΔI are inversely related with ΔG therefore there will be a negative sign. Also the multipliers will be smaller than 1 in both the cases, so the resulting equation becomes: ΔAPE ≡ ΔG - kΔC - kΔI Where k is the multiplier of each individual variable. Read More