American Democratic President Ronald Reagan and OPEC Oil Prices - Essay Example

1. The proponent of Reaganomics was the fortieth American Democratic President Ronald Reagan. This policy was based on the supply side of the economy. In this theory, it was put that the most viable way to promote the growth of the US economy in the later part of the last century was to cut down taxes, mostly the corporate taxes. The then President believed in ‘peace through strength’. The tax rates have fallen over the last thirty years and the households and the corporations have benefited from large amounts of savings. Since the taxes have fallen, the investors’ profits and workers’ wages have increased. There have been more investments and more growth of GDP (Pethokoukis 2012). 2. a. Short Run The rise in OPEC oil prices as a result of fall in supply leads to a fall in demand for oil. The import of oil reduces by the oil importing countries. The prices of goods in the economy rise, and the rise depends upon the economy’s dependence on oil imports. Hence the rate of inflation soars high causing a macroeconomic slowdown (See figure below). b. Long run The rate at which the economies recover from the recession depends upon the monetary policies adopted by the government. If the money supply curve is more elastic, the government targets to put control upon the interest rate. At lower interest rates the investors would be encouraged to make investments and the economy would recover faster. 3. Adaptive expectation is based on the principle that economic agents build their expectation of any macroeconomic variable, as the inflation rate or price level, as a weighted average of their past observations regarding that variable. Adaptive expectations are used in forecasting figures taking into consideration the interest and inflation rates. In this formation the agents ignore the changes taking place in the monetary and fiscal policies and only base their expectations on the past observations. One of the components of the rational expectation hypothesis, Robert E. Lucas, has emphasized upon the fact that the economic agents exhibit rational behavior by making a forecast of the economic variables taking into consideration the past as well as the present information available. If the government announces an inflation rate and chooses a different rate and increases the money supply, producers would increase output following the increase in prices. In the short run, this would increase output level in the economy, but with rational expectations, the agents would endogenize the discretionary policy of the government, at which point output can no longer be affected. 4. Stagflation is defined “as the coincidence of low or negative output growth” (Bernanke & Rogoff 2001) coupled with high inflation. Inflation is the effect of monetary expansions in the economy. High inflation causes the real money supply to fall, in turn causing a decrease in growth of output. From the point of view of inflation and unemployment, stagflation is defined as “the coincidence of high unemployment and increasing inflation” (Bernanke & Rogoff 2001). The natural rate of unemployment is the level of unemployment that exists in the economy with full employment prevailing in the economy. The interpretation of the Phillips curve depends upon this concept. The trade-off between inflation and unemployment is represented by the Phillips curve. The curve can be represented by the equation: Πe – π = -a(u – un); Πe : denotes expected rate of inflation π : actual rate of inflation u : actual rate of unemployment un : natural rate of unemployment The policy makers of any economy chooses the least undesirable point on the Phillips curve and then undertakes the monetary and fiscal policies in order to move the economy towards the chosen point (Kennedy 2000). 1. A. If Mexico encounters a severe inflationary pressure the prices of the goods that Mexico exports would rise. This implies that the Mexican exports would seem too expensive to the importers of the United States and they would reduce their demand for the Mexican goods. Hence the demand for the Mexican peso would fall leading to depreciation of the peso. Depreciation implies fall in the value of a country’s currency compared to the currencies of its trading partners. B. During a severe recession the interest rates in the US economy would be very high and the high rates of inflation would lead to a decrease in consumer spending. This would lead to a devaluation of the US dollar. Since the US dollar depreciates, the Mexican peso would experience an appreciation. The Mexican exporters would face a lower valued US dollar and the value of the Mexican currency would therefore rise. C. If the interest rates in the US increases then the investment and hence the GDP of the country would fall. This would cause the purchasing power of the people of US to fall. This situation is similar to that of recession in the US. The Mexican peso would appreciate in this case. D. If American tourism in Mexico falls then the demand for Mexican peso would fall. This would reduce the value of the peso. The Mexican peso would depreciate in this case. 2. Given, the current exchange rate is 5.5 francs/$. The price of a shirt marketed by Celio of Paris is 220 francs. The exchange rate is the ratio of the foreign currency to the domestic currency. The exchange rate in simple words is the price of one country’s currency expressed in terms of the price of the currency of another currency. In this case, the price of 5.5 francs is 1 dollar. Therefore the price of the shirt, which costs 220 francs, in dollars would be $40. 3. If the franc depreciates 9 percent from its previous value, the price of the shirt would be lesser in terms of dollar. Before depreciation, the cost of the shirt was 40 dollars. Now, due to depreciation, the francs command lesser dollars. Conversely, in terms of dollar, the US importer would have lesser amounts to pay for the shirt. At present, the dollar is equivalent to 5.995 francs. This would imply that the shirt whose price is 220 francs, that commanded 40 dollars before depreciation would now bring only 36.70 dollars approximately after francs depreciates. 4. The GDP of the country in which the currency depreciates, also gets adversely affected. The country’s exporters need to pay more than before for the same amounts of exports and simultaneously, lesser amounts of foreign currency would enter the country. The higher import costs would lead to a deficit in the current account. The burden of increase in the price of importable is shifted upon the consumers. This creates inflation which is known as cost-push inflation. Thus the purchasing power of the people falls and they demand less than before. This in turn reduces the output level in the economy and the GDP falls. References Bernanke, BS & Rogoff, K 2001, NBER: Macroeconomics Annual 2001, MIT Press. Kennedy P (2000), Macroeconomic Essentials: Understanding Economics in the News, MIT Press. Pethokoukis, J 2012, After 30 years, The New York Times admits Reaganomics worked. Available from:  < http://www.aei-ideas.org/2012/11/after-30-years-the-new-york-times-admits-reaganomics-worked/>. [29 January 2013]. Read More