Real GDP and IS-LM Analysis - Essay Example

1. Aggregate demand is defined as a schedule that shows the quantities of current aggregate output (real GDP) that consumers, businesses and government are willing and able to purchase at various price levels. a. Explain the general relationship between IS-LM analysis and this definition of aggregate demand. (10 points) IS-LM subdivides total demand into two sections: (a) willingness to buy and (b) ability to buy. IS-LM is based on the fact that the produced quantity is able to satisfy the market’s demand. The ability to purchase is shown by the LM curve while the willingness to purchase is indicated by IS curve. b. What aspect demand behavior does monetary policy influence? Explain verbally how the IS-LM analysis is affected by an increase in money supply. (10 points) Policy variable in LM curve is referred to as money supply. The curve illustrates government, businesses and consumers ability to buy actual Gross Domestic Product. MV=PY (the equation used in determining exchange) indicates the quantity of M (money supply) that is required to support certain units of PY (nominal GDP) for V (certain quantities of money). Expansion monetary principle has the ability to buy extra outputs and the ability to adjust money supply. When LM curve shifts outwards, the increase in demand for the actual GDP is realized at each unit of actual interest rates. c. Suppose government expenditures are increased to stimulate economic activity but no other policy action is taken. Explain why and under what conditions an increase in government expenditures will increase aggregate demand. (20 points) As the government increases its spending, interest rates also rise since initial rise in actual Gross Domestic Product triggers bond sales to compensate for additional output assuming the supply of money is constant. Increase in interest rates is alsso influenced by the government’s move to borrow money to cater for the rise in expenditures. A rise in purchase of bonds increases money’s effective velocity. Expansionary monetary rules only works in a condition where people have held their cash as assets, and when they react to the increased interest rates by cutting on the money held through buying more bonds. 2. Explain why the aggregate supply curve is vertical (in a graph with Price on the vertical axis and real GDP on the horizontal axis) under Classical economic assumptions and positively sloped in Keynesian analysis. (30 points) When workers have fully adjusted to the economic conditions, there is a vertical curve in aggregate supply. Full adjustments to economic situations and response to changes in labor market is possible because the workers have sufficient knowledge of the economic situation. The overall result is wage levels will decrease or increase depending on the price. Positive slope is seen in the supply curve when workers are not informed of the actual value productive efforts. They will put much focus on relative wages in addition to negotiating implicit and explicit contracts with employers. When employment levels fall, actual GDP levels also fall. The reaction gives an aggregate curve that is positively sloped since there is a fall in prices during the downturn. 3. Explain the following statement: “Autonomous expenditure multiplier effects do not occur when classical assumptions about money demand prevail (in other words, the multiplier is zero).” (20 points) Shifts in autonomous expenses indicate multiplier effects since these changes impacts changes in effective money velocity as rates of interests change. There is a direct relation between actual interest rates and effective velocity of money. Keynes argues that when uncertainty occurs, people go for interest rate premiums for asset risks in the market. Typically, uncertainties do not exist basing the argument on classical assumptions, and money do not have to be held as assets. Therefore, shifts in rates of interest have no impact on money’s effective velocity. 4. There has been much in the news recently about the declining labor force participation. From the 1960s to now the labor force participation rate for men has fallen from 95% to 84%. a. What has Robert Moffitt found out about the employment to Population ratio? (10 points) Moffitt indicates that there was a fall of 2.7% in the value of men’s employment to population between 1999 and 2007. Women’s side experienced a fall of 1.7%. Moffitt is not sure of the cause of decline. b. Why does William Galston think this is important? (10 points) Galston believes that unless participation rates in labor and ratio of employment to population return to initial levels, it will be difficult to realize a return to vigorous growth in economy. Fiscal policy funded by borrowing in credit markets is more effective (in increasing real GDP) when there is greater uncertainty in financial markets. Explain this statement. You can use IS-LM analysis in answering, but that is not required. Be sure to define the symbols for any variables and parameters you use in your answer. 25 points. Fiscal policy allows the government to manage problems resulting from risk aversion the money market. People tend to hoard money so as to insulate themselves from risks resulting from having their assets placed in the market. Hoarding ability to keep money away from circulation helps in reducing the adverse effects of effective money. The fall in velocity of money reduces the quantity of actual GDP that can be supported by money supply. People will need interest rate premiums when there are uncertainties in the market to cover losses that may occur in the market assets. Rates of interest need adjustment to avoid money being hoarded. Rising rates of interest have no impact on money’s effective velocity assuming that the certainty is perfect. Velocity of money will only be affected when there are cases of uncertainties in the rising rates of interest. In such cases, velocity increase while hoarding falls with the rates of interest. Expansionary fiscal rule impacts the economy by triggering a rise in interest rates in addition to increasing velocity of money. Asset demand or hoarding will be more sensitive to interest rates (elastic) with increases in uncertainties. Therefore, expansionary fiscal policy will e most effective when uncertainty levels are greater. 1. Explain this statement. According to Keynesian aggregate demand theory, expansionary fiscal policy (introduced without an expansion of the money supply) stimulates economic activity by creating inflation. 25 points. Cyclical unemployment is realized since real wages are higher that the productivity marginal at full occupation level. Companies will cut the number of employees when the actual salary surpasses marginal productivity up to the level where productivity average rises to match the actual wage at the lowest level of the total employment. Actual wage should fall to initiate an increase in GDP and employment levels. Keynes supposes that labor contracts, uncertainties, and concentration on relative salaries stops employees from voluntarily increasing their labor supply when recession strikes. Consequently, wages do not fall such that they maintain sufficient employment levels. To ensure a reduction in actual wage, the prices have to be raised. As such, the expansionary money rule reduces actual wage, stimulates economic activities, and increases employment rates. 2. Explain why implicit and explicit labor contracts contribute to the observed direct relationship between the price level and the real GDP in the aggregate supply function. 25 points. Labor contracts are vital in defining uncertainty to insulate the interests of employees and employers. The demerits of contracts are evident in that they give a fixed value of money for longer periods. As a result, wages reduce gradually compared to prices during downturns. The overall result is that actual money wages will increase above peripheral productivities. Employers will be compelled to cut employee numbers. The actual GDP level falls. In the occasion of a downturn, the reduction in prices is realized together with a fall in Gross Domestic Product. This is a case of direct relationship between the two parameters. Contracts may also control the rapid rise in wages in relation to prices in times of economic recovery. Thus, it is profitable to recruit extra employees since their actual wages will be declining when prices inflate. Actual GDP is increased with an in increase in employment levels. 3. The economy is improving, but growth is not as robust as it has been after previous recessions. In your opinion, is more rapid growth going to come in the near future? Cite at least three facts drawn from unemployment trends, job growth, GDP growth, consumer confidence, inflation rates, improvements in manufacturing and the Federal Reserve’s policy on quantitative easing to support your position. 25 points. Responses will differ but must consist of parameters such as current information on labor (job growth, participation rates of labor force, unemployment rates), growth in GDP, indices of consumer confidence, growth in manufacturing employment, foreign vs domestic sales in manufacturing industries, and Fed’s quantitative easing data. The response need to have a precise opinion and the information should have a clear exhibit supporting the opinion. Economics 332 – Third Examination 1. Monetary policy is more effective when the interest rate sensitivity of investment is large. Explain why. a) Refer to the IS-LM analysis in your answer. b) Also, refer to changes that take place in the bond and capital markets when the money supply grows. a) A wide investment sensitivity in demand to interest rate occurs in an IS curve that is curved since interest values defines the slope’s denominator. Raising the levels of supply reduces LM curve’s intercept. The curve will shift to the right; an indication of increase in actual GDP value. GDP equilibrium increases steadily for a given value of LM curve in a situation where IS curve has a flat shape. b) Money supply expansions affect the quantity of available money in that they push more than the needed quantities in into the economy. The excess of the needed amount to buy current aggregate production is deposited in the market as bonds, thus an increase in lower interest rates. Investors increase their investments when they have gained high sensitivity to low interest rates compared to situations where the rates are unimportant. Therefore, it is evident that the investor’s increased sensitivity to the rates of interests is directly proportional to increased variations in GDP in instances of money supply increment. 2. Explain, from the Keynesian perspective, why the aggregate demand schedule is negatively slope. Your answer should both describe a) what happens in the IS-LM analysis (how does the equilibrium change when prices change) and b) what happens in markets when prices change. Price level increments reduce actual stock of money. a) LM curve has an upward turn since its intercept increases with the increase in interest rates equilibrium. A rise in interest rate reduces GDP equilibrium and investment rates. It is evident that the increase in prices is indirectly proportional to actual GDP. b) Increasing prices indicates that money need to fund transactions is insufficient. Money will be withdrawn from invested bonds to cater for the output. Interest rates can be raised by reducing the flow of loanable finances. The rising interest rates increase aggregate GDP demand. 3. Compare the aggregate supply schedule from the classical perspective with the aggregate supply schedule from the Keynesian view when money wages are flexible but do not change proportionally with price changes. a) Compare the informational and behavioral assumptions that underlie their difference in opinion. b) Explain how these different behaviors affect the slope of aggregate supply. a) Classical economists believe that the employers and employees are aware of productivity, price levels and employee wages and that people in the labor market are capable of making rational decisions. Keynes stated that are unaware of employee productivity and that workers base their labor decisions on expected price levels that do not relate to the real price levels. Workers tend to focus on their relative wages without considering what their colleagues get. Therefore, they resist cuts that may reduce their pay. They create contracts to insure their pay against unpredictable environments. b) Whenever there is a fall in prices, there is a reduction in labour demand. In a classical design, rational and learned employees allow for reductions in money wages when the actual reduction is directly proportional to reduction in prices. At full employment level, the output and employment will be maintained. Employees tend to resist changes in wages in the Keynesian design and supply if labor does not correctly adjust to the reducing demand for labor. Wages reduce ‘un-proportionally’ to the prices the implication of this decline causes a fall in actual output and employment level. 4. George Will recently wrote an article about the growth of entitlement spending in the US. Specifically, he mentioned that from 1/2010 to 12/2011, the economy created 1.73 million nonfarm jobs and 790,000 workers became disability recipients. For the 15 years ending in December 2011, the United States added 8.8 million nonfarm private sector jobs and 4.1 million workers on disability rolls. How does this relate to Keynes’ view of involuntary unemployment? Keynes noted that cyclical unemployment is classified as involuntary employment since many employees are unaware of real market conditions. This approach is exposed to criticism in that uncertainty in employment markets is not enough to assume that employees will be the victims of market procedures. Employees need not dwell in their utility on how to maximize on job decisions to understand that they are able to get jobs if they reduce the reservation wage. Using this perception, employees are voluntarily unemployed as much as there are jobs, but at low wage rates. The controversy pops up in the modern world where employees are in positions to trick the system in order to receive undeserved benefits even if they have voluntarily decided to avoid employment. The evident rise in impaired wages over the past fifteen years adds weight to this perception (George Will hypothesizes that several impaired victims are voluntarily impaired). Read More