Competing in the Global Marketplace - Assignment Example

BUSINESS ECONOMICS 3 Keynes believed that the ical view of savings and investment was wrong.’ What was Keynes’ own view of savings and investment? The classical view assumed that the supply of savings determined the amount of investment in business or industrial assets. Since such savings were placed in banks and business people went to banks for their funding needs, the amount of investment was a function of the amount of available savings. Keynes view was that investment decisions were determined by other factors such as prospects for long-term profitability as well as the level of interest rates. To illustrate his point that the classical view was wrong, suppose that people decide to save more and to consume less. As a consequence, expenditures would decline while savings would increase. If the saving is not immediately converted into investment and then back to expenditures, investment demand would not expand by enough to offset the fall in consumption demand, so that total demand would fall. An excess supply would follow, firms would cut back on production, income would decrease, workers would be laid off. As peoples incomes drop, both their savings and consumption would also drop. By the time income has fallen far enough so that again savings and investment are in equilibrium, a recession would have become the order of the day. What this scenario leads to is the conclusion that an increase in saving can lead to a decrease in expenditure, decreasing production, and a recession – the so-called paradox of thrift. This is diametrically opposite to the classical view that savings is good because it leads to more investment which in turn leads to more economic growth. As a backdrop, the classical economists in the tradition of Adam Smiths concept of the invisible hand believed in the markets ability to regulate itself through the pricing mechanism. The laissez faire theory was anchored on the belief that whatever aberrations or glitches there were occurring in the short run would naturally return to its potential output and employment in the long run. Keynes disagreed, and he initiated an inquiry into the causes of short-term problems that produced the Great Depression and similar conditions that could recur in the future. He believed in an economic framework that would focus on economic stabilization in the short run. He believed that government should intervene through its tools of macroeconomic policies to influence the demand side of the economy in order to deal with recessions, inflation and unemployment. (See Baumol and Blinder, 205). 2. Describe the objectives of expansionary fiscal policy and how such a policy would be implemented by Government. Fiscal policy came into focus as a macroeconomic tool that the government can use in order to counteract a trend that could lead to a recession. Policy makers would have asked the people to spend, as President Franklin D. Roosevelt tried to do during the Depression in the 1930s, in order to create jobs and restore the economy to health. However, this was not easy to do because if not enough people followed his prescription, it would not be sufficient to cause more spending and generate a multiplier effect for the economy to be stimulated towards job creation. Under such circumstances, the government should step in and provide the needed increased spending by decreasing taxes, increasing government spending, or both, even if such a policy would cause a fiscal deficit. The government would thus provide the initial impetus, increasing peoples incomes. As their incomes increase, they would spend more, and then the multiplier process would be in effect to create more spending, more incomes, and more employment. Keynesian economists believe that in times of recession spending is a public good because it benefits everyone, so government should spend or find ways of inducing private individuals to spend (Colander 254). The government can use aggregate demand management, an attempt to control the aggregate level of spending in the economy. It involves the governments exercise of control over aggregate expenditures and thereby the aggregate output and income. The multiplier effect would multiply the initial effect into a larger effect on aggregate demand and thus on income. The effectiveness of fiscal policy depends on the governments ability to perceive a problem situation accurately and to respond quickly. The government can use fiscal policy through changes in taxes and spending to offset any fluctuations in other economic variables thus keeping the economy balanced leading to its potential level of income. Recessions can be prevented if the government uses a counter-cyclical fiscal policy, one that would offset any change in aggregate expenditure that would create a business cycle. The term fine tuning is used to describe a fiscal policy designed to keep the economy always at its target or potential level of income (Colander 257). 3. Explain the movements in Australia’s exchange rates in the last five years. There are three principal fundamental determinants of a countrys exchange rates: 1) a countrys income as measured by the Gross Domestic Product, 2) its prices as indicated by the Consumer Price Index (inflation factor), and 3) the interest rate. When a countrys income falls, demand for imports falls, leading to the fall in demand for foreign currencies, and therefore the supply of the local currency falls. The price of the Australian dollar rises, or appreciates. If a country is experiencing an inflation, foreign goods become cheaper, the demand for imports rises, which can lead to the depreciation of the domestic currency. Finally, when interest rates rise in Australia, the demand for the local currency rises, and the Australian dollar appreciates relative to other currencies. Below is a chart of the value of the Australian dollar in terms of the US dollar. An appreciation of the Australian currency would be denoted by a fall in the value of the US dollar in the chart. If a short-period moving average were drawn to smooth the lines, one might see that the Australian dollar fell during the first half of 2004, and then rose (indicated by the line falling) for most of the next three quarters. For the next year or so, the currency just moved down gradually, then it began to appreciate from mid 2006 until it nearly hit parity with the US dollar in July. From that point on a steep drop (that is, the chart line rises) in the value of the Australian dollar occurred. Fig. Value of US$ to A$ for 5 years to Nov. 10, 2008 http://finance.yahoo.com/echarts The appreciation of the Australian dollars in recent years prior to mid-2008 was caused by the substantial gain in the countrys terms of trade (TOT), which had risen about 40 per cent in four years, according to the International Monetary Fund (IMF). This means that Australias export prices for metals and agricultural products had risen in relation to the prices of its imports over that period. There were also strong capital inflows on account of the interest rate differentials between domestic rates and foreign rates, attracting foreign money. The currency appreciation helped check inflation as imports could be acquired relatively cheaply. Starting July, however, the decline in the worlds credit markets triggered a decline in the demand for Australian assets, and funds were withdrawn jointly with the fall of the stock market.. Although it was estimated by the IMF that the impact of the credit market turbulence caused by the subprime mortgage loan losses on Australia was limited, still the the foreign exchange market reacted quite strongly, causing the Australian dollar to fall nearly 50 per cent in October 2008, at one time hitting the AU$1.60 to the US dollar. However, because previously the Australian currency had been overvalued, the present exchange rate would seem broadly to be in line with s medium term fundamentals. Due to the increasing incidence of globalisation and deregulation, the Australian dollar has been heavily influenced by international factors. These include overseas interest rate differentials, upward and downward movements of global stock markets, levels of global growth and demand, the level of overseas confidence and the incidence of geopolitical jitters around the world. An example of this would be the 2007 subprime market crash in the U.S. which affected international stock markets. The Reserve Bank of Australias contractionary (high-interest rate) stance over 2007 has caused the Australian dollar to reach 23 year highs against the U.S. dollar. The other favourable condition for the Australian dollars popularity include the expansionary stance of the U.S. Federal Reserve due to the slowing of the U.S. economy.(IMF report) The Australian Dollar is also influenced by domestic factors. These include, level of interest rates and expectations, level of economic growth and other economic indicators such as inflation. The Reserve Bank of Australia can also influence the level of exchange rates during times of heavy volatility by participating in the forex market as a buyer and seller of the currency. In most instances, the "dirty float" is meant to act as a buffer against an external economic shock before its effects become disruptive to the domestic economy (IMF report) 4. What is the relationship between the slope of the consumption function and the size of the multiplier? The consumption function is central to Keynes theory of economic fluctuations as discussed in his General Theory published in 1936. Because he had no access to sophisticated computer technology during his time, Keynes made some “conjectures” about the consumption function. One of these was that the marginal propensity to consume – defined as the amount consumed out of an additional dollar of income – is between zero and one. He assumed that men are as a rule disposed to increase their consumption increases but not by as much as the increase in income. He also posited that the ratio of consumption to income – the average propensity to consume – falls as income rises. Thirdly, he assumed that income is the primary determinant of consumption and that interest rate is not important. The marginal propensity to consume is the slope of the consumption function. The said slope is what determines the size of the multiplier. The following formula will illustrate this concept; Multiplier = ΔY / ΔI = 1 / (1-MPC) where the Multiplier is the result of multiplying the change in income Y by change in investment I. The multiplier is derived by obtaining the residual of the marginal propensity to consume which is equal to the marginal propensity to save (MPS) By way of example, if the marginal propensity to consume is .75, the residual would be .25 – the marginal propensity to save. Obtaining the reciprocal of the MPS (l/.25), we obtain the multiplier of 4. If we apply this to aggregate data of the economy, we can assume, for example, that an autonomous expenditure $500 billion would have the effect of increasing the real Gross Domestic Product (GDP) by this amount at the outset. In the second round the larger GDP induces greater expenditure. Induced expenditure rises by 0.75 times the increase in real GDP of $500 billion and will further induce an increase in expenditure of .75 ($500b) or $375 billion. And the process repeats itself through the next rounds until the cumulative increase in the real GDP reaches $2000 billion, which is the product of the original money released and the multiplier 4. (See Parkin 266) The principle states that the greater the marginal propensity to consume, the greater the multiplier, and the greater the impact on the real GDP. 5. ‘Monopolies do not produce an efficient allocation of society’s resources.’ Discuss briefly. A monopolist tends to produce fewer outputs than would a competitive industry with the same demand and cost conditions. (Baumol and Blinder 264). The monopolists demand curve slopes downward, which means that if he produces less output, his price will increase. Because he is not subject to any retaliatory or competitive action as he would be under the other market structures (oligopoly, monopolistic competition, and perfect competition), he can produce less than would be justified. In other words, he is producing “too little” and critics would say he is “gouging the public”. Under the premise of efficient resource allocation, marginal utility (MU) should be equal to marginal cost (MC). Because the monopolist charges a price where marginal cost is less than marginal utility, too little a share of societys resources is being used to produce his monopolized commodity. The monopolist does not increase production although consumers are willing to pay an additional unit of the good that exceeds what it costs to produce that unit (MC), because he raises output by one unit, the marginal revenue the monopolist will get will be less than the price the consumer will pay for the additional unit (Baumol and Blinder 265). In sum, there is an inefficient allocation of resources because the monopolist produces too little and charges too high a price for his commodity. This is an instance where the price mechanism assumed in the laissez faire theory does not apply. 6. Define the term ‘marginal propensity to save.’ Estimate the marginal propensity to save in Utopia where a $100 million increase in disposable income leads to an increase in savings of $40 million. The marginal propensity to save may be defined as MPS = (change in savings)/(change in income). Since the change in income must equal the change in savings plus the change in consumption expenditure, this concept is related to the marginal propensity to consume (MPS) by the formula MPS = 1 – MPC. If there is an increase in disposable income by $100 million in Utopia, and this leads to an increase in savings by $40 million, the formula would yield the following: MPS = ΔS / ΔY MPS = 40 / 100 = 0.4 [If used in the computation of a multiplier, the result would be l/.4. The multiplier would be 2.5. The original $100 would have the multiplier effect of $250] 7. Over recent years, the Reserve Bank of Australia raised interest rates in order to control inflation. Briefly describe the effects of this monetary policy in the Australian economy. Changes in real interest rates affect the publics demand for goods and services mainly by affecting borrowing costs, the availability of bank loans, the wealth of households, and foreign exchange rates. For example, a decrease in real interest rates lowers the cost of borrowing; which in turn leads businesses to increase investment spending, and households to buy durable goods, such as cars and homes. (See http://www.frbsf.org/publications/federalreserve/monetary/goals.html) When the Reserve Bank of Australia raised interest rates, the immediate impact of this policy was to increase the cost of borrowing in banks as these banks obtained them at a high discount rate from the RBA. They could only lend at a higher rate to their borrowers to protect their spreads. Less lending means contraction in both investment and consumption, and the banking system may have resorted to borrowing from abroad where interest rates were lower to compensate for loan scarcity. This may have explained the high level of external debt registered by Australia over the years. A central bank needs to strike a fine balance between controlling inflation and stimulating economic growth, which often are contradictory objectives. Because interest rates in Australia were higher than in most countries this may have encouraged foreign money to be attracted to acquire Australian financial assets in order to take advantage of the interest rate differential. This in effect would contribute to Australian external liabilities on the equity side. This did not make Australian bonds and equities attractive for the local investors because they had less money to invest but foreigners may have seen an opportunity to profit from the relatively higher interest rates than in their home countries or elsewhere. In the short run, higher interest rates in Australia tend to increase the foreign exchange value of the Australian dollar, which increases the prices of Australia-produced goods sold abroad and reduces the prices Australians pay for imports. This leads to lower aggregate spending on goods and services produced in Australia. Higher real interest rates make equities and similar investments less attractive than bonds and other debt instruments; consequently, common stock prices tend to stagnate or fall. Households with stocks in their portfolio find that the value of their holdings are lower, and this decrease in wealth make them restrain spending. Lower stock prices make it less attractive for businesses to invest in fixed assets by the issuance of stocks. In 2008, GDP and inflation in Australia fell by 0.2 percent, allowing a 50 basis point easing in the policy interest rate. The impact dissipates quickly with the economy back to baseline by 2010. The exchange rate has depreciated recently as interest rate differentials narrowed and some commodity prices eased. It is evident that the results of any interest rate change can be mixed. This requires close monitoring by central bank authorities of the impact of their interest-rate policy decisions. 8. What two major forces have led to greater globalisation in markets and production? Explain each briefly. The two major forces that have led to greater globalisation in markets and production are: 1) The decline in barriers to the free flow of goods, services, and capital that has occurred since the end of the Second World War; and 2) Technological change, particularly the dramatic developments, in recent years, in communication, information processing, and transportation technologies.(Hill 9f) The removal of the barriers to the free flow of goods, services and capital were promoted by GATT and then by the World Trade Organization which replaced it. The measures to liberalize global trade and investment have pursued up to the Doha round and the present, including the cutting of tariffs, the phaseout of subsidies to agricultural producers, the limiting of the use of anti-dumping laws, and the reduction of barriers to foreign direct investments (FDIs). The number of bilateral investment treaties have progressed by leaps and bounds, growing tenfold, in 2002, from its previous 1980 level. The globalisation of markets meant that goods produced in one nation could be sold to nearly all countries worldwide The globalisation of production meant that products of multinational companies could produced in diverse international locations, and the production of parts, such as jet airplane parts of Boeing could be efficiently integrated backward in many countries. Major advances in communications, information processing, and transportation technology have been tremendous since the end of the Second World War, with the introduction and the universal reach of the Internet and the World Wide Web, creating a global audience. And transportation technologies have created a "global village" The development of the microprocessor has made possible the explosive growth of low-cost high-power computing as well as advances in satellite, optical fibre and wireless technologies. The cost of microprocessors has continued to fall as well as the cost of global communications, making it possible to coordinate and control global business operations from one site. The Internet has created huge potential for the spread of a global culture and for the effective use of e-commerce for marketing by businesses. We have a global electronic market places which would have been unimaginable years ago. WORKS CITED Baumol, William J. & Alan S. Blinder. Microeconomics: Principles and Policy. 7th ed. Orlando, FL: Dryden Press, 1997 Colander, David C. Macroeconomics. 4th ed. New York: McGraw-Hill, 2001 Hill, Charles W. L. International Business: Competing in the Global Marketplace. 5th ed. New York: McGraw-Hill, 2005 Hill, Charles W. L. & Gareth R. Jones. Strategic Management: An Integrated Approach. 6th ed. Boston, MA: Houghton Mifflin Co., 2004 Krugman, Paul R. & Maurice Obstfeld. International Economics: Theory and Practice. New York: HarperCollins, 1991 Mankiw, N. Gregory. Macroeconomics. 3rd ed. New York: Worth Publishers, 1997 Parkin, Michael. Macroeconomics. 5th ed. Don Mills, Ontario: Wesley Publishing, 2000 2008 International Monetary Fund September 2008 IMF Country Report No. 08/312 http://finance.yahoo.com/echarts http://www.imf.org/external/np/sec/pn/2007/pn07112.htm. http://www.frbsf.org/publications/federalreserve/monetary/goals.html Read More