Macroeconomic Theory - Assignment Example

Question 1 (a): According to macroeconomic theory, the relation between exchange rates and interest rates is based on the no arbitrage policy. This policy basically states that any asset that is available in the global must be available at the same price in the world regardless of the currency of exchange. Therefore, an apple which is available in Japan must be the same value in Japanese yen as it world in the U.S. in dollars. This same rationale is applicable to the securities market as well as the services market. Therefore, one could say that if i1 is the interest rate in country 1 and i2 is the interest rate in country two with the exchange rate between the countries being Ex1; then, the following identity must hold. (1 + i1) = (1 + Ex1)* (1 + i2) Therefore, an increase in the interest rates in Australia will see the Australian currency depreciate against the dollar. This basically means that there would be more Australian dollars now available per Japanese Yen. Hence we can gauge from this knowledge that the prices of Australian products in Yen would decrease as a product worth $99 would cost 9.9 yen if the exchange rate is $10/yen. However, if the Australian currency devalues and come to $11/yen, this same product would now cost 9 yen. Therefore, Australian net exports would increase as Japanese would prefer to buy items from Australia as they would be able to get them at a cheaper rate as compared to before the increase in the interest rates by the Australian Government. Question 1 (b) i): Inflation rate Policy rule 1 Policy rule 1 Policy rule 2 Policy rule 2 (nominal interest rate = i) (real interest rate = r) (nominal interest rate = i) (real interest rate =r) 0 2 2 2 2 2 5 3 5 3 4 7 3 8 4 6 9 3 11 5 8 11 3 14 6 After applying the basic hypothesis that relates interest rates and inflation rates i.e. real interest rates are equal to nominal interest rates minus the cost of increasing prices of products and services and the decreasing spend able income power of the currency of the country. Also, given the assumption that economy’s real interest rate trend is 3%, we can clearly see that policy 1 is the better policy prescription in this regard as it is able to maintain the real interest rate at the 3 per cent level by appropriately catering to the systematic increase in the level of inflation. Policy 2 is not as workable because it is unable to maintain the real interest at the necessary level of 3 per cent showing the choosing policy 1 in this specific case as the policy is a forgone conclusion. Question 1 (b) ii): The basic definition of the aggregate expenditure curve is that it is the aggregate demand for goods and services drawn as a function of the level of national income. Based on this information, we can see that the increase in inflation will lead to an inordinate decrease in the spending powers of the consumers as their real income will not increase by this amendment in the policy prescription. Due to this average Expenditure as a function of national income would decrease for every level of income. The most basic reason for implementing this new policy is an attempt to boost the net exports of the country as discussed earlier. The Aggregate demand line will shift down and to the left due to which the GDP would fall in the long run, and inflation would decrease in the long run in order to restore full equilibrium output. This is because the short run supply aggregate supply is horizontal; therefore, a shift to the left would decrease the equilibrium level output. However, the decrease spending power would see people move towards cheaper substitutes; especially imported goods which would hamper the country due to which inflation would fall, hence, allowing people to buy the same level of goods as before the change in the policy prescription. Thus, the aggregate demand curve would shift back to its original position as the long run aggregate supply is horizontal which would mean that there could be only one optimal full employment level of output. Question 2 (a): The oldest policy for economic management and ascertaining stability is the monetary policy of a country. This policy basically is control the central bank holds over the supply of money and the policy related to the management of this supply. To put in simple word, monetary policy can be termed as monetary management as the policy inherently is the control on the money supply in a country. Here, we would like to ascertain the responses of changes that are brought about in the monetary policy to inflation, the GDP and interest rates. The factors which the government can directly apply to alter the monetary policy include: Changes in Bank Rate Policy or the money supply in the market: Bank rate or re-discount rate basically is the rate at which the commercial banks operating in a country and able to get a loan from the Central Bank in the country. For instance, the State Bank of Pakistan charges 10% bank rate from the commercial banks operating in Pakistan for a loan. By altering this interest rate, the central bank is able to control and manage the supply of money in the country. It can also do the same by decreasing the money supply in the market by printing less currency and withdrawing currency from the market. In the instance of inflation, the central bank can increase the rate of interest to counter the effects of inflation. This change will see the commercial banks also increase the interest rate that they offer on the loans that they give to the general public, as their own cost of loans would have increased. Now, the increased inflation would not sustain in light of the increased nominal interest rate of the country as the price of investment would fall in order to increase investments. Therefore, inflation can be completely controlled by the monetary policy. Moving along, we see the change in GDP in light of an increased monetary expansion would be such that the GDP would fall decrease and the interest rates would fall as the LM curve would shift to the right. In the short run, there would be no effect on the level of inflation as we are assuming the economy is operating under the Keynesian model and hence, prices are sticky. However, in the long run, inflation would increase which would shift the LM curve back up and to the right to its original position, restoring the original level of GDP and interest rates; all the while increasing the level of inflation in the country. [1] [2] [3] Question 2 (b): Money demand and supply are the basic ingredients that determine the LM curve in the IS-LM and subsequently the AS-AD framework. Therefore, the interest rates that are prevalent in a country are directly dependent on the monetary demand and supply. Now, an increase in money supply ceteris paribus would decrease the interest rates in the country and vice versa whereas an increase in monetary demand ceteris paribus would also increase the interest rate in the country. The strength of the monetary policy lies on the supply side as money supply is the instrument that is directly handled by the central government. Therefore, a strong change in the monetary policy would usually be indicative on the supply side as the change would be much more objective and realizable in the market. Money demand, however, is a much more abstract notion as the real money demand cannot be properly transmitted to the central government due to which their actions come as a result of a bets approximation or a pre-emptive strike to a possible future level of money demand, hence, the strength of the monetary policy dwindles in this aspect of the macroeconomics. Question 3 (a): Fiscal policy is basically the use of government spending and revenue collection which can directly or indirectly influence the economy i.e. the prevalent interest rate and output of the economy. Fiscal policy can be contrasted with the other main type of economic policy such as monetary policy, which can be termed as monetary management as the policy inherently is the control on the money supply in a country. Now the two major instruments which are used to maneuver the fiscal policy in a country are the level of government spending and the level of taxes that are levied on the people in the economy. Changes that are brought about to the level of government spending and taxation in a country have the ability to impact the following set of variables in the economy: Aggregate demand and the level of economic activity The pattern of resource allocation The distribution of income. Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible standpoints of fiscal policy are neutral, expansionary and contractionary: A neutral fiscal policy basically means that the budget that is being run by the government in balanced i.e. G = T (Government spending = Tax revenue). So, the tax revenue that is generated by the government fully funds the government spending that takes place in the country and overall the budget outcome has a neutral effect on the level of economic activity. An expansionary stance on the fiscal policy forum basically means that there is a net increase in the government spending i.e. G > T (Government spending > Tax revenue) through a rise in government spending or a fall in the tax revenue collection or perhaps even a combination of the two instruments. This would fundamentally lead the economy to larger budget deficit or a smaller budget surplus than what the government previously experienced, or even a budget deficit if the government was undergoing a neutral fiscal policy in the previous economic term and hence, had a balanced budget. Suffice to say, expansionary fiscal policy is usually associated with a budget deficit. Therefore, taking a cue from the expansionary fiscal policy, a contractionary fiscal policy is the case when the government runs a budget surplus i.e. G < T (Government spending > Tax revenue) which usually occurs in the event of reduced net government spending or increased taxation revenue due to stricter taxation policies on the people in the economy or even a combination of both of these articles. These would eventually lead the economy to a lower budget deficit or a larger surplus, if the government was undergoing a neutral fiscal policy in the previous economic term and hence, had a balanced budget. So, we can conclude that contractionary fiscal policy is usually associated with a surplus. The basic reason behind the decision of the government to run a budget deficit late in 2008 is due to the fact that they have tried to incorporate an expansionary fiscal policy whereby the tax revenues that they wanted to ascertain from the people in the economy have been decreased in light of the crushing global economic crisis that has ravaged the global business setup and increasingly adversely affected the people in Australia. In addition, they also aim to increase governmental spending in order to provide greater relief to the population in the face of this economic crisis with greater efforts towards job creation, unemployment benefits and family pensions etc. Question 3 (b) i): If the government increases public infrastructure spending, then the first and foremost change that would take place would be an augmentation of the government’s share in the total spending of the economy. Now in economics, crowding out is any reductions in private consumption or investment that occurs because of an increase in government spending. If the increase in government spending is financed by a tax increase, the tax increase would tend to reduce private consumption. If instead the increase in government spending is not accompanied by a tax increase, government borrowing to finance the increased government spending would increase interest rates, leading to a reduction in private investment. Therefore, we can see that there definitely will be a crowding out effect in this case as public infrastructure investment will drive the private investors out of infrastructural outlays and into other avenues of investment. Question 3 (b) ii): This part of the assignment demonstrates an economic activity which comes in complete contrast to the one discussed earlier as the withdrawal of governmental spending from infrastructural projects will lead to a crowding in effect as private investors would look to undertake government projects, all the while the government investing in the defense sector. Therefore, the overall spending in the economy would remain the same as in part i) assuming foreign direct investment and investment from national investors outside the country remain the same. However, spending on governmental projects would increase as compared to private projects and they would now undertake a larger share of the overall spending in an economy. Question 4 (a): The debate raging between the pros and cons of trade barriers can be extended to hundreds of pages, however, we will only be looking at the critical factors that characterize this debate. Conventional analysis of this economic framework shows that free trade increases the global level of output which is calculated by the accumulated sum total of the output of all the countries combined together in the world. This is largely due to the fact that free trade allows for specialization amongst countries. Specialization basically is the phenomenon whereby nations are able to allocate their specific scarce resources towards the production of those specific goods and services for which these specific nations hold a comparative advantage over each other. The benefits of specialization in addition to the economies that can be realized due to increased free trade amongst countries all lead to the augmentation of the global production possibility frontier. This augmentation of the global production possibility frontier is indicative of the fact that the absolute measure of the goods and services that is produced is the highest under free trade as compared to any other politico-economic regime. It must also be noted that not only are the absolute measure of the goods and services that is produced is the highest under free trade but also the particular combination of goods and services that are produced also ascertain the highest level of utility for the consumers of these goods and services. On the counter side, we have the proponents of the economic theory known as fair trade. Fair trade is basically is an organized social movement which also doubles as a market based approach towards economics whereby the basic objective is to assist the producers in developing countries, in order to promote sustainability in these regions. This notion basically advocates the payment of a ‘fair price’ in addition to social as well as environmental standards in geographic areas that are related to the production of a wide assortment of goods and services. The basic focus is on the exports from the developing countries to the developed countries most notably handicrafts, coffee, cocoa, sugar, tea, bananas, honey, cotton, wine, fresh fruit, chocolate and flowers. Trade barriers are present in a number of forms, some of which are listed below. Identification and proper disbanding of these forms can lead to a decrease in trade barriers: Import duty Import licences Export licences Import quotas Tariffs Subsidies Non-tariff barriers to trade Voluntary Export Restraints Local Content Requirements Embargo Question 4 (b): As stated earlier, the benefits of specialization in addition to the economies that can be realized due to increased free trade amongst countries all lead to the augmentation of the global production possibility frontier. This augmentation of the global production possibility frontier is indicative of the fact that the absolute measure of the goods and services that is produced is the highest under free trade as compared to any other politico-economic regime. This formulates the major reason behind the advocacy of free trade as one solution to disentangle the global economic crisis as the overall product output would increase in the global economy which would benefit all the countries suffering from the crisis. Question 4 (c): There are potentially many gains in economic welfare to be achieved through free trade: Increased production possibility frontier Benefits of comparative advantage and economies of scale Increased surplus for producers and consumers No deadweight loss of economic surplus By critically analyzing these benefits which had been earmarked by Adam Smith as the economic benefits from trade are still applicable in today’s contemporary global economic landscape especially since the advent of the economic crisis. Transaction costs have certainly dented the consumer and producer’s surpluses in the modern business setup which ahs also led to birth of some deadweight loss, yet this change cannot distance us from the reality that these four reasons are still existent and applicable to modern trading activities in global economics. Question 5 (a): Foreign exchange rate is an article of trade which, like any other tradable entity fluctuates in price and valuation over different time stamps across periods of economic activity. There are various reasons which can be attributed to these fluctuations, some of which are given here: Raising the level of interest rates in a country increases the ‘hot’ money that flows into that specific country from other regions around the globe, which leads to an increase in demand of the domestic currencies, due to which the home currency appreciates in value as well as in demand. Relative rates of inflation affect this country’s ability to compete in the international market, consequently if the economy of the country is experiencing higher levels of inflation as compared to its trading alliances then its purchasing power would decrease dramatically and the subsequent demand for this currency would also decrease. Speculation is a major instigator of changes in exchange rate as many have seen this phenomenon in play in the global economy; where some might that a currency is ‘over-heating’ which is why it would be devalued soon which might cause investors to move their money from this currency to another, which would decrease the demand of this currency which would see it actually depreciating in the world market. International trade is another major reason behind the fluctuation of the exchange rates in the global economy largely based on the statistics of the level of export and import that a country undertakes as countries which are selling a greater number of goods and services than their trading partners would want their currency to appreciate whereas those who are importing highly normally prefer to see a fall in the value of their currency as they are spending more to their trading partners than they gain from them. Many believe that political and psychological factors have a major impact on the determination of exchange rates. Many currencies usually behave in a set pattern which they have followed for large periods of time for e.g. Swiss franc as a refuge currency. The U.S. Dollar, in addition to the Swiss franc, is also considered a safer haven currency whenever there is a political crisis anywhere in the world. Governments are known to participate in foreign exchange market activities in order to influence the value of their currencies; which they are able to ascertain either by flooding the market with their domestic currency in an attempt to lower the price or conversely by buying large volumes of their own currency from the open market in order to raise the price. This is known as Central Bank intervention. However, the size and volume of the foreign exchange market makes it impossible for any one entity to "drive" the market for any length of time. Question 5 (b) i): GDP = Net Exports + Government Expenditure + Investments + Private Consumption = Net Exports + Government Expenditure + (National Savings + CA) + Private Consumption = 2500 + 1500 + 5000 + 2500 + 5000 = 16500 Question 5 (b) ii): This economy has been able to attract a net flow of foreign savings which is determine able by the fact that net exports are a positive entity, therefore, more money has flown into the country as a result of the purchase of national goods by foreign buyers as opposed to money leaving the country in lieu of the purchase of international goods by local buyers. Question 6 (a): Despite the presence of several international financial institutions for the stabilizing of the world economy, we have decided to focus on one particular organization i.e. the Bank of International Settlements and try and determine the mechanisms that are in place to ascertain monetary regulation of the global economy. The role of the Bank of International Settlements is of a great magnitude largely due to the fact that the major reason behind its creation i.e. transfer of funds as a result of a peace treaty has become somewhat of an archaic practice as peace treaties remain elusive in this day and age. Therefore, its best role now is that of third party moderator and monetary regulator for the 55 member states that are affiliated with it. Central monetary regulation is very important in the present, as exchange rate fluctuations are an Achilles heel for almost all the nations around the world especially those who economies are based on their exports. In addition, there is an absence of a hypothetical ‘international currency’ which can be used by nations whilst they are trading commodities or services between each other, therefore, the role of the organization becomes doubly importance for nations around the world in the present day as the Bank of International Settlements can help provide the monetary stability that can help reduce if not essentially eliminate the threat of the fluctuating currency exchange rates. [4] Monetary regulation is a very important concept for nations regardless of their time of existence; this concept was as important before the Great Depression as it was immediately after the culmination of World War II or the Cold War as it is today. For this matter, nations around the world have employed different systems of managing currency exchange rates such as the fixed exchange rate regime, the semi-fixed or pegged exchange rate regimes and the floating exchange rate regime which we see being applied by economies in the world today. There is no doubt in the fact that the role of the Bank of International Settlements is limited and even if it were to be expanded, it would start to coincide with the role of the International Monetary Fund or the World Bank. Therefore, propositions to immediately expand it might seem a bit premature at this point in time. However, considering the organization to be merely an organization of happenstance which has not applicable function in the modern day and age would be considered a sheer folly as the role the Bank of International Settlements plays in the monetary policy management of its 55 member states and with it the entire world in general certainly make us realize that the Bank of International Settlements is a necessity in this day and age for nations against their vulnerabilities to floating exchange rate regimes. [5] Question 6 (b): There are two main ways that economies of this type can increase capital stock: Government deficit require lending from the private sector. Smaller deficit means less lending to the government, so more money can be lent to private investors, which means a larger capital stock. Increase in household savings would mean more money to invest, which would lead to larger capital stock. If the savings rates of mature industrialized nations also decrease, then people would be more interested in investing money in these industrialized nations as opposed to the developing nations which would drive investment out of the developing nations which would subsequently led to a permanent gap between the industrialized and the developing countries which would adversely affect the prospects of these developing countries of catching up to their mature industrialized counterparts. Bibliography: 1. Ahearne, Alan G. Ammer, John Doyle, Brian M. Kole, Linda S. and Martin, Robert F. (2005) ‘House Prices and Monetary Policy: A Cross-Country Study’ International Finance Discussion Papers Number 841, Board of Governors of the Federal Reserve System 2. Benito, A., J. Thompson, M. Waldron, and R. Wood (2006). "House Prices and Consumer Spending (420 KB PDF),” Bank of England Quarterly Bulletin, vol. 46 (Summer), 142-54. 3. Calza, A., T. Monacelli, and L. Stracca (2007). "Mortgage Markets, Collateral Constraints, and Monetary Policy: Do Institutional Factors Matter?" CFS Working Paper Series No. 2007/10 (Frankfurt: Center for Financial Studies). 4. "About BIS". Web page of Bank for International Settlements. http://www.bis.org/about/index.htm [Retrieved on March 11, 2009] 5. McQuillan, Lawrence J. and Peter C. Montgomery, “The International Monetary Fund: Financial Medic to the World” (Standford: Hoover Institution Press, 1999) p5-229 Read More