The Central Bank within the Economy - Assignment Example

Answers to Questions Question I Consider a macroeconomy was initially at equilibrium level of real GDP. Using an aggregate demand and aggregate supply diagram or model of the economy, graphically illustrate and discuss the short-run and long-run effects of the following events upon the economy:  1.The Central Bank within the economy lifts interest rates.  When the central bank lifts the interest rates through a decrease in money supply, there will be a movement along the IS curve. Output will decrease as investment will decrease and savings will increase. Consumption falls because of the substitution effect toward saving. Demand for money will decrease, so LM will shift inward. As a result, the AD curve will shift inward as well (McConnell & Brue, 2008, p.190 - 1). In the long run, AS depends on natural unemployment and potential output, regardless of the level of interest rates (Guerrieria, 2009, p.9). See Figure 1 below for a graphical representation. Figure 1: The IS – LM and the Corresponding AD – AS Diagram 2. There is an increase in private domestic investment spending.  Private domestic saving is defined as S(hh)=Y-T-C, and it equals investment in equilibrium (Guerrierib, 2009, p.3). If now investment increases, as shown on the I – S diagram, it must be that output increases. The IS curve will shift out, and so will the AD curve. The resulting interest rates and prices will be higher. However, in the long run the aggregate supply curve will remain at the natural unemployment and potential output levels. Aggregate demand might decrease due to higher interest rates and return to the previous level of AD. Figure 2 The Investment - Saving, IS – LM and the Corresponding AD – AS Diagram 3.An increase in international oil prices.  An increase in international oil price is a shock to the aggregate supply, as now input prices are higher. Input prices will become higher, which should decrease investment. Aggregate supply will decrease as a result of a decrease in production. Prices will increase and output will decrease. In the long run, prices will adjust as aggregate demand will decrease due to an increase in prices, and long run AS will remain unaffected. Figure 3 The AD – AS Diagram 4. An appreciation in the foreign exchange rate value of the economy’s currency.  When domestic currency becomes more expensive, exports decrease and imports increase. Net exports decrease, so does output. Since net exports decrease, IS shifts in, as does AD. The IS curve is defined as S=I+NX (Gurrierib, 2008, p.3). However, now that imports of input goods are cheaper abroad, the short run AS might shift out. The effects are a decrease in prices and an increase in output. In the long run, output will return to its potential level. Figure 4 The AD – AS Diagram 5. A fall in real estate prices in the capital cities of the country (hint: think of the effect upon one’s wealth level)  Real estate prices determine the households’ level of personal wealth. Higher expected income increases the demand for goods and services. As a result, AD shifts out and prices increase. In the long run, higher prices decrease AD and the economy returns to its equilibrium long run levels. In the long run, output will return to its potential level. Figure 5 The AD – AS Diagram 6. The country’s main exports fall in price while the goods the country’s imports from abroad rise in price (3 marks). When export prices decrease and import prices increase, net exports increase. As a result, the IS curve shifts out, also shifting out AD. However, unlike in question (4), now input goods imported from abroad become more expensive. As a result, the short run AS shifts in. New prices are higher, whereas output decreases. Long run prices might remain higher. Long run output and employment will remain at potential levels, as AS might shift out eventually due to a higher AD. Figure 6 The AD – AS Diagram Question II Collect an article from an Australian newspaper that relates to the current macroeconomy. In a paragraph indicate which section of the course it applies to, why you selected the article and provide a brief summary of what the article is about (1 mark) (one paragraph - no more than a 100 words)  The article chosen is about the growth rate of GDP and its potential level. According to a BBC article by Michael Blythe (2012), the Australian economy has been growing faster this year than previous, at 4.3% comparing to 3%. The concern is that this level is not sustainable because of a recession in Europe, an export market to Australia, as well as domestic AD. However, there have been technological improvements, which might have shifted the long run AS curve. As a result, the article might be correct being optimistic about long run AS and sustainability of the current output. Increased efficiency reduces prices and keeps aggregate demand at high levels. Figure 7 The AD – AS Diagram Question III Many people find the current unemployment figures for Australia a bit unbelievable. Why is this? (1 mark) (one paragraph - 100 words)  In August of 2012, the unemployment rate in Australia amounted to 5.2% (Australian Bureau of Statistics, 2012). The same argument is valid here as it was in the previous question. If output is unsustainably large, then unemployment is unsustainably low as well. As a result, wages should increase with time, which should increase unemployment. However, this fact does not take into consideration that technological improvements might have taken place in the Australian economy, which would have increased labor productivity and thus decreased unemployment, as well as increased profits for firms. For the 2013 - 2015 period, the unemployment rate is forecasted at 4.8%, which is below the world average of 4.97% (EconomyWatch Content Team, 2010). Figure 8 The AD – AS Diagram Question IV Use the simple Keynesian model to assess the implications for equilibrium GDP and the level of savings of an increase in the savings function. What would happen to equilibrium income if there is a sustained rise in private investment spending? (2 Marks) According to the Keynesian model, prices and wages are inflexible in the longer run (McConnell & Brue, 2008, p.389). As a result, the supply curve is horizontal (McConnel & Brue, 2008, p.389). As a result, unlike in the AD – AS model, when real output decreases, price remain constant. If full employment is reached, the supply curve becomes vertical as in the AD – AS model (McConnell& Brue, 2008, p.389). When savings increase, investment increases as more funds are available. Aggregate demand increases. Prices are sticky, so output and employment increase. If the economy is at full employment, prices will increase, whereas unemployment and output will remain the same (see Figure 9). The same analysis applies to increased investment expenditures. Figure 9 AD – AS Diagram Question V State the difference between:  ( definition + example) no more then 500w in total  -Inflation and deflation.  According to McConnell and Brue (2008), “[i]nflation is a rise in the general level of prices” (p.162), meaning that when inflation takes place, a previously bought bundle of goods has now become more expensive. Deflation is the opposite of inflation: the general level of prices decreases. Now goods have become cheaper. Inflation takes place when the economy is above its long run output level, and deflation when the economy is below the long run output level. Figure 10 Inflation and Deflation -between the interest rate and the exchange rate  When domestic currency depreciates, more goods can be bought at home than abroad. This implies that the exchange rate between the domestic and foreign currency has depreciated for the domestic currency. As a result, exchange rate is a rate at which one currency is exchanged for another. Interest rate is a rate at which a borrower pays the interest of the loan to the lender. It is usually defined as the percent of the principal. Higher interest rates imply higher demand for domestic currency from abroad, and in turn higher exchange rate. Figure 11 Exchange Rate and Interest Rate Relationship - between the balance of payments deficit and the budget deficit  Balance of payments is a sum of all financial transactions that take place between domestic residents and residents of all other countries, such as exports and imports of goods and services (McConnell & Brue, 2008, p.428). Balance of payments deficit is thus the negative sum, where domestic residents import more than they export. Higher AD and prices imply higher imports and thus a widening balance of payments deficit. Budget deficit, on the other hand, is the amount by which federal expenditures exceed revenues. They too could be related to the balance of payments deficit if the government exports more than it imports. Figure 12 Budget Deficit and Balance of Payments Diagrams - between the trade deficit and net foreign debt (2 marks)  A trade deficit occurs when domestic consumers import more foreign goods than they export. Gross foreign debt is measured as non – equity financial claims on domestic residents by foreign residents (Parliament of Australia, 2012). Likewise, net foreign debt is measured as gross foreign debt minus the non – equity debts such as foreign reserves (Australian Parliament, 2012). A trade deficit gives rise to foreign debt, as domestic currency in foreign hands arising from domestic trade deficit results in foreigners buying domestic security bonds, which is foreign debt. The second diagram in Figure 13 shows how a trade deficit results in an increased demand for central bank’s reserves, which are a form of foreign debt. Figure 13 Trade Deficit and Foreign Net debt Diagram Question VI Assuming that the money market is initially in equilibrium, trace through the effects of a rise in the money supply on the money market on the interest rate and also on output, employment and the price level. (2 marks) graph+small description 1 sentence) The money market is described as a relation between money supply and demand. It is in equilibrium when they are equal, as in equation (1) below, where the left hand side is real money demand and the right hand side is real money supply: (1) A money supply increase leads to an increase in the left hand side: interest rates decrease as money becomes cheaper to obtain (see the money market diagram below). However, this new interest rate is too low and demand for goods and services increases, shifting LM and thus the AD curve out (see the IS – LM diagram below). As a result, output and employment increase. Figure 14 Money Market and IS – LM Diagram Question VII Distinguish between demand pull and cost push inflation. Why might it be difficult to establish the extent to which a given rate of inflation is demand pull or cost push? (2 marks)  Graph + description 1 sentence  Demand pull inflation occurs when economy is at full employment, but demand increases. As a result, instead of expanded real output, prices increase (McConnel & Brue, 2008, p.203). Cost push inflation takes place when output and employment decline, while prices increase as a result of increasing input prices (McConnell & Brue, 2008, p.164). Problems in distinguishing between them arise in a full employment economy when demand pull inflation increases wages and prices of inputs for others firms, which then increase output prices and thus cost push inflation (McConnell & Brue, 2008, p.165). Figure 15 Demand Pull and Cost Push Inflation Question VIII Using the AD-AS model show how the Australian economy has continued to expand year after year. What are the macroeconomic dangers facing Australia? That is, are there any dark clouds, be they domestic or international ones, which could threaten the Australian economy? (2 marks)  Since 1995, inflation has been increasing unsteadily (Parsons, 2011, p.9). GDP has been growing since 1995 and is predicted to grow into 2013 as well (Parsons, 2011, p.6). As a result, AD and AS have been shifting to the right, and possibly LRAS as well (Lowe, 2012). If predictions are not correct about LRAS, the long run outcome might be an increased inflation and unemployment. Moreover, international recessions might decrease the AD, creating a recession in the Australian economy. Figure 16 Long Term Developments of the Australian Economy Question IX The central bank decided to implement an expansionary policy action. What would you expect to happen to the nominal interest rate, the real interest rate and the money supply? Under what economic circumstances would this type of policy action be most likely appropriate for the country? (2 marks)  An expansionary monetary policy increases real money supply, decreasing the real interest rate and increasing consumption and investment. Nominal interest rate decreases, shifting LM curve out. Once inflationary expectations are developed, and prices start increasing, the LM curve returns to its previous position, confirming monetary neutrality in the long run. If prices are sticky, then output can be affected by this policy. Moreover, if a country is below the potential output, an expansionary monetary policy will increase investment, AD and thus also output and employment (Kaplan, 2002). Interest rates will eventually return to as LM shifts again in. Figure 17 IS – LM Diagram Question X Why has the Australian dollar soared over the last five years? What are the domestic economic repercussions for producers and for consumers? (3 marks)  The Australian dollars has increased since 1983 because of an increasing demand for Australian goods such as rural and mineral commodities, as well as financial flows (Ravimohan, 2010, p.2). Producers suffer and exports are more expensive, which decreases demand abroad, and at home, for domestic goods. However, consumers benefit as now imports are cheaper. In the long run, unemployment could increase, and export industries could go out of business as they are not competitive to other world companies (Ravimohan, 2010, p.5). Figure 18 The Relationship between Exchange Rates and Real Economy References Australian Bureau of Statistics (2012). Main Features. Australian Bureau of Statistics. Retrieved from http://www.abs.gov.au/ausstats/abs@.nsf/Latestproducts/6202.0Main%20Features1Aug%202012?opendocument&tabname=Summary&prodno=6202.0&issue=Aug%202012&num=&view= Blythe, M. (2012, June 6). Australia’s economy grows more than expected. BBC. Retrieved from http://www.bbc.co.uk/news/business-18336521 EconomyWatch Content Team (2010). Australia economic forecast. Economy Watch. Retrieved from http://www.economywatch.com/world_economy/australia/economic-forecast.html Guerreria, V. (2009). Lecture notes: AS – AD model. MIT. Retrieved from http://ocw.mit.edu/courses/economics/14-02-principles-of-macroeconomics-fall-2009/lecture-notes/MIT14_02F09_lec13.pdf Guerreriab, V. (2009). Lecture note: IS – LM model. MIT. Retrieved from http://ocw.mit.edu/courses/economics/14-02-principles-of-macroeconomics-fall-2009/lecture-notes/MIT14_02F09_lec11_12.pdf Kaplan, J. (2002). The Federal Reserve and monetary policy. University of Colorado. Retrieved from http://www.colorado.edu/Economics/courses/econ2020/section11/section11-main.html Lowe, P. (2012). Developments in the mining and non – mining economies. Reserve Bank of Australia. Retrieved from http://www.rba.gov.au/speeches/2012/sp-dg-140512.html McConnel, C. and Brue S.L. (2008). Macroeconomics: Principles, Problems and Policies. New York: McGraw-Hill/Irwin. Parsons, S. (2011). The economics of natural disasters. Reserve Bank of Australia. Retrieved from http://www.rba.gov.au/econ-compet/2011/pdf/second-prize.pdf Ravimohan, A. (2010). Appreciation of Australia’s real exchange rate: Causes and effects. Reserve Bank of Australia. Retrieved from http://www.rba.gov.au/econ-compet/2010/pdf/first-year.pdf Read More