The Balance of Payment - Assignment Example

INTRODUCTION TO ECONOMICS ASSIGNMENT 2 This assignment is divided into two sections. Each is worth 50% of the marks. Write your answers in the spaces provided; do not include any other sheets, do not write on the back of the sheets. You should answer all questions. No marks will be awarded for those parts of answers which exceed the space limits. Please write your answers clearly and use diagrams where appropriate. Section A (5 marks per question) 1. If the government runs a budget surplus, and the private sector invests less than it saves there must be a balance of payments surplus. YES. It is TRUE. The balance of payment (BOP) accounts for all the money that is paid by both the public and private sectors in a country. Balance of payment surplus is a situation where the money received exceed the money paid by a country. This situation is normally favourable because the country gets more money than it spends. A country that experiences a balance of payment surplus has a lot of exportations. In order to sustain this exportation, its government as well as the private sectors must invest less and save more, in order to provide adequate capital to finance this high level of production that is needed for export and perhaps get enough to lend to other countries that are importing the countrys produce. However, this economic stimulus is only sustainable in the short-term because in the long-term, the country will need to increase its investment in order to boost its domestic market, which is important for an all-round economy. 2. An increase in disposable income decreases the average propensity to save. This statement is not true. The average propensity to save (APS) refers to the percentage of income that is saved by individuals or a country, which is typically represented by savings as a percentage of total disposable income, that is: APS = [Household savings/Total household disposable income]*100 According to Keynesian theory, the average propensity to save increases with the increase in income, and usually an increase in income leads to an increase in disposable income. What this means is that, when the income of consumers increases, they are left with plenty of money after spending some of it – this excess income after consumption is saved for future consumption and investment. 3. In a Keynesian economy with proportional taxes, if the rate of indirect tax is increased and the rate of direct tax is decreased by the same amount national income will go up. This statement is NOT TRUE. The proposition of Keynesiaon regarding tax cuts is that, given that tax reduction increases the household’s disposable income, the households tend to increase their expenditure, which, in effect, boosts the demand for products. In response, the level of production in the domestic business is increased. This, in effect, means that tax reduction boosts the economy creating more jobs and better income. However, it is important to note that the Keynesian theory differentiates direct tax from indirect taxes. According to Keynesian theory, direct taxes are more favourable than indirect taxes, for example, because they are progressive, which means the corporations or individuals that earn higher-income pay higher taxes to the government. On the other hand, indirect taxes are considered to be regressive because their increase affects those who earn the lowest income in the economy simply because they spend most of their income on consumption hence carrying the heaviest tax burden. What this means is that, when the rate of indirect tax is increased at the same proportion that the rate of direct tax is decreased, the effect of increasing the indirect tax will be more than the effect of decreasing the direct tax. Therefore, if the poorest in the economy are burdened by imposing more taxes on them, they respond by causing the demand in the economy to decrease, hence contracting the internal market. This also leads to a decrease in investment and competitiveness and of course a decrease in the national income. 4. The larger is the marginal propensity to consume the less steep is the IS curve. This statement is TRUE: Marginal propensity to consume (MPC) is the proportion of the total increase in income that is consumed rather than being saved. IS curve is a representation of a closed economy devoid of government – it shows the combinations of the national income and interest rate for which savings equal investment? As indicated in the graphs above, MPC is one of the determinants of the slope ness of IS curve. Ideally, a steeper aggregate demand is created by an increase in the MPC. In the graph, c’ represents the increased MPC. When the steeper graph of aggregate demand is plotted, it becomes clear that the second IS curve is steeper due to a higher MPC. 5. A decrease in the price-level shifts the LM curve to the right. This statement is TRUE. LM curve is an upward-sloping curve showing the combination of levels of real income and interest rates in which the market is at equilibrium. From the graph, clearly, as the price level is reduced, the equilibrium becomes higher while the LM curve shifts further towards the right. This is because a reduction in the price level leaves the consumers with more money to spend on goods and services, a factor that stimulates aggregate demand in the economy. As the price level becomes lower, this process continues to produce an even higher equilibrium level with LM shifting further downwards and to the right (Sowell, 2006). 6. In a fixed price IS/LM model with a lump sum direct tax, the balanced budget multiplier is equal to one. This statement is TRUE. In the case of a balanced budget multiplier, all taxes are considered to be lump-sum and hence the assumption that they have no relationship with the income while the economy is considered to operate free from foreign trade (closed economy). Therefore, the balanced budget multiplier is 1 in this special case. In a closed economy where taxes are only in lump-sum, a simple multiplier of 1/(1-c) would be generated. In addition, the tax multiplier is –c/(1-c) while the balanced-multiplier is unity as shown below: 7. If the non-bank public decides to hold a lower ratio of cash to deposits, the interest rate will fall. This statement is TRUE. When the non-public decides to hold a lower ratio of cash to deposits, it means that the non-public holds less cash, but deposit more cash in the banks. As a result, the banks can have ample credit, which they can lend to willing borrowers. The money supply (M/P), which is increased when the non-public makes more deposits shifts from M0/P to M1/P. An increase in the money supply makes the money supply function (Ms) to shift to MS’, which stimulates the aggregate demand. The result is an excess on loanable reserves, which, in effect, causes the banks to reduce the interest rates that they charge to their customers as shown in the graph. 8. In an IS/LM economy an increase in autonomous consumption expenditure increases the price of bonds. A A’ InterestiA Rate i IS1 IS2 Aggregate output, Y This statement is not TRUE. Among the factors that cause the IS curve to shift includes an increase in autonomous consumption, which shifts the IS curve to the right and shifts aggregate demand upwards (see graph). Initially, the IS curve is at IS1. Following this scenario, autonomous consumption expenditure, which results from the increase in confidence regarding the economy, increases following increase consumer’s optimism about the future of the economy. Consequently, the equilibrium level of the total production caused by the increased consumer expenditure when the interest is held constant at iA. When consumer consumption is increased, the production level in the economy is increased, hence raising the demand for credit by investors, so they can sustain the increased demand. As a result, many companies issue bonds at higher interest rates and lower prices. In other words, the increased supply of bonds forces their prices to come down (Sowell, 2006). 9. In a classical economy, a decrease in the money supply decreases/increases the interest rate. This statement is not TRUE. Classical economy operates under the principle that money has no influence on real variables. They add that real money demand depends on the real volume of transactions (y), the bonds nominal interest rates or the opportunity cost, and the price that the transactions are carried out. Supposing similar transactions are made at higher prices, then there would be a comparative increase in nominal necessity for money. The assumption that nominal money demand results from the price level, and real money demand can be represented by the following function: Mdnominal = L(i,Y).P, The second assumption that states that nominal money supply is represented as follows: Fed: Msnominal = M. In conclusion, the following function is required for the money. M = L(i,Y).P It is known that the real interest rate and real output are products of the conditions for equilibrium in the products markets. The real interest rates and equilibrium are also determinants of real consumption, real investment, real savings, and all other variables, but money do not play a part in any of these real variables as it is neutral. The money market equilibrium can be illustrated by a money-price diagram, where the vertical line at M represents the money supply. The slope 1/L(i,Y) is the line that represents money demand, and, which depends on real output, expected inflation and the real interest rate. P Md = L(r+πe,Y)*P MS M The figure above shows the expected inflation, and the real interest rate for a given output -the price level is proportionally raised, and the price level is reduced proportionally if the money supply is reduced. 10. In the Quantity Theory of Money, a decrease in real national income will not change the price level. This statement is TRUE because quantity theory of money assumes that price level can only be influenced by a change in money supply and therefore, a decrease in real national income will not cause any changes in the price level. The theory provides that money supply has a proportional and a direct relationship with the price level. In other words, when the money supply in the economy is increased, the price of goods increases in the same proportion. The fact that a change in price level can only be increased by a change in the money supply is an argument supported by classical economists, who believe that velocity of money and real income would not change in the short-term. As illustrated in the graph, the average price level is the most important factor that determines the money supply within the economy. Consumers demand more money when the price of goods is high and demand little money when the cost of goods and services is low. As shown in the graph above, it is a change in the money supply or money demand that will bring about a change in the price level and clearly, the national income does not bring about any changes (Sowell, 2006). Section B (25 marks per question) 1. An IS/LM economy with fixed prices and unemployed resources is described by the following relationships: C=100+0.75*466.7 C=450 Consumption: C = 100 + 0.75Y Investment: I = 150 – 5r Government expenditure G = 100 Indirect tax: Te = 0.25Y Money demand: (MD/P) = 4Y – 40r Money supply: MS = 800 Where Y is national income, r is the interest rate and the price level is fixed at P = 1. a) Calculate equilibrium national income. [5 marks] Commodity market equilibrium (IS) will be present where; Y = C + I Y =100 + 0.75Y + 150-5r Y-0.75Y -100-150+5r =0 0.25Y+5r- 250 = 0 Monetary equilibrium (LM) exists where. MS = MDT + MDS 800 = 4Y – 40r 4Y-40r-800=0 Solving the simultaneous equation: 0.25Y+5r- 250 = 0 4Y-40r-800=0 2Y+40r-2000=0 4Y-40r-800=0 6Y-2800=0 6Y=2800 Y(Equlibrum national income) = 466.7 b) Calculate the government expenditure multiplier for the IS/LM economy and explain your result. [5 marks] MPC= ΔC/ΔY How to derive MPC from the consumption function: Consumption: C = 100 + 0.75Y In this function, 100 is autonomous consumption; that is, the amount that will be consumed if the disposable income is zero – this amount can be sourced by withdrawal of savings or by borrowing. That having been said, 0.75 is the marginal propensity to consume(MPC). K(multiplier) = 1/[1-MPC] K= 1/1-0.75 K = 1/0.25 K = 4 times. Explanation: If a particular increase in government spending leads to a finer increase in aggregate demand than the change in government spending itself, then we say that the government spending has been multiplied and will have a finer expansionary effect than the aggregate demand. The multiplier of 4 is the number of times the government spending leads to an increase in aggregate demand. For example, assuming that the government spending increases by $100 billion, then the increase in the aggregate demand is 4*$100 billion = $400 billion. This effect can be illustrated in the graph above, where the AD has shifted upwards with the magnitude of that increase in aggregate demand. However, it is important to note that the increase in aggregate demand is more than the initial aggregate demand, and hence it will shift upwards more because of the effect of the multiplier (Sowell, 2006). c) Suppose that the government wishes to change its expenditure so that the budget is balanced. What level of G should it choose and what is the effect on national income? [5marks] Y=C+I+G 466.7=100+0.75[466.7]+150-r+G G =466.7-100-350-150+r 0.25Y+5r- 250 = 0 0.25[466.7]+5r=250 5r=250-116.7 5r=134 R=26.8 G = -106.5 The government should reduce its expenditure by 106.5. This would reduce the national income. d) Suppose that we have the original IS/LM system with G = 100, but now assume that we have a classical economy where the price level is perfectly flexible and full-employment income is Y = 400. Find the price level for this economy [hint: start with the IS curve]. [5 marks] The above graph shows a representation of the aggregate supply curve in relation to the price level and the real production. At the equilibrium, the real production is equal to the employment income which is 400. We shall assume full-employment because, according to classical economists, this condition is maintained regardless of the price level. The government expenditure, on the other hand, will determine the aggregate demand. However, this will not determine the price level because it is perfectly flexible. The aggregate supply curve will be the one to determine the level of price, which in this case is 400. e) Now starting from the classical economy equilibrium in (d) suppose that the government cuts its expenditure from G = 100 to G = 50. What happens to investment and the price level? Explain your result. [5 marks] Considering that price level can only be influenced by a change in money supply, a decrease in government expenditure will not cause any changes in the price level. However, investment will change as follows: Y=C+I+G 400 = 100+I+ [100+0.75(400)] 400= 500+I I = -100 The investment will be -100 at equlibreum. 2. In an economy, the expectations augmented Phillips curve is  where, at a given date, t:  is the rate of change of wages (in percent)  is the expected rate of change of prices (in percent)  is the unemployment rate (in percent) In addition, prices are set as a markup on wages, so that the actual rate of price inflation  ; and expectations of price inflation are formed according to  a) Graph this Phillips curve for  and then for . Calculate the Non-Accelerating Inflation Rate of Unemployment (NAIRU). [5 marks] Inflation Pt = 20 B Phillips Curve Pt =10 A Unemployment 2 3 P0=40-10Ut +[P1-P0]/P0 2P0=40-10Ut +[P1-P0] 3P0=40-10Ut +P1 3P0=40-10Ut+0.9P0 price = 10: 30= 40-10Ut+9 10Ut =40-30+9 10Ut =19 Ut ~ 2% Price = 20 30= 40-10Ut+18 10Ut =40-30+18 10Ut =28 Ut ~ 3% The Non-Accelerating Inflation Rate of Unemployment (NAIRU), which is also known as’long-term Philips curve’ is the particular level of unemployment in an economy, which does not result to increase in inflation. NAIRU is a representation of an equilibrium between the labor market and the state of the economy (Sowell, 2006). b) Suppose there is initially no inflation and the economy is at the NAIRU unemployment rate. If the government uses aggregate demand policies to set the unemployment rate at 3 percent for four periods, calculate the inflation rate over each of these periods. [5 marks] Solution Unemployment rate = 3% Wt = 40 – 10(3) +20/4 Wt = 15% The inflation rate = 15% for each of the periods c) After experiencing the inflation over four periods (from part (b)) the government decides to reduce inflation by raising the unemployment to 6 percent. How long will it take to reach zero inflation? [5 marks] Wt = 40 – 10(6) +5 = -15% It will take only one period. d) How would your results in (b) and (c) above change if the Phillips curve was  ? What is the implication for government policy? [5 marks] Wt = 20 – 5(3) +5 = 10% The inflation rate would have reduced. The government can use the second Phillips curve if the rate of inflation is not very high. This will avoid imposing macroeconomic policies that can be counterproductive to the economy. e) How does the result in (b) change if expectations adapt more slowly, in particular  ? What is the implication for policy? [5 marks] The rate of inflation would be lower. This means that the measures taken by the government to curb inflation will be of lower magnitude because the assumption will be that the rate of inflation is relatively low. Reference Sowell, T., 2006. On Clssical Economics. London: Sage. Read More