Beyond Microeconomics - Theory of Employment, Interest, and Money - Assignment Example

Microeconomics Course: SECTION 1 1. Aggregate market is defined as a schedule that shows the quantities of current total 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 study and this definition of total demand. (10 points) The analysis of the IS-LM model has two components; the IS curve which represents the desire to make a purchase decision. The LM curve, on the other hand represents the capacity to make a purchase. Thus, the IS-LM analysis shows when the desire and capability of making a purchase are arrived at, that are equilibrium. This is determined by the levels of income as well as the assets that have been accumulated. It is worth noting that the money market is represented by the LM curve while the product market is represented by the IS curve. Therefore, when these two curves change they eventually affect the aggregate market which is usually defined by the IS-LM curves. This in turn means that only when the both markets are symmetrical is the total output that the consumers, businesses and governments are able and willing to buy. b. What aspect market behavior does monetary policy influence? Explain verbally how the IS-LM analysis is affected by an increase in the money supply. (10 points) The monetary policy is determined by the LM curve that represents an knowledge of consumers, businesses and governments to purchase. The shift of the LM curve shows an increase to the right that depicts a change in the ability to purchase. The expansion of the monetary policy, however does not change the interest rates rather, it illustrates a rise in the money supply in turn causing a rise in the rise, in the market for the real GDP. This means that the consumers, businesses and the governments are able to buy more outputs. 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) The Expansionary fiscal policy is aimed at stimulating the economy. The fact that government expenditure is an element that determines the total demand, then an increase in will eventually trigger the economic activities. A spark in the economy will be as a result of increased government spending hence giving rise in the total demand. The rise in the government spending will affect people who are holding money as a form of an asset to purchase bonds as well as other additional outputs because of the increase in the interest rates in the economy. It is of paramount importance, however, to note that, this situation, however, is only evident when the money supply is constant. 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 employees are well aware of their economic environment, they are in a better position to acknowledge to the adjustments in the labor markets in a more rational way. This is when the aggregate supply curve is vertical. In this situation, the full level of employment is maintained when money wages rise and fall equally. In this case, the real GDP is maintained due to the change in the level of price On the other hand, the aggregate supply curve is sloped in the case where the employees are not aware of their value attached to the work and effort. As a result, they rely on negotiated contractual agreements with their employers. Consequently the real GDP of the economy falls as a result of lack of proportionality in the level of price and the real wages. Thus, full employment is declined due to a fall in price during the recession period, Keynesian (2006). . 3. Explain the following statement: “Autonomous expenditure multiplier effects do not occur when classical assumptions about money market prevail (in other words, the multiplier is zero).” (20 points) Keynes (2006) proposes that when there is a state of uncertainty in the economy, under the classical assumptions, they do not hold money as assets because of the changes in the interest rates. As such, the changes in autonomous spending have multiple results, because there are relative changes in the circulation of money that is put in economic activity. Since there is no uncertainty under these assumptions, then holding money in this case does not make sense. This means that the changes in the interest rates do not impact or make a difference in the money that is being held. 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) Robert Moffitt (2008) alludes to the considerable decline in the employment to population for men at a ratio of 2.7 percentage points from 1990 to 2007 while that of women declined at a ratio of 1.7 percentage points. This represents a total decline of 2.3 percent of the whole people. However, Moffitt is not sure of the genesis of this fall in the employment to people. b) Why does William Galston think this is necessary? (10 points) William Galston (1989) observes that it is outside chance that the dynamic growth rate of the economy will pick up, if the rates of labor support and the levels of employment to people do not go back to the historical levels. SECTION 2 1. 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 is an approach that the government uses in order to curb the issue of having too many risks in the money markets. Ideally, people tend to hoard money as an asset during situations of uncertainty in the financial markets thus bringing a slowdown in the velocity of money as well as creating a hindrance in the circulation of money in the economy. Ultimately, the reduction in the velocity of money, in a money market, consequently causes a reduction in the real GPD in the economy. The solution in this case is to push up the interest rates so that people can release the money they have hoarded. This will in turn lead to more people putting the assets in the markets which include the real estates, the stock and bond markets and the commodities purchased. However, in a situation where there is certainty in the financial markets, then people do not hold money as an asset. This means therefore that increasing the interest rates will not have any effect on the velocity of money. It is important to note that with the expansionary fiscal policy comes more sensitivity on the interest rate because there is much uncertainty in the financial markets. 2. 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). The expansionary fiscal policy triggers the economy by increasing the employment opportunities and reducing the real wage. When the real wage is higher than the marginal productivity then it follows that there is going to be more unemployment. In order for the real GDP of an economy to increase, then the real wage should reduce to create enough room for employment. This can be caused by an increase in the price levels or the cutting down of wages. Keynesian (2006),argues that, during recession periods in the economy, the putting more emphasis on relative money wages and having numerous labor contracts is a major hindrance to the productivity of workers. This means, therefore, that, during the recession, wages do not reduce proportionately to stimulate full employment. In this scenario, it is important to increase the price levels in order to attain full employment, reduce the real wage and rejuvenate the economy. 3. 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 essential especially when there is uncertainty in the financial markets. It is for this reason that they influence both the real wage and the real GDP in the aggregate supply function. For instance during recessions money wages rarely decrease compared to price levels resulting in an increase, in the real wage. This is because of the fact that labor contracts result to fixed wages over considerably long periods of time. Consequently, this forces employers to remove some of the workers and ultimately reducing the real GDP of the economy as a whole. Also, contracts hinder the rise of real wages from rising greatly as those of the prices when there is a recovery that leads to employments because the real wage decreases with the inflation of price levels. This in turn gives rise in the real GDP. Economics 332 – Third Examination 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 large elasticity (sensitivity) of investment demand to interest rates results in a flat IS curve because the interest rate parameter is in the denominator of the slope. Increasing the money supply reduces the intercept of the LM curve, shifting it to the right and increasing the equilibrium value of real GDP. The equilibrium value of GDP increases more for any given shift in the LM cure when the IS curve is flat (the policy is more effective when interest sensitivity of investment demand is high). (b) A money supply growth makes extra money accessible than is required to pay for the current level of collective production. The surplus of cash outside what is required for dealings is put in the bond market which pushes interest tariff lower. The lower interest tariff promotes extra investment. When investors are extremely sensitive to interest tariff, they will increase investment proportionally more for any given decline in interest rates than they will when interest tariff is not a significant result in their savings decisions. Therefore, greater sensitivity to interest rate changes by investors causes proportionally greater changes in GDP for any given increase in the money supply. 2. Explain, from the Keynesian view, why the aggregate demand schedule is negatively slope. Your response 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. A rise in the price level reduces the real money stock. (a) As a result, the LM plan shifts up since the cut off of LM rises and the balance interest charge goes up. The growing interest fee decreases savings and the balance level of real GDP. Therefore, the rising value level is associated with falling real GDP. (b) An increasing cost level earnings that there is no longer enough funds to fund dealings, so money is withdrawn from the bond market to pay for extra costly output. Reducing the supply of loanable funds increases the interest fee. The increase in the interest fee reduces investment and, therefore, total demand for GDP. 3. Compare the aggregate supply schedule from the classical view with the total 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 total supply. (a) Classical economists implicit that employees and employers had excellent information this is to say that, they are aware of worker productivity, the actual level of prices and the capital salary earned by employees and that everyone in the employment market makes coherent decisions. Keynes argued that people do not know workers’ productivity and worker base their employment decisions on the expected price level which is not equal to the actual price level. Instead, workers focus on relative wages that are what they are paid relative to other workers and resist money wage cuts that reduce their relative pay. They form contracts to protect their pay in uncertain environments and these implicit and explicit contracts reinforce money wage rigidity. (b) Labor market is reduced when prices fall. In the classical model, well informed and standard workers accept money wage reductions that are comparative to the reject in prices. Service and output are maintained at the full service stage. Keynesian model, states that, employees oppose money wage changes and work supply do not completely regulate to declining labor market caused by a fall in prices. As a result, money wages fall less than proportionally, compared to prices and the impact of the decline in labor market causes employment and real output to decline, as well Keysian (2006). 4. George Will, (1986) 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? According to Keynes,(2006) cyclical unemployment is instinctive unemployment since employees are misinformed about actual market conditions. The disapproval of this approach (first criticized by Jacob Viner although he stated that uncertainty in labor markets does not necessarily mean that workers are victims of business processes. This means that Workers do not have to know their utility maximizing employment decision to understand that they can get a job if they lower their reservation wage. Keynes states that, workers are always voluntarily unemployed if jobs are available at lower wages and they do not take these jobs. This argument has a new twist in the contemporary world where workers can receive unemployment reimbursement which may cause them to the game the system to collect benefits when they are, in fact, voluntarily unemployed. The major increase in disability payments over the past 15 years adds support to this position. Work cited Keynes, John Maynard. General theory of employment, interest and money. Atlantic Publishers & Dist, 2006. Ainslie, George. "Beyond Microeconomics. Conflict among Interests in a Multiple Self as a Determinant of Value.”." The multiple self (1986): 133-175. Read More