Expectations and Exchange Rate Dynamics - Assignment Example

Darling warns that the economic times faced by Britain and the rest of the world 'are arguably the worst they've been in 60 years'. Darling is true when he made his claim that Britain and the rest of the world are facing the worst of economic times in 60 years. Bernanke (1983) suggests this has been predisposed by credit crunch that is sweeping across the globe that has decreased loan lending by financial institutions. Schwert (1999) indicates that credit crunch has led into unsustainable high interest rates and stimulated lower investment. Bloom et al. (2007) argues that credit crash has led into unsustainable stock market volatility. Bernanke (1983) shows that companies have reacted to credit crunch by withdrawing from making investments. This, according to Bernanke (1983) is a catalyst to decreased economic activity. Bloom et al. (2007) indicates that companies have withheld investment waiting for economy to recover. Bernanke (1983) argues that creative destruction has prevailed across the globe and productive companies are likely to grow at the expense of the unproductive firms. Bloom et al. (2007) suggest in countries where credit crunch began earlier, productive companies and unproductive companies’ have totally withdrawn from making investment and this has frozen interference of creative destruction principle. Bernanke (1983) proposes that such a scenario has lead into zero productive growth for productive companies while unproductive companies have failed to shrink their market share. According to Schwert (1999) credit crunch has led into decrease in sales of secondary consumer wants like cars, fridges and television sets. Financial reporting of many manufacturing companies indicates increase in debts and this has triggered many companies to lay off many of their work force in order to remain in business. In this restructuring process, many companies are decreasing their wages and salaries. This implies, credit crunch has catalyzed increase in unemployment rates and stimulated an environment for inflation to sweep across developing countries. In one way, increase in fuel costs has increased costs of production that has in turn decreased net profits that manufacturing companies posted in the first quarter, second and the third quarter of 2008 financial year. The effects of credit crunch have witnessed increase in standards of living at the expense of increase in unemployment rates. The costs of food stuff have increased while the value of housing units has decreased. There is therefore a high likelihood of decrease in national income due to decrease in taxes and government revenue and increase in government spending. 2a Using one diagram, show the relationship between national income and the different components of aggregate demand in a closed economy with a government sector 2b Carefully explain how a housing market crash which reduces people's wealth could affect aggregate demand and national income Branson, William and Litvack (1976) argue that a housing market crash has an effect of reducing people’s wealth. Branson, William and Litvack (1976) points out that crash in housing markets affects aggregate demand and national income hence negatively affects the economy. Crouch (1972) indicates that a decrease in household prices has an effect of decreasing household wealth and negatively affects equity. Laidler (1969) affirms that fast decrease in house prices have an effect of reducing consumer spending. Darby (1976) shows that people who invest in mortgages with hope of remortgaging when houses increase their value are exposed to risks of negative equity when housing market crash prevails. Schwert (1999) argues that when prices of houses falls, aggregate demand decreases and this has an effect of reducing economic growth that is a function of national income subject to net domestic product. Schwert (1999) and Bernanke (1983) have indicated that in severe cases, sharp decrease in prices of houses leads results into recession that predisposes negative economic growth. Bloom et al. (2007) proposes that fall in household value negatively is a function of inflation pressures in the economy. Bloom et al. (2007) and Laidler (1969) agree that fall in house prices leads into sharp fall in interest rates that are charged by banks. Laidler (1969) argues that a lower interest rate imposed by banks is meant to stimulate positive economic growth and is a catalyst towards attaining economic equilibrium. Darby (1976) proposes that poor economic environment predisposed by decreased house prices will see banks posting declines in their reserves as they write off bad debts. Bloom et al. (2007) and Laidler (1969) agree that in the prevailing environment of credit crunch, cost of interbank lending sharply increases as household value decreases showing an inverse relationship. Branson, William and Litvack (1976) agrees that lending to consumers who use houses as security to secure decreases following decrease in house prices showing a direct relationship. Schwert (1999) and Bernanke (1983) propose that decrease in house prices decreases mortgage approvals. Laidler (1969) indicates that fall in house value reduces consumer loans and this is due to decrease in demand for houses and decrease in consumer confidence as people struggle to be able to borrow. Schwert (1999) and Bernanke (1983) agree that decrease in house prices leads into gradual or sharp decline in profits posted by banks and predispose a decrease in share value. 2c Assuming the economy was in equilibrium (at full employment) before the crash, briefly outline how the government could respond to restore that equilibrium, and the effect its policies could have Debelle and Stevens (1995) suggests that a government can use counter-cyclical fiscal policy to achieve tax and transfer that can bring about full employment. Debelle and Stevens (1995) argue that taxes and transfers have inverse relationship with respect to aggregate demand that is a function of consumption (C). They further illustrate that counter-cyclical policy is a two phase derived function that seeks to investigate change in consumption that could bring about full employment and determines the necessary tax change or transfer change that could lead into change in consumption. According to Louis (1995) and Debelle and Stevens (1995) change in consumption (ΔC) is found by evaluating change in government purchase that is a function of autonomous spending such that when magnified by a magnifier quantity Q, it should give the required change in equilibrium output. For instance, if we have equilibrium Y of £ 600.00 units and a multiplier quantity of 10 at full employment represented by £700.00 units, the consumption would there fore change by £10 units to attain full equilibrium. This is represented as Change in autonomous spending × multiplier quantity = change in equilibrium ΔC ×10 =£100 units therefore ΔC= £10 units. In evaluation of tax or transfer change, mpc formula is employed in which mpc = ΔC/ΔY, implying, ΔC=mpc ×ΔY thus ΔY=ΔC/mpc. This means ΔY=ΔC/mpc hence £10.00units/0.9=£11.11units (We assume that consumer spending is of the order £9.00units with a saving of £1.00unit). This means the government will be required to increase transfers by £11.11units or cut taxes by £11.11units. This will increase household income by £11.11units. Showing that consumer spending will definitely increase by 90% of the £11.11units or £10.00units. This gives strong evidence that consumption (C) will increase by £10.00units and it will be magnified by multiplier quantity of 10 that will increase national income equilibrium by £100.00units paving way for full employment and eventually stabilize the economy. Bloom et al. (2007) points out that at for full employment to exist saving and intended investment must be equal. Bernanke (1983) agrees that in the Classical model interest rates are a function of savings and investment. Schwert (1999) proposes that with respect to Keynesians, interest rates lose their power as the economy moves off full employment. Crouch (1972) suggests that in the event economy falls below full employment, companies are would not be able to sell all their output and employees are exposed to risks of job loss. Crouch (1972) and Bloom et al. (2007) show that low interest rates are powerless to foster a climate for increased borrowing and spending. Bloom et al. (2007) indicate that velocity of money fluctuates when employment equilibrium is distorted. When economy weakens, people and businesses tend to withhold their money. Crouch (1972) points out that in the event the government pumps in money, it has no effect on the real dross domestic product since people and financial institutions have no confidence and opportunities to spend, borrow and lend. What constraints limit the ability of government to counter an economic downturn? Dornbusch (1976) indicates that aggregate supply is perfectly inelastic and whatever happens to aggregate demand is irrelevant for any real variables. Dornbusch (1976) argues that irrespective of how adggregate demand shifts, the economy makes the natural rate of output and employs the full employment level of workers1. Debelle and Stevens proposes that aggregate demand is a tool for establishing price level. Debelle and Stevens (1995) and Dornbusch (1976) both argue that a change in the money supply doesn’t affect price level only. They propose that any other variable that shifts aggregate demand positively or negatively has a short term effect on economy because of interplay of isostacy principle. Dornbusch (1976) indicates that economy has self-correcting mechanisms and government doesn’t need to intervene. Sims (1980) shows that intervention of government prevents slow down or prevent adjusting process of the economy. Sims (1980) and Dornbusch (1976) agree that if government increases income and reduce poverty by increasing wages and salaries, the government would create unemployment and negatively affect recovery process to full employment level of production. Sims (1980) proposes that increase in production costs lead into decrease of wages or salaries until such a point that unemployement levels are eliminated. Dornbusch (1976) suggests this has an effect of bringing production to its original level before downturn at which the governemt is supposed to intervene by rasing wages again to compensate for inflation. Sims (1980) indicates that if government increased aggregate demand with aim of improving production beyond full employment, the government would only have increased the price level. Dornbusch (1976) suggests that the governemt should instead adopt laissez-faire policy and do nothing about the downturn. Murphy (1992) and Louis (1995) suggest that economy has a business cycle and can have periods when it is not at full employmenti. Laidler (1969) argues that a countries economy has a great likelihood of bouncing back to normal state by virtue of Classical model however hard a government tries to interfere with self correcting mechanisms. Laidler (1969) proposes that the governemtn ought to give economy chance to absorb the initial problem before it adjusts. Laidler (1969) suggests that wages and priclevels are not flexible but are sticky relative to downward trend. Crouch (1972) adds that wages and price levels are not subject to adjust fast to show corresponding changes in supply and demand and therefore the government should adopt a laissez-Faire policy. Darby (1976) and Branson and Litvack (1976) both agree that government should not interfere because there exists three main factors that government control cannot fully implement. Darby (1976) suggests existence of company contracts with employees and supplies that the company cannot lower prices that it pays for inputs and therefore the company cannot lower prices of its output. Branson and Litvack (1976) indicate that a company may be reluctant in lowering wages and prices because sellers are likely to fight back a downward move than an upward move. Laidler (1969) proposes that a company incurs costs in order to effect a price change like changing information in a computer and reprinting of all price list in hard copies. Branson and Litvack (1976) argue that companies are reluctant to change prices unless the price change is permanent. Parkin and Bade (2000) cite availability of implicit agreements as a challenge that government faces. Parkin and Bade (2000) argue that buyers and sellers concentrate more on stability than volatility of prices. Laidler (1969) suggests employees demand income levels that are not subject to fluctuations subject to changes in demand and supply. Dornbusch (1980) proposes that companies prefer predictable production costs as opposed to fluctuating production costs. Dornbusch (1980) and Dornbusch, Fischer and Sparks (1982) agree that companies forge for non-fluctuating prices since consumers are sensitive to changes in prices. Laidler (1969) proposes that consumers forge for predictable price Darby (1976) and Laidler (1969) agree that wages and prices don’t change so much even when the business climate is not favorable and they don’t show any significant reliable shift when business climate is strong. 2d Illustrate the effects you have analysed in 2b and 2c diagrammatically According to Darby (1976) a simplified economy is characterized by two decision units that are the household sector and the business sector. Darby (1976) suggests the decision units are linked by flows of goods, expenditure, output and labor inputs. Crouch (1972) argues that presence of a market balances each pair of flows that is a function of expenditure - output, output - income and income - expenditure. Darby (1976) and Crouch (1972) agree that goods market balances the demand that is a derivative of expenditure and supply of goods that is a derivative of output. Dornbusch, Fischer and Sparks (1982) suggest that labor market balances the demand and supply of labor balances incomes with input. Darby (1976), Crouch (1972) and Dornbusch, Fischer and Sparks(1982) agree that financial markets balance the supply that is a derivative of saving and demand that is a derivative of investment for funds hence equilibrates income and expenditure. Model of a closed economy Branson and Litvack (1976) expanded the model of closed economy to include the external sector that is a function of imports and exports and net borrowing from overseas. Branson and Litvack (1976) argue that in a closed economy income, expenditure and output should be equal and are derivatives of three aspects of output GDP (I), GDP (P) and GDP (E). Laidler (1969) and Darby (1976) agree that GDP (I) =GDP (P) =GDP (E). Crouch (1972) agrees the same scenario is observed also in economy where GDP (E) is measured as a derivative of expenditure that is a difference of exports and imports. Branson and Litvack (1976) agree that expenditure GDP (E) and output GDP (P) are derivatives of goods market. Branson and Litvack (1976) and Crouch (1972) agree that output is a function of income GDP (I) subject to factor markets and on the other hand income that is a derivative of expenditure as a function of financial markets. Laidler (1969) argues that increase in expenditure as a derivative of fiscal expansion leads into increase in inflow of imports as a derivative of outflow of income. Crouch (1972) suggests this affects production in the domestic goods market stimulating lower exports that lead into lower inflow of income. Parkin and Bade (2000) argue that this acts as a stimulus leading into increase of interest rates in the financial markets that is characterized by increase of exchange rate. Crouch (1972) and Laidler (1969) agree that increase in exchange rate contracts export outflow and open import inflow. Crouch (1972), Laidler (1969) and Branson and Litvack (1976) suggest that if import and export flows are great any increase in internal circulation resulting from increase in expenditure subject to fiscal expansion is crowded out. Crouch (1972) proposes that injection of funds into the financial market subject to monetary expansion leads into lower interest rates and lower exchange rate. Crouch (1972) and Laidler (1969) argue that lower interest rates lead into greater level of expenditure for a given level of income that is a derivative of lower saving and higher investment. Crouch (1972) suggests this effect lowers exchange rate. Crouch (1972) and Laidler (1969) show that decrease in exchange rate reduces inflow of import while increasing larger outflow of export simultaneously. Therefore increase in expenditure is maintained. Crouch (1972) indicates that the more open the economy is, the more the effect of monetary policy is observed relative to fiscal policy and the more important the financial market compared to the other balancing markets prevails. Effect of price regulation Increase in price levels distorts national income indicating that people are not materially any better. The government can adopt a fiscal measure to increase production and regulate prices with aim of protecting the consumers. Production will increase to a level where output balances marginal costs and set new price level. The production original equilibrium at a price represented by OP and output OM, where MR=MC. This price is unreasonably high and the output is restricted to a low level. The government fixes a lower regulatory price represented by OP1 it will be noticed that over the range of P1 J producers can produce any output but are rewarded the fixed price represented by OP1. Therefore the average revenue and marginal revenue will be equal over this range. With the new price represented by OP1, the equilibrium position is at J where new MR=MC. This gives producers maximum profits represented by PJKL corresponding to a new output represented by OM1. If producers’ output is less that or more than OM1 the profits will be less. Tax regulation The government can impose tax regulations like lump-sum taxes that are characterized by fixed amounts of taxes that must be paid regardless of the output. The government can also impose specific taxes that are derivatives of tax per unit of output or percentage of tax on the value of production. Specific tax AC1 and MC1 are the average and marginal costs before a specific tax is imposed. The equilibrium price is represented by OP and OM. The total profits are represented by PQRS. AC2 and MC2 are the average and marginal costs after specific tax is imposed. The difference between the two is the amount of specific tax per unit. The new equilibrium output is represented by OM1 and the price is OP1. The total profits are reduced to PJKL. The tax amount received by the government is LKHG. The old equilibrium point is represented by T and the new equilibrium is F. the consumers are going to suffer from high prices and lower output. Lump-sum tax In lump-sum tax, the government achieves two goals thus, it secures tax proceeds from the producers and consumers are not adversely affected. AC1 is the average cost before taxation. The average cost curve shifts to AC2 under the impact of lump-sum tax. The initial equilibrium before tax remains the way it was since there is no change in MC. The equilibrium output is represented by OM and price OP. the equilibrium output will be represented by OM and price OP. profits are represented by PQRS before tax. After tax profits are represented by PQKL. The lump-sum tax is represented by LKRS. The equilibrium point remains T and has undergoes no change. The main challenge in implementation of government policies are revolves around the challenge of break-even point of companies. Break-even point is a level of output where the total revenue is equal to total costs. It is taken as a point where there is no profit or loss2. Break even point occurs at point Q when both and revenue function are linear and difference between TR and TC functions is zero at point Q. price is also constant. Break even point represented by OM, below OM there occurs loss and above point Q, output exceeds point OM and reduces profits. In the case of non-linear conditions, price change occurs with increase in output. Demand curve has a negative gradient and cost function is cubic. There exists two even break even points represented by points Q and R. the area between Q and R shows profit margins while the fields below point Q and above point R represent losses incurred if production is scaled at these points. Read More