Concepts of Equilibrium Real Exchange Rates - Assignment Example

Macro-Economics Name Institution 1. An economy that is initially at equilibrium, would respond to various changes in the following manner. (a) Central bank lifts interest rates. When this happens, the cost of credit goes up and consequently the money supply in the economy reduces. The level of economic activity reduces since there are little funds to back it. Consumers’ purchasing power reduces. The demand levels fall creating a case of excess supply in the market in the short-run. The diagram below illustrates creation of excess supply in the long-run: KEY price D1 D0 S P0 – initial price, P1 – new price. level p0 Q0 – original quantity demanded P1 D0D0 - original aggregate demand D1D1 – new aggregate demand Q0 to Q1 – excess supply S D0 Q1 – new quantity demanded D1 Q1 Q 0 Quantity Demanded The supply remains constant in the short-run as demand falls. Eventually, the suppliers will be forced to reduce the prices in the long run to create a new equilibrium. (b) Increase in private domestic investment spending When businesses increase their investment expenditure, aggregate supply increases. With the demand remaining constant in the short-run another case of excess supply is created as the figure below exemplifies. S0 key Price D p0 – original price S1 S0 S0 – original AS P0 S1S1 – New AS Q0 to Q1 – excess supply S0 S1 D Q0 Q1 Quantity Supplied In the long run the prices have to fall to stipulate demand upwards so as the suppliers can be able to sell all what they bring in the market. So a new equilibrium is created in the long-run by way of reduction in prices as demonstrated by the arrow. (c) An increase in international oil prices. This makes production more expensive and hence producers are likely to cut down their production or increase their prices to remain at their original production capacity. Should the suppliers cut down production a case of market deficit will be created as the figure below shows: s1 key Price D p0 – original price S0 S0 S0 – original AS P0 S1S1 – New AS Q0 to Q1 - Deficit S1 S0 D Q1 Q0 Quantity The market corrects this situation through price hike that blocks potential consumers from affording the commodity. The hike in prices also acts to entice more suppliers to increase the volume of commodity they take to the market (Almoguera, Douglas & Herrera, 2011). (d) Appreciation of the foreign exchange rate value of the economy’s currency The implication of this is that the local citizens and businesses will have a higher ability to buy. Once they exploit this, they will increase their expenditure in both consumables and capital items. A market deficit will be experienced in the short-run, but this will be corrected in the long-run thorough normal price mechanism. (e) A fall in real estate prices in the capital cities of the country This fall will not affect the equilibrium in the short-run since real estate is not fast selling item. The wealth of individuals owning the real estate will reduce and in the long-run they are likely to revise their consumption budget downwards. When this happens there will be reduction in aggregate demand and hence a case of excess supply will follow. (f) The country main exports fall in price while the goods the country imports rise in price At the onset both the export and the import volume drop. The effects will counter one another since what is not exported is made up for by what is not imported. However, the effects may not be proportionate since the value of imports may not be equal to the value of exports, or the change in price for each may not be equal. 2. The article from Herald Sun relates to the currency exchange rates where it evaluates the fall in value of the Australian Dollar against the US Dollar. The article attributes the fall to a number of factors. One of those is the weaker domestic share market. This means that few transactions involving the Australian Dollar are carried out in the local money market and where the impact affects the demand side of the currency then its value falls in the short-run. Another reason is the lower prices of ore prices in the international market. This scenario reduces the country’s level of foreign currency reserves hence increasing the cost of buying them in the local money markets. Finally, the Australian Dollar has fallen against the US Dollar due to the intervention of the US central bank in stimulus plan to boost the economy. This development strengthened the currency against its rivals (APP, 2012). 3. Many people consider the current unemployment levels in Australia a bit unbelievable due to a number of reasons. One is the size of the economy, being thirteenth largest in the world. From experts point of view such an economy would be expected to harbour so many transactions, with a lot of economic activity that would keep every citizen engaged. The second attribute could be traced to the geographical location of the country and the levels of education in that region. The country is surrounded by countries without enough professional manpower hence cross border labour transfers would not put pressure to the locals. Again those countries would be expected to source labour resources from Australia hence further reducing the levels of local unemployment. This has not been the case and this becomes the source of concern from many quarters. 4. Typically saving represents a leakage from the economic main stream. However, it is expected that what is saved will come back in form of private investment thus balancing back the equilibrium. At equilibrium level of GDP, the level of savings is equal to the amount of planned investment. Investment hence acts as an injection to income-expenditure stream. When the investment is sustainable then the income levels will rise persistently since new investment injects higher than proportionate level of leakage of savings. 5. (a) Inflation refers to persistent increase in prices of all commodities in the economy, brought about either by increase in level of aggregate demand or supply shocks in production of vital items in an economy. Deflation is the persistent fall in average prices of commodities brought about improvement in the level of supply or reduction in the level of aggregate demand. (b) Interest rate refers to the rate at which commercial banks access borrowing from the central bank. Exchange rate refers to the rate at which the local currency trades with a currency of another country or the number of local currency units required to buy a unit of a foreign currency. (c) Balance of payments deficit is a situation where the country makes more payments for foreign transactions than it receives hence more currency moves out of the country than that jetting in. Budget deficit refers to a situation where the national budget has a larger figure on the expenditure than on the revenue side. (d) Trade deficit refers to a situation where a country has more import value of goods and services as compared with exports leading to net outflow of domestic currency. Foreign debt refers to money owed by local government to foreign countries or international financial institutions. This results from government borrowing to finance its budget when other revenue sources cannot cover all the expenditure requirements. 6. A money market that is initially at equilibrium will respond to a rise in money supply in the following manner: The interest rates will fall. This is due to the inverse relationship that subsists between money supply and the interest rates. When there is a high level of money in circulation the central bank would want to reduce the same to save the country from inflationary tendencies. The central bank will do that by increasing the interest rates so as to make loans less affordable and reduce the commercial banks’ ability to create credit. There is a direct relationship between money supply and output levels. When there are high levels of liquid money circulating in the economy, then there is the ability to buy. This state of affairs pushes aggregate demand up, propelling suppliers to boost their production. They will be able to do this since money is available and loans can be accessed at lower bank rates. When production is on the rise then employment is also on the rise. As producers strive to increase their level of output, they hire more factors of production including labour. The employment levels hence go up though the situation is not sustainable in the long-run. The price level goes up since the consumers and investors’ ability to buy is strengthened. In an attempt to increase, production the producers increase the demand of raw materials and their supply remaining constant their prices go up. 7 Demand pull inflation is the type of inflation that results from increased level of demand by investors and households. This results from these agent having higher amounts of money to spend, demand more commodities in the market propagating producers to hike prices to capitalize on the situation and to enable them hire more factors of production to increase their production volumes. Cost push inflation results from persistent increase in prices of factors of production. The producers pass on the added costs to the final consumer in form of higher prices. The higher costs of factors of production may be resulting from supply shocks due to some reasons, say bad weather conditions for agricultural produce. 8. An expansion in the economy of Australia year to year can be represented by the simple model herein: Price Level D1 S0 D0 s1 S0 S1 D1 D0 Q0 Q1 Real GDP Key D0D0 – initial aggregate demand D1D1 – new aggregate demand S0S0 – initial aggregate supply S1S1 – new aggregate supply Q0 – initial Real GDP Q1 – new Real GDP As the economy expands there is an increase in the price level as exemplified by the arrow. The danger that precipitates is for the price level to increase without proportionate increase in real GDP. Such a scenario would be a ‘false’ expansion since the increase in value of output would merely be as a result of inflationary tendencies. Low output levels would push the country to import more putting a strain on the balance of payment accounts as well as currency exchange rates. 9 When the central bank employs an expansionary policy the following would happen: The money supply would increase. This is because the banks’ ability to create credit increases and are able to lend more. This means that both investors and households will be better placed to access loans and level of money in circulation will generally be higher. The nominal interest rates fall since the banks set these rates based on the rates imposed upon them by the central bank. Since the banks will access central bank borrowing at a cheaper cost, they consequently avail the loan to individuals at reduced nominal rates. Expansionary policy feeds inflation to some extent. This means that the real interest rates will rise since the lenders must cover themselves fully from the effects of inflation. An expansionary policy is appropriate in situations of low money supply. In such cases the level of economic activity is low and the same is corrected by allowing more money to enter into the economic system. 10. The Australian dollar has soured over the last five years due to the general falls of the country’s export commodities in the international market including the crucial iron ore. When this happens, the country’s foreign exchange reserves are strained. Traders continue demanding more of foreign currencies to make imports thus increasing the cost of those currencies against the local currency. References Almoguera, P.A., Douglas, C.C. & Herrera A.M. (2011). Testing for the Cartel in OPEC: Non- cooperative Collusion or just Non-cooperative?" Oxford Review of Economic Policy, 27, 144-168. APP, (2012). Dollar falls as iron ore price falls. Herald Sun. www.heraldsun.com/au/business/australian-dollar-lower-after-mixed-us-data/story. Retrieved 15th October 2012. Driver R. & Westaway P. (2001). Concepts of equilibrium real exchange rates. Mimeo. Bank of England. LaFrance, J.T. (1985) “Linear Demand Functions in Theory and Practice.” J. Econ. Theory 37, no. 1, 147-66. Lane P.R. (2001). The new open-economy macroeconomics: A survey. Journal of International Economics, 54, 235–266. Read More