Microeconomics: Problem-Solving Questions - Assignment Example

Microeconomics: Problem-solving Questions Name Course/Unit Instructor 14 October 2012 Question 1 Figure 1: AD-AS graph Source: Hall & Lieberman, 2007 When the central bank lifts interest rates, spending on investment reduce, which facilitates reduction in aggregate demand. In the long-run, reduced investment spending results in unemployment that reduces overall output in the economy (Wessels, 2006). In the figure above, aggregate demand is likely to shift to the left of AD to a point like AD0. Increase in private domestic investment spending push the aggregate demand curve outward, and in the long-run, the output increase as the effect of investment spread in the economy (AD shifts to AD’) and output increase from (RDO to RDO’). An increase in international oil shifts the aggregate supply curve inward, precipitating rise in aggregate commodity prices that reduce. As factor costs increase in long-term, investment decline and output in the economy reduce (Wessels, 2006). In the figure below aggregate supply changes (shift) from AS1 to AS2. This indicates that real domestic output decrease. Figure 2: AS graph Source: Hall & Lieberman, 2007 An appreciation in the foreign exchange rate value of the economy’s currency will discourage domestic production for export, hence fewer exports will be realised and more imports will be enter the economy. Imports become cheaper as compared to export. Decrease in export and increase in imports will shift the aggregate demand curve outward, thus overall output will be increase. A fall in real estate prices in the capital cities of the country will shift the aggregate supply curve outward, meaning consumption will increase that pushes the output of the economy up (Wessels, 2006). In the graph below, this is indicated by shift from AS1 to AS2. Figure 3: AS graph Source: Hall & Lieberman, 2007 Lastly, in the case the country’s main exports fall in price while the goods the country imports from abroad rise in price, the aggregate demand shift outward, meaning increase in aggregate output for the economy. This is indicated in the figure 1 where aggregate demand shift from AD to AD’. Question 2 The selected macroeconomic issue concerns Australia’s monetary policy. This is a concept covered in the course, specifically in the area of exchange rates, capital flows and monetary policy. The primary goal of this section in the course was to establish how aggregate economy is affected by economic actions of change in exchange rates, capital flows and the monetary and fiscal policies. The interest in this current macroeconomic aspect in the country is informed by the fact that recent developments in the economic have forced the government to get involved in establishing macroeconomic policies such as monetary policy and fiscal policy to address the concerns of economy appropriately. The selected article is titled ‘Australian dollar rises as RBA signals ease with money policy’ (Glynn, 2012). It was published on July 17, 2012, by the Australian Newspaper. The article talks about the government step in the month of July not to cut interest rates due to the fact that the economy had shown strong prospects of growth. Moreover, the Australian government was interested in establishing the actual impact of earlier monetary policy (cut interest rates) to the economy. In other words, in the month of July, Australian government was confident that its monetary policy in the previous two months had contributed to stability of the economy. In this way, monetary policy can be said to have a general role of ensuring macroeconomic stability in the economy (Glynn, 2012). Besides, monetary policy has been linked to low inflation, steady economic growth, balance-of-payment equilibrium, and interest and exchange-rate stability (Hossain, 2012). Question 3 The general feeling among majority of people is that unemployment figures are manipulated by government bureaucracies for political reasons other than economic purposes (Sloan, 2011). For the time, the government has been releasing the unemployment figures; fluctuations in the figures have been evident, whereby independent analysts have calculated the unemployment figures to be twice the figures that government normally releases (Sloan, 2011). Although this may hold little truth until actual facts are generated, it is clear that the mistrust people normally have with regard to these figures shows how these figures will continued to be suspected. Sloan (2011) observes that mistrust of unemployment rates originates from the history of Australian Bureau of Statistics to manipulate the definition of unemployment. This manipulation of unemployment definition has led the government to regard those who work for one hour per week as employed, when in real sense they should be regarded as unemployed (Sloan, 2011). At the same time, there are those underemployed workers, who are working fewer hours as they would wish. Again, the government statistics just consider these to be employed (Sloan, 2011). On overall, these three issues: failure of the Australian Bureau of Statistics to accurately define unemployment, inability to consider those working one hour per week as unemployed improper consideration of underemployment concept, has largely informed many people that in deed unemployment rates as released by the government cannot be believed. Question 4 Figure 4: Simple Keynesian model Source: Hall & Lieberman, 2007 Determination of equilibrium GDP takes place using two approaches: aggregate expenditure = aggregate output and saving = investment (Jain, Ohri & Ohri, 2011). According to Keynesian model, when full-employment is realised then equilibrium exist (Jain, Ohri & Ohri, 2011). At the same time, Keynesian argues that investments should not equal savings, where this can be explained by the fact that investment constitutes a function of the expected rate of return as well as interest rate (Jain, Ohri & Ohri, 2011). As a result, initiative to increase savings may leads to lowering of interest rate and at same time provides an incentive for investment to increase, although the expected rate of return remains low investment, which does not rise in proportion to the saving (Jain, Ohri & Ohri, 2011). In the same measure the level of aggregate demand will go down, and this will cause realisation of insufficient demand that facilitates equilibrium with less than full employment (Jain, Ohri & Ohri, 2011). The theory further introduces the concept of propensity to consume, whereby an increase in investment is seen to results in an increase in income, due to the increased consumption behaviour of people, thereby, denying them opportunity to save. As a result, the people only spend a fraction of the increased income, and the rest is channelled back in the economy. Therefore, the picture that is derived here is that any small increase in investment tends to have larger cumulative impact on the income (Jain, Ohri & Ohri, 2011). Lastly, more investment spending is largely to increase GDP due to the effect of propensity to consume. Question 5 Inflation is described as a situation where prices of goods and services are increasing in line with decrease in the overall value of the currency (Boyes & Melvin, 2012). On its part, deflation is characterised by decline or shrink in the purchasing power, where prices of products and services are falling, although the unemployment rate does not respond as reduction takes place (Boyes & Melvin, 2012). Deflation is always responsible for decrease output and income (Boyes & Melvin, 2012). Deflation when compared to inflation is perceived to be disastrous. The difference between interest rate and exchange rate is reflected in the way the interest rate influence the aggregate economy and exchange rate affects only imports and exports (Boyes & Melvin, 2012). Interest rate can either increase or reduce investments that after the larger economy, while exchange rate affect the export and import positively or negatively. Budget deficits is experienced when the government spends more that it has in terms of revenues, thereby being forced to seek borrowing from private sector (Boyes & Melvin, 2012). On the other hand, balance of payment involves flow of money in and out of the nation. The balance of payment deficit emerges when total export falls as compared to imports (Boyes & Melvin, 2012). Trade deficit is what a country receives after subtracting imports from export. In this case imports are more than export. Foreign debt on the other hand constitutes the excess value that is derived when total revenue is subtracted from total borrowing. In case total borrowing exceeds total revenue, then a foreign debt is realised (Boyes & Melvin, 2012). Question 6 Increase in money supply has effect on the money market where it affects interest rate, output, employment and price level. An increase in money supply is regarded as a monetary policy (expansionary money policy) that functions by raising the output in the economy (Kroon, 2007). At the same time, increase in money supply creates an excess supply of money that is dealt with by lowering home interest rate (Kroon, 2007). Decline in home interest rate spurs investments as borrowing from banks increase. More investments means that employment opportunities are created, hence, more employment is likely to be realised when supply of money in the economy increase (Kroon, 2007). At the same time, increase in supply of money encourages household spending and consumption on both housing and other consumer durables. The combined effect of all these increase economic activities of the economy; thus act as a boost to the economy. Besides, more money supply in the economy results in situation where the domestic currency has or is forced to depreciate and this enables the home products to become cheaper relative to foreign products as prices continue to go down. Eventually, the aggregate demand increases. Lastly, the usefulness of monetary policy has been described to depend on the magnitude of the events in the chain, especially on the relationship between the interest rate and planned investment (Kroon, 2007). Question 7 The theory of demand-pull inflation posits that when there is excess aggregate demand in the economy that surpasses existing aggregate supply; prices tend to rise in order to respond to the imbalance that is created (MacDonald, 1999). This theory draws heavily from the impact of expansionary money policy that leads to increase in consumption, hence increase in demand. When this happens, and the economy is already in full employment, the prices of products are forced to go up (MacDonald, 1999). In most cases demand-pull inflation becomes a threat when an economy has experienced a strong boom with GDP rising faster than the long run trend of growth of potential GDP (MacDonald, 1999). Major causes include depreciation of the exchange rate, fiscal stimulus policy by government, monetary stimulus, and improved business confidence (MacDonald, 1999). On the other hand, cost-push inflation occurs when majority of businesses are responding to rising costs, by increasing prices in order to safeguard their profit margins (MacDonald, 1999). Therefore, rise in price comes as a result of rise in factor costs. Some of the notable causes of this type of inflation include over-expansion of money supply, expansion of bank credit, deficit financing and ordinary monetary factors (MacDonald, 1999). In most cases, it is difficult to distinguish the two inflations due to ‘inflation spiral’ (MacDonald, 1999). This is to say, demand-pull and cost-push inflationary pressures in most cases occur together in an intertwined relationship. Question 8 Figure 5: AD-AS diagram of Australian economy Source: Hall & Lieberman, 2007 AD-AS Model constitutes an economic model that is critical in analysing and explaining relations of price level and real production. This relation has further become critical in analysing numerous aspects in the economy such as business cycles, gross domestic product, unemployment, inflation, policies to do with stabilization, and other macroeconomic issues (Berg, 2010). As a result, AD-AS model explains and shows the interaction that takes place between aggregate demand and aggregate supply (Berg, 2010). In other words, this model is used to explain the general changes that take place in an overall economic system of any country. Expansion in the Australian economy can be said to mean that there is increase in GDP per capita. At the same time, this implies the economic growth is being realised in the economy that results in a shift to a new production possibility curve. A number of aspects can be said to explain this economic growth: change in input prices, change in productivity of resources and increase in favourable legal-institutional environment (Berg, 2010). At the same time the economic growth in the country can be explain by factors such as use of efficient technology and exploitation of more resources. As a result, aggregate demand shifts (AD to AD1) and output shift (RDOE to RDOFE). On the other hand, some of the macroeconomic dangers facing Australia include soaring of the Australian dollar that is impacting negatively on the exports, domestic products and services are becoming expensive, tourism is declining, and overall domestic consumption is reducing (Berg, 2010). As a result, economy in future by becomes weak and unstable. Question 9 When the central bank decides to implement an expansionary policy action, it can choose on two options: implement an expansionary monetary policy and expansionary fiscal policy (Sexton, 2010). This case dwells on the earlier. Implementing expansionary monetary policy means that the central bank can initiate money supply increase or reduction in interest rates (Sexton, 2010). The goal of expansionary monetary policy is to increase aggregate demand. Expansionary money policy is in most cases appropriate during recession (Sexton, 2010). During the period, expansionary monetary policy leads to increase in supply of money in the economy. Immediately this happens, the interest rates decline, reducing the cost of borrowing and return to saving. When this happens, firms are motivated to increase their investments, while household consumption and spending increase. In turn, the quantity demanded of goods and services increase at each and every price level. On the other hand, increase money supply in short-term results in both nominal interest rate and the real interest rate to decline (Sexton, 2010). This is because consumers and financial intermediaries are yet to anticipate the inflation, hence both interest rates decline. Subsequently, as consumers and producers recognise that the price level is increasing, they immediately take steps to maintain their real income. This leads to rise in nominal wages, thereby prompting nominal and real interest rates to start rising (Sexton, 2010). Question 10 In 2010, the Australian dollar hit a record high that has not been witnessed since the floating of the dollar (Glynn, 2010). A number of factors explain the Australia’s dollar soar. First, Australia is ranked among the best countries with most-traded currency in the world, and as a result, Aussie dollar attracts interest from central banks, hence distancing from USA dollar in terms of diversifying their reserves (Glynn, 2010).Therefore, Aussie dollar is able to draw in funds and related speculative accounts. At t the same time, Aussie dollar soar is linked to Australia’s mineral boom and import commodity strong ties with Asian countries like China (Glynn, 2010). But, this dollar soar has a number of repercussions both to domestic producers and consumers. It has led to dearth of other economic sectors outside the mining sector, government revenues have reduced, levels of tourism gone down, education impacted negatively, and company profits and margins declined (Glynn, 2010). In this manner, domestic exporters continue to lose as domestic products become expensive in international market. Consumption has reduced in key sectors of goods and service products due to increasing expensiveness of domestic products and services. This can be evidenced by the increasing number of domestic tourists going overseas (Glynn, 2010). References Berg, H. V. (2010). International Finance and Open-Economy Macroeconomics: Theory, History, and Policy. London: World Scientific. Boyes, W., & Melvin, M. (2012). Macroeconomics. Mason: Cengage Learning. Glynn, J. (2010, October 15). Soaring Australian Dollar to Reshape Boom Economy. Retrieved October, 13, 2012, from the Wall Street Journal: http://online.wsj.com/article/SB10001424052748704049904575553921754648874.html. Glynn, J. (2012, July 17). Australian Dollar Rises as RBA Signals Ease with Monetary Policy. Retrieved October, 13, 2012, from The Australian: http://www.theaustralian.com.au/business/markets/australian-dollar-rises-as-rba-signals-ease-with-monetary-policy/story-e6frg94o-1226428297406. Hall, R. E., & Lieberman, M. (2007). Macroeconomics: Principles and Applications. Mason: Cengage Learning. Hossain, A. A. (2012). Macroeconomic and Monetary Policy Issues in Indonesia. London: Routledge. Jain, T. R., Ohri, V. K., & Ohri, M. (2011). Principles of Macroeconomics. New Delhi: FK Publications. Kroon, G. E. (2007). Macroeconomics the Easy Way. New York: Barron's Educational Series. MacDonald, N. T. (1999). Macroeconomics and Business: An Interactive Approach. London: Cengage Learning EMEA. Sexton, R. L. (2010). Exploring Macroeconomics. Mason: Cengage Learning. Sloan, J. (2011, October 17). Do the Employment Statistics Lie? Retrieved October, 13, 2012, from ABC News: http://www.abc.net.au/unleashed/3574380.html. Wessels, W. J. (2006). Economics. New York: Barron's Educational Series. Read More