Econometrics for Economic and Financial Analysis - Assignment Example

Macroeconomics Name Institution Question 1 As a policy advisor, the best action that I would recommend is rapid reduction of deficits amidst the risk of lower growth because any move contrary to this would translate into continued adverse effects on the economy such as high interest rates and inflation (Nachrowi, 2006). As such, appropriate measures must be implemented towards reduction of the budget deficits (Nachrowi, 2006). The high interest rates and inflation would dissuade investments from foreign investors thus leading to slow or failure by the economy to recover or further contraction the economy. Reduction of deficits would contribute to lowering of the interest rates with consequent strengthening of the economy through a lower domestic currency value. The economy’s exports would have a lower market value whereas the imports become more expensive (Boye & Melvin, 2013). Rapid reduction of budget deficits in the short run would translate to increase in employment because a country whose exports are cheaper due to a low currency value would export more goods (Copeland, 2008). This would increase the safety net spending, reduce the revenue earned from the imposed taxes, and partially offsets the austerity measures. The government expenditure contributes to the GDP of an economy and therefore reduction of this spending would lead to a higher debt-GDP ratio. The high debt- GDP ratio can be reduced by reduction of budget deficits where the government ought to either increase its taxes or reduce its expenditure (Boye & Melvin, 2013). Rapid reduction of deficits would reduce the money supply as the government may decide to buy short-term gilts from the banking sector. In such a situation, the banks would overlook the fact that these gilts are near money of which they can maintain investors’ borrowings and customers lending (Nachrowi, 2006). Reduction of government expenditure would reduce the Gross Domestic Product (GDP), which would subsequently lower the aggregate Demand (AD). The ideology only holds in the short run when budget deficits are rapidly reduced. In the long run, reduction of government spending would result to reduced inflation due to the reduced demand and lower costs of the input prices. However, So long as there is a depression of output, the economy would only experience negligible inflationary pressure. Rapid reduction of budget deficits would also serve to reduce the crowding out effect. Crowding out creates a scenario in which a government opts to finance its expenditure with either deficit spending or taxes. This economic strategy leaves private businesses with less finances and eventually “crowding them out” (Boye & Melvin, 2013).Whenever the government borrows large sums of money to finance its operations, it increases interest rate which discourage investors and individuals from borrowing money to finance and expand their businesses and this reduces their investment activities and spending. This implies that when budget deficits are rapidly reduced, the interest rates in the business sector would substantially reduce and investors would be more willing to acquire loans, which would now be cheaper to finance. As a result, the spending and investment activities of the private sector would significantly ameliorate and this would eventually avoid the crowding out effect (Boye & Melvin, 2013). On the other hand, reducing the deficits slowly at the risk of capital flight would do the economy more damage than good because a cost benefit analysis would clearly show the benefits obtained from gradual reduction of budget deficits are surpassed by the drawbacks an economy may be subjected to because of capital flight. Capital flight occurs when money or assets rapidly flows outside a country which may be because of an economic consequence such as gradual reduction of budget deficits (Boye & Melvin, 2013). In both economically advanced and starved countries, capital flight is perceived as a domestic savings diversion from the financing of domestic real investments and which serves to favor the foreign investments. Consequently, development of the economy and the pace for growth becomes retarded more so because capital has been transferred to foreign countries. This leads to increases the demand for foreign currency especially those currencies that exert pressure on exchange. The most vital concern pertaining to capital flight is that it tends to reduce welfare of an economy in the sense that it causes a net loss in total resources (real) that are at the disposal of an economy for both growth and investments (Nachrowi, 2006). The loss is more damaging when capital belongs to the citizens of the affected country because apart from their assets losing their nominal value, they are also burdened with the loss of faith in their economy as well as a devaluation of their currency. This leads to a decreased purchasing power of the assets and makes it highly expensive to import goods. This would be brought about by the increased supply of local currency, which is often accompanied by a drop in exchange rates (Copeland, 2008). Exchange rates are the rates at which the currency of one country can be exchanged in terms of another. Moreover, net exports will also increase because they are a component of aggregate demand. An overvalued exchange rate contributes to increased expectations of depreciation in future (Boye & Melvin, 2013). Therefore, in order to avoid any impending future losses of the welfare, citizens will be motivated to hold some of their assets abroad. Capital flight can also have diverse effects on the economic growth and instability especially in those developing countries, which are deemed as “capital scarce”. This is because money would be idly held up in bank accounts abroad as opposed to being invested in infrastructure, sanitation and education and the citizens will eventually be forced to pay back that money with an additional interest (Copeland, 2008). The authorities in developing countries would therefore face restricted access to financial markets internationally, which gives rise to short run negative shocks that cannot be smoothed by external borrowing (Boye & Melvin, 2013). This would reduce the incentive of the government to respond to shocks by either borrowing or applying fiscal expenditures. Moreover, the citizens who can manipulate economic resources and are financially afloat would send the resources abroad where returns are much higher while those who can’t afford will be subjected to consequences in their home country. A practical example occurred in the former “Zaire” where foreign aids and loans were given to Mobutu who was a corrupt leader even though people were aware that he would eventually embezzle the funds (Jhigan, 2003). During the debts crisis in the 1980, most lending countries were apprehensive that the provision of external funds to developing countries (cash starved) would be futile only if a significant amount of the lent amount would flow back as capital flight (Jhigan, 2003). The main sources of finance for these countries were non-guaranteed private inflows among them being Foreign Direct Investment (FDI). Concisely, an economy would reduce budget deficits rapidly and face the repercussions of slow economic growth rather than gradually reducing deficits and be confronted with the consequences of capital flight on exchange rates, economic growth and Foreign Direct Investments (FDI) which may take the economy much longer to be resilient. Question 2 Money supply target The money supply is determined through monetary policy by the central bank. An economy is forced to work with the availed money supply whether its currency, reserves or deposits. However, the economy does not manipulate the quantity of money, as it is solely the role of the central bank. An advantage of using a money supply target is that it represents the economy’s output. The relationship has been shown in the equation MV=PY where M is the money supply in the economy, V is the velocity in which money cycles in the economy, P and Y represent the price and output produced in an economy respectively (Jhigan, 2003). An increase in money supply (M) implies that there would be more money used in an economy while an increase in V (velocity of money) implies that the money changes hands faster, which increases the supply of money. (P*Y) should equal the total goods produced and should equate to the money supply floating in the economy under that period. A money supply target therefore is a better depiction of the economy’s state and the government would be in a position to pinpoint any slight divergence from its goals and objectives in regards to the economy’s performance (Copeland, 2008). A drawback in using money supply target is that it would affect the Aggregate Demand (AD). Any increase in the supply of money would increase the aggregate demand and vice versa (Nachrowi, 2006). An expansionary monetary policy would enhance the purchasing power of the government, businesses, and households. The aggregate demand would therefore increase due to increased net exports, investment expenditures, consumption expenditures and government purchases. This causes the aggregate demand curve to shift to the right (Jhigan, 2003). The drawback of increased AD is that with increased money supply, there would be too much money circulating in the economy which lowers the level of interest rates and triggers inflation. Inflation Target In a contemporary economy context, the monetary policy most countries are using entail a focus on inflation to boost economic growth. The main advantage of using an inflation target is that it is more applicable because in periods of low inflation, the economy may be undergoing a recession whose growth may only be boosted by targeting a higher inflation rate (Copeland, 2008). In addition, the inflation target can also manipulate the money supply target in the sense that any measures the government may take to increase the level of inflation would affect the supply of money due to the increased commodity prices. Inflation target may therefore be used to either alter or control the supply target while the supply target only alters the inflation target. The drawback in the use of an inflation target is that any monetary policies that are undertaken to control the level of either supply of money or inflation would affect the employment levels of a country (Nachrowi, 2006). Measures undertaken to curb inflation would tend to reduce the levels of unemployment and vice versa. As a result, most countries are torn between the balancing of inflation and unemployment because ceteris paribus inflation levels and levels of unemployment are inversely proportional. This is denoted in the Philips curve, which denotes the tradeoff between inflation and unemployment (Jhigan, 2003). Accordingly, the Phillips curve has been deemed as too simplistic with unemployment rates that are supplanted by inflation predictors on the basis of the supply measures of velocity of money such as the money zero maturity (MZM) which is only affected by unemployment (only in the short run). The governments may therefore control inflation and unemployment rates using a Keynesian policy. Fiscal or monetary policy may only be applied in stimulating the economy by lowering the unemployment rate and raising the GDP. This would eventually lead to a higher interest rate at the costs of lower rates of unemployment. Part b The inflation target in Australia was adjusted in terms of the Consumer Price Index, which was followed by decisions to exclude interest rates from the CPI, which would remove any hindrances to its usage as the only inflation target. The adjustment reflected a judgment that the benefits of using CPI outweighed the negative effects on the grounds of greater volatility (Copeland, 2008). Conducting the monetary policy under inflation target enabled Australia to achieve the targeted inflation rate of 2-3 percent (Fraser, 1993). This target was a medium-term average target, which acknowledges the innate variability of inflation and allows some targets/objectives for the counter cyclical policy to an extent that is consistent with the targets set in the short run. It is apparent that the reported growth performance in Australia was satisfactory as compared with the outcomes obtained from the two preceding decades. In the period between 1973 and 1993, the growth of GDP averaged to 3.0E percent. However, in mid 1993, it reported a positive change as it reported a higher figure, which was 4.3E percent (Fraser, 1993). Having held its inflation levels low, Australia has not had any association with the apparent costs in the economic growth. On the contrary, growth sustainability and improvement has been the subject of the prevailing inflation environment because the benefits earned from low inflation are long term. Rapid growth without increasing inflation levels also implies that the productivity growth in Australia has improved because of the inflation target monetary policies that have been set in place. However, many policy reforms and non-policy reforms have been employed to bring about the transition. In the second half of 1994, the labor markets in Australia had tightened significantly even though the financial markets were more concerned in the possibility of rapid gains in employment, which would heighten the pressure on wages and eventually prices (Fraser, 1993). . References Boyes, W. J., & Melvin, M. (2013). Economics. Disney: Cengage Learning. Copeland, L. S. (2008). Exchange rates and international finance. Harlow, England: Prentice Hall / Financial Times. Fraser, B.W. (1993). Some aspects of monetary policy: Reserve Bank of Australia Bulletin, April, 1–7. Jhigan, M.L. (2003). Macroeconomic Theory: Delhi: Vrinda Publications (P) LTD. Nachrowi, D.N. (2006). Approach and practice of econometrics for economic and financial analysis, Indonesia: University of Indonesia publication. Read More