Introduction to Microeconomics - Assignment Example

Name: Tutor: Institution: Date: INTRODUCTORY MACROECONOMICS Question 1: Effect of increase in domestic saving on the current account, investment and interest rate in both the national and foreign economies. Effect on current account. Domestic saving for a particular country gets determined by a variety of factors, including demographic characteristics, time preference and income distribution. The current account is the difference between domestic savings and investments. An increase in the local economies, therefore, will result in a surplus in the current account. Where, CD, ID and GD indicate expenditure on domestic production only — that is, excluding expenditure on imports. On the other hand, foreign economies with more investment opportunities for its entrepreneurs can afford to have low levels of domestic savings and deficit on the current account is common. Effect on investment. Unlike in a closed open Economy, the savings need not equal investment. There is a relatively minimal relationship between domestic savings and level of investment in an open economy with capital mobility. However, if the domestic saving is increased by reducing the national deficit through raising income taxes, disposable personal and business income is reduced. Potential investments, therefore, are deflected elsewhere. This would result have an offsetting effect to the rise in savings by the public. Moreover, if the rate of taxation of corporation increase, retained profits would decline substantially thus reducing the level of dividends available. The actual rate of interest would rise if the level of investments in enhanced. It is because more investments reduces capital distribution to other sectors thus affecting the supply of money in those sectors. Economists such as Feldstein and Horioka have previously studied the relationship and came up with an empirical estimation relationship below; Effect on interest rates. A small open economy is an economy smaller enough such that the actions of the economy do not influence the global rate of interest. A large open economy on the other hand influences the world interest rate directly through its fiscal policies. An increase in domestic saving therefore would lead to a decline in interest rates, thus stimulating investment. It, therefore, means that investment would always equal saving. Some Economists (for instance, Keynes) argues prevailing rates of interest do not have an effect on the levels of both investments and national savings. It would mean therefore that significant interest rate changes would be needed for them to be once again equivalent to the change. Keynes proposed a short run model where the demand and supply of money dictates the level of interest rates. Domestic savings could, therefore, surpass investments levels for some time leading to recession. Question 2: According to the Treasurer, Mr. Joe Hockey, and the 2014 Budget was designed to reduce the deficit but increase employment. Why such a policy would not fit well in the income – expenditure analysis. The mid-year Australian economic update by Treasurer Joe Hockey showed a deficit of $40.4 billion that gets expected for the 2015 financial year. Despite the fact that the 2014 Budget (according to Mr. Hockey) was designed to reduce the deficit but increase employment, it may not be the case as highlighted by the shadow Treasurer Chris Bowen. The statement showed an economic growth of 2.5% that would strengthen to 3% over the years to follow. However, the report also forecasted increase in unemployment to levels higher than that predicted in the may budget (news.com.au, 2015). One can attribute it to the fact that the factors of production tend to improve significantly in an economy improving in terms of growth rate, demography, borrowing and repayment, income and wealth, and assets and debt. The criterion for increasing debt gets directly related to income. A little income economy would, therefore, need to borrow less thus lowering its level of deficit, a little income economy being one with low employment rates. It applies for the administrative government and individual debtors, financial institutions and private businesses. It is therefore of utmost importance that both the government and individuals limit their levels of borrowing and maintain a favorable leverage position so that income is always higher than level of credit financing. Economies that characterized by involuntary unemployment either due to inadequate demand or purchasing power corresponds with low levels of the deficit. It therefore means Treasurer Joe Hockey’s argument for reducing the deficit at the same time is impracticable. How such a policy might achieve the desired effect. Such a strategy would only work in an economy driven by high employment where the recommended strategy to reduce deficits in a budget is to reduce government spending and raise taxation. Budgetary deficits however are best dealt with by examining the cause and effect of the particular deficit in the economy. Some of the ways the policy could achieve the desired effect is through; i. Cut Spending: - depending on the type of government spending that is cut, the policy may or may not work. For instance, reducing the pension spending therefore making people work longer before retirement may lead to an actual increase in productive capacity. ii. Raise taxes: - similar to spending cuts in effect in that, it relies on the type and timing of the fee increase. During periods of crisis, for instance, the global financial crisis, a tax increase on certain commodities or services will lead to a significant drop in the spending on them. On the other hand, during growth, a tax increase may not affect spending as much. iii. Economic Growth - represents the best way in which the deficit reduction policy could work by representing the fiscal shortage as a portion of growth (GDP). Growth occurs in tandem with an increase in employment. A high-employment budget can then be used to cut deficit by driving growth on productivity rather than financing through borrowings [Source: Budgetpapers, CommSec] The Federal Budget for 2014, indicates that Mr. Hockey’s assertions did not work in that; The Net debt rose to 13.9% of GDP in 2014/15 fiscal year. Economic growth dropped from 2.75% to 2.50% as a result of the budget Deficit tax of 2% was applied to income brackets above $180,000 for three years. The increase in income tax decreased the labour supply due to its diminishing effect on the after-tax wage rate. An effect that then raises the equilibrium wage rate, reduce employment and, therefore, decrease potential GDP. Question 3: Australian Government Response to the 2008 Global Financial Crisis (GFC). Response: - Fiscal Stimulus Policy. The Australian Government responded by announcing a $10.4 billion stimulus package immediately after the downturn. The package represented roughly 1% of the GDP. “The package was comprised of $8.7 billion that would flow to pensioners and low-income families in the form of cash bonuses. $1.5 billion was to support housing construction, and $187 million for new training” (Treasury, 2015). In the periods leading to the announcement of the policies, considerable thought into the structure and form of the package had been undertaken by the Government and its advisers. It, therefore, made it much faster and easier to rely on the policy given the uncertainty in the possible outcomes. The plan was to channel the stimulus package into the weak and sensitive sectors of the economy which at that time were the housing and consumption sectors. It was important to support these sectors especially the consumption sector which comprised 60% of the economy (Treasury, 2015). Sector 1: Housing: - the package was immediate and targeted new home owners. The package was however limited to within the first months of the response The fact that such a policy had worked previously in the early 2000s in enhancing construction of houses meant it could get relied upon Sector 2: Consumers: - just like the housing package, it rolled out immediately. Substantial cash bonuses, therefore, got paid to pensioners and low-income households within weeks of the policy announcement. Families with high consumption propensities would naturally use up extra income that accrue or in this case, received compared to others thus optimized the overall economic effects of the stimulus package within a short period. Rationale: The thinking behind housing package of the stimulus was the fact that the government was also aware of the little demand for owner-occupied housing due to skyrocketing interest rates and high migrations. It, therefore, anticipated that that rolling out the stimulus packages then and not later could result in positive effects without any substantial activity changes being required at policy withdrawal stage (Treasury, 2015). The government also wanted to provide cash assistance to the low-class members of its population. To achieve the motive, the consumption stimulus package was the package tool and this was ensured through the use of Authorised Deposit-taking Instituitions ADI –this was necessitated by the fact that guaranteed deposits had previously being successful in dealing with such a crisis in the Republic of Ireland and Great Britain. It is clear to understand why the Australian government felt the need for ADIs during the GFC of 2008. It involved a guaranteed deposit of up to $A1 million for every depositor. Inter-trading among financial institutions was adversely affected due to banks declining claims from other institutions. The RBA then provided credit to the market through outright repurchase contracts with bankers (REPOs) and by so doing, increased the maturity period of assets securities that qualified for repurchase. In the immediate months following the GFC, the Government considered the policy as a form of prudent response to the then deteriorating global economic conditions, to be followed up with additional stimulus later. With that in mind, Government advisors in preparation for the possibility of the financial crisis taking longer than anticipated. The Government, therefore, planned to fast-track the kick off of major infrastructure projects. In late 2008, the initial stages of the key projects worth $A4.7million commenced. There was also the likelihood of the recession increasing; hence the Government wanted to use the policies as a way of supporting the workforce. The plans went beyond the support for aggregate demand. Criticism of the Policy i. There is little or no impact of fiscal transfers by the Government to households since the recession is considered a temporary economic event. McKibbin and Stoeckel (2009) argued that most families operate with a going concern and are not constrained by lack of liquid assets. ii. Other economists presume that, in the knowledge that they would have to pay higher taxes in the future as a result of fiscal transfers, rational households would save rather than spend the additional income (Taylor, 2009). This argument gets more grip from the fact that there was a rise in savings by households through the growth got attributed to consumers being more cautious in the face of uncertain economic conditions. iii. Also, the impact of the fiscal stimulus would be entirely offset by an appreciation of the exchange rate, as is always the case in modern macroeconomic models subject to such economic shock conditions. However, instead of the expected appreciation, the exchange rate fell sharply during the downturn. iv. Some critics also argue that the policy did not work at all. They argue that currently, the S&P/ASX 200 is as low as 5,400points, which is way below the pre-GFC periods. They attribute the slow recovery to the fact that; Pensioners did not have the chance to replace their lost investments with the grants since they were already living off their savings. Pre-retirees had a short time left before retirement. Therefore, the policy did not offer enough time for them to recover. Reports have shown that the Global Financial Crisis had a substantial impact on the many old employees nearing retirement due to the timing. Risk-averse investors risked selling their investments at rock bottom that is always a bad financial decision. Conclusion Some have suggested that the same impact of the Stimulus Package could have been achieved more effectively and efficiently by use of monetary policy that would involve lowering of interest rates. However, standard estimates of the transmission delays of such a system would mean extra financial stimuli alone could not have achieved the intended quick and much-needed response that the fiscal stimulus policy met. There was also the fact that monetary policy would have involved transmission subject to difficulties in the prevailing economic conditions. It, therefore, implies that the suggested effect would have been smaller and less effective. The fiscal stimulus policy, therefore, was an excellent response by the Australian Government. References www.wikipedia.org/GDP Laidler, D. E. W. (1974). Introduction to microeconomics. New York: Basic Books. Jones, P., & Cullis, J. (2004). Microeonomics. Oxford: Oxford University Press. Wonnacott, P., & Wonnacott, R. J. (1982). An introduction to microeconomics. New York: McGraw-Hill. Krugman, P. R., & Wells, R. (2013). Microeconomics. New York: Worth. Stockman, A. C., & Stockman, A. C. (1996). Introduction to microeconomics. Fort Worth: Dryden Press. Davidson, P., Smolensky, E., & Leven, C. L. (1964). Aggregate supply and demand analysis. New York: Harper & Row. Fischer, S., Dornbusch, R., & Schmalensee, R. (1988). Introduction to microeconomics. New York: McGraw-Hill. Blomqvist, A., Wonnacott, P., & Wonnacott, R. J. (1987). An introduction to microeconomics. Toronto: McGraw-Hill Ryerson. Read More