Factors That Determine the Demand for and Supply of Money, According to Yun - Assignment Example

Macroeconomics Assessment Student’s Name Subject Professor University/Institution Location Date Question 1: (a) i. Michael’s gross investment= initial investment + new investment =$400,000 + $500,000 =$900,000 Depreciation = $100,000 Net investment during 2012 = $500,000 ii. Michael’s capital at the end of 2012 = Gross investment – depreciation =$900,000 - $100,000 = $800,000 (b) i. Lori’s savings in 2012 = Net income – consumption – interest on savings = 20000 – 15300 -300 =$ 4400 ii. Lori’s wealth at end of 2012 = Assets + savings + interest on savings =1000 + 9400 + 300 = $10,700 (c) i. when the government has a budget surplus of $1 billion, Real interest rates= 8% Quantity of investment = $6.5 billion which is represented by the demand for loanable funds. Quantity of private saving = $7.5 billion Crowding out effect occurs when the increased interest rates results to a decreased or reduced levels of private investment spending due to increased government borrowing thus dampening the initial increase of total levels of investment spending. In this case there is crowding out effect resulting from the increased levels of interest rate from 4% to 8% lowering the level of investment to $6.5 from $ 8.5. This could be due to increased government borrowing that encouraged savings, thus the increase in interest rates. (C) ii. when the government has a budget deficit of $1 billion, Real interest rates= 6% Quantity of investment = $7.5 billion which is represented by the demand for loanable funds. Quantity of private saving = $6.5 billion In this case there is no crowding out effect. This is because the private sector is able to borrow at the prevailing levels of interest rate, i.e. at 6% interest rate the level of private investment spending is $ 7.5. The fact that level of investment is high than the level of private saving (6.5) implies that individuals are discourage to save by the low levels of interest rate. iii. According to (Barro, 1989), Ricardo-Baro effect is a theory that postulates that when government spending increases the demand for loanable funds reduces, households and firms increase their savings thus the state of the economy remains unchanged. In this case if the government has a budget deficit the households will respond by increasing their savings thus raising the interest rates which in return will lower the level of investment. Therefore, interest rate will be equal to 8% while level of investment will be $6.5. Question 2: (a) .The official measures of money are M1 and M2. M1 refers to all cash balances available to the public in form of currency in hands, traveler’s checks, demand deposits and other deposits against which the owner can draw checks. On the other hand M2 comprises of M1, time deposits, fixed savings accounts as well as money balances in retail money market mutual funds. (Hafer and Jansen 1991) (b) Coins are referred to as fiat money meaning that they are a legal tender enforced by the government; therefore, no one can refuse to accept them. Cheques and visas are on the other hand referred to as fiduciary money meaning that they are used as money on the basis of trust between or among the people using them. (c) Functions of money include;- Money acts as a medium of exchange in country that enhances exchange of goods and services. However for this function to be accomplished there has to be a legal right or general acceptance of money so that it is accepted by all involved in exchange as a legal tender. Money is used as a store of wealth. People keep their wealth in form of money with financial institutions. This may either be in terms of demand deposits or time deposits as well as cash balances. Money is considered as the most convenient way in which people keep their wealth. Money serves as a unit of account; the standard unit measure of the value of goods and services in the market as well as other transactions. This function helps in the facilitation of debts and deferred payments since it value is not much affected by fluctuations in the market. Money also serves as a measure of wealth; the more money one has determines his or her wellness status in terms of financial class. Some also use money as means of investment and the investments one has made using money can be used to measure how well or rich one is. (d) Factors that determine the demand for and supply of money, according to Yun (1996) The demand for money is determined by three main factors as regards to Keynesian economists. This determinants include; transactionary purposes, precautionary and speculative purposes. According to Keynes, transactionary purposes mean that people hold money so that they may be able to carry out their day-to-day businesses and other financial transactions. Precautionary purposes of holding money are to cater for emergencies in future, while speculative demand for money is the holding of money for the purposes of taking advantage of chances of future investments that may arise. Speculative demand for money depends on the levels of interest rates, at high interest rates in the bonds market people prefer to invest rather than hold money and vice versa. Transactionary and precautionary demand for money depends on the level of income of an individual. The high the income the high the amount held for transactionary and precautionary purposes. Supply of money on the other hand depends on;- The level of the high powered money and the size of the money multiplier. High powered money refers to the currency issued by the government into economy. While money multiplier is the ratio of money supply and the high powered money that determines how the banks multiplies demand deposits. The bank rate policy is another determinant of money supply. This is the maximum rate at which the Central Bank, of a country provides loans to the commercial banks. The higher the rate the lower the money supply. This is because high bank rate, also known as the window rate, discourages the banks from borrowing from the Central Bank and this lowers the available loanable funds for the public. Open market operation also determines money supply in that when the government purchases and sells securities through the Central Bank it increases and reduces the money supply in the economy respectively. Through deficit financing the money supply in a country is also affected in that, when the government seeks to finance the deficit by borrowing from the central bank, the central bank creates more currency. This in return increases the amount of money in circulation Minimum capital requirements by the central bank for the starting of commercial banks, is another factor that affects money supply. Minimum capital requirement is the money that a commercial bank is supposed to deposit with the Central Bank for it to be given a trading license. The higher the minimum capital requirement the fewer the banks, hence low money supply. Effects of increase/ decrease in money supply on interest rates Increase in money supply shifts the supply curve to the right. This results to a fall in the interest rate equilibrium. On the other hand, decrease in money supply causes the equilibrium to rise as illustrated in figure1 below. Note;- I-is the interest rate MS-is the money supply Mad- is the money demand Ms1 Ms 2 I ro r1 0 Money demand/supply Fig.1 Question 3: (a) Factors that determine the change in demand for and supply of forex Economic factors; according to Tylor et al (2001) includes policies by the central bank, marketing economic reports and other economic indicators. They also include importing and exporting companies, banks and foreign investors as well as speculators in marketing activities. Political factors within a country for example domestic and international political issues affect the currency market a lot. The perception and psychology of traders is another factor that really affects the currency market. An increase in demand for the foreign currency for example demand for pound by the USA, causes a rise in the exchange rate i.e. the pound appreciates while the dollar depreciates. The demand curve shifts to left leading to a fall in demand for pound and a rise in demand for dollar. On the supply side the curve shifts to the right indicating an increase in the supply of pounds. The new interaction of supply and demand curve occurs at a lower exchange rate and but at an appreciated dollar. The vice versa occur in the event of a decrease in supply of the pounds. (b) . i. The depreciation of the US dollar would be due to increased foreign investment by the citizens of the US. This means that when US investors invest heavenly for example in Japan, there will be a heavy outflow of the dollar from US leading to its depreciation. Another possible reason that would have resulted to a fall in the value of the dollar would be due to the general rise in prices of goods in USA as compared to their trading partner in this case the Japanese. When the prices of goods in US rises in relation to Japanese’s goods people would go for Japanese goods. This would result to an increased demand for the yen by USA citizens hence depreciation of US dollar. ii. The events reduced the demand for US dollar, for instance in the case of US investors wanting to invest in Japan they would demand for more yen than dollars so that they may invest in Japan. On the other hand US citizens would demand more yen to enable them purchase goods from Japan where they are cheaper as compared to US. Question 4: (a) .i The foreseen risk of global crises was due to the then suppressed economic growth of the developed nations that was caused by the then high taxes and great efforts to finance household and corporate debts (Hatzius et al 2010). ii. Effects of recession in Australia’s short-run equilibrium price AS P1 P2 AD1 AD2 Q2 Q1 Output Fig,2 The short-run equilibrium is obtained by the intersection of short-run aggregate demand and the short-run aggregate supply. Initially the equilibrium is at P1Q1 but due to recession the equilibrium fell to P2Q2. The fall in equilibrium was due to reduced aggregate demand whose fall was caused by the recession in the country (Karunaratne 1999). (b) Aggregate demand (AD) and aggregate supply (AS) model illustrate and the short run equilibrium Aggregate demand refers to the summation of all consumers’ needs for goods and services that they are willing to consume and able to pay for at a given time in the market. Aggregate supply on the other hand refers to the total goods and services that the producers are able and willing to provide into the market. Fig.3 In the short-run the quantity demanded in the market is represented by the curve, SRAD (short-run aggregate demand curve) which is negatively slopping. The curve is negatively sloped because as the price of goods falls more goods are demanded by the consumers; demand moves in the opposite direction from prices. The short-run supply curve slopes from left to right, that is, it is positively sloped indicating that an increase in the price goods leads to increased supply of goods and services. In the short-run the equilibrium occurs at the point of intersection of the two curves, p*q*. Fig.4 Any expationary perturbation in the market that may cause an increase in aggregate demand, would lead to a shift in SRAD curve to the right. This shifts the short-run equilibrium from p*q* to p**q**. (c) key reasons why real GDP fluctuates around the potential GDP PGDP RGDP GDP Fig.5 0 N Note;- PGDP- is the potential GDP RGDP- is the real GDP N- is the labour From the diagram above real GDP fluctuates around the upward sloping potential GDP. This is caused by the changes in prices of goods which in return affect the wage rates and thus leading to varying effects on labour N. Unemployment is the main cause of the fluctuations on real GDP (Taylor 2001). References Barro, R J 1989 The Ricardian approach to budget deficits. Hafer, R W, & Jansen, D W 1991 The demand for money in the United States: evidence from cointegration tests Journal of Money, Credit and Banking, 155-168. Hatzius, J, Hooper, P, Mishkin, F S, Schoenholtz, K L, & Watson, M W 2010 Financial conditions indexes: A fresh look after the financial crisis No w16150 National Bureau of Economic Research. Karunaratne, N D 1999 The yield curve as a predictor of growth and recession in Australia No Discussion Paper No 255. Sarno, L, & Taylor, M P 2001 Official intervention in the foreign exchange market: is it effective, and, if so, how does it work?. Taylor, J B 2001 The role of the exchange rate in monetary-policy rules American Economic Review, 263-267. Yun, T 1996 Nominal price rigidity, money supply endogeneity, and business cycles Journal of Monetary Economics, 372, 345-370. Read More