Macroeconomics and Effect of Fiscal Stimulus - Essay Example

Macroeconomics Table of Contents Answers to Questions and 3 3 Answers to questions 2 5 Answer to Question No. 4 7 Answer to Question No. 5 7 Answerto Question No. 6 8 Answer to Question No. 7 8 Answer to Question No. 8 9 Answer to question numbered 9 9 Answer to question numbered 10 10 Answers to Questions 1 and 3 In the goods market, equilibrium can be defined as the situation where peoples’ planned (ex-ante) expenditure exactly matches the realized (ex-post) expenditure, since under such a condition when peoples’ expectations have materialized, they don’t have any incentive to alter their behaviour. The actual or realized expenditure is the amount households, firms and government spend on goods and services, i.e. GDP (Y), while planned expenditure (E) is the amount they would like to spend on the same goods and services. Now the three major determinants of the planned expenditure are consumption, investment and govt. expenditure, thus E = C + I + G……………… (1) Again C = c0 + c1(Y-T) I = I bar Substituting in (1) we have: E = c0 + c1(Y-T) + Ibar + G……… (2) Finally according to the definition of the equilibrium, equating E with Y gives: Y = E => Y = c0 + c1(Y-T) + Ibar + G Collecting Y terms on the L.H.S. and dividing through (1-c1), we get: Y = 1/ (1-c1) [c0 + Ibar + G – c1T]……… (3) Another way to reach eqn. (3) is to start from the equilibrium at the market for loanable funds. National saving (S) can be considered to be the supply of loans in the economy and national (gross) investments (I) as demand for the loans. Now, S = (Y-C-T) + (T-G), where, Y-C-T = gross private savings and T-G = gross public savings. Hence for the equilibrium, equating demand and supply we get: S = I……… (4) => (Y-C-T) + (T-G) = Ibar => Y-C-G = Ibar => Y = c0 + c1(Y-T) + Ibar + G Rearranging Y terms and diving through (1-c1) we get eqn. (3): Y = 1/ (1-c1) [c0 + Ibar + G – c1T]……… (3) Hence the proof. Effect of Fiscal stimulus: (a) Rise in govt. expenditure: The govt. expenditure multiplier is 1/ (1-c1), as calculated from eqn. (3), where, c1 = MPC. In this example MPC is 0.8. Hence, a £1 rise in govt. expenditure will raise the GDP by £1/ (1-0.8) = £5. Therefore a £100 million rise in the govt. expenditure will raise the GDP by 5 x £100 million = £500 million. (b) Tax-cut: Again from the equation (3) we can calculate the tax-cut multiplier to be c1/ (1-c1). In this example, c1 = 0.8 and hence the value of the multiplier will be 0.8/ (1-0.8) = 4. Therefore a £1 cut in the income tax would raise the GDP by the amount of £4 and so a £100 million of tax cut shall raise the GDP by 4 x £100 million = £400 million. (c) Balanced Budget: If now G goes up by £100 million GDP would rise by £500 million. Again if this increased G is financed by raising T by £100 million, i.e. if T goes up by £100 million, GDP would fall by £400 million. Hence the net effect of this balanced budget fiscal stimulus on GDP would be £ (500 – 400) million = £100 million, i.e. GDP would rise exactly by the amount spent on the public activities. Answers to questions 2 We know that the money supply (M) is the sum of currency (C) and bank deposits (D) and the monetary base (B) or High Powered Money is defined to be the sum of reserves (R) and currency. M = C + D……. (1) And B = C + R……….... (2) Let c be the share of total money held as currency. Therefore, C = c.M…….. (3) and D = (1-c).M…...... (4) Moreover let θ be the proportion of gross bank deposit, that the banks want to keep as reserve, i.e. θ = R/D => R = θ.D => R = θ.(1-c).M ……. (5) [From equation (4)] Now by definition, money multiplier m = Money Supply / High powered money => m = M / B => m = M / (C +R) => m = M / [c.M + θ.(1-c).M] [Substituting from eqn. 5] => m = M / [c + θ.(1-c)].M Finally cancelling the M terms, we get: m = 1 / c + θ.(1-c) ……… (6) Again in this example, θ = 0.05 and c = 40% = 0.4. Substituting these values in equation 6 we obtain m = 1 / [0.4 + 0.05*(1- 0.4)] i.e. m = 2.33. Hence value of the money multiplier in the present context is 2.33. Now if the high powered money goes up by £100 million, then money supply should increase by 2.33 x £100 million = £233 million. Answer to Question No. 4 In an economy in the short run, the prices as well as wages tend to be sticky. Hence, people often prefer to stay unemployed since they cannot get the right wage for their labour. This is the case that determines the natural rate of unemployment. Again, prices in the short run are sticky as well and thus are used to determine the real wages of workers that they consider to maintain a similar standard of living throughout. The wage setting equation is, W/P = w * (P/Pe) and the price setting equation is, p = P + a(Y – Y*) Answer to Question No. 5 ADAS Model is a part of the classical model in economics that considers money to be neutral. According to the quantity theory of money, MV = PY where M = Money Supply, V = Velocity of money transmission, P = Price and Y = output. So, as M rises, as in the short and medium term, output cannot change, so, keeping V constant, it must be accompanied by a rise in P, thus causing inflation. Answer to Question No. 6 This expression shows that change in the level of inflation in a period depends on the change in the rate of unemployment in that period. This expression is the one derived by Okun’s Law and is a good measure to introduce wage indexation in an economy since unemployment rate in an economy is the most important determinant of any modifications in the wage rate and inflation rate is the one upon which any index should be based. Answer to Question No. 7 The uncovered interest rate parity shows that the rate of interest between any two countries in an era of liberalisation are bound to be equal otherwise it leads to an arbitrage profit. Here it stands for domestic rate of interest and it* for the foreign rate of interest. Et stands for the nominal rate of exchange in the present period and the one with e as a superscript stands for expected rate of exchange. Answer to Question No. 8 Here € stands for the real rate of exchange. Here the equation shows that net exports can be derived by subtracting imports (IM) from gross exports (X) in an economy. Now, the original expression in this case is, € NX = € X(Y*, €) – IM (Y, €) Here € X(Y*, €) = gross exports in terms of foreign currency IM (Y, €) = net imports in terms of domestic currency Subtracting the two will give us the expression for net exports expresses in terms of foreign currency .Dividing the entire expression by € gives us the net exports in terms of domestic currency. Answer to question numbered 9 In the short run, an expansionary fiscal policy will lead to a rise in the total production in an economy and a contractionary fiscal policy leads to a fall in the total production. Answer to question numbered 10 In case of the first equation, devaluation causes a fall in the value of Pe. But as the equation is actually an identity, so, this must be supported by a rise in the remaining expression. Thus, F must rise implying either 1-Y/L should rise or Z must rise. If 1-Y/L rises, it leads to a fall in Y and a rise in Z implies a rise in imports. In the second equation, as Pe falls in value, Y must rise with G and T remaining constant. Read More