Major Issues in Economics - Assignment Example

Economics Assignment Question 2 (25 Case study: Does a stock market crash affect the economy (e.g. consumer confidence and spending, investments)?A stock market crash affects the economy in various ways. Usually stock market is a key gauge of the economy as it affects the amount of money being ploughed back into the economy and the confidence consumer has in the stability of their earnings. Stock market crash leads to low confidence in investors as result of losses suffered due to low returns from their investments. As a consequence of stock market crash, investors tend to miss out investment opportunities and as such leads to low investment. Stock trading is one way firms use to generate money to fund their growth and buy new equipments and a crash denies them the needed money to expand. When firms spend less money on expansion, they are infusing fewer funds into the economy which leads to slow economic growth. Stock market crash causes job losses and this highly impacts the economy. During recession firms tend to cut operation costs by firing workers. With less money to spend consumers will not afford durable and luxury items. Hence, unemployment in the long run negatively impact the consumer durable and real estate sectors of economy since it lead to fall in prices in commercial and real estate sectors. Additionally, when investor’s money is lost as result of stock market crash, they tend to spend less. This in essence leads to low consumer spending which negatively affects the economy. Immediately following the attack on the US on 11 Sept 2001, the stock markets plunged and many observers expected a recession in the US (and possibly elsewhere). Using the AD-AS model, explain their prediction. There are reasons that led many observers to predict a recession in the US when the stock markets plunged. Stocks are pieces of ownership in a firm and thus the stock markets are indicator of shareholders’ confidence in the future earnings of these firms. Corporate earnings depend on the stability of country’s economic standing and therefore stock markets reflect how a country is economically stable. Their crash reflects a loss of confidence in the economy and if not restored it leads to recession. This due to the fact that the stock markets crash lead to a fall in aggregate demand (AD) (demand side shock) as a result of less wealth for consumers. In addition, it implies less financing for new projects, since trading of stocks is one way that firms raise funds required to expand. They also predicted a recession in US economy because declining stock markets can kick-start a rise in oil prices which would increase the cost of manufacturing and this in essence would cause the short run aggregate supply (AS) curve to shift to the left. Aggregate supply (AS) shock lowers real GDP and increases inflation and this result to recession. A crash in US stock markets in the long run lead would lead to a slowdown in the global economy since provides 20 percent of the worlds output (Layton et al, 2012). Question 3 (15%) Explain how each of the following affects consumption demand: a)    The expectation is that a prolonged expansion will occur in the next year. As consumers have better expectation about the economy in particular in their jobs and income prospects they usually spent more and this leads to increase in consumption demand. This is because of the increase of their confidence about the future. b) Stock prices rise sharply. A sharp rise in stock prices will lead to increased consumption demand. An increase in stock prices leads to increase in consumers’ wealth and disposal income since sell of stocks is one way they get money to spend. As the buying power of consumers increase they tend to spend more. c)    The price level falls by 10%. Consumption demand is inversely related to the price level. So when price levels falls by 10% the consumption demand may increase by more or less the same level. As the price of goods and services falls, consumers tend to spend more because their buying power has increased as a result of a fall in price level. d)    The interest rate on consumer loans rises sharply. When the bank interest rate on consumer loans rises sharply borrowing becomes expensive. Consumers therefore tend to borrow less and since they have liitle disposable money to spend they buy less and this in essence leads to a decrease in consuptuion demand. e)    Income taxes decrease. Lower income taxes will lead to increased consumption demand. This is because a decrease in income taxes leads to increase in consumer earnings since their income taxes deductions have been reduced. Thus, consumers have more disposal income and this encourages more spending. Question 4 (35%) Report Writing: "The expansionary policies implemented in Australia in 2008/9 by the Rudd Government and the Reserve Bank of Australia were unnecessary and will result in a period of unwanted inflation". Executive Summary During the Global Financial Crisis (GFC), the Australian economy did better than other developed economies and continues to perform so in the face of current European financial turmoil. During this period, Australia’s financial system was remarkably strong despite stressed financial conditions. While her economic growth dwindled, it did not fall into recession like many other developed economies. This can be attributed to the concerted efforts of the Rudd Government via discretionary fiscal expansion and tough monetary policy responses by the RBA at that time. Whilst the delivery of various government’s fiscal stimulus initiatives were open to censure, there is no doubt the underlying strength of her economy and its fiscal and monetary policies ensured the country did fall into period of unwanted inflation. This paper discusses how the expansionary policies implemented in Australia in 2008/9 by the Rudd Government and the Reserve Bank of Australia ensured that the country did not fall into recession. Introduction Like all other developed countries, Australia was not spared by wrath of the global financial crisis (GFC) of 2008/9, but its effect could have be more worse. At the time leading up to and through the GFC Australia’s businesses faced strict credit terms and higher investiment costs. In addition, the stock market plunged thus raising the cost of investiment from the sell of shares. Further, a decrease in demand for australia’s goods and services led to decline in trade and the exchange rate. This in essence led to the decline of household financial wealth by nearly 16% (Layton et al, 2012). The remarkable fall in both consumer and business confidence led to slow economic growth as result of decreased consuption demand and dwindling investiment. These combined to effect the Australia financial standing and were shown in revised gross domestic product(GDP) growth, unemployment rate as well as individuals’ incomes. Nevertheless, whilst the economy slowed under the weight of GFC, the downturn was less severe compared to other developed countries (see table.1 in the index page). In view of a looming economic slowdown, the Government and the Reserve Bank of Australia (RBA) implemented the expansionary policies in Australia which saved Australia from a period of unwanted inflation. How Australia responded GFC In view of the fast growing economic slowdown, the Government and the RBA implemented expansionary monetary policies in Australia in order to contain unwanted inflation. This was done through cut income taxes and increasing government spending. This monetary policy and fiscal policy action was aimed at eliminating the effects of the global economic slowdown on low income earners, who are the severely impacted by it because they faced binding credit conditions and were not able to mantain their consumption levels. Expansionary fiscal policy also aimed at increasing economic activity by stimulating increases in consumption demand via relaxing credit terms and as such reduce economic recessionary gap. The other reason why the Rudd Government and the RBA implemented these expansionary fiscal policies was to enhance both consumer and business confidence which was dwindling. This in essence allowed sustainable economic activity and smoothened the operations of the Australia’s financial system. Basically, a positive effects on business consumer confidence lowers the risk of increased precautionary investiments, and leads to increased spending. This in turn sustain domestic consumption demand and and enhance increased economic growth which leads to a balanced inflation rate since inflation can not be zero in an expanding economy. Similarly, increases in business confidence were expected to lead to increased investment spending and low unemployment rates. The expansionary fiscal policies were geared toward striking a balance between handling inflation and reacting to the risks posed by GFC. The government had strengthened its fiscal position by consolidating a $21.7 billion surplus to be used for future policy flexibility. The government used this financial strength to cushion low income households from the effects of GFC by cutting taxes and increasing their social and retirement benefits. In addition, the RBA came in to safeguard growth and financial strength by delivering liquidity to financial firms as global money markets became dysfunctional. RBA also moved in to curtail economic slowdown by decreasing the official cash rate quickly. This alternative was not available to other countries whose their interest rates were already low (Layton et al, 2012). This monetary and fiscal policy action was geared toward controlling inflation to between 2% and 3%. RBA moved in to keep inflation between 2% and 3% (“inflation targeting”) by lowering banks interest rates (Layton et al, 2012). The cuts in interest bank rates, led to increase inflation as it was below the target. The rate of inflation should not be zero over a business cycle. This is because in the expansion phase of the business cycle there is a slight increase in inflation and this phase leads to a desirable increase in economic growth. Higher inflation is harmful to the economy as prices can rise rapidly, however some inflation as shown by the RBA’s target is an indicator of a well developing economy. The Rudd government also implemented a raft of proactive fiscal policy responses. For instance, it raised its security bonds by nearly $25 billion to allow the smooth running of the country’s financial markets. This was of particular help to non-authorized deposit-taking firms as it enhanced their competition in mortgage market. As the outlook of global financial and economy further worsened, the government responded by enacting a $10.4 billion economic security strategy. This strategy focused on first six months in year 2009 and was directed to sectors severely affected by GFC such as household consumption and residential investment. This strategy was complemented with a $42 billion nation building and jobs plan initiative which also aimed at boosting the earnings of low and middle income earners as well as small investments. Conclusion The expansionary policies implemented in Australia in 2008/9 helped the country to cope with adverse effect of GFC better than other developed economies. Contrary to other global economies where bank interest rate were already low, her fiscal policy was strict as the RBA fought with the increased inflation, allowing a scope to reduce bank interest rates at the time leading up to and through the GFC. These policies helped the country to lower its office cash rates from 7.5 percent in late 2008 to 3 percent within seven months. In a nut shell, the monetary policy and fiscal policy action during GFC saved Australians from a period of unwanted inflation. These expansionary monetary policies helped Australia induce an increase in the price of real assets and credit, this in essence controlled inflation during GFC. They also helped Australia’s financial institutions make it through the economic slowdown and have remained stable since then. As a result of these policies business and consumer confidence rebounded and unemployment rates felled to a low of 3.9 percent in 2009 (Layton et al, 2012). These policies further helped the country recover earlier and with more strength as a result of the cuts in interest rates, and the timely and remarkable fiscal and monetary policy response. See table 2 and 3 in the indexes page. Recommendations For the Australian economy to continue performing better the government and RBA should put in place a raft of fiscal and monetary measures. The Australian financial institutions should hold high capital levels so as to survive the shocks of a new GFC and in case of a crash of her property market. This is because her financial institutions’ major susceptibility is their exposure to extremely indebted households as a result residential mortgage lending. The country should also put in place well coordinated and centralized guidelines for the regulation of all financial institutions. With more a coherent regulatory framework, with the Australian Prudential Regulation Authority (APRA) being the single prudential regulator for the financial services sector, the country can survive several shocks experienced in other developed economies. The country should also put in force a strong regulatory regime and licensing system for financial sales, advice and dealings in relation to financial products. This in essence will shield the Australian market from riskier products offered by foreign investment banks. The government should also put in force laws that would permit deposit-taking financial institutions to issue covered bonds to cushion them from bad debts. Indexes Table. 1 showing GDP growth rate: 2007-2014 Country/Year 2007 2008 2009 2010 2011 2012 2013 2014 Australia 4.8 2.2 1 2.3 2.7 2.9 3 3.1 Canada 2.5 0.4 -2.6 2.9 1.8 2.2 2.7 2.6 United Kingdom 2.6 0.5 -5 0.7 0.9 1.2 1.5 1.4 United States 2.1 0.4 -2.4 2.8 1.6 1.9 2.2 2.3 Data from RBA website Table 4: Balance Budget Balance % of GDP: 2007-2014 Country/Year 2007 2008 2009 2010 2011 2012 2013 2014 Australia 1.7 0.9 -3.7 -3.1 -2.1 -1.3 -0.9 -0.7 Canada 1.5 1.5 -4 -3.7 -2.9 -2.1 -1.3 -1.2 United Kingdom -2.6 -4.9 -11.4 -13.5 -11.5 -10.1 -8.9 -8 Data from RBA website Table 3: Government Consumption as a percent of GDP: 2005- 2014 Country/Year 2007 2008 2009 2010 2011 2012 2013 2014 Australia 3.3 3.3 2.4 2.6 2.4 2.2 2.1 2.1 Canada 3.2 3.7 3 3.3 0.8 1.1 1.5 1.4 United Kingdom 1.2 2.6 2 1.6 -1.5 -2.1 -2.1 -2 Data from RBA website Question 5 (15%) In Japan, potential GDP is 600 trillion yen (¥) and the table shows Japan’s aggregate demand and short-run aggregate supply schedule. Price level Real GDP demanded (trillions of yen) Real GDP supplied in the short–run (trillions of yen) 75 600 400 85 550 450 95 500 500 105 450 550 115 400 600 125 350 650 135 300 700 a. A graph of the aggregate demand curve and the short-run aggregate supply curve b. From the graph (intersection) The short-run equilibrium real GDP = 500 trillion yen (¥) price level = 95 c. Yes Japan has recessionary gap, Japan’s Potential GDP is 600 trillion yen (¥) Therefore the magnitude of recessionary gap = Japan’s Potential GDP - short-run equilibrium real GDP = 600 trillion yen (¥) - 500 trillion yen (¥) = 100 trillion yen (¥)   References Layton, A., Robinson, T., Tucker, I. B. (2012).Economics for today. South Melbourne, Victoria: Cengage Learning Australia.   Read More