Economy and Investments - Math Problem Example

Running Head: [short [institute of affiliation Consider an economy in which investment (I) equals 400, governmentpurchases (G) equals 800, taxes (T) equal 600, exports (X) equals 200, and imports (M) equal 250. The consumption function is: C = 100 + 0.8(Y-T) What is equilibrium GDP? What will equilibrium GDP equal if government expenditures increase 200? What will equilibrium GDP equal if taxes decrease 200? Why are the results different? (150 – 200 words) Scenario 1: Y=100+0.80(Y-600) +400+800+200-250 Y=770+0.80Y 0.20Y=770 Y=3850 Scenario 2: Government spending is increased by 200 Y=100+0.80(Y-600) +400+1000+200-250 Y=970+0.80Y 0.20Y=970 Y=4850 Scenario 3: Taxes are decreased by 200 Y=100+0.80(Y-400) +400+800+200-250 Y=930+0.80Y 0.20Y=930 Y=4650 The difference in the figures lies in the effect of the multiplier in the model. When one of the elements in the income function is increased, the whole economy is not increased by that amount, but by the amount multiplied with a multiplier. The multiplier for consumption, investment, government spending and net exports is equivalent to 1/(1-b), where b is the marginal propensity to consume. Because the marginal propensity to consumer is 0.80, the marginal propensity to save is 1-0.8 or 0.2. By dividing 1 by 0.2, we get 5 which is the multiplier for the whole model of the economy. For every increase or decrease in the factors in the income function, it is multiplied by 5. Hence, the increase in government spending in scenario 2 caused a total increase in the economy of 1000, from 3850 to 4850. The multiplier for taxes, however, is different. The multiplier for taxes is equivalent to b/(1-b), where 0.8/(1-.08) is equivalent to 4. Taxes, as we know have an effect on the consumption function, as it either decreases or increases disposable income. Therefore, by decreasing the taxes by 200, the effect is not multiplied by the same multiplier as 5, but multiplied only by 4, which results an increase in the total GDP of 800. Hence, from 3850, the GDP increases to 4650. 2. The dollar depreciates relative to the Japanese yen; will the Sony stereo become more or less expensive? What effect will this have on the demand for Sony stereos? Demonstrate using supply and demand analysis. (150 – 200 words) When one currency depreciates, the other currency which it is compared against appreciates. In this case, the currency against which the dollar is compared is the Japanese Yen; the demand for dollars is the supply of yen, as the supply of dollars is the demand for the Japanese yen. When the dollar depreciates, this means in this case that the Japanese yen appreciates. Dollar depreciation means a shift in the demand curve in the foreign exchange market of yens and dollars. When the supply for dollars is the demand for yen, lower supply of dollars mean lower demand for yen. This results in a lower exchange rate where the amount of yen for a dollar decreases. This causes Japanese products more expensive to the market because of the lower exchange rate--the quantity of dollars will decrease as Sony stereos become more expensive—the demand for Sony stereos is affected through a leftward decrease. 3. How has technology impacted the globalization process? Is this positive or negative in the short run? What about the long run? Explain your answers. (150 – 200 words) Technology has impacted the globalization process greatly, in that it has significantly lowered down the costs of doing business with and in the other countries. Better technology aids globalization as many businesses can now reach more people across continents more efficiently. Better technology has impacted globalization in reducing costs in a number of ways. One of which, as mentioned is by extending the reach of the businesses through the interned. With the help of the internet, doing business with customers from other countries is a lot easier. Another impact of globalization in businesses is that with the presence of more accessible information, the market has become competitive, which forces businesses to become more efficient in order to compete. This has reduced the costs of doing business significantly. Apart from communication, better technology has allowed more businesses to come up with manufacturing processes and equipment that can be easily transferred to other countries they intend to operate. Better technology has a lot of positive impacts in the short run, I think would continue to contribute more in the long run in the form of more efficient economic activities, as well as new improved technology. Better technology, as previously stated has enabled exchange of knowledge which allows more efficient technology available in the economy after a short period, which is beneficial to an economy as a whole. 4. If the Federal Reserve sells government bonds, will short-term interest rates increase or decrease? Explain how this will affect aggregate demand and the rate of growth of the economy. (150 – 200 words) Monetary policy affects sectors in the economy that are interest-sensitive, such that interest rates and credit conditions have significant effect in encouraging aggregate demand overall. By either raising or curbing the interest rates, the government can affect the aggregate demand—which in its composition comprises consumption and investments, which are greatly affected by these interest rates. When Fed sells bonds, the bond holders get the bonds from the government in exchange for money. This selling of bonds decreases the money that bond holders have. This decrease in the money that bond holders when they purchased the bonds from the government decreases the money supply in the economy in return. This decrease in the supply of money therefore raises the interest rates of the short-term government bonds, as interest rate is the price to holding money. By aiming to increase the interest rates, government is in a way aiming to slow down the economy by giving them more incentive to put their money in the bonds, and to curb down consumption and investment. By discouraging people to spend their money and put into businesses, demand for labor will once again decrease with the decrease in the demand for products of businesses. This demand for labor will in turn curb down employment for people; sometimes resulting in increased unemployment which reduces the purchasing power of the people as a whole, and further decreases consumption. And this decrease in consumption and investment will in turn contribute to the decrease the aggregate demand, which will cause a shift in order to settle for lower price levels or inflation as the economy slows down. 5. What are the tools at the Federal Reserve’s disposal? Describe the limitations on the ability of the Fed to expand the money supply. (150 – 200 words) the Fed buys bonds Buying bonds is one of the ways for government to administer monetary policy and control the money supply. When the Fed buys bonds, it increases the money supply in the process. When Fed buys bonds, it gets the bonds from bond holders in exchange for money. This buying of bonds increases the money that bond holders have. This increase in the money that bond holders have increases the money supply in the economy in return. Bond holders can either use them for consumption, or save them to another bank, which in turn uses as capital for loans. Thus, the money supply the economy is increased to a certain amount by a given money multiplier. the Fed raises the discount rate When the Fed raises the discount rate, it encourages people to buy government securities for the hope of higher returns. When people buy government securities, they pay the money in exchange for the bond that they will hold which will pay off interest in return. This action on the part of Fed, because it required payment of money in exchange for bonds to be given to bond holders, it decreases the supply of money in the economy. Money goes to Fed after the payment for bonds, thus raising discount rate decreases the money supply in an economy. the Fed raises the reserve requirement Reserve requirement is the percentage of cash reserves that the Fed requires of a bank to retain. This means that this percentage of cash reserves should not be part of the cash that banks can loan to other people or business entities. If a bank can loan the amount that is not restricted to reserve requirement of Fed to another bank, which the other bank can do to other banks as well, the money supply of the economy grows. When the reserve requirement is increased, the amount of cash reserves that a bank can loan to individuals and other economic entities are reduced. This reduction in amount that can be loaned to economic entities in effect restricts the money that is accessible to the individuals or economic entities that may avail the loan, thus restricts money supply. This is the effect to money supply when Fed increases the reserve requirement for banks. Reference List Appleyard, Field, & Cobb., (2006), International Economics (5th ed.). McGraw-Hill Irwin Barro, R. J., (1997). Macroeconomics. 5th ed. Cambridge, Massachusetts: MIT Press. Samuelson, P. A. & Nordhaus, W. D., (2004), Economics (International Ed.). McGraw-Hill Irwin. Read More