Starting from a position of equilibrium, use the IS/LM model toshow the impact of a decrease in government spending. How can the monetaryauthorities offset the impact of this policy? What happens to investment? Willthe Monetary authorities be able to pursue this policy if they have reached thezero lower-bound of the interest rate? What else can they do in this case? Explain Whatis Fiscal Policy? Fiscal policy is when the central government adjusts it’sspending patterns to monitor and influence the nations economy. A way in whichthey do this is by manipulating taxes (increasing or decreasing), changing theamount of spending they do as a government (G), etc.
Adecrease in the Government Spending (G) will normally result in the IS curveshifting to the left. When this happens the interest rate will fall and so willoutput as it moves along the LM curve. As this happens, the transactionaldemand of money will decrease and assuming a steady money supply, interestrates will fall. Whatwill happen to investment? Investment will increase as interest rates fall asinvestment is sensitive to the interest rate.
However, as interest ratesdecrease so does the output and this will offset the effect that happened onthe interest rates. 2. Comment on this statement: “To stabilise the level of income, thegovernment should increase its spending whenever the interest rate falls anddecrease its spending whenever the interest rate rises.” Tofully answer this question, we need to see the factors that are causing theinterest rate to change. Firstly, it could be coming from the demand side ofthe economy which would result in the IS curve shifting or it could be comingfrom the monetary side of the economy which would cause the LM curve to shift.Theoretically if the government decided to increase it’s spending, it wouldshift the IS curve to the right causing the interest rates to increase andcausing income to decrease and vice versa for the government to decrease it’sspending. But we are only seeing what the government should do when theinterest rate falls or rise, we need to see why it fluctuates. So,a reason for why the interest rate falls or rises is when the Central Bankundergo a Monetary Policy.
This is when they either increase or decrease themoney in supply in the economy. When the money supply increases, the interestrate in the economy decreases. When there is less money in the economy, theinterest rate will increase. So,all this Monetary Policy affects the LM curve, causing it to shift either rightor left. The government by reducing or increasing their spending is merelyoffsetting the affect that the monetary policy has cause to the equilibrium.They will increase or decrease until a new equilibrium is reached in themarket.
3. Is the incomemultiplier with respect to government spending larger or smaller in the modelincorporating the international sector than it is in the same model without aninternational sector? Explain. Assume (i) a fixed exchange rate system and (ii)a flexible exchange rate system. In both cases, assume a BP curve is flatterthan the LM curve.Let’s assume an increase in governmentspending. This increase will shift our IS curve outwards (to the right). Thisshift will not result in a balance of payments surplus which has been pointedout at point B.
Assuming a Closed economy model. Assuming also a fixed exchangerate, the government (Central Bank) will increase their money supply in orderto balance out the payments. This increase in money supply will cause the LMcurve to shift to LM1.
The new equilibrium is seen at C. Impact on the openeconomy is greater as seen on the graph as opposed to the impact on that of aclosed economy due to the fact that C causes more of an impact than that of B. GRAPHUnder a Floating exchange rate whenthere is the same conditions as above where government spending has increase andthere is now a surplus in BP, under floating we do not go to the Central bankto control money supply to balance our payments. This surplus will lead tocurrency appreciation.
This appreciation will shift the BP upwards and the IScurve to the left (decrease in exports) until they meet at point C. Impactunder floating exchange rate is greater in a closed economy than on an openeconomy. Graph. 4. Suppose the economy is at potential output, but with abalance of payments deficit; show that under a fixed exchange rate, the B of Pdeficit leads to unemployment, while under a flexible rate, the B of P deficitis likely to lead to inflation.
Assumethat the BP curve is steeper than the LM curveUnder a fixed exchange rate, as seen inthe graph below, the Balance of payments deficit leads to an increase inunemployment. Why? Market equilibrium is seen at Point A, this point is clearlyunder the BP line meaning that there is a balance of payments deficit. Under afixed exchange rate system where the Central Bank controls foreign currency,they will decrease the money supply in circulation to reduce this deficit.
Thisreduction in Money supply will cause the LM curve to shift to the new positionLM1. There is a new equilibrium and a balance of payments at point B, howeverpoint B has a lower output and this means that unemployment will be higher atpoint B than it is at point A. Under flexible exchange rates systeminstead of a reduction of the money supply, a depreciation will occur. Thisdepreciation causes the BP and the IS curves to shift to the right until thecross with the LM curve. This is the new equilibrium.
What we can say aboutthis equilibrium is that the interest rates stay the same but output increases.This increase in output eventually leads to inflation in the economy. 5. Using the WS and PS relations, graphically illustrate and explain theeffects of a less rigorous enforcement of existing competition laws on the equilibrium real wage,the natural rate of unemployment, the natural level of unemployment and thenatural level of output. Ifcompetition laws were to be less enforced and stringent the effect that iswould have would be a somewhat negative one for the economy. Let’s assume thatthe laws for wages were to be relaxed, then firms can increase prices as theyfeel. This in turn would cause the Price setting Line to fall and that wouldlead to a fall in the real wage which in turn leads to an increase inunemployment rate which increase the Natural rate of unemployment as shown inthe graph below.The naturalrate of output (which is associated with the natural rate of employment) issuch that, at the associated rate of employment the real wage chosen in WS isequal to the real wage implied by PS.
This means that less enforcement ofcompetition laws will have an effect on the natural level of output. The lesspeople working (more unemployed) the less output will be produced and the lesswage given to each worker means they are worth less and will have no motivationto work and produce less leading to inefficiencies and a drop-in output perworker. 6.
Explain why when evaluating the implementation of an expansionary monetarypolicy it is often argued that this policy is only effective in the short runand that it is ultimately neutral in the medium run.Whatis Monetary policy? Monetary policy is when the Central Bank or whoevercontrols the supply of money in a country changes or determines the size andthe growth rate of the money supply in circulation in the economy. This is denotedby the LM curve. Generally there are two types, Contractionary where money outputand supply decreases to control inflation or, in the case of this questionExpansionary where they increase the amount of money in circulation to lower interestrates and lower unemployment.Monetaryexpansion causes the LM curve to shift down and for the Aggregate demand curveto shift to the right. The interest rate will then decrease and thus causingthe output to increase due to the increase in investments due to less demandfor transactional use of money.
Inthe short run an expansionary monetary policy decreases the interest rates,increases the output level (to above the natural rate) and increases the pricelevel. Inthe medium run there is no change to the interest rate as it rises back to it’snatural level, no change in the output and the price will be higher than at theoutset. 7. Explainthe relationship between unemployment and inflation as depicted in the Phillipscurve. Does this relationship also hold in the long run? Generally,the relationship between is a negative relationship. As employees expect pricesto rise, they want more money to adjust for the inflation.
And as prices gethigher, people will need to find a job to sustain themselves with the prices,therefore as inflation increases, unemployment decreases (in the short-run) asis shown in the Phillips-Curve. Anotherexample is that low unemployment leads to higher nominal wages, which willdrive the firm to increase their prices. The increase in prices causesinflation to rise in the economy. Does this hold? No. Over time the original relationship betweeninflation and unemployment as depicted in the Philips curve changes due tochanges in the way workers form their inflationary expectations. 8.
Discussthe implications of decreasing returns to capital within the context of longrun economic growth. What is the steady state? What is Okun’s law? Explain. What is Growth? Economic growth is normally measured as a %increase in GDP (Gross domestic product) during one year. Growth can come in tworecognizable forms. The first is that an economy can grow extensively by makinguse of more resources (labour, capital). The second is intensively which meansthat it uses the same amount of resources but in a more efficient way with thehelp of technology for example. In short, decreasingreturns to capital will lead to an increase in capital per worker which willlead to smaller and smaller increases in output as shown in the graph below.
In the long run of economic growth, the decreases in returnsto capital will cause K, the capital per worker to shift along the productionline ‘sy’. This is because there will be more capital per worker. However,there will be a point where the effect of such will decrease and decrease everytime due to the economy reaching it’s ‘steady-state’.
A steady-state economy is an economyconsisting of constant capital and a constant population size (labour). Ineffect, such an economy does not grow but it stays in a stable state as shownin the graph below. Whatis Okun’s Law? Okun found that the unemployment rateand the difference between potential GDP growth and real GDP growth interactedin a specific relationship over time. Okun’s law “is intended to tell ushow much of a country’s grossdomestic product (GDP) may belost when the unemployment rate is above its natural rate.” 9.
Graphically illustrate and explain the effects of technological change on theSolow growth model. In your graph,clearly label all curves and equilibria. What is the Solow Growth Model? The Solow growth model is aneconomic model designed in use when answering questions related to the long runeconomic growth of an economy. The Solow Model is set or based on the frameworkof neoclassical economics. The model attempts at explaining long-run economicgrowth by looking at certain criteria in the economy. Such criteria are;Capital accumulation, labour (population growth) and the increases inefficiency of productivity (technological advances). Modelstates that a sustained rise in capital investment in the market increases thegrowth rate at which the economy grows only for a temporary amount of time dueto the ratio of capital to labor increasing but then marginal products of extracapital will decline. This is when the economy goes back on the ‘long-termgrowth path’ as stated by the model.
So,what is this long-term growth path called? It’s often referred to as the’steady-state growth path’ and this is achieved when output, labor and capitalin the economy have found a rate at which they all grow at the same ratetherefore output per worker and capital per worker are constant in this path. Thetechnological effects on the Solow Growth Model. Technological advances areconsidered to be labor improving and increasing the productivity of labor for agiven level of capital. Let us suppose and improvement in technology, in theoryquality of capital will increase due to improvements in technology and theworkers who are in contact with the capital are using the capital moreefficiently and will effectively be increasing their output.
Therefore, theoutput per worker with a technological advancement has increased. A shortexample, if the rate of new technological improvement is said to be 2% a year,then this technology needs (capital stock) needs to be updated yearly at 2% toensure that it’s workers are working in an efficient manner. If the new technologyis not embraced, then the new improvements will yield no gains in output perworker at that particular firm. When weintroduce technology to the model, the newly introduced technology creates anincrease in growth in productivity due to the new efficiencies it brings alongwith it. New technology can be said to be exogenous when it is introduced toproductivity, this means that the technology doesn’t need to be altered orpushed to become an efficient addition.
The Diagram of the Solow model changes when new technology isadded. Since new technology has been introduced to the economy it will nowbegin to produce more at a growing rate. The output of the economy depends onthe technology, the investment rate, and the population growth rate. If theserates consistently grow, the economy will reach its steady state. ReferencesColorado.edu.(2018).
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