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Intermediate Macroeconomics

Intermediate Macroeconomics Tutorial Questions Topic: ‘Fiscal Policy and the Open Income-Expenditure Model’ Tutorial 2: week 4 (19-23 August) N.B.: The readings for this tutorial are indicated in Topic 2 of the reading guide. 1 . In the Keynesian theory of output what is mechanism that brings about the equilibrium level of output determined by aggregate demand? 2. ‘The stance of fiscal policy cannot be measured by the size of the actual budget deficit. ‘ Why not? Can the stance of fiscal policy be measured? 3.

Show this equilibrium diagrammatically and iscuss the implications for the position and slope of the AD schedule of the inclusion of the international sector. (b) Derive the expenditure multipliers with respect to Go and Ox. How does the size of the government expenditure multiplier compare with that derived for the three sector model with exogenous taxes (I. E. Derived in Q. 2 (a) in Tutorial 1). What is the economic explanation for the difference between the two multipliers? (c) Suppose there is an increase in the marginal propensity to import.

What might cause such an increase? What effect will the increase have on the size of the government expenditure multiplier? (d) Assume thatch= 100, c =

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0. 8, 50, MO = 60, 0. 1, and m = 0. 12. What are the equilibrium values of Y and M? What are the values of the government budget balance and the balance of trade? What do these values imply for the relationship between private saving and private investment in an open economy? (e) How does an open economy finance an excess of national investment over its saving and any budget surplus? ) Suppose a large depreciation of the real exchange rate causes Ox to increase from 200 to 330 and Mo to decline from 60 to 30. What effect does this have on the balance of trade? Discussion Questions: In the aftermath of the global financial crisis a number of advanced nations accumulated large public debt (I. E. US, I-J, Italy and Greece) while there economy remained in recession or experienced a slow recovery. In these economic conditions why might a fiscal austerity policy adopted by some of these nations to reduce their public debt be counter-productive?

Intermediate macroeconomics

In 2005 the growth rate declined sharply and fluctuated steadily until 2012. The GAP is based on the spending patterns from 1990. GAP per capita growth rate The GAP per capita growth rate moved similar to the GAP the difference is in the figures. Inflation rate From 1990 the inflation rate increased by more each year up to 1994 when it decreased slightly and rose sharply thereafter (1995). It then decreased in 1996 and began to fluctuate in the years that follow until 2012. Lending interest rate (nominal interest rate) The lending or nominal interest rate varies within the range of 15% to 32%.

Increasing and decreasing slightly over the years. Unemployment rate Country Nigeria 28 2. 9 5. 8 21 Australia 7. 5 6. 4 6 5. 1 4. 2 5. 6 c) Unemployment On average, Australia’s unemployment rate is much lower compared to that of Nigeria. Inflation In the given time period, the inflation rate in Nigeria is higher as compared to

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Australian inflation rate. GAP per capita growth rate Australia’s GAP per capita growth rate is lower than that of Nigeria. Real GAP growth rate Insignia’s GAP growth rate is relatively steady and is higher as compared to

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Australia’s GAP growth rate.

Inflation rate In 2013 to 2016 the inflation rate is likely to be moderate or downward moving provided that the authorities keep the monetary policy tightened and lower prices. Considering the increase in food productivity in the economy food prices should be lower. Keeping the fuel prices stable will have an influence on the inflation rate. The inflation rate is likely to rise only slightly based on the trends and observations and an increase in the economy’s consumer expenditure. Unemployment Australian unemployment is likely to increase slightly and then decrease steadily over the years to 2016.

On the other hand Insignia’s unemployment rate is expected to keep rising in the next few years. Interest rate The Australian interest rate is likely to keep rising from 2013 to 2016. Economic implications on the future trends. Provided that inflation does rise in Australia, there might be an effect on the costs of inflation for example the cost of changing prices (menu costs). When inflation distorts relative prices in the economy, consumer decisions are distorted and markets are sees able to allocate resources to their best users in other words variation in relative prices can lead to the misapplication of resources.

According to the fisher effect which occurs as a result of the fisher equation and the classical dichotomy, when the expected inflation rises, the interest rates will rise as well (this is most likely in the long run). There might also be tax distortions and increased uncertainty. Question two In the article selected the author talks about how budget deficits affect the economy. The author states that there is considerable controversy about what effects these deficits nave on the economy.

Firstly these deficits nave an detect on national saying which is made up of private saving (the after tax income that households save rather than consume) and public saving (the tax revenue that government saves rather than spends). When the government runs a budget deficit it reduces national saving below private saving. Since national saving equals investment plus net exports in an open economy it is obvious that when budget deficit reduces national saving it reduces either investment or net exports or both. Budget deficits also create a flow of assets abroad, when a country imports more than it exports it gives up assets in return.

These assets may be the local currency. Business firms choose the economy’s level of investment and domestic and foreign customers choose net exports. If the government runs a deficit there are forces that influence firms to invest less and foreigners to buy fewer domestic goods. These forces are interest rates and exchange rates. Interest rates are determined in the market for loans, where savers lend money to households and firms who desire funds to invest. A decline in national saving reduces the supply of loans available to private borrowers, which pushes up the interest rate (the price of a loan).

Faced with higher interest rates, households and firms choose to reduce investment. Higher interest rates also affect the flow of capital across national boundaries. When domestic assets pay higher returns, they are more attractive to investors both at home and abroad. The increased demand for domestic assets affects the market for foreign currency: if a foreigner wants to buy a domestic bond, he must first acquire the domestic currency. Thus, a rise in interest rates increases the demand for the domestic currency in the market for foreign exchange, causing the currency to appreciate.

The appreciation of the currency, in turn, affects trade in goods and services. With a stronger currency, domestic goods are more expensive for foreigners, and foreign goods are cheaper for domestic residents. Exports fall, imports rise, and the trade balance moves toward deficit. To sum up the effect of deficits: government budget deficits reduce national saving, reduce investment, reduce net exports, and create a corresponding flow of assets overseas. These effects occur because deficits also raise interest rates and the value of the currency in the market for foreign exchange.

If budget deficits crowd out capital, national income falls because less is produced. In addition to affecting total income, deficits also alter factor prices: wages (the return to labor) and profits (the return to the owners of capital). In addition to their effects on macroeconomic performance, budget deficits have a more direct implication for the future: the resulting government debt may force the government to raise taxes when the debt comes due. These future taxes reduce household incomes in two ways?directly through the tax payments and indirectly through the deadweight loss that arises as axes distort incentives.

Alternatively, if taxes do not rise, the government may be forced to cut transfer payments or other spending to free up funds to pay the debt. One surprising fact is that the government may never need to raise taxes or cut spending at all. Instead, it can simply roll over its debt: it can pay off interest and maturing debt by issuing new debt. At first this policy might appear unsustainable, because the level of debt increases forever at the rate of interest. Yet as long as the rate of GAP growth is higher than the interest rate, the ratio of debt to G’ falls over mime.

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