Question#1: Use Keynesian cross to explain why fiscal policy has a multiplied effect on national income.
Answer: The equation for calculation of national income under Keynesian model is Y=C+I+G+(X-M). In this formula, the Y denotes national income, C denotes level of consumption, I denote level of investment done in the economy, G denotes government’s expenditure, X denotes imports, and M denotes imports of an economy. With the help of this formula, the governments drive fiscal policies for the economy. With the help of this equation, it has been said by Keynes himself that when the consumption is increased, the government expenditure is increased. The increment of both C& G leads to rise in income as predicted by a model derive by Keynesian called Keynes cross model. In the model we were said to keep other factor constant. This increase in the government spending will be increase in the income with more than one dollar spent.
Question#2: Use the theory of liquidity preference to explain that why increase in the money supply lowers the interest rate. What does this explanation assume about price level?
The liquidity preference theory states that, when all being constant, the demand for holding the money on hand depends on the interest rate offered for saving the money. The reason behind the logic is that the opportunity cost of holding money is the interest that can be received after investing it. Graph#10 of chapter 10 of the text book illustrates the equilibrium of demand and supply of money in the money market; after a right hand sift in the money supply curve will increase the demand for money in the market which will result in fall in the interest rate of the market.
With the increase in the level of government purchases, planned expenditure (PE) curve will move upwards to the left and it will show a growth in the short run output level at the given level of interest rate. For explaining the situation graphically, graph 5 of the assigned text book is scanned and pasted.
Planned Expenditure (PE) curve will move downwards on the left side when the level of tax increases in the economy. The increase in the level of tax will reduce short run output with established interest rate. It can be seen by the help of graph pasted that an increase in the level of tax has lowered the PE curve from its earlier position and the output (Y) decreases by the amount of ∆Y.
With the equal increase in taxes and government purchases, the output level of the economy will increase. That is, if there is an increase in tax and government purchases by one unit then the output level will also increase by one unit.
The equation for calculating P.E is as follows: PE=CY-T+I+G. If the values of variable C, I, G, and T are substituted with the values given in question, the following equation in the graph is derived. PE=200+0.75Y-100+100+100;PE=400+0.75Y-75;PE=0.75Y+325.
At equilibrium level, output is equals to planned expenditure i.e. Y=PE. If the equation of PE derived in option is substituted in the condition written, the equilibrium output level is calculated. Y=0.75Y+325;0.25Y=325;Y=1300.
As per the situation, if the government expenditures (G) is increased to 125. Then the formula for calculating PE will change i.e. PE=200+0.75Y-100+100+125;PE=425+0.75Y-75;PE=0.75Y+350. With the change in PE, the output level will also increases; Y=0.75Y+350;0.25Y=350;Y=1400. it can be said that with a increase of 25 units in the government expenditure, the output increases by 100 units.
For an increase in the income level to 1,600 units, the income level obtained earlier must be increased by 300 points (1600-1300=300). The formula for calculating the government purchase multiplier is 1/ (1-mpc). It is known form the consumption equation given in the question that the mpc equals to 0.75. By substituting the value of mpc in the government purchase multiplier, we get a value of 4 as answer. This means that to increase the income by 300 units, the government purchases must be increased by 75 (300/4=75) units from current expenditure i.e. the government expenditure should be of 175 units (100+75=175).
The total money supply (M) is 1,000 units and the price level (P) is 2 units. Then the real money (M/P)s = 500 at the interest rate of 10% and the money demand function is denoted by the following equation;
The graph can be formed from the above descriptions.
In money market, the equilibrium is attained by developing an equality in money demand and money supply i.e. MS=MD. For knowing about the equilibrium interest rate, the value of money supply can be taken from option a solution i.e. 500; and the value of MD is denoted by the formula of 1000 – 100r. By substituting the values in the equality of MS and MD, we get the following equation; 500=1000-100r. Solving the equation for the values of r we get; 100r=1000-500;100r=500;r=5.
And if the money supply (MS) is increased from 1000 units to 1200 units and the price level is remain the same then the new supply for real balances (M/P) will be 600 units (1200/2=600). The r for the new real balance will change i.e. 600=1000-100r⋯r=4%. From the calculations it is evident that r has decreased by 1% with the 200 units increase in the supply of money.
For increasing the interest rate of the economy, central bank must reduce the money supply (M) while keeping the price level constant.
After substituting the values of price level (P) and r = 7%, we get;
Answer: The aggregate demand curve slopes downwards because it shows that, at low price level increase the real money with the consumers, the interest rate is also decreases. The aggregate demand curve also elaborates the results from IS-LM model.
Answer: The increase in taxes leads to decrease in investment, decrease in consumption, increase in income.
Problem and application:
With the decision of hardware up-gradation of computer systems in an office due to technological change, the level of investments done by the company on technology will increase. That is, companies want to invest in the technology irrespective of the interest rate in the market. The increase in the investment of goods will move the IS curve to the right hand side of the graph. This raise will increase the income and the employment level, which will leads to increase in interest rate. As a result of increase in income, the demand of money will increase too. To control the demand of money the central bank will increase the interest rate. This increase in interest rate will partially offset the increase in demand of money. Overall, the income, consumption, taxes and investment must rise.
With the increase in withdrawing cash, the demand for cash is increased and the LM curve is shifted upwards and the interest rate rises; which eventually bring down the level of income. With the fall in the level of income, the investment will fall leading to increase in demand for money which eventually will lead to increase in the interest rate. For keeping the output constant, the Central Bank has to increase the money supply to bring down the interest rate. By doing the above, the LM curve will move down to the right of graph and its original position will be restored. So this whole scenario is nullifying all the efforts done by the reactions following the effects.
With a devotion to save more, the consumers will consume less; and as a result the consumption curve will shift downwards with IS shifting inward. With less consumption the level of saving will be raised which will create the situations for Central Bank to increase the money supply. There will be a downward shift to the right of graph in LM curve with the increase in money supply. With the increase in money supply, the interest rate will fall with high investment and the output level will be the same.
With the increase in money supply (MS), the LM curve will shift to the right side of graph in short run and the equilibrium point will shift from point A to point B as shown in the picture. The shift in equilibrium point will make changes in the levels of output and in the level of interest rate, i.e. the interest rate will fall and the output will increase. As the output has increased in the long run, the prices will also eventually increase. This will lead to increase in the interest rate of the economy. With the increase in the interest rate, the LM curve will shift back to its original place bring the level of output and money supply back to its original position. Therefore, in long run, there is no impact of increase in money supply on other important variables associated with long run.
In graph, it can be observed that the initial equilibrium point is at point A on the intersection of LM1 and IS1. If the government expenditure is increased, then the IS curve will shift upward to the right. This will change the equilibrium point and the interest rate from A to B and from r1 to r2 respectively in the short run. After the movement of IS, the long run equilibrium level of output is has increased too, this will lead towards the increment in the price level. The increase in price level will reduce the balance of equilibrium and in the result the LM curve will shifts towards left side of the graph. The movement of LM curve will increase the interest rate more than the increment caused due to movement in IS for short run. The new equilibrium level of the economy at point C where the output level is being same with the higher interest rate and price.
In this picture the original equilibrium is at point A where LM1, IS1 and Y coincide. With an increase in the tax level, the disposable income of the consumer will fall resulting in lower savings. This situation will shift the IS curve to the left and the new equilibrium point B will be created in the short run with decrease in output and decrease in interest rate. In long run, the prices will begin to decrease too as the output is below the equilibrium level. To fortify that the LM curve will shift to the right; this will make more real money balances as the interest rate will fall to its new low of r3 which will increase the level of income. The new equilibrium point with respect to shift in LM curve will be point C.
The original equilibrium point in the graph is at Y1 where LM and IS1 intersect. With the increase in government purchases, IS1 is shifted to the right and IS2 is created. There is no change in the LM by the increment of government purchases. It remains the same by making more demand of money on the disposable income rather than making demands for total expenditure.
The original market equilibrium point is point A in the graph at the intersection of LM and IS1. Tax cuts increase the disposable income of the consumers. With the tax cuts, the IS curve shifts right to IS2. With the assumption that money demand depends on disposable income then, the LM curve shift upward to LM2 and the new equilibrium point at point B is created. The new equilibrium point shows low output and high interest rate, which can drastically impact the dependency of disposable income for generating the money demand.
Answer: In floating exchange rate regime, the reduction in money demand can cause by the reduction in the money supply. This will cause the LM curve to move left on the graph and will create a new equilibrium point with higher exchange rate. The higher exchange rate will reduce the trade balance as the aggregate income decreases.
Fixed exchange rate regime creates a pressure on the exchange rate driving forces of the government to sell out the dollars in order to buy some other foreign currencies. This helps the government in increasing the money supply which will bring the LM to its original position of equilibrium where the trade balance is unchanged.
Answer: Impossible trinity in the economic spectrum is theory that states that it is impossible for a country’s economy that all the following three exists at the same time:
An independent Monetary policy,
A fixed exchange rate, and
Free capital movement i.e. absence of capital control.
Therefore, a nation must strive for only one side of corner rather than to go for all sides at once.
Problems and application:
Fall in consumers’ confidence will shift the IS and Planned expenditure to the left side of graph under the conditions of floating exchange rate. This fall in IS will be absorbed by the increase in net exports and the aggregate output will not be changed. A fall in IS curve will bring a fall in money supply which will shift the LM curve inwards to the left. With that movement in LM curve, the exchange rate will not be changed and there will be no change in net exports.
With the buying of more foreign cars the rate of imports will increase and it will move the net exports curve and IS curve to the left. While the economy in floating exchange rate, its aggregate output will not change but on the other hand its net exports will fall. Economy running under fixed exchange rate, the aggregate output and net exports will fall at the same time with the fall in IS curve. This fall in IS curve will make a leftward movement of LM curve.
The movement of LM curve to the right will reduce the demand for money. This will leads to an increase in the equilibrium level of output. Under the floating exchange rate, the exchange rate will be lowered and the output will increase which will leads to increase in net exports and income. But in fixed exchange rate, the LM curve will return to its original position therefore there will be no change in aggregate income.
Policy makers are mainly concerned the reasonable exchange rate so that the Canadian imports are encouraged so that the total level of exports is more than the imports. In short run where prices are close to each other, real exchange rate is affected by any shift in the nominal exchange rate. But, in long run the prices tend to adjust over time and the PPP is likely to be hold. When the local Canadian exchange rate will appreciate, the buyers of foreign country will buy the products from other countries in the result of Canadian products will become expensive. Therefore the main focus of the Canadian government is to make the Canadian producers sell their product abroad to maintain the positive trade of balance. As the result, the more foreign currency will come to Canada for exchange with Canadian dollars.
With the decrease in money supply and/or increase in exports, the domestic industry will be more competitive in comparison of foreign counterpart. This competitiveness will leads to the increase in net exports and the income will remain the same.
In a small open economy following the floating exchange rate, a tax cut will shift the LM curve to the left and the IS curve will move to right. If the similar economy follows the fixed exchange rate, then the LM curve will move to the right for keeping the same exchange rate and the IS curve will also move to the right. The disposable income will increase in the result of tax cut. If the interest rate is remains constant, then the M/P will increase. The increase in money supply will reduce the exchange rate while the interest rate is constant.
For Alberta, the use of floating exchange rate is convenient to be used with British Columbia and Ontario. While making the decisions related to exchange rate, it must be known that each province has acted differently to the economic downfall by the establishing unique monetary and fiscal policies. For example, if Ontario is using the expansionary monetary policy then the Alberta can be in benefit if it uses low exchange rates for Ontario.
For fixing the ripple effects of recession and for creating jobs, both the monetary and fiscal policies are used. A tax cut will help the economy in creating more jobs by putting more money in the pockets of businessmen and consumers. Discretionary spending also helps in creating the jobs by direct hiring, by sending contracts to hire workers, increase the subsidies of the business so that they do not lay off the workers. Expansionary fiscal policies will be used to reproduce the investment opportunities by decreasing the interest rate which lead towards creating new jobs.
For any reason, if the Albertans are unable to buy the wine of Ontario then they have to look for other sources for importing the wine. This will impact the balance of trade of the economy in short run. In long run, the balance of trade will be normal as the importers will change their import source.