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ECONOMICS 301

Running Head: ECONOMICS 301

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1. How are presidential election outcomes related to the performance of the economy?

The performance of the economy relies heavily on the kind of leadership to be instituted in the country. This is because it’s the authorities who will dictate the regulatory environment and the provision of opportunities mostly in the private sector. According to political scientists who considered the US scenario depicted that if Mitt Romney was to win the presidential ticket, unemployment was to drop by 0.3% as compared to Obama. This is mainly because of the kind of leadership the two individual’s exhibit. Thus presidential elections denote economic performance in a country. Above all expectations that arise from the citizens lead to higher interest rates in the country which in turn lead to motivation of investment plans among investors and other stakeholders hence harnessing the economy.

2. Discuss the difference between Microeconomics and Macroeconomics.

Microeconomics is the study of particular markets, and segments of the economy. It looks at issues such as consumer behavior, individual labor markets, and the theory of firms. On the other hand Macroeconomics is the study of the whole economy. It looks at ‘aggregate’ variables, such as aggregate demand, national output and inflation.

3. Use the concepts of gross and net investment to distinguish between an economy that has a rising stock of capital and one that has a falling stock of capital. “In 1933 net private domestic investment was minus $6 billion. This means that in that particular year the economy produced no capital goods at all.” Do you agree? Why or why not? Explain: “Though net investment can be positive, negative, or zero, it is quite impossible for gross investment to be less than zero.”

When gross investment exceeds depreciation, net investment is positive and production capacity expands; the economy ends the year with more physical capital than it started with. When gross investment equals depreciation, net investment is zero and production capacity is said to be static; the economy ends the year with the same amount of physical capital. When depreciation exceeds gross investment, net investment is negative and production capacity declines; the economy ends the year with less physical capital. The first statement is wrong. Just because net investment was a minus $6 billion in 1993 does not mean the economy produced no new capital goods in that year. It simply means depreciation exceeded gross investment by $6 billion. So the economy ended the year with $6 billion less capital.

The second statement is correct. If only one $20 spade is bought by a construction firm in the entire economy in a year and no other physical capital is bought, then gross investment is $20—a positive amount. This is true even if net investment is highly negative because depreciation is well above $20. If not even this $20 spade has been bought, then gross investment would have been zero. But gross investment can never be less than zero.

4. What are the major factors that have affected U.S. household consumption since the recession in 2001?

· Household consumption has been flat or diminished. Income and employment have been stagnant or declining. Economic trends indicate minimal growth.

· Wars in Iraq and Afghanistan are a drain on human and material resources.

· Energy producers have increased the percentage of household budgets for utilities and fuel.

5. Briefly explain how the following would shift the IS function to the right.

a) A change to lump-sum taxation (Specify whether increase or decrease is needed to shift IS curve to the right.

b) A change to government spending (Specify whether increase or decrease is needed to shift IS curve to the right.

a. A decrease in lump sum tax causes the IS curve to shift to the right, this is because the consumer will be willing to move to a higher indifference curve that offers more satisfaction in line with the budget constraint.

b. A higher Government spending will spur the economy and shift the IS curve out. An increase in government spending leads to → increase in planned injections → negative unplanned investment (stocks go down) → increase in output → increase in transactions demand for money → decrease in speculative demand for money → increase in interest rate → decrease in investment → some crowding out which leads to the increase in output being more modest than it would otherwise be.

6. Explain briefly how a change to the following MS, MD, or P (ceteris paribus) would shift the LM function to the right. Include in your discussion whether the variable would have to increase or decrease to cause the rightward LM shift. Discuss which of these the FED exercises control over.

a. If the money supply increases, ceteris paribus, the interest rate is lower at each level of Y, or in other words, the LM curve shifts right. That is because at any given level of output Y, more money means a lower interest rate.

b. A decrease in money demand will shift the LM curve to the right this is due to the lower interest rates at output Y.

c. The LM curve shifts right when prices fall, this is because when prices are low they increase real money balances which actually shift the LM curve to the right.

When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve to the right. The result is that the intersection of the supply and demand curves and occurs at a lower price and a higher equilibrium interest rate, and the interest rate rises. With the liquidity preference framework, the decrease in the money supply shifts the money supply curve to the left, and the equilibrium interest rate rises. Hence the money supply curve is crucial in FED application.

7. By how much will GDP change if firms increase their investment by $8 billion and the MPC is .80? If the MPC is .67?

GDP will increase $40 billion if the MPC is .80. An MPC of .80 will produce a multiplier of 5. The multiplier times the $8 billion change in spending will change GDP by $40 billion. Change in GDP = Change in Investment x (1/ (1 - MPC)) $40 billion = $8 billion x (1/ (1 - .8)). GDP will increase by approximately $24 billion when the MPC is .67

8. Suppose that private sector spending is highly sensitive to a change in interest rate. Compare the effectiveness of monetary and fiscal policy in terms of rising and lowering real GDP

If private sector spending is highly sensitive to a change in the interest rate, then the IS curve is relatively flat. The main effect of a fiscal expansion will be a higher interest rate that reduces private sector spending almost as much as the fiscal expansion increases autonomous spending. As a result, the fiscal expansion causes very little increase in output. In the case of a fiscal contraction, the effect of the lower interest rate on private sector spending almost offsets the effect of the fiscal contraction. As a result, fiscal policy is unable to have much of an impact on output.

On the other hand, monetary policy is quite capable of changing output if private sector spending is highly sensitive to a change in the interest rate. A policy of tight money will result in a sharp contraction of private sector spending as the interest rate rises. Easy money will provide a large stimulus to private sector spending as the interest rate falls.

9. Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve this same increase in aggregate demand? Why the difference? Determine one possible combination of government spending increases and tax decreases that would accomplish this same goal.

In this problem, the multiplier is 1/.2 or 5 so, the required increase in government spending = $5 billion. For the tax cut question, initial spending of $5 billion is still required, but only .8 (= MPC) of a tax cut will be spent. So .8 x tax cut = $5 billion or tax cut = $6.25 billion. Part of the tax reduction ($1.25 billion) is saved, not spent. One combination: a $1 billion increase in government spending and a $5 billion tax cut.

10. What are government’s fiscal policy options for ending severe demand-pull inflation? Use the aggregate demand-aggregate supply model to show the impact of these policies on the price level. Which of these fiscal policy options do you think might be favored by a person who wants to preserve the size of government? A person who thinks the public sector is too large?

Options are to reduce government spending, increase taxes, or some combination of both. If the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. A person wanting to preserve the size of government might favor a tax hike and would want to preserve government spending programs. Someone who thinks that the public sector is too large might favor cuts in government spending since this would reduce the size of government. The ratchet effect implies that prices are rigid downward.

11. Explain why relatively flat as opposite relatively steep labor demand curves are more consistent with the empirical observation that there are relatively minor changes in the real wage rate over the course of the business cycle.

If the short-run aggregate supply curve is relatively flat, then a change in aggregate demand results mainly in a change in output and only a small change in the price level, given the nominal wage rate. Therefore, there is little change in the real wage rate, given the nominal wage rate. Furthermore, if the demand for labor curve is relatively flat, it will not take much of a change in the nominal wage rate relative to the price level to return the real wage to the equilibrium real wage rate. Therefore, the price level changes that result from the shifts of the SAS due to changes in the nominal wage should occur at a rate that is similar to the rate of change in the nominal wage.

If, on the other hand, the SAS curve is relatively steep, then a change in aggregate demand shows up mainly as a change in the price level, resulting in a large change in the real wage rate, given the nominal wage rate. The same logic applied in the previous paragraph would show why there would need to be a large change in the nominal wage rate relative to the price level necessary to restore that labor market to equilibrium if the labor demand curve is relatively steep. Therefore, the empirical observation that there are relatively minor changes in the real wage rate over the course of a business cycle is more consistent with relatively flat labor demand and short-run aggregate supply curves.

12. Is sustainable long-run equilibrium always reached when the AD and SAS curves intersect? Why or why not?

No. The economy is in short-run equilibrium when the AD and SAS curves intersect, but not necessarily in long-run equilibrium. It will be a sustainable long-run equilibrium only if the economy finds itself operating on both the labor demand curve and the labor supply curve. This occurs only where the labor demand and labor supply curves intersect, so there is no pressure to change. At that point the actual real wage equals the equilibrium real wage and Y = YN. At any other combination of W, P, and Y, the SAS curve will shift as expectations are adjusted.

13. If the equilibrium real wage remains constant, what happens to the nominal wage when the actual inflation rate exceeds the expected inflation rate?

When the equilibrium real wage is constant and output is at the natural rate, the nominal wage will be increasing at the same rate as the inflation rate. If output is greater than the natural rate and actual inflation exceeds expected inflation, then the actual real wage would be falling. In this case, we would expect workers to try to increase the rate of growth of nominal wages.

14. In the steady state, the government benefits from inflation.” Explain

The government is assumed to have a desired level of expenditures equal to a fraction, -y, of national income. Its revenue sources are threefold: various corporate, interest-income, and capital gains taxes; the issuance of money; and a labor-income tax. When we compare steady states attainable through different rates of inflation, the labor-income tax will be assumed to vary so as to maintain the government's budget-balance condition. Even if labor is supplied elastically, this tax will affect the real variables of the system only insofar as it changes savings and ultimately the capital stock. Since the real level of money balances is m, and the labor force is growing at rate n, which will therefore be the growth rate of output and capital in the steady state, the government can issue money at the rate of MN without causing any inflation in the price level. Inflation at rate TT produces extra revenue of TRM.

References

Flemming, J. S. (1976). Inflation. London: Oxford University Press.

Pen, J. (1965). Modern economics. Baltimore: Penguin Books.

Samuelson, P. A., & Nordhaus, W. D. (1985). Economics. New York: McGraw-Hill.