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1303AFE Economics for Decision Making 1
Written Assignment 2
VERSION B
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Instructions:
Submission deadline for the assignment is Monday 18 May 2020, 3:00pm.
- Your assignment must be typed in a word document in .doc or .docx format – no pdf or pages. Assignments submitted in any format other than word will not be marked.
- For calculation questions, you are required to display all workings.
- If you are drawing diagrams, then you must draw your diagrams by hand; then scan (or take a picture) and insert your drawings into your word document.
- The online submission point of your completed assignment can be found under ‘Assessment’ tab, Written Assignment folder, in the course website. When submitting students must also fill in the digital cover sheet provided in the folder. Failure to follow the submission requirements may result in a null mark.
In preparing for this assignment I fully expect that you have gone through the lecture slides and listened to the lecture recordings, have gone through the workshop questions, done the practice questions and have read the extra notes provided as a MINIMUM REQUIREMENT. Expect that you may have to do more research and study than this to do well in the assignment.
Question 1 on a combination of topics 6 and 9 (20 marks)
- Assume that the reserve ratio in a country is 2%.
- Use a formula to calculate the simple money multiplier, show all steps involved in the calculation. (2 marks)
- Suppose that in 2019 customers deposit $200 into their banks. Based on the simple money multiplier calculated in part (i), calculate the total amount which the money supply in the banking system will eventually increase to. Show all steps involved in the calculation. (2 marks)
- Assume the amount of funds deposited by customers in 2020 stands at $400. and the reserve ratio increases to 8%. Will the money supply in the banking system increase, decrease or stay the same from 2019 levels? If it increases or decreases, calculate by how much it will change. If it stays the same, explain why. Show all steps involved in any calculations. (6 marks)
- Inflation in the country of Hypothetica is currently 5%, above the target range of its central bank.
- What does this tell you regarding Hypothetica’s likely output gap? Illustrate it using an AS-AD diagram, and briefly explain your diagram (6 marks)
- In this situation, what is the central bank likely to do with regard to monetary policy? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (there is no need to draw a diagram, but you can if you feel it helps you explain your answer) (2 marks)
- What happens if the central bank does not intervene? Will the economy eventually return to long-run equilibrium (potential GDP)? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (there is no need to draw a diagram, but you can if you feel it helps you explain your answer). (2 marks)
Question 2 on Topic 8 (10 marks)
- The Australian government has recently announced a raft of fiscal expansionary/stimulus measures that will lead to a significant increase in the Australian government’s budget deficit. Given the material presented in this course cover the pros and cons of budget surpluses and deficits, we know that one view put forward is that ‘government budget deficits are bad. Do you agree or disagree with this statement? Briefly justify your answer. (5 marks)
- Imagine a scenario where not only has the Australian government managed to pull Australia out of recession but has actually managed to get the economy moving so well that current output (real GDP) is above potential GDP.
- What type of fiscal policy has the government used to try and get Australia to potential GDP? Draw an AD-AS diagram to illustrate this situation (including the initial situation). Explain the figure in some detail. By this, we mean do not just explain the changes in the diagram, but also state what components of the AD and AS curves are changing (if any), and in which direction. (4 marks)
- Can the existence of a fiscal multiplier help the government in terms of its commitments to reach potential GDP level of output? Provide a brief example. (1 mark)
| Subject | Economics | Pages | 10 | Style | APA |
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Answer
Economics for Decision Making
Question 1a
- Money Multiplier = 1/ Reserve Ratio
If the reserve ratio is 2%, the Money Multiplier = 1/0.02 = 50
Money Multiplier = 50
- If $200 is deposited in 2019, then the amount kept in the reserves is equivalent to $200 (0.02), while the rest $200(0.98) will be provided as loans to the economy. The $200 (0.98) will be continuously be rotated in the economy as loans for long as the country keeps its reserve ratio. The money in supply in the economy will increase to $10,000 based on the multiplier effect.
$200 * 50 = $10,000
- If the deposits increase to $400 in 2020 and the reserve ration = 8%, the multiplier effect changes to; 12.5.
The new money supply in the economy increases to: $400 * 12.5 = $5,000
The changes in the money supply from 2019 to 2020 are, therefore, a negative of 50% (5000-10,000)/10,000.
The change indicates that the higher the reserve ratio, the lower the multiplier effect, which reduces the amount in supply within the economy.
Question 1b
- Aggregate demand and Aggregate Supply Curve
The aggregate demand and aggregate supply indicated above illustrate changes based on inflationary conditions within the economy. If the graph shifts to the left below, the target inflation rate means that the total demand is low, the situation will reflect and economic recession when the output in the economy is negative (Khan Academy, 2020). Under the attached graph, the equilibrium is at point A, where the aggregate demand is initiated AD0 and intersects the long-term aggregate supply curve LRAS0 and the short-term aggregate supply curve SRAS0. At this point, the long-term equilibrium price is achieved at P0, and the actual GDP is estimated as follows;
GDP = (Potential GDP) Y0. In case of a recession where the demand is low, the equilibrium shifts to the left at point B, and the long-term aggregate demand and short-term aggregate supply are estimated as AD1 and SRAS0, respectively. At this point, a new and lower equilibrium price level is achieved P1 and, as a result, a lower gross domestic product Y1. Hence, the short-term recession in the economy is equal to the original and targeted GDP and the new GDP; (Y0 – Y1).
- The remedy for the government to control the recessionary movement would be to increase money supply into the economy through some of the following monetary expansionary tools; First, the government through its central bank or federal reserve can initiate an open market purchase of government treasury bills and bonds to have more money into the economy. Second, the government can lower the reserve ratio and have a higher circulation of money into the economy, creating more demand for investments, solving unemployment, and creating room for the production of local products. Finally, the central bank could lower the discount rate to encourage borrowing for an investment of low to large businesses (Principles of Economics , 2020).
- In case the government chooses not to intervene, economic conditions find a new equilibrium at their own peril. For example, a lower price level will result in lower prices of inputs, which in the long run, increase production output in the economy, and a new equilibrium is achieved.
Question 2
A budget deficit is not suitable for the Australian government. Budget deficit simply means that the government expenses or payments exceed the revenues collected in its balance of payment account. However, we cannot say that budget deficits are always bad for the economy due to the following reasons. First, budget deficits are a stimulator for economic growth. By spending more on infrastructure projects such as building roads, employment opportunities are created, there is also a higher rate of investments, which in the long-run, results in increased income. A country that spends more on the greater good has higher economic growth and GDP (Daniel, 2015). Second, budget deficits provide protection. Many governments spend more on defense on their territories, which provides a safe haven for investment opportunities since there are lower external attacks from foreign nations. A government has a responsibility to protect its citizens, and in case of natural calamities such as floods and hurricanes, budget deficits are necessary. Third, budget deficits would be essential in cases of economic recession, and a state is forced to spend more for the revival of its economy. However, prolonged deficits could ruin the Australian economy in the following ways; First, there will be an increase in the national debt as a percent of the national GDP. The country is exposed to hyperinflation, lower currency value, and auction of government assets due to high debt levels. Second, it raises the opportunity cost of debt payments. A higher debt level for the Australian economy will see most of its national income channeled to the repayment of the national debt. Third, the Australian government experiences a crowding effect where too much borrowing from the private sector reduces the money that is available to spend. Fourth, budget deficits result in higher inflation levels, which raises the price level of consumable goods, which is unsustainable in the future. Fifth, there is too much dependence on foreign aid from the international monetary fund, world bank, and from foreign countries. Too much reliance affects decisions on fiscal and monetary policies (Christina D & David H, 2010). Overall, the most vital areas are to have better budgetary planning structures, which minimizes budget deficits and economic recession.
Question 4b
- AD-AS Diagram on Real GDP and Potential GDP
Long term and short-term changes in the gross domestic product can be illustrated by the aggregate demand and the aggregate supply model. In the future economic productivity shifts the aggregate supply to the right. The vertical line indicates the potential GDP or full employment of the gross domestic product. The AD/AS diagram indicated above shows an equilibrium level of the real GDP below the potential GDP. The Equilibrium point E0 indicates a recession. However, a resurgent growth in the economy from a recessionary condition would shift the equilibrium point to E1 closer to the potential GDP. The shift or recessionary economic measures undertaken by the Australian governments are expshiftd by the difference in Y1 – Y0. Some of the positive economic measures that would force the shift, including the cutting of government expenditures to stimulate growth in the economy. Most governments prefer cutting recurrent spending on allowances and substantial compensation packages for their employees (Ranjay, Nitin, & Franz, 2010). The Australian government could also consider the devaluation of its currency to make its exports and tourism activities more attractive in the international market and hence improve its balance of payments towards a surplus. The Australian government could also consider economic stimulus through cheaper loans that encourage investments within the economy, employ a large number of people, and encouraging consumption of locally made goods.
- Yes, the existence of a fiscal multiplier can help the government reach its potential gross domestic product. The fiscal multiplier theory argues that as long as the state’s monetary propensity to consume remains greater than zero, there is greater government spending, which leads to a higher national income. (Christina D & David H, 2010) Hence, a government can reach its potential GDP as there is a higher consumption and spending level that stimulates growth and, thus, a higher income in the future.
References
Christina D, R., & David H, H. (2010). The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks. American Economic Review , 763-801.
Daniel, M. (2015). The Impact of Government Spending on Economic Growth. ROE Institute for Economic Policy Studies , 1-18.
Khan Academy. (2020). How the AD/AS model incorporates growth, unemployment, and inflation. Retrieved from Khan Academy : https://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/macro-changes-in-the-ad-as-model-in-the-short-run/a/how-the-ad-as-model-incorporates-growth-unemployment-and-inflation-cnx
Principles of Economics . (2020). Using Fiscal Policy to Fight Recession, Unemployment, and Inflation . Retrieved from Principles of Economics : https://opentextbc.ca/principlesofeconomics/chapter/30-4-using-fiscal-policy-to-fight-recession-unemployment-and-inflation/
Ranjay , G., Nitin, N., & Franz, W. (2010). Roaring out of Recession. Retrieved from Havard Business Review: https://hbr.org/2010/03/roaring-out-of-recession
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