Starting from a position of equilibrium, use the IS/LM model to
show the impact of a decrease in government spending. How can the monetary
authorities offset the impact of this policy? What happens to investment? Will
the Monetary authorities be able to pursue this policy if they have reached the
zero lower-bound of the interest rate? What else can they do in this case? Explain
is Fiscal Policy? Fiscal policy is when the central government adjusts it’s
spending patterns to monitor and influence the nations economy. A way in which
they do this is by manipulating taxes (increasing or decreasing), changing the
amount of spending they do as a government (G), etc.
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decrease in the Government Spending (G) will normally result in the IS curve
shifting to the left. When this happens the interest rate will fall and so will
output as it moves along the LM curve. As this happens, the transactional
demand of money will decrease and assuming a steady money supply, interest
rates will fall.
will happen to investment? Investment will increase as interest rates fall as
investment is sensitive to the interest rate. However, as interest rates
decrease so does the output and this will offset the effect that happened on
the interest rates.
Comment on this statement: “To stabilise the level of income, the
government should increase its spending whenever the interest rate falls and
decrease its spending whenever the interest rate rises.”
fully answer this question, we need to see the factors that are causing the
interest rate to change. Firstly, it could be coming from the demand side of
the economy which would result in the IS curve shifting or it could be coming
from 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 would
shift the IS curve to the right causing the interest rates to increase and
causing income to decrease and vice versa for the government to decrease it’s
spending. But we are only seeing what the government should do when the
interest rate falls or rise, we need to see why it fluctuates.
a reason for why the interest rate falls or rises is when the Central Bank
undergo a Monetary Policy. This is when they either increase or decrease the
money in supply in the economy. When the money supply increases, the interest
rate in the economy decreases. When there is less money in the economy, the
interest rate will increase.
all this Monetary Policy affects the LM curve, causing it to shift either right
or left. The government by reducing or increasing their spending is merely
offsetting the affect that the monetary policy has cause to the equilibrium.
They will increase or decrease until a new equilibrium is reached in the
Is the income
multiplier with respect to government spending larger or smaller in the model
incorporating the international sector than it is in the same model without an
international sector? Explain. Assume (i) a fixed exchange rate system and (ii)
a flexible exchange rate system. In both cases, assume a BP curve is flatter
than the LM curve.
Let’s assume an increase in government
spending. This increase will shift our IS curve outwards (to the right). This
shift will not result in a balance of payments surplus which has been pointed
out at point B. Assuming a Closed economy model. Assuming also a fixed exchange
rate, the government (Central Bank) will increase their money supply in order
to balance out the payments. This increase in money supply will cause the LM
curve to shift to LM1. The new equilibrium is seen at C. Impact on the open
economy is greater as seen on the graph as opposed to the impact on that of a
closed economy due to the fact that C causes more of an impact than that of B.
Under a Floating exchange rate when
there is the same conditions as above where government spending has increase
and there is now a surplus in BP, under floating we do not go to the Central
bank to control money supply to balance our payments. This surplus will lead to
currency appreciation. This appreciation will shift the BP upwards and the IS
curve to the left (decrease in exports) until they meet at point C. Impact
under floating exchange rate is greater in a closed economy than on an open
4. Suppose the economy is at potential output, but with a balance of
payments deficit; show that under a fixed exchange rate, the B of P deficit
leads to unemployment, while under a flexible rate, the B of P deficit is
likely to lead to inflation. Assume that
the BP curve is steeper than the LM curve
Under a fixed exchange rate, as seen in
the graph below, the Balance of payments deficit leads to an increase in
unemployment. Why? Market equilibrium is seen at Point A, this point is clearly
under the BP line meaning that there is a balance of payments deficit. Under a
fixed exchange rate system where the Central Bank controls foreign currency,
they will decrease the money supply in circulation to reduce this deficit. This
reduction in Money supply will cause the LM curve to shift to the new position
LM1. There is a new equilibrium and a balance of payments at point B, however
point B has a lower output and this means that unemployment will be higher at
point B than it is at point A.
Under flexible exchange rates system
instead of a reduction of the money supply, a depreciation will occur. This
depreciation causes the BP and the IS curves to shift to the right until the
cross with the LM curve. This is the new equilibrium. What we can say about
this 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 the effects
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 the natural level of
competition laws were to be less enforced and stringent the effect that is
would have would be a somewhat negative one for the economy. Let’s assume that
the laws for wages were to be relaxed, then firms can increase prices as they
feel. This in turn would cause the Price setting Line to fall and that would
lead to a fall in the real wage which in turn leads to an increase in
unemployment rate which increase the Natural rate of unemployment as shown in
the graph below.
rate of output (which is associated with the natural rate of employment) is
such that, at the associated rate of employment the real wage chosen in WS is
equal to the real wage implied by PS. This means that less enforcement of
competition laws will have an effect on the natural level of output. The less
people working (more unemployed) the less output will be produced and the less
wage given to each worker means they are worth less and will have no motivation
to work and produce less leading to inefficiencies and a drop-in output per
6. Explain why when evaluating the
implementation of an expansionary monetary policy it is often argued that this
policy is only effective in the short run and that it is ultimately neutral in
the medium run.
is Monetary policy? Monetary policy is when the Central Bank or whoever
controls the supply of money in a country changes or determines the size and
the growth rate of the money supply in circulation in the economy. This is
denoted by the LM curve. Generally there are two types, Contractionary where
money output and supply decreases to control inflation or, in the case of this
question Expansionary where they increase the amount of money in circulation to
lower interest rates and lower unemployment.
expansion causes the LM curve to shift down and for the Aggregate demand curve
to shift to the right. The interest rate will then decrease and thus causing
the output to increase due to the increase in investments due to less demand
for transactional use of money.
the short run an expansionary monetary policy decreases the interest rates,
increases the output level (to above the natural rate) and increases the price
the medium run there is no change to the interest rate as it rises back to it’s
natural level, no change in the output and the price will be higher than at the
the relationship between unemployment and inflation as depicted in the Phillips
curve. Does this relationship also hold in the long run?
the relationship between is a negative relationship. As employees expect prices
to rise, they want more money to adjust for the inflation. And as prices get
higher, people will need to find a job to sustain themselves with the prices,
therefore as inflation increases, unemployment decreases (in the short-run) as
is shown in the Phillips-Curve.
example is that low unemployment leads to higher nominal wages, which will
drive the firm to increase their prices. The increase in prices causes
inflation to rise in the economy.
Does this hold? No. Over time the original relationship between
inflation and unemployment as depicted in the Philips curve changes due to
changes in the way workers form their inflationary expectations.
Discuss the implications of decreasing returns to capital within the context of
long run economic growth. What is the steady state? What is Okun’s law?
What is Growth? Economic growth is normally measured as a %
increase in GDP (Gross domestic product) during one year. Growth can come in
two recognizable forms. The first is that an economy can grow extensively by
making use of more resources (labour, capital). The second is intensively which
means that it uses the same amount of resources but in a more efficient way
with the help of technology for example.
decreasing returns to capital will lead to an increase in capital per worker
which will lead to smaller and smaller increases in output as shown in the
In the long run of economic growth, the decreases in returns
to capital will cause K, the capital per worker to shift along the production
line ‘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 every
time due to the economy reaching it’s ‘steady-state’.
A steady-state economy is an economy
consisting of constant capital and a constant population size (labour). In
effect, such an economy does not grow but it stays in a stable state as shown
in the graph below.
is Okun’s Law? In simple terms, it is the change in unemployment with regards
to change in output growth. Okun had found that the difference in potential GDP
and real GDP growth and unemployment interact over time.
In the graph above representing Okun’s Law, we can see this
relationship. As we can see there is a negative relationship between
unemployment and Output growth (which actually is a positive thing). As
unemployment shrinks, the output growth of the economy can be seen to grow.
This is what Okun’s law sets out to explain to us.
Graphically illustrate and explain the effects of technological change on the
Solow growth model. In your graph,
clearly label all curves and equilibria.
What is the Solow Growth Model? The Solow growth model is an
economic model designed in use when answering questions related to the long run
economic growth of an economy. The Solow Model is set or based on the framework
of neoclassical economics. The model attempts at explaining long-run economic
growth by looking at certain criteria in the economy. Such criteria are;
Capital accumulation, labour (population growth) and the increases in
efficiency of productivity (technological advances).
states that a sustained rise in capital investment in the market increases the
growth rate at which the economy grows only for a temporary amount of time due
to the ratio of capital to labor increasing but then marginal products of extra
capital will decline. This is when the economy goes back on the ‘long-term
growth path’ as stated by the model.
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 capital
in the economy have found a rate at which they all grow at the same rate
therefore output per worker and capital per worker are constant in this path.
technological effects on the Solow Growth Model. Technological advances are
considered to be labor improving and increasing the productivity of labor for a
given level of capital. Let us suppose and improvement in technology, in theory
quality of capital will increase due to improvements in technology and the
workers who are in contact with the capital are using the capital more
efficiently and will effectively be increasing their output. Therefore, the
output per worker with a technological advancement has increased.
example, 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% to
ensure that it’s workers are working in an efficient manner. If the new
technology is not embraced, then the new improvements will yield no gains in
output per worker at that particular firm.
introduce technology to the model, the newly introduced technology creates an
increase in growth in productivity due to the new efficiencies it brings along
with it. New technology can be said to be exogenous when it is introduced to
productivity, this means that the technology doesn’t need to be altered or
pushed to become an efficient addition.
The Diagram of the Solow model changes when new technology is
added. Since new technology has been introduced to the economy it will now
begin to produce more at a growing rate. The output of the economy depends on
the technology, the investment rate, and the population growth rate. If these
rates consistently grow, the economy will reach its steady state.
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