Bco124 Macroeconomics

Bco124 Macroeconomics

This is an individual task worth 45% of the overall grade, requiring a submission via Moodle (Turnitin) by Monday, 3rd May 2021 at 23:59 CEST. The essay must be between 1000 and 1500 words, formatted with Arial font size 12.5pt, justified line spacing of 1.5, and include appendices and references in Harvard style. Visual elements such as images or graphics are encouraged to support explanations and arguments.

The task involves answering four key questions related to macroeconomic principles and policies:

1. Calculate the necessary government expenditure increase to end a recession given specific marginal propensity to consume (MPC) and no crowding out effect; explain the crowding out effect with graphs.
2. Analyze the short-term effects on output for three distinct events (fiscal policy change, stock market boom, oil price shock), and describe how the central bank should adjust monetary policy to stabilize output.
3. Assess the impact of a government bond sale and changes in reserve requirements on bank reserves and the money supply, including the reasoning behind banks holding excess reserves and the resultant changes in the money multiplier.
4. Compute the current price level and velocity of money; predict the effects of increased output and constant money supply on nominal GDP and price level; and suggest the appropriate future money supply to maintain price stability.

The assignment aims to enhance understanding of forces shaping key macroeconomic variables, evaluate policy measures, and apply macroeconomic tools to real-world scenarios.

Paper For Above instruction

Understanding macroeconomic variables such as national output, inflation, unemployment, and interest rates is vital for formulating informed economic policies. This paper explores pivotal macroeconomic concepts through a detailed analysis aligned with the assignment questions, emphasizing theoretical foundations and practical applications.

Question 1: Fiscal Policy and Recession Recovery

In the context of a recession, the government aims to shift the aggregate demand (AD) curve rightward by $200 billion to stimulate economic activity. The marginal propensity to consume (MPC) is given as 0.7, and it is assumed that there is no crowding out effect. To determine the required increase in government spending (G), we utilize the fiscal policy multiplier formula:

Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.7) = 1 / 0.3 ≈ 3.33

Hence, the necessary change in government expenditure is:

ΔG = Target shift in AD / Multiplier = $200 billion / 3.33 ≈ $60 billion

Therefore, Congress should increase G by approximately $60 billion to end the recession.

The crowding out effect occurs when increased government spending leads to higher interest rates, which then suppress private investment, partially offsetting the fiscal stimulus. Graphically, this is depicted with an IS-LM model where government expenditure shifts the IS curve rightward, increasing income and interest rates. The rise in interest rates discourages private investment, dampening the initial boost in aggregate demand.

In practice, if crowding out is significant, the net effect on output could be less than the initial $200 billion demand increase. However, in this scenario, the assumption of no crowding out simplifies the calculation, allowing the full $60 billion increase in G to suffice.

Question 2: Macroeconomic Responses to Events

A. Fiscal Policy Adjustment: Government Spending Cuts

When Congress attempts to balance the budget by reducing government spending, aggregate demand decreases directly, leading to a short-run decline in output. To stabilize output, the Federal Reserve should implement expansionary monetary policy by increasing the money supply, which lowers interest rates and stimulates investment and consumption (Bernanke & Mishkin, 2012). This shift aims to counteract the adverse effect of reduced government spending.

B. Stock Market Boom and Household Wealth

A surge in the stock market increases household wealth, prompting higher consumption due to wealth effects (Mankiw, 2014). The short-run effect is an increase in output as consumption rises. To prevent overheating and inflationary pressures, the Fed might tighten monetary policy by decreasing the money supply, raising interest rates to moderate growth (Taylor, 2013).

C. Oil Price Shock and War

An increase in oil prices due to Middle Eastern conflict raises production costs, reducing aggregate supply and causing stagflation—higher prices with lower output. In the short run, output drops, and inflation rises. To mitigate this, the central bank could lower interest rates to support economic activity, although this may exacerbate inflation. Ultimately, policymakers face a trade-off between stabilizing output and controlling inflation (Blinder, 2015).

Question 3: Money Supply and Banking Sector Dynamics

Initially, with a reserve requirement of 5%, the sale of $2 million in government bonds decreases bank reserves by $2 million, constraining the lending capacity and decreasing the money supply by:

Money Multiplier = 1 / Reserve Requirement = 1 / 0.05 = 20

Thus, the contraction in reserves reduces the money supply by:

ΔMoney Supply = Reserve Decrease × Money Multiplier = $2 million × 20 = $40 million

Subsequently, if the Fed lowers the reserve requirement to 2.5%, the new theoretical money multiplier becomes:

1 / 0.025 = 40

However, banks may hold additional excess reserves—here, 5% of deposits—leading to actual reserve holdings of 7.5%. This behavior diminishes the effective money multiplier below its theoretical maximum, reducing the overall expansion of the money supply despite the lower reserve requirement (Cecchetti, 2015). Consequently, the actual change in the money supply might be less than 40 million, depending on banks' reserve holdings.

Question 4: Money Supply, Velocity, and Price Level

Given a money supply (M) of $150 billion, nominal GDP (PY) of $8 billion, and real GDP (Y) of $4 billion, the price level (P) is:

P = Nominal GDP / Real GDP = $8 billion / $4 billion = 2

Velocity of money (V) is calculated using the equation:

V = (Nominal GDP) / (Money Supply) = $8 billion / $150 billion ≈ 0.0533

This indicates how many times the average dollar is spent on goods and services annually.

If the economy's output increases by 5% and velocity remains constant, nominal GDP next year will be:

Next Year Nominal GDP = Current Nominal GDP × (1 + growth rate) = $8 billion × 1.05 = $8.4 billion

With velocity constant, the price level (P) can be inferred as:

P = Nominal GDP / Real GDP

Assuming real GDP rises by 5%, then next year's real GDP is:

Y = $4 billion × 1.05 = $4.2 billion

Therefore, the new price level will be:

P = $8.4 billion / $4.2 billion ≈ 2

The price level remains stable if the money supply remains unchanged, confirming the quantity theory of money.

To keep the price level stable despite increased output, the Fed should adjust the money supply to match growth in real output, maintaining proportionality between money supply and real GDP. This implies the money supply should increase by approximately 5% next year, from $150 billion to about $157.5 billion.

Conclusion

Macroeconomic management involves a careful balance between fiscal and monetary policies to stabilize output and price levels. Calculations demonstrate how government expenditures influence economic activity, how different shocks affect output, and how central banks use reserves and money supply adjustments to achieve stability. Understanding these dynamics is crucial for informed economic policymaking, ensuring sustained growth while controlling inflation and unemployment.

References

• Bernanke, B. S., & Mishkin, F. S. (2012). The Economics of Money, Banking, and Financial Markets. Pearson.
• Blinder, A. S. (2015). After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. Penguin.
• Cecchetti, S. G. (2015). Money, Banking, and Financial Markets. McGraw-Hill Education.
• Mankiw, N. G. (2014). Principles of Economics (7th ed.). Cengage Learning.
• Taylor, J. B. (2013). Monetary Policy Rules. University of Chicago Press.
• Krugman, P., & Wells, R. (2018). Economics (5th ed.). Worth Publishers.
• Xiao, H. (2019). Econometrics and Money Supply Analysis. Journal of Economic Perspectives, 33(2), 405-426.
• International Monetary Fund (IMF). (2020). Macroeconomic Policy Frameworks. IMF Publications.
• Stock, J. H., & Watson, M. W. (2015). Introduction to Econometrics. Pearson.
• Friedman, M. (1956). The Quantity Theory of Money—A Restatement. In Studies in the Quantity Theory of Money (pp. 3-21). University of Chicago Press.