Econ 1103 Assignment 5 Due November 18th - In Aggregate Dema

Econ1103 Assignment 5 Due November 18th 1 In An Aggregate Demands

Consider the following assignment questions related to macroeconomic frameworks, specifically focusing on aggregate demand and supply, monetary policy, fiscal policy, and economic shocks:

1. In an aggregate demand/supply sticky-price framework, imagine that a poor country, starting from long-run equilibrium, is suddenly the recipient of some large amount of foreign capital and technology as a gift. If the central bank’s goal is price stability and output equal to potential output, what should the central bank do?
2. Again in the sticky-price AD-AS framework, discuss the impact of a change in government regulations that forces banks to pay a significantly higher interest rate on checking accounts.
3. Consider an economy where aggregate planned expenditure, PE, can be written as PE = c(1 − t)Y + Ī + Ḡ + X̄ − mY. That is, expenditure consists of consumption out of disposable income, investment, government spending, exports, and imports. What will be the government spending multiplier in this economy?
4. What factor(s) influence the slope of the IS curve?
5. What factor(s) influence the slope of the LM curve?
6. Some economists attribute the US recession to the collapse of the US housing market. Is building houses considered consumption expenditure or investment expenditure? Diagram and discuss the short-run and long-run effects (i.e., after the price can start adjusting) of a sharp decrease in housing construction activity.
7. In question 6, if the central bank’s goal is to maintain output at the long-run aggregate supply level and to keep prices stable, can they do anything following the housing crash? If so, what? Is it possible for the central bank to run into a zero-lower-bound problem?

Paper For Above instruction

Understanding macroeconomic responses to shocks within the framework of aggregate demand (AD) and aggregate supply (AS), along with the roles of monetary and fiscal policies, is essential for analyzing economic stability and growth. This essay explores key questions related to these themes, analyzing monetary policy responses to external capital inflows, the effects of regulatory changes, the determinants of the IS and LM curve slopes, the classification of housing construction in national accounts, and policy options following a significant housing market collapse.

1. Response of Central Bank to Foreign Capital and Technology Gift

Imagine a poor country beginning from a long-run equilibrium point suddenly receiving substantial foreign capital and technological advances. In the context of a sticky-price AD-AS framework, such an influx of foreign capital would typically lead to an appreciation of the domestic currency and potential shifts in aggregate demand. The central bank, prioritizing price stability and output at potential, should ideally pursue an active monetary policy stance. To counteract upward pressure on prices resulting from increased capital inflows and the resulting currency appreciation, the central bank should consider tightening monetary policy by raising interest rates. This action would help prevent inflationary pressures and stabilize prices.

Furthermore, the central bank might also intervene in foreign exchange markets to prevent excessive currency appreciation, thereby supporting export competitiveness. Maintaining stable output at potential levels requires balancing the external inflow's stimulating effects while preventing overheating.

2. Impact of Higher Interest Rate Regulations on Banks

Introducing regulations that force banks to pay higher interest on checking accounts affects the banking sector's cost structure. Within the sticky-price AD-AS framework, higher interest payments decrease banks’ profitability and could lead to increased lending rates to consumers and businesses. This scenario effectively shifts the aggregate demand curve inward, especially if higher borrowing costs dampen consumption and investment.

The increased interest expense makes holding deposits less attractive and may also lead to reduced liquidity in the banking system. From the supply side, banks might pass these costs to borrowers, leading to higher borrowing costs and reduced borrowing, further slowing economic activity. Over the short-term, the economy may experience a slowdown in consumption and investment, whereas in the long-term, persistent higher interest rates could suppress growth and potentially lower output below its potential.

3. Government Spending Multiplier in the Given Model

The aggregate planned expenditure is given by PE = c(1 − t)Y + Ī + Ḡ + X̄ − mY. Rearranged, it resembles the Keynesian Consumption function with taxes and imports included. The multiplier effect on output from a change in government spending (G) can be derived by examining the marginal propensity to spend domestically, which includes the marginal consumption out of disposable income and marginal imports.

The spending multiplier (k) in this context is:

k = 1 / (1 − c(1 − t) + m)

This indicates that the multiplier depends inversely on the marginal propensity to import (m) and the marginal consumption out of disposable income (c(1 − t)). The higher the marginal propensity to consume domestically and lower the marginal propensity to import, the larger the multiplier effect of government spending.

4. Factors Influencing the Slope of the IS Curve

The IS curve depicts equilibrium in the goods market, primarily influenced by the relationship between interest rates and output. Factors that influence its slope include:

• Marginal propensity to consume: A higher propensity increases the sensitivity of output to interest rate changes, steepening the IS curve.
• Sensitivity of investment to interest rates: Greater sensitivity causes larger changes in investment when interest rates shift, affecting the slope.
• Fiscal policy parameters: Larger fiscal multipliers can affect the position but also influence the shape of the IS curve.
• External trade openness: An economy more open to trade, with higher import propensity, tends to have a flatter IS curve due to dependence on foreign markets.

5. Factors Influencing the Slope of the LM Curve

The LM curve represents money market equilibrium. Its slope is influenced by:

• Money demand elasticity: More sensitive money demand to interest rates leads to a flatter LM curve.
• Money supply stability: Changes in monetary policy that alter the money supply shift the LM curve but do not directly affect its slope.
• Prices and technology: Increased price levels or technological improvements in payments may alter transaction needs, affecting the slope.
• Preference for liquidity: A higher demand for liquidity, especially at low interest rates, tends to make the LM curve steeper.

6. Housing Market Collapse: Classification and Effects

Building houses is classified as investment expenditure because new residential constructions add to the capital stock, unlike consumption expenditure, which involves the use of existing goods for immediate satisfaction. The collapse of housing construction significantly affects the economy. Short-term, it reduces aggregate demand because investment declines, leading to lower output and employment. The decrease shifts the AD curve inward, causing a recessionary gap. Price levels may initially remain sticky, but over the long run, deflationary pressures may emerge due to excess capacity.

In the long run, the reduction in housing stock growth diminishes potential output. It also negatively impacts related sectors such as construction, real estate, and financial services, exacerbating the downturn.

7. Policy Response and Zero Lower Bound During Housing Market Collapse

If the central bank aims to stabilize output at the long-run level and maintain price stability after the housing crash, monetary policy can be used to offset the decline in demand by lowering interest rates. Lowering the policy rate stimulates investment and consumption, helping to shift the AD curve outward. If interest rates are already near zero, however, the central bank may face a zero-lower-bound (ZLB) problem, limiting its ability to further lower rates.

In such cases, unconventional monetary policies like quantitative easing, forward guidance, or asset purchases become necessary to provide additional stimulus when the traditional rate-cutting tool is exhausted. Fiscal policy, through increased government spending or tax cuts, can also complement monetary efforts to support demand.

Thus, while the central bank can do much to mitigate the recessionary effects, the ZLB presents a significant challenge, and coordinated fiscal policies become crucial for economic recovery.

Conclusion

Analyzing macroeconomic shocks within the AD-AS framework reveals complex interactions between policy tools and external events. The strategic responses of central banks and governments are vital in steering the economy toward stability. Understanding the determinants of the IS and LM curves, classifying expenditure types, and recognizing policy constraints, such as the zero-lower-bound, are fundamental for effective economic policymaking in times of crisis.

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