Econ 202 Principles Of Macroeconomics Due In Class 11292017

Econ 202 Principles Of Macroeconomicsdue In Class 11292017proble

Econ 202: Principles of Macroeconomics Due in class: 11/29/2017. The assignment involves analyzing the effects of fiscal policy changes on the economy's GDP and government budget, illustrating the impact of international financial events on currency valuation, and calculating purchasing power parity (PPP) exchange rates compared to official rates, along with assessing currency overvaluation or undervaluation.

Paper For Above instruction

The principles of macroeconomics provide a foundational understanding of how government policies and international factors influence national economies and currency valuations. This paper explores three critical aspects: the effect of fiscal policy on the economy's GDP and budget, the movement of currency values in response to external shocks, and the calculation of PPP rates to evaluate currency valuation relative to their actual purchasing power.

Impact of Fiscal Policy on GDP and Government Budget

Fiscal policy, comprising government spending and taxation, directly affects economic activity and government budgets. When analyzing changes such as increases in government expenditure or taxes, we employ the Keynesian multiplier effect to estimate the initial impact on GDP. The marginal propensity to consume (MPC), given as 0.75, plays a pivotal role in determining the multiplier; the concept reflects the proportion of additional income spent on consumption.

The spending multiplier is calculated as 1/(1 - MPC), which in this case equals 1/(1 - 0.75) = 4. This means that a $1 increase in government spending ultimately results in a $4 change in the GDP.

Scenario a: Increase in Government Spending by $1000

An increase in government spending by $1000 initially raises GDP by 4 * $1000 = $4000. Since government spending directly affects the budget, the initial change in the budget is a deficit increase of $1000. However, the rise in GDP leads to higher tax revenues, which partially offset this deficit due to increased income and consumption.

Tax revenues increase proportionally to the MPC's complement; specifically, total tax revenue change can be estimated as the marginal tax rate times the increased GDP. Assuming a balanced budget initially, the net effect on the budget after the multiplier effect will depend on the tax rate and the size of the initial expenditure increase. If fiscal policy assumes no change in taxes, the resulting effect is an increased deficit of $1000, amplified by the GDP increase.

Scenario b: Increase in Taxes by $1000

An increase in taxes by $1000 directly reduces disposable income, which, via the MPC, dampens consumption and reduces GDP. The decrease in GDP is calculated as the multiplier times the initial tax increase: -4 * $1000 = -$4000.

This fiscal contraction reduces tax revenue further, potentially leading to a deficit reduction, but the flow-on effect may impact overall economic activity. The net change in the budget is an initial increase in taxes of $1000, but the overall deficit may shift depending on how the decreased GDP reduces other tax collections, which could provide a stabilizing or worsening effect on the budget.

Effect of International Events on Currency Value

The value of a currency relative to another can be understood through the supply and demand for that currency in foreign exchange markets. Changes in economic conditions such as income levels, price levels, and interest rates influence these supply and demand dynamics.

a. Britain’s income increases

An increase in British income raises the demand for foreign goods, including imports. To pay for imports, British residents need to buy more foreign currency (e.g., USD), which increases the supply of British pounds on the foreign exchange market. This increased supply causes the pound to depreciate relative to the dollar, moving leftward along the demand curve or downward if plotting the exchange rate.

b. Britain’s price level declines relative to the US

A decline in Britain’s price level makes British goods relatively cheaper, increasing exports and reducing imports. Higher exports increase demand for the pound, causing it to appreciate relative to the dollar. On a supply-demand graph, this manifests as an increased demand for pounds, shifting the demand curve rightward or causing the exchange rate to rise.

c. Britain’s interest rates decline relative to US interest rates

Lower interest rates in Britain make British assets less attractive to investors, decreasing demand for British assets and the pound. Consequently, the supply of pounds increases in exchange for dollars, leading to depreciation of the pound against the dollar. This process is driven by the decreased attractiveness of British financial instruments.

Calculating PPP and Currency Valuation

Purchasing Power Parity (PPP) theory suggests that in the long run, exchange rates adjust so that identical baskets of goods cost the same in different countries when valued at the prevailing exchange rate. By comparing the cost of baskets in different countries with the official exchange rates, we can assess whether currencies are overvalued or undervalued.

Given Data:

• Official exchange rates:
  • $1 = 0.90 euro
  • $1 = 3.13 BRL
  • $1 = 1.39 SGD
• Cost of Basket in USD:
  • Milk: $5
  • Bread: $4
  • Cheese: $6
  • Eggs: $5
• Cost of Basket in Euros:
  • Milk: 7 euros
  • Bread: 4 euros
  • Cheese: 6 euros
  • Eggs: 5 euros
• Cost of Basket in BRL:
  • Milk: 4 BRL
  • Bread: 3 BRL
  • Cheese: 4 BRL
  • Eggs: 5 BRL
• Cost of Basket in SGD:
  • Milk: 4 SGD
  • Bread: 3 SGD
  • Cheese: 4 SGD
  • Eggs: 5 SGD

Calculating PPP Exchange Rates:

The PPP rate for each currency is obtained by dividing the cost of the basket in that country by the cost in USD, then comparing this to the official exchange rate. For simplicity, the average price of the basket in each location is considered.

Euro:

Total basket cost in Euros = 7 + 4 + 6 + 5 = 22 euros.

The equivalent USD value of this basket based on market rates: 22 euros / 0.90 euro per dollar ≈ $24.44.

Cost of the basket in USD: $5 + $4 + $6 + $5 = $20.

Since the value of the basket in Euros is $24.44, the PPP exchange rate is approximately 22 euros / 24.44 dollars ≈ 0.90 euro per dollar, aligning with the official rate.

However, actual disparities can indicate over- or undervaluation.

Brazil (BRL):

Total basket cost in BRL = 4 + 3 + 4 + 5 = 16 BRL.

The market exchange rate is 1 USD = 3.13 BRL.

Based on PPP, the equivalent USD value of the basket: 16 BRL / 3.13 ≈ $5.11.

Total USD cost of basket: $20; same as with Euro, the PPP rate is roughly (cost in BRL)/(cost in USD) = 16/20 = 0.80 BRL per dollar.

Singapore Dollar (SGD):

Total basket in SGD = 4 + 3 + 4 + 5 = 16 SGD.

Market exchange rate: 1.39 SGD per USD.

PPP rate calculation: 16 SGD / 1.39 ≈ $11.51.

Using the USD cost, the basket is $20; thus, the PPP exchange rate: 16/20 = 0.80 SGD per dollar.

Assessment of Currency Valuation

Comparing the calculated PPP rates with the official rates indicates whether a currency is overvalued or undervalued.

• Euro: The PPP aligns with the official rate, suggesting the euro is fairly valued.
• Brazilian real (BRL): The PPP rate (approximately 0.80) is less than the official rate (3.13), implying the real is overvalued relative to the dollar, or the dollar is undervalued compared to PPP.
• Singapore dollar (SGD): Similar to BRL, the PPP rate (0.80) is less than the official (1.39), indicating the SGD might be overvalued relative to its PPP rate, or the USD is undervalued.

Conclusion

In summary, fiscal policy changes significantly influence a nation's GDP and budget, with government spending multipliers amplifying initial effects. International economic events like income changes, price level shifts, and interest rate variations substantially impact currency values by altering supply-demand dynamics in forex markets. Lastly, PPP calculations provide essential insights into whether currencies are over- or undervalued, guiding policymakers and investors in understanding real exchange rates versus market rates. These interconnected macroeconomic concepts illustrate the complex mechanisms driving national and global economic stability.

References

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