Macro Economics

 

Part One

1) What is meant by full employment? Why isn't the full employment rate zero? (5 Marks)
2) How are the effects of anticipated and unanticipated inflation different on individuals and the economy?
3) Describe in detail the types of unemployment, their consequences and provide an example of each as it applies in context.
4) If the government of Canada was to establish an electronic job bank on the Internet, how could such a job bank reduce frictional unemployment?  Why would it most likely have no effect on cyclical unemployment?


Part Two

 
5) Explain how value added is used to compute GDP.
6) Why aren't financial transactions, sales of secondhand goods, and household production included in measuring GDP?
7) How does a recession in Europe affect Canada's aggregate demand and Canada's aggregate demand curve?
8) What is the multiplier? How is it calculated? Why is the multiplier related only to consumption spending?
9) Suppose the government believes the economy is operating beyond the full-employment real GDP. What kind of fiscal policy would it pursue? Would it matter if the belief was correct or not? How?
10) What happens to the price of bonds when the Bank of Canada is selling bonds? What happens to the interest rate? What happens to the money supply?
11) Suppose the government pursues expansionary fiscal policy by lowering tax rates. What are the expected demand-side effects? What are the possible offsets to the demand-side effect? How might supply-side effects change these results?
 

Part Three

 
12) Describe the functions of money and provide an example of how each can be applied to money as we use it, as well as a non-money item such as a bank card or debit card (that makes it not money).
13) Explain how a currency drain affects the size of the money multiplier. In your explanation, suppose that a bank gains $1 million in new deposits and reserves. Further, suppose that the desired reserve ratio is 10 percent and the currency drain is 33.33 percent.
14) Describe how desired reserves are used in the banking structure in Canada.  More specifically, who sets the desired reserves and how are they used to expand the money supply.
15) What are the tools available to the Governor of the bank of Canada to control the money supply?  Describe in detail how each is used to increase or decrease the money supply.
16) Describe with the aid of diagrams the effect of an increase in the money supply on interest rates and in turn aggregate demand and the price level.
 

 

Answer 1

 

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Full employment is that situation in the economy in which all the labor resources available or the working people available are used in an economically efficient manner. Here, the highest number of skilled, as well as unskilled people in the economy who have the potential to get employed, are embodied at any given point of time. The rest of the unemployment is frictional (Hubbard, 2009).
The full employment rate isn’t zero because whenever full employment is considered, the economists ignore some amount of frictional unemployment and structural unemployment that exists in the economy along with full employment (Hubbard, 2009). So, it is not practically possible that there exists 100% employment in the economy at a given point in time.  

 


Answer 2

 


Effects of anticipated and unanticipated inflation on individuals and the economy:
When inflation is anticipated, accurate predictions about inflation can be made by individuals and the economy and proper steps can be taken to reduce the harms and save themselves from the effects of inflation. 
When inflation is unanticipated, the individuals and economy cannot predict inflation in a correct manner and near future, an uncertainty remains.
Due to unanticipated inflation, the redistribution of income and wealth occurs, but anticipated inflation leads to much smaller redistribution of income and wealth. The government is benefitted from unanticipated inflation as when the nominal income of people increases, the government earns more tax revenue. But it makes the net exports of the economy fall. Also, due to unanticipated inflation, the purchasing power of those people who are living off a fixed income reduces like the retired people and hence their standard of living also reduces. On the other hand, these people benefit from anticipated inflation.

 


Answer 3

 


Types of unemployment and their consequences with examples:
1. Structural unemployment
In this unemployment, the labor market is unable to give jobs to every person who is looking for it. For some jobs, the demand increases as enough skills are available in the market for that job and some jobs become outmoded and they are no longer demanded by people. A person is said to be structurally unemployed when his skills become un-useful or if his job is sent to other nations.  
Consequences: It leads to rising income inequality because the worker when gets older, loses the required skills of the job. This also increases the discrepancy between young and old workers. It becomes very difficult to find people with the required skills at the appropriate time.
Example: Suppose an invention in the automobile raised the demand for mechanics and the demand for farriers got reduced.
2. Frictional unemployment
This unemployment is a period between two jobs when a person is finding a new job, or he is transitioning from one job to other. This type of unemployment is present all the time in the economy to some extent. This arises when the miss-match occurs between jobs and employees.
Example: A girl graduates from college, and she starts looking for a job. It took her four months to find the job so for that time she was frictionally unemployed.
3. Cyclical unemployment
When the aggregate demand in the economy is not enough that it could give jobs to all those people who want to work. It occurs when the demand for goods declines, the production declines, and hence fewer people are needed to work in the company. The result of this unemployment is that the people who are unemployed exceed the number of job vacancies.
Example: During the recession, an autoworker was laid off because people were buying fewer cars. The manufacturers of cars did not need more people as demand was less. If in the future, the demand for cars increased, then more jobs for auto workers will be created (Hubbard, 2009).

 


Answer 4

 


If the government of Canada was to establish an electronic job bank on the Internet:
Frictional unemployment will be reduced as it will take less time for people to find a new job or to transmit from one job to another. It will have no impact on cyclical unemployment because aggregate demand in the economy will not rise and it could not give jobs to all those people who want to work.

 


Answer 5

 


GDP can be calculated using a value-added approach. For this, all the values that are added to a good during the process of production are summed up. For calculating the value addition to the product between firms, the price at which it was sold is taken, and it is subtracted from the price at which it was purchased. The dollar amount that a product contributed to GDP is obtained when all the value-added over the entire production process is summed up.

 


Answer 6

 


Financial transactions, sales of secondhand goods, and household products are not included in measuring GDP because they do not contribute to production activities directly. Second-hand goods will be included once only when they were purchased for the first time, resale is not included. Financial transactions are taken only when bonds and stocks are transacted, only the investments by companies on capital goods are considered. Household production is not a ‘productive’ activity as it is not adding any value in monetary terms. 

 


Answer 7

 


Recession in Europe affects Canada's aggregate demand and Canada's aggregate demand curve as during this time, the output of economy falls, so fewer products are produced and unemployment increases so people have less money. The aggregate demand falls and the demand curve shifts left due to a decrease in demand.  

 


Answer 8

 


The multiplier is “estimated number by which the amount of capital investment (or a change in some other component of aggregate demand) is multiplied to give the total amount by which the national income is increased. This multiplier takes all direct and indirect benefits from that investment (or from the change in demand) into account. Expressed as the reciprocal of the marginal propensity to save”
Multiplier= 1/MPC where MPC is marginal propensity to consume

 


Answer 9

 


When an economy operates beyond the full employment level, the additional input is not produced and more money is spent to buy few goods. In this case, the government uses a fiscal policy where it will increase the interest rate. This is a correct step as it will reduce the money supply in the economy and control the situation.  

 


Answer 10  

 


When Bank of Canada sells more bonds, the supply of bonds increases and thus the price falls.  As the price falls, the rate of interest on bonds increases as there is an inverse relationship between price and interest rate of bonds. The money supply reduces as people buy it and reduces their purchasing power.  

 


Answer 11

 


When the expansionary fiscal policy is adopted, and the rate of taxes is lowered, the purchasing power of people increases and money gets pumped into the economy. The demand starts to rise, but the production may not increase to that extent (Hubbard, 2009). In the long run as businesses also start paying a lower rate of taxes, they have more money to invest. Hence, they increase production, produce more, and supply more (Amadeo & Amadeo, 2016).


Answer 12


Functions of money are: It is used for buying and selling things hence it is a medium for exchange. It is a standard for measuring the relative worth of products (Hubbard, 2009). Since the value of money can be retained, so it is used to store wealth. It is used in the form of credit or debit cards as they are used for buying things, they can be retained for a long time by maintaining cash balances in them.


Answer 13


Due to the currency drain, the money will be kept by the people in the form of cash, and it will not be put in banks. Hence, the rate of investment will decline, and a multiplier will reduce.  In the above situation, the bank does not have enough resources as it has to maintain a reserve ratio but the currency drain is also more.

 


Answer 14

 


Desired reserves are set by the central bank in Canada. This is used to expand the money supply as when the central bank has to increase the supply of money; it reduces the reserve ratio i.e. the commercial banks have to keep fewer reserves with the central bank, and it can lend more money to the public. By doing this, the money is pumped in the economy and money supply increases.

 


Answer 15

 


To control the money supply, the governor can go for open market operations in which he sells the bonds when he has to reduce the money supply and buys the bonds when he has to increase the money supply. It can increase the bank rate which will make the commercial banks borrow less from it and reduce the money supply (Hubbard, 2009). If it decreases the bank rate, the commercial bank will borrow more from the central bank and increase the money supply. Also, the bank can increase or reduce the reserve ratio to control the money supply (Amadeo & Amadeo, 2016).
 

 

Answer 16

 


 
In the above diagram, Md is the money demand and Ms is the money supply. The interest rate is ‘I’. When a contractionary monetary policy is adopted, the money supply reduces to M’s, and the interest rate rises to I’.
 
In the above diagram, the economy was at point ‘a’ initially when aggregate demand AD met aggregate supply AS and the price level was p. After the inflation and contractionary monetary policy, the demand reduced to AD’ and the price fell top’.
 

 


References:

 


Amadeo, K., & Amadeo, K. (2016). Only Central Banks Legally Create Money Out of Thin Air. About.com News & Issues. Retrieved 6 April 2016, from http://useconomy.about.com/od/glossary/g/Monetary_policy.htm
Contractionary Monetary Policy: Slowing the Economy Down - Video & Lesson Transcript | Study.com. (2016). Study.com. Retrieved 6 April 2016, from http://study.com/academy/lesson/contractionary-monetary-policy-slowing-the-economy-down.html
Federal Reserve Bank of Atlanta. (2016). Frbatlanta.org. Retrieved 6 April 2016, from https://www.frbatlanta.org/cenfis/publications/notesfromthevault/1501
Moffatt, M. (2016). Expansionary Monetary vs Contractionary Monetary Policy. About.com Education. Retrieved 6 April 2016, from http://economics.about.com/cs/money/a/policy_2.htm
What is the Fed: Monetary Policy. (2016). Federal Reserve Bank of San Francisco. Retrieved 6 April 2016, from http://www.frbsf.org/education/teacher-resources/what-is-the-fed/monetary-policy
Finance & Development. (2016). Finance & Development | F&D. Retrieved 6 April 2016, from http://www.imf.org/external/pubs/ft/fandd/basics/monpol.htm
Nominal vs. Real GDP, and the GDP Deflator - CFA Level 1 | Investopedia. (2008). Investopedia. Retrieved 6 April 2016, from http://www.investopedia.com/exam-guide/cfa-level-1/macroeconomics/nominal-real-gdp-deflator.asp
Hubbard, R. (2009). Macroeconomics. Frenchs Forest, N.S.W.: Pearson Prentice Hall. 
 

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