Economics Questions (Essay Sample)

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Economics Questions.
Suppose the Reserve Bank of Australia (RBA) is concerned about recession and wants to adopt an expansionary monetary policy. Explain, using the IS-LM diagram(s), how the effectiveness of monetary policy may depend on a interest sensitivity of investment spending.
Through an expansionary monetary policy, the Reserve bank of Australia aims at either increasing its interest rates to attract investor spending or by increasing the money supply. The interest sensitivity of investment spending affects the reactions of investors to reduced interest rates (Sinai et.al 2000, P. 12). In case of high interest sensitivity, investors will be willing to borrow money from banks at the reduced interest rates. Reduced interest rates in the banks may result from an open market strategy by the government or from reduced discount rates. Figure 1 below, shows a case where investors are willing to borrow from banks at the low interest rates due to the expansionary monetary policy; the result is a shift of the LM curve to the left LM2. The level of real output will increase due to the increased levels of investment. In the long run, the inflation rate will reduce and the countries aggregate demand shall increase (Sinai et.al, 2000, P. 23).
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Figure 1: IS-LM diagram showing shift in LM curve due to expansionary monetary policy
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Figure 2:IS-LM diagram showing a liquidity gap expansionary monetary policy
However, in the case of low interest sensitivity to investor spending, people are not willing to spend their money. People prefer to keep their money rather than borrow loans from banks. The result is a scenario whereby the monetary policy by the Reserve Bank of Australia does not affect the interest rate. The resulting scenario is a liquidity trap (as shown in figure 2 ) where investors are not willing to hold their incomes on declining assets. Because of the failed monetary policy the country fails to grow its real output. During the period of recession investors do not purchase in government bonds for the fear of deflation.
b) Interest sensitivity of money demand.
Interest sensitivity to money demand affects how people shall respond to changes in interest rates. Positive reaction to changes in interest rates could result in a success, in the expansionary monetary policy of the FBA. Where money demand has a high interest sensitivity, the result is an increase in bond demand when the policy is implemented (Sinai et.al 2000, P. 26). People are also willing to borrow money from banks at the low interest rates. In this case, the monetary policy will be a success. However, in case the money demand of the economy is low, it would be inadvisable to implement the policy. This is because very few people will be willing to hold on to cash as an asset because of its opportunity cost. During a recession, people are willing to hold their assets in other forms rather than cash. If this is continued it may result in an economy facing stagflation.
After the Second World War, many countries, including the USA, experienced a baby boom—an increase in population growth rate.
Use the Solow model to demonstrate the effect of a baby boom on the steady state capital-labor ratio, standard of living, and real GDP.
Labor productivity is the main determinant of the real GDP per capita and in general, the country’s standard of living. The Solow growth model forms the basis of an economist’s direction of thoughts. Understanding the Solow growth model enlightens the baby boom effect on the steady state capital-labor ratio, standard of living, and real GDP. The baby boom can be equated to a marked increase in the labor force. Labor force increase or decrease affects the denominator of the capital-labor ratio that is the capital stock. If there is an evident growth increase of the labor force that is occurring in a faster pace compared to the capital stock, there will be a fall of the capital-labor ratio. Consequently, if the labor forces increases slower than the capital stock, there will be a rise in the capital-labor ratio.






Figure 3: An Increase in the Capital – Labor Ratio
Source: (lee et.al, 1995)
One can use the Solow growth model to further explain reasons why there are higher living standards in some countries and this context, the baby boom effect on the living standards in the United States. If there is an increase in the labor force, there will be a steeper break-even investment line which in-turn affect the steady state capital – labor ratio to decrease that is k1 to k2. A capital-labor ratio that is lower causes a lower level of a laborer’s real GDP hence a lower real GDP per capital level. The Solow Growth model estimates that a higher growth rate in the labor force leads to lower living standard.
A labor force growth rate and the rate of depreciation have an effect on the break-even investment line slope in a similar manner. Consequently, the Solow growth model estimates that a greater rate of depreciation leads to lower living standard (lee et.al 1995, P. 13).


Figure 4: An Increase in the Labour Force Growth Rate
Source: (lee et.al 1995, P. 12 )
The US economy experienced strong growth in real GDP per capita during the years of baby boom. Use the Solow model to reconcile this fact with your answer to part (a).
The growth rate increase of the labor force reduces a labor’s steady state level of real GDP (Deardorff 2006, P. 11). However, it does not reduce the laborer’s real GDP steady state growth rate. In line with this difference in the baby boom occurrence rate hardly explains the steady-state growth rates differences in the United States. There is a state of equilibrium in the Solow growth model when the ratio of capital to labor is constant. It is argued that when the rationed capital to labor IS constant, there is a constant real GDP per laborer. The model explains how the total growth rate of a country’s economy largely depends on the population growth (lee et.al, 1995, P. 13). Hence, the baby boom effect on the steady state capital-labor ratio, standard of living, and real GDP is that of an increase.
Taking into account the real GDP production function per worker, y = Af (k) where, y represents the real GDP per worker, k represents capital per worker or the ratio of the capital to labor. On the other hand, is the measure that represents the total level of economic efficiency. Assuming that the total productivity factor is constant and it is equal to one, the production function will be y = f (k).


Figure 5: The effect on the capital–labor ratio Source: (lee et.al, 1995)
An increase in the saving rate, that is an S1 to S2 shift, is a clear upward shift of the investment curve. This shift indicates that the level of investment is higher compared to that of depreciation. Consequently, the capital-labor ratio rises from its initial steady state value K1 to K2 which in-turn records an increase in the real GDP per worker. However, from the analysis it cannot be ruled out that the saving rate increase affects real GDP’s steady state growth.
A saving rate increases the level of real GDP per laborer to a greater steady state level. Since the living standard is a measure of the real GDP per capita which depends on a labourers real GDP, it is logical to state that saving rate changes affect the steady state level of the living standard (Deardorff 2006, P. 16).
Concluding from this analysis, government policies that bring about change in the saving rate, are equated to having a level effect, that is, they increase the real GDP per capita and raise the living standards to a higher level. However, these changes will not have a growth effect where there will be no sustained increase in the living standards over time.
3. The Classical Macroeconomic model suggests that there is no need for the government to stabilize the economy with monetary or fiscal Policy. Use AD-AS diagram to discuss this statement. Explain, using the AD-AS diagram, how the stabilization policies can be very effective in the model that assumes price stickiness in the short-run?
Classical economists explain their school or thought based on two assumptions That the values of real variables can be evaluated without one need of knowing the interest rate or the price level of the economy. Another assumption is that the interest rate and equilibrium price level are determined by the central banks rate of money supply (Sinai et.al 2000, P. 29). In the classical model, one can argue that money is viewed as a neutral factor. From their arguments, increasing the money supplied to the economy through a fiscal or monetary policy only results to a rise in the inflation rate. This is based on the Quantity of money equation where MV=PY, where M is the money supply V P is the price level is the velocity of money Y is the real GDP. In the ...