Financial Crisis And Loss Of Wealth

2a. A financial crisis causes significant loss of wealth in Country Z. Show and discuss impact.

Loss of wealth leads to a decrease in investment which leads to reduction in employment and the aggregate supply decreases as well. Decrease in aggregate supply leads to increase in prices as the demand for goods is higher than the supply. This leads to increase in inflation as demonstrated by the figure below.

inflation rateprice AS2

ADAS 105 2.0 102 100 4.0 5.0 unemployment 12 14.3 16 Quantity

The price will increase to 105, the inflation rate will increase and the quantity will decrease to 12. Increase in inflation rate and decrease in the investment leads to decrease in the real GDP.

b). In order to curb the situation the government through the federal bank should use the expansionary monetary policy. this will increase the amount of money that is in circulation in the economy. This will lead to an increase in investment which will increase aggregate supply. This will lead to a decrease in the prices and the inflation will be decrease and hence unemployment will decrease and there will be more people employed. Increase in investments and decrease in inflation leads to a decrease in the real GDP.

As demonstrated above the supply curve will shift from AS2 to AS3. This will lead to lower price 100 and there will be an increase in quantity demanded to 16.

c). A decrease in government spending decreases the quantity of money in the economy. It also limits the accessibility of producers to accessing goods that have been subsidized. This has direct effect on the aggregate supply. A reduction in the government spending will lead to a reduction in aggregate supply. This will lead to a increase in the prices of good s and services and inflation will increase. It will also lead to a reduction in the employment rate as there will be less revenue to pay for the employees. Decrease in government spending and increase in inflation leads to a decrease in the real GDP.

On the graph it will have the same effect as the loss in wealth. This is because inflation will increase and aggregate supply will decrease.

3. P AD AS p2 p AD2 q q2Output

An increase in aggregate demand will shift the AD curve to AD2, this will lead to an increase in the average price level from p to p2 and the suppliers will stop exporting more of their products as the domestic price will be more suitable for them. This will mean that there will be an increase in the quantity produced and supplied to the domestic market. Output will therefore increase from q to q2.

b). Why might the government worry that aggregate demand has expanded too much?

Increase in aggregate demand is due to scarcity of the goods that were earlier on supplied to the market. This will lead to increase in prices and inflation will increase. Inflation depreciated the currency of a country and this will lead to a trade deficit and to a state of scarcity in the country.

c). Give an example of a fiscal policy that could effectively deal with this problem and explain how it would work.

A good fiscal policy will be taxes. This will be in the form of tariffs and quotas placed on the exports. Higher tariffs will be placed to ensure that the more a company exports goods to other countries the more taxes they pay to the government. The high tariff should be based on quantity; this is where the quota comes in. A specific tax rate will be charged to different volumes of goods that are to exported. The higher the volume of goods, the higher the tax charged. Then there will be a specific volume that cannot be exceeded regardless of whether the exporter is willing to pay the tax. This will discourage high volumes of goods from being exported.

d). Give an example of a monetary policy that could counteract excessive aggregate demand. Explain how that policy would work.

Excessive aggregate is caused by the fact that people have enough money to spend. The best monetary policy is the contractionary monetary policy. This is because it will decrease the quantity of money that is circulating in the economy. This will reduce the rate at which people will be demanding for goods as they will have less money to send. Some of the tools that can be used to ensure that there is a contraction n the money supply is increase in the interest rates by the federal bank through the commercial banks, increase in the reserve requirement by the federal banks from the commercial banks and sale of government bonds and treasury bills in the open market operations (OMO).

4a. which economist is proposing an expansionary fiscal policy?

Economist A is proposing an expansionary fiscal policy because he is proposing that the government increase its spending in the economy. This is through physical capital like the improvement in the infrastructure that will open up the country and lead to proper exploitation of opportunities by both the government and private investors.

Expansionary monetary policy?

Economist B is proposing an expansionary monetary policy because he wants there to be an increase in the money supply and consequently the amount of money that is circulating in the economy. This can be implemented from his suggestion by decreasing the interest rates and will make the people to borrow more money for investment and increase aggregate supply and increase employment.

Which policy is likely to be more successful? Be sure to state carefully why you believe this?

The expansionary fiscal policy is better for the economy, this is because it will open up the economy to more exploitation. Increase in the money supply directly using the monetary policy is not suitable because:

It will lead to inflation which will devalue the Sweden currency, make exports cheaper and imports more extensive. This will eventually temper with the balance of trade as there will be a trade deficit.

According to the Keynesian school of thought, monetary policy is only effective in the short run because in the long run the economy gets caught up in the liquidity trap where the interest rates are not responsive to any changes in the quantity of money supplied.

Low interest rates discourage savings and this leads to lack of money in the commercial banks to lend out to the people. This will decrease the amount of money in the banks reserve and can easily lead to a recession as the banks will refuse to give out any loans and will refuse for people to make any withdrawals as they are unable to create money.

P D D2 S1 S

1.8

1.5

1.1

Q2 Q1 Q3

6.

There is a significant economic slowdown in the EU, one of the US’ largest trading partners.

An economic slowdown in the EU would lead to a decrease in the quantity of dollars demanded in the EU as the commercial activities would have decreased. This will lead to a shift in the demand curve to the left from D to D1. This will decrease the value of the dollar, meaning the dollar will depreciate and the quantity demanded will decrease from Q1 to Q2

Growing fears about the health of the euro zone triggers capital flight away from the EU into the US.

There will be an increase in the demand for dollars as the Euro Zone would like the fears not be confirmed and come true. This will make the demand curve to shift outwards and the dollar will appreciate as the quantity demanded will increase in the Euro Zone.

Due to concerns about potential inflationary pressures, the Fed has decided to employ contractionary monetary policy.

Contractionary monetary policy is meant to decrease the quantity of dollars that are circulating. This means the supply of dollars will decrease. The supply curve will then shift to the left and the dollar will appreciate in value but the quantity of dollars will decrease.