Macroeconomics/Business Economics

ASSIGNMENT 2
Q1. Explain why the saving curve slopes upward and the investment curve slopes downward in the
saving-investment diagram. Give two examples of changes that would shift the saving curve to the
right, and two examples of changes that would shift the investment curve to the right.
Answer# 1:
In the saving-investment diagram, the saving curve slopes upward because as the real interest rate
increases, individuals and businesses are incentivized to save more. Higher interest rates provide a greater
return on savings, encouraging more saving behavior. Conversely, the investment curve slopes downward
because as the real interest rate decreases, the cost of borrowing falls, making it cheaper for businesses to
invest in capital. Thus, lower interest rates stimulate more investment.
Examples of changes that would shift the saving curve to the right:
1.Increased consumer confidence: If consumers expect future income to rise, they may choose to save
more today, shifting the saving curve to the right.
2.Tax incentives for saving: Policies that provide tax benefits for savings accounts or retirement plans
can encourage higher saving rates, leading to a rightward shift in the saving curve.
Examples of changes that would shift the investment curve to the right:
1.Technological advancements: Innovations that improve productivity can make investment projects
more attractive, leading to an increase in investment at all interest rates, thus shifting the investment curve
to the right.
2.Lower business taxes: A reduction in corporate taxes can increase after-tax profits, encouraging firms
to invest more, which would shift the investment curve to the right.
These shifts reflect changes in economic conditions that affect saving and investment behaviors in the
economy.
Q2. Use the saving-investment diagram to analyze the effects of the following on national saving,
investment, and the real interest rate. Explain your reasoning.
a. Consumers become more future-oriented and thus decide to save more.
b. The government announces a large, one-time bonus payment to veterans returning from a war.
The bonus will be financed by additional taxes levied on the general population over the next five
years.
c. The government introduces an investment tax credit (offset by other types of taxes, so total tax
collections remain unchanged).
Answer# 2:
In the saving-investment diagram, various changes can impact national saving, investment, and the real
interest rate.
a. When consumers become more future-oriented and decide to save more, the saving curve shifts to the
right. This increase in national saving lowers the equilibrium real interest rate, making borrowing cheaper
and encouraging higher investment levels.
b. The announcement of a large, one-time bonus payment to veterans, financed by future taxes, initially
boosts consumption but ultimately shifts the saving curve to the left. This results in lower national saving,
a higher real interest rate, and potentially reduced investment as borrowing costs increase.
c. The introduction of an investment tax credit incentivizes businesses to invest by lowering the effective
cost of capital, shifting the investment curve to the right. This can lead to increased investment levels, and
while total tax collections remain unchanged, the higher investment demand may raise the real interest
rate if saving does not increase correspondingly.
Q3. Components of the User Cost of Capital:
Answer#3:
The user cost of capital consists of two main components:
Depreciation: This represents the loss of value of a capital good over time due to wear and tear or
obsolescence. It is a cost because it reflects the reduction in the capital's value that the firm must account
for when using the assets.
Opportunity Cost of Capital: This is the return that could have been earned if the funds used to
purchase the capital good were invested elsewhere. It is a cost because it represents the foregone earnings
from alternative investments that the firm could have pursued instead of acquiring the capital good.
Both components are essential in determining the overall cost of using capital goods, as they reflect the
economic realities of capital utilization, and the trade-offs involved in investment decisions.
Q4. Permanent vs. Temporary Increase in Government Purchases:
A permanent increase in government purchases has a larger effect on the economy compared to a
temporary increase of the same amount. In the saving-investment diagram, this can be evaluated as
follows:
Permanent Increase: A permanent increase in government spending signals to consumers and
businesses that future taxes will rise to finance this spending. This expectation leads to a decrease in
current consumption as individuals save more in anticipation of higher future taxes. The saving curve
shifts to the right due to increased saving behavior, which can lower the real interest rate. The increased
government spending also raises demand for goods and services, leading to higher investment as
businesses respond to increased demand.
Temporary Increase: In contrast, a temporary increase in government purchases does not significantly
alter expectations about future taxes. Consumers may not change their saving behavior as much, leading
to a smaller shift in the saving curve. The real interest rate may not decrease as much, and the overall
impact on investment is limited compared to a permanent increase.
Thus, the larger and more sustained effects of a permanent increase in government purchases on
consumption, investment, and the real interest rate stem from the long-term expectations it creates
regarding future fiscal policy.
Q5. Analyze the effects on a large open economy of a temporary adverse supply shock that hits only
the foreign economy. Discuss the impact on the home country's national saving, investment, and
current account balance and on the world real interest rate. How does your answer differ if the
adverse supply shock is worldwide?
Answer#5:
In a large open economy, the effects of a temporary adverse supply shock that impacts only the foreign
economy can be analyzed as follows:
Effects of a Temporary Adverse Supply Shock:
Foreign Economy Shock:
National Saving: May increase in the home country as imports from the foreign economy decline.
Investment: Could decrease due to uncertainty and reduced business confidence.
Current Account Balance: Likely improves as exports to the foreign economy rise while imports fall.
World Real Interest Rate: May decrease due to lower global demand for capital.
Worldwide Shock: National Saving: Likely decreases as both economies face reduced output and
income.
Investment: Expected to decline sharply due to decreased demand and heightened uncertainty.
Current Account Balance: May not improve significantly; exports could decline alongside imports.
World Real Interest Rate: Likely drops more significantly as global investment demand falls.
A localized shock can improve the home country's current account and saving, while a worldwide shock
leads to broader declines in saving, investment, and potentially negative impacts on the current account.
Q6: Relationship Between Price Level and Nominal Money Supply?
Answer# 6:
The relationship between the price level and the nominal money supply is generally described by the
Quantity Theory of Money, which states that an increase in the nominal money supply, all else being
equal, leads to a proportional increase in the price level. This means that if the money supply increases,
prices tend to rise, assuming the output remains constant. Regarding inflation and the growth rate of the
nominal money supply, there is a direct relationship: if the growth rate of the nominal money supply
exceeds the growth rate of real output, inflation is likely to occur. Conversely, if the money supply grows
at a slower rate than real output, deflation may occur.
Q7: Effects on Demand for M1 and M2?
Answer# 7:
a. Raising Check Limits on Money Market Accounts: Increasing the maximum number of checks that can
be written on money market mutual funds and money market deposit accounts from three to thirty would
likely increase the demand for M2, as these accounts are part of M2. However, it may not significantly
affect M1, which includes only the most liquid forms of money (like cash and checking accounts).
b. Introduction of Home Equity Lines of Credit: This would likely increase the demand for M1, as
homeowners can now access funds more easily and write checks against their home equity. It may also
increase M2 demand, as it adds liquidity to the money supply.
c. Stock Market Crash: A stock market crash would likely increase the demand for M1, as individuals
may prefer to hold liquid assets (cash) during times of uncertainty. The demand for M2 may also increase
as people move funds into safer, more liquid forms of savings.
Q8: Terms for Economic Activity?
Answer# 8:
The terms used to describe how a variable moves when economic activity is rising or falling are
"procyclical" (variables that move in the same direction as the economy) and "countercyclical" (variables
that move in the opposite direction). The timing of cyclical changes in economic variables is described
using "leading indicators" (which predict future movements) and "lagging indicators" (which follow
economic trends).
Q9: Position of the FE Line?
Answer# 9:
The position of the Full Employment (FE) line is determined by the economy's productive capacity,
which is influenced by factors such as labor supply, technology, and capital stock. Two examples of
changes that would s
Shift the FE line to the right include:
An increase in the labor force participation rate, leading to more workers available for production.
Technological advancements that improve productivity, allowing the economy to produce more goods
and services at full employment.
Q10: IS-LM Model and Permanent Increase in Oil Prices?
In the IS-LM model, a permanent increase in the price of oil acts as a negative supply shock. This would
lead to higher production costs for firms, shifting the short-run aggregate supply (SRAS) curve to the left.
The immediate effects would include:
Current Output: A decrease in output as firms reduce production due to higher costs.
Employment: A decline in employment as firms cut back on hiring or lay off workers in response to
reduced output.
Real Wage: The real wage may initially rise due to higher prices, but over time, it could fall as firms
adjust to the new cost structure and reduce employment.
Overall, the economy would experience lower output and employment levels, with potential inflationary
pressures due to increased production costs