Question

1. Outline how counter cyclical fiscal policy and balanced budget fiscal policy would close a recessionary gap. Be specific on goals, how each theory would achieve those goals, how they would close the gap, and potential negative effects.   2. According to monetary policy, explain how the Bank of Canada would react to a recession. Be specific on goals, how they would achieve those goals, how they would close the gap, and potential negative effects.

2.According to monetary policy, explain how the Bank of Canada would react to a recession. Be specific on goals, how they would achieve those goals, how they would close the gap, and potential negative effects.

3.Please describe how the PPC curve represents scarcity, choice and opportunity cost.

4.When would a PPC curve be a straight line rather than a curved line?

5.Discuss the differences calculating GDP using the expenditure approach and income approach.

Answer 1

ANS) PART 1

The recessionary gap can be closed with expansionary fiscal policy --

an increase in government purchases,

a decrease in taxes, or

an increase in transfer payments.

This policy shifts the aggregate demand curve to the right and closes the gap.

Expansionary fiscal policy is designed to close a recessionary gap by changing aggregate expenditures and shifting the aggregate demand curve. A recessionary gap is closed with a rightward shift of the aggregate demand curve. ... This policy shifts the aggregate demand curve to the right and closes the gap.

Explanation: how this theory would achieve goals, how they would close the gap, and potential negative effects:

Graphically, we see that fiscal policy, whether through change in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. Figure 1 illustrates the process by using an aggregate demand/aggregate supply diagram in a growing economy. The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90.

One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) is an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.

Figure 1. A Healthy, Growing Economy. In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. But if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.

Aggregate demand and aggregate supply do not always move neatly together. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes. For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand.

Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. If recession threatens, the central bank uses an expansionary monetary policy to increase the supply of money, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the supply of money, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.

EXPANSIONARY FISCAL POLICY

Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in taxes. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investments by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased spending by the federal government on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investments, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.

Consider first the situation in Figure 2, which is similar to the U.S. economy during the recession in 2008–2009. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP as indicated by the LRAS curve. At the equilibrium (E0), a recession occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP.

Figure 2. Expansionary Fiscal Policy. The original equilibrium (E0) represents a recession, occurring at a quantity of output (Y0) below potential GDP. However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP which is shown by the LRAS curve. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small.

Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? After the Great Recession of 2008–2009 (which started, actually, in very late 2007), U.S. government spending rose from 19.6% of GDP in 2007 to 24.6% in 2009, while tax revenues declined from 18.5% of GDP in 2007 to 14.8% in 2009. The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that expansionary fiscal policy be implemented through spending increases. The Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending, according to the Congressional Budget Office. However, state and local governments, whose budgets were also hard hit by the recession, began cutting their spending—a policy that offset federal expansionary policy.

The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. But the AD–AS model can be used both by advocates of smaller government, who seek to reduce taxes and government spending, and by advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help to inform decisions about whether taxes or spending should be changed, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one.

ANS :PART 2

When the Bank of Canada has clearly stated objectives and takes policy actions that affirm those objectives, the result is an increase in its credibility. This credibility, in turn, helps to keep expectations of future inflation close to the inflation target—what is sometimes called an anchoring of inflation expectations. The importance of well-anchored inflation expectations is best illustrated by recalling what happens when such anchoring is not present, as in the 1970s and 1980s. During those years, the inflation-control process was difficult because economic shocks led to adjustments in expectations which, in turn, led to behaviour that influenced actual inflation. An important lesson learned since the early 1990s, in Canada and elsewhere, is that keeping inflation expectations well anchored is an important part of keeping actual inflation low and relatively stable.

In order to understand the informational requirements for monetary policy, it is helpful to reconsider the nature of the transmission mechanism. Its adds two types of uncertainty.

The first type involves uncertainty about the details in the transmission mechanism itself; that is, uncertainty about the precise nature of the linkages between key macroeconomic variables. This uncertainty is shown by the pink numbered balloons.

The second type is uncertainty about current and future economic developments in the domestic and world economies, as shown by the yellow starbursts.

The nature of the uncertainty in each case is as follows:

1. Term structure.

How do the Bank's changes in the target overnight interest rate lead to changes in longer-term interest rates?

Are the changes always in the same direction?

What magnitude of changes are observed for longer-term interest rates?
2. Foreign exchange market.

How do the Bank's changes in the target overnight interest rate lead to changes in the exchange rate?

How big a change in the exchange rate typically follows a change in the policy rate by the Bank of Canada?

NEGATIVE

Economic Projections

Economic research and current analysis are not independent activities. In order to conduct thorough empirical economic research, knowledge of the data is essential, and such knowledge typically comes from experience in current analysis. Conversely, the ability to interpret current data—what is going on and why?—requires a thorough knowledge of economic relationships that comes from experience in research. This ongoing interaction between research and current analysis explains why many economists at the Bank of Canada are in positions that require a regular transition between current analysis duties and research projects

The world rarely turns out as the model projects, for two reasons.

First, the model itself, though extremely complex, is nonetheless a highly simplified description of the real economy. It lacks the remarkable and changing complexity that actually characterizes any modern economy.

Second, the data that are fed into the model, as good as they are, are also imperfect, and the Bank's best predictions regarding what is actually happening in the Canadian and world economies may well turn out to be wrong in some way.

ANS:PART 3

The Production Possibilities Curve (PPC) is a model that captures scarcity and the opportunity costs of choices when faced with the possibility of producing two goods or services. ... The bowed out shape of the PPC in Figure indicates that there are increasing opportunity costs of production.

For example, suppose Carmen splits her time as a carpenter between making tables and building bookshelves. The PPC would show the maximum amount of either tables or bookshelves she could build given her current resources. The shape of the PPC would indicate whether she had increasing or constant opportunity costs.

The Production Possibilities Curve (PPC) is a model used to show the tradeoffs associated with allocating resources between the production of two goods. The PPC can be used to illustrate the concepts of scarcity, opportunity cost, efficiency, inefficiency, economic growth, and contractions.

For example, suppose Carmen splits her time as a carpenter between making tables and building bookshelves. The PPC would show the maximum amount of either tables or bookshelves she could build given her current resources. The shape of the PPC would indicate whether she had increasing or constant opportunity costs.

Figure 1: A production possibilities curve that reflects increasing opportunity costs

The Production Possibilities Curve (PPC) is a model that captures scarcity and the opportunity costs of choices when faced with the possibility of producing two goods or services. Points on the interior of the PPC are inefficient, points on the PPC are efficient, and points beyond the PPC are unattainable. The opportunity cost of moving from one efficient combination of production to another efficient combination of production is how much of one good is given up in order to get more of the other good.

The shape of the PPC also gives us information on the production technology (in other words, how the resources are combined to produce these goods). The bowed out shape of the PPC in Figure 111 indicates that there are increasing opportunity costs of production.

We can also use the PPC model to illustrate economic growth, which is represented by a shift of the PPC. Figure 2,an agent that has experienced economic growth. Combinations that were once impossible, such as 6 iPads and 4 watches, are now on the new PPC, thanks to the increase in resources or technology.

FIGURE 2

ANS :PART 4

The Income Approach and the Expenditure Approach to Measuring the GDP of a Nation

GDP is generally understood to represent the health of a nation’s economy, and most people realize that if GDP is growing, things are going well, while if it’s falling things have turned sour in the economy. But what, precisely, does GDP measures? There are two primary methods for measuring GDP, which should yield the same result even though they measure completely different factors.

• The income approach: measures the total incomes earned by households in a nation in a year.
• The expenditure approach: measures the total amount spent on the goods produced by a country in a year.

By examining the circular flow model of a nation’s economy, we can demonstrate why every dollar earned by a household in a nation’s resource market will ultimately be spent in the product market, or leaked through taxes, savings, and import spending, leading to injections in the form of government spending, investment and export sales.