Question

QUESTION 3

[100 marks]

What is the business cycle? How do economists analyse business cycles?

         [15 marks]

Net exports (NX) are a component of gross domestic product (GDP). What are net exports and why are they included in GDP?                [10 marks]

Explain how an appreciation in the nominal interest rate would affect the real interest rate, and net exports.                                              [15 marks]

Explain the difference between fixed and floating exchange rate regimes. What are the costs and benefits associated with a fixed exchange rate regime?                                                                                                [20 marks]

What is net capital outflow (NCO)? If we know a country is running a trade surplus, what does this tell us about its NCO?                           [15 marks]

What is the theory of purchasing power parity? What are the limitations of this theory?                                                                                     [20 marks]

Answer 1

What is the business cycle? How do economists analyse business cycles?

The business cycle is also known as the economic cycle or trade cycle, is the downward and upward movement of gross domestic product (GDP) around its long-term growth trend.

The length of a business cycle is the period of time containing a single boom and contraction in sequence. These fluctuations typically involve shifts over time between periods of relatively rapid economic growth (expansions or booms), and periods of relative stagnation or decline (contractions or recessions).

From an economists point of view, business cycles are not merely fluctuations in aggregate economic activity. The critical feature that distinguishes them from the seasonal and other short term variations is that the fluctuations are widely diffused over the economy – its industry, its commercial dealings, and its tangles of finance. The economy of a country is a system of closely interrelated parts. Economist understand business cycles and master the workings of an economic system organized largely in a network of free enterprises searching for profit. The problem of how business cycles come about is therefore inseparable from the problem of how a capitalist economy functions.

Expansion is measured from the trough (or bottom) of the previous business cycle to the peak of the current cycle, while recession is measured from the peak to the trough. In the United States, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) determines the dates for business cycles. Committee members do this by looking at real GDP and other indicators including real income, employment, industrial production, and wholesale-retail sales. Combining these measures with debt and market measures helps understand the causes of expansions.

Net exports (NX) are a component of gross domestic product (GDP). What are net exports and why are they included in GDP?                

Net exports are the value of a country's total exports minus the value of its total imports. It is a measure used to calculate aggregate expenditures or the gross domestic product (GDP) of a country with an open economy. In other words, net exports equal the amount by which foreign spending on a home country's goods and services exceeds the home country's spending on foreign goods and services.

Net exports is also known as the balance of trade; positive net exports represent a trade surplus, and negative net exports imply a trade deficit.

Explain how an appreciation in the nominal interest rate would affect the real interest rate, and net exports.           

Acording to the Fisher effect, tthe real interest rate equals to the nominal interest rate minus the expected inflation rate. Therefore, real interest rates increase as nominal rate increases at the same rate of inflation. If inflation increases, real rate will still increase but the amount with which real rate increases will be comparitively less.

Increase in Nominal interest rates happen to affect the exchange rate and net exports (NX) with a shift in two steps: it will first increase the value of NX (since the currency appreciates quickly while the volume of exports or imports decrease slowly) and then decrease it until it reaches a lower level than before the shock.

Explain the difference between fixed and floating exchange rate regimes. What are the costs and benefits associated with a fixed exchange rate regime?   

Difference between Fixed and Floating Exchange Rate:

Fixed exchange rate and flexible exchange rate are two exchange rate systems, differ in the sense that when the exchange rate of the country is attached to the another currency or gold prices, is called fixed exchange rate, whereas if it depends on the supply and demand of money in the market is called flexible exchange rate.

BASIS FOR COMPARISON	FIXED EXCHANGE RATE	FLEXIBLE EXCHANGE RATE
Meaning	Fixed exchange rate refers to a rate which the government sets and maintains at the same level.	Flexible exchange rate is a rate that variate according to the market forces.
Determined by	Government or central bank	Demand and Supply forces
Changes in currency price	Devaluation and Revaluation	Depreciation and Appreciation
Speculation	Takes place when there is rumor about change in government policy.	Very common
Self-adjusting mechanism	Operates through variation in supply of money, domestic interest rate and price.	Operates to remove external instability by change in forex rate.

Cost and Benefits of Fixed Exchange Rate:

Benefits

• 1. Promotes International Trade:

  Fixed or stable exchange rates ensure certainty about the foreign payments and inspire confidence among the importers and exporters. This helps to promote international trade.

  2. Necessary for Small Nations:

  Fixed exchange rates are even more essential for the smaller nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously affect the process of economic growth in these economies.

  3. Promotes International Investment:

  Fixed exchange rates promote international investments. If the exchange rates are fluctuating, the lenders and investors will not be prepared to lend for long-term invest­ments.

  4. Removes Speculation:

  Fixed exchange rates eliminate the speculative activities in the international transactions. There is no possibility of panic flight of capital from one country to another in the system of fixed exchange rates.

  5. Necessary for Small Nations:

  Fixed exchange rates arc even more essential for the smaller nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously disturb the process of economic growth of these economies.

  6. Necessary for Developing Countries:

  Fixed exchanges rates are necessary and desirable for the developing countries for carrying out planned development efforts. Fluctuating rates disturb the smooth process of economic development and restrict the inflow of foreign capital.

  7. Suitable for Currency Area:

  A fixed or stable exchange rate system is most suitable to a world of currency areas, such as the sterling area. If the exchange rates of the countries in the common currency area are flexible, the fluctuations in the leading country, like England (whose currency dominates), will also disturb the exchange rates of the whole area.

  8. Economic Stabilization:

  Fixed foreign exchange rate ensures internal economic stabilization and checks unwarranted changes in the prices within the economy. In a system of flexible exchange rates, the liquidity preference is high because the businessmen will like to enjoy wind fall gains from the fluctuating exchange rates. This tends to Increase price and hoarding activities in country.

  9. Not Permanently Fixed:

  Under the fixed exchange rate system, the exchange rate does not remain fixed or is permanently frozen. Rather the rate is changed at the appropriate time to correct the fundamental disequilibrium in the balance of payments.

Costs

1. Outmoded System:

Fixed exchange rate system worked successfully under the favorable conditions of gold standard during 19th century when

(a) the countries permitted the balance of payments to influence the domestic economic policy;

(b) there was coordination of monetary policies of the trading countries;

(c) the central banks primarily aimed at maintaining the external value of the currency in their respective countries; and

(d) the prices were more flexible. Since all these conditions are absent today, the smooth functioning of the fixed exchange rate system is not possible.

2. Discourage Foreign Investment:

Fixed exchange rates are not permanently fixed or rigid. Therefore, such a system discourages long-term foreign investment which is considered available under the really fixed exchange rate system.

3. Monetary Dependence:

Under the fixed exchange rate system, a country is deprived of its monetary independence. It requires a country to pursue a policy of monetary expansion or contraction in order to maintain stability in its rate of exchange.

4. Cost-Price Relationship not Reflected:

The fixed exchange rate system does not reflect the true cost-price relationship between the currencies of the countries. No two countries follow the same economic policies. Therefore the cost-price relationship between them go on changing. If the exchange rate is to reflect the changing cost-price relationship between the countries, it must be flexible.

5. Not a Genuinely Fixed System:

The system of fixed exchange rates provides neither the expectation of permanently stable rates as found in the gold standard system, nor the continuous and sensitive adjustment of a freely fluctuating exchange rate.

6. Difficulties of IMF System:

The system of fixed or pegged exchange rates, as followed by the International Monetary Fund (IMF), is in reality a system of managed flexibility.

What is net capital outflow (NCO)? If we know a country is running a trade surplus, what does this tell us about its NCO?       

Net capital outflow (NCO) is the net flow of funds being invested abroad by a country during a certain period of time (usually a year). A positive NCO means that the country invests outside more than the world invests in it and vice versa.

Imbalances in the net capital outflow (NCO) are associated with imbalances in the trade balance (or net exports, NX), following the identity NCO = NX. Each exchange that affects the net capital outflow, also affects net exports in the same amount. If running a trade surplus, the excess in foreign currency, a country receives is being used to buy assets from abroad.

What is the theory of purchasing power parity? What are the limitations of this theory?

Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries.

Limitations of PPP theory

1. The theory proposes a direct functional relation between the purchasing powers of the currencies of two countries and their exchange rate. However, in reality there is no such direct and precise link between the two. There are many factors apart from the purchasing power of currencies, such as tariff, speculation, capital flows, etc., which significantly affect the rate of exchange.

2. According to the theory, to calculate the new equilibrium rate one must know the base rate i.e., the old equilibrium rate. But it is difficult to ascertain the particular rate which actually prevailed between the currencies as the equilibrium rate.

3. Moreover, the calculated new rate would represent the equilibrium rate at purchasing power parity only if economic conditions have remained unchanged.

4. According to some critics, the purchasing power parity theory may hold good only in case of prices of goods entering into the foreign trade, but it is illogical to apply it in terms of general indices as there cannot be any direct relation between the internal and international prices of good just confined to only domestic markets of the trading countries. Keynes, therefore, remarks that" confined to internationally traded commodities, the purchasing power parity theory becomes an empty truism."

5. The theory assumes that, we are regaling with a similar group of commodities in both countries. This assumption is not tenable, when the very base of international trade is geographical specialisation in production. Moreover, the concept of a change in the price is vague in theory.

Prices of all commodities never move uniformly. Prices of some commodities rise or fall much more than those of others. Under such conditions, no simple comparison can be made between the price movements in different countries.