Question

The Kingdom of Wrigley is an archipelago in the South Pacific. The economy is based on fishing and agriculture, and currently imports more than it exports. The economy is doing good right now, but not great, and the banking system is stable, yet fragile. The central bank is not independent and follows the instructions of The King.

The King, wanting new economic ideas, and having been told you took at a macroeconomics class before moving to the Kingdom, invites you to the palace to meet with his son, the Crown

Prince, and also the Finance Minister. The Crown Prince has a number of questions for you: [Be sure to include what questions you would ask the Crown Prince.]

1. The Prince and the Finance Minister are planning on splitting the responsibilities of fiscal and monetary policy, with the Prince focusing on the more important one, which one would you recommend the Prince oversee himself and why?

1. The Prince would like to use the expenditure method to calculate the Kingdom’s GDP, explain how that works to him and recommend what he should focus on to grow the economy.

1. Are there any specific strategies we might employ to grow the economy, and if yes, which one is best for us?

1. Our small army and navy are effective, but what should we be prepared to do economically if we feel an invasion by a foreign power is imminent and we might have to increase military spending? What options do we have? Which would you recommend and why?

1. Both men harbor great confusion with regards to the different economic multipliers. Without using too much math, explain the multipliers to them in a manner they can understand. What do they illustrate and are they important? Why or why not?

1. The Crown Prince believes the economy is operating at near full efficiency in its current state. Is cutting taxes a good idea for stimulating the economy? Why or why not? If not, what should he do to grow the economy?

1. One of the islands in the Kingdom is very poor on the aggregate and seems stuck. Explain why that might be. What might the Prince do to improve the economy of that island?

1. The Crown Prince is aware that the United States employs a Fed Rule when setting interest rates. Explain how that is used and what it illustrates. Can that help him make decisions? Would it change during a pandemic?

1. Are there criteria that we can use to evaluate our economic policies? Can you give us any examples?

1. We currently import more than we export. Is a tariff on imports a good idea? Are there any other trading strategies we might explore? What should we focus on?

Answer 1

Its a matter of debate that which one is more effective between fiscal and monetary policy. In situation like liquidity trap fiscal policies are more effective and incase of a situation where money demand is completely interest insensitive or money demand is extremely income sensitive fiscal policy will not effective. So there are pros and cons of both. But I would suggest Mr.Finance minister to keep fiscal authority under his umbrella and make the monetary authority independent. It is because in my view controlling monetary authority by crown prince who is ofcourse works under political influence would undermine the objective of monetary policies. In some situation fiscal policy can be really effective in directly creating employment opportunities rather than depending monetary policy's indirect effects like lowering interest rates encouraging business to invest.

To understand the expenditure method of calculating GDP it is the simplest way. It shows the flows between firms and households in an economy that produces one good, bread from one input labor. The inner loop represents the flows of labor and bread: households sell their labor to firm and firm sell the produced bread to household. The outerloop represents the flow of dollars: households pay the firms for the bread, the firm pays the wages and profit to the households. In this economy GDP is the both the total expenditure on bread and total income from the production of bread. In an economy that produces only bread we can compute GDP by adding the total expenditure on bread but in Real economies which include the production and sale of vast number of goods and services, calculation become a complex task.The formula for GDP is

GDP=C+I+G+(X-M)

C= consumer spending

I=Investment spending

G=Government Purchases

X=export, M=Import

To attain a higher standard of living crown prince must focus on the ways of GDP of the country.

Now coming to the question is their any specific strategy to grow the economy. Well for a small economy like this, I would suggest the govt to focus on export oriented policies like providing export subsidies. Export led growth has been the proven formula for success as it happened in case of south asian tigers. And if you want to play a game for the long run then govt must drive its resources to improve human capital. Higher human capital means high productivity, which will result in higher output and GDP per capita.

Ofcourse national security is an important thing for which govt have to invest its resources in defense. But we have to remember defense is an unproductive sector particularly when you have to import all the weapons and ammunition from abroad. I would suggest try to gain the knowledge of technology built a home industry for weapons rather than importing it. In this way it can be a export sector and a good source of inflow of dollars in the economy. Above all you are small country I suggest you keep good diplomatic relation with other nations to keep defense spending at minimum particularly if you are a importer of defense goods.

Ofcourse multipliers are important and very effective in certain situation. Lets first consider the tax multiplier, first you have to understand few other concepts which are really easy basically no maths involved. Each one of you earn an amount of income and you give a certain amount of tax to the govt and the rest is called 'disposable income'. Now in this disposable income you consume a part and save the rest. Now suppose govt reduce tax your income will be higher you will be able to spend more i.e consume more. Higher consumption from each of you will increase the aggregate demand in the economy firms will higher more labor to cope with this increased demand, firms will produce higher output, earn higher profit then wages will rise so that means income rise again so consumption rise again and this process will go on.

Pretty much same occur with govt expenditure mulitipler. Govt increase in expenditure that means more money in the hand of people so you could spend more and the process very nearly same as in the case of tax multipler.

Tax cutting is good or not depends on the budget deficit situation of the country. If budget deficit within limit a tax cut which lower the state revenue may not be harmful. As it will raise peopls's disposable income and will have a multiplier effect. But govt have to mange its resources efficiently a budget deficit beyond economy's limit and capabilities is a burden and it can cause a high inflation in the country.

One island is poor so I would recommend state need to intervene directly to improve the situation. Identify the few key sectors and invest in them, so they can facilitate growth of other related sector by forward and backward linkage. For example say an economy which is in poor condition, so investing steel industry and make it big can pull up the coal industry through backward linkage as coal is necessary in steel industry. Goods need to be transported so investment in steel may pull up railways by forward linkage. So just like that govt need to identify the key sectors and invest in them. Govt also need to invest in education to improve human capital.