Question

Assumptions embodied in the questions These questions address the short run effects of financial shocks and policy responses on the overall economic performance of a small open economy that initially runs a current account deficit. They refer to a length of run over which the productive capital stock is fixed, determined by previous investment. New investment creates expenditure on current GDP but does not yet affect current production capacity. External factor income flows net out at zero. Most questions require diagrams that represent the domestic financial capital market and the market for foreign exchange, interlinked by the balance of payments (BoP = CA + KA = 0), and the money market, interlinked in turn with the financial capital market by the interest rate. Unless otherwise stated, assume there is no expected inflation (πe = 0, so the nominal and real yields on long assets are equal, i = r), and assume at the outset that all markets clear, including the labour market, and hence the nominal wage, W, is flexible. Revise these assumptions only if and when instructed.

In a near zero-short-yield financial environment, and confronted with a pandemic, the government shuts down its entertainment services sector and enforces the shutdown by law.

a) Explain whether this shock arises from the supply or demand side of the economy.

b) Discuss the possible effects on financial markets. For example, would you expect yields and asset prices to rise or fall, and why?

c) Discuss whether generic expansionary fiscal and monetary policy could be effective in avoiding a subsequent recession.

d) Considering the zero short-yield environment, explain what types of policies would best address the economic effects of the shutdown.

e) If the government implements the policies you recommend, irrespective of the mix of instruments they embody, explain whether some monetary expansion might always be helpful during the shutdown and recovery period.

Answer 1

Given :

  BoP = CA + KA = 0,

πe = 0,

i = r,

(a) An economic shock refers to any change to fundamental macroeconomic variables or relationships that has a substantial effect on macroeconomic outcomes and measures of economic performance, such as unemployment, consumption, and inflation. Shocks are often unpredictable and are usually the result of events thought to be beyond the scope of normal economic. Weather this shock arises from the supply or demand side of the economy.

(b) One of the dangers of historically low interest rates is they can inflate asset prices. As a result, things such as stocks, bonds, and real estate trade at higher valuations than they would otherwise support. For stocks, this can lead to higher-than-normal price-to-earnings ratios, PEG ratios, dividend-adjusted PEG ratios, price-to-book-value ratios, price-to-cash-flow ratios, price-to-sales ratios, and lower-than-normal earnings yields and dividend yields.

(c) When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: monetary policy or fiscal policy.

(d) As with production and use of any fuels, aspects of biofuel production and use have benefits and adverse effects. The potential environmental effects from the production and use of algal biofuels, the potential influence of perceived or actual impacts on societal acceptance, and some of the health impacts potentially emanating from the specific environmental effects. Potential environmental effects discussed in this chapter include those resulting from land-use changes, water quality, net greenhousegas (GHG) emissions, air quality, biodiversity, waste generation, and effects from genetically engineered algae (with an emphasis on new or enhanced traits).

(e) Monetary policy is policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often as an attempt to reduce inflation or the interest rate to ensure price stability and general trust of the value and stability of the nation's currency.The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. Central banks have three main methods of monetary policy: open market operations, the discount rate and the reserve requirements.