Economics 248 Assignment 2 (version B)

This assignment has a maximum total of 100 marks and is worth 10 percent of your total grade for this course. You should complete it after completing your course work for Units 4, 5, and 6. Answer each question clearly and concisely.

1. The Canadian consumer confidence rebounded sharply in September 2012. This is a significant rebound since the plunge in October 2008. According to some analysts, the good news from Europe and the jump in the stock market appear to have had an effect on Canadian consumer confidence.                    (10 marks)

a.       Explain the various factors that buoyed the Canadian consumer confidence in 2012.

b.      Explain and draw a graph to illustrate how a rise in consumer confidence can change real GDP and the price level in the short run.

c.       If the economy was operating at full- employment equilibrium, describe the state of equilibrium after the increase in consumer confidence. In what way might consumer expectations have a self-fulfilling prophecy?

d.      Why do changes in consumer spending play such a large role in the business cycle?

e.       Explain how the economy can adjust in the long run to restore full-employment equilibrium. Draw a graph to illustrate this adjustment process.

1. a.   Differentiate between monetary policy instruments and monetary policy tools .

(5 marks)

b.      Describe the two key tools of monetary policy, and describe how they would be used by the Bank of Canada to implement a contractionary monetary policy.                                                                                           (5 marks)

1. The economy of Kenya is in recession, and the recessionary gap is large. The World Bank hires you as its economist and asks you to                  (10 marks)

a.       describe the discretionary and automatic fiscal policy actions that might occur.

b.      describe a discretionary fiscal stimulation package that could be used that would not bring a budget deficit.

c.       describe the risks of discretionary fiscal policy in this situation.

d.      explain the argument that lower corporate tax rates can increase tax revenue in Kenya. Consider the Laffer curve in your explanation.

a. Discretionary fiscal policy is made more difficult due to lags in recognizing the need for changed fiscal policy and the lags that occur with enacting the changed fiscal policy. Implementing the modified fiscal policy usually requires legislative action, which takes a long time to implement. 
Automatic stabilizers, without specific new legislation, increase (decrease) budget deficits during times of recessions (booms). They enact countercyclical policy without the lags associated with legislative policy changes.
b. Discretionary fiscal policy such as a “stimulus package" is the sort of package does not come about automatically. There is no provision that says that the government will pay out a certain level of money if economic activity slows.  Instead, the government must draft and pass a bill to specifically lay out what sorts of stimulus spending will occur. Discretionary fiscal policy provides an alternative way to stimulate the economy when aggregate demand and interest rates are low and when prices are falling or may soon be falling. A stimulus can be achieved without increasing budget deficits if the fiscal policy acts by providing an incentive for increased private spending.
c. Ultimately, if risks regarding the future course of fiscal policy are substantial, and if its credibility is undermined, unsustainable fiscal policies will have an impact on the creditworthiness of the government. In the extreme, this may lead to reduced access to capital markets for funding debt. But even more moderate debt levels are problematic. They impair the operation of automatic stabilisers. In addition, the effectiveness of fiscal policy measures could decrease as awareness increases among the public that the fiscal policy course is not sustainable, so that countervailing measures in the future are anticipated. Furthermore, increasing debt ratios lead to rising tax burdens, either now or in the future. This exacerbates current tax distortions and reduces work incentives, thus leading to less economic growth.
d. Lowering the rate would actually increase tax revenue because corporations could dedicate more resources to taxable, profit-generating activities.

1. a.   Explain the concept of the multiplier, and explain the role of the marginal

propensity to save (MPS) in determining the size of the multiplier.

(4 marks)

b.      Explain how the size of the multiplier will change when one brings in the role of the marginal tax rate.                                                                   (2 marks)

c.       Using the concepts in parts (a) and (b) above, calculate the slope of the AE curve and the size of the multiplier if MPS = 0.35. Then, calculate the revised slope of the AE curve and the multiplier when you know that the imports and the marginal tax rate will reduce the slope of the AE curve by another 0.20.

(4 marks)

1. The economy has seen the unemployment rate decrease from 8.56 percent to 6.15 percent, the inflation rate increase from 1.4 percent to 3.2 percent, and there has been a 17 percent increase in consumer spending and a 22.5 percent increase in investment spending in the same time period.

a.       Given the above, what would you predict about the overall direction of the economy? Explain your answer by referring to each of the indicators cited.

(5 marks)

b.      Describe the fiscal policy that will already be automatically operating, as well as the appropriate discretionary fiscal policy that the government should adopt, given the above situation.                                                     (3 marks)

c.       Describe the appropriate monetary policy that the Bank of Canada should be operating, given the above situation.                                       (2 marks)

1. Describe the contrasting views of the Keynesians and the monetarists with regard to an appropriate expansionary policy to bring an economy out of a period of high unemployment caused by a weak aggregate demand.                      (10 marks)

1. Suppose that Canada can produce 1500 tons of wheat or 500 tons of steel.  Suppose that Brazil can produce 1000 tons of wheat or 1500 tons of steel.                                                                                                                              (10 marks)

a.       What is the opportunity cost of 1 unit of wheat in Canada? Show your work.

b.      What is the opportunity cost of 1 unit of steel in Brazil? Show your work.

c.       Which country has a comparative advantage in producing steel? Explain why.

d.      Suppose that trade takes place between Canada and Brazil. Which good will Brazil import from Canada? Explain why.

1. a.   Describe an export subsidy, and explain the gains and losses that might arise

from such practice.                                                                        (5 marks)

b.      Why are developing countries in Africa especially affected by export subsidies in industrial countries?                                                       (5 marks)

a.Export subsidy is a government policy to encourage export of goods and discourage sale of goods on the domestic market through direct payments, low-cost loans, tax relief for exporters, or government-financed international advertising. An export subsidy reduces the price paid by foreign importers, which means domestic consumers pay more than foreign consumers. The WTO prohibits most subsidies directly linked to the volume of exports.
Export subsidies can cause inflation: the government subsidises the industry based on costs, but an increase in the subsidy is directly spent on wage hikes demanded by employees. Now the wages in the subsidised industry are higher than elsewhere, which causes the other employees demand higher wages, which are then reflected in prices, resulting in inflation everywhere in the economy.
b. While advocates of liberalization in the economies of the developing countries have called for reduction in subsidies, the high levels of subsidies in developed countries have increased significantly especially in the OECD countries. While the Uruguay Round advocates the reduction of subsidies in most developing countries, subsidies have been on the increase in OECD countries and the United States.

1. In 2012, the Canadian dollar appreciated against the US dollar. Explain the effects of this appreciation on each of the following.                                     (10 marks)

a.       Canadian importers of goods from the US

b.      Canadian firms that sell commodities to US buyers

c.       American tourists who come to Canada

d.      US investors who had purchased Canadian securities prior to this currency appreciation

1. Global Insight (GI) forecasting firm predicted that the Canadian economy will bounce back by a stronger than expected 1.0% on annualized basis in the third quarter of 2012 and with a further 0.1% in the fourth quarter of 2012. The firm also expects moderate growth overall in 2013.                             (10 marks)

a.       What evidence does GI present to support the view that Canada had entered a recovery?

b.      Use a short-run Phillips curve to explain why the inflation rate may increase over the course of 2012.

Under what circumstances might the inflation rate not