UNIVERSITY OF ESSEX DEPARTMENT OF ECONOMICS ASSESSED WORK COVER SHEET Module code and title:.........................вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦...................вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦... Family Name: вЂ¦.вЂ¦вЂ¦вЂ¦..............вЂ¦...вЂ¦.......вЂ¦..Given Names:вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦...вЂ¦.......вЂ¦................. (BLOCK CAPITALS) (BLOCK CAPITALS) Registration number: вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦ Please read the following carefully: In signing this cover sheet you confirm: 1. That the attached work complies with University regulations governing academic offences, in particular regulations 6.20 and 6.21. Please follow the link, Information and Publications, from the UniversityвЂ™s website, to University Regulations, Policy and Procedures, to Academic Offences Procedures. 2. 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UNIVERSITY OF ESSEX SPING TERM 2014 DEPARTMENT OF ECONOMICS EC111 вЂ“ INRODUCTION TO ECONOMICS ASSIGNMENT 2 This assignment is to be handed in to Room 5B.209 before 12 noon on Monday 3rd March 2014. You will be receive and electronic receipt. You should not hand in assignments to your class teacher. Please note that the University has a zero tolerance policy on late submission of coursework. Any assignment submitted after the deadline will receive a mark of zero (see Undergraduate Economics Handbook). Please make sure that your NAME and the name of your CLASS TEACHER are printed clearly on the front page of your assignment. This assignment is divided into two sections. Each is worth 50 percent of the marks. Write your answer in the spaces provided. You should answer all the questions. Use diagrams or mathematical expressions where appropriate. YOUR NAME:вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦ (Block capitals only) CLASS NUMBER:вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦ CLASS TEACHERвЂ™S NAME:вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦вЂ¦ (Block capitals only) SECTION A (10 questions, 5 marks each) State whether each statement is true or false giving a brief explanation in the space provided. Use diagrams where appropriate. Your mark will depend on your explanation e.g. even if the statement is correct, putting вЂњTRUEвЂќ will get no marks unless you justify your answer. 1. Direct tax is a tax paid on consumption goods. FALSE Direct tax is a tax levied on incomes, not expenditures. Taxes levied at the point of sale of good are indirect taxes, such a VAT. 2. An increase in the marginal propensity to save increases the value of the Keynesian multiplier. FALSE: The consumption function is: ( Saving is: < 1. ) ; the marginal propensity to save is 1 вЂ“ b, where 0 < b The multiplier is derived (in familiar notation, in a closed economy and with a lump sum direct tax for simplicity) from . So equilibrium national income is: ( ) The multiplier is smaller the larger is (1 вЂ“ b). [This is enough but, just to note that it also true in the full IS/LM model where М… ( ) ( ) There are extra terms in the multiplier (and further terms would be included if we take taxes to depend on national income). But it remains true that and increase in (1 вЂ“ b) reduces the value of the multiplier.] 3. If the government increases its expenditure and its (lump sum) direct tax by the same amount, there will be no increase in national income. FALSE In the basic Keynesian model we have: national income is: . So ( ) If direct tax and government spending increased by the same amount: ( , we have: ) In this setting the balanced budget multiplier is 1 because the first round effect of the tax change is smaller than the first round effect of government expenditure. [In an IS/LM setting the balanced budget multiplier is less than one but still positive]. 4. An increase in the interest rate reduces the present value of an investment project by more the further in the future are the revenues from the investment. TRUE The present value of a stream of future income is: ( ) ( ) ( ) The further in the future the larger is the discount factor. In the example from the lecture the PV of project A falls by more than that of project B when the interest rate increases because A is spread over a longer time horizon. Year 1 Year 2 Project A ( Project B PV; r = 0.1 200 PV; r = 0.2 175 200 183 ) 5. In an IS/LM economy an increase in the indirect tax rate will reduce investment. FALSE: A increase in the indirect tax rate reduces national income for a given interest rate, i.e. it reduces the multiplier, which means that the IS curve shifts to the left. Where we have (in the usual notation): . The IS curve is: r LM IS1 IS2 Y The leftward shift of the IS curve reduces national income and also the interest rate. As investment is given by: , the fall in the interest rate increases investment. 6. If the central bank raises the reserve requirements of the banking system the money supply will fall. TRUE: The money multiplier is (in familiar notation): ( ( ) ) The derivation of the money multiplier is in the lecture notesвЂ”I have skipped it here. The banking systemвЂ™s (cash) reserve to deposit ratio is Оё. Increasing Оё will reduce the money multiplier. But note that if the banks, for prudential reasons, choose a value of Оё that is above the new reserve requirements than it might not have any effect. 7. An increase in national income, with a constant money supply, will reduce the price of bonds. TRUE An increase in national income shifts the demand for money to the right. If the money supply is fixed, then people will try to sell bonds in order to hold more money for transactions. The price of bonds falls and the therefore the interest rate increases (because c/Pb = r) by just en to induce the public to hold the original amount of bonds. MS r MD2 (Y2) MD1 (Y1) M 8. If labour supply and labour demand are equal, there will be job vacancies but no unemployment. . FALSE W/P E LS V= U (W/P)1 E LD L In a realistic labour market there will always be some unemployment. Turnover means that there will be both vacancies and unemployment. Vacancies are the distance between labour demand and the EE curve; unemployment is the distance between labour supply and the EE curve. At the equilibrium of labour supply and demand vacancies are equal to unemployment. 9. In the long run there is no trade-off between inflation and unemployment. TRUE LRPC М‡ М‡ ( ) М‡ ( ) М‡ ( ) U1 U* U The short run Phillips curve is downward sloping. But there is a different SRPC for each level of expected price inflation. If the unemployment rate was held below U* (e.g. at U1) wages would rise faster than expected inflation (e.g. at М‡ ( )). Wage inflation feeds through to prices so that net period expected price inflation will be М‡ ( ). Wage inflation will be again be higher than expected inflation so the inflation rate will continue to accelerate. The only unemployment rate that keeps inflation stable is U* which is the Non-Accelerating Inflation Rate of Unemployment. The long run Philips curve is vertical. 10. If the unemployment rate is higher than the Non Accelerating Inflation Rate of Unemployment (NAIRU) the price level must be falling. FALSE In the familiar notation we have: Phillips curve: М‡ М‡ Markup equation: М‡ М‡ (1) (2) Expectations formation: М‡ М‡ (3) Substituting (2) and (3) into (1) we have: М‡ М‡ The unemployment rate for a constant rate of inflation, М‡ So: М‡ М‡ ( М‡ , is the NAIRU ) If unemployment is higher than the NAIRU then the inflation rate will be falling( М‡ М‡ ), but the price level will not necessarily be falling, e.g. М‡ . SECTION B (2 questions, 25 marks each) 1. A closed economy with a fixed price level has the following relationships: Consumption: Y = 50 + 0.8Yd, Investment: I = 150 вЂ“ 10r Government expenditure: G = 250 Direct tax: Td = 0.25Y Real money demand: MD/P = 0.5Y вЂ“ 20r Money Supply MS = 400 Y is national income; Yd is disposable income and r is the interest rate. The price level, P, is fixed at P = 1. a) [7 marks] Find equilibrium national income. The IS curve: Y = C + I + G Y = 50 + 0.8 (1 вЂ“ 0.25)Y + 150 вЂ“ 10 r + 250 Y = 1125 вЂ“ 25r The LM curve: MS = MD/P 400/1 = 0.5 Y вЂ“ 20r Y = 800 + 40r Solving for r 1125 вЂ“ 25r = 800 + 40r; r = 5 Using the IS curve, Y = 1125 вЂ“ 125 = 1000. (Using the LM curve gives the same result). b) [6 marks] Now the consumption function shifts down to become: C = 0.8Yd. Suppose that in order to maintain the original income level government could either increase government expenditure or cut the tax rate. Find the necessary level of government spending or tax rate. Which of these policies would be preferred and why? If income is to be maintained at Y = 1000 then, from the LM curve, the interest rate must stay at r = 5 as in (a) above For an expansion of G we have the IS curve: Y = 0.8(1 вЂ“ 0.25)Y + 150 вЂ“ 10 (5) + G For Y = 1000 we have: 1000 (1 вЂ“ 0.6) = 100 + G; G = 300 The budget deficit is G вЂ“ Td = 300 вЂ“ 0.25(1000) = 50 Alternatively, to calculate the tax rate necessary to keep Y = 1000: Y = 0.8(1 вЂ“ td)Y + 150 вЂ“ 10 (5) + 250 1000(1 вЂ“ 0.8(1 вЂ“ td)) = 350; 800td = 150; td = 0.1875 The government might prefer to use tax policy as this can be introduced quickly whereas large public works take time to plan. On the other hand the government may be concerned about the deficit: When government expenditure is used the deficit is: G вЂ“ Td = 300 вЂ“ 0.25(1000) = 50 When the tax rate is used the deficit is: G вЂ“ Td = 250 вЂ“ 0.1875(1000) = 62.5 Changes in direct tax are less powerful because the first round effect is on income and not expenditure. Tax must be reduced by more to obtain the same effect on income and thus the deficit is higher. c) [6 marks] With the consumption function as in (b) above, in the absence of fiscal policy, would monetary policy be an effective alternative? By how much should the money supply be increased? The IS curve: Y = 0.8 (1 вЂ“ 0.25)Y + 150 вЂ“ 10 r + 250 For Y = 1000 the interest rate must be reduced to zero, which is just possible. This increases investment from 100 to 150, compensating for the downward shift in consumption. The LM curve: MS/P = 0.5 Y вЂ“ 20r For r = 0 and Y = 1000 (with P = 1) the money supply must be raised from 400 to 500. d) [6 marks] Now suppose that wages and prices were perfectly flexible and full employment national income is Y = 1000. With the money supply at the original level, MS = 400, what is the effect of the downward shift in the consumption function on investment and the interest rate? Compare this outcome with (c ) above and explain. We now have a classical model in which the economy is always at full employment. The IS curve: as in (c ) above, for Y = 1000 the interest rate must be r = 0; I = 150 вЂ“ 10(0) = 150. This is the same as in (c ) above. The LM curve: for r = 0 and MS = 400 gives P = 0.8. In the classical economy the fall in the price level raised the real money supply to MS/P = 400/0.8 = 500, the same as in (c ) above. In the classical model prices adjust and no policy intervention is necessary. The fall in the price level is equivalent to the same proportionate increase in the money supply. 2. Use economic analysis to answer the following questions with reference to the British economy in the global financial crisis (GFC) and its aftermath. a. [5 marks] What caused the GFC and how would you expect it to have affected the money multiplier during and immediately after the crisis? The GFC was financial crisis that started in 2007 and became a full crisis with the failure of the US investment bank Lehman Brothers, in September 2008. The deeper cause was that banks in the US and elsewhere had bought securities that were repackaged sub-prime mortgages, on which there were widespread defaults. Banks that held these securities looked at risk of becoming illiquid and vulnerable to failure. Interbank lending began to dry up and banks sought to raise their reserve ratios to protect themselves, One implication follows from the derivation of the money multiplier, given in the lecture notes as: ( ( ) ) If the banks raised their reserve to deposit ratio, Оё, then the multiplier will fall. (Also if the publicвЂ™s ratio of cash to deposits, Пѓ, fell this would also decrease the multiplier.) This means that for a given amount of high-powered money, H, the money supply, M, would fall. b. [5 marks] Comment on the Bank of EnglandвЂ™s response in the first two years after the crisis. What is meant by the вЂ�zero boundвЂ™ for interest rates? Does it mean that there is no further scope for monetary policy to stimulate the economy? In order to stabilize the financial system the Bank (together with the Treasury) assisted in rescuing Northern Rock and guaranteed deposits, and then took shares in two major banks, Lloyds and Royal Bank of Scotland. The Bank dramatically reduced its base rate from 5.5 percent at the end of 2007 to 0.5 percent by the middle of 2009. The lower bound for interest rates is zero. If it was negative then the lender would be paying interest to the borrower. No lender would do this, as it would be more profitable not to lend. One the base rate had been reduced to zero there was little scope to reduce it further. But the Bank embarked on Quantitative Easing, a version of what was formerly known as Open Market Operations. This involved purchasing large amounts of long-term assets principally government bonds (gilts)--в‚¤200B up to 2010, and ВЈ375B up to now. So there was some further scope and the aim was to increase bond prices and bring down long term interest rates (or yields) more generally. (The evidence suggests that the effect of the first round of QE was to reduce the interest rate on bonds by about 1 percentage point (100 basis points). c. [5 marks] Using IS/LM analysis show in a diagram what reaching the zero lower bound for the interest rate implies about the effectiveness of fiscal policy. r LM1 IS1 LM2 IS2 Y Being close to the lower bound means that the LM curve is very flat over that range. A shift in the LM curve from LM1 to LM2 would reduce the interest rate by very little (e.g. along IS1) and have little effect on national income. On the other hand fiscal policy would be more effective. Shifting from IS1 to IS2 has a larger effect on national income. It does not drive up the interest rate by very much (as the LM curve is flat) and so and increase in government expenditure does not вЂ�crowd outвЂ™ investment. d. [5marks] The governmentвЂ™s budget deficit rose substantially during the recession. How would you identify how much of that increase was due to fiscal stimulus and how much was due to the recession itself. The way to do this is to calculate the вЂ�structuralвЂ™ or вЂ�adjustedвЂ™ budget deficit. This shows how much the deficit would have changed if national income was unchanged (or more precisely for a constant income gap). G2 G, T t1 Y G1 t2 Y Y2 Y1 Y In the diagram the budget initially has a deficit of G1 вЂ“ t1Y1 at income Y1. In the recession the government increases its expenditure and lowers the tax rate, but the recession still reduces income to Y2. The deficit increases to G2 вЂ“ t2Y2. The structural deficit increases by much less: G2 вЂ“ t2Y1.This is the part that can be attributed to the change in policy. e. [5 marks] Most observers believe that the fiscal multiplier is low--less than 2, and possibly around 1. Examine possible reasons for the low multiplier. There are a number of reasons why the multiplier is fairly low: Consider a multiplier in which taxes are related to income and we have an open economy where imports are also related to income. The expression for the expenditure multiplier would be: The multiplier will be lower: (i) the lower is b (the MPC), (ii) the higher are the tax rates (td and te), and (iii) the higher is the marginal propensity to import. [E.g. for b = 0.6; td = 0.25; te = 0.2; f = 0.25, the multiplier would be 1.] Another reason the multiplier may be low is that it is measured for times when fiscal policy crowds out other components of spending. This could be because (in the IS/LM setting) it raises interest rates which reduces investment. Or if there is close to full employment there could be supply constraints that lead to reduced consumption or investment. Government spending and tax policy may have other, more indirect, effects e,g, on consumer confidence or business expectations. But it is likely to depend on the exact circumstances whether such effects would enhance or diminish the impact of a fiscal stimulus.