# Economics the short run. The Phillips curve

Economics 248 Assignment 2 (version A)

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 coursework for units 4, 5, and 6. Answer each question clearly
and concisely.

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GM
announced that it will close its Oshawa truck plant in 2009 and a Windsor
transmission plant in 2010. Ford also plans a 10 percent cut in
white-collar, salaried positions. In total, over 4,000 direct jobs will be
lost. This is chilling news for Ontario, because for every job in an
assembly plant, there are 7.5 jobs with auto-parts suppliers and other companies.
Using appropriate diagrams, answer the following questions.

(10 marks)

a.
Is there a trade-off between the
unemployment rate and the inflation rate in the short run? How can the Phillips
curve be used to answer this question?

Yes, there is a trade-off between the unemployment rate
and the inflation rate in the short-run. The unemployment rate and the
inflation rate have a negative relationship in the short run. The Phillips
curve shows that a higher inflation rate results in a lower unemployment rate.
(2 marks)

b.
What is the relationship between
the Phillips curve, aggregate demand, and aggregate supply?

The short-run Phillips curve is similar to the short-run
aggregate supply curve. This is because any change in the short-run aggregate
supply curve increases the price level. In addition, any increase in the real
GDP results in a change in the short-run Phillips curve. This means that the
inflation rate will rise but the unemployment rate will go down.

However, any change on the SAS curve that results in lower
price level and a decrease in real GDP will lead to a change on the short-run
Phillips curve. This change shows that the inflation rate will go lower and the
unemployment rate will rise. When aggregate demand unexpectedly goes higher, both
the real GDP and price level rise. This rise in real GDP brings down the unemployment
rate, but the increase in prices increases inflation.

(2 marks)

c.
If the unemployment rate and
inflation are both rising, can this be explained by a movement along a given
Phillips curve? What must be happening to aggregate demand and aggregate
supply? What must be happening to the Phillips curve?

The relationship between the unemployment rate and
inflation rate on the Phillips curve is negative. Therefore, if the
unemployment rate and inflation both rise, a change on the along a given
Phillips curve cannot explain it. The result of any change along the Phillips
curve can be two types: 1. an increase in unemployment and decrease in
inflation; 2. a decrease in unemployment and an increase in inflation.

If both the inflation rate and the unemployment rate
rise, it means that the change is happening in the long-run in Philips Curve. When
unemployment is constant and inflation rises as the Phillips curve is a
vertical line.

(2 marks)

d.
If the Bank of Canada continues to
take an expansionary monetary policy, how are the unemployment rate and inflation
affected? (Use both the Phillips curve and AS-AD graphs in your explanation.)

The expansionary monetary policy is an action that tries
to push the economy up by adding money to the economy. With more money, readily
available people will invest and consume more. This will cause the aggregate
demand to shift up along the aggregate supply curve (AS-AD). If the Bank of
Canada continues to use this policy, the unemployment rate will decrease and
inflation will increase (Phillips curve).

(2 marks)

e.
Is there a trade-off between the
unemployment rate and inflation in the long run? How is the long-run aggregate
supply curve related to the long-run Phillips curve?

No, there is no trade-off between the unemployment rate
and inflation in the long run. The long-run Phillips curve does not shift with
a fall or increase in expected inflation. In the long-run, the inflation rate
remains constant. The only variable is the inflation rate.

The long-run aggregate
supply curve shows that fluctuations in the price level do not change the
natural rate of unemployment. In relation, the long-run Phillips curve shows
that any fluctuations in the inflation do not affect the unemployment level.

(2 marks)

a.   Distinguish between monetary policy instruments
and monetary policy tools.

Monetary policy instruments are things that the central
bank uses to change money supply. An example of an instrument is a bond. The
central bank change the monetary base by buy or sell. Monetary policy tools are
the techniques that the central bank uses to change the monetary base. The
tools are the actions taken, and the instruments are the things used to make
the action happen.

(5 marks)

b.
Describe any two key tools of
monetary policy, and describe how they would be used to implement expansionary monetary
policy.

There are several monetary policy tools available to
achieve these goals: reducing the monetary base, increasing reserve
requirements, and increasing interest rates.

The first tool of monetary policy is open market
operations. In expansionary monetary policy central bank would buy the bonds
and put more money in the market.

(5 marks)

If
the Bank of Canada sells \$400 million worth of bonds to the public in an
open market operation, what is the change in the quantity of money that
will eventually result? Assume that the currency drain is 0.15 and the
desired reserve ratio is 0.05, and show your calculations.

Money multiplier = (1+ 0.15) / (.15+0.05) = 5.75

So, the change in quantity of money resulting = 5.75*100
= \$575 million

(10 marks)

4.
a.   Explain the concept of the multiplier, and explain the role of the
marginal propensity to consume in determining the size of the multiplier.

The marginal propensity to save
(MPS) refers to the increase in saving (non-purchase of current goods and
services) that results from an increase in income i.e. The marginal propensity
to save might be defined as the proportion of each additional dollar of household
income that is used for saving. It is also used as an alternative term for the
slope of the saving line.

An important implication of
Marginal Propensity to save is measurement of the multiplier. A multiplier
measures the magnified change in aggregate product i.e. the gross domestic
product, resulting from a change in an autonomous variable (for example,
government expenditure, investment expenditures, etc.).

(4 marks)

b.
Explain how the size of the
multiplier will change when the role of the marginal tax rate is brought in.

The tax multiplier is the
negative marginal propensity to consume times one minus the slope of the
aggregate expenditures line.

The key feature of the simple tax
multiplier that differentiates it from the simple expenditures multiplier is
how taxes affect aggregate expenditures. To be clearer, taxes do not affect
aggregate expenditures directly. They affect it indirectly by changing
disposable income and consumption. This gives rise to two important differences
compared to the simple expenditures multiplier.

(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 MPC
= 0.75. 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 0.10.

If MPS = 0.20, then the size of
the multiplier is m = 1/MPS = 1/0.2 = 5. The slope of the AE curve will be 0.2.
The positive slope of the aggregate expenditures line is the sum of the
marginal propensity to consume (MPC), marginal propensity to invest (MPI), and
marginal propensity for government purchases (MPG), less the marginal
propensity to import (MPM).

If the imports and the marginal
tax rate will reduce the slope of the AE curve by another 0.25, the revised
slope of the AE curve will be 0.2 + 0.25 = 0.45. The multiplier will be 1/0.45
= 2.22.

(4 marks)

The
economy has seen the unemployment rate increase from 6 percent to 9.5
percent and the inflation rate decrease from 2.8 percent to 1.2 percent,
and there has been a 24 percent decline in consumer spending and a 45
percent decline in investment spending in the same time period.

(10 marks)

a.
What would you predict about the
overall direction of the above economy? Explain your answer.

The overall direction of the
economy is heading to a recession because it is defined as a significant
decline in activity spread across the economy lasting more than a few months. A
recession is triggered by a decrease in autonomous expenditure that decreases
aggregate planned expenditure. Real GDP exceeds aggregate planned expenditure
at the turning point into a recession. Inventories start piling up, due to a
decline in consumer spending, firms cut production and real GDP beings to
decline. According to the expenditure approach, GDP is measured as the sum of
personal expenditures on consumer goods and services, business investment,
government expenditures on goods and services, and net exports. There was a
decline in consumer spending which would lower GDP. There was a decline in
investment spending which would also lead to a lower GDP. The unemployment rate
increased therefore less people are being productive which lowers GDP. A
decrease in investment decreases real GDP which decreases consumption
expenditure.

(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.

The government should increase
the interest rate and also put some money in the market so that there is more
consumer spending and investment spending

(3 marks)

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

The appropriate monetary policy
that the Bank of Canada should be operating would include cutting interest
rates. Lower interest rates make it cheaper to borrow which should encourage
spending and investment. This may lead to higher aggregate demand and economic
growth.

(2 marks)

Describe
the contrasting views of the Keynesians and the monetarists with regard to
an appropriate contractionary (tightening) policy to bring an economy out
of a period of high inflation caused by excess aggregate demand.

The Keynesians note that higher
government spending in a recession can help the economy to recover. They note
that insufficient demand causes unemployment and that excessive demand results
in inflation; government should therefore manipulate the level of aggregate
demand by adjusting levels of government expenditure and taxation.

Monetarists note that it is
important to control the money supply and inflation. Monetarists fault
Keynesians for relying too much on government spending and taxation policies,
which over-stimulates the economy, causing the inflation.

The Keynesians believe that
higher government spending in a recession can help the economy to recover. They
believe that insufficient demand causes unemployment and that excessive demand
causes in inflation. They also believe that the government should manipulate
the level of aggregate demand by adjusting levels of government expenditure and
taxation. The Keynesians would argue that a contractionary policy is not
effective in the long-run and that an expansionary policy should be used. Monetarists
believe that it is important to control the money supply and inflation.
Monetarists think that Keynesians rely too much on government spending and
taxation policies because they believe it over-stimulates the economy and
causes the inflation. The monetarists believe that contractionary policy is
appropriate to bring the economy out of a period of high inflation. According
to them, contractionary policy shifts the AD curve to left, which indicates
lower inflation

(10 marks)

Suppose
that Kiribati can produce 1,500 tons of breadfruit or 1,000 tons of fish
and that Tuvalu can produce 900 tons of breadfruit or 2,000 tons of fish.

(10 marks)

a.      What is the opportunity cost of one ton of fish in Kiribati?

Opportunity cost of 1 ton of fish
in Kiribati = 1500/1000 = 1.5 ton of breadfruit

(2.5 marks)

b.     What is the opportunity cost of one ton of fish in Tuvalu? Show

Opportunity cost of 1 ton of fish
in Tavalu = 900/2000 = 0.45 ton of breadfruit

(2.5 marks)

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

Tavalu has comparative advantage
in producing fish, as the opportunity cost is lower there

(2.5 marks)

d.     Suppose trade takes place between Kiribati and Tuvalu. Which
good will Kiribati import from Tuvalu? Explain why.

Kiribati will import fish from
Tavalu, as Tavalu has comparative advantage in producing fish while Kiribati
has advantage in producing breadfruit, so it would look to produce breadfruit
and import fish

(2.5 marks)

a.   Discuss
three tools that government can use to influence imports.

Three tools government can use to influence imports are

1) Import quotas: government can put restrictions on the
number of units that a firm can import. This Form of quantitative restriction
on imports can help government reduce the volume of imports.

2) Import tariff: Another way to control imports is to
put import tariff on goods. 3) Government can appreciate or depreciate the
currency in order to affect the imports. Appreciation would cause an increase
in imports.

(5 marks)

b.
Discuss and evaluate the two
classical arguments for trade protection and restriction.

First argument is infant industry argument, which says
that new industries can be safeguarded from foreign competition by introducing
trade barriers such as import tariff and import quotas. Another argument for
protection is that it provides an incentive to poor countries to raise their environmental
standards—free trade with the richer and “greener” countries is a reward for
improved environmental standards.

(5 marks)

In 2015,
the Canadian dollar depreciated against the US dollar. Explain the effects
of this depreciation on each of the following.

(10
marks)

a.      Canadian exporters of goods to the United States

When the Canadian dollar
depreciates against the US dollar, any imports form the Canada will be cheaper
for the US. Canada will be able to export more to the US.

(2.5 marks)

b.     Canadian firms that bought machinery and equipment from US
suppliers

When the Canadian dollar depreciates
against the US dollar, equipment from US suppliers will be more expensive for
Canadian firm and they will buy less.

(2.5 marks)

c.      Cross-border shoppers from Canada who shopped for goods in the United
States

When the Canadian dollar depreciates
against the US dollar, this depreciation of the currency makes the shopping in
the US more expensive. Therefore, we expect a fall in the quantity of cross-border

(2.5 marks)

d.     Retired Canadians who lived in Arizona and Florida during the
winter months.

It will decrease the quantity of
retired Canadians who lived in Arizona and Florida during the winter months.
Because it is more expensive for them to line in the US.

(2.5 marks)

Consider
the Republic of Netflex’s balance of payments in 2014:

Foreign investment into Netflex

+22

Imports of goods and services

?378

?5

Exports of goods and services

+370

Net transfers

+3

Statistical discrepancy

+5

Net interest payments

?14

Organize the above data into the
appropriate categories for the current and capital accounts, and determine the
current account balance, the capital account balance, and the official
settlements account balance.

Current Account                        Millions of Dollars

Imports of goods and services       -378

Exports of goods and services        +370

Net interest payments                    -14

Net transfers                                   +3

Current Account Balance               -19

Capital Account

Foreign investment into Netflix         +22

Netflix investment abroad                  -5

Statistical discrepancy                          5

Capital account balance                       32

Official Settlement Account               -13

Official settlement account
balance   -13

(10 marks)

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