(a) Why do some economists claim that we should not worry too much about inflation? The economists claim that, as a result of the under-read measure of the inflation since they don’t take account of qualitative improvements over time. A small amount of inflation makes it possible to give adequate pay cuts, making it easier to shed labor over time as people find better opportunities rather than having to make redundancies.
(b) Other economists think that there are significant costs associated with inflation above 2-3%. What are they? Briefly discuss (2 marks)
They are Shoe-leather, Relative price variability, Menu cost, and Inflation-induced tax distortion.
• Menu cost: It is due to price change, and can be thought as an outcome of the cost of the decision, information, and implementation resulting in bounded rationality. Because of this expense, there will be no change of prices with every change in supply and demand by different firms leading to nominal rigidity. At the point whereby the prices of the commodities become sticky is, therefore, the net result of menu costs at a particular time. For sufficient disparity to be achieved between the equilibrium market price and the firm’s current price, the stickiness will allow firms to hesitate this change in their prices to ensure the distribution of commodities into the market. The change in firm prices should not be done until the price change, and this will bring additional revenue to cover the menu cost.
• Relative price variability: This is the price of commodities such as services or goods in terms of another, for instance, it is the ratio of two prices. It can also be expressed as a ratio a weighted average of all other goods available in the market to the price of a particular good. It observed that, for the economic agents, the inflation make it difficult for them to immediately distinguish any increase in the price of a particular good which is as a result of relative price changes because of price change caused by inflation of prices in general.
• Inflation-induced tax distortion: It has been observed that all tax distort cause people to change their behavior and brings less efficient allocation of the economic resources. During low inflation, the value of money increases while for higher inflation the real value of money decreases.
• Shoe leather cost: It is the opportunity costs of time and the effort that the individuals expend by holding less cash, therefore, is one of the impacts of inflation. People are discouraged holding a huge amount of cash since the value deteriorates rapidly relative to rising of prices in the economy. The cash in bank accounts of some individuals compels them to make trips to the bank to get the money to pay for services and goods. These regular trips to the bank wear their shoe leather thus a shoe-leather cost.
2. According to new legislation, all workers can earn the same wage specified in the annual contract which they sign on 1st January no matter what happens to prices of final goods and services during that year. This year, the prices of final goods and services fall unexpectedly after the contract has been written on 1 January. In this exercise, you must illustrate what happens in the economy in the following AD-AS figure in the short-run. We assume that the economy starts at potential output, depicted in point A below.
a)(3marks) Start from Point A, demonstrate how the quantity of aggregate output supplied response to the fall in prices of final goods and services using the figure below? Explain your answer.
There will be a shift from SRAS0 to SRAS1 which is an outward shift of short-run aggregate supply. An increase in AS would increase the output quantity and lowers the final price level of the commodity, and this will result in less unemployment and less inflation ( Rao, 2016).
When the price of final good fall, the short-run aggregate supply curve shift from point A downwards, the productivity increases are making a combination of higher output, lower unemployment and finally, lowers the rate of inflation while real GDP increases.
b) (3 marks) Start from Point A, demonstrate what happens when firms and workers are permitted to renegotiate their wage contracts? Explain your answer.
SRAS0 will shift from A to SRAS2 is an inward shift of short-run aggregate supply.
There will be a sudden change in price from point A upwards. This sudden change will allow the negative supply shock to shift the aggregate supply leftwards, increasing the price level of goods and services the firm produced and eventually decreasing the final output and it may cause stagflation due to a combination of falling output and the rising prices.
3. We studied how the Reserve Bank of Australia (RBA) can influence the money supply in the Australian financial market. Answer each question briefly.
a) How does the open market operation increase the number of dollars in circulation? (2marks)
The domestic market operations allow the capital market interest rates and the cash rate to be fed through a whole structure of lending and deposit rates. Most of loans and deposits are at short-term or variable rates thus there is a high cash rate to lending and deposit rates therefore an increase in money circulation within an economy. The people, therefore, get their money by cashing checks or withdrawing cash. For instance, individuals demand a significant amount of cash for vacation and shopping during the holiday seasons and for vacations. This will eventually increase the circulation of money in the economy.
b) How does the reserve ratio influence the money supply? (2 marks)
When the reserve requirement for all banks is to be raised or lowered according to the decision of the RBA, it will allow for the immediate and direct impact on the money supply to the economy. Therefore the money that can be allowed to multiply through a process of multiple deposits is equal to that amount of cash that can be loaned out (Destain, 2016). This money can now filter through the economy as the consumer and businesses borrow it to invest. The multiplier effect will eventually change as the average reserve ratio changes and thus changes the money supply. The fraction of money deposited to the banks by the customer is sometimes required to be withholding the reserve with the central bank and is represented by the reserve ratio. The reserve ratio can be therefore set by the Federal Reserve and gives the central bank authority to change as well as influence the supply of money in the economy.
What do you think happens to the money multiplier (M) in a financial crisis and what is the likely impact of the change in M to the economy? (2 marks)
According to Friedman, (2017), money multiplier is a ratio of deposits to reserves in a banking system, during the financial crisis; the (M) will reduce as there will be few deposits to the bank as the reserves remain constant since it is a percentage of the total amount of money deposited at a particular time. The change in money multipliers will eventually lower the circulation of money in the economy hence reduced resources to the people. The central bank can adjust the reserve requirement to loosen or tighten the money supply. When inflation is increased, the central bank will often raise reserve requirements to reduce the money multiplier.
4 Name the movies which are based on the financial crisis (1mark)
Inside Job (2010, Dir. Charles Ferguson)
Wall Street: Money Never Sleeps (2011, Dir. Oliver Stone)
Margin Call (2011, Dir. JC Chandor)
Rollover (1981, Dir. Alan J. Pakula)
Too Big To Fail (2011, Dir. Curtis Hanson)
5. (3 marks) Have a look at the following article,
https://www.theguardian.com/business/grogonomics/2018/mar/08/australia-isnt-in-recession-but-we-might-as-well-be
The recession is the period of negative economic growth for the two consecutive quarters and mostly caused by the fall in aggregated demand thus a drop in GDP. When the growth of the country reduced to a little value, there will be an increased unemployment and spare capacity.
The Australian government has some choices to make while dealing with the economic recession (Cencini, Gnos, and Rossi, 2016). The most likely attempt is to stimulate the economy by encouraging the individuals to spend more money for the circulation. High circulation of money in the economy can be achieved if the government decides to choose to offer a tax break to give people to access more money and eventually making them more likely to continue spending. Additional capital can be created whenever the government lowers the taxes employed by the consumer or by creating tax credits to the consumers and it will eventually make them pay more. The production will increase, or it can be maintained at the current level.
Reference
Cencini, A., Gnos, C. and Rossi, S., 2016. Quantum macroeconomics: A tribute to Bernard Schmitt. Cuadernos de Economía, 39(110), pp.65-75.
Destais, C., 2016. Central bank currency swaps and the international monetary system. Emerging Markets Finance and Trade, 52(10), pp.2253-2266.
Friedman, M., 2017. Quantity theory of money. The New Palgrave Dictionary of Economics, pp.1-31.
Rao, B.B. ed., 2016. Aggregate demand and supply: A critique of orthodox macroeconomic modelling. Springer.
