Macroeconomics: Fiscal And Monetary Policy, Exchange Rates, Economic Integration, Phillips Curve, Goods And Services, Money And Labour Markets, Factors Affecting Capital Essay.

Fiscal and Monetary Policy

1.In a closed economy, the output (Y) can be determined by the following equation:

Y = C(Y-T) + I + G, where, C denoted the consumption expenditure, T denotes the tax imposed by the government or the earnings of the government, I denotes the investment expenditure and G shows the amount of government expenditure in the economy (Mankiw 2014).

Thus, to increase the equilibrium output of the closed economy the government of the concerned economy can take expansionary fiscal policies, which include increase in the government expenditure, reduction in tax imposed, thereby inducing increase in the consumption expenditure by increasing the disposable income (Y-T). These expansionary fiscal policies can lead to an increase in the aggregate demand in the economy, thereby shifting the IS curve in the following way:

                                               

On the other hand, the equilibrium output can also be increased though expansionary monetary policies, which may include lowering of the rate of interest prevailing in the economy, which in turn leads to an increase in money supply in the economy and greater amount of money in the hands of people, thereby leading to increased in aggregate demand in the economy (Burda and Wyplosz 2013). This increases the output in the economy shown as follows:

                                                            

2.The nominal exchange rate of the domestic currency of a country can be defined as the amount of foreign currency which can be exchanged for one unit of the domestic currency of the country. However, the real exchange rate of the domestic currency of a country shows the actual purchasing power of the currency of the country, that is how much goods and services of the country itself can be exchanged for the goods and services produced in the foreign countries (Heijdra 2017).

Thus, Real exchange rate = Nominal exchange rate*(Foreign price/Domestic price)

On the other hand, the fixed exchange rate is that exchange rate which remain pegged at a predetermined rate and does not change regularly, which can be shown as follows:

                                                                     

Exchange Rates

In cases of fixed exchange rate systems, any increase or decrease in export or import dynamics of the country does not lead to depreciation or appreciation of the value of its domestic currency with respect of foreign currency but is adjusted in terms of demand and supply of the foreign currency in order to keep the exchange rate in the country same.

On the other hand, floating exchange rates are those which vary according to the fluctuations in the international foreign exchange markets, which can be shown as follows:

                                                                     

In these instances, when the demand for foreign currencies increases, it leads to an appreciation of the value of the foreign currency in terms of the domestic currency, thereby increasing the exchange rate of the domestic currency of the country.

3. The European Union, being an agreement among the European countries, was primarily formed with the objective of economic integration, which targets the reduction and removal of trade barriers (both tariff as well as non-tariff ones) in order to ensure free trade among the member countries, which not only involves free flow of goods and services but also eased movement of productive resources across the member countries (Dassonneville and Lewis-Beck 2014).

The reduction of the trade barriers and economic integration, which have been done by the EU, are expected to have several benefits on the overall economy, which can be shown with the help of the following figure:

                                                                  

As is evident from the above figure, with economic integration and imposition of free trade, the overall price of products falls due to increase in competition, which results in higher consumer surplus (1). The increase in import and export activities also lead to increase in production of the industries which lead to economies of scale. The welfare of the society also increases (2+4) (Blanchard and Giavazzi 2003). However, the tariff revenue of the government falls, but due to the increased productivity, economies cost efficiency, economies of scale and consumer surplus, both aggregate demand and supply in the economies across the EU are expected to increase, thereby contributing positively to economic growth.

Economic Integration

4.In the economy of the United Kingdom, there exists a trade-off between inflation and unemployment. When the economic productivity in the country is increased, it leads to creation of more scopes of employment. This increased employment leads to increase in the economic welfare of the population which in turn leads to aggregate demand in the economy. This increases the overall price levels in the economy (Palley 2012). Thus, there exists an inverse relationship between inflation and unemployment in UK, which can be shown with the help the following figure of Phillip’s Curve:

                                                                           

Keeping the trade-off into account, the government of the country needs to design the policies in such a way so as to maintain a balance between the inflation and unemployment of the country. An efficient policy to reduce inflation is of that of contractionary fiscal policy, which however reduces aggregate demand thereby leading to increase in unemployment and vice versa. This in turn leads to the need for balanced strategic framework for the country.

5.The equilibrium in the goods and service markets occur at the point where the demand for the same is equal to the supply of the same, which can be shown as follows:

                                                                   

Here, Q* is the equilibrium quantity and P* is the equilibrium price levels (Johnson 2017).

The equilibrium in the labour market, occurs at the point where labour demand is equal to the labour supply:

                                                                             

Here, the market reached equilibrium at the labour demand and supply level L*, with the equilibrium wage being W*.

The equilibrium in the money market occurs, where money demand is equal to money supply:

                                                                                    

Phillips Curve

In the short run, the money supply remains constant. Thus, the equilibrium occurs at the point where the supply curve intersects demand curve, with M* being the equilibrium quantity of money and R* being the equilibrium rate of interest.

6.Expansionary fiscal policy increases investment (public or private), thereby increasing the output of the economy while the contractionary ones lead to decrease in investment and output:

                                                                              

                                                                                                  (Source: As created by the author)

                                                                                    

On the other hand, expansionary monetary policy reduces the rate of interest, thereby increasing investment and vice versa as they are inversely related:

                                                                             

Thus, an expansionary policy shifts the LM curve rightwards, increasing output and vice versa:

                                                                  

                                                                                     (Source: As created by the author)

7.The primary factors affecting investment and capital formation in an economy are as follows:

1. Rate of interest- A higher rate of interest lowers investment and vice versa
2. Economic Growth- When an economy prospers, the investment in the economy rises, as can be seen from the inflow of investment in the UK in between 2005 and 2015, due to the increase in the economic growth of the country at that time (Persson and Tabellini 2012).
3. Technology- Technological innovation and progress also induces higher investment
4. Confidence- The confidence in the market also leads to greater investment in the same, which was seen to be occurring in the economies of UK, USA before 2007. 

References:

Blanchard, O. and Giavazzi, F., 2003. Macroeconomic effects of regulation and deregulation in goods and labor markets. The Quarterly Journal of Economics, 118(3), pp.879-907.

Burda, M. and Wyplosz, C., 2013. Macroeconomics: a European text. Oxford university press.

Dassonneville, R. and Lewis-Beck, M.S., 2014. Macroeconomics, economic crisis and electoral outcomes: A national European pool. Acta Politica, 49(4), pp.372-394.

Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.

Johnson, H.G., 2017. Macroeconomics and monetary theory. Routledge.

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Palley, T., 2012. The economics of the Phillips curve: Formation of inflation expectations versus incorporation of inflation expectations. Structural Change and Economic Dynamics, 23(3), pp.221-230.

Persson, T. and Tabellini, G., 2012. Macroeconomic policy, credibility and politics. Routledge.