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TECO401 Principles Of Economics And Macroeconomics

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Question:

a) John and Alice would be willing to pay $1,500 monthly rent to live in a house of the same quality as the one they are thinking to purchase. Should they buy the house?

b) Does the answer to part a change if they are willing to pay $2,000 monthly rent?

c) Does the answer to part a change if the real interest rate is 4% instead of 6%?

d) Does the answer to part a change if the developer offers to sell John and Alice the house for $150,000?

e) Why do home-building companies dislike high interest rates?

Suppose the economy is initially in long-run equilibrium. Now, due to decline in house prices, consumers reduce their consumption spending.

a.Explain how the decline in consumer spending affects the AD curve.

b. Explain how your answer to part an affects the economy’s short-run equilibrium. Use an AD-AS diagram to illustrate your answer.

c. Now, in addition to the decline in consumer spending, suppose that the economy experiences a negative inflation shock.

(i) Explain how the adverse inflation shock affects the AD curve.

(ii) Discuss, using AD-AS diagrams, what choices the government now must make regarding stabilisation policy.

 

Answer:

The key difference between Nominal GDP and Real GDP is that the computation of nominal GDP is based on the prices in the year of computation while Real GDP is based on prices of the base year. As a result, the effect of any inflation or price increase is not reflected in the real GDP (Mankiw, 2016).

Nominal GDP (2015) = 100*10 + 300*4 + 200*20 = $ 6,200

Nominal GDP (2018) = 130*14 + 250*6 + 130*25 = $ 6,570

Real GDP (2015) = 100*10 + 300*4 + 200*20 = $ 6,200

Real GDP (2018) = 130*10 + 250*4 + 130*20 = $ 4,900

Percentage change in real GDP from 2015 to 2018 = [(4900-6200)/6200]*100= - 20.97%

Based on the above GDP computation, it is apparent that there is a drop of 20.97% in real GDP over the 2015 base which may be attributed to decrease in quantity of rice production (from 300kg to 250kg) and decrease in shoes production (from 200 pairs to 130 pairs).

Marginal product of labour may be defined as the incremental computer assembled by the addition of an extra worker. The value of this marginal product would be equal to the incremental revenue that an extra worker would produce (Krugman & Wells, 2015).  The relevant computations are summarised in the table below.

Number of Workers

Computers assembled per day

 Marginal Product

Value of marginal product

1

12

 12-0 = 12

180*12-120*12= $720 

2

22

22-12 = 10 

180*10-120*10= $600 

3

30

30-22 = 8 

180*8-120*8= $480 

4

36

36-30 = 6 

180*6-120*6= $360 

5

40

40-36 = 4 

180*4-120*4= $240 

 
 

The labour demand for Alex is captured in the table below.

  1. In the given case, the selling price of each computer is $ 220. The marginal product and its value are computed in the table below.

Number of Workers

Computers assembled per day

 Marginal Product

Value of marginal product

1

12

 12-0 = 12

220*12-120*12= $1200 

2

22

22-12 = 10 

220*10-120*10= $1000

3

30

30-22 = 8 

220*8-120*8= $800

4

36

36-30 = 6 

220*6-120*6= $600

5

40

40-36 = 4 

220*4-120*4= $400

 
 

The labour demand for Alex at the altered selling price of $ 220 per computer is captured in the table below.

In the given case the productivity of labour is increased by 50%, the computers assembled per day would increase by 50% for each labour input level (Froyen, 2013). Further, the selling price of the computer is $ 200 per unit. The marginal product and its value are computed in the table below.

Number of Workers

Computers assembled per day

 Marginal Product

Value of marginal product

1

18

 18-0 = 18

200*18-120*18= $1440

2

33

33-18 = 15

200*15-120*15= $1300

3

45

45-33 = 12

200*12-120*12= $960

4

54

54-45 = 9

200*9-120*9= $720

5

60

60-54 = 6 

200*6-120*6= $480

The labour demand for Alex at the altered selling price of $ 200 per computer and labour productivity is enhanced by 50% is captured in the table below.

In order to decide if John and Alice should buy the house or not, a comparison of annual rent costs and annual expenses related to the house would need to be undertaken.

Annual rent costs = 1500*12 = $ 18,000

Annual expenses related to house = 4% of house value = (4/100)*200,000 = $ 8,000

Annual interest cost related to house = 6% of house value = (6/100)*200,000 = $ 12,000

Total annual expenses for the house = 8000 + 12000 = $ 20,000

It is evident from the above computation that annual rent costs are lower than annual expenses for the houseand hence John and Alice should not buy the house.

  1. The annual expenses related to the house remain at $ 20,000. However, the monthly rent that they are willing to pay increases to $ 2,000 per month.

Hence, annual rent costs = 2000*12 = $ 24,000

It is evident that buying the house would lead to lower annual expenses in comparison to renting and hence John and Alice should buy the house.

  1. The interest rate on loan has now decreased to 4% p.a. from 6% p.a. previously.
 

Annual rent costs = 1500*12 = $ 18,000

Annual interest cost related to house = % of house value = (4/100)*200,000 = $ 8,000

Total annual expenses for the house = 8000 + 8000 = $ 16,000

It is evident from the above computation that annual rent costs are higher than annual expenses for the house and hence John and Alice should buy the house.

  1. Now the cost of the house has become $ 150,000 instead of $ 200,000 previously.

Annual rent costs = 1500*12 = $ 18,000

Annual expenses related to house = 4% of house value = (4/100)*150,000 = $ 6,000

Annual interest cost related to house = 6% of house value = (6/100)*150,000 = $ 9,000

Total annual expenses for the house = 6000 + 9000 = $ 15,000

It is evident from the above computation that annual rent costs are higher than annual expenses for the house and hence John and Alice should buy the house. Hence, the decision has changed from part (a).

Home building companies tend to dislike high interest rates since these would mean that the potential home buyers would be reluctant in assuming mortgage for buying houses which would result in higher unsold inventory for home building companies. Also, on account of lower demand of new homes from customers, there would be fall in the prices besides a fall in the business as the new homes construction would slow down so that the available inventory is absorbed.

  1. PAE= C+ IP+ G + NX = 6000 + 0.5(Y-4000) + 2,000 + 4,500 + 500 = 11,000 + 0.5Y
 

From the above equation, autonomous expenditure = $ 11,000

Multiplier = 1/(1-MPC) = 1/(1-0.5) = 2

For equilibrium, Y = C + IP + G + NX

Hence, Y = 11000 + 0.5Y

Solving the above, Y = $ 22,000

The potential GDP is given as $ 21,000 and hence the output gap is ($22,000-$ 21,000) = $1,000

  1. The short term equilibrium is highlighted in the following Keynesian cross diagram.
  1. It is apparent that the gap is $1,000 and the multiplier factor is 2. As a result, the autonomous expenditure would have to decrease by (1000/2) = $ 500
  2. If the government decides to fill the output gap by increasing taxes, then the same needs to be increased by $ 1,000 so that the output gap becomes zero. Thus, the amount of tax would change from $ 4,000 to $ 5,000

The decline in consumer spending would tend to shift the AD curve to the left. This is because consumer spending is one of the key components of aggregate demand. Further, the lower consumer spending would tend to lower the demand of various goods and services by the consumers which would be reflected in leftwards shift of AD (McConnell, ,Brue & Flynn, 2014).

  1. The impact on the short term equilibrium on account of the above described AD curve shift is summarised below.

There is a shift of AD curve from AD1 to AD2. In the short run, there is no change in the aggregate supply which remains as the previous level as AS. The result is that there is a decrease in both equilibrium price and also equilibrium real GDP. Hence, in the short run owing to lesser AD, the prices would become lower and also real GDP growth would be adversely impacted (Koutsoyiannis,2013).

  1. (i) On account of the negative inflation shock, there would be a fall in the prices which reflects that the supply is significantly higher than the corresponding demand. As a result, the investment spending would be adversely impacted as there would be lower capacity utilisation and hence the installation of new capacities would be deferred. Thus, there would be lowering of investment spending which would have additional adverse impact on AD curve as investment spending also is a key component of AD besides consumer spending (Dombusch, Fischer &Startz, 2015).
  2. ii) Considering that there is an excess of supply, it is imperative that the government needs to create incremental demand so as to support prices and ensure that the GDP growth enhances. In this regards, the recommended measure would be to increase government spending which would lead to higher AD and hence enable stabilisation of the economy. Over a period of time, higher government spending would result in higher disposable income for the people and thus increase demand which therefore would stimuli investment spending (Barro, 2017).  This would lead to increase in the AD with a rightward shift as indicated below.

As is apparent from the above graph, there is increase in prices coupled with real GDP growth.

 

References

Barro, R. (2017). Macroeconomics: A Modern Approach (4thed.). London: Cengage Learning.

Dombusch, R., Fischer, S. & Startz, R. (2015).Macroeconomics (10thed.). New York: McGraw Hill Publications.

Froyen, A. (2013), Macroeconomics (3rded.). New Delhi: Pearson Education.

Koutsoyiannis, A. (2013). Modern Macroeconomics (4th ed.). London: Palgrave McMillan.

Krugman, P. & Wells, R. (2015).Macroeconomics (3rd ed.). London: Worth Publishers.

Mankiw, G. (2016). Principles of Macroeconomics (6th ed.). London: Cengage Learning.

McConnell, C., Brue, S. & Flynn, S. (2014). Macroeconomics: Principles, Problems, & Policies (20thed.). New York:  McGraw Hill Publications.

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