Fluctuations in Government Spending and Business Cycles
1. a) Figure 1: Equilibrium effects on real output, consumption, investment, the price level, employment and the real wage
There is an increase in the real interest rate and rise in the level of output (from Y1 to y2) when Government increase its spending temporarily under the real business cycle model. Additionally, there is also an ambiguous rise in the level of prices (from p1 to p2) since there is an ambiguous money demand net effect. The rise in the level of prices facilitates an increase in the level of investment and wages, however, consumption is reduced. Demand for money increases as portrayed by the money demand curve shifting to the right.
Two issues arise from using fluctuations in Government to explain Business cycles. First and foremost investment is predicted as countercyclical since there is crowding out of investment by higher clearing interest rates in the market. Secondly, wages are predicted as countercyclical. In other words there is falling of the wages. Therefore, there is a general reduction in consumption, increase in the interest rates and increase in consumption due to arise in the level of output. Business cycles can be explained by fluctuations in government expenditure due to its impact on the level of income. From figure 1, fall in prices leads to an increase in a consumer’s income due to increased government spending. However, a decline in government spending would lead to a reduction in the consumer income from Y2 to Y1 due to an increase in prices from P2 to P1 (figure 2). Fluctuations in government spending determine the level of investment where the level of investment is high due to increased government spending and low due to reduced government Spending.
Figure 2: Effect government spending on business cycles.
2. a)
A temporary increase in government spending leads to a subsequent increase in the level of investment and wage rate from W2 to W1. An increase in the wage rate motivates workers to work harder hence enhancing the level of efficiency and real output. An increase in output leads to a decline in the price level hence leading to a rise in the consumption level.
b) The effects of government spending are inconsistent with business facts in the real economic world due to inconsistent levels of investment by both foreign powers and domestic entrepreneurs.
3a) It is important to strengthen the relationship between interest for cash and the costs for loans, (Gabaix, 2020). The amount of loans fluctuates in relation to the level of the interest rates. When interest rates decrease, the level of money demanded also falls, (Piazzesi, Rogers and Schneider, 2019). However, an increase in money demand is caused by a fall in the level of inflation that leads to limited money being circulated in the economy (figure 3).
Figure 3: The relationship between inflation and money demand.
b) Figure 4: Decrease in the total factor productivity
The anticipated increase in the total factor productivity will lead to a rise in the level of output, wage rate (a) and a fall in the rate of interest rates (b) and price level.
Relationship between Interest Rates, Inflation, and Money Demand
4a) C1+ C2/1+r = V1 + Y1 – T1 + Y2 – T2/1 + r
b) PV = CF/ (1 + r) t
c) MPk – d = r
Figure 5: Optimal investment schedule
Real interest rate
d) Figure 6: Labor market and goods market equilibrium
e) Figure 7: Equilibrium effects
At a given price Po, the economy is in equilibrium at a certain price E1 and the level of output increases highly to Y2. This leads to a temporary reduction in the level of taxes. The temporary decrease in taxes leads to an increase in the level of investment, consumption, the real interest rate, aggregate output (Yo Y1), employment and the real wage.
f) Figure 8: Equilibrium effects on the macro economic variables.
According to Van Beveren (2018), a temporary increase in total factor productivity enhances the level of output, leads to a decline in the level of interest rates and price level, and enhances wages. The high output increases the level of capital and investment which calls for more labor (employment).
5a) An increase in the supply of a currency from S1 to S2 in figure nine below while holding demand constant implies that the prices of goods will depreciate. Nevertheless, an increase in demand also leads to depreciation of prices implying a reduction in the level of investment, nominal exchange rate, price level account surplus and absorption.
Figure 9: Flexible exchange rates
b) Figure 10: Eqiulibrium above the fixed rate
From figure 10 above, there is a shortage for the country’s currency at a fixed rate that forces the equilibrium level to shift upwards. However, the rate is fixed and equilibrium cannot change. For the fixed rate to change (figure 2), the government has to sell its own currency from its own exchange reserves from foreign nations instead. This leads to reduction in the level of investment, nominal exchange rate, price level account surplus and absorption.
Figure 11: equilibrium below the fixed rate.
c) When the government chooses to stabilize the price level, a flexible exchange rate system is preferable so that the level of investment increases to stabilize the high prices for scarce commodities when the exchange rates are high.
d) In part c, the fixed exchange rate leads to limited levels of investment in case the country’s currency depreciates hence leading to high price levels of commodities. When monetary policy intervenes, inflation is controlled to its lowest.
6a) Neo-Fisherism suggests that central banks should increase inflation by enhancing their nominal interest rate targets. This principle seems radical since central bankers believe that minimizing interest rates rises the level of inflation hence making it inacceptible.
b) Unconventional monetary policy incorporates both quantitative easing and negative interest rates. Quantitative easing incorporates the central bank buying securities from the open market with no relation to the government bonds. Negative interest rates incorporates the central bank charging commercial banks an interest rate on all their deposits. These policies may not work due to inherent non-linearities related to the level of interest rates.
Optimal Investment Schedules
7a) Increasing the level of technology will enhance the level of efficiency in production hence leading to a wide market for Canada’s finished goods.
Increasing the level of investment will lead to an increase in the tax base hence facilitating an increase in government revenue.
Increasing the level of research and innovation will help to seek for new markets in foreign nations and promote production of unique commodities.
b) Unemployment. Most citizens in most countries lost their jobs during the lockdown and have not yet got one in 2022 hence reducing the tax base. Hence, governments have resorted to taxing investemnts highly.
Inflation. Due to an increase in production post government restrictions against COVID-19, high taxes are being imposed on enterprises to facilitate economic recovery. However, this has come with an increase in prices of commodities hence leading to a fall in demand.
Changes in interest rates. These have been unstable since countries were differently affected by COVID-19.
8a) High risk of a fiscal crisis. When debts keep on increasing, investors lose hopes of the government’s ability to pay back hence demanding higher interest rates to block the government from borrowing. This creates broad economic consequences.
Limited national savings and level of income. Accumulation of debts leads to a reduction in the level of investment and an increase in the level of interest rates. When the government borrows more money, a high percentage of savings is allocated towards government securities hence decreasing the level of investment and making the workforce less productive.
b) Through taxation, An and Chong (2015) suggest that the government collects revenue which is used to clear debts. It is important to note that in most cases in order to finance the various expenditures, Government in most cases increases tax. Taxes include business tax, local income tax, state and federal taxes. There are also sin taxes like on tobacco and alcohol products, estate tax, property tax and corporate taxes. However, taxation as a tool of reducing deficit is associated with compliance challenges. None compliance to tax distorts competition and undermines revenue and also raises equity compromise issues which may negative impact the overall revenue mobilization objectives of the Government both in the short and long run period. Also, increases in taxes has a negative impacts on investments and profits
Spending. The government spends its savings on productive projects and making improvements in public entities to generate more revenue for paying debts, (Barbosa, 2018). However, Government spending is associated with long run inflationary pressures which may have a negative impact on the economy. Also, changes in Government spending impacts the levels of unemployment, investment and revenues
References
An, Z., & Chong, Z. (2015). Debt centralization and soft budget constraint. Public Finance and Management, 15(2), 153.
Barbosa, F. D. H. (2018). Government Budget Constraint. In Macroeconomic Theory (pp. 307-338). Springer, Cham.
Gabaix, X. (2020). A behavioral New Keynesian model. American Economic Review, 110(8), 2271-2327.
Piazzesi, M., Rogers, C., & Schneider, M. (2019). Money and banking in a New Keynesian model. Standford WP.
Van Beveren, I. (2012). Total factor productivity estimation: A practical review. Journal of economic surveys, 26(1), 98-128.
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