Economic Downturns

Questions: 1: Classical economists and Keynesian economists both have different views on the causes of economic downturns, as well as what to do about restoring the economy to long-run equilibrium. Explain in 4-5 sentences how and why these two views differ. In an economic downturn, what does a classical economist believe will happen? What about a Keynesian economist? Using an LRAS-SRAS-AD diagram, illustrate either the Keynesian or the Classical view of how the economy should return to long-run equilibrium after an economic downturn (recessionary gap). For full credit, be sure to explain each step in your answer. 2: The below information gives details on the U.S. balance of payments for 2013 ($ billion). Exports of goods 1,592 Imports of goods 2,294 Exports of services 682 Imports of services 456 Factor income receipts 773 Factor income payments 574 Unilateral transfers (net) -123 Private asset sales and 373 Official asset sales and purchases -2 purchases (net) (net) 1. Calculate the current account and financial account balance. For full credit, show all steps in your answer.2. Adding the current account to the financial account balance should give you a zero balance of payments. Calculate the balance of payments for this example. Explain in 1-2 sentences why the balance of payments in this example is not equal to zero.3.What effect did the collapse of the U.S. housing bubble and the ensuing recession have on international capital flows into the United States increase or decrease, and why? (Hint: U.S. interest rates plummeted during the recession.) Explain in 2-3 sentences. 3: Illustrate the effects of the following events on the value of the British pound relative to the value of the U.S. dollar. For full credit, label the axes and explain how you arrived at your answer. Britain's income decreases Britain's price level increases relative to the U.S. price level Britain's interest rates decline relative to U.S. interest rates 4: Use the relationship between the nominal exchange rate and the real exchange rate that was discussed in class to determine the answers to the following questions. For full credit, show how you arrived at your answer. Year Nominal Exchange Price level (U.S.) Price level (foreign) Rate (U.S.) 2011 2.335 105.2 108.3 2012 2.590 105.9 108.5 2013 3.015 106.0 109.0 2014 3.020 107.3 110.8 2015 3.446 107.3 112.6 Calculate the real exchange rate in the U.S. in 2012. Round your answer to three decimal places. Calculate the percentage change in the nominal exchange rate in the U.S. between 2013 and 2014. Round your answer to three decimal places. Calculate the percentage change in the real exchange rate in the U.S. between 2013 and 2014. Round your answer to three decimal places. Did imports from the U.S. get cheaper or more expensive between 2013 and 2014? Explain in a sentence Answers: 1. In accordance with the new Keynesian theory, economic downturns are due to lack of coordination. Such problems can arise due to the setting of prices and wages as these can anticipate the actions of other price and wage setters. The union leaders negotiate wages that are further concerened about concessions that other unions can win. According to Keynesian theory, the economy comprises of 2 firms and that if there is a decline in the money supply then each firm should decide whether or not it should cut the price. Each and every firm needs to maxize their profits, and that the profit relies not only on the pricing decision but also on other decisions made by another firm. And when no one firm makes a reduction in the price, the amount of the real money is quite below par due to which recessions occur. According to the classical economists, the government involvement and spending can result in a slow economic growth by decreasing the private sector and increasing the public sector as classical economists believe that the business investments and consumer spending signifies the most essential parts of the countrys economic growth. 2. In the Keynesian theory, the four components are consumption, investment, net exports and Government. The equlibrium level is attained when the current production is equal to the planned aggregate expenditures. At this particular point, there is never an incentive for the firms to make any alteration in the production plans. 2. Current Account balance = Exports imports + net income abroad + net current transfers CAB = (1592+682) (2294+456) + (773-574) + (-123) CAB = (-400) Financial Account balance = Differences between the sale of private assets to foreigners and purchases of private assets held abroad and differences between the sale of official assets to foreigners and purchases of official assets held abroad FAB = 373 -2 = 371 Adding of CAB to FAB does not give the value of 0 This is because there is no capital account. BOP = -400 +371 BOP = (-29) The bursting of housing bubble and ensung recession will result in the change in the returns expected to housing assets and will in turn result in the capital reallocation within the United States. When there is a collapse in the housing bubble, consumers feel less wealthy and hence reduce their spending and that the investors would get lower capital gains from the investments and hence, consider other assets. This shift can be to a one specific country or another country. When there is a flow in investment to offshort assets then the capital movements would definitely generate a change in the CAB, exports and imports and hence the real exchange rates as well. 3. When the British income increases, the demand schedule for US dollars will make it shift towards outwards which reflects the increase in income of British pounds and hence there would be an increase in demand for US goods. More than this, the supply schedule for US dollars for sale will not change. The equilibrium rate of exchange of the US dollars would rise. 1. Higher prices in Britain will result in making the imports less expensive. The Britain citizens will likely increase their spending on imports from US, shifting the demand for US dollars to the right from D0 to D1. At the same moment of time, the US would find out the Britishs goods to be more and hence it will make a reduction in their export demand from the British. The supply of US dollars will also shift to the left i.e. from S0 to S1. The result is the increase in the price of US dollars.2. A lower interest rates will definitely lessen the return rate on British GBP below the return rate on dollars which leads the investors to make a shift in the investments in US assets and hence a decrease in the US dollars to GBP exchange rate. This is shown below in terms of an increase in the GBP interest rate and vice versa. 4.1. Real Exchange rate in 2012 = Nominal exchange rate x domestic price / Foreign price Real exchange rate in 2012 = 2.590 x 105.9/108.5 Real exchange rate in 2012 = 2.532. Percentage change in the nominal exchange rate = 3.020-3.015/3.015 x 100 Percentage change = 0.166%3. Real exchange rate in 2013 = 3.015x106/109 Real exchange rate = 2.93 Real exchange rate in 2014 = 3.020x107.3/110.8 Real exchange rate = 2.92 Percentage change = decrease of 0.34%4. Real exchange rate decreases results in the exports to be cheaper as there will be a decrease in the leakages from the circular flow of income.