1.Explain the effects of inflation, interest rates, exchanges rates and consumer
ID: 1114667 • Letter: 1
Question
1.Explain the effects of inflation, interest rates, exchanges rates and consumer demand on international trade and the economy in terms of trade deficits and surpluses. Include consideration of open economies versus closed economies.
2. Explain how trade policy and budget deficits can impact the health of an economy. Include consideration of capital flight.
3.As per the study materials, who are the poorest 4 groups in the U.S. and what are the social ills they are likely to experience? Describe 5 policies that are designed to help the poor and discuss the problem with high marginal tax rates.
4. Discuss the government and the central bank’s approaches to tackling inflationary and recessionary events in the economy. In addition, discuss whether or not the central bank should aim to have zero inflation? Lastly, should the central bank be governed based on mandated rules or the discretionary expertise of its leadership?
Explanation / Answer
1. inflation causes trade deficit. Inflation results in higher production cost thus rendering exports in-competitive. Reduction in exports result in widening trade deficit.
Higher interest rates help reduce inflation making exports more competitive – improving Terms of Trade. An increase in interest rate also reduces consumer spending. Lower consumer spending leads to lower import spending and therefore lead to trade surplus.
A lower currency makes a country's export cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower a country's balance of trade (trade deficit) while a lower exchange rate would increase it.
Consumer demand is affected by inflation and interest rates. With rising prices(inflation), cost of production increases, consumer demand falls(due to higher prices), reduction in expprts leading to widening of trade deficit.
2. According to the New Trade Theory, under imperfect competition restrictions to trade might be welfare improving. As far as imperfect competition is concerned, trade restrictions in the international arena are then used to win market power (monopoly power, oligopoly power or become the winner in monopolistic competition). Market power can be used to get rid of foreign competitors in various ways. E. g. products can be temporarily underpriced (sold below marginal cost) until competitors will have left the market (predatory pricing). After that producers with market power will switch to mark-up pricing. Having market power (in international terms) is equivalent to be able to increase output and the market share. As it is well-known these strategies will allow to produce at decreasing average cost in industries characterized by economies of scale. In such an environment smaller foreign competitors have no chance because they cannot produce under economies of scale. This leads to national welfare.
When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls. Lower investment means lower capital accumulation and slower economic growth.
3. The problems facing the working poor are as follows:
i.The working poor hold the lowest paying, most unstable jobs.
ii. They lack full-year employment and are mostly engaged in contractual jobs.
iii. They lack higher education.
iv. They have less access to healthcare.
The main objective of the policies designed to help the poor are:
i. wage supplements
ii. assistance with career advancements
iii. Income support for the unemployed
iv. improved access to support services
v. helping low wage workers meet basic needs and offset work expenditure
A marginal tax rate is the amount of tax paid on the additional dollar of income. The marginal tax rate for individuals will increase as tax rate increases. This method of taxation aims to fairly tax individuals based upon their earnings, with low income earners being taxed at a lower rate than high income earners.
The problem arises that higher taxation at higher income levels leads to the wealthy spending money to exploit tax law loopholes and find creative ways to shelter earnings and assets as a result they often end up paying less tax than the less well-off, depriving the government of revenue.
4. The government can use a contractionary monetary policy to control inflation. Such a policy reduces the money supply, decreasing bond prices and increasing interest rates. This results in reduced spending and increased savings.
In order to tackle recession the government can resort to fiscal policies like reducing taxes or creating tax credits for businesses that would provide an incentive for business to continue or increase their production and investment, resulting in increased employment and an infusion of money into the economy.
Inflation not only reduces the value of assets and savings but also the value of money. So, in the long run inflation does not produce any growth. But, inflation at a decent pace helps in the growth of the economy. The growth of a economy and inflation are directly proportional. Therefore, countries always try to maintain a level of inflation in order to achieve economic growth. Although, high inflation is harmful for the economy. This is the reason why central bank do not aim at zero inflation as that would lead to stagnation of economy.
Central Banks should be governed based on rule based policies. Laying down and sticking to consistent rules is crucial for conducting and evaluating economic policy. Discretionary policies produce suboptimal results because they pursue less predictable, more interventionist policies with a focus on short-term fine-tuning.
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