Question

Question 4

1. Assume that after years of economic recovery, the US economy has reached its natural rate of output. Explain with a diagram how a continuous rise in oil prices affects the price and output levels of the US.

2. Based on your answer in (a), what kind of fiscal policy can be implemented to restore the output level back to its natural rate? Illustrate your answer with a diagram. What will happen to the price and output levels?

3. How does the crowding out effect reduce the increase in aggregate demand caused by an expansionary fiscal policy? Explain with a diagram.

Question 5

1. How does each of the following events affect Japan's net capital outflow?

1. Economic rebound pushes up Japan's interest rate.

(ii) JVC, a Japanese electronics company, sets up a factory in mainland China.

2. Suppose the Japanese government runs a budget deficit to boom its economy. Discuss in detail how it affects the real interest rate, net capital outflow, real exchange rate, and the trade balance of Japan. Illustrate your answer with diagrams.

Answer 1

Solution 4 A

Continous risr in oil prices causes the rates of petrol and diesel to increase and hence transport costs increases substantially. This decreases firms productivity levels to great extent as measure to save costs. This will lead to situations of hyperinflation as well as growth in real GDP.

Solution 4 B

To curb situations of hyperinflation the government shall adopt contractionary fiscal policy by reducing government expenditure and increasing taxation. This reduces the prices in market because aggregate demand falls. As results the real GDP falls to its natural output rate.

Solution 4C

Many times when government adopts expansionary fiscal policy to boost economic prosperity which then leads to increase in interest rates. This dampens investment spending and deters the expected growth in aggregate demand which leads to what we call as Croeding out effect.

Question 5 A

If Japans interest rate rise it causes investors to invest more money into Japan and hence net capital outflow decreases while net capital inflow increases.

JVC if sets up factory in China the revenue and expenditure flows in that country and hence net capital outflow increases.

Solution 5B

Expansionary fiscal policy causes government to borroe more money from foreign or larger banks and hence money demand increases causing interest rates to rise. This causes fomestic currency to appreciated and real exchange rate thus appreciates real exchange rate. Also investors tend to invest more where interest rate is higber causing rise in FII and hence Net capital outflow decreases and net capital inflow increases . Now since currency appreciates it causes rise in imports and decrease in exports and hence trade deficit widens.