Closed Economy Processes - Essay Example

Economics work: In a Closed economy with fully flexible wages and prices what is the effect on the rate of interest, the price level and the level of output of 1.) A doubling in the nominal quantity of money 2.) An increase in the willingness to work 3.) A fall in the average propensity to save 1.) A doubling in the nominal quantity of money A closed economy is an economy whose national income and output does not include the foreign sector, that is to say exports and imports are not included in the calculation of national output. In a closed economy where flexible wages and prices then an increase in the nominal quantity mean that the money in circulation in that economy will increase. The LM curve joins together rates of interest and national income at which the monetary sector is at equilibrium, therefore doubling the nominal quantity of money supplied will cause a shift in the LM curve as shown below. The increase in the nominal quantity of money will cause the LM curve to shift from LM1 to LM2; Output will rise from Y1 to Y2, the interest rates will go down as indicated by the movement from I1 to I2. An increase in money supply will cause an increase in the level of prices. (Stretton (1999)) The law of demand states that when the level of demand rises beyond the level of supply then the price rises, if the level of demand falls below the level of supply then the level of prices will go down, but the level of the price fall depends on the elasticity of supply and demand. Theoretically the increase in prices is caused by the increase in customer expenditure and this causes an increase in aggregate demand and as according to the law of demand and supply, when demand increases the prices will rise. therefore in this case the level of prices will rise in the short run but will eventually move back to the original position in the long run when the high prices eventually causes an incentive to suppliers who eventually meet the demand and therefore prices will fall. Aggr dd is the aggregate demand while Agg ss are the aggregate supply, when you increase the money supply in an economy, people will tend to spend the money and therefore the aggregate demand increases therefore shifting the aggregate demand to the left, when aggregate demand increases beyond the level of aggregate supply the price of goods rises as depicted by the movement from p2 to p1, national output increases from y1 to y2. For a government to increase the money supply it simply needs to decrease the interest rates which can be defined as the opportunity cost of borrowing money, when the interest rates are decreased the opportunity cost of borrowing money decreases and more people will acquire loans and borrow funds from banks, this will increase the amount of money in the economy. Another way in which the government can increase the money supply is through decreasing the reserve ratio maintained by the central bank such that banks will now be required to maintain a lower amount with that bank and therefore they will be in a position to undertake credit creation and therefore increase money supply. 2.) An increase in the willingness to work An increase in the willingness to work means that the marginal productivity of labour increases, this increase in labour productivity therefore output will rise. The cost of production will go down and supply will rise, when supply rises we expect prices to go down due to the law of demand. An increase in the willingness to work is therefore an advantage to the economy, this is because an increase in the willingness to work will increase the marginal productivity of labour and therefore increase the productivity of labour and at the same time reduce of the cost of production of the various goods and services in an economy. Therefore the increase in the willingness to work will cause a shift in the aggregate supply because the producers will now have the opportunity to produce more at lower costs, prices will also go down due to the fact that supply exceeds the demand in the economy. This is shown by the diagram below the increase in productivity will cause the aggregate supply to shift. When the aggregate supply shifts to the left the output level rises, prices will go down as indicated by the movement from Price P1 to P2, interest rates will go up due to the shift in the IS curve which shifts from IS 1 to IS 2. (Stretton (1999)) 3.) A fall in the average propensity to save When the average propensity to save falls then the rate of investment and savings go down, when the level of investment go down we expect that the level of output will go down, when output falls prices of goods go up and also the interest rates will go up, this is caused by the fact that people will want to obtain loans in order to invest and therefore interest rates rise, less investments also means that the supply of goods will be below the quantity demanded and therefore prices will eventually rise. A change in the propensity to save will cause a change in the level of investment, a decline in the average propensity to save will cause the level of investment to fall, when the level of investment falls then the national output will eventually fall and this is caused by the fact that lower levels of investment leads to lower aggregate supply. Lower supply dictates that the level of demand will be higher than the level of demand; this will cause a shift in the level of prices which will rise. However as a result of the certain changes that occur in an economy, a free market economy will always adjust automatically due to the forces of demand and supply, changes will only occur in the short run but in the long run the market will eventually stabilise. (Stretton (1999)). this can be seen by the fact that when demand increases prices increase, an increase in the level of prices will cause other firms to come up to meet the required demand and also to acquire profits associated with the high prices, as the firms open up and compete, the level of supply increases and this eventually push prices down and therefore the market goes back to the original equilibrium. A rise in the average propensity to save will cause an upward shift in the level of investment, if the level of investment rises the national output also raises, aggregate supply rises and therefore the price of goods and services in an economy will go down. The government aim therefore should be reduce the level of prices that indicate the level of inflation in the economy, an increase in money supply will cause inflation, lowering interest rates causes' inflation and therefore every government should observe this increases to avoid inflation and also increase the level of output. cost push inflation and demand push inflation are common in most economies, the demand push economy is caused by an increase in the level of demand beyond the level of the supply while the cost push inflation is caused by an increase in the cost of production brought about by an an increase in the cost for raw materials and also labour. References: Hugh Stretton (1999) Economics: A New Introduction, Pluto Press, USA Paul Anthony Samuelson (1964) Economics, McGraw-Hill publishers, USA John Pheby (1988) Methodology and Economics: A Critical Introduction, Macmillan publisher, UK Thomas A. Boylan and Paschal Francis (1995) Beyond Rhetoric and Realism in Economics: towards a reformulation of economic methodology, Rout ledge, UK S Goodall and Ian Livingstone (1970) Economics and Development: an introduction, Oxford University Press, Oxford Read More