#7. Paranoia, the largest country in central Antarctica, receives word of an imm
ID: 1200860 • Letter: #
Question
#7. Paranoia, the largest country in central Antarctica, receives word of an imminent penguin attack. The news causes expectations about the future to be shaken. As a consequence, there is a sharp decline in investment spending plans.
a. Explain in detail the effects of such an event on the economy of Paranoia assuming no response on the part of the central bank or the Treasury. (Ms,T, and G all remain constant). Make sure you discuss the adjustments in the goods market and the money market.
b. To counter the fall in investment, the king of Paranoia calls for a proposal to increase government spending. To finance the program, the chancellor of the exchequer has proposed three alternativ options:
1. Finance the expenditures with an equal increase in taxes.
2. Keep tax revenues constant and borrow the money from the public by issuing new government bonds.
3. Keep taxes constant and finance the expenditures by printing new money.
Consider the three financing options and rank them from most expansionary to least expansionary. Explain your ranking.
Please answer in much details
Explanation / Answer
answer a) with the word of penguin attack coming Paranoia,the investments has been shaken causing economy in jeopardy and order disturbed.these attacks will definitely affect the future prospects of money as well as goods market.
By Goods Market, we mean all the buying and selling of goods and services
By Money Market, we mean the interaction between demand for money and the supply of money (the size of the money stock) as set by the Federal Reserve working through the banking system.
A. The money market determines the interest rate. The demand for money in the money market is affected by income (which is determined in the goods market).
B. The goods market determines income, which depends on planned investment. Planned investment in turn depends on the interest rate (which is determined in the money market).
Thus with fall in investment there will be disequilibrium both in money and goods market.
As the investments falls,rate of interest increases causing more increase in savings and less demand for goods ,it will further lead to unplanned increase in inventories till the time the stock doesnt get clear.
If something changes in goods markets and affects Y, this in turn will affect Md and hence affect r.
If something changes in money markets and affects r, this in turn will affect Ip, and hence affect Y.
answer b)ranking them from most expansionary to least expansionary
1. keep taxes constant and finance the expenditures by printing new money- thus resorting to deficit financing
2. Keep tax revenues constant and borrow the money from the public by issuing new government bonds- finding better returns in government bonds private investment will increase which government can use further for PUMP PRIMING.
3.Finance the expenditures with an equal increase in taxes.
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