Assignment 3

Name Tashi Dorji P U4578225 Chapter 25 Problem 6 (34 marks) The government is proposing to lower the tax rate on labour income and asks you to report on the supply-side effects of such an action. Answer the following questions using appropriate diagrams. You are being asked about directions of change, not exact magnitudes. a) (4 marks) What will happen to the supply of labour and why? The supply of labour will increase. The supply of labour curve will shift rightward. The supply of labour increases because at each real wage rate, the after-tax wage rate received by workers will be high given a decrease in the tax rate on labour income.

Increase in the supply of labour

Real Wage Rate

Labour b) (4 marks) What will happen to the demand for labour and why? The demand for labour will remain the same. The demand for labour depends on the productivity of labour, which remains the same irrespective of decrease or increase in the tax rate on labour income. c) (4 marks) What will happen to equilibrium employment and why? The equilibrium level of employment will increase. With the rightward shift in the supply of labour curve, the real wage rate decreases, and the quantity of labour demanded increases along the demand for labour curve. Equilibrium employment increases.

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Realwag e rate Increase in the equilibrium employment Labour d) (4 marks) What will happen to the equilibrium pre-tax wage rate? The equilibrium pre-tax wage rate will decrease. When government levies lower tax, the labourers have higher wage rate after-tax wage rate. The supply of labour will shift rightward and the demand for labour curve will move downward along the curve. The equilibrium pre-tax wage rate will decrease.

Realwag e rate

Decrease in the equilibrium employment

Labour

e) (4 marks) What will happen to the equilibrium after-tax wage rate? The equilibrium after-tax wage rate will increase. The decrease in the tax rate on labour income decreases the wedge between the pre-tax wage rate and the after-tax wage rate. The pre-tax wage rate decreases but not by as much as the decrease in tax. So the after-tax wage rate will increase.

LS + tax LS (less tax) LS

Realwag e rate

Increase in the equilibrium after-tax wage rate

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f) (4 marks) What will happen to potential GDP? Potential GDP will increase. The equilibrium level of employment is the full employment. So as full employment increases, potential GDP increases along the production function.

Realwag e rate

Labour

Increase in potential GDP RealGD P

Labour g) (6 marks) How would your answers to the above questions change if at the same time as cutting the labour income tax rate, the government increased the indirect taxes by the same amount as the cut in labour income tax? If the government cuts the labour income tax rate and increases the indirect taxes by same amount and at the same time, then there will be no change in the supply of the labour curve. Following are the answers of each of the above questions: a) The supply of labour will remain the same b) The demand for labour remain the same c) The equilibrium employment will not change d) The equilibrium pre-tax wage rate will not change e) The equilibrium after-tax wage rate increase f) The potential GDP will remain the same 3

h) (4 marks) What evidence would you present to the government to support the view that a higher tax on labour income will have a significant effect on the labour market? The cross-country evidence on marginal income tax rates and employment suggests that tax rates on labour income have a significant effect on the labour market.

Chapter 26 Problem 6 (20 marks) You are given the following information about the economy of Freezone: The people and businesses in Freezone have bank deposits of $500 billion and hold $100 billion in notes and coins. The banks hold deposits at the Freezone central bank of $5 billion, and they keep $5 billion in notes and coins in their vaults and ATM machines. Calculate Given: Bank reserves; R = $10 billion ($5 billion [bank deposits] + $5 [billion notes and coins]) Currency;

C = $100 billion

Deposits;

D = $500 billion

a) (4 marks) The monetary base The monetary base is $110 billion. The monetary base is the sum of notes with the nonbank private sector, and banks’ deposits at the central bank. MB = C + R = 100 + 10 = $110 billion b) (4 marks) The quantity of money The quantity of money is $600 billion. In Freezone, deposits are $500 billion and currency is $100 billion, so the quantity of money is $600 billion. c) (4 marks) The banks’ reserve ratio The banks’ reserve ratio is 2 percent. The banks’ reserve ratio is the percent of deposits that is held as reserves. B = R/D x 100 = (10/500) × 100 = 2%. 4

d) (4 marks) The currency drain ratio The currency drain is 20 percent. The currency drain is the percent of the quantity of money that is held as currency by households and firms. They currency drain depends on the proportion of money people prefer to hold as currency. Currency drain ratio =C/D x 100 = 100/500 x 100 = 20% e) (4 marks) The money multiplier The money multiplier is 5.45 MM =MS/MB =(1+a)/ (a+b) = (1+ C/D)/ (C/D +R/D) = (C+D)/(C+R) = (100+500)/ (100 + 10) = 5.45

Chapter 27 Problem 4 (16 marks) The target for the cash rate is 4 per cent a year and the Reserve Bank wants to decrease it by 0.25 percentage points. a) (5 marks) Does the Reserve Bank buy or sell securities in the open market to lower the cash rate? The Reserve Bank will buy securities from the open market to lower the cash rate. The purchase of the securities increases the bank reserves and the cash rate adjusts to make the quantity it reserves demanded equal the quantity supplied. The Reserve Bank uses open market operations to change the quantity of reserves supplied so that the equilibrium cash rate hits the cash rate target. To maintain its target cash rate, the Reserve Bank buys securities to offset any deficit and sells securities to offset any surplus.

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The Reserve Bank

Liabilities

Assets Reserves of commercial bank

Securities + $100 The RBA buys securities from a bank…

+$100

…and pays for the securities by increasing the reserves of the bank

The commercial bank Assets

Liabilities

Securities -$100 Securities +$100

b) (5 marks) Describe the changes in the balance sheets of the Reserve Bank and a commercial bank following the open market operation. When the Reserve Bank buys securities in the open market, it increases reserves. Both Reserve Bank assets and liabilities increase by the amount of the purchases. The Commercial Bank selling securities in exchange for reserves, so there is no change in its total assets and liabilities. c) (6 marks) Draw a graph like Fig. 27.5 to illustrate the effects of the Reserve Bank’s actions in the market for reserves. The Reserve Bank has increased the supply of reserves. The supply curve for reserves moves rightwards from RS0 to RS1 and the cash rate decreases from 4% to 3.75 %. Here, the target cash rate is 4 per cent a year. The demand curve for reserves by the banks is RD. The higher the cash rate, the smaller is the quantity of reserves demanded. The Reserve Bank’s open market operations determine the supply of reserve, RS. The cash rate adjusts to make the quantity of reserves demanded equal the quantity supplied. The Reserve Bank hits its cash rate target by supplying the quantity of reserves that makes the equilibrium cash rate equal its target. 6

As the Reserve Bank wants to decrease the cash rate by 0.25 percentage points so the bank buys securities. Therefore, the supply of reserve increases. The supply curve of reserve (RS) shifts rightward from RS0 to RS1 (as shown in the figure) and the cash rate decreases from 4% per year to 3.75% per year. RS0 RS1

Cash rate (percent per year)

5.0 4.5

Shift in the supply curve

4.0 3.5 3.0 2.5 RD

2.0

Reserves

Chapter 28 Problem 8 (30 marks) Australia has a lower inflation rate than the United States. Australia also has more rapid economic growth. The Reserve Bank does not intervene in the foreign exchange market. What can you say about each of the following (and why)? a) (6 marks) The exchange rate The exchange rate will rise. If Australia has a lower inflation rate than the United States the exchange rate value of Australia is expected to increase. When Australia has more rapid economic growth than US, the exchange rate of Australian dollars will rise. Low inflation in Australia means the increase in prices of goods and services in US is more than the price of goods and services in Australia. Australia will demand good and services of US. On the other hand, US will demand more goods and services from Australia. Therefore, the demand for Australian dollars will rise and exchange rate of Australian dollars will increase. Rapid economic growth means the aggregate demand for goods and services in Australia is higher than US. The demand for Australian dollars will increase when the demand

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means goods and services of Australia increases. The exchange rate of Australian dollars in comparison to US will rise. b) (6 marks) The expected exchange rate The expected exchange rate will increase When Australia has low inflation and higher economic growth than US, the demand for dollars will increase and the expected exchange rate will increase. Given that the Australia dollars is appreciating more than the US dollars, the expected exchange rate of Australian dollars will increase. In addition to above, a lower inflation rate and more rapid economic growth of Australia as compared with United States, the rise of the price level in Australia will be less than the price level in US. People will expect foreign exchange value of the Australian dollar to rise. The exchange rate has to rise to maintain purchasing power parity. c) (6 marks) The interest rate differential When Australia has low inflation and higher economic growth than US, people can earn more interest from assets in Australia than from US. The gap of interest rates between Australia and US is called the interest rate differential. The Australian interest rate differential will be higher than US. d) (6 marks) Interest rate parity When Australia has low inflation and higher economic growth than US, people can earn more interest from bank deposits in Australia than from US. Money is worth what it can earn. Funds will move into Australia, because people can earn more money from investing into banks in Australia than US. The demand for Australian dollars will increase and exchange rate will rise. Australia will have higher interest rate parity than US. e) (6 marks) Purchasing power parity Purchasing power parity means equal value of money. When Australia has low inflation and higher economic growth than US, the dollar value of Australia will increase. Money is worth what I will buy. Money buys more in Australia than US. The purchasing power parity will increase in Australia.

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