Assume that consumers in economy ZYX spend, on average, 80% to 90% of any new (a
ID: 1094888 • Letter: A
Question
Assume that consumers in economy ZYX spend, on average, 80% to 90% of any new (additional) disposable income to purchase goods and services. Based on a simple 3- sector Keynesian type economy, this might suggest a government expenditures multiplier in the range of 5 to 10, and a tax multiplier in the range of -4 to -9. In this country, the Obama "stimulus package" of some 830 Billion (2009 ARRA) produced nothing even remotely resembling such income increasing results.
The question: Explain. In short there seems a very significant divergence between "the theory" and "the reality" regarding the effectiveness of fiscal stimulus. How does one account for that?
In addition to the failure of the $830 billion "stimulus package" to produce the kind of "GDP bump" promised by proponents of the program, it also failed to deliver on the claim that it would ensure that the US unemployment rate would not reach 8%, and that it would even bring the rate down to 5% by the end of 2013.
The question: Explain.
If the current income level in a market driven economy is above equilibrium, macroeconomic theory suggests that an automatic adjustment will take place.
The question. (A) How does the economy know that it is not in equilibrium and that and adjustment should take place? (B) What would cause the adjustment to occur? (C) What would be the nature of the adjustment? (D) How would the economy know when to stop adjusting?
Explanation / Answer
First Part: The most simple and likely explanation is sentiment or consumer confidence. Today the entire market is driven by sentiment. The US dollar is not backed by any physical. We just take the word of the governtment of US on it. In a similar way the market and investments are all driven by forces that are based on trust and confidence. No matter how much money you pour into the system until and unless people believe in the system and are willing to take risk you cannot move the economy.
(A) How does the economy know that it is not in equilibrium and that and adjustment should take place?
The economy is in disequilibrium when there is a mismatch. By mismatch i mean when the resources ae used in the wrong proportion. When some resources are over utilised and some under utilised.
(B) What would cause the adjustment to occur?
The over and under utilised resources will create opposite forces that will crack the market. Once people realise the mismatch there will be a correction. Whether the correction is slow or instanteneous depends on several factors.
(C) What would be the nature of the adjustment?
The nature of adjustment would be to devalue those who were running after the over utilised resources and reward those who were betting on the under utilised resources. But the nature also depends a lot on the governments role and how they have decided to steer the economy.
(D) How would the economy know when to stop adjusting?
You dont. There is always a disequlibrium in the economy. It would stop only when every single individual behaves rationally. However a normal target is to keep the inflation under 0-1% in developed countries and 4-5% in developing countries. Interest rates too at similar numbers.