Answer to Question #207799 in Macroeconomics for ber

Question

Consider a 2-period economy populated with consumers that have the same income and the same preferences. There is also a government whose objective is to spend 60 in period 0 and 150 in period 1. This government can issue bonds in period 0. Each bond pays an interest rate r. Consumers can also issue bonds at the same interest rate. Consumers' optimal decisions, given r, imply that aggregate consumption C0* is equal to 2/3(Yo – To) + 2/3(Y1 – T1)/(1+r). Suppose that Yo = 300 and that income is expected to remain at this level in period 1.

A major recession begins in period 0. As a result, economic activity falls by 18 in period 0. National income is expected to fall by 20 in period 1. Consumers believe these economists.

a) Use a graph to explain why the equilibrium interest rate r falls from 0.25 to 0.2 in period 0 because of this recession.

c) Economists were wrong. The recession does not continue into period 1 so that y1 remains at 300. How does this new information affect consumers? Explain.

Answer 1

a.

During recession the following effects may be observed in the country:

• Economic activities reduces
• Consumer income reduces
• Consumer become pessimist due to which they decrease their expenditure and increase the amount of savings

Deliberate measures are taken by the government to take out the economy from the recessionary situations. The following measures will be taken:

• Expansionary Fiscal Policy: Fiscal policy refers to revenue and expenditure policy adopted by the government. Under expansionary fiscal policy, the rate of taxation is reduced so that people in the country have to pay less amount of taxes and their in-hand money increases. When they have more money in hand they will tend to spend more which will raise the aggregate demand and eventually raise the consumption also.

C_o = 2/3(Yo – To) + 2/3(Y1 – T1)/(1+r)

T_o (Taxation) will be reduced then C₀ (Aggregate consumption) will increase.

• Expansionary monetary policy: Monetary policy refers to the macro-economic policy of the government in which the central bank adjusts the interest rate in order to increase or decrease the money supply in the economy. During recession, the central bank reduces the interest rate in order to encourage people to borrow more money and spend/invest. Thus, the interest rate will be reduced from 2.5 to 2 and consequently the demand for loanable funds will increase from L to L1.

c

In period 0, there was recession. Everyone in the economy was expecting less returns on investment as the interest rates were low. 

When new information is received:

In period 1, recession did not continue. As a result, everyone in the economy started expecting higher returns now. People became optimistic and want to invest more. Since, in period 0 the interest rate was low, therefore people start borrowing more money and invest it to get higher returns. The money supply in the economy increases which is a clear indication of increase in the purchasing power of money in the hands of the consumers. Thus, the aggregate consumption will increase due to the new information that recession is no longer going to continue.