a. Differentiate between monetary policy instruments and monetary policy tools

(5 marks)

Monetary policy instruments are things that the central bank used to change money supply. An example of an instrument is a bond. The central bank can buy or sell bonds to change the monetary base. Monetary policy tools are the techniques that the central bank uses to change the monetary base. The tools are the actions taken, and the instruments are the things used to make the action happen.

b.     Describe the two key tools of monetary policy and describe how they would be used by the Bank of Canada to implement a contractionary monetary policy.                                                                                       (5 marks)

One of the key tools of monetary policy is the inflation control target.  The inflation control target is made to increase the total consumer price index over a period of time. The inflation control target is used by the Bank of Canada to keep the consumer price index inflation rate at 2% per year. A contractionary monetary policy is used to expand the money supply more slowly. With the Bank of Canada trying to keep in increase between 1 and 3 percent the money supply is grow slowly. The other tool used in monetary policy is the flexible exchange rate. A flexible exchange rate is an exchange rate that fluctuates in relation to the supply and demand of other currencies. Canada has a flexible exchange rate, which helps to achieve and maintain the inflation target. By having a flexible exchange rate it helps the Canadian economy adjust to internal and external influences.

1. The economy of Kenya is in recession, and the recessionary gap is large. The World Bank hires you as its economist and asks you to (10 marks)

a.      describe the discretionary and automatic fiscal policy actions that might occur.

A discretionary fiscal policy can be put in place by parliament. Parliament can change their spending or their tax law to increase production and employment. An automatic fiscal policy can be triggered by the economy. The fall in the unemployment rate can be triggered by a decrease in the unemployment benefits.

b.     describe a discretionary fiscal stimulation package that could be used that would not bring a budget deficit.

c.      describe the risks of discretionary fiscal policy in this situation.

d.     explain the argument that lower corporate tax rates can increase tax revenue in Kenya. Consider the Laffer curve in your explanation.

The Laffer curve reaches a peak as the tax rate increases, increasing tax revenue. At the peak it is the most you can tax to get the greatest tax revenue. The Laffer curve shows that the continuous increases of the tax rates past the peak will lower the tax revenue.

1. a. Explain the concept of the multiplier, and explain the role of the marginal

propensity to save (MPS) in determining the size of the multiplier.

(4 marks)

b.     Explain how the size of the multiplier will change when one brings in the role of the marginal tax rate.                                                                    (2 marks)

c.      Using the concepts in parts a and b above, calculate the slope of the AE curve and the size of the multiplier if MPS = 0.20. Then, calculate the revised slope of the AE curve and the multiplier when you know that the imports and the marginal tax rate will reduce the slope of the AE curve by another 0.25.

(4 marks)

1. The economy has seen the unemployment rate decrease from 8.56 percent to 6.15 percent, the inflation rate increase from 1.4 percent to 3.2 percent, and there has been a 17 percent increase in consumer spending and a 22.5 percent increase in investment spending in the same time period.

a.      Given the above, what would you predict about the overall direction of the economy? Explain your answer by referring to each of the indicators cited.

(5 marks)

The economy’s unemployment rate is decreasing so more of the population is working. The inflation rate is increasing so the average price of goods is increasing. There is more of a demand in relation to the supply, which is also shown by the increase in consumer spending. The economy is growing because the unemployment rate is decreasing. More people are working and earning money, which contributes to economic growth. The economy is also growing because consumers are increasing their spending and there is an increase in investment spending. Economies grow when the inflation rate rises, which is causes by the aggregate demand increasing faster than the aggregate supply.

b.     Describe the fiscal policy that will already be automatically operating, as well as the appropriate discretionary fiscal policy that the government should adopt, given the above situation.                                                  (3 marks)

c.      Describe the appropriate monetary policy that the Bank of Canada should be operating, given the above situation.                                       (2 marks)

1. Describe the contrasting views of the Keynesians and the monetarists with regard to an appropriate expansionary policy to bring an economy out of a period of high unemployment caused by insufficient aggregate demand. (10 marks)

A Keynesian view is that when an economy is left alone it would rarely operate at full employment and that to achieve full employment help from fiscal policy and monetary policy is needed. Expectations have a very significant influence on aggregate demand. The economy will enter into a recession when people hear badly about future profits. A Monetarist view is that they believe that the economy is self-regulating and will normally operate at full employment provided that the monetary policy is reasonable and the pace of money growth is maintained. The most significant influence on aggregate demand in the monetarist view is the quantity of money. The Bank of Canada controls the quantity of money. Fluctuation in aggregate demand can be minimized if the Bank of Canada can keep the money growing at a steady pace. The biggest difference between the views of Keynesians and Monetarists is what changes the aggregate demand. To bring an economy out off high unemployment a Keynesian will call for a fiscal and monetary policy and try to offset the insufficient aggregate demand. By actively taking part in the fiscal and monetary policies, unemployment will be reduced and the economy will start to make its way out of a recession. To bring an economy out of high unemployment a Monetarist would reduce taxes and make sure that the growth of the quantity of money is kept steady. As long as taxes remain low no active stabilization will be needed to offset low aggregate demand.

1. Suppose that Canada can produce 1000 tons of wheat or 500 tons of steel, and that Brazil can produce 750 tons of wheat or 1350 tons of steel. (10 marks)

a.      What is the opportunity cost of 1 unit of wheat in Canada? Show your work.

b.     What is the opportunity cost of 1 unit of steel in Brazil? Show your work.

c.      Which country has a comparative advantage in producing steel? Explain why.

d.     Suppose that trade takes place between Canada and Brazil. Which good will Brazil import from Canada? Explain why.

1. a. Describe an export subsidy, and explain the gains and losses that might arise

from such practice.                                                                       (5 marks)

An export subsidy is a government policy that encourages the export of goods through loans, tax relief, government financed international advertising or direct payments. A gain from this is that it is cheaper for foreign importers to bring goods and services to their country. It is also economical to have an export subsidy because if a country does not use up all of its goods and resources they can export it to other countries at a subsidized rate as to not be wasteful. A loss from an export subsidy is that it causes inefficient underproduction in the country in which the export subsidy applies to. When a country is given an export subsidy it makes it harder for producers in the country to produce because its cheaper to import from countries offering an export subsidy.

b.     Why are developing countries in Africa especially affected by export subsidies in industrial countries?                                                  (5 marks)

Developing countries are affected by export subsidies because it makes it hard for them to compete in the global market. By providing export subsidies to developing countries, industrial countries are enabling a slowdown in production of the same good in the developing country. It becomes cheaper for the developing countries to buy from industrial countries because of the subsidized cost. This can really hurt developing countries because they have less of a need to grow their own economy because it is easier to buy from other countries.