- Use the Quantity Theory of Money equation (MV=PY) to predict what will happen in the following scenarios, that is:
Which variables will be directly affected (it will be one on each side) and will there be inflation, deflation or neither and by approximately how much:
a. The monetary authorities predict 5% growth in production this year, expand the money supply accordingly but real production only grows at 2%.
b. There is a major cyber attack and electronic banking is ceased for one month.
c. The monetary authorities did not foresee a huge immigration increase which increased the demand for money by 5% more than the authorities anticipated.
- Many European countries have very difficult employment rules – it is very hard to fire people once they are hired. Let’s apply this concept to marriage. If the law was written in such a way that divorce was very hard, do you think:
a. The number of marriages would increase or decrease? Why?
b. The divorce rate would increase or decrease? Why?
c. If we could measure it, would marriages be happier or less so?
- There are several theories about what causes inflation and while these theories can create inflationary pressures there is really only one cause of inflation and one cure. What are they?
- What is the key difference in how Keynes and the Classicals view an economy in a downturn?
- If Keynes is correct what are two reasons there may be stickiness in the adjustment mechanism?
Full Answer Section
- Scenario:A large immigration increase raises the demand for money by 5% more than anticipated by the monetary authorities.
- Affected Variables:
- M:Remains unchanged (as the authorities didn't adjust for the increase)
- Y:Potentially increases due to the influx of workers.
- Inflation/Deflation:Inflation is likely, as the demand for goods and services increases with more people, but the money supply remains unchanged.
- Magnitude:Difficult to estimate without knowing the exact increase in demand and the elasticity of supply.
Explanation: The unchanged money supply cannot meet the increased demand, leading to price increases.
- Marriage and Divorce Laws
- Number of Marriages:
- Likely Impact:The number of marriages would likely decrease.
- Reasoning:The difficulty of divorce would create a greater sense of risk associated with marriage. People may be less likely to enter into a commitment if they perceive it as very difficult to exit.
- Divorce Rate:
- Likely Impact:The divorce rate would decrease significantly.
- Reasoning:The law would create a disincentive for divorce, making it less appealing even if marriages are unhappy.
- Marriage Happiness:
- Potential Impact:Difficult to say for certain. Some argue that a less likely divorce would lead to greater commitment and potentially happier marriages. However, others argue that the inability to leave a bad situation could increase marital conflict and unhappiness.
- Inflation:
- Cause:Inflation is primarily caused by an excess of money supply relative to the available goods and services. This creates "too much money chasing too few goods."
- Cure:The primary cure for inflation is to reduce the money supply. This can be achieved through monetary policy tools like raising interest rates or reducing government spending.
- Keynesian vs. Classical Views on Downturn:
- Keynesian:Focuses on the role of government intervention in stimulating demand to overcome a downturn. Keynesians argue that the market doesn't always self-correct quickly and that government spending and fiscal policy are necessary.
- Classicals:Believe in market forces and self-correction. They argue that government intervention can be counterproductive and that markets will naturally adjust to a downturn through price adjustments and reduced wages.
- Keynesian Stickiness in Adjustment:
- Wage Stickiness:Workers may resist wage reductions during downturns, leading to unemployment instead of price adjustments. This can make it difficult for the economy to self-correct.
- Price Stickiness:Firms may be reluctant to lower prices, especially in the short term, due to factors like menu costs, concerns about price wars, and the perceived impact on brand image. This can hinder the adjustment process.
Conclusion:
Understanding economic concepts like the Quantity Theory of Money, different schools of thought, and the causes and cures of inflation is crucial for navigating economic challenges. The scenarios discussed highlight the complex interplay of factors influencing economic outcomes and the need for informed policy decisions to address economic fluctuations.
Sample Answer
Analyzing Economic Scenarios
Here's an analysis of the scenarios you presented, along with explanations for each:
1. Quantity Theory of Money
MV = PY
Where:
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M: Money Supply
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V: Velocity of Money (how quickly money changes hands)
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P: Price Level (inflation)
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Y: Real Output (production)
a. Production Growth and Money Supply
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Scenario: The monetary authorities predict 5% growth in production, expand the money supply accordingly, but real production only grows at 2%.
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Affected Variables:
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M: Increases by 5%
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Y: Increases by 2%
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Inflation/Deflation: Inflation will likely occur.
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Magnitude: Inflation will be approximately 3% (5% - 2%).
Explanation: The money supply has increased more than the real output, leading to an excess of money chasing fewer goods and services, causing prices to rise.
b. Cyber Attack on Banking
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Scenario: A major cyber attack halts electronic banking for one month.
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Affected Variables:
-
Inflation/Deflation: Deflation is likely.
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Magnitude: Difficult to estimate precisely, but deflation will likely be significant, given the disruption to economic activity.
Explanation: The reduced velocity of money and the decline in production will lead to a decrease in demand, putting downward pressure on prices.
c. Unexpected Immigration Increase