Q.no.1:
The financial crisis that hit the United States first and then the world economy starting in fall 2007 meant that the future prospects of many firms looked gloomy at best for some time. Comment on the effect of a recession on the investment curve (only) and on the level of savings, investment, and the equilibrium real interest rate. Show your answer using a graph.
Answer:
A depression is a severe economic downturn that lasts for several years. It is characterized by falling Gross Domestic Product (GDP) and high unemployment rates.
What started as a financial crisis in the United States has quickly unfolded into an economic crisis. The very first impact of this crisis was felt through rapidly declining equity markets. In some cases coupled with massive outward capital flows. This was an indication of massive retraction of investment from the market. Recession causes a downfall in macroeconomic indicators, such as investment, employment, household income, profits etc. This leads to a rise in unemployment rate and bankruptcies.
Discussing the investment curve in this situation, as it is know, during recession interest rate normally falls to encourage investments by offering cheap rates for borrowing money.
The interest rate however has an inverse relation to the recession. The interest rate shows a negative trend so as to attract investment.
An economy in recession may make people cautious, hit by recession or not, watching peers losing their jobs they will opt to save rather than spend or invest.
Joshua Shapiro, Chief United States Economist said “Consumers are rational, they respond to incentives and conditions, and right now the conditions and incentives are: spend as little as you can, and pay down as much as you can. You hunker down. That’s what the consumer’s doing.” (http://www.nytimes.com)
Q.no.2:
How will a fall in domestic investment affect the trade surplus and net capital outflows in the domestic economy, the trade deficit and capital inflows in the rest of the world, investment in both economies, and the world real interest rate?
Answer:
A trade surplus exists when exports exceeds imports, during the financial crisis of 2007, however US exports declined sharply relative to imports, a situation that has persisted in 1990s. This recent excess of imports over exports resulted in trade deficit.
Net capital outflows are the purchases of foreign assets by domestic residents less the purchases of domestic assets by foreigners. In the scenario where the domestic investment is on decline the net capital outflows will increase as the faith of the investor would be more on a healthier economy, comparative to the one facing financial crisis.
Considering the fall in domestic investment only will have a positive impact on the rest of the world’s economy. As the investors rational behaviour will be inclined towards foreign economy. Also, in such situation the imports will surpass the exports decreasing the trade deficit of the rest of the world. As people will no longer invest their money in exports due to the fear of decline in demand, which may be a consequence of a fall in consumption as people may be saving a lot. Similarly the world’s net capital inflows will increase.
Recessions can and do lead to a decrease in investment spending. Focusing on the investment in both economies, the level of FDI in the domestic economy will fall due to increased risk, and low confidence of the investor. However it would have a contrary impact on the world’s economy, as the attention of the investor would be diverted from the domestic economy. Another reason for this might be a lower real interest rate, that may attract funds from the investor.
Q.no.3:
Some developing countries have suffered banking crises in which depositors lost part or all of their deposits (in some countries there is no deposit insurance). This type of crisis decreases depositors’ confidence in the banking system. What would be the effect of a rumour about a banking crisis on checkable deposits in such a country? What would be the effect of on reserves and the monetary base?
Answer:
Banking Crisis: “When bank debt holders suddenly demand that banks convert their debt claims into cash to an extent that the banks are forced to suspend the convertibility of their debt into cash”
(Calomiris and Gorton, 1991)
A rumor about a banking crisis can lead the banking system to the ‘Bank Run’ situation, a phenomenon in which depositors of the bank withdraw their deposits, as they lose faith in the banking system and fear to lose their funds in case of a bank failure. It has been observed in the past that a run on one bank lead to a loss of confidence in other banks, which caused additional bank runs.
Banks are assumed to be the nucleus to business activity. Therefore, when they go through any financial crisis, central bank and the governments usually intervene to the rescue, by offering urgent liquidity and several forms of bailout programs. Accounting the effects of banking crisis on reserves and monetary base, the reserve banks or the state bank may adopt very macro prudential approach. The process starts with the monetary base, which is also called high-powered money. The reserve bank will increase the monetary base, though public’s priority for currency over checkable deposits does not have any impact on the monetary base yet an increase in the bank reserve component may raise the monetary base. Banks shall begin to hold more excess reserves than they had checkable deposits. The reserve bank will opt for purchasing more assets; this will also result in an increase in the monetary base.
http://www.nytimes.com)
