Arnold Mouende MNDNGO004

Question 1:

a) A decrease in the real interest has two effects which are substitution and income effect. The
substitution effect is represented on the graph as the consumer will move along their
indifference curve from point A to point B. The effect of the substitution effect is the current
consumption will increase as shown on the x axis from point c1 to point c2 and future
consumption will decrease as shown from point c’3 to point c’4 on the y axis. Savings will result
in a net decrease as current consumption for the consumer has increased. The other scenario
would be the income effect, and this is represented on the graph as the consumer moves from
indifference curve 1 to indifference curve 2 represented by the line CB. The income effect will
result in current consumption to decrease as shown on the x axis from point c2 to point c5 and a
decrease in future consumption from point c’4 to point c’6 on the y axis. The effect is that
savings will increase while both future and current consumption decrease. The overall
movement of current consumption is that it will decrease while future consumption is
ambiguous. If the substitution effect is greater than the income effect, the current consumption
will decrease while future consumption will increase, and savings will increase.

b) The consumer has the initial budget constraint AB as shown on the graph a temporary increase
in income will shift the initial budget from AB to CD as shown. The effect of the temporary
Arnold Mouende MNDNGO004

increase is that a consumer will not consumer the entire increase and saves some away for the
future and this is shown from point G to point K represents the consumption of the entire
temporary increase in income at c3 but the consumer only consumes until point c2 and will be
at point H of the indifference curve 2. Overall a temporary increase in consumption results in a
decrease in current consumption and an increase in future consumption as well as savings. A
permanent increase in income will shift the consumers budget line from CD to EF and the effect
of this is that the consumer will increase their overall consumption as shown in line HI which
represents current consumption from c2 to c3 as opposed to consumption being at line HL
which is represent by consumption from c2 to c4 where consumption behaviour does not
change. Overall a permanent increase in income will result in an increase in current
consumption and a decrease in future consumption.

c) I agree with the statement that budget deficits are not always bad because budget deficits could
lead to economic growth in the long run as it can finance extra capital spending. This is good
because a higher spending on infrastructure or education can improve the supply side of the
economy in terms of improving marginal product of labour from the improved education quality
and technological advancement increasing the total factor product from the improvement of
infrastructure. Another good aspect of increasing the budget deficit would be that the
Arnold Mouende MNDNGO004

government will be more capable of managing the economy. This is due to the Keynesian
ideology that having an extra fiscal influence in the economy would allow the government to
keep output as close to potential output as possible in addition to managing unemployment.
Government deficits can be bad due to financing issues. The problem with government deficits
is that financing them would be a difficult as a possible solution would be to offer higher interest
rates to attract more investors but the effect of this is that in the long run the government will
have to increase taxes which may decrease spending from the private sector and households.
Another reason a government deficit may be bad is that borrowing may add to the pre existing
national debt which means that the government will have to spend more on interests payments
which is an opportunity cost as those fund may have been used in other areas of concern.
Another concern for increasing the budget deficit is that adding more debt may result in an
increase in wasteful spending. A increase in national debt may affect the growth of the private
sector in a negative way. This comes from Neo-liberalism as the believe that adding to the
government debt increases wasteful spending by the government which would be used more
efficiently by the private sector which would also help it grow. Therefore, increasing the
government deficit is not always bad as there are favourable outcomes.

Question 2:

a) Asymmetric information is the scenario which two parties are entering a transaction and one
party lacks crucial information about another party which may impact the decision-making
process and the outcome of the transaction. The problems asymmetric information can result in
adverse selection and moral hazards. Moral Hazard is the scenario in which a party as incentive
to engage in undesirable immoral activities after the transaction has occurred for example a
borrower may engage in activities that make it more unlikely to pay back a bank loan. Adverse
selection is the scenario which parties with undesirable traits will take part in a transaction that
may cost another party. An example of adverse selection is that risky individuals are more likely
to apply for a bank loan and riskiness is an undesirable trait.

b) Asymmetric information is seen as a source of bank panics because banks cannot distinguish
between good borrows and bad borrowers as the bad borrowers will copy the actions of good
borrowers where the probability of the bank lending to a good borrower is b and lending to a
bad borrower is 1-b. Due to asymmetric information in the credit markets the banks do not offer
the same interests rates that they receive thus they added interest to borrowers due to
asymmetric information. If asymmetric information were to increase the probability b of lending
to a good borrower decreases while the probability of lending to a bad borrower increases and
the bank would increase the interest rate as a way to counteract the uncertainty and prevent
future losses of defaulting borrowers. Thus b represents the information asymmetry a bank
faces which means that as b increases the bank will increase the interest rate to borrowers due
Arnold Mouende MNDNGO004

to increased uncertainty conversely when information asymmetry decreases b increases and

banks lowers the interest rate for borrowers due to less uncertainty. This shows why
information asymmetry is a source of bank panic.

c) The Central Banks are currently lenders of last resort and this is a case where a bank needs the
Central Bank to lend funds at a penalty rate due to being below the required reserve. I do not
agree with Mishkin’s on the lender of last resort role as he explains that banks must offer
interest rate lower than the market rates to firms normally which would boost production and
income and prevent another financial crisis. The reason I do not agree is that businesses that are
bound to fail are going to continue lending more money which is in a sense wasteful as the
money can be used elsewhere furthermore it encourages excessive borrowing which may leave
banks with a shortage while inflation rates may increase. The problems with the expanded role
is that there is nobody to supervise how much is lent to firms and it encourages spending which
may be difficult to control and may push up inflation as it would be hard to manage such a
system.