Problem set-2

Course EEP-I Batch 2020-22

1. Case let:

Zimbabwe was one of the richest and most developed countries on the African continent before
the turn of the 21st century.  Zimbabwe was uncharacteristically economically developed for a
sub-Saharan country, in fact the most developed only behind South Africa.   How did this once
model African economy became a near failed state? The event that set off this decade long crisis
was a mismanaged policy by President Robert Mugabe. Mugabe acted very radically in the early
80's when he implemented a policy of land reforms. In August of 2007, a BBC article
summarized the situation perfectly when they said "The seizure of white farms was [what]
opened and thus began the long slide into today's economic crisis". The political-economic
landscape has been defined by competing ownership of resources.
Rhodesia was a British colony and then became a de-facto European governed country in the
mid 60's. After years of conflict and civil war, power was transferred to the native Africans, and
a legitimate state Zimbabwe was created. One of the first policy actions was made by prime
minister (later president) Mugabe was to re-distribute land. In Zimbabwe, the white minority,
constituting 5 % of the population owned 80% of the lands, while the majority native Africans
were left to scrape a living on the remaining, mostly un-arable, overcrowded common
lands.  These plans to re-distribute lands fell through when buyouts ceased after it was found out
land was being handed to those close to Mugabe. Soon thereafter, land was simple seized by
Mugabe's government. Much of the colonial history as well as the post-colonial issue of
maintaining political reign but not having economic empowerment was the issue that has led to
Zimbabwe having such a horrendous economy today. It is understood then that the controversial
policy took form due to the deep roots of and hatred of Zimbabwe's colonial history.
This economic dilemma has been years in the making. Throughout the colonial history of
Zimbabwe, and through the80's and 90's, Zimbabwe has experienced large scale agricultural
exports and relative economic success, once second only behind South Africa. But with these
land reforms being implemented, much of the marginalized people began to live off of the once
managed natural resources that were the main exports and source of income for Zimbabwe. The
demand for these resources only grew since the 1980's. The commercial farming sector had been
one of the main sources of Zimbabwe's economic wealth, making it a net exporter and employing
over 400,000 workers. The move from this to the mismanagement and decentralization of the
farming sector has led to the overall economic chaos. Because of the land reform policy,
Zimbabwe has had to become an importer of food, now received as aid due to its inability to
receive loans because of its arrears on past loans and failure to implement new policy. The fiscal
mismanagement, of which an infrastructure for sound financial management was never created,
has led to an unsustainable fiscal deficit, hyperinflation, and an extremely overvalued official
exchange rate. 
The country that had once provided much of the grain to the world has barely any food to put on
the shelves in the supermarket.  Also, Zimbabwe's involvement in the civil war in the
Democratic Republic of the Congo drained much of the monetary reserves that Zimbabwe had at
the turn of the 21st century. The national bank of Zimbabwe continues to print money to fund the
deficit.  In 1998, the inflation rate was 32 percent, a very high number for any country. In 2008,
the annual inflation rate was 11.2 million percentage points, practically costing more to print the
money than the money is worth.  The GDP growth rate of 2008 was -12.6 percent, more than
doubling from the year before. Per Capita GDP remains one of the lowest, at U.S. $200, and an
unemployment rate of 80 percent. All of these factors make Zimbabwe one of the most
impoverished countries in the world. There is no room to invest in infrastructure or financial
institutions. Zimbabwe has over 5 billion dollars in external debt and imports over 2 billion
dollars of commodities, while only having a little over 6 million dollars in actual revenue. 1 U.S.
Dollar is worth 30,000 Zimbabwe Dollars in 2008, more than doubling in since the previous
year. The numbers are astounding to say the least. The land control policy has become one of the
most controversial issues, and is seen to be the event that caused the horrific downturn of
Zimbabwe's economy.
The economic crisis at hand is not that is one that is easily solved. Zimbabwe is constantly on the
verge of collapse, which could cause an unnecessary security issue for the international
community. Riots and violence engulf the country into a literal mania, going past the emotions
and into actual actions. It is one of the worst case scenarios possible. Foreign aid is hard to give
as it is certain to end up in the wrong hands. But with current political reform it may be possible
to invest into an intelligible financial system and in infrastructure where resources can be used as
they were in the past and foreign investment can increase.  Also, the IMF and World Bank, and
other foreign lenders will be likely to lend money if the new economic infrastructure would be
established as planned. All of this would hopefully lead Zimbabwe out of spiraling deficit and
unbelievable hyper-inflation. Otherwise, a serious human rights violation would be the only
other means that a foreign power would be forced to enter the region, which would hopefully not
be the case.
Explain the situation with the help of Fiscal and monetary policy. Give your suggestion
how Zimbabwe can overcome this worst situation.

2. “When crude prices, barring geo-political shocks, are expected to remain low over the
year. Weak demand conditions have also moderated inflation excluding food and fuel.
These factors have significantly reduced the momentum of inflation”- explain in detail.

NUMERICAL PROBLEM

3.

For an economy with the following specifications:

Consumption: C= 100+0.9 Yd
Lump sum tax; T= (1/3) Y
Investment: I=600-30i
Government expenditure: G=300
Transaction demand for money: L1= 0.4Y
Speculative demand for money: L2=-50i
Nominal Money supply: M̅ = 1040
Price Level=2
Full employment level of income=2500
a) Derive the Fiscal policy equation (Y=C+I+G) and monetary policy equation (Money
supply=Money Demand) [Money supply here it is in real terms =nominal MS /price and
money demand is transaction demand and speculative demand]. Then compute the
equilibrium levels of income and rate of interest from the two equations.
b) Fiscal Multiplier
c) Is the government budget is surplus or deficit?
d) Compute the change required in the level of government expenditure to achieve full
employment level of income.
e) If f MPC changes to 0.6 what will be the effect on rate of interest and national income?

4. An economy shows the following features:

Consumption, C=30+.8(Y-T)
Tax, T=60
Government expenditure, G=60
Investment, I=128-21i
Money Demand, L=.3Y-9i
Real Money Supply = 60
Exports, X=50
Imports, M=10+.1Y
a) Obtain the Fiscal policy equation and monetary policy equation same as earlier sum
of the economy
b) Find out equilibrium income and rate of interest
c) Find Balance of Trade

5. For an economy with the following specifications:

Consumption: C= 86+0.8 Yd
Transfer payment =-20
Investment: I=24-20i
Government expenditure: G=60
Transaction demand for money: Mt= 0.5Y
Speculative demand for money: Msp=300-40i
Money supply: Ms= 440
Full employment level of income Y(f)=1100
a) Derive the IS and LM equation and compute the equilibrium levels of income and rate of
interest.
b) What shall be the additional export in order to achieve full employment level of income.
c) How will the additional export be affected if the tax function T=10+0.1Y is introduced?