Macro Questions PDF - Introductory Macroeconomics

lOMoARcPSD|40757087 Macro Questions Introductory Macroeconomics (University of Melbourne) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 THE ULTIMATE MACROECONOMICS EXAM GUIDE LECTURE 1: Measurement and Meaning of GDP.................................................................. 2 MULTIPLE-CHOICE QUESTIONS..................................................................................................... 2 SHORT ANSWER QUESTIONS........................................................................................................ 5 LECTURE 2: Inflation, Interest Rate, Saving, Investment....................................................... 7 MULTIPLE-CHOICE QUESTIONS..................................................................................................... 7 SHORT ANSWER QUESTIONS.......................................................................................................10 LECTURE 3: The Labour Market & Short-term Economic Fluctuations................................ 15 MULTIPLE-CHOICE QUESTIONS....................................................................................................15 SHORT ANSWER QUESTIONS.......................................................................................................20 LECTURE 4: Keynesian Model of the Economy.................................................................... 23 MULTIPLE-CHOICE QUESTIONS....................................................................................................23 SHORT ANSWER QUESTIONS.......................................................................................................27 LECTURE 5: Fiscal Policy and Financial Markets.................................................................. 33 MULTIPLE-CHOICE QUESTIONS....................................................................................................34 SHORT ANSWER QUESTIONS.......................................................................................................37 LECTURE 6: Monetary Policy, Aggregate Demand, Aggregate Supply............................... 42 MULTIPLE-CHOICE QUESTIONS....................................................................................................42 SHORT ANSWER QUESTIONS.......................................................................................................43 LECTURE 7: Aggregate Demand and Aggregate Supply..................................................... 46 MULTIPLE-CHOICE QUESTIONS....................................................................................................46 SHORT ANSWER QUESTIONS.......................................................................................................48 LECTURE 8: Economic Growth............................................................................................. 52 MULTIPLE-CHOICE QUESTIONS....................................................................................................52 SHORT ANSWER QUESTIONS.......................................................................................................57 LECTURE 9: International Trade.......................................................................................... 67 MULTIPLE-CHOICE QUESTIONS....................................................................................................67 SHORT ANSWER QUESTIONS.......................................................................................................70 LECTURE 10: International Trade and Exchange Rate......................................................... 72 MULTIPLE-CHOICE QUESTIONS....................................................................................................72 SHORT ANSWER QUESTIONS.......................................................................................................74 LECTURE 11: Exchange Rate and Balance of Payments...................................................... 78 MULTIPLE-CHOICE QUESTIONS....................................................................................................78 SHORT ANSWER QUESTIONS.......................................................................................................81 Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 LECTURE 1: Measurement and Meaning of GDP MULTIPLE-CHOICE QUESTIONS 1. Which of the following transactions would be included in the measurement of GDP? a) The purchase of $5,000 worth of shares in a company that is listed on the Australian Stock Exchange. b) The purchase of an investment house that was built in the 1960s c) The payment of a pension by the government to an elderly individual. d) None of the above. 2. Which of the following statements is false: a) Household production, such as the provision of cooking, cleaning and childcare, are not included in GDP since they are not market activities. b) The provision of government services, such as education, are not included in GDP since they are not market activities. c) Transactions related to criminal activities, such as the purchase of illicit drugs, are not included in GDP. d) When GDP is calculated, it does not adjust for the depletion of natural non-renewable resources. 3. Suppose the total market value of all final goods and services produced in a particular country in 2009 is $500 billion and the total market value of final goods and services sold is $450 billion. We can conclude that a) GDP in 2009 is $450 billion. b) Intended investment (I), in 2009 is $50 billion c) GDP in 2009 is $500 billion. d) inventories in 2009 fell by $50 billion. 4. Which of the following is an example of a final good or service? a) a maths textbook you purchase with the intent of selling after your course is over b) coffee beans that are purchased by a restaurant owner from a wholesale food distributer c) the chips that a large manufacturer of notebook computers purchases d) the timber a builder purchases for the construction of a house 5. Which of the following events would result in an increase in a country’s GDP? a) the value of $10,000 of shares purchased in BHP-Billiton b) the Baillieu Library is sold to a private buyer c) a family takes its baby to a commercial childcare rather than to the baby’s grandparents for babysitting d) the purchase of an imported motor car 6. Suppose total government spending over a year is $275 billion of which $150 billion is spending on a system of payments made to low-income families, $75 billion is spent on the construction of roads and other infrastructure, and $50 billion is paid on salaries for Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 workers in the education sector. What is the government’s contribution to GDP in that year? a) $125 billion b) $275 billion c) $200 billion d) $550 billion 7. Over a three-month period, not everything that is produced is necessarily purchased (i.e., there might be inventories of unsold stock). Yet, economists maintain that in any period, the values of production and expenditure will be the equal. This statement is a) False because if there are inventories of unsold stock, expenditure can never be equal to production b) True as inventories will be treated as an investment expenditure by firms for a particular period c) False because if there are inventories of unsold stock, expenditure will be less than production d) True as inventories will be added to expenditure as it will be sold in the next period 8. Suppose a loaf of bread that is ultimately sold to a customer at The Corner Store is produced by the following production process: Name of company Revenues Cost of purchased inputs Seed supplier $1.00 $0.00 Mildura Wheat Co-op $2.00 $1.00 The Corner Shop $3.50 $2.00 What is the sum of the value added of all the firms? a) $1.00 b) $2.00 c) $2.75 d) $3.50 e) $6.50 9. The values of real and nominal GDP must necessarily be equal in the current period if a) GDP is measured using the production or value-added measure b) the current period and base or reference period are the same c) the quantity of GDP has not changed since the base or reference period d) the rate of inflation has fallen since the base or reference period e) GDP is measured using the expenditure approach 10. The rate of growth of real GDP per head may not be a satisfactory measure of change in a country’s standard of living because it a) fails to take account of the rate of population growth. b) takes account of “externalities” which can have both a good and a bad effect on the population. c) gives no indication of the distribution of income. d) does not allow for change in the general price level. e) is not influenced by changes in the exchange rate 11. Given the following data for an economy, compute the investment component of GDP: Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 Consumption expenditures 1000 Imports 600 Government purchases 700 Exports 500 Government payments to retirees 200 Household purchases of durable goods 300 Beginning-of-year inventories 400 End-of-year inventories 700 Business fixed investment 500 a) 300 b) 400 c) 800 d) 900 e) 1500 12. Suppose a jar of orange marmalade that is ultimately sold to a customer at The Corner Store is produced by the following production process: Name of company revenues Cost of purchased imports Citrus Growers $0.75 $0.00 Mildura Jam Company $2.00 $0.75 The Corner Shop $2.50 $2.00 What is the value added of The Corner Shop? a) $0 b) $0.50 c) $0.75 d) $1.25 e) $2 13. Apple Island is an economy that only produces computers. Aluminium and silicon are used as intermediate inputs. Each computer is valued at $2000 each; 200 000 are sold to consumers, 300 000 are sold to the government and 100 000 are sold abroad. 50,000 computers are imported. The value of GDP in this economy is a) $0.4 billion b) $0.6 billion c) $1 billion d) $1.2 billion e) unknown without more information 14. Suppose that the total expenditures for a typical household in 2000 equalled $2500 per month, while the cost of purchasing exactly the same items in 2003 was $3000. If 2000 is the base year, the CPI for the year 2003 equals a) 0.83 b) 1.00 c) 1.20 d) 1.25 e) 1.30 Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 15. Which of the following transactions would not affect the aggregate level of Australian GDP? a) The purchase by an Australian citizen of shares in a telecommunications company b) A consumer in New Zealand purchasing a car manufactured in Australia c) An Australian firm that purchases some capital machinery that is produced domestically using intermediate inputs from overseas d) The government paying teachers for educating students 16. Gross domestic product is a measure of a) the market value of final goods and services produced in a country during a given time period b) the market value of intermediate goods and services produced in a country during a given time period c) the social value of final goods and services produced in a country during a given time period d) the economic value of intermediate goods and services produced in a country during a given time period 17. If the quantity of output produced remains unchanged between 2018 and 2028 but the price of all goods falls by 10 per cent over this period, then from 2018 to 2028 a) the percentage change in real GDP will be larger than the percentage change in nominal GDP b) the percentage change in nominal GDP will be larger than the percentage change in real GDP c) the percentage change in nominal GDP will equal the percentage change in real GDP d) We cannot compare changes in nominal GDP to changes in real GDP without further information 18. Which of the following transactions would be included in the measurement of GDP? a) The purchase of $5,000 worth of shares in a company that is listed on the Australian Stock Exchange. b) The purchase of an investment house that was built in the 1960s. c) The payment of a pension by the government to an elderly individual. d) None of the above 19. A construction company produces a $500,000 new house after purchasing $100,000 worth of wood, steel and other material. It pays $150,000 to workers to build the house. What is the contribution to GDP of this company? a) $250,000 b) $400,000 c) $500,000 d) None of the above SHORT ANSWER QUESTIONS Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 1. When comparing data across countries, economists often scale a variable by dividing by GDP. For example, to get an idea of the role of government in an economy, economists would divide the level of government spending by the level of GDP. Explain why this is a useful thing to do. Economies vary by a great amount in size due to, for example, population size. If we are interested in evaluating differences, in say, the role of the government in an economy it would not necessarily make sense to compare the level of government spending. A large economy like China would have much greater government spending than a small economy like Nepal. To compare the role of government in the economy it would make more sense to compare the ratio of government spending to GDP. As a follow up question, you can ask in what other ways economic variables can be scaled to make them more comparable across countries. Concretely, suppose you wanted to compare living standards across countries, then you may compare output per person or consumption per person which would imply scaling by the population size. 2. Economists often (implicitly) use GDP as a measure of how well an economy is performing. Do you think that GDP is a good measure of welfare of a society? In what ways is GDP a good measure of welfare and in what ways would GDP be an inadequate measure of welfare? Explain your answer. What do you think are alternative ways of measuring welfare? Why is GDP a good measure of welfare? - Job and income opportunities - Positive correlation with education, health outcomes, gender equality o Countries with higher GDP are more productive o Greater productiveness allows people to pursue a broader range of opportunities and leads to greater levels of happiness Why is GDP a bad measure of welfare? - Doesn’t account for: o Quality of life (crime, discrimination, etc) o Environmental degradation o Poverty and inequality - Excludes non-market activity Alternative measures: - Human development index (includes health and education in addition to income - Revealed preferences (e.g., migration) 3. Distinguish between ‘final’ goods and services and ‘intermediate’ goods and services A final good or service is one that will not be transformed further in the market sector in Australia. An intermediate good or service is sold to another firm in Australia to be further transformed. Final goods are accounted for in the GDP, whilst intermediate goods are not. 4. Distinguish between nominal GDP, real GDP index and Chain Volume Index Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 Nominal GDP is a measure of GDP in which the quantities produced are valued at current year prices. Nominal GDP measures the current dollar value of production. Contrastingly, the real GDP measures the actual physical volume of production. It measures the quantity, whilst keeping prices constant. The Chain volume index focuses on addressing the problems that the fixed base index does not. Unlike the fixed base index, the chain volume index does not focus on one base year, and instead adapts to prevent prices from reflecting outdated bundles of goods. Hence, the further away in time one is from the base year, the less relevant the base year prices are. 5. Over a three-month period, not everything that is produced is necessarily purchased (i.e., there might be inventories of unsold stock). Yet, economists maintain that in any period, the values of production and expenditure will be the equal. How can this be? An item may be produced within a period but not necessarily purchased. This item is treated as adding to a firm’s inventory stock and changes in inventories over a particular period of time are recorded as an investment expenditure by firms. 6. In measuring GDP using the expenditure method, explain how inventories are treated. Why are inventories treated in this manner? The addition of inventories to a firm is treated as an investment expenditure. The rundown of inventories at a firm is subtracted from investment expenditure. Inventories are treated in this manner because if a firm produces a product that is not sold, it is assumed that the firm purchases the product. This assumption is made so that the expenditure and the production method of calculating GDP lead to the same outcome. LECTURE 2: Inflation, Interest Rate, Saving, Investment MULTIPLE-CHOICE QUESTIONS 1. If both the lender and borrower agree on an 4% interest rate, both expect a 2% inflation rate, and inflation turns out to be -0.5%, then _____ by the deflation a) the borrower is hurt and the lender gains b) the borrower gains and the lender is hurt c)neither the borrower nor the lender is hurt d) both the borrower and lender are hurt 2. Which of the following would reduce investment undertaken by firms? a) decrease in the real interest rate b) a fall in the price of output produced by the firm c) a decrease in the price of intermediate inputs purchased by the firm d) a decrease in the preference for overseas produced products Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 3. Assume workers and firms agree to long-term wage contracts that are set in nominal terms. If inflation is higher than expected, then workers will be _____ and firms will be ____. a) better, better b) better, worse c) worse, better d) worse, worse 4. In a perfectly competitive labour market, a decrease in the equilibrium wage and an increase in equilibrium employment may arise due to a) an increase in the number of people in the working age population b) a reduction in the marginal product of labour due to the depreciation of capital goods c) an improvement in technology that raises the marginal product of labour d) a reduction in the willingness of individuals to work due to an increase in household wealth 5. Suppose that nominal GDP in an economy in year 1 is $500 million and in year 2 is $600 million. If the price level of the goods and services produced has increased from an index number of 120 to an index number of 130 then, a) while nominal GDP increased between year 1 and year 2, real GDP must have decreased. b) while nominal GDP has decreased between year 1 and year 2, real GDP must have increased. c) while prices of the goods and services have increased by 10% between year 1 and year 2, real GDP has decreased by only 5%. d) while there has been inflation over this period, real GDP has still increased. 6. If the general level of prices is decreasing at a rate of 10% per year, we would expect that the real interest rate will be a) less than 10% b) the same as the nominal interest rate c) 10 % or higher d) less than 5% e) none of the above 7. Holding all else equal, the National Saving schedule shifts to the right when a) there is a fall in the real rate of interest b) the government budget moves from deficit to surplus c) firms increase their investment d) the value of the marginal product of capital falls e) government expenditure rises 8. Which of the following would reduce investment undertaken by firms? a) a decrease in the real interest rate b) a fall in the price of output produced by the firm c) a decrease in the price of intermediate inputs purchased by the firm d) a decrease in the consumers' preference for similar overseas produced products e) none of the above Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 9. If borrowers and lenders expecting 5% inflation agree to a long-term debt contract and inflation turns out to be 3%, then: a) borrowers gain and lenders gain b) borrowers gain and lenders lose c) borrowers lose and lenders lose d) borrowers lose and lenders gain e) none of the above 10. One of the economic costs associated with inflation is that it can lead to inefficiency in resource allocation. This is because a) the prices of all goods and services are increasing b) inflation leads to an increase in the nominal rate of interest c) firms and households cannot always distinguish relative price changes from general price changes d) inflation leads to an increase in the real rate of interest e) inflation reduces national saving 11. If a borrower and lender agree to an interest rate on a loan when inflation is expected to be 10% and inflation turns out to be 7% over the life of the loan, then the borrower _____ and the lender ______. a) gains; gains b) gains; loses c) is not affected; gains d) loses; gains e) loses; loses 12. If the real interest rate is 3% and the inflation rate is 7%, then the nominal interest rate is approximately a) 3% b) 4% c) 7% d) 10% e) 21% 13. Suppose the inflation rate is 10% and the nominal interest rate on a ten-year bond is 8%. The real interest rate on the ten-year bond will be a) positive b) zero c) negative d) increasing e) decreasing 14. Holding all else equal, _________ in the ________ of saving will _________ the ___________ of wealth. a) a decrease; stock; increase; flow b) an increase; flow; decrease; stock Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 c) an increase; stock; increase; flow d) a decrease; flow; increase; stock e) an increase; flow; increase; stock 15. If the economy is experiencing deflation and relative prices are constant, then a) the rate of growth of nominal GDP will exceed the rate of growth of real GDP. b) the rate of growth of real GDP will exceed the rate of growth of nominal GDP. c) the rate of growth of nominal GDP will equal the rate of growth of real GDP. d) we are unable to determine without further information the relative rates of growth of nominal and real GDP 16. Holding other factors constant, if there is an increase in uncertainty that makes people feel less secure in their jobs, then the real interest will ____ and the equilibrium quantity of national saving and investment will _____. (Assume no change in the government’s budget deficit.) a) increase, increase b) increase; decrease c) increase, no change d) decrease, increase e) decrease; decrease 17. The exact form of the Fisher equation is &'( a) 1 + 𝜋 = &') &'( b) 1 + 𝑖 = &'+ &') c) 1 + 𝑟 = &'+ d) 1 + 𝑖 = 1 − 𝜋 − (1 + 𝑟) 18. If inflation is unexpectedly high, then we can expect that lenders will be _______ off and borrowers will be ______ off, as a result. a) better, better b) better, worse c) worse, better d) worse, worse 19. If inflation and the real interest rate both rise by 2 percentage points, then the nominal interest rate a) must be decreasing b) must be approximately unchanged c) must be increasing d) may increase or decrease depending upon productivity SHORT ANSWER QUESTIONS 1. Inflation and the value of money: a) The average quarterly inflation rate in Australia from 1973-1979 was 2.9 per cent. What is the implied average annual inflation rate for over this period? Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 1.029 x 1.029 x 1.029 x 1.029 = (1.029)4 = 1.1211 = 12.1% b) Suppose an individual began 1973 with $100 and the quarterly inflation rate was 2.9 per cent. What would the individual’s real value of wealth (in 1973 dollars) be at the end of 1979 if they had held their wealth in cash with a zero nominal interest rate? From the start of 1973 to end of 1979 is 7 years Use the annual inflation rate of 12.1% as calculated above 100 (1 + 1.1211)3 = 44.91 &') General formula: (&'+)! , where i is the interest rate, 𝜋 is the inflation rate, and n is the number of periods c) A hyperinflation is a period in which the rate of inflation becomes very high. A specific but somewhat arbitrary definition of a hyperinflation is that it is a period in which the monthly inflation rate exceeds 50 per cent. Suppose an individual began with $100 of wealth in 1973 and the monthly inflation rate was 50 per cent. What would be the individual’s real value of wealth (in 1973 dollars) be at the end of 1979 if they held their wealth in cash with a zero nominal interest rate? From the start of 1973 to end of 1979 is 7 years 7 x 12 = 84 months Use the monthly rate of inflation of 50% 100 ≈ $0 (1 + 0.5)56 2. What are the costs of inflation? Shoe leather costs - hold too little cash Inflation erodes the real purchasing power of any given amount of cash. The longer cash is held during a period of inflation, the larger is this reduction in purchasing power. Noise in the price system - Hard to infer what relative prices are like when inflation is high. Tax system is nominal - bracket creep Without indexing, an inflation that raises people’s nominal incomes would force them to pay an increasing percentage of their income in taxes as they move into higher tax brackets, even though their real incomes may not have increased. Redistribution of wealth - In other words, the effect of the inflation is not to destroy purchasing power but to redistribute it, in this case from the workers to the employer. If Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 inflation had been lower than expected, the workers would have enjoyed greater purchasing power than they anticipated, and the employer would have been the loser. Planning difficulties - High and erratic inflation can make long-term planning difficult. Menu costs - The act of changing prices itself can impose significant costs. 3. There has been a decline in the saving rate of Japanese households that began in the early 1990s. What potential factors do you think are responsible for this decline in the saving rate? According to the lifestyle theory of consumption, income fluctuates over an individual’s lifetime, whilst consumption tends to stay relatively consistent. Since Japan has an ageing population, there are fewer working age individuals that are saving and more elderly individuals that are dissaving. The net effect is a decline in the aggregate saving rate in the economy as the overall population ages. 4. Figure 1 (RHS) shows the long run behaviour of both mining investment and non-mining investment in Australia. In the early 2000s, Australia experienced a mining boom. During that time, there was a large increase in mining investment and a simultaneous decrease in investment in other non-mining industries. Would it be possible to explain an increase in mining investment and a simultaneous decrease in other (non-mining) investment in our model of savings and investment? Explain your reasoning. - Investment in the mining sector differs from investment in the non-mining sector o An increase in the price of output for the mining sector shifts out the revenue marginal product of capital in the mining sector - Leads to an increase in overall investment demand which is the sum of mining and non-mining investment o Change in overall investment demand leads to an increase in the equilibrium interest rate o As a result, even though there is no change in price or the marginal product of capital in the non-mining sector, there are still effects associated with changes in interest rates caused by general equilibrium 5. Why do many economists believe that inflation reduces the efficiency with which prices allocate resources? Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 - Efficient resource allocation relies on relative price changes (e.g., if the price of good X relative to good Y increases, resources should be shifted out of the production of Y towards X) - Inflation makes it harder to interpret price singles - Suppose the price of good X increases. Firms will not be able to tell whether this is a relative price increase (in which case resources should be reallocated) or just a general increase in price (in which case, resources do not necessarily need to be reallocated). 6. What do we mean by a ‘real interest rate’? Can a real interest rate be negative? Why or why not? A real interest rate is the percentage increase in the real purchasing power of a financial asset. We can calculate the real interest rate using the Fisher equation which is approximately equal to the real interest rate (r) = the nominal interest rate (i) subtract the inflation rate (𝜋). Typically, nominal interest rates must be above zero, as holding currency (or cash) provides a nominal interest rate return of zero, it is hard to convince people to hold financial assets with a negative rate of return. Despite that a real interest rate will still be negative if inflation exceeds the nominal rate of interest. In that case, the high rate of price growth relative to the nominal interest rate implies that real purchasing power provided by a financial asset may be declining over time. 7. Distinguish between a ‘stock’ and ‘flow’ as concepts. Describe the following economic variables as describing either a ‘stock’ or a ‘flow’: - GDP (FLOW) - Savings (FLOW) - Wealth (STOCK) - Investment (FLOW) At a given point in time there is a stock of wealth available. The rest of the concepts are flow concepts. Note that if GDP is a flow concept, the its components (C, I,G, X, M) must also be flow concepts. 8. Deflation is a decline in the price level. Economists typically argue that deflation is costly since it discourages consumption and investment. Explain why this is the case. Deflation is costly since it discourages consumption spending and investment spending. This can be seen through the Fisher equation, in which it implies that negative inflation tends to raise the real interest rate. A higher real interest rate tends to discourage both consumption and investment. This is because individuals can use their income to save today or consume today. If prices are declining, then by holding on to their wealth and not consuming, individuals will be able to afford to purchase more goods in the future. Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 A similar effect applies to investment. An increase in the real interest rate is a disincentive to invest. Firms invest today in order to make future profits. The real interest rate is a measure of the opportunity cost of investing. For example, if house prices are falling, then people will have a tendency to wait and see before purchasing a house, as individuals do not want to purchase a home and then see the value of the home fall by a significant amount. 9. One common view of technology is that it increases productivity. Suppose the development of the microcomputer increased the productivity of labour in the late 20th century. Use a competitive model of the labour market to discuss what effect this change in technology will have upon wages and employment. Explain your reasoning and use a diagram to illustrate these effects. Initially the labour market is in equilibrium. However, the introduction of the microcomputer shifts demand for labour outwards, implying that there is a greater demand for employment. This shift in the labour demand curve will hence raise the wage as well, as now the position of the labour demand curve is higher upon the labour supply curve, thus increasing the wage. 10. Suppose the economy is in a situation in which the level of output lies below potential output. Suppose further that the government does not take active policy actions to return the economy to equilibrium. Describe the mechanism via which the economy will return to its long run equilibrium. What happens to the expenditure components during this transition? When the economy is at a level of output below potential output there is the tendency for inflation to decline. As inflation declines there is a reduction in the real interest rate. As the real interest rate falls, there is an increase in both consumption since saving becomes less attractive with lower interest rates and there is an increase in investment as the opportunity cost of investment falls. The above also describes how the expenditure components of GDP respond in this transition. There is an increase in consumption as interest rates are lower and output (income) is now higher. There is an increase in investment with lower interest rates. Government spending and exports are exogenous in this model and unchanged from their original levels. 11. Using Okun’s Law, answer the following questions. Explain your reasoning. The data is hypothetical. Year Real GDP Potential GDP u* (per cent) u (per cent) 2010 7480 8000 (a) 6 2011 8100 (b) 5 5 2012 (c) 8200 4.5 4 2013 8415 8250 5 (d) a) In 2010, would u* be larger, smaller, or the same as u? b) In 2011, would Potential GDP be larger, smaller or the same as Real GDP? c) In 2012, would Real GDP be larger, smaller or the same as Potential GDP? d) In 2013, would u be larger, smaller or the same as u*? Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 Okun’s Law: (𝑦 − 𝑦 ∗ ) 100 × = −𝛽 (𝑢 − 𝑢 ∗) 𝑦∗ Okun’s Law suggests that: a) u* would be smaller than u since output is below potential output b) Potential GDP must be equal to Real GDP since u=u* c) Real GDP must be above potential GDP since u is below u* d) u must be below u* since to move from potential to real GDP there is an increase in output which reduces unemployment 12. What do we mean by the term real interest rate? How do changes in the real interest rate affect consumption and investment? The real interest rate describes how much purchasing power increases by investing in an asset. Algebraically, this is described in the following form 1+𝑖 1+𝑟 = 1+𝜋 𝑟 ≈1−𝜋 where i is the nominal interest rate and π is the inflation rate. The nominal interest rate determines how much an asset returns in monetary value, but we divide by the rate of inflation to determine how much the value of real purchasing power has changed Our standard assumption is that increases in the real interest rate reduce both consumption and investment. Consumption is reduced since a higher real interest rate increases the return on saving. Investment decreases since the real interest rate is the opportunity cost associated with investment. LECTURE 3: The Labour Market & Short-term Economic Fluctuations MULTIPLE-CHOICE QUESTIONS 1. Which of the following statements if false? a) The labour force is deﬁned as the total number of people that are working or available and seeking to work. b) The labour force is deﬁned as the total number of people that are working or available and not seeking to work. c) The labour force participation rate is the number of people in the labour force divided by the total working age population. d) The unemployment rate is the number of unemployed people divided by the total labour force. 2. Suppose that the production function for a firm is Y=ZLβ where Z is a fixed constant greater than zero and is a fixed constant between 0 and 1. Which of the following is true? a) The marginal product of labour is βZLβ − 1 b) The marginal product of labour is Z c)The marginal product of labour “diminishes” as L decreases. d) The second derivative of the production function is greater than 0. Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 3. If we look at data published by the Australian Bureau of Statistics, we find the following data for June 2019: Working age population: 20.6 million Employed population: 12.9 million Unemployed population: 0.7 million Then ___________million of people of working age are not actively employed or looking for a job, the unemployment rate is _______________ and the labour force participation rate is ____________________ a) 7.7; 5.5%; 65% b) 7.0; 5.1%; 66% c) 12.2; 5.0%; 64% d) 13.6; 5.2%; 63% 4. In 2010 a country’s real GDP is 7480, potential GDP is 8000 and unemployment rate is 6%, then using Okun’s Law the natural rate of unemployment in this country would be a) larger than unemployment rate b) smaller than unemployment rate c) same as the unemployment rate d) indeterminate unless we know the participation rate 5. Due to an improvement in technology the marginal product of labour increases. As a result, in a perfectly competitive labour market we would expect a) Equilibrium wage rate will increase and level of employment will decrease b) Equilibrium wage rate will decrease and level of employment will decrease c) Equilibrium wage rate will increase and level of employment will increase d) Equilibrium wage rate will decrease and level of employment will remain the same 6. The following table provides information about production at the ABC Steel Company. Number of workers Kilos of steel produced Marginal product (000’s) 000’s kilos 0 0 -- 1 60 60 2 100 40 3 130 30 4 150 20 5 160 10 How many workers will the ABC Steel Company hire if the going money wage for steel workers is $44 000, and the price of steel is $1500 per 1000 kilo? a) 1 b) 2 c) 3 d) 4 e) 5 7. If the unemployment rate equals the natural rate of unemployment a) the economy must be at a trough in the business cycle b) potential output is greater than actual output Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 c) there is an expansionary output gap d) all unemployment is because of cyclical factors e) cyclical factors are not leading to any unemployment 8. Holding all else constant, the perfectly competitive model of the labour market predicts that a technological breakthrough that increases the productivity of workers will a) shift the demand curve for labour to the right, decrease the real wage and increase employment b) shift the demand curve for labour to the right, increase the real wage and increase employment c) shift the demand curve for labour to the left, decrease the real wage and increase employment d) shift the demand curve for labour to the left, increase the real wage and increase employment e) none of the above 9. Holding other factors constant, if a tax cut moves the government budget from surplus to deficit, then the real interest rate will ___ and the equilibrium quantity of national saving and investment will ____. a) increase, increase b) increase, decrease c) increase, not change d) decrease, increase e) not change, decrease 10. Data for an economy shows that the unemployment rate is 6%, the participation rate is 60%, and 20 million people 15 years or older are not in the labour force. How many people are in the labour force in this economy? a) 8 million b) 10 million c) 20 million d) 30 million e) 60 million 11. The natural rate of unemployment is the sum of a) frictional and cyclical unemployment b) frictional and structural unemployment c) cyclical and structural unemployment d) frictional, cyclical and structural unemployment e) none of the above 12. Holding all else constant, the value of the marginal product of labour for a particular firm will increase if a) the market demand curve for the firm’s product shifts to the left b) the firm employs more labour c) the government pays a subsidy to the firm for every worker it employs d) the supply curve for labour in that industry shifts to the right Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 e) none of the above 13. The statistical bureau of Ozland undertakes a monthly labour force survey. It estimates that the population of working age is 35,000. Employment is 15,000 and unemployment is 1000. Which of the following statements is true? a) The unemployment rate is 6.67% and the participation rate is 45.7% b) The unemployment rate is 6.25% and the participation rate is 45.7% c) The unemployment rate is 6.25% and the participation rate is 42.9% d) The unemployment rate is 2.86% and the participation rate is 42.9% 14. In the perfectly competitive model of the labour market, the demand curve for labour shifts to the right when the a) real wage increases. b) real wage decreases. c) price of the output produced by labour increases. d) price of the output produced by labour decreases. 15. The following table provides information about production at the ABC Steel Company. Number of workers Kilos of steel produced Marginal product (000’s) 000’s kilos 0 0 -- 1 60 60 2 100 40 3 130 30 4 150 20 5 160 10 How many workers will the ABC Steel Company hire if the wage for steel workers is $25 000, and the price of steel is $1300 per 1000 kilo? a) 1 b) 2 c) 3 d) 4 e) 5 16. In the perfectly competitive model of the labour market, the demand curve for labour of a firm shifts to the right when the a) nominal wage increases. b) nominal wage decreases. c) the marginal product of labour increases d) the marginal product of labour decreases e) price of the output produced by labour decreases. 17. Suppose potential GDP in Australia is $100 billion. Assume the textbook version of Okun's Law holds with “Beta” = 1.7, when cyclical unemployment increases from 0 to 1 per cent, actual GDP will be a) $101.7 billion b) $98 billion Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 c) $108 billion d) $98.3 billion e) $100 billion 18. If potential output grows faster than actual output, we expect a) frictional unemployment to increase b) cyclical unemployment to increase c) structural unemployment to decrease d) none of the above 19. In a perfectly competitive labour market, a decrease in the equilibrium wage and an increase in equilibrium employment may arise due to a) an increase in the number of people in the working age population b) a reduction in the marginal product of labour due to the depreciation of capital goods c) an improvement in technology that raises the marginal product of labour d) a reduction in the willingness of individuals to work due to an increase in household wealth 20. If a firm is maximising profit in a competitive market, it will set employment so that a) the value of the marginal product of labour equals the real wage b) the value of the marginal product of labour equals the nominal wage c) the marginal product of labour equals the nominal wage d) the marginal product of labour equals the price of output 21. Suppose the government wishes to reduce output to eliminate an expansionary output gap. To do so, it could________ government spending or shift the monetary policy reaction function_______ a) increase, upwards b) decrease, upwards c) increase, downwards d) decrease, downwards 22. Which of the following would not be expected to alter the position of the labour supply curve in a perfectly competitive economy? a) an increase in the retirement age of workers b) an inflow of immigrants due to a war in a neighbouring country c) an increase in the productivity of firms in the economy that raises wages d) changes in social attitudes making it more acceptable for women to participate in the labour market 23. It is possible to write output per worker as a function of capital per worker because we assume the production function a) has diminishing marginal returns b) has constant returns to scale c) features a constant labour share of output d) all of the above Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 24. In the context of a perfectly competitive model of the labour market, an increase in technology that raises the marginal product of labour at any given level of employment would be expected, in equilibrium, to a) reduce the amount of labour required to produce a given amount of output and hence increase unemployment. b) shift the labour demand curve outwards and lead to an increase in employment and wages. c) have no effect upon labour supply or labour demand curves and hence have no impact on employment or wages. d) reduce the supply of labour to the market and result in an increase in wages but a fall in employment. 25. Suppose there is an increase in the working age population. At the same time a decrease in the unemployment rate and no change in labour force participation rate. Then it must be the case that a) the number of unemployed people must decline b) the number of employed individuals in the economy must have decreased c) the number of working age people outside of the labour force must have increased d) none of the above 26. According to Okun's Law (as described in lectures), an increase in the output gap must a) increase frictional unemployment b) increase cyclical unemployment c) increase structural unemployment d) none of the above 27. If the population of a country is 300 million, of whom 250 million are of working age, the unemployment rate is 5% and the participation rate is 65%, the number of employed and unemployed workers are, respectively a) 155.5 million and 8.750 million b) 195.0 million and 15.5 million c) 175.5 million and 12.55 million d) 154.4 million and 8.125 million SHORT ANSWER QUESTIONS 1. The following graph gives the unemployment rate for individuals aged 15-19 and for individuals aged 20- 24. Clearly, the unemployment rate for those aged 15- 19 is systematically higher than that of those aged 20-24. In the context of the perfectly competitive model of the labour market, provide an explanation for the systematic difference observed in the unemployment rates of the two groups. Are you convinced by this explanation? If not, suggest a possible alternative explanation (or explanations). Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 - 1. In the perfectly competitive model, there should be some non-market clearing wage determination; otherwise, it is unlikely that we would be seeing unemployment of those magnitudes o Could take the form of minimum wages, union bargaining or perhaps a mechanism associated with imperfect markets - 2. If wages do not clear the labour market, higher unemployment for the 15- to 19- year-olds might reflect their relatively lower productivity, so that the demand curve is closer to the origins (assuming labour supply is roughly the same for both) o Creates relatively greater excess supply for the 15- to 19-year-olds - 3. Higher frictional unemployment for young people as they leave education, greater mobility for young people (more preparedness to leave a job) 2. A common production function used in macroeconomics is the Cobb-Douglas production function. The level of output produced, Y, is a function of capital, K, and labour, L, as well as some level of technology A>0. The exact specification for the Cobb- Douglas production function is given below: 𝑌=𝐴𝐾𝛼𝐿(1―𝛼) where α is a fixed constant between 0 and 1. a) For this production function, calculate the marginal product of labour, holding capital, K, and technology, A, constant. Marginal product of labour for a Cobb-Douglas production function with respect to labour, 𝑑𝑌 = (1 − 𝛼 )𝐴𝐾 E 𝐿FE 𝑑𝐿 b) Show that the marginal product of labour diminishes as the level of labour employed increases. What happens to the marginal product of labour if the level of capital increases (holding labour constant)? To show that this derivative is declining we can look at the second derivative which is 𝑑G𝑌 = −𝛼(1 − 𝛼 )𝐴𝐾 E 𝐿FEF& 𝑑𝐿 G For any positive values of K and L this derivative is negative. It implies that as L becomes larger, the marginal product becomes smaller, i.e., it is declining. Finally, if K increases, then the marginal product becomes larger at any given level of L. To see this, we could evaluate the following: 𝑑G 𝑌 = 𝛼 (1 − 𝛼 )𝐴𝐾 EF& 𝐿FE 𝑑𝐿𝑑𝐾 Which is positive for all relevant values of K and L. Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 3. There is a close relationship between the Australian and the US economy. During the 1990s, economists at the Reserve Bank of Australia estimated that the most determinant of Australian GDP growth, was growth in the USA. Do you think this relationship is a causal relationship? That is, does growth in the USA create growth in Australia or vice versa? Without studying international macroeconomics in detail, what possible mechanisms do you think could explain a close relationship between real GDP growth in Australia and the USA? There are a number of plausible mechanisms via which US economic activity could affect Australia: a) International trade – the US will demand more goods and services produced in Australia when the economy is growing rapidly. This increase in demand for Australian exports will tend to increase Australian economic activity b) Confidence or animal spirits – it is possible that confidence is an important determinant of economic activity. If the US economy is booming, it is plausible that this optimism will spill over to the Australian economy c) Technological transfer – it is possible that technologies developed in the US will increase productivity or demand in the US will be able to be transferred to Australia. If so, there could be a similar increase in output d) Financial Markets – financial markets are global, so if there is easy access to credit in the US, there may also be easier access to credit in Australia 4. The first order condition associated with a firm hiring labour in the labour market is below: 𝝏𝒇(𝒌, 𝒍) 𝒑× −𝒘=𝟎 𝝏𝒍 Provide an economic interpretation for this equation The equation states the value of the marginal product of labour less the wage equals zero. Alternatively, the price multiplied by the marginal product of labour must equal the wage rate for firms to be profit maximising. The effect of hiring an additional worker depends upon the price of output (p) multiplied by the additional output that this worker PQ(R,S) produces less the cost of hiring this worker which is the wage (w). PS This equation describes the optimal condition for labour demand by firms in a competitive market. If this condition is not satisfied, firms can alter their employment decisions to raise profits. If the left-hand side of our equation exceeds zero then firms can increase profits by raising employment. If the left-hand side of our equation is less than zero, firms can raise profits by reducing labour. Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 5. Suppose the economy is in a situation in which the level of output lies below potential output. Suppose further that the government does not take active policy actions to return the economy to equilibrium. Describe the mechanism via which the economy will return to its long run equilibrium. What happens to the expenditure components during this transition? When the economy is at a level of output below potential output there is the tendency for inflation to decline. As inflation declines there is a reduction in the real interest rate. As the real interest rate falls, there is an increase in both consumption since saving becomes less attractive with lower interest rates and there is an increase in investment as the opportunity cost of investment falls. The above also describes how the expenditure components of GDP respond in this transition. There is an increase in consumption as interest rates are lower and output (income) is now higher. There is an increase in investment with lower interest rates. Government spending and exports are exogenous in this model and unchanged from their original levels. LECTURE 4: Keynesian Model of the Economy MULTIPLE-CHOICE QUESTIONS 1. Use the following information about the economy to answer the question: Household saving $300 Business saving $700 Government purchases $1000 Government transfers and interest payments $500 Government tax collections $1500 GDP $5000 Private saving equals ____ and national saving equals ____. a) 300, -200 b) 700, 0 c) 1000, 1000 d) 1000, 1500 e) 1500, 1000 2. Public saving is positive when a) there is a government budget surplus b) there is a government budget deficit. c) the government's budget is balanced. d) after-tax income of households and businesses is greater than consumption expenditures. e) after-tax income of households and businesses is less than consumption expenditure. 3. In a closed economy, should national saving exceed investment, we would expect a) a fall in the real interest rate leading to more saving and less investment Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 b) a fall in the real interest rate leading to less saving and more investment c) a leftward shift in the NS curve and a rightward shift of the I curve d) a rightward shift in the NS curve and a leftward shift of the I curve e) no change as long as this is an equilibrium 4. In a closed economy suppose there is an increase in the budget surplus. Assume that the behaviour of the private sector remains unchanged. In equilibrium in the market for loanable funds, we would expect investment to_______ and real interest rates to_______ a) decrease, decrease b) increase, decrease c) decrease, increase d) increase, increase 5. In an open economy, if national savings exceeds investment, it implies that a) net exports must be positive b) consumption must be less than investment c) government saving exceeds private saving d) the currency must depreciate in the long run 6. Which of the following will decrease planned aggregate expenditure? a) households prefer homemade meals to restaurant meals b) government shut down schools as a part of major merger c) business profitability expected to go down d) all of the above 7. If there is a decrease in planned aggregate expenditure, we would expect equilibrium output to: a) increase b) decrease c) remain same d) be indeterminant 8. Consider the following components of a two sector Keynesian 45-degree diagram. If potential GDP is equal to 1200, by how much does planned investment need to increase in order for GDP to equal potential GDP? a) 10 b) 20 c) 30 d) 40 9. A four-sector economy is described by the following equations: Cd = 1800 + 0.6 (Y-T) IP = 900 T = 100 G = 100 Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 X = 50 Solve for the equilibrium level of output in this economy a) 2950 b) 4975 c) 5975 d) 6975 10. Suppose Ozland’s government imposes a new tax on internet users, so that everyone will have to pay a flat $100 fee per month on top of the regular rates for usage. This new rule will: a) Increase Ozland’s marginal propensity to consume b) Decrease Ozland’s marginal propensity to consume c) Decrease the equilibrium level of output in Ozland d) Increase the equilibrium level of output in Ozland 11. Where Y is GDP, C is consumption, I is investment, T is net taxes and G is government spending, if there is no trade, then private saving equals a) C + I + G – T b) Y – C – I – G + T c) Y – C d) Y – T – C 12. The monetary policy reaction function implies that nominal interest rates will: a) rise if there is a rise in both the inflation and the output gap b) rise if there is a fall in both the inflation and the output gap c) rise but only if the inflation rises more than the output gap rises d) fall if the output gap rises more than the inflation 13. The monetary policy reaction function, as discussed in lectures, describes how a) real interest rates react to unemployment and inflation b) nominal interest rates react to the output gap and unemployment c) real interest rates react to the output gap and inflation d) nominal interest rates react to real interest rates and inflation 14. All else being equal, a steeper planned aggregate expenditure function is consistent with a) a smaller marginal propensity to consume and a smaller multiplier. b) a smaller marginal propensity to consume and a larger multiplier. c) a larger marginal propensity to consume and a larger multiplier. d) a larger marginal propensity to consume and a smaller multiplier. 15. In a simple three sector Keynesian economy, the multiplier is larger the ________ the marginal propensity to consume and the________ the marginal rate of tax. a) larger, larger b) larger, smaller c) smaller, larger d) smaller, smaller Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 16. The multiplier in the simple Keynesian model should become larger when there is a(n)__ in the marginal propensity to consume and a(n)__ in the marginal rate of taxation. a) decrease, decrease b) decrease, increase c) increase, decrease d) increase, increase 17. In our four sector Keynesian model, an equilibrium in which leakages are equal to injections can be described by: a) S + T + M = IP + G + X b) S + T + G = IP + M + X c) S - IP = X M d) MV = P Y 18. Consider a simple Keynesian model of the economy with fixed prices. If output is less than planned aggregate expenditure, then a) actual investment exceeds planned investment b) there will be a build-up of inventories c) firms will decrease the amount of output they produce d) actual inventory accumulation is less than desired 19. In the simple Keynesian model studied in lectures, we believe that Y = P AE is a reasonable equilibrium condition. If Y > P AE, there will be an unexpected_____ of inventories and if Y < P AE, there will be an unexpected ______of inventories. a) decrease, decrease b) increase, decrease c) decrease, increase d) increase, increase 20. Consider a simple fixed-price Keynesian model with households, firms and a government sector. Suppose the marginal rate of tax is 0.4 and the marginal propensity to consume is 0.66. Then an increase in investment expenditure of 100 units will a) increase equilibrium output by approximately 150 units b) increase equilibrium output by approximately 166 units c) increase equilibrium output by approximately 266 units d) increase equilibrium output by approximately 750 units 21. An increase in the marginal rate of tax, with other things equal, should lead to a) a decrease in the size of the Keynesian multiplier b) an increase in the size of the Keynesian multiplier c) no change in the size of the Keynesian multiplier d) an indeterminate effect on the size of the Keynesian multiplier Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 22. Consider a simple Keynesian model with households, firms and a government sector. Suppose the marginal rate of tax is 0.4 and the marginal propensity to consume is 0.66. Then an increase in investment expenditure of 100 units will a) increase equilibrium output by 150 units b) increase equilibrium output by 166 units c) increase equilibrium output by 266 units d) increase equilibrium output by 750 units 23. Consider the simple Keynesian model with Cd = 500 + 0.6(Y -T) IP = 300 G = 300 X = 180 T = 200 + 0.25 Y What is the equilibrium level of output (to the nearest whole number) in this economy? a) 1555 b) 1800 c) 1815 d) none of the above 24. Consider the market for loanable funds. Suppose there is an increase in uncertainty that makes people less confident and hence reduces their consumption. In equilibrium, we should expect an ______ shift of the _____ curve and a(n) ____ in the equilibrium real interest rate. a) inward, investment, decline b) inward, saving, increase c) outward, saving, increase d) none of the above SHORT ANSWER QUESTIONS 1. For the following two-sector economy, find exogenous expenditure, short-run equilibrium output, and the output gap. By how much would exogenous expenditure have to change to eliminate the output gap? Cd = 3,000 + 0.5Y Ip = 1,500 Y* = 12,000 First, we solve for the equilibrium level of output. The equilibrium condition is: 𝑌 = 𝑃𝐴𝐸 𝑌 = 3000 + 0.5𝑌 + 1500 𝑌 = 4500 + 0.5𝑌 0.5𝑌 = 4500 𝑌 = 9000 We find out that output is 3000 units lower than potential output. To remove this contractionary gap, we would need to increase aggregate expenditure. & In this setting, we find that the multiplier is equal to two (&FY.Z). Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 To increase output by 3000 units, it therefore implies that we would need to increase aggregate expenditure by 3000/2 = 1500 units 2.Consider the four-sector economy described by the following equations: 𝐶𝑑=1800+0.6(𝑌―𝑇) 𝐼𝑃 =900 𝑇=100 𝐺=100 𝑋=50 Suppose taxation increases by 50 units and government expenditure increases by 50 units at the same time. What happens to the equilibrium level of output? Define the budget surplus as T-G. What happens to the budget surplus? First, we find the equilibrium amount which is equal to 6975 𝑌 = 1800 + 0.6(𝑌 − 100) + 900 + 100 + 50 0.4𝑌 = 2790 𝑌 = 6975 Second, if we increase government spending and taxation by 50 units then the relationship between aggregate expenditure and income is given by 𝑃𝐴𝐸 = 𝐶 c + 𝐼 d + 𝐺 + 𝑋 = 1800 + 0.6(𝑌 − 150) + 900 + 150 + 50 = 2900 − 90 + 0.6𝑌 𝑌 = 2810 + 0.6𝑌 0.4𝑌 = 2810 𝑌 = 7025 Equilibrium GDP has increased by 50. An example of the balanced budget multiplier - An increase in government expenditure financed by an equivalent increase in exogenous taxes produces a change in equilibrium GDP equal to the change in expenditure (the ‘balanced budget’ multiplier is 1) - There is no impact of this policy on the budget surplus - The change in G equals the change in T 3. What impact do you think Covid-19 has had upon the exogenous expenditure components of Planned Aggregate Expenditure in our simple Keynesian model? Explain your reasoning. Recall that 𝑃𝐴𝐸 = 𝐶 c + 𝐼 d + 𝐺 + 𝑋 Covid-19 has a large reduction in Cd, IP and X. Consumption of domestic goods and services has declined dramatically in recent months - People have naturally reduced consumption as a precaution to prevent becoming ill - Policies to prevent the spread of Covid-19 have relied upon social distancing and the closure of certain businesses in certain regions o Directly reduce the consumption demand of households Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 - The crisis has also had an impact upon the financial situations that households face o With greater uncertainty about the future, they may reduce consumption Also, likely that investment will reduce drastically in recent months - A lot of uncertainty about the future economic outlook - Currently, many businesses are not profitable, and it is unclear when they will become profitable again o Direct impact upon the marginal revenue product of capital o Reduce the desired level of capital stock in the economy and reduce investment A large decline in exports - Some of Australia’s key exports = tourism and educational services o Hit hard by the closure of borders - In equilibrium, this would lead to a large drop in equilibrium output 4. Consider the following Keynesian model of an economy used for policy purposes. C = 3,600 + 0.75(Y – T) – 10,000r IP = 2,000 – 5,000r G = 1,800 X = 8,000 M = 1,000 + 0.25(Y – T) T = 3,000. The real interest rate is expressed as a decimal and has a value of 0.10. a) If Y* is 30,000 by how much would G have to increase or decrease to make equilibrium Y equal to Y*? Show in an appropriate diagram to describe the economy and your findings. 𝑌 = 350 + 0.75𝑌 + 1500 + 1800 + 8000 − 250 − 0.25𝑌 𝑌 = 11400 + 0.5𝑌 𝑌 = 22800 & & The multiplier for G is &Fe'f = &FY.3Z'Y.GZ = 2 (gYYYYFGG5YY) If Y* is 30,000 then G would have to rise by = 3600 G DESCRIBING THE FIGURE: - Initially at equilibrium, planned aggregate expenditure and output are equal and planned injections equal withdrawals - At point A, there is a contractionary output gap of 7200. o If government increases its expenditure by 3600, this will shift the planned injection line upwards and hence PAE curve upwards too o Now PAE is greater than output Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 produced, which will result in an unplanned decline in inventories, giving signal to firms to produce more o As firms produce more, output will increase, due to the marginal propensity to consume creating a ripple effect - The economy will move towards a new equilibrium point B, along the PAE curve o Which, with the multiplier effect, we find how much of the exogenous component we need to increase to eliminate the contractionary gap (G=3600) o The multiplier effect continues to raise output until it reaches the equilibrium at the potential level of output Y* o Moving from A to B also means, from Okun’s law, that unemployment will decrease and will be equal to the natural rate b) Suppose in this economy the central bank is very credible and effective while fiscal policy stimulates the economy only with a long period of lag. Also, we know that given the recent inflation experience is at the lower end of the central bank’s target and suppose that it is not so concerned about inflation but more focused on reducing unemployment. Use the AD-AS model to show how a monetary policy can reduce the output gap assuming expected inflation is fixed and equal to the actual inflation. Monetary policy can be described by Taylor’s Rule which depicts the central bank’s behaviour of setting the real interest rate as a tool to respond to output gap and inflation Using the AD-AS model, we have a short run equilibrium at a lower point potential level of output = thus we have a contractionary output gap, and unemployment rate is higher than the natural rate - Monetary policy implemented by the central bank would meand that it will reduce interest rate at all levels of inflation using its policy reaction function to stimulate the economy o Shift down of the PRF curve - Since the central bank is credible and hence able to anchor the inflation target, it will shift the AD curve to the right without much fear of initiating any higher expected inflation - Also, we know that currently the inflation rate is well below the target rate o So, a lower interest rate will stimulate consumption, enhance investment as borrowing cost will go down - We will have a rightward shift of the AD curve whilst the AS curve remains the same as expected inflation also remains the same - Although, even if there is no stabilisation policy initiative, through self-correction economy, the same outcome will prevail o This, however, will take a very long time, especially when the output gap is large 5. Suppose it is possible that the equilibrium level of output may not be that level of output which will fully employ all of our factors of production. In other words, Ye may not equal Y*. For the following economy, find exogenous expenditure, equilibrium output, Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 and the output gap (Y* = potential output). By how much would exogenous expenditure have to change to eliminate the output gap? C = 3,000 + 0.5Y IP= 1,500 Y* = 12,000 Equilibrium Y will be such that PAE = Ye = 4500 + 0.5Y & ⇒Y = 4500 + 0.5Y Multiplier = &FY.Z = 2 ⇒(1 – 0.5) Y = 4500 So Ye = 9000Y* = 12,000 so there is a gap of 3000 to be made up. The multiplier is 2, so exogenous expenditure has to change by 1500 to drive Y up to 12000. 6. Consider a four-sector model of the economy and assume that 𝑪𝒅 = 𝑪k + 𝒄(𝒀 − 𝑻) − 𝜸𝒄𝒓 𝑻=𝑻 k + 𝒕𝒀 𝑰 = 𝑰t − 𝜸𝒊𝒓 𝑷 And G and X are exogenous components. a) What is the economic interpretation we give to the parameter c and to the parameter γc? c is the marginal propensity to consume. For every additional unit of disposable income that a household earns, c is consumed. The parameter γc describes how responsive consumption is to changes in the real interest rate. A higher value of γc implies a larger reduction in demand for domestic goods as r increases. b) Derive an algebraic equation that describes the equilibrium level of output as a function of exogenous variables. Combining, 𝑌 = 𝐶 c + 𝐼d + 𝐺 + 𝑋 = 𝐶̅ + 𝑐(𝑌 − 𝑇 − 𝑡𝑌) − 𝛾𝑐𝑟 + 𝐼 ̅ − 𝛾𝑖𝑟 + 𝐺 This can be rearranged to provide an equation that describes Y as a function of exogenous variables, explicitly (1 − 𝑐 + 𝑐𝑡)𝑌 = 𝐶̅ + 𝐼 ̅ + 𝐺 − 𝑐𝑇t − (𝛾𝑐 + 𝛾𝑖 )𝑟 𝐶̅ + 𝐼 ̅ + 𝐺 − 𝑐𝑇t − (𝛾𝑐 + 𝛾𝑖 )𝑟 𝑌= 1 − 𝑐 (1 − 𝑡 ) On the left-hand side is the equilibrium level of output. On the right-hand side are a set of exogenous variables. c. Briefly, explain what happens if Y exceeds planned aggregate expenditure. What happens if Y is less than planned aggregate expenditure? Case 1: If output exceeds planned aggregate expenditure then the amount that firms are producing exceeds that amount that households, firms, and government intend on purchasing. The difference is built up in inventories. This build-up in inventories is Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 unintended and firms will start to reduce the level of output they produce until equilibrium is restored. The opposite happens if Y is less than planned expenditure. In this case, the amount that different sectors expect to spend on the economy exceeds the actual level of output produced. This can occur only if there is a rundown of inventories in the economy. This rundown of inventories will encourage firms to increase output 7. Consider a four-sector model of the economy and assume that 𝑪𝒅 = 𝑪k + 𝒄(𝒀 − 𝑻) 𝑻=𝑻 k + 𝒕𝒀 𝑰 = t𝑰 𝑷 And G and X are exogenous components. a. What is the equilibrium condition that is used in this simple Keynesian model? Why is this condition reasonable? The equilibrium condition in the simple Keynesian model is that Y = P AE. In this setting the amount of (actual) investment that firms undertake is equal to the planned investment by firms. This implies that there is no unintended build up or rundown of inventories. If Y > P AE then it would imply actual inventories are increasing above planned inventories and firms would have an incentive to reduce output. If Y < P AE then it would imply actual inventories are below the planned level. Firms would have an incentive to increase output. b. Suppose that the government reduces the marginal rate of income tax. What effect will this have upon the equilibrium level of output? Describe the adjustment process from the initial to the new equilibrium. Explain your reasoning in detail and use a relevant diagram(s). What is the impact upon the overall tax revenue of the government? The equilibrium level of output will increase. To show this, a reduction in the marginal rate of tax increases the slope of the PAE line. This leads to a higher level of equilibrium output, with the level of output increasing. The adjustment mechanism is as follows: at the original equilibrium it will be the case that PAE > Y after the reduction in the marginal rate of income tax. This means that planned inventories exceed actual desired inventories. Firms respond by increasing output until Y = PAE. To find the impact upon taxation note that there are two effects. First, the marginal rate of tax is decreasing which at the same level of output should lower taxation. Second, the level of output is increasing, which should increase taxation. Is it possible for tax to increase above the original level? In short, no. This is because leakages equal injections in equilibrium. That is, 𝑆 + 𝑇 + 𝑀 = 𝐼 d + 𝐺 + 𝑋, injections are at an exogenous fixed level. In moving to a higher level of equilibrium output, there must be an increase in savings as income rises and tax at any level of Y falls. This implies that taxation must decrease since M are fixed. Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 8a. Monetary Policy in Keynesian Models of the Macroeconomy a) Recall that the Keynesian consumption function is: 𝑪𝒅 = 𝑪 k + 𝒄(𝒀―𝑻)―𝜸𝒄 𝒓 Provide an intuitive explanation for this equation. Define all terms. The equation states that demand for domestic consumption depends on three components: - An exogenous component given by 𝐶̅ - A component that depends upon disposable income (Y-T) with c being the marginal propensity to consume out of disposable income - A component that depends upon the real interest rate. The term 𝛾e measures the responsiveness of consumption to changes in the real interest rate b) Consider the simple Keynesian model studied in lectures with fixed prices. Suppose consumption demand is given by the function described in part a) above, and investment demand is given by 𝑰𝑷 = 𝑰t―𝜸𝒍 𝒓 What is the effect of an increase in the real interest rate on economic activity? Use a diagram to help explain your answer. - An increase in the interest rate leads to a decline in consumption and investment - This is true because as the real interest rate rises, the return on saving becomes higher and this induces a decline in consumption - Furthermore, the real interest rate reflects the opportunity cost of investment - As this opportunity cost rises, there is a decline in investment by firms - This shifts down PAE and leads to a lower equilibrium level c) Consider the AD-AS model with flexible prices. Assume that an economy is initially in an equilibrium with output equal to potential output. Then suppose the central bank alters its policy reaction function so that for any given inflation rate and output gap it sets a lower real interest rate. Explain what effect this change in policy will have upon the short run in the AD-AS model. The shift down in the policy reaction function implies that at any given level of output and inflation, the central banks set a lower real interest rate. This leads to an increase in consumption and investment demand at any given inflation and level of output. - The change in consumption and investment behaviour leads to an outwards shift in the AD curve - Suppose we start at a level of inflation and output on our original AD curve. This change in policy will lead to a lower real interest rate that raises consumption and investment expenditure. At the same output and inflation rate it will be the case that PAE > Y. To return to equilibrium where Y = PAE we need to increase the level of output, hence the AD curve shifts to the right. - In the short run the equilibrium in the model moves to our new intersection of the AD-AS curves with a higher level of output and a higher level of inflation Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 d) Explain the impact of the policy change considered in part c) above, on the long run behaviour of the economy. Describe how inflation and output change over time. Inflation is not equal to expectations and that over time inflation expectations will adjust. This leads to a rise in inflationary expectations. This rise in inflationary expectations leads to the AS curve to shift up over time. - Output and inflation changes over time from the short run to the long run equilibrium - From the short equilibrium there is a decline in output, travelling back to the potential output over time - Looking at inflation, in continues to rise to a higher point e) Part of the challenge of monetary policy is that the level of potential output is not observed. Assume that the economy is in an equilibrium with output equal to potential output. Suppose the latest economic news leads the central bank to incorrectly raise their estimate of potential output. Use the AD-AS model to describe what will happen to output and inflation in both the short run and long run as a result of this mistake. Explain your reasoning in full. - If the central bank believes that potential output has risen, then for any level output, the perceived output gap is smaller (or more negative) than the true or actual output gap - In this situation, the smaller perceived output gap will result in a lower level of the real interest rate. This lower level of the real interest rate will lead to a shift out in the AD curve - The long run implications of this policy mistake: o In the short run inflation exceeds expectations so inflation expectations rise over time o This leads to a shift up in the AS curve until we read a new equilibrium with higher inflation and output equal to potential output LECTURE 5: Fiscal Policy and Financial Markets MULTIPLE-CHOICE QUESTIONS 1. An economy is described by the following equations: C = 1600 + 0.8(Y – T), IP = 1000, G = 1,800, X = M = 0, T = 3,000 + 0.01Y. What is the short-run equilibrium level of output in this economy? a) 7600.5 b) 7650.4 c) 8420.5 d) 9615.4 Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 2. An economy is described by the following equations: C = 1600 + 0.8(Y – T), IP = 1000, G = 1,800, X = M = 0, T = 3,000 + 0.01Y. Suppose the flow of GDP consistent with full employment is 10,000. What marginal tax rate would achieve full employment? a) 0 b) 0.1 c) 0.2 d) 0.3 3. Consider the four-sector economy. To remind you, 𝑪𝒅 = 𝑪} + 𝒄(𝒀 − 𝑻), 𝒘𝒉𝒆𝒓𝒆 𝑪} 𝒊𝒔 𝒂𝒖𝒕𝒐𝒏𝒐𝒎𝒐𝒖𝒔 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝑻 = 𝑻} + 𝒕𝒀, 𝒘𝒉𝒆𝒓𝒆 𝑻} 𝒊𝒔 𝒆𝒙𝒐𝒈𝒆𝒏𝒐𝒖𝒔 and in which IP, G, X are exogenous constants. An increase in G will increase the output by the multiplier, a) 1/ (1 – c – cT) b) 1/ (1 – c + ct) c) 1/ (1 – cT) d) 1/ (1-c) 4. If a firm seeks to raise funds to undertake an investment, what options are available to it? a) Receive a loan from a bank or other financial institution b) Sell bonds in capital markets or issue equity in stock markets c) Firms may rely upon their savings d) All of the above 5. If M is the quantity of money, V is the velocity of money, P is the price level and Y is the real level of output then the Quantity Theory of Money states that, a) VY = MP b) Y = P/ MV c) M = V/ PY d) MV = PY 6. Since 1990, money supply in the Japanese economy has doubled. Over the same period, nominal GDP in Japan has stayed almost constant. According to the Quantity Theory of Money, this suggests that a) the level of real GDP must have decreased. b) the level of real GDP must have increased. c) the velocity of money must have decreased. d) none of the above 7. In the context of the basic Keynesian model studied in this subject, which of the following statements is incorrect? Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 a) An increase in exogenous consumption results in a steeper planned aggregate expenditure line. b) An exogenous payment from the government to households moves the withdrawals schedule downwards. c) An exogenous fall in exports results in an unplanned increase in inventories. d) Firms adjust their production in response to unplanned changes in inventories. 8. Suppose there is no government sector in an economy of Notaxland and is open to trade. So PAE = C + I + X – M. We will write the consumption function as 𝑪 = 𝑪k + 𝒄𝒀 and the import function as 𝑴 = 𝑴 k + 𝒎𝒀. Exports (X) and investment (I) are exogenous. Imagine c has a value of 0.80 and that m has a value of 0.2. What is the (approximate) value of the “exogenous consumption multiplier” in this economy? a) 1.33 b) 1.67 c) 2.50 d) 5.00 9. Given the following information about a particular economy, by how much would exogenous expenditure have to change to eliminate the output gap? C = 2,000 + 0.75Y Ip =500 Y* = 14,000 a) 250 b) 500 c) 1000 d) 2,000 10. A decrease in real interest rates in our model of the loanable funds market could be brought about by a) A decline in the marginal product of capital b) A reduction in the government budget surplus. c) An increase in marginal propensity to consume. d) None of the above 11. Government regulation has some control over the reserve to deposit ratio that banks maintain. Other things equal, an increase in this ratio will be expected to a) have no effect upon the economy b) increase the supply of money and increase the price level c) reduce the supply of money and reduce the price level d) none of the above 12. Which of the following is an example of an automatic stabiliser? a) a progressive income tax system b) the monetary policy reaction function c) spending by the government on public transportation infrastructure d) all of the above Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 13. Suppose real GDP is growing at 4% per year and velocity is stable. According to the quantity theory of money, a central bank that wants to achieve inflation of 2% per year should: a) shrink the money supply at 2% per year b) expand the money supply at 2% per year c) keep the money supply constant d) none of the above SHORT ANSWER QUESTIONS 1. An economy is described by the following equations: C = 400 + 0.8(Y – T), IP = 1000, G = 3,000, X = M = 0, T = 3,000 + 0.05Y. a) Find a numerical equation relating planned aggregate expenditure to output. 𝑃𝐴𝐸 = 𝐶 + 𝐼 d + 𝐺 + 𝑋 − 𝑀 = 400 + 0.8‰𝑌 − (3000 + 0.05𝑌)Š + 1000 + 3000 b) Solve for short-run equilibrium output. 𝑌 = 𝑃𝐴𝐸 = 400 + 0.8‰𝑌 − (3000 + 0.05𝑌)Š + 1000 + 3000 = 2000 + 0.76𝑌 This allows us to solve for Y = 8333.3 c) Is the government’s budget in deficit or surplus at this level of equilibrium output? At this level of output government spending is 3000. Tax revenue is 3000 + 0.05Y = 3416.65, so the budget is in surplus, as T>G. In this economy, as long as Y>0, we will have a budget surplus *It is easy to see for any positive Y that tax exceeds government spending. d) What is the value of the multiplier? 𝑌 = 𝐶̅ + 𝑐‰𝑌 − (𝑇t + 𝑡𝑌)Š + 𝐼 d + 𝐺 Rearrange the equilibrium condition to find the multiplier: 1 1 𝑜𝑟 1 − 𝑐 + 𝑐𝑡 1 − 𝑐(1 − 𝑐𝑡) The multiplier in this equation is 1 = 4.16 1 − 0.76 e) Suppose potential GDP = 10,500. What level of exogenous taxation would ensure actual GDP equals potential GDP? Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 If potential GDP = 10,500 we can find the level of 𝑇k to achieve this in the following manner: 𝑌 = 𝐶̅ + 𝑐‰𝑌 − (𝑇t + 𝑡𝑌)Š + 𝐼 d + 𝐺 (1 − 𝑐 + 𝑐𝑡)𝑌 = 𝐶̅ + 𝑐𝑇k + 𝐼 d + 𝐺 𝐶̅ − 𝑐 𝑇k + 𝐼 d + 𝐺 𝑌= 1 − 𝑐 + 𝑐𝑡 Now substituting in for Y = 10,500 and leaving 𝑇k unknown, we find, 400 + 1000 + 3000 − 0.8𝑇k 10500 = 1 − 0.8 + 0.8(0.05) k We can rearrange to solve for 𝑇 = 2350 f) What are the implications for the government’s budget of the tax change you identified in part (e)? What does this imply for the level of public debt? Under this tax scheme total government spending is still 3000. Total tax revenue is 2350+0.05(10500) = 2875, so government spending is less than tax revenue and the level of public debt will be increasing. 2. In lectures we assumed that all imports were spent on consumption. Suppose now that imports are both consumed by households but that some of government expenditure is also spent on imports. How would we need to modify our key equilibrium equation (given below) to account for this modification? 𝑌=𝐶𝑑+𝐼𝑝+𝐺+𝑋 Assume that households and governments can achieve their planned expenditures, then 𝑃𝐴𝐸 = 𝐶 + 𝐼 d + 𝐺 + 𝑋 − 𝑀 In this case if all imports are consumed by households or government, C +G = Cd +Gd + M, and Gd represents the demand for domestic goods by the government and the other notation is standard. Our key equation could be represented as 𝐶 + 𝐼d + 𝐺 + 𝑋 − 𝑀 = 𝐶 c + 𝐺c + 𝑀 + 𝐼d + 𝑋 − 𝑀 𝑃𝐴𝐸 = 𝐶 c + 𝐺 c + 𝐼 d + 𝑋 3. In the United States during the Great Depression, there were a series of bank failures. These bank failures had two effects. First, households typically increased the currency holdings and reduced deposits at financial intermediaries. Second, financial intermediaries typically increased the amount of reserves they held. a) What effect would this change in behaviour by households and by financial intermediaries have upon the level of money? - Increase in the reserve to deposit ratio reduces the money supply Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 o Same is true if households increase the amount of currency they hold – the money multiplier becomes smaller - Basic intuition behind the money multiplier = a bank may lend to a customer – the customer then makes a deposit in the bank, and the bank is then able to lend out a portion of this deposit out to other customers - This process repeats generating a multiplier effect Consider what happens if the banks makes a loan to a customer who holds the value of the loan in currency rather than as a deposit in a bank account - In this case, the bank does not receive a deposit after making a loan and is unable to lend out further money - The multiplier process stops As consumers hold a larger portion of their financial wealth in currency then banks will be receiving a lower level of bank deposits and this will reduce the multiplier - The effect during the Depression is that households withdrew money from banks due to the risk of bank failure - The greater currency holdings lead to a decrease in the money multiplier and this led to a reduction in money supply b) What effect would this change in money supply have upon prices, assuming that a quantity theory of money is an accurate description of reality? Quantity theory of money: 𝑀𝑉 = 𝑃𝑦 The change in money supply would induce a large decline in price level. c) What impact upon real interest rates would we expect from these changes in the behaviour of households and financial intermediaries? - The level of nominal interest rates declined in the USA to low levels during the Great Depression o As evidenced that monetary conditions were supportive of domestic economic activity - Problem = high levels of deflation implied that real interest rates remained quite high Fisher Equation: 𝑟 = 𝑖 − 𝜋 - 𝑖 fell but high levels of inflation o therefore, r remained high 4. A three-sector economy is described by the following equations: 𝐶𝑑=300+0.6 (𝑌―𝑇) 𝐼𝑃 =500 G = 1000 T = 1000 + 0.1Y a) Find an equation linking planned aggregate expenditure to output. Downloaded by Zoe Su ([email protected]) lOMoARcPSD|40757087 The equilibrium condition of the model is that planned aggregate expenditure equals output. The following equation relates planned aggregate expenditure to output: 𝑃𝐴𝐸 = 𝐶 c + 𝐼 d + 𝐺 = 300 + 0.6(𝑌 − 𝑇) + 500 + 1000 = 300 + 0.6(𝑌 − (1000 + 0.1𝑌) + 500 + 1000 = 1800 + 0.6(𝑌 − 1000 − 0.1𝑌) = 1200 + 0.54𝑌 b) What is the level of exogenous expenditure in this economy? The level of exogenous spending is 1200. c) What do we mean by the marginal propensity to consume? What is the marginal propensity to consume in this economy? The marginal propensity to consume reflects by how much consumption increases when there is a one unit increase in household disposable income. In this economy, the marginal propensity to consume is 0.6 => 60% of disposable income will be spent on consumption. d) What

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