Macroeconomics Tutorial Solutions (BBUS Year 2) PDF

Macro Economics tutorial solutions – Exam 1 – BBUS year 2 (note * are for CA Exam 1) Introduction to Economics *Q1. Economics is the study of how individuals and society manage their scarce resources. *Q2. Scarcity in economics refers to the fact that peoples’ wants are unlimited whereas the resou...

Macro Economics tutorial solutions – Exam 1 – BBUS year 2 (note * are for CA Exam 1) Introduction to Economics *Q1. Economics is the study of how individuals and society manage their scarce resources. *Q2. Scarcity in economics refers to the fact that peoples’ wants are unlimited whereas the resources to satisfy them are limited. Example: Land is of a limited supply. *Q3. Microeconomics is concerned with small parts of the economic system and is a model that explains the behaviour of individuals and firms in the economy. *Q4. Macroeconomics is concerned with the economy as a whole and studies the determinants of total output, inflation, unemployment, national income and economic growth. *Q5a. A mixed economic system is where governments choose to intervene in markets side by side with private enterprise. This is how most economies in the world operate. *Q5b. A command economy is where governments make almost all the economic decisions. *Q6. The main macroeconomic aims/objectives of government are: - Economic growth (4%) - Low unemployment (4%) - Low inflation (2%) - Long run balance of public finances *Q7. Classical economists believe in a laissez-faire economy, which entails free trade and little/minimal government intervention. They believe that government intervention can be grossly inefficient. The Keynesian model promotes that the government should take an active stance in stabilising the economy to minimise the effects of a boom/bust cycle and thus minimise cyclical inflation and unemployment. *Q8. The four factors of production are Land, Labour, Capital and Enterprise 1 The payment for factors of production are Rent, Wages, Interest and Profit 2 Topic 1 – National Income – Questions and Answers *Q1. Define Gross Domestic Product (GDP)  GDP is the total value of all goods and services produced in a country over one year regardless of who produces them.  NI or GDP = C + I + G + X – M.  Consumption (C), Investment (I), Government expenditure on goods and services (G), Exports (X) & Imports (M). *Q2. Define Gross National Product (GNP)  GNP is total value of all goods and services produced by Irish residents over one year regardless of where they are produced.  GNP = GDP + F  F is net factor income/payments from the rest of the world.  Example of F: profit repatriation by foreign-owned multi-national companies (MNCs) *Q3. GDP at current market prices in 2023 was €509.9bn and Net Factor Income from the rest of the world was €-121.9bn, then GNP at current market prices in 2023 was:  GNP = GDP + F  GNP = €509.9bn + (€-121.9bn)  GNP = €388.0bn *Q4. Give one reason why net factor income/payments from the rest of the world is usually a negative figure for Ireland.  Ireland has a large amount of foreign direct investment due to our relative low corporation tax which is currently 12.5% (Note: this rate has increased to 15% for larger companies with a global annual turnover of over €750m). This results in a large amount of profit repatriation by big multi-national companies (MNCs).  Thus, Irelands GNP is usually being lower than GDP. *Q5. Given that nominal GDP in 2023 was €509,952m and the Irish population is 5.282m, estimate nominal GDP per capita to the nearest €00 for Ireland in 2023. Why can GDP per capita be useful? GDP per capita = GDP/population = €509,952 / 5.282 = €96,545 = €96,500 per capita It is useful for international comparisons across countries as a measure of wealth. Note: the values must be in a common currency and adjusted for purchasing power parity. Ireland’s GDP per capita is around the 3rd highest in the world. 3 *Q6. Given that GDP at current market prices in 2023 was €509.9bn and GDP deflator/inflator in 2023 was +3.61% (0.0361), calculate GDP at constant market prices (or real GDP) to one decimal place in billions of euro in 2023. Real GDP = Nom GDP/GDP deflator = €509.9/ (1+0.0361) = €509.9/1.0361 = €492.1bn (This is the 2023 GDP figure in 2022 prices) *Q7. GNP at current market prices in 2023 was €388.0bn and Depreciation was €128.3bn, then NNP at current market prices in 2023 was:  NNP = GNP - Depreciation  NNP = €388.0bn - €128.3bn  NNP = €259.7bn *Q8. GDP at constant market prices in 2022 was €520.9bn and in 2023 was €492.1bn. Calculate real GDP growth for 2023 to one decimal place. Real GDP growth = ((492.1 – 520.9) / 520.9) × 100 = (-28.8 / 520.9) × 100 = -5.5% *Q9. When is an economy generally classified to be in recession? An economy is classified to be in recession if there is a fall in real GDP (negative growth) for two consecutive quarters (six months) or more. It is a period of temporary economic decline during which trade and industrial activity decreases. Q10. Gross National Disposable Income (GNDI) is:  Gross National Disposable Income is the total amount available to Irish residents to consume and invest.  GNDI = GNI + R  R represents net factor transfer payments from the rest of the world  (approx. -€4bn to -5bn in Ireland)  E.g., EU funding and subsidies – overseas development assistance 4 *Q11. Briefly explain the income approach to measuring National Income or GDP and what are the approximate proportions of each component?  This is the addition of all incomes earned by the basic factors of production in the country in a particular year.  All incomes from productive activity i.e., wages, salaries, profits, interest & rent Wages & Salaries & Employers’ PRSI contributions (direct employment) 40 % Other (corporate profits, self-employed income, rental income, interest, 60 dividends etc.) % *Q12. Briefly explain the expenditure approach to measuring National Income or GDP and what are the approximate proportions of each component?  This is the addition of all expenditure on ‘final’ on goods and services produced in the country in a particular year.  GDP = C + I + G + X – M  It must exclude expenditure on intermediate and 2nd hand goods.  = ‘National product at market prices’ Consumption 30% Investment 26% Government 11% Expenditure Net Exports 33% (X – M = 135% - 102%) *Q13. Briefly explain the output or value-added approach to measuring National Income or GDP and what are the approximate proportions of each component?  It is the total of the value added at each stage of production in the country in a particular year.  We only include the value added and not the value of the intermediate good.  For services we count the cost of supplying the service as the value of its output.  = ‘National product at factor cost’ GDP by sector: Industry 36% Service 64% 5 6 *Q14. Illustrate and explain the the circular flow of income model for an open economy highlighting the leakages and injections from the circular flow. (3) Expenditure (1) Factors of Production (2) Income (4) Goods & Services (GNP) Investmen Savings Exports t Banks etc Imports Gov Foreign Taxes Exp *Injections Sector Government *Leakages Explanation:  Households own the factors of production, (land, labour and capital), which they make available to the firms in return for income, (rent, wages and interest).  Firm owners receive a profit.  Households purchase all the goods and services firms produce with the income they have earned.  *Income = Output = Expenditure  *NI = GDP = C + I + G + X - M  Not all income is spent. A proportion is saved into financial institutions which is a leakage from the circular flow. This is injected back into to the circular flow in the form of investments.  Not all income is received. A proportion is taken by the government in the form of tax which is a leakage from the circular flow. This is injected back into to the circular flow in the form of government expenditure.  Not all income is spent on domestic products and services. A proportion is spent on imports which is a leakage from the circular flow. Foreign expenditure on exports is an injection back into to the circular flow. 7 *Q15. Outline and explain one problem in measuring GDP. (1st bullet point is important) *1. The underground or the black economy  This economy consists of unreported or undetected economic activity. E.g., illegal transactions such as drug trafficking and other transactions such as small building jobs that are kept hidden to avoid tax.  Output from the black economy is estimated to be about 10% of GDP thus understating the true value of GDP. 2. Non-market activities  Activities such as do-it-yourself repairs or cooking and cleaning in the home or stay at home Mums/Dads are not included in GNP.  Excluding these items understates the true value of GNP. 3. Spillover effects  Pollution is a negative spillover or external diseconomy when the affected parties do not receive compensation.  A neighbours’ nice garden or a national park is a positive spillover or external economy as others benefit without payment.  Excluding negative spillovers overstates GNP and excluding positive spillovers understates GNP. Q16. Outline two uses of National Income calculations. 1. As a measure our standard of living  GNP at constant market prices must be used as it is adjusted for inflation.   in GNP may be due to  in working hours or  in working conditions.  If  in GNP is due to military expenditure or crime fighting or pollution control 2. For Standard of Living Comparison  Per capita figures should be used in a common currency and adjusted for purchasing power parity.  Amount of taxes and how they are spent. 3. Used in the calculation of the growth of investment income  GNP shows a relationship between the level of investment and growth or between profits and the level of investment.  Useful for business planning process. 4. Used by government for economic programming and planning  The statistics for the various components of national income assists government planning.  E.g., consumption spending and foreign trade. 8 *Q17. State and explain two possible advantages to a country with good economic growth rates. (1st two bullet points are the most significant)  *Increased employment. - A rise in GNP will lead to increased demand for goods and services with more labour being demanded to produce these.  *Improved government finances. - With a rise in spending, indirect tax revenue rises; more people at work will result in an increase in direct tax revenue; expenditure on social welfare should fall.  Effects on Balance of Payments. - If the extra GNP results from increased output and if some of this output is exported then our Balance of Payments position improves.  Improved standard of living. - Higher GNP results in increased wealth in the economy allowing us to buy more goods and services / a reduction in poverty.  Effects on Emigration. - If job opportunities exist then people who had planned to emigrate may remain and more immigrants may be attracted to the economy, thereby increasing the demand for new goods and services.  Investment opportunities. - Rising GNP indicates a growing economy and this may attract more investment. *Q18. State and explain two possible disadvantages to a country with good economic growth rates. (1st two bullet points are the most significant)  *Inflationary pressures. - With the rise in the level of economic activity, the level of demand inflation will rise if the economy is at the full employment level of output.  *Labour shortages and wage inflation. - The rise in demand for goods & services may increase the demand for labour in certain sectors, resulting in labour shortages. This in turn will result in demand for wage increases as expectations by workers may increase with respect to pay increases. This represents a loss in our international competitiveness.  Increased demand for imports. - An increase in GNP increases our income and spending power and demand for imports may rise worsening our Balance of Payments position.  Revised expectations by citizens. - During an economic boom our expectations grow and there may be conflicts. With rising GNP, we may revise our expectations upwards.  Pressure in housing market. - The rise in GNP will increase spending power and cause further inflation in the property market.  Inequitable distribution of wealth. - Rising GNP will increase the wealth of the wealthy disproportionately while poverty may continue to exist.  Pressure on state infrastructure. - Higher GNP results in greater demand for scarce resources / more damage to the environment e.g., more demand for cars.  High economic growth can lead to inefficiencies in an economy and gross overspending. 9 Topic 2a – INFLATION – Questions and Answers *Q1. If the consumer price index (CPI) in 2022 was 112.3 and in 2023 was 119.4, calculate the inflation/deflation rate to one decimal place for 2023? CPI = ((Pt – Pt-1)/Pt-1)× 100 = ((119.4–112.3)/112.3) × 100 = (7.1/112.3) × 100 = 6.3% Q2. Outline two problems with using the CPI to measure a nation’s inflation rate.  Different families do not buy similar goods. Therefore, the weight applied to each product group may not be correct for everyone e.g., smokers and non-smokers.  Price changes alone are noted in the index, changes in quality will be ignored.  The prices different consumers pay can vary. E.g., price difference between stores, bulk buying. Q3. Outline two uses of the CPI.  It is used to calculate the rate of inflation, and this in turn is used to calculate real GNP and economic growth.  Trade unions use the CPI when they seek wage increases.  To calculate the return on index (CPI) linked savings products.  It is used for indexing social welfare payments and calculating tax free allowances in order to maintain the real value of payments.  It can be used for comparisons across countries (e.g., HICP within the EU). *Q4. Explain demand-pull inflation and what policies the government can implement to reduce this type of inflation.  Demand-pull inflation is a situation where AD persistently exceeds AS at current prices so that prices are being pulled up.  This occurs when resources are fully employed, and the economy cannot produce enough goods and services to meet the demands of its citizens.  An  in Aggregate Demand  an  in prices  If unemployed resources exist an increase in AD can bring them into use and should not cause inflationary pressure.  AS will   the initial  in AD will have little effect on the price level.  The government should implement the following deflationary policies: o Contractionary fiscal policy i.e.,  taxation and/or  government expenditure. o Tight monetary policy i.e.,  interest rates   investment expenditure & C. (Note: our interest rates are controlled by ECB) o This will lead to a fall in real incomes and purchasing power  a  in AD. 10 *Q5. Explain cost-push inflation and what policies the government can implement to reduce this type of inflation.  Cost push inflation occurs when the selling price of goods and services are increased to compensate the producer for an increase in the costs of production.   Price ’s is due to an autonomous ’s in the firm’s costs.  These costs may be of an external or internal nature.  Internal cost-push can be described as ‘wage-push’ inflation.  This occurs when wages  faster than productivity    Wage ’s are not due to an  in AD but rather an independent factor is pushing up wages.  External cost inflation can start with an  in the price of imported raw materials such as energy products (oil, gas, electricity etc.).  A small open economy can do little about an  in world P’s (imported inflation).  Alternatively, a fall in the country’s exchange rate  import prices  and can cause cost-push inflation.  Whatever the external cause it starts a wage-price spiral.  The government could implement the following policies to reduce cost-push inflation: o Prevent external factors from starting a wage-price spiral. o Reduce our high dependency on imports such as oil and gas. o Introduce prices and incomes policies such as wage agreements that will curtail wage inflation to respectable levels. o Hold down prices in nationalised industries (ceiling/maximum pricing). Q6. Define creeping inflation and suppressed inflation.  Creeping Inflation occurs when the inflation rate is stable for a period but gradually creeps up.  Suppressed Inflation  Even when D > S it is possible for a government to prevent prices   Could result in shortages, queues, and black markets Q7. Define strato-inflation.  Strato-Inflation is an inflation rate of between 10% and hundreds % without ever reaching hyper-inflation. Q8. Define hyper-inflation.  Hyper-inflation occurs when inflation rates are very large.  Money loses all value. 11   E.g., German 1922-23, Bolivia 11,000% in 1985!  It is usually the result of a political crisis. *Q9. Define stagflation.  Stag – Inflation occurs when both high inflation and high unemployment exist.  Stagnation in economic activity combines with price inflation. Q10. Define mark-up inflation.  Mark-up Inflation is due to the impact of indirect taxes.  An  in indirect taxes  an  in prices  a further  in wage demands *Q11. Outline two effects of inflation. (1st five bullet points are important)  *Loss of purchasing power o Inflation reduces the value of money, leading to a loss of purchasing power. o People on fixed incomes (e.g., pensioners etc.) experience a reduction in real wages = nominal wages / inflation rate  *Inflation erodes international competitiveness (exports and imports). This can have a serious impact on economic growth and unemployment. o If domestic prices  faster than overseas competitors   M and X ,  Balance of Payments deficit, a fall in GDP and an  in unemployment. o Domestic industry becomes less competitive resulting in a  in X demand, employment and growth.  *Redistribution of Income o Inflation will redistribute income whereby lenders/savers will lose at the expense of debtors/borrowers who will gain. o The lender/saver loses out if the actual rate of inflation turns out to be higher than the expected rate built into contracts.  ‘Shoe leather costs’, or increased consumption o When inflation is greater than expected, there will be little incentive to hold money. This results in more trips to the bank to withdraw cash and to spend.  *‘Menu’ Costs o This refers to the resources required to change price lists when prices are rising or falling. The introduction of bar codes has reduced this cost.  Hyper-inflation may eventually lead to dollarisation. o In high inflation countries, local currency becomes worthless (exchange rate is falling). People switch to hard/strong currency like the $ or the €. This can destabilise the economy.  The government may benefit from inflation. 12  o If income tax allowances are fixed in money terms, inflation can raise tax revenue by pulling more people into higher tax brackets - a process known as ‘fiscal drag’.  Speculation is encouraged as people transfer their wealth out of cash into land, property, shares, antiques, gold etc.  Efficiency o Demand-pull inflation is associated with buoyant business conditions and sellers’ markets. Pressure to improve the product and performance is less and can lead to inefficiency. o The opposite is true in the case of cost-push inflation.  Producers may be encouraged to produce more to exploit profit opportunities e.g. housing in Ireland Q12. If the nominal interest rate is 3 per cent and the inflation rate is 2 per cent, calculate the real interest rate? Real interest rate = Nominal interest rate – Inflation rate = 3% - 2% = 1% *Q13. Briefly discuss Ireland’s historical inflation rates from 1970 to date.  In the early 1970’s Ireland’s inflation rates were rising due the oil crisis of 1973, which led to very large increases in oil prices  imported cost push inflation.  Inflation hit a high of 20.9% in 1975.  It fell in 1976, 1977 and by 1978 it was 7.6%.  A 2nd oil crisis hit in 1979, which saw inflation rise back up over 20% in 1981.  Since 1984 inflation has been a single figure.  From 1996 to 1999 Irelands inflation rates were quite low ranging from 1.5% to 2.5%.  Our inflation rate increased substantially in 2000 to 5.6% due to our ‘Celtic tiger’ consumer driven economy  demand-pull inflation.  In 2001 and 2002 inflation fell to around 4.8% and by 2004 it was down to 2.2 %.  *The main objective of the ECB is for inflation (HICP) in the EU to be 2.0%.  Ireland’s inflation rate from 2006 to 2008 was around 4 to 5%.  Ireland’s inflation rate as measured by HICP during this time was around 3%.  In 2009 and 2010 we had negative inflation or deflation due to economic recession.  Ireland’s inflation rate was relatively flat from 2010 to 2022 at around 0%  The inflation rate in 2023 averaged 6.3%.  Inflation in Ireland and globally increased significantly in 2022-2023 as economies opened up post covid and due to the energy crisis caused by the Russian-Ukrainian war.  *The current rate of inflation is 1.7% (Aug 2024). 13 Topic 2b – UNEMPLOYMENT – Questions and Answers Q1. List the main factors the affect the size of our population.  Natural increase/decrease = Birth rate – Death rate  Net migration = Immigration – Emigration *Q2. The Labour Force is made up of:  Labour Force = total number in employment + total number of people unemployed  The labour force includes everyone of working age who is willing and available for work at the going wage rate for the type of work they are qualified to do. *Q3. A person is defined as unemployed if:  A person is defined as unemployed if he or she is actively looking for work and willing to accept employment at the going wage rate for the type of work he or she is qualified to do. *Q4a. If the total number of people in employment in 2nd quarter of 2024 was 2,754,200 and the total number of people unemployed was 131,200, calculate the unemployment rate for Q2 2024 to one decimal place.  Labour Force = employed + unemployed  Labour Force = 2,754,200 + 131,200 = 2,885,400  U/E rate = (No Unemployed / Labour Force) * 100  U/E rate = (131,200 / 2,885,400) * 100 = 0.04547*100 = 4.5% *Q4b. If the number of people in the labour force is 2.9 million and the population aged 15 years and over is 4.4m, calculate the labour force participation rate.  LF participation rate = (Labour Force / Pop aged 15 years and over) * 100  Participation rate = (2.9m / 4.4m) * 100 = 0.66*100 = 66% 14 Q5. How does Ireland’s unemployment rate compare to international rates?  *Ireland’s unemployment rate currently is 4.3% (Sept 2024).  However, during Covid-19 the unemployment rate increased to 16%.  The EU average is about 6.0% with the Eurozone about 6.4%.  The US rate is 4.3%, the UK rate 4.4% and Japan 2.7%. The German rate is 3.7%.  From mid 90’s to mid 2000 Ireland’s unemployment rate was steady at a full employment rate of about 4.5%, which was relatively low by international standards.  Ireland’s unemployment rate for 2023 and 2024 is expected to be around 4% Q6. What is the approximate breakdown of employment by the following sectors? Agriculture: 4% Industry: 18% Services: 78% (Industry: 22%, Services: 78% approx.) *Q7. Explain cyclical unemployment and how it can be resolved.  Cyclical unemployment is caused by changes in the business cycle over time - alternate booms and slumps in the level of economic activity.  *Cyclical unemployment occurs during a recession.  *It is also referred to as demand deficient unemployment.  Expansionary fiscal policy by reducing tax rates and/or increasing government expenditure. This will increase the level of aggregate demand and thus reduce cyclical unemployment. Note that this may also lead to inflation and a balance of payments deficit. *Q8. Explain frictional unemployment and how it can be resolved  Frictional unemployment arises because of friction in the labour market as workers spend some time out of work.  Workers may be “between jobs” – voluntary or non-voluntary.  There may be a reduction in the demand for labour in a particular occupation, though jobs are available in other occupations.  *Mismatching of job skills by occupation.  It may be the result of a lack of knowledge of vacancies.  The government can reduce this unemployment by having a job notification system and retraining. 15 *Q9. Explain structural unemployment and how it can be resolved.  *Structural unemployment refers to a permanent decline in employment in industries located in a particular region.  It results from the structural decline of industries unable to compete or adapt to changing technology, demand, and new products, which may be caused by growth in international competition.  *Mismatching of jobs by geographical location and industry.  A regional policy may be necessary to tackle structural unemployment and mobility of labour.  Retraining is very important, as particular skills are no longer required. Q10. Explain seasonal unemployment.  Seasonal unemployment arises because some industries are busy for only part of the year e.g., the tourist industry.  This type of unemployment is difficult to avoid.  It leads to relatively low rates of pay for long hours. *Q11. Outline two costs or effects associated with unemployment (1st two bullet points are important)  *The government’s budget will automatically worsen with an increased deficit or a reduced surplus. o Social welfare expenditure increases due to the cost of paying unemployment assistance. o There will be a loss of tax revenue since the unemployed do not pay tax and have reduced purchasing power   direct and indirect tax revenues. o There will be a heavy tax burden on the employed.  Unemployed people will have a loss of income not recovered by unemployment benefits.  A family’s standard of living goes down.  There will be a loss of output and income to the economy.  Unemployed people may experience low self-esteem leading to stress, suffering and other psychological problems.  Unemployment is strongly connected with poverty.  Crime may increase due to a lack of something to do and this will lead to extra costs for law enforcement. 16 *Q12. Plot the Phillips curve on the diagram below and explain its shape. Infl U/E Explanation:  *The Phillips curve shows the inverse relationship between inflation and unemployment. Phillips identified that an inverse relationship existed between these two variables.  U/E   Inflation  U/E   Inflation  This was based on the logic that a fall in unemployment levels would lead to an increase in the level of aggregate demand as the economy grows which would lead to inflationary pressures and a rise in the price level. 17 Topic 3 – Theory of Income Determination – Questions and Answers *Q1. (i) Assuming an MPC of 0.9, calculate the simple Keynesian multiplier. 1 / (1-MPC) = 1 / (1 - 0.9) = 1 / 0.1 = 10 (ii) Assuming an MPC of 0.8, calculate the simple Keynesian multiplier. 1 / (1-MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5 *(iii) Assuming an MPS of 0.2, an MPT of 0.3 and an MPM of 0.4, calculate the Keynesian multiplier. 1 / MPS + MPT + MPM = 1 / (0.2 + 0.3 + 0.4) = 1 / 0.9 = 1.11 *(iv) Using the multipliers in each case above, calculate the effect on final GNP if the government injects €1bn into the economy. (i) €1bn * 10 = €10bn = final change in GNP (ii) €1bn * 5 = €5bn = final change in GNP (iii) €1bn * 1.11 = €1.11bn = final change in GNP 18 Q2. Illustrate and explain the life cycle theory of consumption. € Consumptio n B C A Age Consumption = f (Lifetime Income) Save when Y rises during the middle and latter stages of working life – area B Dis-save when Y is low during the start of working life - area A (e.g. borrow for house, car or college education)) and dis-save when Y falls at retirement – area C (e.g. dip into savings made for retirement) Consumption levels would remain at much the same level over our lifetime = Consumption line 19 *Q3. Illustrate the AD schedule and explain its negative slope and the various factors that affect its location. Give one example of an AD shock. P level P1 P2 AD GNP GNP1 GNP2 A decrease in the price level will lead to an  C as good and services become cheaper to purchase. There will also be an  NX as domestic goods and services become more internationally competitive. Thus a  P →  AD and vice versa. * If the price is held constant, an autonomous  C, I, G, X or  M shifts the AD curve to the right and vice versa. Eg. Expansionary fiscal policies such as  G or  T shifts the AD to the right. Expansionary monetary policies such as  interest rates →  I and  C also shift the AD to the right. Contractionary fiscal and monetary will shift the AD to the left Examples of AD shocks: Shock AD curve September 11th attacks Left Obama’s fiscal injection Right Sudden Govt Exp cutbacks Left Global Financial crisis 2008 Left Firms cancel investment in new plant Left 20 *Q4. Illustrate the AS schedule and explain its positive slope and the main factors that affect its location. Give one example of an AS shock. P level AS P1 P2 GNP2 GNP1 GNP There is a positive relationship between the price level (P) and real GNP on the supply side. Profit = Total revenue - Total cost = (P  Output) - (Pi  Inputs) Assuming the price of inputs (Pi) constant,  P  Revenue  profit  real GNP The increase in profits encourages firms to expand output. *Location of AS curve:  Price of inputs or  in productivity (output per worker) which will shift the AS curve to the left and vice versa. Some examples: Shock ` AS curve  price of oil (e.g. 1973 & 1979) Left  wages Right  electricity charges Right  productivity Right  price of raw materials Left 21 *Q5. Illustrate the equilibrium of the AD and AS schedules and briefly explain what happens when the AD schedule shifts to the right. P level AS0 P1 P0 ED AD1 AD0 GNP0 GNP1 GNP Explain: AD shifts right → at the initial price level P 0, there is now excess demand → this will cause the price level to rise to P1 → overall equilibrium price increases (inflation) and GNP increases (unemployment falls) *Q6. Illustrate the equilibrium of the AD and AS schedules and briefly explain what happens when the AD schedule shifts to the left. P level AS0 P0 ES P1 AD1 AD0 22  GNP1 GNP0 GNP Explain: AD curve shifts left → At the initial price level P 0, there is now excess supply → this will cause the price level to fall to P 1 → overall equilibrium price falls (deflation) and GNP decreases (unemployment rises) *Q7. Illustrate the equilibrium of the AD and AS schedules and briefly explain what happens when the AS schedule shifts to the right. P level AS0 AS1 P0 ES P1 AD0 GNP0 GNP1 GNP Explain: AS curve shifts right → at the initial price level P0, there is now excess supply → this will cause the price level to fall to P 1 → overall equilibrium price decreases (deflation) and GNP increases (unemployment falls) 23 *Q8. Illustrate the equilibrium of the AD and AS schedules and briefly explain what happens when the AS schedule shifts to the left. P level AS1 AS0 P1 P0 ED AD0 GNP1 GNP0 GNP Explain: AS shift left → at the initial price level P 0, there is now excess demand → this will cause the price level to rise to P1 → overall equilibrium price increases (inflation) and GNP decreases (unemployment rises) 24 *Q9. With the aid of the AS/AD model, outline the differences between Keynesian and Classical economist’s views in how an economy can restore itself to the full employment level of GNP following a recession caused by a demand-side shock. LRAS  The economy is initially at point A (P1 and GNP*). This represents the full employment level of GNP, which is the level of output that can be produced given the current state of technology and the size of the labour force without causing inflationary pressure.  A demand-side shock implies that the AD curve suddenly shifts to the left causing a recession. The economy moves from point A to point B.  This leads to an increase in unemployment and a fall in the overall price level.  Classical economists believe that the key variable in the adjustment process is the real wage (W/P).  At the point A, there is a particular real wage, which is consistent with the economy being at natural real GNP. 25  At the point B, the real wage has increased.  This is because the price level has fallen while the nominal wage is unchanged.  If workers recognize this and accept a cut in nominal wages to restore the original real wage, the short-run AS curve will shift down to the right.  The economy now moves to the point C and back to natural real GNP.  Therefore, classical economists take a long-run perspective on how the economy operates.  They argue that the economy will automatically revert to natural real GNP following some disturbance.  Classical school advocates a non-interventionist policy stance with little or no government interference in the adjustment process.  Only policies should be:  1. Speed up the rate at which prices and wages adjust. This should keep the economy near natural real GNP. 2. Introduce measures to increase natural real GNP. Emphasise supply-side, rather than demand-side, policies.  Keynes on the other hand argued that wages are inflexible in a downward direction and this could cause the economy to get stuck at the point B.  Recessions can last a long time, and this is costly in terms of lost output and high unemployment.  Keynes recommended an interventionist policy stance, using fiscal policy.  An increase in government expenditure (G) and/or a cut in taxes would shift the AD curve back to its original position point A. Result is that the recession is short-lived.  Hence, Keynesian economics is associated with an active policy stance with direct government intervention.  Therefore, the fundamental difference between Keynes and Classical economists is: o Classical economists believe in a laissez-faire economy, which entails free trade and little/minimal government intervention in the adjustment process. They believe that government intervention can be grossly inefficient. 26  o The Keynesian model promotes that the government should take an active stance in stabilising the economy to minimise the effects of a boom/bust cycle and thus minimise cyclical inflation and unemployment. Fiscal Policy and Monetary policy definition *Q1. (i) Define Fiscal Policy.  Fiscal Policy refers to the use of government expenditure and taxation in order to influence aggregate expenditure and thus aggregate output. (ii)How is expansionary fiscal policy implemented?  Government Expenditure and/or Taxation  AD and GNP (iii) How is contractionary fiscal policy implemented?  Government Expenditure and/or Taxation  AD and GNP *Q2. (i) Define Monetary Policy.  Monetary Policy refers to the use of interest rates to achieve economic objectives (ii)How is expansionary (easy) monetary policy implemented?  Interest Rates  Investment & Consumption  AD and GNP (iii) How is contractionary (tight) monetary policy implemented?  Interest Rates  Investment & Consumption  AD and GNP 27