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Macro Questions
Introductory Macroeconomics (University of Melbourne)
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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
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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
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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:
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Consumption expenditures
Imports
Government purchases
Exports
Government payments to retirees
Household purchases of durable goods
Beginning-of-year inventories
End-of-year inventories
Business fixed investment
a) 300
b) 400
c) 800
d) 900
e) 1500
1000
600
700
500
200
300
400
700
500
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
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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
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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
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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
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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
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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
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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?
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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
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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?
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-
-
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.
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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)
b)
c)
d)
In 2010, would u* be larger, smaller, or the same as u?
In 2011, would Potential GDP be larger, smaller or the same as Real GDP?
In 2012, would Real GDP be larger, smaller or the same as Potential GDP?
In 2013, would u be larger, smaller or the same as u*?
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Okun’s Law:
100 ×
(𝑦 − 𝑦 ∗ )
= −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.
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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
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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
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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
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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
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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 2024. Clearly, the unemployment rate for those aged 1519 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).
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-
-
-
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 19year-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 CobbDouglas 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&
G
𝑑𝐿
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.
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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.
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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
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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
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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
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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
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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).
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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
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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
If Y* is 30,000 then G would have to rise by
(gYYYYFGG5YY)
G
= 3600
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
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-
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,
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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
&
Multiplier = &FY.Z = 2
⇒Y = 4500 + 0.5Y
⇒(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
k + 𝒄(𝒀 − 𝑻) − 𝜸𝒄𝒓
𝑪𝒅 = 𝑪
k + 𝒕𝒀
𝑻=𝑻
𝑷
𝑰 = 𝑰t − 𝜸𝒊𝒓
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
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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
k + 𝒄(𝒀 − 𝑻)
𝑪𝒅 = 𝑪
k + 𝒕𝒀
𝑻=𝑻
𝑷
𝑰 = t𝑰
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.
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8a. Monetary Policy in Keynesian Models of the Macroeconomy
a) Recall that the Keynesian consumption function is:
k + 𝒄(𝒀―𝑻)―𝜸𝒄 𝒓
𝑪𝒅 = 𝑪
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
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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
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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?
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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
k + 𝒄𝒀 and
trade. So PAE = C + I + X – M. We will write the consumption function as 𝑪 = 𝑪
k + 𝒎𝒀. Exports (X) and investment (I) are exogenous.
the import function as 𝑴 = 𝑴
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
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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?
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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
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-
-
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.
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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 is the equilibrium level of GDP?
𝑌 = 1200 + 0.54𝑌
𝑌 = 2608.7
The exogenous level of planned aggregate expenditure is 1200. The equilibrium level of
output, solving above is Y = 2608.7.
e) What is the value of the multiplier in this economy?
The multiplier is given by
&
&Fe'e•
&
In this economy, the multiplier is &FY.Ž'Y.Ž • Y.& = 2.17
f) Sketch a graph of the PAE and the consumption function, labelling the axes of the
graph. Discuss the economic meaning of (a) a movement from left to right along the graph
of the consumption function; and (b) a parallel upward shift of the consumption function.
a)
b)
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5. In recent months, there has been some discussion of a free trade agreement between
Australia and Indonesia. Each country has agreed to abolish almost all tariffs on the goods
of the other country. Government of both countries are hopeful that this agreement will
benefit both the economies.
Use the Keynesian model of the macroeconomy to describe what effect this will have
upon the Australian economy. Be specific and describe what components of expenditure
are affected and why. Discuss the adjustment process associated in moving from an initial
equilibrium (before the agreement) to a final equilibrium (after the agreement) in detail.
In particular, discuss the mechanism that leads to a change in output. Include a relevant
diagram
Initially assume that the economy is at an equilibrium that can be described by planned
aggregate expenditure equalling actual output. Keeping all else same, with the free trade
agreement, exports will increase, thus causing an exogenous upwards shift of the PAE.
This will increase PAE at Y0, so that PAE > Y0. Now a disequilibrium exists, increase in
exports, increase output by the same amount, however, as output increases there will also
be an increase in consumption due to the marginal propensity to consume. At this
disequilibrium, an unplanned decrease in inventories will provide a signal for firms to
produce more. Thus, this increase in output will continue until we reach a new equilibrium.
Through this multiplier effect, there will be a larger increase in Y, in comparison to the
increase in exports.
At the new short run equilibrium, the change in output will exceed the change in exogenous
spending. This is because, as output increases, income also increased, causing endogenous
consumption to increase, thus leading the multiplier effect to change the output.
6. What is the money multiplier? Provide an intuitive explanation for why the multiplier
exists. Other things being equal, what happens to the multiplier if there is an increase in
the marginal propensity to save?
The multiplier captures the idea that a small change in exogenous expenditure leads to a
larger change in output. The intuition behind this result is that an exogenous
change in expenditure becomes the income for other individuals in society. With a
Keynesian consumption function this increase in income is partly saved and partly
consumed. This increase is consumption provides a further increase in income that leads to
further expenditure.
The value of the multiplier in a setting with taxation is
1
𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
1 − 𝑐(1 − 𝑡)
If there is an increase in the marginal propensity to save there will be a decrease in the
multiplier. The increase in the marginal propensity to save leads to less consumption for any
given increase in income. This lower increase in consumption leads to a lower increase in
output (and lower further increase in consumption).
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7. What is the money multiplier? Explain intuitively why the money multiplier exists.
Suppose the government decides to use regulation to increase the level of bank reserves
relative to deposits. Explain what effect this change in policy will have upon total money
supply.
The money multiplier is the idea that an increase in currency held in bank reserves
can lead to an even larger increase in money supply. The basic idea is that under fractional
reserve banking, when there is an increase in bank reserves it can loan out these new
reserves to customers and the loans will eventually be deposited into the banking system
allowing further banks to make new loans. An increase in the level of reserves to deposits
reduces the money multiplier and causes the supply of money to shrink.
8. The policy known as ‘austerity’ measure was introduced throughout the Eurozone in
2010 in order to reduce public debt. Using the government budget constraint equation
identify which variables are relevant in this measure. Discuss.
Government budget constraint:
𝐺• + 𝑄• + 𝑟𝐵•F& = 𝑇• + (𝐵• − 𝐵•F& )
Where, 𝐺• = government expenditure would decrease
𝑄• = transfer payments would decrease
𝑇• = tax revenue would increase
LECTURE 6: Monetary Policy, Aggregate Demand, Aggregate Supply
MULTIPLE-CHOICE QUESTIONS
1. During the second half of the 1970s, the Reserve Bank of Australia, and other central
banks around the world followed a process of monetary targeting on the quantity theory
of money. Since early 1990s RBA abandoned the process of monetary targeting due to
factors such as _________________ and moved towards ___________________.
a) deregulation and technological progress in the financial sector; velocity targeting
b) high cost of printing money; interest rate targeting
c) deregulation and technological progress in the financial sector; inflation targeting
d) unstable velocity of money: interest rate targeting
2. The policy reaction function, followed by central banks around the world, is a numerical
description of how real interest rates vary in response to changes in the output gap and
inflation, can be written as:
𝑌−𝑌∗
𝑟 = 𝑟̅ + 𝛼𝑦
+ 𝛼+ 𝜋
𝑌∗
3. Given the policy reaction function, we would expect the central bank to have
a) a larger value for coefficient in front of inflation if they are not aggressive in fighting
inflation
b) a larger value for the coefficient in front of the output gap if they are aggressive in
fighting cyclical unemployment
c) a larger value for the output gap coefficient if business confidence is falling
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d) a larger value for the inflation coefficient if inflation is becoming negative
4. Which factor will cause a movement along the AD Curve?
a) A loss in business confidence
b) An increase in the size of the budget deficit
c) Growth in the world economy that increases the demand for our exports
d) A rise in inflation in the domestic economy
5. 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
6. The sale of government securities in the unsecured overnight interbank market by the
RBA will typically_______the interest rate in this market, and_________ economic activity
a) raise, decrease
b) raise, increase
c) lower, decrease
d) lower, increase
7. The government budget constraint may be written as the change in government debt
equals:
a) Gt – Qt – Tt + rBt-1
b) Gt – Tt + rBt-1
c) Gt + Qt – Tt + rBt-1
d) Gt + Qt – Tt – rBt-1
SHORT ANSWER QUESTIONS
1. In 2008, at the height of the Global Financial Crisis, the Federal Government
introduced the Financial Claims Scheme to provide insurance to depositors up to the value
of $250,000. They also guaranteed larger deposits and wholesale funding by banks up
until 2015. This deposit insurance effectively meant that if a bank or financial
intermediary went bankrupt, the government would compensate the depositor.
a) What effect do you think guaranteeing deposits would have upon the ability and cost
of banks and other financial institutions to raise funds?
The decision to guarantee deposits made it easier for banks to raise funds
There are a few issues that are worth highlighting:
- when deposit insurance was introduced, there was a significant amount of
uncertainty in financial markets at this time
o this included uncertainty regarding the balance sheet position of major banks
and as a result, uncertainty regarding their future solvency
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-
-
this uncertainty raised the cost of funding for Australian banks – essentially banks
were viewed as more risky
o people seeking to invest in Australian banks would require a higher rate of
return to do so (that is, raised the risk premium)
this was exacerbated by several other countries offering deposit insurance for
financial institutions based in those countries
o this further increased the risk associated with investing in Australian banks
b) If it became difficult for banks to raise funds, what impact do you think this would
have upon the real economy? Explain your reasoning.
-
-
If it became difficult for banks to obtain funds for financial intermediation, we would
expect that it would be difficult for firms within the economy to finance investment
o This decline in investment would have implications upon the equilibrium
level of output and employment in the economy
The financial sector is responsible for allocating resources to their most productive
use
o If financial intermediaries are unable to raise funds, then firms may be
constrained in their investment decisions
2. If monetary policy was operated using a mechanical policy reaction function, we could
replace a central bank governor with a computer that would determine interest rates.
Why do you think central bank governors still exist and have not been replaced by
computers? If policy rules do not reflect how central bank governors operate, do you think
there is a problem in using them in macroeconomic models?
The monetary policy function is really an approximation of how central banks behave. A key
part of central bank behaviour would be to use discretion or judgement in monetary policy.
This discretion allows centra bankers to set interest rates that may vary from what is implied
by a policy reaction function. The following points highlight why judgement may be a useful
aspect of monetary policy:
- Central banks use a lot more information than just the output gap and interest rates
in determining monetary policy. They collect more detailed information regarding
the state of the domestic economy, and they would also have more information
about the international economy and its expected future. This information may be
important in assessing the current state of the economy and what is the appropriate
policy stance
- Policy reaction functions are set as being dependent upon unobserved variables. The
output gap, for example, is not something that a central banker or statistician can go
out and measure. It requires some judgement to estimate the output gap
Not only that, but the above points imply that policy reaction functions are really an
approximation of the behaviour of how a central bank behaves. This does not necessarily
mean that the use of a policy reaction function is problematic. As long as the policy reaction
function is a relatively good approximation of reality, it may still be a useful element of
macroeconomic models that helps simplify reality and provide insights
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3. Suppose that the AD curve is downward sloping solely due to the response of the real
interest rate to inflation as a result of the central bank’s policy reaction function. In such a
setting, what factors determine the slope of the AD curve?
The AD curve is downward sloping because as inflation rises, the central bank will raise real
interest rates to reduce aggregate demand. There are two key aspects that will determine
the slope of the AD curve:
- 1. The policy reaction function of the central bank – how rapidly will it raise real
interest rates as inflation becomes higher?
o Suppose the policy reaction function is very steep in (𝜋,r) space. It implies an
increase in inflation leads to a large increase in r.
o Other things being equal, this will cause a larger decrease in planned
aggregate expenditure. This implies that the AD curve will be relatively flat
- 2. How responsive are households and firms to the interest rate
o Suppose households and firms respond to higher interest rates by reducing
planned aggregate expenditure by a large amount.
o Other things being equal, this implies that when inflation increases, the real
interest rate becomes larger, and households and firms reduce planned
aggregate expenditure by a greater amount. Hence the AD curve is flatter
4. In the context of our two-sector model, how would a decision by the Reserve Bank of
Australia to increase interest rates influence planned aggregate expenditure and the
equilibrium level of output? Illustrate the short-run macroeconomic effects using a 45degree line diagram.
If it means a rise in real interest rate it will lower planned investment for each level of Y and
so the PAE curve will shift down (it will likely also affect demand for C especially consumer)
at the existing level of output (assuming we start out in equilibrium) that means excess
supply and output will fall until it reaches the point where the (now lower) PAE curve
intersects the 45-degree line.
5. What is the effect of a Central Bank Anti-Inflation policy?
-
-
High rates of inflation are not consistent with a high rate of economic growth and
full employment
RBA has the control of inflation as their primary policy objective and have an
explicitly stated inflation target
Sometimes, with inflation at unacceptably high rates, and even with the economy at
potential output, central banks decide that they must raise interest rates
significantly to reduce inflation to a lower level
So, the central bank will be shifting its policy reaction function upwards – sometimes
expressed as ‘getting tougher on inflation’
The effect and intention of the tighter monetary policy is to shift the AD curve to the
left
So, when a contractionary gap begins to occur…
o Unemployment will exceed the natural rate
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o Only a moderate effect on inflation in the short run, due to inflation inertia
o Eventually, contractionary gap causes actual and expected inflation to decline
o AS shifts down
6. Currently the interest rate that the Reserve Bank of Australia (RBA) targets is near
record lows below 1 per cent. Explain why this limits the ability of the RBA to increase
output via conventional monetary policy. In your explanation, make sure to discuss how
monetary policy affects the behaviour of different sectors of the economy.
The RBA operates by changing interest rates. Interest rates cannot go below zero by a
significant amount. As a result, there is limited ability for the RBA to lower interest rates
further. As interest rates fall, it encourages households to reduce saving and increase
consumption and it encourages firms to increase investment. Both mechanisms should raise
the amount of aggregate demand in the economy.
LECTURE 7: Aggregate Demand and Aggregate Supply
MULTIPLE-CHOICE QUESTIONS
1. In the AD-AS model, a temporary shock to the aggregate supply function that leads to
an increase in inflation, with other things equal, will have
a) a negative effect on output in the short run but no long-term impact on inflation or
output
b) a positive effect on output in the short run but no long-term impact on inflation or output
c) a negative effect on output in the short run and long run
d) a positive effect on output in the short run and long run
2. In the context of the aggregate demand and aggregate supply model, if the central
bank shifts it’s policy reaction function down by lowering the aggregate demand 𝒓t will
__________ and in the long run the rate of inflation will ____________ it was before the
change made by the central bank.
a) shift to the right; be higher than
b) be unchanged; be the same as
c) shift to the left; be higher or lower than
d) shift to the right; be lower than
3. The idea of inflation inertia refers to the fact that,
a) the inflation changes slowly over time
b) interest rates for different financial assets are linked by arbitrage
c) if firms output exceeds potential output, then the inflation rate will rise
d) all of the above
4. In the context of the AD-AS model, an increase in potential output will cause:
a) The AD curve to shift to the right and lead to a rise in output and inflation in the short
run.
b) The AS curve to shift to the right and lead to a rise in output and a decline in inflation in
the short run.
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c) The AD curve to shift to the left and lead to a fall in output and a rise in inflation in the
short run.
d) The AS curve to shift to the left and lead to a fall in output and a rise in inflation in the
short run.
5. An economy’s aggregate demand curve is given by the following relationship: Yt =
13,000 – 20,000πt. The economy’s potential output is 12,000. Initially the rate of inflation
is 4 per cent. That is, πt = 04.
The initial short run equilibrium level of output ____________, the economy is in a
______________ output gap; in the long run equilibrium output and inflation rate will be
_________ and __________ respectively.
a) 12,000; expansionary; 12,000; 0.05
b) 12,200; expansionary; 12,000; 0.05
c) 13,000; expansionary; 13,000; 0.04
d) 13,200; expansionary; 13,200; 0.04
6. Assume that an economy begins in an equilibrium with output equal to potential
output and actual inflation equal to expectations. Holding all else constant, and using the
AD-AS model, the short run and long run effects of a loss of business confidence will
a) reduce investment and short run output, however long run output will be restored at
potential level and inflation rate will be lower.
b) reduce investment and short run output, and long run output and inflation rate will also
be lower.
c) reduce investment and short run output, however long run output will be greater than
potential level and inflation rate will be lower.
d) reduce investment and short run output, however long run output will be restored at
potential level and inflation rate will be higher.
7. Assume that an economy begins in an equilibrium with output equal to potential
output and actual inflation equal to expectations. Holding all else constant, and using the
AD-AS model, the short run and long run effects of an increase in the size of government
spending will
a) increase short run output, however long run output will be lower than potential output
with a higher inflation rate than the initial equilibrium.
b) decrease short run output, however long run output will be restored at potential output
with a lower inflation rate than the initial equilibrium.
c) increase short run output, however long run output will be restored to potential output
with a higher inflation rate than the initial equilibrium.
d) decrease short run output, however long run output will be restored to potential output
with a higher inflation rate than the initial equilibrium.
8. In the context of the AD-AS model, which of the following events would be consistent
with an increase in inflation and an increase in output in the short run?
a) A reduction in consumer confidence due to uncertainty regarding the international
economy
b) An increase in expectations regarding future inflation
c) A reduction in expectations regarding future inflation
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d) An increase in optimism of firms regarding the profitability of future investments
9. Consider the AD-AS model and assume an economy is initially in a long run equilibrium.
Suppose there is an increase in consumer demand due to an increase in optimism about
the future labour market conditions. In the final long run equilibrium, we would expect
inflation and output.
a) lower, higher
b) lower, unchanged
c) higher, higher
d) higher, unchanged
10. The slope of the aggregate supply curve in (y, π)-space depends upon
a) the response of the central bank to inflation
b) the response of households to changes in the real interest rate
c) the response of firms to the output gap
d) all of the above
11. If the central bank raises the domestic real interest rate, we expect the exchange rate
to__________ and capital inflows to_________.
a) appreciate, decrease
b) appreciate, increase
c) depreciate, decrease
d) depreciate, increase
12. In the AD-AS model, a temporary shock to the aggregate supply function that leads to
an increase in inflation, with other things equal, will have
a) a negative effect on output in the short run but no long-term impact on inflation or
output
b) a positive effect on output in the short run but no long-term impact on inflation or output
c) a negative effect on output in the short run and long run
d) a positive effect on output in the short run and long run
13. The AD curve is
Y = 22,000 - 10,000 pi
Y = 7,000 + 10,000 pi
where Y is output, and pi is inflation. What is the equilibrium level of output and inflation
in this economy?
a) inflation is 0.75 percent and output is 14,500
b) inflation is 1.25 percent and output is 16,000
c) inflation is 3.2 percent and output is 12,000
d) inflation is 2.7 percent and output is 14,000
SHORT ANSWER QUESTIONS
1. If we look at inflation in Australia, we find that it was relatively high in the 1970s and
1980s. Inflation declined in the early 1990s and remained at low levels until today.
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a) One interpretation of this history is that the central bank became more aggressive in
reacting to inflation in the early 1990s. Describe what effect this would have upon the
policy reaction function of the RBA. Describe what impact this change in the policy
reaction function has upon the AD Curve and short-run equilibrium in the AD-AS model.
In the short run a more aggressive response to inflation implies that the policy reaction
function will shift upwards. This shift upwards in the policy reaction function will lead to a
shift inwards of the AD curve. The short run equilibrium outcome is that output will decline.
b) What happens to equilibrium in the long run because of the more aggressive policy of
the central bank towards inflation? What happens to output and the inflation rate?
As output is now below the potential output, the new short run equilibrium found in part a,
does not represent the long run equilibrium. At the short run equilibrium, firms would
desire to sell more, and they respond by decreasing the rate at which price increases. This
leads to a fall in the inflation rate, and the SRAS curve shifts downwards, and continues to
do so until the economy is back at potential output. As inflation declines, real interest rate
falls, and this leads planned aggregate expenditure to increase.
c) If we think about the reduction in inflation that happened in the late 1980s and early
1990s, what do you think were the benefits of the decline in inflation? What do you think
were the costs associated with the decline in inflation?
By reducing inflation, the RBA has reduced these costs. This reduction in the costs of
inflation has been the benefit. The cost associated with the reduction in inflation is that
there was a significant increase in unemployment rate.
d) What structural features of the economy do you think would help reduce the costs
associated with an episode in which there is a decrease in inflation brought about by
monetary policy?
There are a number of structural features that may help reduce the costs associated with
bringing inflation downwards:
- How quickly do inflation expectations adjust to new circumstances? In general, the
more rapidly the adjustment the lower will be the rise in unemployment
- How quickly do prices adjust? If prices are able to adjust very quickly, then we may
be able to return to our long run equilibrium very quickly
- Some features of the labour market may affect the cost of adjustment
o For example, as output declines by how much does unemployment rise?
§ This may depend upon labour market institutions. In many countries,
a reduction in hours worked in the aggregate economy occurs with
only a small reduction in hours per worker but a large reduction in
number of workers
§ In some countries, a reduction in hours worked occurs with only a
small reduction in employment and a relatively large reduction in
hours per worker. It is likely that this case will lead to lower costs.
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2. Is there any role for the financial sector in the AD-AS model? Can we incorporate
shocks to the financial sector into this model? If so, how?
-
-
-
-
-
There is no direct role of the financial sector in the AD-AS model. In the model we
talk about households, firms, the government and the overseas sector and we make
assumptions regarding how these different sectors of the economy behave.
Implicitly, in those assumptions there is some assumed ability regarding how the
financial sector operates – for example, firms are able to finance investment to some
degree and that households are able to borrow to consume.
o But that is for the most part kept to the background
If we wanted to incorporate shocks to the financial sector to the AD-AS model we
would have to say that events in the financial sector lead to some sort of change in
the behaviour of households or firms, or potentially other sectors of the economy
o For example, the failure of financial intermediaries may lead to a reduction in
exogenous investment by firms if firms have difficulty in finding finances
One of the criticisms of the AD-AS model would be that the way in which financial
markets is incorporated into the model is arbitrary
o Makes it hard to know what effects shocks to financial intermediaries will
have upon endogenous variables or how different policy responses will
impact upon economic outcomes
§ E.g., in the financial crisis in the USA there were proposals to bail out
the banks and proposals to help households that could not repay their
housing loans. It is difficult in this AD-AS model to compare these
different policies
A frequent critique of macroeconomics after the crisis was that economists had not
paid any attention to the importance of financial factors in understanding the
macroeconomy
3. How does a positive inflation shock effect the AD-AS model?
- Short run: Inflation increases, real interest rate increases, output decreases
- Long-run: inflation decreases, real interest rate decreases, output increases
Once the initial inflation shock hits, the RBA can promptly react with a contractionary
monetary policy. Increasing the cash rate should result in lower inflation, which also leads to
a lower real interest rate over time. The government can also assist the economy to correct
itself into equilibrium by implementing a budgetary policy.
4. How does an exogenous increase in planned investment affect the AD-AS model?
- Short run: output increases, inflation is unchanged
- Long-run: inflation increases, output decreases
When there is an expansionary output gap (Y>Y*), there is a tendency for inflation to rise
above expected inflation, therefore inflation expectations rise. Both the government and
RBA can contribute to the long run movement shifting a higher SRAS, with a contractionary
stance in monetary and budgetary policy.
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5. Suppose the monetary policymaker alters the monetary policy reaction function so that
it raises real interest rates by a larger amount for any change in inflation. Explain (in
words) what impact this will have upon equilibrium output and inflation in the short run.
A monetary policy maker that changes policy in this way will in general, set a higher real
interest rate for any given level of inflation. This implies that at any inflation rate, there will
be less planned aggregate expenditure since consumption and investment both decrease
with the real interest rate. This implies a shift inwards of our AD curve. In the short run this
shift inwards of the AD curve will lead to an equilibrium decrease in output and inflation in a
short run equilibrium.
6. Suppose the level of output in the Australian economy currently lies below the level of
potential output. Using our model of the AD-AS model, explain how in the long run the
Australian economy would adjust assuming there is no intervention by fiscal or monetary
policymakers. Be sure to provide the economic intuition for this result.
At a level of output below potential there is a tendency for firms to raise prices by
less than expected. This causes the rate of inflation to fall and moves us along the aggregate
demand curve. as we do so, output rises until we return to equilibrium.
7a. Suppose the Australian government increases the level of government spending.
Explain how an increase in government spending impact upon the position of the AD and
AS curves. Explain your answer in detail
-
-
Outward shift in the AD curve (to the right) = represents an increase in government
spending
o Raises equilibrium output at each level of inflation
The SRAS curve depends upon expected inflation and is left unchanged by the
government spending
LRAS curve depends upon the value of potential output and is unchanged by changes
in government spending
b. What will be the impact of the increase in government spending on the level of output
and inflation in the short run of the AD-AS model? What will be the impact on the level of
output and inflation in the long run of the AD-AS model? For simplicity, assume that the
economy is initially in a position where the level of output equals potential output and
inflation equals expected inflation
-
The short run = a shift in the AD curve as discussed in part a
o An increase in output and no change in inflation
The long run = a shift up in the SRAS curve
o This results in an increase in inflation and output returns to potential output
The reason for this increase in inflation = output exceeds potential output
c. Continuing on from part (b), how will the different components of aggregate
expenditure be affected by the increase in government spending? Analyse both the short
run and the long run effect upon the components of aggregate expenditure.
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By assumption exports are unaffected. The level of exogenous government spending
rises in both the short run and the long run. In the short run output is increased and
inflation unaffected. The increase in output raises the real interest rate via the response of
the central bank. This increase in the real interest rate reduces investment. In the short run,
moving on to consumption there are two effects. The higher real interest rate reduces
consumption but the increase in output will tend to increase consumption. In the short run,
the effect on consumption is ambiguous1.
1
If the marginal propensity to consume is small, there will be a small effect of the increase
in output and most likely consumption will fall. On the other hand, if consumption is not
responsive to interest rates then the rise in interest rates will have little effect on
consumption and most likely consumption will rise
8. During the early 1990s in Australia, a recession was brought about by an increase in real
interest rates as a result of changes in the behaviour of monetary policy. Explain how this
change in behaviour in monetary policy would be reflected in our AD-AS model. What
were the costs and benefits associated with this change in behaviour?
A change in the behaviour of the central bank in the early 1990s raised inflation rates above
what had previously been expected on the basis of past behaviour. As a result of this change
in policy, the AD curve shifts inwards and we find that there is a reduction in output and a
decrease in inflation. In the long run, inflation expectations decline and real interest rates
fall. This eventually leads to an increase in output as the economy returns to potential
output.
When thinking about the costs and benefits of this policy change, the cost was the high
unemployment experienced during the early 1990s. The benefit of this policy is that it
reduced the inflation rate and that this reduction was sustained for a prolonged period of
time.
LECTURE 8: Economic Growth
MULTIPLE-CHOICE QUESTIONS
1. To a large extent, the level of output per person determines living standards, the key
factor in determining long-run living standards is
a) growth in hours worked
b) growth in average labour productivity
c) growth in nominal wages
d) growth in population size
2. The Cobb-Douglas production function is given by 𝒀 = 𝑨𝑲𝜶 𝑳𝟏F𝜶 . Here α is a given
parameter that satisfies 0 < α < 1. The marginal product of capital is _______ and shows
_________ returns to capital. The Cobb-Douglas production function displays __________
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and the level of output per worker can be written as a function of the level of
____________
›
a) 𝛼 œ ; diminishing marginal; constant returns to scale; capital per worker
›
b) (1 – α)œ ; increasing marginal; decreasing returns to scale; capital per worker
›
c) 𝛼 ; diminishing marginal; constant returns to scale; technology
œ
›
d) 𝛼 œ ; diminishing marginal; increasing returns to scale; capital per worker
3. According to the Solow-Swan model the transition equation for capital per worker can
be represented by the following equation:
𝑌
𝐾
𝐾
𝜃 Ÿ = (𝑑 + 𝑛 ) + ∆
𝐿
𝐿
𝐿
4. If there is an increase in the rate of saving in Australia then the steady state level of
capital per worker will _________ and the level of output per worker will also
___________.
a) decrease, increase
b) decrease; decrease
c) increase; decrease
d) increase, increase
5. The Cobb-Douglas production function is given by 𝒀 = 𝑨𝑲𝜶 𝑳𝟏F𝜶 . Here α is a given
parameter that satisfies 0 < α < 1. Further assume the wage w is equal to the marginal
product of labour and the interest rate r is equal to the marginal product of capital. Also
recall that the income approach to National Accounts implies: Y = wL + rK . We can say
that the share of income labour receives, and capital receives, respectively will be:
a) (1 – α) and α
b) α and (1 – α)
c) (1 – α)w and αr
d) (1 – α)L and α
6. In the Solow-Swan model discussed in lectures, an increase in the rate of depreciation
of capital stock leads, in equilibrium, to
a) an increase in capital per worker and output per worker.
b) a decrease in capital per worker and output per worker.
c) an increase in capital per worker but no change in output per worker.
d) no change in capital per worker but an increase in output per worker.
7. Which of the following production functions does not feature constant returns to scale?
a) 𝑌• = 𝐾•Y.g 𝐿Y.3
•
b) 𝑌• = 0.6𝐾• + 0.4𝐿•
c) 𝑌• = (𝐾• − 1)Y.Ž 𝐿Y.6
•
d) 𝑌• = 6𝐾• + 4𝐿•
8. Which of the following production functions does not feature constant returns to scale?
a) 𝑦• = 𝑘•Y.6 𝑙•Y.Ž
b) 𝑦• = 𝑘• + 𝑙•
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c) 𝑦• = 1.3𝑘• + 𝑙•
d) 𝑦• = 𝑘•Y.g 𝑙•Y.5
9. Suppose two countries have the same production function and identical rates of
population growth and depreciation and share the same technology. However, Country B
has a relatively higher rate of saving than Country A. According to the Solow-Swan model,
a) Country B will have a lower long run level of per capita income than Country A.
b) Country B will have the same long run level of per capita income as Country A.
c) Country B will have a higher long run level of per capita income than Country A.
d) Whether or not Country B has a higher level of per capita income than Country A depends
on whether the long run rate of economic growth is higher in Country B than in Country A.
10. In the context of the Solow-Swan model studied in this subject, which of the following
statements is correct?
a) An increase in the proportion of income saved has negative effect on the growth in per
capita income in the long run
b) A fall in the rate of population growth raises the steady-state capital-labour ratio.
c) An improvement in technology has no implications for the economy's steady-state
capital labour ratio.
d) An increase in per capita income is only possible if there is an increase in the economy's
total factor productivity.
11. In the Solow-Swan model discussed in lectures, an increase in the rate of depreciation
of capital stock leads, in equilibrium, to
a) an increase in capital per worker and output per worker.
b) a decrease in capital per worker and output per worker.
c) an increase in capital per worker but no change in output per worker.
d) no change in capital per worker but an increase in output per worker.
12. The Republic of Ostralaya has experienced a 5 per cent increase in output this year, a 2
per cent rise in capital stock, and a 3 per cent increase in total hours worked. Assuming a
Cobb-Douglas production function where capital income accounts for 30 per cent of GDP,
calculate how much output growth is explained by capital accumulation, labour, and total
factor productivity.
a) Output growth is explained by 0.3% capital accumulation, 1.7% labour and 3% total factor
productivity.
b) Output growth is explained by 0.5% capital accumulation, 2.2% labour and 2.3% total
factor productivity.
c) Output growth is explained by 0.6% capital accumulation, 2.1% labour and 2.3% total
factor productivity.
d) Output growth is explained by 2% capital accumulation, 2% labour and 1% total factor
productivity.
13. Which of the following assumptions does a growth accounting exercise not rely upon?
a) constant returns to scale in the production function
b) competitive markets with factors of production paid their marginal value
c) a constant saving rate independent of the level of income
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d) a production function that depends upon capital, labour, and technology
14. Which of the following statements regarding convergence hypothesis is not true?
a) The convergence hypothesis is implied by the Solow-Swan model
b) Countries with similar characteristics will share a similar steady state and countries will
have similar output per worker in the long run
c) If absolute convergence is true, poor countries must grow faster than rich countries over
some period of time
d) Evidence suggests that the absolute convergence hypothesis is always correct
15. Assuming a Cobb-Douglas production function with constant returns to scale, then, as
L rises with K and A constant, it will be the case
a) Both the marginal product of labour and the marginal product of capital will fall
b) Both the marginal product of labour and the marginal product of capital will rise
c) The marginal product of labour will rise and the marginal product of capital will fall
d) The marginal product of labour will fall and the marginal product of capital will rise
16. Assume a Cobb-Douglas production function with constant returns to scale. Suppose
the size of the capital stock doubled. Then we would expect that
a) output would double.
b) output would increase, but it would more than double
c) output would increase, but it would less than double
d) on a graph having the capital-labour ratio on the horizontal axis and output per worker
on the vertical axis, the production function would shift up.
17. Imagine a Solow-Swan model with A constant. The saving rate is 𝜽, the population
growth rate n, and the depreciation rate d. When the model has reached equilibrium (ie
“the steady state”) the capital stock K will:
a) Be constant
b) Be rising at the rate n
c) Be rising at the rate (d + n)
d) Be rising at the rate θ(Y/L)/(d + n)
18. Imagine a Solow-Swan model with A constant. The saving rate is 𝜽 and the rate of
population growth is n. When the Solow-Swan model has reached equilibrium (ie “the
steady state”), it will be the case that:
∆œ
a) ¥ œ ¦ = 𝑛
∆œ
›
b) ¥ œ ¦ = 𝜃 ¥ § ¦
∆œ
¨
c) ¥ œ ¦ = (§ )
d) None of the above
19. A country has experienced a 6% increase in output this year, no change in its capital
stock but a 2% increase in labour input. Assuming a Cobb-Douglas production function
where the capital share of income is 0.4, the rate of output growth which is explained by
labour input growth must be.
a) 6%
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b) 2%
c) 1.2%
d) 0.8%
20. For the Cobb-Douglas production function, 𝒀 = 𝑨𝑲𝜶 𝑳𝟏F𝜶 , the marginal product of
labour is
a) 𝛼𝐴𝐾 EF& 𝐿&FE
b) 𝛼
c) (1 − 𝛼)𝐾 E 𝐿FE
›
d) (1 − 𝛼) §•'
21. In the steady state of the Solow-Swan model studied in lectures, the rate of growth in
output per capita is_________ and the rate of growth in output equals the_________ .
a) positive, saving rate
b) positive, population growth rate
c) zero, saving rate
d) zero, population growth rate
22. Consider the Solow-Swan model discussed in lectures. Suppose that the economy
starts with an initial level of capital per worker above the steady state level of capital per
worker. In the transition to the steady state equilibrium, we find that output per worker
_____and capital per worker______.
a) decreases, decreases
b) decreases, increases
c) increases, decreases
d) increases, increases
23. Which of the following assumptions does a growth accounting exercise not rely upon?
a) constant returns to scale in the production function
b) competitive markets with factors of production paid their marginal value
c) a constant saving rate independent of the level of income
d) a production function that depends upon capital, labour, and technology
24. Which of the following is not an assumption required in growth accounting?
a) the production function is Cobb-Douglas
b) the production function has constant returns to scale
c) the level of savings equals investment
d) markets for labour and capital are perfectly competitive
25. Consider the Solow-Swan model. Suppose the saving rate is 30 percent, the
depreciation rate is 5 percent, and the population growth rate is 1 percent. The
production function is
Y = K(1/2) L(1/2)
What is the steady state level of capital per worker?
a) 4
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b) 16
c) 25
d) none of the above
26. Over the 1960-1980 period, real output in Scomoland grew at an annual rate of 3
percent. Capital grew at an annual rate of 2 percent and labour at an annual rate of 2
percent. The labour share of output is 60 per cent. What is the annual growth rate of TFP
for this economy?
a) 1 percent
b) 1.5 percent
c) 1.6 percent
d) 1.7 percent
27. In the country of Melbournville, the saving rate is 25 percent, and the depreciation
rate is 3 percent. The production function is of the following form, Y = K1/2L1/2. In the
steady state equilibrium, the level of output per worker is 5. What is the growth rate of
population in this economy in the steady state equilibrium?
a) 2 percent
b) 3 percent
c) 4 percent
d) none of the above
28. Consider the Solow-Swan model. Which of the following statements is false?
a) An increase in the population growth rate will lead to an increase in steady state output
growth.
b) An increase in total factor productivity will raise output per worker and also consumption
per worker.
c) Increases in the saving rate will always raise output in steady state but may increase or
decrease consumption.
d) An increase in depreciation will lead to an increase in steady state capital growth.
SHORT ANSWER QUESTIONS
1. In the context of the Solow-Swan model, use a
diagram, to show the qualitative effect of an increase
in the population growth rate, n, and an increase in the
level of technology, A upon the steady state level of
output per capita. Do these results seem sensible to
you?
-
The impact of an increase in population growth,
n, is shown in Figure 1.
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-
-
o The key points to note are that the
(d+n)k/l line shifts upwards in our Solow
diagram
o The intersection of the 𝜃𝑦/𝑙 and
(n+d)k/l moves from A to B
§ This leads to a lower steady state
level of capital per worker
§ This reduces the level of output
per worker
The impact of an increase in the level of
technology, A, is given in Figure 2
o It causes a shift up in the production
function (y/l to (y/l)’) and a shift up in
the savings function (𝜃y/l to 𝜃(y/l)’)
o This moves our equilibrium from A, higher up to B
o The net effect is greater capital per worker and output per worker in
equilibrium
These results are generally regarded as quite intuitive and sensible
2. If we look at economic history, we see that growth rates of output per capita were
typically very low prior to the 1750s. In the post-1750 period, a set of countries has
attained sustained growth in output per capita of about 2 per cent per year. In the context
of the Solow-Swan model, what changes could account for a sustained increase in
economic growth in the post-1750 period?
There are a few factors that could be considered:
- Capital accumulation does not lead to permanent growth in capital per worker or
output per worker
o The results from the Solow-Swan model show that if the saving rate is
constant, that the level of capital per worker will eventually reach a constant
level (that is, a steady state) and in this steady state, output per worker will
also be constant
o If the saving rate increases, there can be a temporary increase in the growth
of output per worker, but this does not lead to permanent growth
- Labour can grow over time and this will increase output, but it will not increase
output per worker when we are in a steady state
- The key implications of the Solow-Swan model is that changes in technology are
what drives changes in the output per capita.
o To explain this permanent growth in living standards it would be necessary
for there to be permanent growth in total factor productivity (That is the A in
the production function)
3. Suppose we consider a production function with the following functional form, 𝑌=𝐴𝐾.
In this case, A is the level of technology and K is the level of capital stock. There is no role
for labour and recall that capital accumulates according to the following equation:
𝑲𝒕'𝟏 = (𝟏―𝒅)𝑲𝒕 + 𝒍𝒕
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a) Maintain the standard assumption that investment is equal to a constant proportion
of output. That is 𝒍𝒕 = 𝜽𝒀𝒕. Use the above information to derive that describes the growth
rate of capital stock for this economy.
Substituting out investment in the capital accumulation equation implies:
𝐾•'& = (1 − 𝑑 )𝐾• + 𝜃𝑌•
= (1 − 𝑑)𝐾• + 𝜃𝐴𝐾•
𝐾•'& − 𝐾• = −𝑑𝐾• + 𝜃𝐴𝐾•
𝐾•'& − 𝐾•
= 𝜃𝐴 − 𝑑
𝐾•
This is an equation that describes the growth rate of capital stock
b) Does this economy have a steady state of capital? If not, what will happen to this
economy over time? What is the key difference between this environment and the
Solow-Swan model that we discussed in lectures and the textbook?
No, this economy does not have a steady state of capital stock except under very special
conditions. If 𝜃𝐴 = 𝑑, then the level of capital is changing over time.
- The amount that is saved is exactly equal to depreciation in this case and the
economy is neither growing nor shrinking
- There is no unique steady state level of capital in this case, rather, the existing level
of capital stock is what the level of capital stock will be in the future
In a second case, 𝜃𝐴 > 𝑑. In this case, the savings by the economy exceed the amount by
which capital depreciates in each period. In this economy, savings will tend to grow over
time. The level of capital in this economy will grow and, due to the production function, the
level of output in this economy will also grow over time
In the third case, 𝜃𝐴 < 𝑑 in which case, the savings are not enough to cover depreciation,
capital will decline over time and the economy will shrink.
The key difference between this equation and the one we covered in class, is that this
production function does not have diminishing marginal returns. Hence, this economy can
display continual economic growth (or decline).
4. a) Imagine two countries both of which are in ‘steady state’ equilibrium growth and
both of which have the same (constant) values of A, d and n but different levels of θ.
(i) Will one country have a higher level of Y/L than the other? Explain your answer.
(ii) Will one country have a higher rate of growth of Y/L than the other? If so, explain how
this occurs (be sure to identify what economic processes or ‘mechanisms’ are involved). If
not, explain why not.
(i) Yes, the one with the higher theta will have a higher equilibrium K/L, and so a higher Y/L
(ii) No, one country will not have a higher growth rate of Y/L than the other. This is because
since A is constant, they are both consistent in the steady state K/L, and thus Y/L will also be
constant in each country and not growing.
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b) Imagine an economy initially in ‘steady state’ equilibrium and that (cet par) the level of
A changes so that it is now higher than it was before. Will this lead to a rise in the
equilibrium level of Y/L? If so, explain how this occurs (be sure to identify what economic
processes or ‘mechanisms’ are involved). If not, explain why not.
Yes, equilibrium Y/L will rise. There will be a direct effect via a rise in A itself impacting on
Y/L given K/L. But there will also be an indirect effect as the rise in A raises S/L (and this
leads to an increase in K/L)
c) Can higher savings rate guarantee sustained higher economic growth for ever? Using
Solow-Swan growth model explain your answer.
Higher savings will cause a temporary period of growth as the economy moves from its
initial steady-state to its new steady-state.
However, once at the new steady-state, growth in per capita GDP ceases. Therefore, it is not
true, at least in the context of the Solow Swan model, that higher saving can sustain higher
economic growth.
5. Use the information below to answer the following questions: “Starting on January 1,
2016, all Chinese couples are allowed to have two children. This marks the end of China’s
one-child policy, ... By the year 2050, commission projections expect the universal twochild policy to result in an extra 30 million working-age people...”
a) Using the Solow-Swan model describe the steady state level of per capita output in
China before the full effect of ‘allowance to have two children’ takes place.
b) What would happen to the steady state level of per capita output in China in 2050?
Explain your answer using the same model.
The original steady-state is shown by point A with its associated steady-state levels of per
capita capital and income given by, respectively k0* and y0*
Now considering the implications of an increase in the rate of population growth, at the
existing steady-state per capita capital stock, the higher rate of population growth means
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more resources need to be found to offset the effects of the higher population; hence the
replacement investment line rotates to the left.
Given the current steady-state level of per capita income, the saving that is now generated
is sufficient to cover the needs of replacement investment. As a result, the per capita capital
stock contracts until a point is reached at which saving once again provides sufficient
resources for replacement investment.
Note that this level of steady-state income is below the level associated with the original
level of population growth rate is n0.
To conclude, all else remaining unchanged, an increase in the rate of population growth
implies a lower steady-state capital stock and hence a lower level of per capita income.
c) Depending on your answer in part (b) what other measure would you suggest
accompanying the ‘two children policy’ for next three decades to ensure maintaining
Chinese economic growth?
Following from part (b) at point B, growth will cease, the per capita capital stock will not
change as saving provides just enough resources for replacement investment, not enough
for any growth to the per capita capital stock. In the long run, with a given level of total
factor productivity, the economy will be at this steady state with zero growth.
If Chinese growth needs to be maintained there will be a need for an increase in
productivity (reflected in an increase in total factor productivity),
This will shift the production function upwards, as a given per capita capital stock will now
yield more per capita income.
At the existing level of per capita capital, k0*, saving now given by the new saving function
S1 = 𝜃𝑦
provides more resources than those needed for replacement investment. As a consequence,
the per capita capital stock grows as the economy moves towards a new steady state.
During this transition phase to the new steady state, per capita income also grows.
Note that once at the new steady state, without further growth in total factor productivity,
growth will once again stop.
6. Suppose an economist conducts a growth accounting exercise on a country and finds
that for a period of time, that output is growing at a rate of 5 per cent on an annual basis.
The growth accounting procedure suggests that 2.1 per cent is due to labour growth, 0.6
per cent is due to capital growth and the remaining 2.3 per cent is due to growth in total
factor productivity.
Now, suppose that errors exist in measuring capital stock. Further, suppose the
statistician tells us that there is a 2 per cent rise in capital stock, but in reality, there was
actually a 5 per cent rise. Explain how the actual contributions of capital, labour and
productivity to output growth vary from our estimates? Does the measurement error
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imply we underestimate or overestimate the role of productivity in explaining growth
when we used the incorrect measure of capital stock?
We apply our standard growth accounting equation:
𝑟𝐾
𝑤𝐿
¯+
𝑌¬ = 𝐴- +
𝐾
𝐿¬
𝑓(𝐾, 𝐿)
𝑓(𝐾, 𝐿)
The growth rate in output equals the growth rate in technology plus the growth rate in
capital multiplied by the share of capital income out of total income plus the growth rate of
labour multiplied by the share of labour income out of total income.
The estimated growth accounting result is:
𝑌¬ = 𝐴
⏟- +
⏟
Z.Y
G.g
𝑟𝐾
𝑤𝐿
¯+
𝐾
𝐿¬
𝑓(𝐾,
𝐿)
𝑓(𝐾,
𝐿)
²³
³´³
³µ ²³
³´³
³µ
Y.Ž
G.&
The value of 𝐴- is residual in this exercise. That is, it is calculated as
𝑟𝐾
𝑤𝐿
¯+
𝐴- = 𝑌¬ − (
𝐾
𝐿¬)
𝑓(𝐾, 𝐿)
𝑓 (𝐾, 𝐿)
Underestimating the growth rate of capital stock will not affect our measures of 𝑌¬or the
¶§
(œ
¯ ).
contribution of labour (
𝐿¬). But it will raise the contribution of capital stock (Q(œ,§) 𝐾
Q(œ,§)
The increase in this value will lead the residual to become smaller.
As a result: underestimating growth in capital stock leads us to overestimating growth in
productivity.
7. Consider the standard Solow-Swan model that we discussed in lectures except assume
that there is zero population growth rate. Suppose there is an increase in total factor
productivity in this economy.
a. Examine what impact this has upon the equilibrium level of capital per worker and
equilibrium level of output per worker.
-
The output per worker function and the saving per worker function shifts upwards
The result is that the economy moves to a higher level of capital per worker and a
higher level of output per worker
This increase in output per worker is partly driven by an increase in productivity but
also an increase in capital per worker
The key point here is that the reason why capital per worker increased is because
there was an increase in productivity
o If we are looking for a casual explanation for why output per worker
increased, then it is the increase in productivity
b. If an economist examined this economy and undertook a growth accounting exercise,
qualitatively, what components would explain the increase in output?
-
They would observe an increase in output, an increase in capital stock, and an
increase in productivity
This implies that some increase in output would be attributed to a rise in
productivity
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-
-
It’s hard to know the exact breakdown between productivity and capital growth
without further information, but the key point is that an increase in productivity can
raise output directly, but it can also raise output per worker by raising the level of
capital per worker
This raises the more general point: a growth accounting approach identifies the
narrow (or proximate) causes of growth by identifying changes in the factors inputs
or productivity, but it doesn’t necessarily identify the underlying causes of growth
(like why productivity has changed)
c. Relate this result to the findings of Paul Krugman and Alwyn Young. They find that
output growth in East Asian economies is driven to a substantial extent by growth in
capital.
Krugman and Young find that much of the growth in successful East Asian economies in the
second half of the 20th century was due to increases in capital stock. This is not necessarily
inconsistent with the Solow-Swan model that predicts productivity growth is the long run
driver of economic growth
1. The increase in productivity leads to an endogenous increase in the capital to labour
ratio. This would be captured in the growth accounting exercise as an increase in capital
stock leading to an increase in output
2. It is also possible that the increase in capital stock in East Asian economies was a
transition to a new steady state equilibrium. If countries start out with a low level of capital
per worker then as they converge to a steady state their output per worker will be rising
over time
8. “In 1960, per capita incomes in Burundi, Haiti, and Nicaragua were $347, $1,512, and
$2,491, respectively. Despite the sevenfold difference in incomes between Nicaragua and
Burundi, all three countries were poor by developed-country standards. Nicaragua’s per
capita income was just 16 percent of the level enjoyed by citizens of the United States at
the time, while Burundi’s income was a paltry 2 percent of US levels. Fifty years later in
2010, per capita incomes in these three countries were basically unchanged, at $396,
$1,411, and $2,289 respectively (all measured in 2005 purchasing power parity-adjusted
US dollars as reported in the Penn World Tables), reflecting negligible real growth in per
capita income over this half-century.”
(Aart Kraayand David McKenzie, “Do Poverty Traps Exist? Assessing the Evidence”
Journal of Economic Perspectives—Volume 28, Number 3—Summer 2014—Pages 127–
148)
Consider these findings in the light of the Solow-Swan model of economic growth.
-
The findings for these economies implicate that per capita real income have
experiences negligible growth
This is inconsistent with the convergence prediction of the Solow-Swan model
Since the United States has experienced growth in real per capita GDP, since 1960,
convergence at least with respect to these economies has failed to eventuate
Convergence
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-
Countries with low per capita capital stocks grow faster than countries with high per
capita capital stocks
Given a similar steady state level of per capita capital, countries’ per capita incomes
eventually attain the same level
However, the convergence prediction requires that economies have the same steady state
and this requires that they have the same underlying fundamentals – the same production
function, the same rate of population growth, the same depreciation rate and the same
savings rate.
This requirement is unlikely to be met in the countries which are the focus of the quotation
9. What is the convergence hypothesis? Why was convergence viewed as an implication of
the Solow-Swan model for a period of time?
The convergence hypothesis is the idea that levels of output on a per capita basis for
different countries will become more similar over time. This implies that economies with a
relatively high output per worker will grow slowly while economies with a relatively low
output per worker will grow relatively quickly. The convergence hypothesis was viewed as
an implication of the Solow-Swan model since in that economic model, countries have a
tendency to converge to a steady state in the long run. In this steady state, the level of
output per capita would be constant and both rich and poor countries would reach the
same level. This would imply that poor countries would have to grow relatively fast when
compared to rich countries over some period of time
10. What is the convergence hypothesis? Is there strong evidence of convergence in the
data? How does the concept of conditional convergence differ from convergence?
Convergence is the idea that economies converge to a steady state. If economies
share a similar steady state, then they should share the same long run equilibrium value of
output per worker and we should expect them to become more similar of time - implying
that the relatively poor countries grow rapidly, and the relatively rich countries grow slowly.
Empirically, the evidence on convergence is quite weak.
Conditional convergence states that countries with similar economic fundamentals are
more likely to converge since they will have a similar steady state. Therefore, conditional
convergence is dependent on countries having the same steady state.
11. What is growth accounting? Explain how measurement error in growth accounting
impacts upon our estimate of the contribution of total factor productivity to growth in
output.
Growth accounting is a process that allocates changes in output to changes in capital stock,
labour, and technology. In words, the percentage change in output over a period of time is
equal to the percentage change in TFP plus the percentage change in capital stock
multiplied by the capital share of output and the percentage change in labour multiplied by
the labour share of output. The growth or contribution of TFP to output growth is estimated
by noting that the growth accounting equation (described above) is one equation, and all
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components of that equation are able to be measured directly except for the growth rate in
TFP. As a result, one way to estimate this equation is to treat it as one equation in which the
growth in TFP is unknown. This implies that if a particular component of the equation that is
observed directly is mismeasured, this mismeasurement will be incorporated into our
measure of TFP growth. The direction of measurement error depends upon which
component is mis-measured. If output is incorrectly measured this will lead to TFP growth
being mis-measured by a similar amount in the same direction. If capital or labour growth
are mis-measured, this will typically lead TFP to being mis-measured in the opposite
direction (so if labour growth is over-estimated) then TFP growth will be under-estimated.
12. Consider the following table:
Country
Output
Capital
Labour
Lilliput
120
100
36
Brobdingnag
64
64
16
Assume that Lilliput and Brobdingnag produce output with the following production
function, 𝒀 = 𝑨𝑲𝟎.𝟓 𝑳𝟎.𝟓 and that the level of productivity, A, is an exogenous constant.
Finally assume that both countries have identical saving rates of 9 per cent, a population
growth rates of 4 per cent and capital depreciates at 5 per cent.
a. What is the level of total factor productivity in Lilliput and in Brobdingnag?
In Lilliput, 120 = A10 · 6 implies that A = 2. In Brobdingnag, 64 = A8 · 4 which implies
that A = 2. Both countries have the same productivity.
b. Which country would you expect to grow faster in output per capita terms in the short
run? Explain your reasoning.
These countries have identical productivity (part a) and are identical in other respects
except for the capital-labour ratio. Brobdingnag has a higher capital labour ratio. This
implies that it must grow slower than Lilliput since they will be converging to the same
steady state and this steady state will have the same capital labour ratio.
c. Suppose instead that the saving rate in Lilliput is 5 per cent, the population growth rate
is 2 per cent and capital depreciation is 4 per cent. Assume Brobdingnag is unchanged
from above. Which country would have a higher growth rate of output per capita? Which
country would have a higher rate of output growth? Explain your reasoning.
If Lilliput has the described parameters, then its steady state is determined by the following:
𝑘 Y.Z
𝑘
0.052 Ÿ
− 0.06 Ÿ = 0
𝑙
𝑙
𝑘
0.1 𝑘 Y.Z
=
( )
𝑙 0.06 𝑙
𝑘
0.1
( )Y.Z =
𝑙
0.06
This equals the capital-labour ratio in Lilliput. Both countries are in steady state and
neither country will be growing without productivity gains.
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13a. Suppose the process of Brexit reduces immigration into the UK. Further suppose that
this reduces the population growth rate. Examine what will be the effects reduced
population growth in the Solow-Swan model. In particular, what happens to the steady
state level of capital per worker and output per worker? What happens to the growth of
output and output per capita in steady state?
The equilibrium level of output per worker will increase. The decline in population growth
rate causes the replacement investment to have a lower slope. The equilibrium level of the
capital-labour ratio rises from (k/l)0 to (k/l)1. Hence, capital per worker and output per
worker increase. In steady state the growth rate of output per worker is constant. This
implies that the growth rate of output per worker is equal to zero. It also implies that the
growth rate of output is equal to the growth rate of the population which is equal to n.
b. Some argue that Brexit may also lead to a decrease in productivity in the UK economy.
Examine what will be the effect of reduced total factor productivity in the Solow-Swan
model. In particular, what happens to the steady state level of capital per worker and
output per worker?
The equilibrium level of capital per worker and output per worker will decline as
a result of a reduction in TFP. To see this, shift the production function and the saving per
worker curve downwards. The new equilibrium occurs at a lower level of capital per worker
and a lower level of output per worker. The level of capital per worker falls from (k/l)0 to
(k/l)1 and output per worker falls from (y/l)0 to (y/l)1.
14. What is growth accounting? Be specific and state or derive a relevant equation. What
did Krugman and Young find when he examined the growth performance of the East Asian
Tiger economies?
Growth accounting is the process of attributing increases in output to increases in
technology and factor inputs.
The growth accounting equation:
𝑟𝐾
𝑤𝐿
¯+
𝑌¬ = 𝐴- +
𝐾
𝐿¬
𝑓(𝐾, 𝐿)
𝑓(𝐾, 𝐿)
Krugman and Young discussed how the increase in output in East Asian Tiger economies is
due in large part to accumulation of capital stock.
15a. Consider the nation of Krugmania that is initially in a steady state equilibrium.
Assume that in this equilibrium it has a saving rate of 20 percent and a depreciation rate
of 2 percent. Further assume that the population in Krugmania is constant and that the
level of output produced in Krugmania can be represented by the following production
function:
𝒀 = 𝑨𝑲𝜶 𝑳𝟏F𝜶
where A = 1 and α = 0.5. Use the Solow-Swan model to determine the level of capital per
worker and output per worker in Krugmania
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Our equilibrium features θA(K/L) α = δK/L. Substituting in values, we find K/L = 100 and Y/L =
10.
b. Now, suppose the level of total factor productivity in Krugmania increases by 20
percent. What is the new steady state level of capital per worker and output per worker?
With the higher level of productivity, we find K/L = 144 and Y /L = 12∗1.2 = 14.4
c. Show the qualitative effects of this increase in total factor productivity upon steady
state output per worker and capital per worker. Briefly, describe the intuition behind this
result
-
comparative statics showing a shift in output per worker and saving per worker
curves
an equilibrium increases in steady state output per worker and capital per worker.
As productivity increases there is an increase in output per worker and part of this
increase is saved, leading to an increase in steady state capital per worker
d. Suppose an economist examines the growth performance of Krugmania following the
increase in total factor productivity, described in part (b), by using a growth accounting
method. Describe what a growth accounting analysis would reveal. Briefly discuss how
this is related to the growth accounting results of Krugman and Young discussed in part a
An economist would find that some of the increase in output is attributed to changes in
technology and some of the increase in output is attributed to changes in capital stock. But
the underlying cause of the increase in output is changes in technology
LECTURE 9: International Trade
MULTIPLE-CHOICE QUESTIONS
1a. The following table shows the number of minutes it takes to produce one unit of each
good. There are two workers in the economy Julia and Tim, each work 8 hours per day.
SHIRT
HAT
Julia
60
120
Tim
30
90
Which of the following statement is true?
a) Julia has a comparative advantage in producing hats and Tim has a comparative
advantage in producing shirts, but Tim has the absolute advantage in both goods
b) Julia has a comparative advantage in producing shirts and Tim has a comparative
advantage in producing hats, but Tim has the absolute advantage in both goods.
c) Julia has a comparative advantage in producing hats and Tim has a comparative
advantage in producing shirts, but Julia has the absolute advantage in both goods.
d) Julia has a comparative advantage in producing hats and Tim has a comparative
advantage in producing shirts, but Tim has an absolute advantage in hats and Julia has an
absolute advantage in shirts.
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1b. Given the information in question 4 at what prices would Julia and Tim both be happy
to trade with each other?
a) They will not trade as there is no gains from trade for Tim as he has absolute advantage in
producing both shirts and hats.
b) If the price of one shirt is 0.2 hats, then Tim will sell shirts to Julia in exchange for hats
c) If the price of one shirt is 0.4 hats, then Tim will sell shirts to Julia in exchange for hats
d) If the price of one shirt is 0.5 hats, then Julia will sell shirts to Tim in exchange for hats
2. Number of minutes to produce one unit of good. Assume an 8-house day for both
workers.
Beer
Nuts
Elaine
10
15
Jerry
15
30
_______________ has the absolute advantage in producing nuts and _______________has
the comparative advantage in producing nuts.
a) Elaine, Elaine
b) Elaine, Jerry
c) Jerry, Elaine
d) Jerry, Jerry
3. Refer to Table 1 below. It describes the time in minutes required for George and Jerry
to
produce one unit of Good A and Good B. George and Jerry each have 120 minutes to
dedicate to production.
Table 1: Time to produce each good
Good A
Good B
George
15
12
Jerry
10
6
Which of the following statements is false?
a) The total amount of Good A that George and Jerry can produce given their time
constraints is 20 units.
b) The total amount of Good B that George and Jerry can produce given their time
constraints is 30 units.
c) Jerry has a comparative advantage in producing Good B
d) George has a comparative advantage in producing Good B
4. Suppose Buranda produces and consumes agricultural and manufacturing products and
has a comparative advantage in producing agricultural products relative to the rest of the
world. Assume that in trade equilibrium with the rest of the world Buranda is not fully
specialised. When trading with the rest of the world,
a) workers in both the agricultural and manufacturing sectors will benefit from trade
b) workers in the agricultural sector will benefit but workers in the manufacturing sector will
be harmed by trade
c) workers in the manufacturing sector will benefit but workers in the agricultural sector will
be harmed by trade
d) workers in both the agricultural and manufacturing sectors will be harmed by trade
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5. Table 1: Number of minutes to produce one unit of a good. Assume an 8-hour day for
both workers
Beer
Nuts
Elaine
10
15
Jerry
15
30
________has the absolute advantage in producing nuts and______ has the comparative
advantage in producing nuts.
a) Elaine, Elaine
b) Elaine, Jerry
c) Jerry, Elaine
d) Jerry, Jerry
6. Suppose there is an increase in demand by Australians for goods produced overseas. In
equilibrium we should see a(n)________in the quantity of funds traded on the foreign
exchange market and a(n)__________ in the value of the Australian dollar.
a) decrease, decrease
b) decrease, increase
c) increase, decrease
d) increase, increase
7. Suppose Buranda produces cabbages and potatoes. In autarky in Buranda, one cabbage
is traded for 2.5 potatoes. Further, assume that Caristan also produces cabbages and
potates and in autarky one cabbage is traded for 4 potatoes. If Buranda and Caristan trade
with each other, we can expect
a) Buranda to export cabbages and the price of one cabbage to be more than 4 potatoes in
the trade equilibrium.
b) Buranda to export cabbages and the price of one cabbage to be less than 4 potatoes in
the trade equilibrium.
c) Buranda to export potatoes and the price of one potato to be less than 2.5 cabbages in
the trade equilibrium.
d) Buranda to export potatoes and the price of one potato to be more than 2.5 cabbages in
the trade equilibrium.
8. Table 1 describes the minutes required for Ben and Jerry to produce one unit of vanilla
ice cream and one unit of chocolate ice cream. Ben and Jerry both work 2 hours per day.
Vanilla
Chocolate
Ben
8
6
Jerry
15
9
Which of the following statements is false?
a) the total amount of vanilla ice cream they can produce given time constraints is 23 units
b) the total amount of chocolate ice cream that they can produce given time constraints is
33.33 units
c) Jerry has a comparative advantage in producing chocolate ice cream
d) Ben has a comparative advantage in producing chocolate ice cream
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9. An economy has two workers, Albo and Scomo. Every day they work, Albo can produce
24 shoes or 24 pants, and Scomo can produce 24 shoes or 12 pants. Suppose that the
market price of pants is 5 shoes per pant. What goods do Albo and Scomo produce?
a) shoes by Albo; shoes by Scomo
b) pants by Albo; pants by Scomo
c) pants by Albo; shoes by Scomo
d) pants by Albo; shoes by Scomo
10. An economy has two workers, Paula and Ricardo. Every day they work, Paula can
produce 8 computers or 16 shirts, and Ricardo can produce 4 computers or 12 shirts. Who
has the comparative advantage for computers and shirts?
a) Paula for computers; Paula for shirts
b) Paula for computers; Ricardo for shirts
c) Ricardo for computers; Paula for shirts
d) Ricardo for computers; Ricardo for shirts
11. Suppose Melbourneville is involved in a trade war. This reduces both imports into
Melbourneville and exports from Melbourneville to the rest of the world. This will _____
the quantity of transactions on the foreign exchange market and cause the Melbourneville
dollar to ______
a) decrease, depreciate
b) decrease, appreciate
c) increase, appreciate
d) unable to determine without further information
SHORT ANSWER QUESTIONS
1. Suppose Bill and Scott are both capable of producing beer and soda. Assume the
following table describes the number of minutes that it takes for each person to produce
each product.
Beer
Soda
Bill
30
15
Scott
60
30
a. What is Bill’s opportunity cost for producing beer? Soda? What about Scott’s?
-
Bill produces a beer in 30 minutes. In that time, he could produce two sodas.
o Hence, the opportunity cost of one beer is two sodas
Equivalently, the opportunity cost of producing one soda is 0.5 beers for Bill
Scott produces a beer in 60 minutes. In that time, he could produce two sodas
o Hence, the opportunity cost on one beer is two sodas
Equivalently, the opportunity cost of producing one soda is 0.5 beers for Scott
b. Are there possible gains from trade in this setting? Explain why or why not?
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-
-
In this case, the opportunity cost of production is exactly the same. As a result, they
are unable to improve productive efficiency via specialisation and there are no gains
from trade available
The only price they would both produce beer if its price was more than two sodas.
They would both produce soda if the price of beer was more than two sodas.
Since the opportunity cost of production is equal, they are unable to realise any
gains from trade
c. Moving to international trade, do you think countries are more likely to gain from
trading with nations with similar characteristics or by trading with nations that have very
different characteristics?
This suggests that countries gain from trade by trading with partners who differ from them.
This allows them to specialise in goods that their partners are less productive in producing
and this allows for greater gains. If countries are identical, then their opportunity cost of
production will be similar, and it will be difficult to realise gains from trade
2. What determines the direction of trade? Do all individuals typically gain when an
economy opens up to trade? Explain your answer.
The direction of trade in an economy is driven by comparative advantage. Comparative
advantage is the idea that some countries have a lower opportunity cost of producing a
particular good or service. So, international trade theory is based on the idea that countries
will produce the goods or services in which they have a lower opportunity cost of producing
and export these goods to the rest of the world. In exchange, countries will import goods or
services in which the opportunity cost of production is relatively high. Trade with the world
economy generally alters prices and these changes in prices can either increase or decrease
welfare of individuals in different sectors of society. If workers are employed in a sector in
which prices rise as goods are exported to the rest of the world, they will typically
experience wage gains and be better off. On the other hand, workers in sectors in which
imports increase will typically see the price of the product they produce fall. This can lead to
a decline in wages and workers being left worse off.
3. Suppose Australia and Bartovia produce only apples and bananas. In autarky, Australia
has a comparative advantage in producing apples. Suppose Australia and Bartovia enter a
free trade agreement. Which product will each country export? What will happen to the
relative price of apples in terms of bananas in Australia in our free trade equilibrium?
What will happen to the relative price of apples in terms of bananas in Bartovia in our free
trade equilibrium? Within the Australian economy, will allowing free trade with Bartovia
necessarily imply that everyone is better off? Explain your reasoning.
Australia will export apples and Bartovia will export bananas. The fact that Australia has a
comparative advantage in producing apples implies that they have a lower opportunity cost
in producing apples. As a result, Australia will tend to export apples to Bartovia. In
exchange, Bartovia will export bananas to Australia. In autarky, this implies that the price of
apples in terms of bananas is low in Australia and high in Bartovia. In a trade equilibrium we
will find a situation in which there is a single world price that equates global supply and
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demand. This price must lie between the autarky prices of the low price in Australia (that
exports apples) and the high price in Bartovia (that imports apples). This implies that the
price of apples must rise in Australia.
There are some individuals within the Australian economy that specialise in producing
bananas. If these individuals continue producing bananas in trade equilibrium then there
will be a decline in their real income and they will be worse off as a result.
4. Why do economists typically view trade as beneficial to all countries involved? In your
answer, explain what are the gains to a country that trades with other nations. Is it
necessarily the case that all individuals within a country are made better off as a result of
trade with other countries? Explain your reasoning.
Trade allows countries to specialise in production so that the most efficient country
with the lowest opportunity cost of production can produce particular goods or services.
This raises the level of production efficiency in a global economy and implies that a greater
amount of output is produced. This raises the possibility that all nations are able to gain
from trade. However, some individuals are potentially worse off since changes in relative
prices can reduce the wage income that they are paid.
LECTURE 10: International Trade and Exchange Rate
MULTIPLE-CHOICE QUESTIONS
1. Consider each of the following situations and state what would be the likely effect on
the value of the Australian dollar, all else being equal?
(i) European computer firms switch from software produced in Australia to software
produced outside of Australia.
(ii) The Australian government imposes a large tariff on imported automobiles that
reduces the expenditure on automobiles.
(iii) Australian shares are perceived as becoming riskier.
(iv) Australian consumers increase their spending on imported goods.
a) (i), (iii), (iv) would cause an appreciation of the Australian dollar
b) (i), (ii), (iii) would cause a depreciation of the Australian dollar
c) (i), (ii), (iv) would cause an appreciation of the Australian dollar
d) (i), (iii), (iv) would cause a depreciation of the Australian dollar
2. The theory of Purchasing Power Parity suggests that if inflation in Australia is higher
than inflation in China, then the value of the Australian dollar should ____ relative to the
Chinese Yuan.
a) appreciate
b) depreciate
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3. Two countries A and B have supply and demand curves for a product as follows, where
Pw represents world price and PA and PB represents autarky prices in country A and B
respectively.
Which of the following is not true?
a) Country A will import the product as PA > Pw
b) Country B will export the product as PB < Pw
c) Both countries will gain from trade as PA > Pw> PB
d) Country A is better off not trading as PA > Pw
4. Using the same information in Question 2, which of the following is true?
a) In a trade equilibrium, the price in each country must be the same and the world demand
for the good must equal the world supply for the good.
b) In a trade equilibrium, consumer surplus in A will be lower and in B will be higher than in
autarky situation.
c) In a trade equilibrium, producer surplus in A will be higher and in B will be lower than in
autarky situation.
d) In a trade equilibrium, the total quantity traded in both countries will be greater than the
autarky equilibrium total quantity traded.
5. According to the theory of purchasing power parity, in a country with low inflation,
a) nominal exchange rate will depreciate in response to its relatively low rate of inflation
b) real exchange rate will adjust in response to inflation differentials.
c) nominal exchange rate will adjust in response to inflation differentials so that the value of
the real exchange rate is always one.
d) has no effect on the nominal or real exchange rate whatsoever
6. In the context of purchasing power parity which of the following statement is not true?
a) prices (in a common currency) for traded goods should be equalised across countries as
long as transport costs are small.
b) the PPP theory is only true in the short run
c) prices for traded goods may differ if there is some non-traded component.
d) PPP theory is based on the law of one price holding in different countries
7. According to the Theory of Absolute Purchasing Power Parity, if the Australian
exchange rate depreciates relative to the US dollar then:
a) inflation in Australia must be higher than inflation in the United States.
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8. If the real exchange rate in Australia appreciates, then
a) the nominal exchange rate in Australia must also be appreciating
b) the rate of domestic inflation in Australia must be greater than the rate of inflation
overseas
c) the price of goods and services in Australia must be becoming relatively more expensive
than the price of goods and services overseas
d) none of the above
9. According to the trilemma, which of the following is a potential cost of adopting a
flexible exchange rate regime?
a) A country may have to restrict the size of capital flows.
b) A country may suffer from a volatile exchange rate.
c) A country loses the ability to conduct independent monetary policy.
d) None of the above
10. Australia is a country with a freely floating exchange rate. Suppose the current
account deficit becomes larger. This means that at the same time,
a) the value of capital outflow must increase.
b) the value of net exports must increase.
c) the capital account surplus must decrease in size.
d) none of the above.
SHORT ANSWER QUESTIONS
1. One of the important events in world trade in recent years has been the escalation of a
trade war between the USA and China. This trade war has increased tariffs in both the
USA and in China. For concreteness, let’s consider what happens to welfare in the USA
economy from the USA imposing tariffs on Chinese goods. Are there any individuals that
gain from the imposition of tariffs? If so, identify these individuals and explain why. Are
there any individuals that lose from the imposition of tariffs? If so, identify these
individuals and explain why. On aggregate, economists advocate that trade is welfare
improving. If that is the case, why would politicians such as Trump advocate a policy that
damages the economy and why would voters support such a politician?
The imposition of tariffs is a way of reducing the degree of trade integration. There are
aggregate welfare gains from trade, but some people tend to lose form trade. By reducing
trade there are aggregate welfare losses but some people benefit from reduced trade.
Individuals welfare depends upon the way they receive. With competitive markets, the
nominal wage rate for a worker producing good k, is given by PkMPL,k. That is, the nominal
wage is the price multiplied by the marginal product of labour. Moving from autarky to
trade changes the prices in different sectors. Similarly, moving from a situation with free
trade to one that is restricted by tariffs will also alter prices.
In this case, tariffs on imports will raise the price of goods that are imported into the
economy. This will help people involved in the production process of this good. To see this
recall that PmMPL,m, where subscript m represents the import sector and imposing tariffs will
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raise Pm. There are also losers as a result of the increase in tariffs. Most notably, the
customers who purchase the product tend to lose as a result of the higher prices.
There are a couple of potential explanations for why tariffs are popular among the public
and why politicians support tariffs.
- The gains from trade tend to be very dispersed among the whole population,
however the costs of trade tend to be very concentrated among a relatively small
number of people
- Many people are unaware of the economic costs of tariffs due to poor
communication by economists
2. In many developed economies there has been an increase in wage inequality. In the last
few decades, workers with a high level of skills have experienced larger increases in wages
than workers who are less skilled.
a. One explanation for the rise in wage inequality focuses upon the role of international
trade and the integration of some large developing economies into the global economy.
Suppose that these large developing economies have a comparative advantage in
products that require unskilled labour. Explain how this will affect the wage differential
between skilled and unskilled workers.
Here, we think of developing economies as having a comparative advantage in production
of goods that require low skill while developed economies have a comparative advantage in
the production of goods that require a relatively high skill level. This follows from the
observation that individuals in developed economies devote a greater amount of their time
to education that we would typically think as of increasing skills.
The theory of international trade suggests that in developed economies (with comparative
advantage in goods requiring high skill), the price of these goods requiring skill to produce
should increase and the wages that are associated with workers that produce these goods
should also increase. Conversely, developed countries will import goods from developing
countries that are intensive in low skill workers. This will typically reduce the price of these
goods and reduce the wages of people who produce these low skilled goods in developed
countries.
b. What other explanations do you think could plausibly explain why the wages of high
skilled workers have increased by a large amount relative to unskilled workers?
The other common explanation for the increase in the college-high wage gap is that
technological change has complemented the abilities of high skilled workers and been a
substitute for the abilities of low skilled workers. We could also think of this in terms of the
competitive labour markets. Technological changes increase the marginal product of skilled
workers and decrease the marginal product of less skilled workers.
3. The following graph shows data on the average price of commodities (i.e., primary
goods that Australia exports) and an index of Australia’s trade weighted nominal
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exchange rate ($A/foreign currency).
Explain why we may expect to see a
positive relationship between
commodity prices and the Australian
trade weighted exchange rate? If
anything, the TWI exchange rate leads
commodity prices. That is movements
in the exchange rate occur prior to
movements in commodity prices. Why
do you think that may occur?
One of the major Australian exports
are commodities and the price of
commodities proxies, at least partly, for the demand for these commodities. An increase in
the demand for commodities will be associated with an increase in demand for the AUD as
international sector will seek to import more goods produced in Australia.
Commodity prices are probably at least partly predictable based upon forecasts of world
economic growth. During periods of high global growth, there is an increased demand for
resources, and this leads to higher commodity prices.
Also, the AUD is a financial asset price. If people predict that the price of a financial asset
will rise in the future then there will be an incentive to purchase the asset today to achieve
some capital gain from the increase in price. Applied to exchange rates, if people believe the
AUD will become more variable in the future due to higher predicted commodity prices,
they will increase demand for the AUD today to try and achieve some profit from future
AUD appreciation.
4. Explain the difference between absolute purchasing power parity and relative
purchasing power parity. What is the underlying rationale for why purchasing power
parity may hold in the long run?
Absolute purchasing power parity suggests that the ratio of prices indices between two
countries measured in the same currency should tend or be equal to one. Relative
purchasing power parity suggests that the ratio of price indices between two countries
measured in the same currency should remain relatively constant over time. In the first
case, the prices of bundles of goods are similar across countries when measured in the same
country. In the second case, the prices of bundles of goods can be different but the changes
in the price of a bundle of goods should be similar in percentage terms when measured in
the same currency. The underlying rationale for purchasing power parity is the idea that
some version of the Law of One Price holds. This is motivated by the idea that producers
wish to send output to regions of the world in which the price of this product is relatively
expensive and away from regions of the world in which the product price is relatively cheap.
This increases supply and reduces prices in expensive parts of the world and reduces supply
and raises prices in parts of the world that are expensive.
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5. What is the theory of Purchasing Power Parity? What is the rationale for this theory?
Discuss reasons for why Purchasing Power Parity may not hold in reality.
The theory of PPP states that prices across countries should be the same (absolute PPP) or
should move together (relative PPP). The basic idea behind PPP is arbitrage implies that
producers will sell their goods in regions that offer the highest price. This activity will imply
that prices should move together. If goods become more expensive in a particular region,
imports into this area will decrease and supply to more expensive areas will increase. These
changes in supply patterns will tend to reduce price differences between regions as
producers seek to sell their products in the most profitable regions.
PPP may not hold in reality due to (i) transportation costs, (ii) the presence of non-traded
goods and (iii) imperfect competition or market power may vary between economies or
over time. All of these are reasons for why price differences between goods will not tend to
disappear over time. If it is expensive to transport goods to an area, then some price
differences will remain. If some goods are non-traded, then price differences will remain.
And if there are differences in competition between regions, then price differences may
persist.
6. Describe the theory of Absolute Purchasing Power Parity. What is the rationale for this
theory? What are some of the possible explanations for the failure of this theory in
reality?
The theory of Absolute Purchasing Power Parity states that
𝑃
𝑒× =1
𝑃Q
where P is the domestic price level in domestic currency, Pf is the foreign price level
in foreign currency and e is the value of the domestic currency, using an indirect quote.
That is, how many units of the foreign currency may be purchased with one unit of
domestic currency. Hence eP is the foreign currency price of purchasing a bundle of
goods in the domestic economy.
The theory of Absolute PPP argues that firms will have an incentive to sell their goods
in the region in which prices (in a common currency) are highest. By moving goods to
regions with high prices, it lowers the price in that region and tends to raise the
price in low-cost areas.
There are a number of reasons why this story fails. One prominent story is transport
costs are high or non-traded goods exist. This generates a wedge in prices between
economies that cannot be arbitraged away. Other possible reasons are i) goods may be
non-standardised or ii) different economies may have different levels of competition.
7. Consider a country that adopts a fixed exchange rate regime. What are the potential
benefits of adopting a fixed exchange rate regime? What are the potential costs of
adopting a fixed exchange rate regime?
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The benefit of introducing a fixed exchange rate is that it reduces the volatility in exchange
rate movements. This makes it easier for trade and financial flows to occur. The negative is
that it means that countries lose some independence of their own monetary policy or that
countries have to restrict financial flows.
LECTURE 11: Exchange Rate and Balance of Payments
MULTIPLE-CHOICE QUESTIONS
1. An increase in the interest rate tends to lead to an appreciation of the domestic
currency due to
a) increase in demand for domestic financial assets by foreigners
b) increase in demand for imports
c) increase in demand for international financial assets by domestic individuals
d) all of the above
2. The Monetary policy trilemma refers to the situation where an economy cannot
simultaneously have
a) independent monetary policy and free capital flows
b) independent monetary policy and a stable exchange rate
c) a stable exchange rate and free capital flows
d) none of the above
3. If the government seeks to maintain a fixed exchange rate at a value above the market
equilibrium
a) it needs to increase the demand for the domestic currency
b) it needs to decrease the demand for the domestic currency
c) it needs to have independent monetary policy and free capital flows
d) its needs to lower interest rates to encourage demand for domestic financial assets by
foreigners
4. The benefits of adopting a flexible exchange rate is that,
a) the exchange rate can be more volatile
b) changes in the interest rate will have no effect on the exchange rate that is determined in
the foreign exchange market
c) in response to shocks to the demand for Australian exports, the value of the currency
would adjust to moderate these effects
d) an economy will be able to well predict the prices of exports and imports
5. Which of the following will not be included in current account balance?
a) The balance of merchandise trade
b) The value of net services of exports and imports
c) The value of net capital inflow
d) The value of net interest income, dividends and labour income
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6. Given the supply and demand model of exchange rate determination, which of the
following will not increase the supply of Australian dollars in the foreign exchange
market?
a) An increase in Australian interest rates relative to foreign interest rates.
b) An increase in foreign interest rates relative to Australian interest rates.
c) An increase in prices in Australia, relative to foreign prices.
d) An increased preference for foreign goods.
7. In an open economy if imports exceed exports, then it must be the case that
a) national saving is greater than investment
b) national saving is less than investment
c) the nominal exchange rate is depreciating
d) the nominal exchange rate is appreciating
8. In an open economy, if the level of net exports rises, it must be the case that
a) there is an increase in saving.
b) there is an increase in investment.
c) the value of saving less investment must fall.
d) none of the above
9. If national saving is less than investment, then
a) exports must be greater than imports
b) the government budget must be in deficit
c) exports must be less than imports
d) inflation must be decreasing
10. If the real exchange rate in Australia appreciates, then
a) the nominal exchange rate in Australia must also be appreciating
b) the rate of domestic inflation in Australia must be greater than the rate of inflation
overseas
c) the price of goods and services in Australia must be becoming relatively more expensive
than the price of goods and services overseas
d) none of the above
11. Suppose a government decides to implement a fixed exchange rate with the value of
domestic currency above its equilibrium value. Further, assume that it does not restrict
capital flows. In that case, we would expect
a) a decrease in foreign currency reserves held by the government
b) an increase in foreign currency reserves held by the government
c) a high level of inflation in the domestic economy
d) a low level of cyclical unemployment
12. Suppose Buranda produces and consumes agricultural and manufacturing products
and has a comparative advantage in producing agricultural products relative to the rest of
the world. Assume that in trade equilibrium with the rest of the world Buranda is not fully
specialised. When trading with the rest of the world,
a) workers in both the agricultural and manufacturing sectors will benefit from trade
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b) workers in the agricultural sector will benefit but workers in the manufacturing sector will
be harmed by trade
c) workers in the manufacturing sector will benefit but workers in the agricultural sector will
be harmed by trade
d) workers in both the agricultural and manufacturing sectors will be harmed by trade
13. Suppose that the countries of Borduria and Syldavia only produce durian and spinach.
Initially, Borduria exports durian to the country of Syldavia. In return, Syldavia exports
spinach to Borduria. Now suppose a trade war takes place and all trade between these
two countries is completely stopped. We would expect, as a result of the trade war, that
a) the price of durian would rise in Borduria and the price of spinach in Syldavia would also
rise.
b) the price of durian would fall in Borduria and the price of spinach in Syldavia would also
fall.
c) the price of durian would fall in Borduria and the price of spinach in Syldavia would rise.
d) none of the above.
14. Suppose there is an increase in demand for goods and services produced in Australia
by consumers in foreign countries. We would expect the quantity of transactions involving
the Australian dollar on the foreign exchange market to and the Australian dollar to.
a) increase, appreciate
b) increase, depreciate
c) decrease, appreciate
d) decrease, depreciate
15. The equations for the demand for and supply of a currency named the ‘Real’ in the
foreign exchange market is
Demand = 40 – 5e
Supply = 20 + 15e
where the nominal exchange rate (e) is expressed as Dollars per Real. If the value of the
Real is fixed at 1.30 Dollars then we would say that the Real was:
a) undervalued
b) overvalued
c) neither undervalued nor overvalued
d) none of the above
16. Imagine only two countries (Country A whose currency is ‘Dollars’ and country B
whose currency is ‘Marks’) in the world. Both currencies are floating freely in foreign
exchange markets. The rate of inflation in A is +10% pa and it is +5% pa in country B. If we
treat country A as the ‘home country’ and PPP holds what will happen to its real exchange
rate? a) it will rise by 5%
b) it will fall by 5%
c) it will fall by 15%
d) it will be unchanged
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17. Suppose some new products are developed overseas. If Australian consumers, as a
result, increase demand for goods produced overseas, we would expect the quantity of
transactions on the foreign exchange market to _____and the Australian dollar to______.
a) increase, appreciate
b) increase, depreciate
c) decrease, appreciate
d) decrease, depreciate
18. Suppose there is an increase in demand for goods and services produced in Australia
by consumers in foreign countries. We would expect the quantity of transactions involving
the Australian dollar on the foreign exchange market to_______ and the Australian dollar
to_______ .
a) increase, appreciate
b) increase, depreciate
c) decrease, appreciate
d) decrease, depreciate
SHORT ANSWER QUESTIONS
1a. Compare and contrast fixed and flexible exchange rates. Discuss the short-run and
long-run determination of the exchange rate in both cases.
Flexible exchange rate: an exchange rate whose value is not officially fixed, but varies
according to the supply and demand for the currency in the foreign exchange market
- Supply of dollars: determinants
- Demand for dollars: determinants
- Equilibrium value of the dollar
- Changes in supply and demand
Fixed exchange rate: an exchange rate whose value is set by official government policy
- Determination of fixed exchange rate
- Equilibrium value of the dollar
- Changes in supply and demand
b. To achieve a particular monetary policy outcome, what is more favourable to have – a
flexible exchange rate or a fixed exchange rate regime? Explain.
Flexible exchange rate: can’t predict future
- Effect of monetary policy on exchange rates, this generates a capital inflow into
Australian economy as assets become more attractive. That capital inflow requires
people to purchase the Australian dollar which generates an appreciation of the
exchange rate
- Exchange rate affects the price of imports and exports. When appreciated exchange
rate, imports increase, and exports decrease
Benefits and costs of fixed exchange rate:
Benefits of a fixed exchange rate:
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-
Can provide discipline to monetary policy to prevent inflation
May encourage cross-border financial or trade flows since fixed exchange rate
provides certainty in economic transactions
Costs of a fixed exchange rate
- Loss of monetary independence – lack of control over interest rates
- Loss of free capital flows
c. In the context of balance of payment theory, if national saving is less than domestic
invest demand what would you expect for the domestic trade balance? What would be the
nature of capital flow and which type of exchange rate will ensure the balance of payment is
balanced.
2. During the last decade, the debt crisis in Europe has meant that many people have
sought to invest funds in Swiss banks and other Swiss investments. Use a supply and
demand framework to describe the effect of the debt crisis on the value of the Swiss
franc. What effect will this change in the value of the Swiss franc have upon the real
economy? Suppose the Swiss central bank wanted to limit the macroeconomic effects of
this change in the value of the currency. Explain what actions the central bank could
undertake to reduce any negative macroeconomic effects.
ON DIAGRAM:
- An increase in the demand for Swiss Francs leading to an appreciation of the Swiss
exchange rate
o The demand curve shits out as foreigners have a greater desire to invest in
Switzerland and the supply curve shifts inwards as people within Switzerland
have a reduced demand for assets overseas
o The net effect is an appreciation of the Swiss Franc
o The effect on the quantity traded is ambiguous
IN WORDS – WHAT THE CENTRAL BANK COULD DO:
The macroeconomic effect of this appreciation is to make goods produced in Switzerland
relatively more expensive and goods produced in foreign countries relatively cheap.
Standard substitution implies that exports will decline, and imports increase. The standard
effect on the macroeconomy will be to reduce output and inflation. There are a number of
responses that the Swiss government could do to try and limit the negative consequences
upon output.
1. The Swiss government can try and reduce the negative impact of an appreciation by
selling Swiss currency in foreign exchange markets. This will reduce the value of the
currency and limit the effects discussed above.
2. The Swiss government could try and reduce interest rates. This will have the standard
macroeconomic effects of increasing consumption and investment. It could also reduce
the value of the exchange rate and limit the negative effects discussed above.
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3. Australia moved from a fixed exchange rate system to a flexible exchange rate system in
the early 1980s. What have been some of the benefits of adopting such a system? What
have been some of the costs of adopting such a system? Answer by discussing the trilemma
associated with international macroeconomic policy.
The flexible exchange rate system has made it easier for the RBA to operate monetary
policy. This has occurred for two reasons. 1) The response to changes in interest rates, has
been supported by movements in the exchange rate. As an example, if the RBA wants to
reduce economic activity it raises the interest rate, and this lowers household and firm
planned aggregate expenditure. At the same time, a rise in the real interest rate encourages
investors to purchase domestic assets that offer a higher relative rate of return. This causes
the exchange rate to appreciate. This appreciation reduces the value of exports into the
economy and raises the value of imports as international goods become relatively cheaper
and domestic goods more expensive.
The second effect of the exchange rate is that natural adjustments in the exchange rate
tend to moderate business cycle fluctuations. For example, during the Asian Financial Crisis
the value of the Australian dollar depreciated as people viewed Australia as a less attractive
region to invest in due to its connection with the Asian region that was going through a
recession. The depreciation in the Australian dollar reduced the price of Australian goods in
other markets and helped moderate the fall in Australian exports in response to the Asian
financial crisis. The converse has happened during periods such as the mining boom in
which in response to high demand for Australian exports, there was an appreciation of the
Australian dollar that moderated the increase in demand for our exports as goods became
more expensive on international markets.
The cost of adopting the flexible exchange rate is that the exchange rate has itself become
more volatile. That is, there are large fluctuations in the value of the exchange rate and this
fluctuations can increase the risk of transactions between Australia and the rest of the
world. This volatility may inhibit either trade or financials flows. This is related to the
trilemma in the following sense. The trilemma states that countries have a number of goals
that they would like policy to achieve:
1. A stable exchange rate
2. Independent monetary policy
3. Free capital flows
An economy with a flexible exchange rate can achieve goals 2 and 3 but typically has to face
volatility in the exchange rate.
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