Answers to the sample exam
Question B.1: State whether the following statements are true or
false.
•
Net exports are equal to GDP – (G + I + G)
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•
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•
Answer: False, the MPS is the change is savings divided by the change
in income.
Changes in government expenditure (G) and/or exports (X) can
result in an increase in GDP through the multiplier effect.
–
•
Answer: True, G and X are components of autonomous spending.
Changes in autonomous spending will give rise to a larger change in
GDP through the multiplier effect.
The unemployment rate is defined as the number of unemployed
divided by the total population.
–
•
Answer: False, the unemployment rate is defined as the number of
unemployed divided by the labour force.
The marginal propensity to consume is equal to 1 minus the
marginal propensity to save.
–
•
Answer: True, the marginal propensity to consume is the fraction of
each new $1 in income that consumers will devote to new consumption.
As the rest of the new $1 is saved, MPS = 1 – MPC.
A recessionary gap is the amount by which aggregate
expenditure exceeds the full employment level of GDP.
–
•
Answer: False, a recessionary gap is the amount by which aggregate
expenditure is short of full employment GDP.
Aggregate expenditure in a closed economy is equal to (C+I+G).
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•
Answer: True, in a closed economy, NX = 0, so the only components of
aggregate expenditure are C, I and G.
The aggregate demand curve shows the relationship between
real GDP and the price level.
–
•
Answer: True, the AD curve shows the relationship between aggregate
expenditure and the price level in an economy.
GDP excludes second-hand goods.
–
•
Answer: True, as in an open economy, Y = C + I + G + NX.
The marginal propensity to save (MPS) is the change in
consumption divided by the change in income.
Answer: True, as second-hand goods were goods produced in a
previous year. Only the services involved in the sale of the second-hand
goods are goods or services produced in this year.
The multiplier tells us that an increase in investment by $100m
will give rise to a smaller than $100m increase in GDP.
–
Answer: False, the multiplier is the factor by which investment will give
rise to a larger increase in GDP.
Question B. 2: Briefly explain the concept of a consumption function.
Explain how changes in net wealth and the price level alter the
consumption function.
–
Answer: A consumption function is the relation between consumer
spending and GDP in an economy. As net wealth rises, we would expect
consumers to consume more, so a rise in net wealth will raise
consumption spending for all levels of GDP- the consumption function
shifts up. A rise in the price level will lower (the real value of) net wealth
and so shift the consumption function down.
Question B.3: The reserve ratio for the banks is 25%. ABC Bank has
$20,000 in deposits and $12,000 in reserves. Assume all other
commercial banks are loaned up.
a) What is the value of ABC Bank’s excess liquidity?
–
Answer: The ABC Bank has $20,000 in deposits, so it must retain
$5,000 in reserves. So the bank has $7,000 in excess liquidity- reserves
over and above that required by law.
b) What is the value of the additional loans that can be made by the
commercial banking system?
– Answer: As we have assumed all other banks are loaned up, only the
ABC Bank’s loans matter. So the ABC bank can loan out the $7,000 in
excess cash it has.
c) What is the money multiplier?
– Answer: The money multiplier is 1/R = 1/0.25 = 4.
d) By how much will total deposits expand if this bank lends all its
excess reserves and there is no leakage from the banking system?
– Answer: Total deposits will expand by the money multiplier times the
excess cash of the ABC bank:
Change in total deposits = 4 x $7,000 = $28,000
Question B. 4: What adverse internal effects may follow
from:
a) a depreciation of the exchange rate and
– Answer: If the exchange rate depreciates, then the A$ becomes cheaper
relative to other currencies, so our exports become cheaper overseas and
foreign imports become more expensive here. There are many possible
detrimental internal effects:
• If Australian producers require a lot of foreign imports in production, this
means the cost of these foreign components rises
• If Australian debt is denominated in foreign currency, then the total value
of the foreign debt rises
• If the economy is already at full employment, a depreciation will increase
NX and so also shift the AD curve to the right. The economy will
experience a boom, and we will have inflation.
b) an appreciation of the exchange rate?
– Answer: If the exchange rate appreciates, then the A$ becomes more
expensive relative to other currencies, so our exports become more
expensive overseas and foreign imports become cheaper here. There are
some possible detrimental internal effects:
• Australian net exports will decline.
• If the economy is at full employment, an appreciation of the exchange
rate will lower NX and so shift the AD curve to the left. The economy will
experience a recession, and until prices and wages adjust, we will have
unemployment.
Question C.1:
a) Use the AD-AS model to compare the causes and policy
implications of (i) demand-pull and (ii) cost-push inflation in
both the short-run and the long-run.
– Answer: Assume we start with the economy at the natural rate of output
and unemployment. Demand-pull inflation is caused by shocks to
aggregate expenditure that push aggregate demand above aggregate
supply at current prices. Cost-push inflation is caused by price shocks that
push aggregate supply below aggregate demand at current prices.
The government can respond in one of two ways. It can manage the AD
curve through fiscal (spending and taxes) or monetary (interest rates)
policy. Or the government can simply do nothing and let the long-run
equilibrium forces in the economy return the economy back to the long-run
levels of output and unemployment.
Policy implications - demand-pull:
Demand-pull inflation- The AD (from AD0 to AD1) curve shifts right driving up
equilibrium Y and P. A rise in the price level equates to inflation in this model,
so the increase in AD (demand) leads to inflation.
AS
P
P1
P0
AD1
AD0
Y0
Y1
The government can respond by shifting the AD curve left through raising
taxes or lowering spending or raising interest rates. The AD curve shifts
back to AD0, and there is no inflation.
AS2
P
AS0
P2
P1
P0
AD1
AD0
Y0
Y1
The do-nothing option would mean that the boom in the short-run leads to
a rise in wages which shifts the AS curve up/left (from AS0 to AS2), so that
prices rise further (to P2). Doing nothing in response to demand-pull
inflation will lead to further inflation.
Policy implications- cost-push inflation:
Cost-push inflation- The AS (from AS0 to AS1) curve shifts left due to rising
production costs in the economy, driving output down and prices up. A
rise in the price level equates to inflation in this model, so the shift up in
AS (increase in costs) leads to inflation.
AS1
AS0
P
P1
P0
Y
AD0
Y1
Y0
The government can respond by shifting the AD curve left through
lowering taxes or raising spending or lowering interest rates. The AD
curve shifts right (from AD0 to AD2) to reduce unemployment and return
GDP to its natural rate.
However the demand management response by the government to lower
unemployment has actually increased inflation in the economy.
AS1
P
AS0
P2
P1
P0
AD2
AD0
Y1
Y0
The do-nothing option would mean that the recession in the short-run
leads to a fall in wages which shifts the AS curve down/right (from AS1
back to AS0), so that prices fall back to the original level (to P0). Doing
nothing in response to cost-push inflation ensures that there is no inflation,
however it may lead to a long period of high unemployment while the
economy adjusts.
AS1
AS0
P
P1
P0
AD0
Y1
Y0
b) In what way does the presence of cost-push inflation
make demand-management policy ineffective?
– Answer: Cost-push inflation makes demand-management policy
ineffective is the sense that the government response does not cancel
inflation. In fact, the government response of increasing spending after the
supply shock leads to more inflation. Demand-management makes the
inflation worse after a supply shock.
Question C. 2:
a) Define the crowding-out effect.
– Answer: In the long-run, the economy always returns to potential GDP.
The crowding-out effect for G is the idea that in the long-run, an increase in
G will come at the expense of other forms of aggregate expenditure.
A particular concern is that an increase in G might increase interest rates and
so reduce investment spending and so lower the long-run capital
accumulation and so growth in the economy. An increase in interest rates
will make the A$ more desirable for investors, appreciate the A$ and so
reduce net exports- another form of crowding out.
b) Is the crowding-out effect likely to be larger during a recession or
when the economy is near full employment? Use the AD-AS model
to substantiate your answer.
– Answer: The crowding-out effect will likely larger when the economy is
near full employment. During a recession, the economy is below potential
GDP, so an increase in G can be met by increasing output. However, as
output gets closer to potential output, as increase in G will result in higher
output and higher prices.
Draw a diagram based on the crowding-out diagrams earlier in this session.
Question C. 3:
a) Define unemployment.
– Answer: To be considered unemployed a person must be (1) not currently
employed and (2) actively looking for a job.
b) Outline the causes of frictional, structural and cyclical
unemployment.
– Answer: To be part of frictional unemployment, a person must have left a
job to search for a new job that betters matches their skills, career path, etc.
To be part of structural unemployment, a person must have left a job that
was eliminated because of changes in the structure of the economy- the
types of goods that we produce. To be part of cyclical unemployment, a
person must have left a job that was eliminated because the economy was
in a recession, but that will likely be added again after the economy returns
to potential GDP.
c) What are the main policies for dealing with each type of
unemployment?
– Answer: To reduce frictional unemployment, the government can reduce
the costs of job search or increase the speed at which job information flows
through the economy. To reduce structural unemployment, the government
can ease the transition of workers out of industries that are closing down
into existing or new industries. Often this will involve relocating and
retraining workers. To reduce cyclical unemployment, the government can
use demand-management policies to reduce the size and duration of
recessions.
Question C. 4:
a) What is the relationship between savings and investment?
Explain whether Australia is a high or low-saver economy.
– Answer: There is no necessary link between savings and investment in a
country, as the gap between I – S can be borrowed from overseas. This
borrowing will raise the level of foreign debt. Australia has a domestic
savings rate about equal to the rest of the developed world.
b) When is a country considered a ‘debtor’ or a ‘creditor’
country? Is Australia a net debtor or a creditor country to
the rest of the world? Explain.
– Answer: A country is considered a ‘debtor’ country if residents of the
country owe more to residents of foreign countries than residents of foreign
countries owe to them. If the reverse is true, the country is considered a
‘creditor’ country. Australia is a net debtor country to the rest of the world.
However recent government budget surpluses have been used to drive
down Australian public and foreign debt.