ECON 102 Tutorial: Week 22
Ayesha Ali
www.lancaster.ac.uk/postgrad/alia10/econ102.html
a.ali11@lancaster.ac.uk
office hours: 8:00AM – 8:50AM tuesdays LUMS C85
Today’s Outline
 Week 22 worksheet – Fiscal Deficits, Sovereign Debt and
Base Money
 Additional Slides at the end contain material from past
exams, and last year’ tutorial material – these might be
helpful for your revision, so I’ve included them.
 Exam 3 will be available for pick up at the end of class, if
you have not already collected it.
Question 1
What magnitudes were set by the Maastricht Treaty as maxima within
the Eurozone for the:
a) sovereign fiscal deficit ratio?
The ratio of the annual general government deficit relative to gross
domestic product (GDP) at market prices, must not exceed 3% at
the end of the preceding fiscal year and neither for any of the two
subsequent years.
b) sovereign debt-to-GDP ratio?
The ratio of gross government debt relative to GDP at market
prices, must not exceed 60% at the end of the preceding fiscal
year.
Note: To join the Eurozone, countries had to show fiscal responsibility (meaning their
government deficits and debt were under control). To do this, they basically had to meet
certain debt and deficit benchmarks for a certain amount of time before being able to join.
Joining the Eurozone meant that certain responsibilities of the country’s central bank are
replaced by the Eurozone central bank.
Question 2
What is the distinction between a narrow money aggregate and a
broad money aggregate?
Narrow money includes only the most liquid assets, the ones most
easily used to spend (currency, checkable deposits).
Broad money adds less liquid types of assets (certificates of deposit,
etc.).
Question 3
Sovereign debt is monetised if:
a)there is a fiscal deficit
b)the Treasury issues new bonds
c) the central bank buys sovereign bonds
d)all of the above
The process of financing government spending by selling government
bonds (sovereign bonds) to a central bank is called 'monetizing the debt'.
The central bank may purchase government bonds by conducting an
open market purchase, i.e. by increasing the monetary base through the
money creation process. If government bonds that have come due are
held by the central bank, the central bank will return any funds paid to it
back to the treasury. Thus, the treasury may 'borrow' money without
needing to repay it.
Question 4
Base money is also known as:
a)exogenous money
b)narrow money
c) outside money
d)all of the above
Base money is defined as notes and coins in circulation, in
bank vaults, and national bank reserve credit.
For this reason base money can also be called outside or
exogenous (they both mean the same thing) – these terms
refer to money that’s formed outside of the private banking
sector, that is just a physical unit of account (i.e. cash).
Because base money does not include other types of
money, it is also called narrow.
Question 5
Base money comprises:
a)banknotes
b)banknotes and bank reserves
c) banknotes, bank reserves and commercial bank
deposits
d)none of the above
The supply of base money is the monopoly of the central bank.
In tangible form it is Bank of England banknotes (in the UK).
More generally, it is now mostly made up of bank reserves (sometimes
called ‘electronic money’).
Together banknotes and reserves are base money (also called ‘narrow’
money, ‘outside’ money and ‘exogenous’ money)
When ‘credit money’ is added (starting with commercial bank deposits),
we move up the liquidity range where the various money aggregates are
called ‘broad money’)
Question 6(a-b)
At year zero
national income is £1000bn
base money is £10bn
sovereign debt is £500bn
In the fiscal year that follows
government expenditure is £50bn
tax revenue is £30bn
annual interest on sovereign debt is 3 pc
annual economic growth is 2 pc
Assume that interest is calculated on sovereign debt at the end of each fiscal year
a)What is magnitude of the primary fiscal deficit?
fiscal deficit = government expenditure – tax revenue
fiscal deficit = £50bn - £30bn
fiscal deficit = £20bn
b) What value of sovereign bonds must be sold by UK Treasury in order to finance
the primary fiscal deficit plus interest?
fiscal deficit + interest =
fiscal deficit + annual interest rate on debt*sovereign debt =
£20bn + 0.03(£500bn) = £35bn
(note: for the gov’t to say their budget is balanced, it must have no deficit and pay off
interest on any government bonds issued.)
Question 6(c-d)
At year zero
national income is £1000bn
base money is £10bn
sovereign debt is £500bn
In the fiscal year that follows
government expenditure is £50bn
tax revenue is £30bn
annual interest on sovereign debt is 3 pc
annual economic growth is 2 pc
Assume that interest is calculated on sovereign debt at the end of each fiscal year
c) If the Bank of England buys one-fifth of the sovereign bonds sold by the UK
Treasury (in part B), by how much does base money increase?
The bank monetizes 1/5 of the £35bn in bonds that the gov’t had to issue in part b.
So:
£35bn/5 = £7bn
d) How much annual interest does the Bank of England receive on the bonds it
holds (in part c)?
So, the bank lends £7bn to the gov’t. In return it gets interest of 3% on that money:
0.03(£7bn) = £0.21bn = £210 million
Question 6(e-f)
In the fiscal year that follows
government expenditure is £50bn
tax revenue is £30bn
annual interest on sovereign debt is 3 pc
annual economic growth is 2 pc
Assume that interest is calculated on sovereign debt at the end of each fiscal year
At year zero
national income is £1000bn
base money is £10bn
sovereign debt is £500bn
e) What happens to the interest received by the Bank of England?
It is returned to the Treasury as seigniorage.
f) What is seigniorage?
Seigniorage is a term that Prof. Steele likes to ask about. Make sure you check your
lecture notes to see how he defines it and what he says about it.
Seigniorage is the difference between the value of money and the cost to produce
it - in other words, the economic cost of producing a currency within a given
economy or country. Seigniorage may be counted as revenue for a government
when the money that is created is worth more than it costs to produce it; Prof
Steele’s definition: it is the monopoly profit received by the issuer of base money.
Question 6(g-i)
At year zero
national income is £1000bn
base money is £10bn
sovereign debt is £500bn
In the fiscal year that follows
government expenditure is £50bn
tax revenue is £30bn
annual interest on sovereign debt is 3 pc
annual economic growth is 2 pc
Assume that interest is calculated on sovereign debt at the end of each fiscal year
g) At the end of the fiscal year, what is the UK’s national income?
At the end of the year we use the annual economic growth rate to calculate NI
NI at year 1 = NI at year 0 *(1 + annual econ. growth rate)
NI at year 1 = £1000bn (1.02) = £1020bn
h) fiscal deficit to GDP ratio?
Fiscal deficit/GDP = £35bn/£1020bn = 0.034
i) debt-to-GDP ratio?
At the end of the year debt is year zero debt plus deficit, so:
debt at year 1 = £500bn + £35bn = £535bn
debt-to-GDP ratio at year 1 = £535bn/£1020bn = 0.525
Question 7
Solve the following equations for a
Keynesian model, and evaluate:
a) the interest rate (r):
b) real income (Y):
Y=C+I+G
𝐶 = 200 + 0.5 𝑌 − 𝑇
𝐼 = 600 − 50𝑟
𝐺 = 200
T = 0.2(Y)
𝐿 𝑟, 𝑌 = 𝑌 − 100𝑟
𝑀/𝑃 = 800
Check your answers here: http://www.lancs.ac.uk/staff/ecagrs/Kmodel.xlsx
Question 7
Solve the following equations for a
Keynesian model, and evaluate:
First, find the IS curve; plug into Y = C + I + G:
So: Y = 200 + 0.5(Y – 0.2 Y) + 600 - 50r + 200
Y = 1000 + 0.5Y – 0.1Y – 50r
Y = 1000 + 0.4Y – 50r
Y - 0.4Y = 1000 – 50r
0.6Y = 1000 – 50r
Y = 1667 – 83r
This is our IS Curve equation.
Y=C+I+G
𝐶 = 200 + 0.5 𝑌 − 𝑇
𝐼 = 600 − 50𝑟
𝐺 = 200
T = 0.2(Y)
𝐿 𝑟, 𝑌 = 𝑌 − 100𝑟
𝑀/𝑃 = 800
Next, find the LM Curve.
We know that Equilibrium in the money market gives the LM curve,
To get this equilibrium, set L(r,y) = M/P
So: Y – 100r = 800
Y = 800 + 100r
This is our LM Curve equation.
In equilibrium IS = LM, so
1667 – 83r = 800 + 100r
867 = 183r
r = 867/183 = 4.73
Question 7 ctd.
Use the above spreadsheet to give the following answers:
c) What is the fiscal deficit as a percentage of GDP?
G = 200, so what is tax revenue?
T = 0.2Y = 0.2*1273 = 254.6
So the government surplus is 254.6 – 200 = 54.6
As a percent of GDP we have 54.6 / 1273 = .04 = 4%
d) Assuming: (i) zero economic growth, and
(ii) a constant annual interest rate of 3%,
ascertain the sovereign-debt-to-GDP ratio after 5 years.
23%
e) If government expenditure is doubled (G = 400) and the income tax rate (t) halved
(T = 0.1Y), ascertain the magnitudes after 5 years of:
(i) the fiscal deficit as a percentage of GDP
16%
(ii) the sovereign-debt-to-GDP ratio?
89%
Next Class
 Schedule Change for Monday Tutorials Week 23:




T01/01 (M 4PM)
T01/02 (M 5PM)
T01/03 (M 6PM)
T01/34 (T 9AM)
→
→
→
→
Tuesday
Friday
Wednesday
Wednesday
2:00PM
3:00 PM
11:00 AM
9:00 AM
Fylde D31
Fylde D31
Fylde D31
Fylde D31
 Week 23 Worksheet: IS-LM and Aggregate Demand

Gerry Steele posts materials & slides on Moodle – use these to
help get through the tutorial worksheet.
Practice Past Exam Questions
(And Questions from Last Year’s
Tutorials)
Please Note: Solutions are not given to tutors for these
questions. The solutions I’ve prepared are only
suggestions only – I cannot guarantee they are correct.
UK National Debt comprises:
(a) the sum of trade deficits over past years
(b) sterling currency notes and coins in
circulation, plus commercial bank deposits
(c) outstanding loans to the state, excluding
sterling currency notes and coins in circulation
(d) outstanding loans to the state, including
sterling currency notes and coins in circulation
2012 Exam Q32
Problem From Last Year
This problem from last year is very similar to Q7, but is written up as a word problem.
See if you can solve it and check your answers against mine in the following slides.
You are given the following information about an economy:
autonomous consumption is £100 billion;
autonomous investment is £500 billion;
the marginal propensity to consume is 0.75;
the coefficient on interest in the marginal efficiency of investment function is 10;
the demand for money function takes the form: MD = 0.5Y – 15r, where Y is the
economy's real output and r is the interest rate expressed as a percentage;
and the real money supply is £850 billion.
Find the equilibrium interest rate (r) and the equilibrium income (Y).
Problem From Last Year
You are given the following information about an economy:
2013/2014
autonomous consumption is £100 billion;
Week 18
autonomous investment is £500 billion;
the marginal propensity to consume is 0.75;
the coefficient on interest in the marginal efficiency of investment function is 10;
the demand for money function takes the form: MD = 0.5Y – 15r, where Y is the
economy's real output and r is the interest rate expressed as a percentage;
and the real money supply is £850 billion.
Find the equations of the IS curve
In the product market, equilibrium occurs when Y = C + I and so:
Note: The coefficient on r is negative here because the lower the
C = 100 + 0.75Y
interst rate, the cheaper it is to invest, so investment will increase.
I = 500 -10r
There is an inverse relationship between the two.
We can plug these in to Y = C + I
Y = 100 + 0.75Y + 500 – 10r
0.25Y = 600 -10r
Y = 2400 – 40r
This is equation of the IS curve.
Problem From Last Year
You are given the following information about an economy:
2013/2014
autonomous consumption is £100 billion;
Week 18
autonomous investment is £500 billion;
the marginal propensity to consume is 0.75;
the coefficient on interest in the marginal efficiency of investment function is 10;
the demand for money function takes the form: MD = 0.5Y – 15r, where Y is the
economy's real output and r is the interest rate expressed as a percentage;
the real money supply is £850 billion.
Find the equations of the LM curve.
In the money market, equilibrium occurs when MD = MS and so:
MD = M S
0.5Y – 15r = 850
0.5Y = 850 + 15r
Y = 1700 + 30r This is the equation of the LM curve.
Problem From Last Year
In part (a) we found:
IS curve: Y = 2400 – 40r
LM curve: Y =1700 + 30r
2013/2014
Week 18
What are the equilibrium income and rate of interest in the economy given the
information above?
To find the equilibrium, set IS equal to LM:
IS = LM
2400 – 40r = 1700 + 30r
70r = 700
r = 10% This is the equilibrium interest rate.
To find the equilibrium income, we can plug this value of r into either expression for
Y and obtain Y = £2,000 billion.
IS Curve is Equilibrium in the Goods Market
To solve for the IS curve set Output (Y) equal to Expenditure
(C+I+G). I is usually a function of interest rate (r). 2013/2014
Week 18
To the up and right of the IS-curve, output is greater than
Expenditure, while to the bottom and left of the IS-Curve,
Output is less than Expenditure.
To shift the IS curve to the
right, we need to increase
Expenditure (usually, I or G).
Likewise, to shift IS to the left,
we would need to decrease
Expenditure.
LM Curve is Equilibrium in the Money Market
To solve for the LM-curve set Money Supply (Ms) equal to
2013/2014
Money Demand (Md).
Week 18
Money Supply is usually constant and Money Demand is
usually a function increasing in output (Y) and decreasing in
interest rates (r).
To shift the LM curve to the
right, we need to increase
Money Supply or decrease
Money Demand (this could be
done through increasing
interest rates).
Likewise, to shift LM to the
left, we would need to
decrease Money Supply or
increase Money Demand
(again, by using interest rates).