Macroeconomics I Exam Revision. Part A: Week Four Economic Growth Based on Week Three Lectures [Also refer to Chapter 20]

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1 Macroeconomics I Exam Revision Part A: Week Four Economic Growth Based on Week Three Lectures [Also refer to Chapter 20] Section 1: Lecture One 1. What is the difference between nominal GDP and real GDP? 2. What factors or conditions do we take as given when we use the aggregate production function model? (3 were mentioned in lectures) Define the model for potential GDP: Yp =?f(??,???,????) where:? =?? =??? =???? = 4. What does constant returns to scale mean? Hint: for output to double, what must happen to the inputs? 5. What does a change in technology mean? If you can, relate it to what would happen to labour and capital. 6. Draw the production possibilities frontier. Using this, or otherwise, derive the aggregate production function. 7. Explain how the diagram in 6. shows that there is diminishing returns to labour. 8. The marginal product of labour is defined by change in? / change in? 9. Circle the correct answer: the higher the demand for labour, the {higher, lower} the real wage. 10. a. Draw the demand for labour curve. b. This is equivalent to the marginal product of labour curve. Why? 11. The only way to increase the demand for labour (i.e. shift the demand for labour curve outwards) is to increase productivity. Show what this looks like on the aggregate production function and the demand for labour curve (two different diagrams). 12. a. Is the supply curve upward sloping or downward sloping? b. Explain why this is the case. Hint: it has something to do with the opportunity cost of labour. 13. Tick the relevant boxes. At the labour market equilibrium,the full employment level of labour corresponds to potential GDP. Which of the following types of unemployment are present?

2 * Frictional unemployment * Cyclical unemployment * Structural unemployment 14. (Part a) Draw the following models: (i) Model 1: The Labour Market This should include the Demand for Labour (DL) and Supply of Labour (SL) curves. Labour is on the horizontal axis, real wage is on the vertical axis. (ii) Model 2: The Aggregate Production Function Labour is on the horizontal axis, output/real GDP is on vertical axis. (iii) Model 3 LAS (Long-Run Aggregate Supply) curve Output is on horizontal axis, price level is on vertical axis. (Part b) Say there is an increase in the labour supply (perhaps from higher unskilled migration). (i) Show what happens in Model 1. Hints: * What is the effect on the labour supply; labour demanded and real wage? * Is there a shift in any of the curves or a movement along any of them? (ii) Show what happens in Model 2. Hints: * What happens to labour and real GDP / output? * Is there a shift or a movement of the aggregate production function? (iii) Show what happens in Model 3. Hints: what happens to output and the price level, and what does the LAS curve do? 15. Redraw Models 1, 2 and 3 from 14(a). 16. Now say there is an increase in capital or technology. Answer the 14(b). Section 2: Lecture Two 17. What is per capita GDP? How is it calculated? 18. Say there is an increase in the population due to migration. What is the effect on GDP? What about per capita GDP? 19. If there is an increase in the demand for labour AND the supply for labour (say due to an increase in skilled migration), what is the effect on the real wage? It might help to draw a diagram of the Labour Market.

3 20. If the labour demand increases, what happens to the labour demand curve? What happens to the quantity supplied, and how is this determined by the change in the real wage? 21. Explain why China is experiencing a faster growing economy using the Aggregate Production Function model with output per unit labour (Y/L) on the vertical axis and capital per unit labour (K/L) on the horizontal axis. Hint: It has something to do with the diminishing returns of capital. 22. Draw the Aggregate Production Function model with capital per unit labour (K/L) on the horizontal axis and output per unit labour (Y/L) on the vertical axis. Show on the diagram the effects of an increase in capital and an increase in labour (unskilled migration). 23. The Classical Growth Theory An increase in increases the wage above the. This leads to an increase in standard of living, which in turn leads to an increase in. Hence, assuming labour increases and capital is fixed, capital per labour. This results in a decrease in productivity and the economy returns to the. That is, overall, there is no increase in the standard of living. This theory earned economics the name the ' '. Sustenance wage / Population / Decreases / Technology / Dismal Science / Capital per labour Is there anything that doesn't make sense about this theory? It might help to read the relevant section in the textbook and refer to the diagrams in the lecture (which are not in the textbook). 24. Neoclassical Theory If there is a (that is, the aggregate production function ), the actual rate of return to investment the expected rate of return. Hence, there is an that is, to invest in more. This thus increases productivity. The given technology is the in this model: economic growth cannot be pursued by simply continuing to increase. This is due to the. Technological / Limit to economic growth / Exceeds Capital / Shifts upwards / Diminishing returns of capital / Incentive to invest Is there anything that doesn't make sense about this theory? It might help to read the relevant section in the textbook and refer to the diagrams in the lecture (which are not in the textbook). 25. New Growth Theory is based on there being no diminishing returns to knowledge and technology. Discuss.

4 Part B: Week Five Finance, Saving and Investment Based on Week Four Material Questions from Chapter 21 of Textbook Please note: Please disregard any questions that ask about material which was not covered in lectures 1. Define finance (page 482) 2. Define money (page 482) 3. Define physical capital (page 482) 4. Define financial capital (page 482) 5. Read the paragraph titled Capital and Investment on page 482. a. What is gross investment? b. What is depreciation? c. What is net investment? 6. Define financial institution (page 484) 7. Read the paragraph titled Funds that Finance Investment on page From page 488, The real interest rate is the opportunity cost of loanable funds. a. The real interest rate {paid, foregone} on borrowing funds is the opportunity cost of borrowing. b. The real interest rate {paid, foregone} when funds are used to buy consumption goods and services or to invest in new capital goods is the opportunity cost of not saving or not lending those funds. 9. The Demand for Loanable Funds (page 488) The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit and international investment or lending during a given period. Our focus here is on investment. We ll bring the other two items into the picture later on. a. What determines investment and the demand for loanable funds to finance it? i. ii. b. Which is responsible for a movement along the demand curve and which is responsible for a shift in the demand curve? 10. Expected profit (page 489) a. Expected profit {rises, falls, fluctuates} during a business cycle expansion and {rises, falls, fluctuates } during a recession. b. Expected profit {rises, falls, fluctuates } when technological change creates new products. c. Expected profit {rises, falls, fluctuates } with contagious swings of optimism and pessimism. 11. The Supply of Loanable Funds (page 489) The quantity of loanable funds supplied is the total funds available from private saving, a government budget surplus and foreign borrowing during a given period. Our focus here is on saving. We ll bring the other two items into the picture later. a. How do you decide how much of your income to save and supply in the loanable funds market? i. ii.

5 iii. iv. v. b. Which is responsible for a movement along the supply curve and which are responsible for a shift in the supply curve? c. Explain the effect on saving of each. 12. Describe the forces that act on the interest rate if there is excess demand for loanable funds, and if there is excess supply for loanable funds (page 490). 13. Describe the effect on the interest rate and the quantity of loanable funds (demanded / supplied) if there is an increase in the demand for loanable funds, and if there is an increase in the supply of loanable funds (page 491). -->See an application of these concepts / models on page 492, The Origins of the Financial Crisis: The U.S. Home-Price Bubble. 14. Government in the Loanable Funds Market (page 493) Governments lend and borrow in the loanable funds market. a. A government surplus {increases, decreases} the {demand, supply} of loanable funds and contributes to financing investment. b. A government deficit {increases, decreases} the {demand, supply} for loanable funds and competes with business for funds. 15. A Government Budget Surplus (page 493) Describe, using a model, the effect of a government budget surplus on the real interest rate, household savings, the quantity of private funds supplied (investment). 16. A Government Budget Deficit (page 494) Describe, using a model, the effect of a government budget surplus on the real interest rate, household savings, the quantity of private funds supplied (investment). 17. The Crowding-Out Effect (page 494) a. What is the crowding-out effect? b. Explain why the crowding-out effect does not decrease investment by the full amount of the government budget deficit. 18. The Ricardo-Barro Effect (page 494) The Ricardo-Barro effect assumes that taxpayers are rational. Explain the effect on the real interest rate under the Ricardo-Barro effect if a government deficit is present. 19. The Global Loanable Funds Market (page 495) Lenders on the supply side of the market want to earn the highest possible real interest rate and they will seek it by looking everywhere else in the world. Borrowers on the demand side of the market want to pay the lowest possible real interest rate and they will seek it by looking everywhere in the world. Financial capital is mobile: it moves to the best advantage of lenders and borrowers. a. The free international mobility of financial capital pulls real interest rates around the world towards equality. Why is this the case? When funds leave the country with the lowest interest rate, a {shortage, surplus} of funds {raises, lowers} the real interest rate in that country. When funds move into the country with the highest interest rate, a {shortage, surplus} of funds {raises, lowers} the real interest rate in that country. b. Lending is risky and the greater the risk, the higher is the interest rate. The interest rate on a risky loan minus that on a safe loan is called the risk premium. International capital mobility brings real

6 interest rates in all parts of the world to equality except for differences that reflect differences in risk differences in the risk premium. 20. An International Borrower and An International Lender (pages ) The equilibrium real interest rate is determined in the global loanable funds market, and national demand and supply determine the quantity of international borrowing or lending. Say that the global market is at equilibrium. With reference to the equilibrium real interest rate set by the global market, use diagrams to illustrate an international borrower and an international lender.

7 Part C: Week Six Money and Inflation Based Week Five Lectures [Also refer to Chapter 22] 0. Review the Global Financial Market and the impact of a Japanese tsunami on Australia's ability to borrow. Section 1: What is Money? 1. What is money? 2. What is a means of payment? 3. What are the functions of money? a. b. c. 4. a. What is the barter system? (See Page 506 of text) b. Why is this not a good system of exchange? 5. What are the characteristics of money that make it generally acceptable, as discussed in lectures? 6. State whether each of the following is money or not, and offer an explanation i. Currency ii. Deposits (at banks or other depository institutions) iii. Cheques iv. Debit cards v. Credit cards Section 2: Official Measure of Money 7. Outline what the following are: a. M0 b. M1 c. M3 d. M6 (note: the textbook calls this 'broad money') 8. Is M1 money? Why / why not? 9. Is M3 and M6 money? Why / why not? 10. What is liquidity? Section 3: The Banking System 11. What are reserves? 12. What do banks do? a. b. c.

8 d. 13. What does the Reserve Bank of Australia (RBA) do? a. What institution controls the money supply / money base? b. Why does it choose to adjust the money supply? Section 4: The Market For Money 15. What is the quantity of money demanded, QD? 16. Fill out the following table: * Column1: The factors that influence QD * Column 2: Shift of or movement along demand curve? * Column 3: If there is an increase in this factor, what is the effect on the quantity of money demanded? 17. Draw the model which shows the short run money market equilibrium. 18. a. Explain the effect of an increase in real GDP on money demand and the interest rate in the short run. b. Explain the effect of an increase in the money base on the quantity of money demanded and the interest rate in the short run. 19. a. Explain the changes that take place in the short run money market model if the interest rate is below the short run equilibrium interest rate (i.e. money demand > money supply) b. Explain the changes that take place in the short run money market model if the interest rate is above the short run equilibrium interest rate (i.e. money demand < money supply) 20. How is the long run equilibrium rate determined? This is sometimes referred to as the natural rate of interest. 21. a. Nominal interest rate =? b. Real interest rate =? c. If the nominal interest rate is 8% and the real interest rate is 4%, what must the inflation rate be? Section 5: The Quantity Theory of Money 22. The quantity theory of money states that MV = PY. a. Define each of the following variables. b. Why is V considered constant? c. What does Y depend on? Does it depend on M? 23. What does the quantity theory of money say about the effect of an increase in the money supply / money base on price?

9 24. The quantity theory of money can also be expressed as M + V = P + Y (see the footnote on Page 520 for the explanation of how this expression can be attained) The nominal interest rate equals the equilibrium real interest rate plus the expected inflation rate. When the money supply changes, the nominal interest rate changes in the short run. The price level adjusts to make the quantity of real money supplied equal to the quantity demanded (i.e. GDP = potential GDP). As referred to above, we assume that the percentage change in V is zero. If there is an increase in GDP by 3% and an increase in the money base by 10%, what is the percentage increase in the price level? Section 6: Creation of money 25. Say there is an increase in the money base by $100,000 i.e. the bank has excess reserves of this amount. Let the reserve to deposits ratio be 0.1. Assume the currency drain is 0. The bank loans out the $100,000 (liability). $100,000 is deposited (assets). a. How much has money has been made? The bank loans out money again. b. i. How much does it loan out? ii. How much does it keep in reserves? What has been loaned out is then deposited. c. How much money has been made? d. i. How much does the bank loan out now? ii. How much does it keep in reserves? What has been loaned out is then deposited. e. How much money has been made? 26. a. Define the money multiplier without the currency drain.

10 b. What is the money multiplier in the above example? c. Define the total amount of money created? d. What is the total amount of money created in the above example? e. Define the money multiplier with the currency drain. f. Say that there was in fact a currency drain equal to 0.1 in the above example. i. What is the money multiplier in the example now? ii. What is the total amount of money created in the example now? 27. [Not a question] An alternative way of deriving the money multiplier, as formulated in the textbook Variables: M = quantity of money produced MB = money base D = deposits C = desired currency holding a = C/D, currency drain b = R/D, the desired reserves-to-deposits ratio M = D + C MB = C + R C = ad R = bd So M = (a+1)d and MB = (a+b)d Change-in-M = (a+1)*(change-in-d) Change-in-MB = (a+b)*(change-in-d) Multiplier = Change-in-M / Change-in-MB Multiplier = (a+1)*(change-in-d) / (a+b)*(change-in-d) Multiplier = (a+1)/(a+b) With no currency drain, a = 0 So, multiplier = 1/b = 1/(R/D) There is yet another way to derive the multiplier but you need to have done Maths IB to understand it properly I think!

11 Part D: Week 8 Aggregate Supply and Demand Based on Week 7 Lectures [Also refer to Chapter 24] 1. a. What is the assumption about prices in the short run? b. Explain one reason that justifies this assumption. 2. What is the assumption about prices in the long run? 3. Why is the Long Run Aggregate Supply (LAS) curve vertical? 4. a. Recall LAS =?f(?,?,?) b. SAS = f(? = movement factors;?,? = shift factors) i. An increase in the price level leads to an increase/decrease in profits? How about nominal wages? ii. An increase in a firm's profits lead to an increase/decrease in supply? 5. a.i. Aggregate demand is equivalent to (list identity). ii. AD = f (? = movement;??????? = shift factors) b. Explain two of the three reasons that justify that aggregate demand is downward sloping in the (PY) space. 6. What happens to the economy in the short run and long run when there is an increase in aggregate demand? Label the short run and long run equilibrium. Instructor's note: So, in the short run, we can operate at 'beyond capacity' (real GDP > potential real GDP), but in the long run, wages increase, the price level increases, actual real GDP returns to potential real GDP) 7. What happens to the economy in the short run when there is an increase in the price of oil? 8. Is an increase in actual GDP above potential GDP economic growth? Why / why not? 9. a. Use an appropriate model to illustrate an increase in potential GDP (ignoring the effect of a change in aggregate demand) b. Why does the SAS curve shift with the LAS curve?

12 Part E: Week 9 Expenditure Multipliers Based on Week 8 Lectures [Also refer to Chapter 25] Section 1 1. Model Consumption (on Y axis) against Real GDP (on X axis) and Saving (on Y axis) against Real GDP (X axis). Label the regions of saving and dissaving. (/4) Section 2 2. What factors of Aggregate Expenditure depend on real GDP? These are known as I _ d Spending. What factors of Aggregate Expenditure are independent of real GDP? These are known as A s Spending. 3. Why is actual consumption equal to expected consumption but actual investment is not necessarily equal to expected investment? 4. a. What defines the equilibrium in the Aggregate Expenditure Model? b. Explain the process by which this equilibrium is established in the Aggregate Expenditure Model with reference to inventories. 5. Why is the slope of the Aggregate Expenditure Curve less than the slope of the 45 degree Y=AE line? Section 3 6. a. Say there is an increase in investment. Explain why real GDP will increase more than this initial increase in investment with reference to the multiplier effect in words and/or by using a diagram. b. Now define the multiplier mathematically. 7. Explain why the multiplier effect is smaller in an open economy (i.e. exports, imports are part of the model) than in a closed economy (no exports or imports). Section 4 8. a. In the Aggregate Expenditure model, we hold what fixed when analysing the effect of a change in autonomous expenditure? b. In the Aggregate Demand model, we hold what fixed when analysing the effect of a change in autonomous expenditure? 9. Derive the Aggregate Demand curve from the Aggregate Expenditure Model. [Hint: the Aggregate Demand curve is the set of equilibra in the Aggregate Expenditure Model.] 10. Show the effect of an increase in exports in the Aggregate Expenditure Model and on the Aggregate Demand curve. 11. We assume prices are fixed in the very short run. Now consider the short run, when prices are not fixed. Say there is an increase in investment. Explain why real GDP does not increase by the full multiplier effect, with reference to the Aggregate Expenditure Model. 12. Explain why the multiplier effect is zero in the long run with reference to the Aggregate Expenditure Model and the AD/SAS/LAS Model.

13 Part F: Week Eleven Fiscal Policy Based on Week Ten Lectures [Also refer to Chapter 27] 1. a. Explain why the autonomous tax multiplier is less than the government expenditure multiplier. b. The balanced budget multiplier show the effect of an equal increase in government expenditure and and autonomous taxes using: (i) maths, and (ii) a diagram. 2. Explain how discretionary expansionary policy can be used by the government to lift the economy out of recession using the AD-SAS-LAS model, with reference to the multiplier effect. 3. Explain how contractionary fiscal policy can be used to reduce inflation evident when the economy is operating at a level of real GDP greater than potential GDP, using the AD-SAS-LAS model. 4. Outline the limitations of discretionary fiscal policy. 5. State the difference between discretionary and automatic fiscal policy. 6. a. Explain why the tax curve is upward-sloping in the (T/G, Y) (budget balance) model, by describing the effect of a change in real GDP on: (i) tax revenues, and (ii) transfer payments made by the government. b. Explain what the government expenditure curve looks like in the same model by describing the effect of a change in real GDP on government expenditure 7. Explain the difference between cyclical and structural balance with the assistance of a diagram. 8. Assume that the structural budget balance is zero when the economy is at potential GDP. Use a diagram to show the effect on the structural budget balance when potential GDP: (i) increases, and (ii) decreases. 9. Suppose that the structural budget balance is zero when the economy is at potential GDP. Assume that potential GDP does not change. Use a diagram to show the effect on the cyclical budget balance when real GDP: (i) increases to a level of output above potential GDP, and (ii) decreases to a level of output below potential GDP. 10. The effect of fiscal policy on the supply-side of the model in terms. a. Discuss the effect of a tax on employment using the aggregate production function model and the labour market. b. Discuss the effect of a tax on interest using the loanable funds market. c. What is the difference between the effect on the economy of a tax on employment and a tax on interest?

14 Part G: Week 12 Monetary Policy Based on Week 11 lectures [Also refer to Chapter 28] 1. Outline the objectives of monetary policy in Australia. 2. Describe the main differences between the following two types of monetary policy: cash rate instrument rule (Taylor's Rule) and the targeting inflation rate rule. 3. What is the instrument and what is the target in the monetary policy of the Reserve Bank of Australia? 4. Outline the two main benefits of using an inflation rate target. 5. Explain the liquidity trap. What are the benefits and disadvantages associated with using fiscal and monetary policy in this situation? 6. Explain how the Reserve Bank uses open market operations to employ monetary policy. 7. Use a diagram to illustrate that the effectiveness of monetary policy depends on how sensitive investment is to interest rates. 8. Suppose the economy is in recession and the Reserve Bank uses expansionary monetary policy to drive the economy forward. a. Use the money demand / money supply model to illustrate the effect on the money supply and the interest rate. b. Use the interest-sensitive expenditure model to show the effect on aggregate expenditure. Remember the interest-sensitive expenditure model has the interest rate plotted on the vertical axis and aggregate expenditure plotted on the horizontal axis. c. Use the aggregate expenditure model to show the effect on real GDP. d. Use the AD/SAS/LAS model to show the effect on aggregate demand, short run aggregate supply, and the price level in: (i) the very short run, (ii) the short run and, (iii) the long run. e. What happens if the Reserve Bank keeps interest rates too low after the economy has recovered from recession?