FEEDBACK TUTORIAL LETTER

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1 FEEDBACK TUTORIAL LETTER 2 nd SEMESTER 2017 ASSIGNMENT 1 INTERMEDIATE MACRO ECONOMICS IMA612S 1

2 FEEDBACK TUTORIAL LETTER ASSIGNMENT 1 SECTION A [20 marks] QUESTION 1 [20 marks, 2 marks each] Correct answer in bold Explanation in italics For each of the following questions, select the most correct answer, from a-d. 1. In general, an economy is improving when: a) GDP growth has increased, unemployment has increased and inflation has increased b) GDP growth has increased, unemployment has decreased and inflation has increased c) GDP growth has increased, unemployment has decreased and inflation has decreased d) GDP growth has increased, unemployment has increased and inflation has decreased Explanation: Positive economic indicators include an increase in GDP growth, a decrease in unemployment and a decrease in inflation. These indicators demonstrate that the economy is growing and potentially developing. Negative economic indicators include a decrease in GDP growth, an increase in unemployment and an increase in inflation. 2. If we were interested in the economic welfare of a country s citizens, we would look at: a) Nominal GDP b) Nominal GDP per capita c) Real GDP d) Real GDP per capita Explanation: Economic welfare refers to the economic position of an individual. If there is an increase in real GDP per capita, there is an improvement in the position of the average person in a country. If there is a decrease in real GDP per capita, there is a decline in the position of the average person in a country. 3. If a country is experiencing an economic downturn and GDP has fallen in two or more successive quarters, we say this country is: a) In a depression b) In a recession c) Experiencing positive growth d) Experiencing no growth 2

3 Explanation: A recession is a period of general economic decline, defined as a contraction in the GDP for six months (two consecutive quarters) or longer. Marked by high unemployment, stagnant wages, and fall in retail sales, a recession generally does not last longer than one year and is much milder than a depression. 4. Stagflation is when: a) There is high unemployment and high inflation b) There is low unemployment and high inflation c) There is high unemployment and low inflation d) There is low unemployment and low inflation Explanation: Stagflation is stagnation (slow growth) accompanied by inflation. It is an economic anomaly where high unemployment (due to economic stagnation) is accompanied by high inflation (instead of low inflation due to falling demand). Triggered first in 1973 by the OPECs four-fold increase in oil prices (which raised all prices, thus slowing economic growth) it was exacerbated by traditional fiscal and monetary policies with which the governments tried to reduce unemployment levels. 5. The Classical Theory of Full Employment says that: a) At a higher wage rate more workers will be employed b) At a lower wage rate more workers will be employed c) The higher the wage rate, the greater the demand for labour d) The wage rate does not impact employment Explanation: According to the Classical Theory of Full Employment, the demand curve for labour is downward sloping, thus at a lower wage rate more workers will be employed (i.e. there is a negative relationship between the wage rate and the demand for labour). 6. According to Say s Law: a) The producing of goods and services by businesses creates a market of consumers for those goods and services b) There must be a market of consumers for goods and services before they can be produced by businesses c) Savings must equal taxes for the economy to be in equilibrium d) Exports must equal imports for the economy to be in equilibrium Explanation: According to Say s Law, supply of businesses creates the demand of consumers, i.e. the producing of goods and services by businesses creates a market of consumers for those goods and services. 7. According to the Keynesian Model: a) The labour market is perfect due to the existence of trade unions and government b) The labour market experiences complete flexibility of wages c) The labour market is imperfect due to the existence of trade unions and government d) The labour market is not impacted by the existence of trade unions and government 3

4 Explanation: Unlike the Classical Theory of Full Employment that stated that wages were perfectly flexible, Keynes argued that the wage rate was not perfectly flexible and the labour market was imperfect due to the existence of trade unions bargaining for higher wage rates and government setting minimum wage rates. 8. According to the Keynesian Model: a) Savings is a function of national consumption b) Savings is a function of national income c) Savings is a function of the national interest rate d) Savings is an autonomous function Explanation: In Keynes theory, savings is a function of national income and is not affected by changes in the rate of interest. This is illustrated where Y (income) = S (savings) + C (consumption). According to Keynes, savings and consumption are directly and linearly related to national income. 9. Complete the following statement: The greater the injections in the economy: a) The greater the multiplier effect b) The lesser the multiplier effect c) The multiplier effect will equal the leakages d) No effect on the multiplier Explanation: The multiplier is equal to the change in national equilibrium income divided by the change in the autonomous variable that brings the change about. The autonomous change that brings it about can be investment, government spending or exports, i.e. the injection to the economy. Therefore the greater the injection to the economy, the greater the multiplier effect. 10. The Withdrawals = Injections equality requires that: a) Savings equals investment b) Imports equals exports c) Taxes equals government spending d) The sum of savings, taxes and imports equals the sum of investment, government spending and exports Explanation: According to the equilibrium equality of injections = withdrawals / leakages, the sum of the injections (investment, government spending and exports) must equal the sum of withdrawals (savings, taxes and imports). This equilibrium condition does not, however, require that the different components of injections equal the different components of withdrawals, e.g. it is not required that investment equals savings or that imports equal exports. 4

5 SECTION B [65 marks] QUESTION 2 [40 marks] Answers in italics The next questions relate to the Keynesian Model. For each of these questions, be sure to show fully the equations and variables you use, and each step taken in determining the answer. Marks will be awarded for showing all your workings. Assume that the economy is open and with government. Investment, government spending, exports and imports are autonomous. Tax is only lump-sum. The price level and interest rate are held constant. The following variables relate to the economy: Firstly, you need to take note of the information provided above. You are told that the economy is open and with government, so you need to take imports, exports and government spending into account. You are also told that investment, government spending, exports and imports are autonomous. This means that these variables are fixed amounts and do not vary with Y (national income). Likewise you are told that tax is a lump-sum, and is therefore not a tax rate that will vary with the level of Y. Finally, you re told that the price level and interest rate are held constant, so you know that this is a short-run model. Table 1: Open economy with government Variable Value (N$ billions) Investment 100 Government spending 300 Lump-sum tax 100 Autonomous consumption 400 Marginal propensity to consume 0.5 Exports 250 Imports 150 a) Calculate the equilibrium level of national income (Y) using the aggregate demand = national income method. Show all workings and round your answer to the closest whole number. (10) The above question is asking you to demonstrate that you understand how to set up the Y = AD equality of the Keynesian model to determine the national equilibrium income level. Thus you must use the Y = AD approach to find Ye. Note that aggregate demand is equal to the sum of consumption, investment, government spending and net exports (exports minus imports). AD = C (Y T) + I + G + X M (2 marks) State the formula. Remember that consumption is a function of disposable income, which is income minus tax. AD = (Y-100) ( ) (3 marks) Plug in the numbers 5

6 AD = Y 50 Gather all the numerical terms and Y terms together AD = Y = Y 0.5 Y = 850 Divide through by 0.5 Y = 1700 (5 marks) Note that it is important to show your workings; even if you don t get awarded the marks for the correct answer you will be awarded marks for stating the formula and showing your workings. b) Calculate the equilibrium level of national income (Y) using the injections = withdrawals (leakages) method. Show all workings and round your answer to the closest whole number. (10) The above question is asking you to demonstrate that you understand how to set up the injections = withdrawals equality of the Keynesian model to determine the national equilibrium income level. Thus you must use the I + G + X = S + T + M approach to find Ye. Note that if you had used the same approach as in (a), you would not have been awarded any marks. I + G + X = S + T + M (2 marks) State the formula = S Plug in the numbers The savings function is the inverse of the consumption function, so: Savings equation: S = -a + (1-b) (Y-T) (4 marks) Or you can find the savings function as S = Y - C = Y - (a + b(y-t)), since the consumption function = a +b(y-t) Multiply out S = Y - a -by + bt S= -a + (1-b) (Y-T) So: S = (Y -100) So, S = = 400 Isolate the Savings function (Y -100) = Y 50 = 800 Note that when you take (-)400 across it becomes positive 0.5 Y = 850 Divide through by 0.5 Y = 1700 (4 marks) Hint: Both of these methods should give you the same equilibrium national income, so check your answers! If your calculations for (a) and (b) did not give you the same answer, then you needed to go back and check both answers to see where you made a mistake. The point of (a) and (b) was for you to show that you know how to find equilibrium national income using both Y = AD and injections = withdrawals methods. c) Reflect the equilibrium national income on an AD AS short-run graph. Fully label your graph, and show the equilibrium national income point. (5) 6

7 The AD AS short-run graph is shown as follows: draw the AD graph as an upward sloping curve, as AD is positively related to Y (increase in AD, increase in national income), with AD on the vertical axis and Y on the horizontal axis. To find the equilibrium point, draw the 45 degree line that shows all the points where AD (aggregate demand) = AS (aggregate supply). Where the AD curve intersects with the 45 degree line is the national income equilibrium point, Ye. It is essential that you label the curves, the axes and the equilibrium points in order to obtain marks. (2 marks) for correct slope of curves (1 mark) for labelling axes (1 mark) for the correctly labelled curves (45 degree line and AD line / national income line) (1 mark) for labelling the equilibrium point d) Reflect the equilibrium national income on an Injections & Withdrawals graph. Fully label your graph, and show the equilibrium national income point. (5) 7

8 The injections = withdrawals graph also has AD on the vertical axis and Y on the horizontal axis. The withdrawals curve (W = S + T + M) is an upward sloping curve, as the higher the national income, the higher the savings, taxes and imports in the economy (remember, the level of taxes, savings and imports depend on the level of national income). The injections curve (I = I + G + X) is a straight horizontal line, as investment, government spending and exports are autonomous of national income / do not change with a change in national income. The national equilibrium income point is found where the injections = withdrawals curve. It is essential that you label the curves, the axes and the equilibrium points in order to obtain marks. (2 marks) for correct slope of curves (1 mark) for labelling axes (1 mark) for the correctly labelled curves (Withdrawals and Injections) (1 mark) for labelling the equilibrium point e) What is the multiplier in this economy? Round your answer to the first decimal point. (5) The formula for the multiplier in this economy, where taxes and imports are lump-sum is (thus you don t need to account for a tax rate or marginal propensity to import): Multiplier = 1/ (1-b) (2 marks) = 1 / (1-0.5) = 2 (3 marks) f) If tax had instead been at a tax rate of t = 0.2, what would the multiplier be in the economy? Round your answer to the first decimal point. (5) The formula for the multiplier in this economy, where taxes are applied at a tax rate (t) and are thus dependent on Y (but imports remain lump-sum) is: Multiplier = 1/(1-b (1-t)) (2 marks) Be careful with the brackets! You need to multiply b into the bracket (1-t): = 1/ (1-b + bt) = 1 / ( (0.2)) Multiply 0.5 by 0.2 = 0.1 8

9 1 /( ) Apply the Brackets, Of, Division, Multiplication, Addition, Subtraction (BODMAS) rule here, so first determine the denominator in brackets = 0.6, then do the division of 1/0.6: = = 1.7 rounded-off ( 3 marks) Note that for (e) and (f), as with (a) and (b), you were awarded marks for showing the formula you used. Also take note of the effect on increasing the taxes (withdrawals) in the economy the multiplier decreased when a tax rate was introduced. QUESTION 3 [25 marks] Assume that the economy is open and with government. Investment, government spending and exports are autonomous. Tax is only lump-sum. The price level and interest rate are held constant. The following variables relate to the economy: As with question 2, you need to take account of the information provided above. Notably, while investment, government spending and exports are autonomous, imports are not autonomous. Thus imports depend on Y (national income) / are a function of Y. Table 2: Open economy with government Variable Value (N$ billions) Investment 600 Government spending 200 Tax 200 Autonomous consumption 400 Marginal propensity to consume 0.6 Exports 400 Autonomous imports 100 Marginal propensity to import 0.4 a) Calculate the equilibrium level of national income (Y). Show all workings and round your answer to the closest whole number. (10) To find national equilibrium income, we must determine where Y = AD (or where injections = withdrawals). Importantly, imports = M m(y-t), where M = autonomous imports (100) and m = Marginal propensity to import (0.4). So now find where Y = AD: Y = AD = C (Y- T) + I + G + X -M -m (Y-T) (2 marks) State the formula AD = (Y-200) (Y-200) (3 marks) Plug in the numbers AD = Y Y +80 Gather all the numerical terms and Y terms together AD = Y =Y 0.8 Y = 1460 Divide through by 0.8 Y = 1825 (5 marks) 9

10 Note that it is important to show your workings; even if you don t get awarded the marks for the correct answer you will be awarded marks for stating the formula and showing your workings. b) Determine the balance of the government budget in equilibrium, state if it is a surplus / deficit and the amount. Round your answer to the closest whole number. (5) The balance of the government budget is government income minus government spending. Government income is generated from tax (T) and government spending is equal to G. From the above table, G = 200 and Taxes = 200 So the balance of government budget = T - G Thus the balance of government budget = = 0 (2 marks) The government is neither in surplus nor deficit, but has a balanced budget (spending equals income) (3 marks) Be sure to always answer a question in full, e.g. where asked to state if it is a surplus / deficit, you must do so. c) Determine what the balance of trade is in equilibrium and state if it is a surplus / deficit, and the amount. Round your answer to the closest whole number. (10) Balance of trade is trade income we earn from exports minus trade income we spend from imports. So balance of trade = X M. From the above table, exports are autonomous and X = 400 Imports are not autonomous, however, and depend on national income Y. To find the balance of trade in equilibrium, we must use the equilibrium level of national income: Y = 1825 (from (a)). Also very important to note is that imports depend on disposable income, which is income minus tax. So the import function is: M + m (Y T), where M = autonomous imports (100) and m = Marginal propensity to import (0.4). Imports = (Y -200) State the formula = ( ) = = 750 (5 marks) Plug in the numbers Balance of trade = X M State the formula Thus the balance of trade = = (2 marks) Since the balance of trade is negative, there is a deficit balance of trade (spending is greater than income) (3 marks) 10

11 SECTION C [15 marks] QUESTION 4 [15 marks] a) Explain what the multiplier is. (5) The multiplier is the measure of the relationship between the change in the equilibrium national income and the autonomous change that brings it about / The multiplier is the ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures / The multiplier is the number by which a change in autonomous real investment or autonomous real consumption is multiplied to get the change in equilibrium real GDP. (5 marks) for any of the above explanations b) Explain how the multiplier effect works. (10) The essence of a multiplier is that total increase in income, outputs or employment is manifold of the original increase in an injection. E.g. if investment of $100 is made, then the income will not rise by $100 only but by a multiple of it. Now consider the first effect of an increase in one of the injections. Suppose we increase investment spending on new machinery by $2 million. The immediate effect of the increase will be to raise national income by full $2m because investment spending is a component of national income. Increased spending on machinery represents higher incomes for those involved in manufacturing the machines. The process does not end there, because the increase in income will brings about additional consumption spending in the next period. This rise in consumption will create a further increase in income in the next period over and above the initial increase and this in turn will bring forth more consumption spending. This process will continue with both consumption and income rising, but the actual increases become smaller and smaller over time until eventually they become insignificant. Note that you needed to explain step for step how the multiplier works, ideally providing a numerical example, to be awarded full marks for (b). (10 marks). TOTAL MARKS: 100 -END OF FEEDBACK TUTORIAL LETTER- 11

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