FEEDBACK TUTORIAL LETTER ASSIGNMENT 2 INTERMEDIATE MACRO ECONOMICS IMA612S

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

2 ASSIGNMENT 2 SECTION A [20 marks] QUESTION 1 [20 marks, 2 marks each] For each of the following questions, select the most correct answer, from a-d. 1. Changing government spending or taxation is known as: a) Fiscal policy b) Monetary policy c) Budget deficit d) Budget surplus 2. The deflationary gap is: a) The amount by which aggregate supply must be increased to push the equilibrium national income, via a multiplier, to the full employment national income. b) The amount by which aggregate demand must be increased to push the equilibrium national income, via a multiplier, to the full employment national income. c) The amount by which aggregate supply must be decreased to push the equilibrium national income, via a multiplier, to the full employment national income. d) The amount by which aggregate demand must be decreased to push the equilibrium national income, via a multiplier, to the full employment national income. 3. Refer to the table below, where each row indicates a different level of savings (S), taxes (T), imports (M), investment (I), government spending (G) and exports (X). At what level of savings is the economy in equilibrium? Withdrawals Injections S T M I G X

3 a) 2 b) 4 c) 6 d) 8 4. Which theory on income and consumption states that consumption and savings are both directly and linearly related to current disposable income: a) Permanent Income Hypothesis b) Relative Income Hypothesis c) Lifecycle Hypothesis d) Absolute Income Hypothesis 5. What does the Phillips Curve illustrate: a) The short-run positive relationship between unemployment and inflation b) The short-run negative relationship between unemployment and inflation c) The long-run positive relationship between unemployment and inflation d) The short-run negative relationship between unemployment and inflation 6. Which of the following is not a determinant of long-run economic growth: a) Growth of the labour force b) Growth of the capital stock c) Increase in price levels d) Technical progress 7. In order for GDP per capita to increase: a) The rate of economic growth caused by the population growth must exceed the rate of the population growth b) The rate of economic growth caused by the population growth must be less than the rate of the population growth c) The rate of population growth caused by the economic growth must exceed the rate of the economic growth d) The rate of population growth caused by the economic growth must be less than the rate of the economic growth 8. A fiscal expansionary policy would cause: a) The IS curve to shift inward, resulting in an increase in Y and P b) The IS curve to shift outward, resulting in an increase in Y and P c) The IS curve to shift inward, resulting in an decrease in Y and P d) The IS curve to shift outward, resulting in an decrease in Y and P 12

4 9. A contractionary monetary policy would cause: a) The LM curve to shift to the right, resulting in an increase in Y and a decrease in r b) The LM curve to shift to the right, resulting in an decrease in Y and an increase in r c) The LM curve to shift to the left, resulting in an decrease in Y and an increase in r d) The LM curve to shift to the left, resulting in an increase in Y and an decrease in r 10. Which of the following statements is true: a) The IS-LM model is a short-run model where the price level can vary b) The IS-LM model is a long-run model where the price level can vary c) The IS-LM model is a short-run model where the price level is fixed d) The IS-LM model is a long-run model where the price level is fixed SECTION B [60 marks] QUESTION 2 [40 marks] The next questions relate to the short-run IS-LM 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. Consider the following short-run model of closed economy: Good Market: C(Y) = Yd I (r) = 100-6r G = 400 T = 100 Money Market: M = 2000 P = 20 L(Y,r) = Y-6r a) State the IS equation (5) IS: Y = C(Y-T) + I(r) + G (2marks) Y = (Y-100) r

5 Y = Y-40-6r Y = Y-6r 0.6Y = 660-6r Y = r (3 marks) b) State the LM equation (5) Md = Ms Y-6r = M/P (2 marks) Y-6r = 2000/20 Y = 6r+100 (3 marks) c) Find the short-run equilibrium interest rate and output level. Round your answer to the first decimal point. (5) Equate IS and LM: So: r = 6r+100 (1 mark) 1000 = 16r r = 62.5 (2 marks) Y = (62.5) = = 475 (2 marks) Check: Y = 6(62.5) = 475 d) Show the short-run equilibrium interest rate and output level on an IS-LM graph. (5) (2 marks) for correct slope of curves (LM upward sloping, IS downward sloping) (1 mark) for labelling axes (1 mark) for the correctly labelled curves (IS and LM) (1 mark) for labelling the equilibrium points (re and Ye) 14

6 e) Show, through the change in the IS equation, what the impact of a greater negative relationship between the interest rate and the level of investment would be on the new short-run equilibrium interest rate and output level (you need to find the new equilibrium interest rate and output level). State in words what happens to the equilibrium interest rate and output level. Round your answers to the first decimal point. (15) Hint: You are required to specify a new investment function. Let the investment function be: I(r) = 100-7r or any number bigger than 6. There should be no change to autonomous investment. Then: IS: Y = C(Y-T) + I(r) + G Y = (Y-100) r Y = Y-40-7r Y = Y-7r 0.6Y = 660-7r Y = r (5 marks) Award marks where students used another number greater than 6. There is no change to the LM function. So the new equilibrium r and Y: Equate IS and LM: So: r = 6r = 17.7r r = 56.5 (3 marks) Y = (56.5) = = 439 (3 marks) Check: Y = 6(56.5) = 439 So, if there is a greater negative relationship between the interest rate and the level of investment, then the equilibrium interest rate is lower (2 marks) and the equilibrium output level is lower (2 marks). QUESTION 3 [20 marks] a) Explain the effect on the equilibrium interest rate and output level of an increase in the real money supply, state if this is an expansionary or contractionary monetary or fiscal policy, and show the effect graphically. Fully label your graph. (10) Increase in real money supply is an expansionary monetary policy (2 marks) There will be a decrease in the equilibrium interest rate and an increase in the output level (4 marks) 15

7 This is shown graphically where the LM curve shifts to the right: (2 marks) for showing the LM curve shifts to the right (1 mark) for showing decrease in r and increase in Y (1 mark) for labelling axes. b) Explain the effect on the equilibrium interest rate and output level of a decrease in taxation, state if this is an expansionary or contractionary monetary or fiscal policy, and show the effect graphically. (10) Decrease in taxation is an expansionary fiscal policy (2 marks) There will be an increase in the equilibrium interest rate and an increase in the output level (4 marks) This is shown graphically where the IS curve shifts to the outwards: 16

8 (2 marks) for showing the IS curve shifts to outwards (1 mark) for showing increase in r and increase in Y (1 mark) for labelling axes. SECTION C [20 marks] QUESTION 4 [20 marks] a) In the long-run AD-AS model, explain the effect of the real wage rate and the price level on aggregate supply. (10) The real wage has a negative effect on firms' employment of labour and thus decreases aggregate supply. (5 marks) The price level has a positive effect on aggregate supply as it induces increases in production. (5 marks) b) Explain the role of international trade in economic development, and highlight some potential issues that less developed countries may experience with increased international trade? (10) International trade is a major earner of foreign exchange. Foreign exchange enables LDCs to use their export revenues to pay for imports (e.g. capital goods and technical information) (5 marks) Issues: LCDs tend to export low-value raw goods / commodities, whereas they tend to import high-value capital goods and technical information, resulting in trade deficits. 17

9 Countries that import more goods than they export will be negatively impacted when the local currency depreciates in value, making imports more expensive. Any other logical reasons. (5 marks) TOTAL MARKS: