ECON1102 MACROECNOMICS 1

MID-SEMESTER EXAM 2013 S2

QUESTION BANK SOLUTIONS

By Zhi Ying Feng

  Explain the three different approaches that can be used to calculate GDP. Briefly indicate why
all three approaches should give the same estimate for GDP.

1. Production method: adding up all the market values of final goods and services produced
domestically
2. Expenditure method: adding up the total amount spent by households, firms, governments and
then add the net exports
3. Income method: adding up the aggregate labour and capital income
These 3 methods should give the same GDP since the total amount spend by households, firms,
governments, exports less imports should be the same as all the domestically produced goods and
services. When money is spent on these goods and services, the revenue is distributed among the
labourers and capital owners, so again it should be equivalent

 Is GDP a good measure of a country’s economic welfare? Discuss

GDP is an imperfect measure of economic welfare because it only captures those goods and services
that are priced and sold in the markets. It does not include:
- Leisure time: pursuit of other activities whose value are not priced
- Non-marketing economic activities: e.g. volunteering
- Environmental degradation: damages to environment and the use of finite resources not reflected
- Quality of life: e.g. healthcare, low crime rates, cannot have a price put on them and be sold
- Economic inequality: GDP per capita assumes equal distribution, which is not the case

However, GDP is still a useful measure of economic welfare because vast majority of goods and
services ARE priced and sold in markets. Thus, using GDP, economist can produce reasonably good
predictions about the welfare of the economy and other relating concepts such as unemployment

 Consider the following national accounts data for 2010

a) Use the above data to calculate GDP for 2010. Explain how you arrive at your figure for GDP
GDP is the sum of domestic consumption, government spending, firm investments and net exports, so it
is given by:
GDP  1200  600  100  500  600  500
 $2100 billion

b) Use the above data to calculate National Saving in 2010. Explain how you arrive at your figure
for National Saving.
National saving is income less consumption and government spending:
Saving  2100  600  1200
 $300 billion

c) Use the above data to calculate Private Saving in 2010. Explain how you arrive at your figure
for Private Saving.
Private savings is income less consumption less net taxes, which is taxes paid less transfer and
interest payments by government:
Private Savings  2100  1200  800  300  40 
 $440 billion
  Explain why the CPI may give a biased measure of the true rate of inflation or cost of living?

CPI measures the changes in cost of living by measuring the cost of a basket of fixed goods with
respect to a base year. However, it tends to give an overestimate of the true change in cost of living:
- Quality adjustment bias: quality of goods and services tend to increase with time, which
often also increases their prices. CPI does not take this into account so while it may show
that prices have increased, it could just be because their quality has increased
- New goods in market: because CPI uses a fixed basket, it may not include some new goods
which will impact the cost of existing items in the basket
- Substitution bias: again, since the basket is fixed, it doesn’t account for the fact that
consumers can just switch to a cheaper substitute should one item in the basket become too
expensive. This way, although prices have increased, it doesn’t necessarily mean the cost of
living has also increased

 Identify and briefly explain the various economic costs associated with inflation.

Costs of inflation are:

- Inflation increases the cost of living so the real purchasing power of people’s money is less
- Shoe-leather cost: additional cost having to frequently visit financial institutions to collect,
deposit and monitor money
- Noise in the price system: it’s hard to tell whether increase in price is due to inflation or just
as a response to rise in demand. To figure this out we need information of prices of other
goods which has associated information costs
- Distortion of tax system: in non-indexed tax systems, inflation cause people to pay more
taxes if their nominal income increases, but in reality their real income has not, so paying
more taxes means people end up with less
- Unexpected redistribution of wealth: inflation can create winners or losers, e.g. workers who
signed contract for wages, only to be hit by inflation so their real wage is cut.
- Menu costs: costs incurred by firms that have to update the cost of their goods and services
to reflect changing prices

 Explain the difference between the nominal interest rate and the real interest rate. Which
rate is most relevant to decisions to borrow and lend. Briefly explain.

The real interest rate is the nominal interest rate less inflation rate. The real interest rate, not the
nominal rate, is relevant to financial decisions since it reflects the true buying power of one’s
money.

 *Explain the Fisher Effect.

The Fisher effect states that the real interest rate in an economy is the nominal interest rate less the
inflation rate. The real interest rate depends on people’s willingness to save and invest remains
fairly constant over time. So if real interest rate is constant then there is a direct relationship
between nominal interest rate and inflation rate
  Explain the various factors that will influence a firm’s decision to purchase a new piece of
capital equipment. What condition would need to be satisfied for the firm to be willing to
invest in the new capital?

Factors influencing decisions on capital investment revolve around its costs and benefits. The costs:
- Price of capital goods, the higher it is, the less reluctant firms will invest
- Real interest rate: if the firm needs to borrow money, then real it reflects the real cost of
paying back the debt. If the firm buys the capital outright, then it measures the opportunity
cost of investing.
The benefits:
- The marginal product the capital will provide, e.g. new technologies that improve efficiency

For the firm to be willing to invest, the condition is that the benefits must be at least equal or greater
than the cost.

 *Explain why the labour demand curve for an individual firm is downward sloping and
indicate the main factors that cause the curve to shift. Will the same factors that cause a shift
in an individual firm’s labour demand curve also shift the aggregate demand curve for
labour? Explain.

Assuming a perfectly competitive labour market, an individual firm cannot affect the wages it pays
or the price it receives for its products. Then, its demand curve is a decreasing function of real
wages, due to diminishing returns to labour, which states that if the capital and other inputs are
constant, then marginal product decrease with increasing quantity of labour. As price takers, firms
will only employ until marginal product of labour equals real wages:
P  MPL  W
Since MPL decreases as a firm employs more workers, real wages also has to fall, implying that the
firm’s demand for labour is decreasing w.r.t. real wages

Factors that shift demand are:

- Increase in the relative price of a firm’s output shifts demand curve right
- Increase in the productivity of the firm’s workers shifts demand curve right

Both these factors will also shift the aggregate demand curve for labour. The demand for labour
depends on the demand for the goods and services, and if their price increases across the market
then that will translate to an increase in overall demand. If the overall productivity of the market
increases then their MPL will also increase and shift demand curve
  Briefly explain the following three motives for saving:
life-cycle
precautionary
bequest
Indicate what effect the widespread availability of home equity loans might have on each form of
saving. {Note: A home equity loan allows households to borrow (usually at a relatively low interest
rate) against the equity they have in their home. (Equity refers to the difference between the market
value of the home and any mortgage debt.)}

Reasons for Saving

- Lifecycle Saving: to meet long-term objectives such as purchasing homes or retirement
- Precautionary Saving: for protection against unexpected setbacks, such as medical
emergencies, or increases in consumption, such as unemployment
- Bequest Saving: to leave a bequest for heirs and others, such as charity or inheritance

Effect of home loan equity:

- Lifecycle: decrease since equity loans makes borrowing more affordable and thus increase
the temptation to spend
- Precautionary: relatively unchanged, since households will still need to prepare for
unexpected setbacks, perhaps even more so if they borrow more money
- Bequest: this is done mainly by high end income earners, so they can probably still keep up
a relatively unchanged level of bequest savings.

 What factors might cause households to under-save relative to some rationally optimal level?

Factors against saving

- Ease of borrowing, e.g. home loan equity encourages spending
- Demonstration effect: high consumption level of others may influence us to spend more to
keep up with the neighbours

 Use a model to show the possible effect of a minimum wage law on the level of employment
in an economy. Briefly explain which workers benefit and which workers lose from a
minimum wage law.

Assuming that the labour market is perfectly competitive, i.e. workers and employers cannot set the
level of wages. The equilibrium wage is where supply and demand of labour intersects. With a
minimum wage:
This increases unemployment since the supply is now greater than the demand. Those who benefits
are the workers from 0 to NA since they now receive a higher wage. The workers who lose out are
those in NA and N, since they will be unemployed as firms cut down on costs, and also N to NB who
will still be unemployed

Explain what is meant by frictional unemployment. Is it likely to be desirable for an economy to

have zero frictional unemployment? Explain. (2 marks)

Frictional unemployment is short-term unemployment associated with process of workers searching

for jobs. Low level of frictional unemployment benefits an economy since it allows workers time to
find the job they are most suited for, which increases output in the long run

 Consider the following quantity and price data for country of Utopia
a) Show how to calculate nominal GDP for Utopia in 2006 and indicate what it measures
Nominal GDP measures the quantities of goods and services produced at current year prices, i.e. the
current dollar value of production
30  $1000  40  $5  100  $6  $30800

b) Show how to use 2006 prices to calculate a measure of real GDP for Utopia in 2005. What
does real GDP measure?
Real GDP measures the quantities of goods and services with respect to the base year prices, in this
case 2006, i.e. it measures the actual physical volume of production
20  $1000  100  $5  50  $6  $20800

c) Show how to calculate a chain-weighted measure of the real growth rate of GDP between
2005 and 2006
Chain-weighted measure of real growth rate of GDP is the average growth rate found by using
either year as base year.
2005 prices 20450 30580 49.5%
2006 prices 20800 30800 48.07%
Average is 48.8%

d) Using 2005 as the base year show how to calculate a chain-weighted estimate of real GDP
for 2006
$20450 1.48785  $30426.5

 Explain what is meant by substitution bias in the CPI and indicate whether it is likely to
cause the CPI to overstate or understate changes in cost of living

The consumer price index measures the cost of a given basket of goods and services in a period
relative to their cost in a base year. Substitution bias means that since the goods and services in the
CPI basket are fixed, the CPI measure itself fails to account for people’s tendency to substitute
expensive goods and services with cheaper ones. As a result, CPI tends to overstate the changes in
cost of living
  Explain the precautionary motive for saving by a household. Briefly discuss how
widespread availability of credit cards might affect precautionary saving

Precautionary saving means savings made to protect families against unexpected setbacks, such as
medical emergencies or unemployment, in which case the source of income for the household may
cease or diminish. Introduction of credit cards allow people to spend money they do not have and
pay this debt back later, which tends to encourage people to spend more, and hence it may decrease
precautionary saving

 Explain the role of the real interest rate in influencing the level of saving and investment in
the economy

Savings can be modelled as an increasing function of real interest rate. If real interest rates were
higher, then individuals will be more likely to save since withholding consumption receives greater
reward in terms of interest payments. Investment can be modelled as a decreasing function of real
interest rate. Real interest rate represent the opportunity cost of saving, so if real interest rates were
high then people would rather save, but if real interest rates were low, then there is less incentive to
withhold the money and thus more likely to spend and invest. Also include the equilibrium diagram
for saving and investment

 The country of OZ is considering the introduction of a compulsory retirement saving

scheme. Under this scheme all workers are required to save 10% of their annual wages and
salaries until they retire. Use the supply and demand model for saving and investment to
explain the likely effects of this scheme on national saving, investment and the real interest
rate in OZ.

Draw the model, state that:

- Saving is an increasing function of real interest rate
- Investment is a decreasing function of real interest rate

Assuming that OZ is a closed economy, it will achieve equilibrium level of saving and interest rate
where the two curves intersect. However, with the introduction of this scheme, the 10% compulsory
saving is equivalent to an increase in saving at all levels of income, thus shifting the savings curve
to the right. As a result, the new equilibrium point will have a lower real interest rate but a higher
quantity of saving and investment.

 Explain what is meant by the natural rate of unemployment. Briefly indicate two factors that
might cause the natural rate of unemployment to vary over time

The natural rate of unemployment is part of total unemployment due to frictional and structural
unemployment, i.e. when cyclical unemployment is zero. It corresponds to the employment when
all resources are utilised at their natural rate, i.e. potential output. Two factors that affect this are:
- Size of the labour force: with a greater working population there will also be more frictional
and structural unemployment
- Level of minimum wage: if it is above the equilibrium real wage then it causes a shortage of
demand of labour, leading to unemployment
  *Identify two factors that might affect the economic welfare of the residents of Australia but
are not included in its GDP. Does the existence of such factors mean that GDP is not a
useful economic concept? Briefly explain

Two factors are:

- Qualities of life in areas, such as low crime rate and healthcare
- Economic inequality, since GDP assumes equal distribution
This only means that GDP is an imperfect measure of economic wellbeing as it only accounts for
goods and services that are priced and sold. However, GDP is still a useful economic concept
because goods and services that are priced and sold do form a majority of a country’s economy, so
GDP gives a fairly good indication of the size of the economy, which usually means that there are
more or better quality goods and services available. This in itself tends to be associated with high
life expectancy too. GDP also has close correlations with other economic concepts such as
unemployment and interest rates

 *Using labour demand and supply model, provide one explanation for increasing wage
inequality

Draw the model, state that:

- Labour market is assumed to be perfectly competitive, firms and workers are price takers
and as individuals cannot affect wages
- Demand for labour is a decreasing function of real wages, since firms are less likely to
employ when wages are high
- Supply for labour is an increasing function of real wages, since people would want to work
more when wages are high

The wage differences between more skilled and less skilled workers are increasing due to
improvements in technology that increases efficiency and productivity.

The demand for skilled workers is greater than the demand for unskilled workers since the value of
output produced by skilled workers are higher, hence they can command a higher price. On the
other hand, the marginal cost of acquiring more skills is greater, so skilled worker’s supply curve is
to the left of unskilled workers. (Draw this)

As a result, the equilibrium wage for more skilled workers will be higher than unskilled workers. As
technology keeps on improving and the value of production by more skilled workers increase, this
gap will continue to broaden and hence increase wage inequality

 Explain the concept of potential output and why actual output can differ from potential
output

Potential output is the amount of output, in terms of real GDP, an economy can produce when using
its resources at normal rate. The actual output can differ from potential output due to two reasons:
- Changes in potential input, e.g. new technologies increase productivity
- Changes in utilisation rate of labour and capital, e.g. a natural disaster may damage a lot of
capital needed for production
  Identify and briefly explain the main features of the business cycle

Main features of a business cycle are periodic expansion and contraction through experiencing
peaks and troughs:
- Expansion is when GDP is rising, indicating good economic performance
- Contraction is when GDP is falling, indicating poor economic performance
- Peaks marks the beginning of a contraction, i.e. the highest point of GDP before a downturn
- Trough marks the end of a contraction, i.e. the lowest point of GDP before a recovery

 Explain the concepts of a) potential output and b) output gap

Potential output is the amount of output, in terms of real GDP, an economy can produce when using
its resources at normal rate. An output gap is when there is a difference between actual output and
potential output, which can have two cases:
- Expansionary gap: when actual output exceeds potential output
- Contractionary gap: when potential output exceeds actual output

 *Explain the concept of Okun’s Law. Discuss the implications of Okun’s law for
policymakers

Okun’s Law is a relationship which states that each extra percentage of cyclic unemployment is
associated with approximately a 1.5% increase in the output gap, measured in terms of GDP. This is
because if cyclic unemployment exists then the economy is not using its resources at the normal rate,
thus actual output is lower planned output, which leads to a contractionary output gap. For
policymakers trying to stabilise the economy, i.e. close out a contractionary gap, Okun’s Law
implies that this can be done through stimulating labour market and encouraging employment,
which translates to a decrease in output gap. Also, because a mathematical relationship exists, the
policymakers can tailor their policies to be more accurate and effective, i.e. not overdo it and end up
with an expansionary gap.

 Explain the concept of planned aggregate expenditure. How does PAE differ from actual
expenditure?

Planned aggregate expenditure is the total planned spending on final goods and services in an
economy. PAE differ from actual expenditure due to firms selling more or less of its inventory than
expected. Unsold inventories are by definition treated as investment by the firm.

 *Explain why the following two conditions are equivalent ways of describing equilibrium in
the Keynesian aggregate expenditure model
- Y = PAE
- INJ = WD

First condition states that equilibrium is when output is equal to planned aggregate expenditure,
while second is when planned injections equals withdrawals. Output is equivalent to income, so the
equilibrium condition is that
Y  PAE
Y  C  I  G  NX
If we subtract T (taxes) and C (household consumption) we get:
Y T  C  I  G  X  M
By definition, savings is income less taxes and consumption, so upon rearrangement we get:
S  I  G  X  M T
S T  M  I G  X
The RHS by definition is injections, i.e. all sources of exogenous expenditure not done by
households. The LHS is by definition withdrawals, i.e. part of income not used for consumption.
Therefore, the two conditions are the same

 Discuss the role played by fixed prices in the Keynesian model of income determination.
Briefly explain what would happen if prices were fully flexible in the short run.

By fixing price in the short run, Keynesian model says that firms will respond to changes in demand
by changing the level of output and employment instead of changing prices. If prices were fully
flexible, then firms can simply raise the price to take advantage of rising demand and vice versa

 Use the Keynesian aggregate expenditure model and appropriate diagrams to explain the
following:
- The paradox of thrift
- The effect on equilibrium GDP of an exogenous decrease in exports

The paradox of thrift is that when a community tries to increase the level of savings, it results in a
lower equilibrium GDP for the economy. This is because increase in saving means a decrease in
consumption, so the savings function shifts upwards and the equilibrium GDP, where it cuts the
planned investments, will shift to the left.

An exogenous decrease in exports means that the PAE curve will shift downwards, thus the point at
which it cuts the 45 degree line will be on the LHS of the original equilibrium GDP

 Explain what is meant by the multiplier? Why, in general, does a one dollar change in
exogenous expenditure produce a larger change in short-run output?

Multiplier is the effect of one unit increase in exogenous expenditure on short-run equilibrium
output. For example, the short run equilibrium is when:
Y  PAE
 C  cT  c 1  t  Y   I P  G  X  mT  m 1  t  Y

 C  cT  I P  G  X  mT    c  m 1  t  Y
1
Ye  C  cT  I P  G  X  mT 
1   c  m 1  t   

1
M
1   c  m 1  t  
The reason that a one dollar change in exogenous expenditure produces a larger change in GDP
output is because a fall in consumer spending not only reduces sales of goods and services directly,
it also indirectly reduces the income of workers and owners in the industries that produces these
goods and services. This in turn causes a chain reaction in spending cuts, so the overall effect on
GDP is much greater.

 Explain the role played by the marginal tax rate in determining the size of the multiplier.
Other things equal, how does a cut in the marginal tax rate affect the size of the multiplier?

The marginal tax rate is the percentage of each extra dollar in income earned that must be paid in
tax and is considered a leakage from the economy. Thus, the marginal tax rate will affect the
proportion of income that is spent on consumption (since some of it now is taken away as tax
instead of just savings). This effectively reduces the marginal propensity to consume. The multiplier
is influenced by the MPC, as it affects the degree to which further flow on injections are passed on
through the economy.

A cut in the marginal tax rate means that individuals now retain a greater proportion of their income
for consumption for each dollar they earn and therefore have a greater MPC. This will increase the
size of the multiplier

(a)Use a diagram to illustrate the concept of short-run equilibrium in the Keynesian aggregate
expenditure model.

(b)Suppose the economy is initially not in equilibrium, explain the process by which the economy
adjusts to equilibrium. What role is played by inventories in this process?

Suppose an economy is out of equilibrium such that withdrawals are greater than planned injections.
This implies that the output that the economy is producing currently exceeds the expenditure plans
of households and firms. Hence, there will be a buildup of unsold inventory, which plays the role of
signaling to producers that they must cut back on production in order to meet declining demand.
This continues until the economy adjusts itself to a situation where the demand from households
and firms equals the production of suppliers - a situation known as equilibrium.

*(c)Use a diagram to explain the difference between potential output and equilibrium output in the
Keynesian model. Explain why the equilibrium level of output can differ from potential output?

Potential output is the output at which an economy can produce when using all of its resources at
normal rates whereas equilibrium output is the output at which the economy's current PAE
intersects the 45 degree line. The potential output will be a vertical line. Equilibrium output can
differ to potential output because often at equilibrium, one or more resources, such as labour for
example, may be underutlised due to a lack in PAE

 Explain the role played by the marginal propensity to import in determining the size of the
multiplier. Other things equal, how does an increase in the marginal propensity to import
affect the size of the multiplier?

The marginal propensity to import is the proportion of consumption that is spent on imports and is
considered a leakage from the economy. The size of the MPI will therefore affect the proportion of
consumption that can be spend on domestic goods (as MPC + MPI + MPS = 1). The multiplier is
influenced by the MPC, as it affects the degree to which further flow on injections are passed on
through the economy. An increase in the MPI means that a greater proportion of an individual’s
disposable income is spent on imports, and consequently less on domestic goods. This will decrease
the size of the MPC and hence reduce the size of the multiplier (K = 1/(1-MPC)).

 Explain what is meant by the government budget constraint. Indicate how it can provide a
link between fiscal policy and public debt.

The government budget constraint essentially means that is spending (on expenditure, transfer
payments and existing interest repayments) must be financed through either taxation or additional
borrowings. This links fiscal policy, which is implemented through the budget, to the level of public
debt. In order for the government to achieve its macroeconomic objectives, it must use fiscal policy
which must be financed through either taxation or borrowings. If it chooses borrowings, this will act
to increase the level of public debt.

 What are the main instruments of fiscal policy? Explain how each might be used to close an
expansionary output gap.

Fiscal policy is the use of the government's budget in order to stablise fluctuations in the business
cycle, redistribute income and reallocate resources. The two main instruments of fiscal policy are
controlling the level of government taxation and expenditure. Changes in government taxation
affect the level of disposable income for consumption whereas changes in expenditure directly
affect the level of government expenditure. Therefore, both of these instruments can be used to
affect PAE and thus move the level of GDP such that it closes an output gap. An expansionary
output gap occurs when actual GDP exceeds that of potential GDP (the level of output at which all
of the economy's resources are utilised at normal rates). This is undesirable for policy makers as it
generally leads to excessive inflation, as firms operate at excess capacity leading to increasing
prices. In order to reduce this expansionary output gap, they will seek to dampen GDP levels. They
can do this by increasing the level of government taxation in order to reduce disposable income.
This in turn will reduce consumption, thus decrease PAE so that GDP decreases. [insert diagram].
In a similar fashion, the government could also decrease government expenditure so as to decrease
PAE and hence decrease GDP.
  Explain the difference between discretionary fiscal policy and automatic stabilisers. Which
one of these will be the main influence on the size of the structural budget deficit? Explain.

Discretionary fiscal policy are deliberate changes to expenditure, taxation or welfare payments that
do not reflect changes in income whereas automatic stablisers are instruments, such as transfer
payments and income tax, inherent in the government's budget that seek to counteract the changes
in real output. Structural budget deficits are long term, persistent budget deficits that arise due to
fundamental imbalances in government’s receipts and payments rather than one off or short term
factors. Discretionary fiscal policy will be the main influence on the size of the structural budget
deficit because it is these explicit changes that have lasting impacts on the budget outcome, not the
cyclical nature of automatic stabilisers.

 A government is considering its fiscal policy response to a decline in exogenous desired

expenditure by households and firms which has produced a large contractionary output gap.
Two alternative policies are under consideration:
- An increase in government spending of $20 billion, or
- A one-time cash payment to all households, which also has a total value of $20 billion

Use the 4-sector Keynesian aggregate expenditure model to explain which of these
policies will have the largest effect on planned aggregate expenditure and on the
level of output.

In the 4 sector Keynesian aggregate expenditure model, PAE = Cd + Ip + G + X. But under

assumptions PAE = C - cT + Ip + G + X + c(1-t)Y. If the government increased spending by $20
billion, this would act to increase PAE by $20 billion. Its impact on output (when output is equated
to PAE) would be $20 billion multiplied by the income-expenditure multiplier. On the other hand, if
a one-time cash payment was employed, this would increase income of households by $20 billion.
However, since a portion of this income is saved (Y = C + S), not all of this $20 billion will trickle
into PAE. Hence PAE will increase by LESS than $20 billion. Therefore, its impact on output will
be the increase of PAE multiplied by the multiplier. It is clear that this increase in output is less than
if the government directly increased spending.

 Suppose a government is concerned about the size of the budget deficit. It decides to
increase government spending by $20 billion, but at the same time to increase exogenous
taxes by $20 billion. Will this policy have any effect on the level of output? Explain your
answer.

An increase in government spending will directly increase PAE by $20 billion (simply by the
formula). An increase in exogenous taxes by $20 billion will decrease income of households by $20
billion.
PAE  C  I P  G  X   m  c  T    c  m 1  t  Y
From this equation, exogenous tax’s contribution to PAE is affected by c-m, whose absolute value
will be less than 1. Hence, the decrease in PAE resulting from the increase in tax will be less than
$20 billion. Therefore, overall PAE will increase slightly and thus the policy will lead to an increase
in output.
  Briefly discuss any complications or issues with fiscal policy that are not accounted for by
the Keynesian aggregate expenditure model.

The Keynesian aggregate expenditure model treats fiscal policy as a way of increasing planned
aggregate expenditure without considering 3 main complications. Firstly, it is that fiscal policy may
indirectly affect the potential output of an economy. In other words, it has unintended supply side
effects that policy makers must consider when designing policies to stablise PAE. Secondly, is that
the reckless use of fiscal policy in combating PAE can lead to large and persistent budget deficits.
These are harmful because they reduce national saving, which in turn reduces investment in new
capital goods - an important source of long-run economic growth. Also, it leaves a burden for future
generations. Finally, fiscal policy is very inflexible due to its lengthy implementation process (half
yearly) as well as political (popularity or need for defense) and social constraints (cannot simply
drastically cut welfare spending).

 Money can be defined by its functions. In the following cases explain whether or not
something is money, and which of the functions of money that it satisfies.
- Credit-card account with a $5,000 limit - It is not money as it is not a store or value. It is
able to be used as a medium of exchange.
- An Apple share - Not money as it can't be used to make purchases. It is a store of value.
- A transaction account with the Commonwealth Bank with a $2000 balance - Money as it
can be used to make purchases. It is a medium of exchange.
- A one ounce gold bar – money since it can be used in transactions, a store of value and
measure economic value
- A $1000 3-month term deposit at a credit union - Not money as it can't be used to make
purchases.

 Explain the assumptions and implications of the quantity theory of money.

The quantity theory of money stems from the equation

M V  P  Y
In other words, the money supply multiplied by velocity is equal to nominal GDP. The quantity
theory makes the assumption that velocity V and output Y is CONSANT, since V is determined by
current payment technologies, which does not change too much over a short period of time.
Therefore, V and y are fixed numbers, this implicates that the money supply and price levels have a
directly proportional relationship. An increase in the money supply by 10% will consequently lead
to a 10% increase in the prices. This has implications when countries are evaluating the impact of
increasing money supply. Under this theory, any increase in money supply will also lead to inflation.
Also, it forewarns the inflation generated when the government decides to finance a budget deficit
through printing money.
  Explain what is meant by open-market-operations. Briefly outline how the RBA uses open-
market-operations to influence the cash rate.

Open market operations refers to the buying or selling of second hand government securities for the
purpose of affecting the supply of reserves in the overnight cash market in order to influence the
cash rate. For example, if the RBA wished to decrease the cash rate, it will decrease its target. This
means the RBA will start buying financial assets from banks and in return place funds into the
exchange settlement accounts of the selling banks. This effectively increases the supply of funds
from S1 to S2 in the overnight cash market, and thus makes it easier for borrowers to negotiate a
lower cash rate as banks have more incentive to lend. As shown in the diagram, the end result is a
decrease in the cash rate from R1 to R2. [Insert Diagram]. If the RBA wanted the cash rate to
increase, then it will sell bonds to the banks instead. This way, banks have less cash available and to
prevent their ESA balance from being inadequate, they will seek to borrow and drive up demand of
cash, thus raising the cash rate. [supply is inelastic, vertical line]

 The Red Taxi company is considering an investment in 10 new cars. Each new car costs
$10,000 to purchase. Red Taxi can borrow at a nominal interest rate of 12 per cent and
expected inflation over the next year is 2 per cent. Over a year the physical depreciation rate
on a car used by Red Taxi is 5 per cent.

(a)Using the above information explain how to calculate the (approximate) dollar cost of capital per
year for the proposed Red Taxi investment.

The capital cost will be the dollar amount paid for it plus the interest that need to be repaid on
borrowing, less any drop in value in the future, i.e. inflation and depreciation
Cost  10 10000  0.12 10 10000  1  0.0510 10000  0.02 10 10000 
 $15100

(b)In order to decide whether or not to undertake the investment what additional information does
Red Taxi require? Under what condition would the investment be undertaken?

It needs to consider the value of marginal product of the cars. Only undertake the investment if the
marginal product, i.e. the benefit, exceeds the capital costs

(c) Suppose that the expected rate of inflation was 5 per cent rather than 2 per cent. Explain whether
this would make Red Taxi more or less likely to undertake the investment.

An increase in inflation will increase the capital gain every year of the cars. This will make the cars
a more attractive investment as the true cost has decreased (since Red Taxi can sell the car after a
year and gain a greater return than before).

(d)Draw a diagram that illustrates investment demand for the Red Taxi company.
(1 mark)

Basically a downward sloping curve with real interest rate on y axis and investment on the x axis.
  *The balance sheet for the banking system in the country of Wensleydale is given below.

The residents of Wensleydale never use currency. Suppose a government tax rebate results in an
increase in deposits in the banking system of 100. The desired reserve to deposit ratio is 10 per cent.

(a)Show the banking systems balance sheet at the time deposits increase by 100. What is the actual
reserve to deposit ratio?

10  100
reserve/deposit ratio   0.55
100  100

(b)Using the balance sheet explain the process by which the banking system seeks to reduce its
level of excess reserves. (Show two rounds of the process.)

To maintain ratio of 0.1, it only needs to hold 20 in reserves, rather than the 110 it has now. Since it
is always more profitable to lend out this extra money, the bank will lend 90 in loans, which will be
deposited again. Thus the reserve now is 110 (20+90) and the deposit is 290 (200+90).

However, this ratio is still not 0.1, the bank only needs to hold 29, thus the bank will loan another
81 and end up with a reserve of 110 (29+81) and deposit of 371. This continues until its reserve is
exactly 10% of the deposit

(c)Show the final balance sheet for the banking system when it has achieved its desired reserve to
deposit ratio.

reserve  110
deposit  110 10  1100
loans  990

(d)What is the money supply in Wensleydale before the tax rebate is paid and after the tax rebate is
paid?

money supply = currency held by public + deposits

M before  0  100  100
M after  0  1100  1100
  The following equations describe the economy for a closed economy.
C = 10 + 0.8(Y-T)
I = 200
G = 100
T = 50 + 0.2Y

(a)Write out the equation for the saving function for this economy.
S  30  0.36Y

(b)Show how to calculate equilibrium output for this economy.

Y  PAE
 10  0.8 Y  50  0.2Y   200  100
 270  0.64Y
Y  750

(c)Calculate the size of the budget surplus at equilibrium output.

Budget Surplus  T  G
T  G  50  0.2  750  200
0

(d)What is the size of the balanced budget multiplier for this economy?
1 1
M   2.77
1  MPC 1  0.64