Revision Questions – Graphical Analysis

Note: These are not model answers. Model answers will be discussed in more detail during
class.

Question 1

With the help of relevant diagrams, show and discuss how changes in income tax policy by the
government is likely to influence the labor market outcomes and supply-side of the economy.

The supply of labour decreases because the tax decreases the after-tax wage rate. The
before-tax real wage rate rises but the after-tax real wage rate falls. The quantity of labour
employed decreases. When the quantity of labour employed decreases, potential GDP
decreases.

The supply-side effect of a rise in the income tax decreases potential GDP and decreases
aggregate supply.
Question 2

Using relevant diagram, illustrate and discuss the impact of government budget deficit on real
interest rates in an economy where households are not rational. On a separate diagram, show and
briefly discuss the impact if households are assumed to be rational.

A government budget deficit increases the demand for loanable funds and competes with
businesses for funds. When real interest rate rises as a result of budget deficit and reduces
investment, crowding-out effect takes place. This is because households are perhaps not
rational / or dont anticipate higher taxes in future and do not increase their savings. There
is no shift in SLF curve.
If households are rational: Higher deficit today would imply higher taxes in future and
lower disposable income. With lower expected future disposable income, savings will
increase. Private savings and the private supply of loanable funds increases to match the
quantity of funds demanded by the government. So the budget deficit has no effect on
either the real interest rate or investment.
Question 3

Assume Solomon’s economy is in recession due to decline in exports earnings. Consequently,

the economy is experiencing high rate of unemployment and crime. You are hired as an
Economist by ADB to assist the government in designing appropriate policy measures. Using
AD-AS model, show and discuss how the government can use appropriate fiscal policy tools to
take the economy out of recession and address unemployment.

At point A, the economy produces real GDP of $1100 that is less than potential GDP.
To take the economy out of the recession, the government can use government spending or
tax or transfer payments tools. An increase in government expenditure or a tax cut
increases aggregate expenditure. The multiplier process increases aggregate demand
further as initial spending or tax cut stimulates further spending in the economy. In the
long run, the economy ends up producing real GDP of $1200 billion dollars but faces
higher price level.
Question 4

Show and briefly discuss how the Reserve Bank can use monetary policy to take the economy
out of recession that resulted from a decline in sugar exports.

Assume the economy is suffering from recession. The Reserve Bank will attempt to
stimulate aggregate demand by increasing the monetary base. An increase in the monetary
base increases the supply of money. The short-term interest rate falls. The increase in the
supply of money increases the supply of loanable funds. The long-term real interest rate
falls; investment increases. Aggregate planned expenditure increases. The multiplier
increases aggregate demand. Real GDP increases and closes the recessionary gap.
Question 5

Assume that the foreign exchange market in Zena is initially in equilibrium. Explain and
illustrate using demand-supply analysis, how the following events will affect the country’s
exchange rate under flexible exchange rate regime. In each case, assume other factors are held
constant. Assume that the currency used is Zenan dollar.

a) Following a recent recession, Zena’s economy recovers faster compared to its trading
partners due to strong macroeconomic policies.

A faster domestic economic recovery means that domestic real GDP rises
relative to those of other trading partners. A relative increase in domestic real
 GDP induces an increase in demand for imports and thus an increase in demand
for foreign exchange to pay for such imports. The demand curve for foreign
exchange shifts rightwards to, say, D1 and the effect is an increase in the
exchange rate; the domestic currency price of foreign currency rises. The
domestic currency depreciates.

b) Expansionary fiscal and monetary policy raises domestic inflation rate relative to
other countries.

Faster rates of inflation mean that domestic prices are increasing relative to
those in other countries. An increase in domestic prices relative to the rest of the
world will, ceteris paribus, make domestically-made goods relatively more
expensive compared with similar goods made in other countries. Domestic
citizens will buy fewer domestic goods and more foreign-made goods, while
foreigners will buy fewer domestically-made goods and more foreign-made
goods. The demand curve for foreign exchange shifts rightwards to D1 and the
supply curve of foreign exchange shifts leftwards to S1, resulting in the exchange
rate rising; the domestic currency price of foreign currency rises. The domestic
currency depreciates.
c) Domestic interest rate rises relative to interest rates in other countries.

If the domestic interest rate rises relative to the rest of the world, domestic assets
become relatively more attractive to hold compared to foreign assets because
their relative yield has risen. There will be less capital outflows from domestic
economy and more capital inflows into domestic economy. The decrease in
capital outflows amounts to a decrease in demand for foreign exchange, while
the increase in capital inflows brings in a greater supply of foreign exchange.
The demand curve for foreign exchange shifts to the left to D1, while the supply
curve of foreign exchange shifts to the right to S1, leading to a fall in the
exchange rate; the domestic currency price of foreign currency falls. The
domestic currency appreciates.
Question 6

Using appropriate diagrams, explain the adjustment process that takes place when aggregate
planned expenditure is not equal to real GDP.

If aggregate planned expenditure exceeds real GDP (the AE curve is above the 45° line),
there is an unplanned decrease in inventories. To restore inventories, firms hire workers
and increase production. Real GDP increases

If aggregate planned expenditure is less than real GDP (the AE curve is below the 45°
line), there is an unplanned increase in inventories. To reduce inventories, firms lay off
workers and decrease production. Real GDP decreases.
Question 7

Illustrate and discuss using relevant diagrams the impact of increase in the aggregate planned
investment expenditure by $100 billion on the aggregate demand curve.

The AE curve shifts upward and the AD curve shifts rightward by an amount equal to the
change in investment multiplied by the multiplier ($200b = $100b *2).