University of Economics, HCMC MBA Program

International School of Business PS 3

ECONOMICS PG
PROBLEM SET 3
Huỳnh Võ Thảo Ngọc – 21000991
Due date: 17:00pm, Aug. 27rd, 2021 on E- Learning
Refer Principles of Economics by Mankiw and give very short answers for the following questions:
1. Distinguish between nominal and real GDP?
 Nominal GDP uses current prices to place a value on the economy’s production of goods and
services, while real GDP uses constant base-year prices to place a value on the economy’s
production of goods and services. It is because real GDP presented the changes in the quantity of
good and services being produced, not affected by changes in price. Thus, real GDP is a measure
of the economy’s production of goods and services.
2. What are differences between GDP deflator and CPI although you can use either to calculate inflation
rate? What is core CPI?

GDP deflator CPI

 Reflects prices of all goods & services
produced domestically.
 Compare the price of currently produced
goods and services to the price off the same
goods and services in the base year.
 The group of goods and services used to
compute the GDP deflator changes
automatically over time
 A measure of the overall level of prices,
measures the current level of prices relative
to the level of prices in the base year
 Reflect price of goods and services bought
by consumers.
 Compare price of a fixed basket of goods
and services to the price of the basket in the
base year
 Same basket of goods and services.
 Measure of the overall level of prices &
measure of the overall cost of goods and
services bought by a typical consumer

 Core CPI: Measure of the overall cost of consumer goods and services exclusing food and energy.

3. What are nominal interest rate and real interest rate? How is real interest rate determined in a closed
economy?
 Norminal interest rate: the interest rate as usually reported without a correction for the effects of
inflation, it is the rate of growth in the dollar value of a deposit or debt
 Real interest rate: the interest rate corrected for the effects of inflation, it is rate of growth in the
purchasing power of a deposit or debt
Real interest rate = Nominal interest rate – Inflation rate
In a closed economy, real interest rate is determined by the equilibrium of supply & demand for money

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University of Economics, HCMC MBA Program
International School of Business PS 3
4. Explain how budget deficit affect the market for loanable fund? What problems does budget deficit
cause in a closed economy and in an open economy?

When the government spends more than it receives in tax revenue, the resulting budget deficit lowers
national saving. The supply of loanable funds decreases, the supply curve shifts to the left and the
equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds
out households and firms that otherwise would borrow to finance investment. Here, when the supply
shifts from S1 to S2, the equilibrium interest rate rises from 5 to 6 percent, and the equilibrium quantity of
loanable funds saved and invested falls from $1,200 billion to $800 billion

What problems does budget deficit cause in a closed economy and in an open economy?

In a closed economy: Budget deficit effects on the supply and demand for loanable funds. As above
explanation, when the government faces a budget deficit, the government will reduce its national savings,
the interest rate rises and investment falls, meanwhile, investment is important for productivity. For long-
run economic growth, lower savings and investment indicates that government budget deficits reduce the
economy’s growth rate.

In an open economy: When the government spending exceeds it revenue in tax, there is a negative public
saving, which reduces the national saving. Consequently, it reduced the supply of loanable fund from S1
to S2. The interest rate increased from r1 to r2. In panel (b), increasing interest rate reduce the Net capital
outflow. In turn, reduces the supply of dollars in the market for foreign currency exchange from S1 to S2
in panel (c). This fall in supply of dollars causes real exchange rate to appreciate from E1 to E2. The
appreciate pushes the trade balance toward deficit. Because this appreciate make US good becomes more
expensive than foreign goods. And, both domestic and foreigner will switch their purchases away from

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University of Economics, HCMC MBA Program
International School of Business PS 3
expensive US product, leading export of US product falls and import foreign product into US increase.
Therefore, the budget deficit in an open economy pushes the trade balance towards deficit.

5. Why does unemploymemt never fall to zero?

Unemployment never falls to zero, but fluctuates around the nature rate of unemployment
(Unemployment rate = Frictional unemployment + Structural unemployment). Tthere are two main types
of unemployment made up the natural unemployment rate as below:
 Frictional unemployment
o Occurs when workers spend time searching for the jobs that best suit their skills and tastes
o Relative short-term for most workers
 Structural unemployment
o Happen when the number of jobs is insufficient for everyone, wages are set above the
equilibrium
o Due to minimum wage, labor union, and efficiency wage
o Usually, longer term

6. How does the fractional reserve banking system create money in an economy? What is money
multiplier? Discuss leverage ratio and risks in the banking industry?

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University of Economics, HCMC MBA Program
International School of Business PS 3
 Fractional reserve banking is a system under which banks keep only a fraction of their deposits
in reserve. The banks use customer deposits to make new loans and award interest on the deposits
made by their customers. The reserves are held as balances in the bank’s account at the central
bank or as currency in the bank. The reserve requirement allows commercial banks to act as
intermediaries between borrowers and savers by giving loans to borrowers and providing
immediate liquidity to depositors who want to make withdrawals. Thus, in a system of fractional–
reserve banking, banks create money.
 Money multiplier: Amount of money the banking system generates with each dollar of reserves.
 Discuss leverage ratio and risks in the banking industry:
The leverage ratio is the ratio of the bank’s total assets (the left side of the balance sheet) to bank
capital (the one item on the right side of the balance sheet that represents the owners’ equity).
Banks rely heavily on leverage, the use of borrowed funds to supplement existing fund for purposes
of investment. Leverage amplifies the positive and negative effect of asset returns on a bank’s
financial position.
A leverage ratio of 20, for example, means that for every $1 in capital that the bank owners have
contributed, the bank has borrowed (via deposits and other loans) $19, which then allows the bank to
hold $20 in assets.
Supposed when the leverage ratio is 20, a 5-percent increase in the value of assets increase the
owner’s equity by 100 percent. If the value of bank assets falls by more than 5 percent, then its assets
will fall below its liabilities, and the bank will be insolvent. In this case, the bank will not have the
resources to pay off all its depositors and other creditors. Widespread insolvency within the financial
system is the one of elements that leads to a financial crisis. So, for 5% fall in the value of the bank
assets, leads to a 100% fall in bank capital.
From this example, when the bank uses a higher leverage ratio, the riskier the bank is bearing.

7. How does central bank control money supply?

To increase the money supply: Central bank can decrease the reserve requirements for commercial
banks to increase money supply, the central bank buys government bonds (OMO) to increase the money
supply. Or, when the Central bank lends to bank, Central bank can adjust money supply by lowering the
discount rate – the interest rate on the loans that Central bank makes to the banks. Lowering discount rate
allows commercial bank to borrow more resources from the central bank to increase the overall supply of
money in the economy

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University of Economics, HCMC MBA Program
International School of Business PS 3
To decrease the money supply: Central bank can decrease the reserve requirements for commercial
banks, sells government bonds. Or, the Central bank can increase the discount rate that banks pay on the
loans from the central bank, which decreases the overall supply of money in the economy

8. Use a diagram to show that when a central bank reduces money supply, price level (inflation) falls?

When the central bank decreases the supply of money, the money supply curve shifts from MS1 to
MS2. The value of money (on the left axis) and the price level (on the right axis) adjust to bring
supply and demand back into balance. The equilibrium moves from point A to point B. Thus, when a
decrease in the money supply makes dollars less plentiful, the price level decreases, making each
dollar more valuable.

9. List down costs of inflation in an economy?

There are 6 types of cost of inflation in an economy:
1. Shoeleather costs
- Resources wasted when inflation encourages people to reduce their money holdings
- Can be substantial
- It includes the time and convenience you must sacrifice to keep less money on hand than you would if
there is no inflation such as the transactions costs of more frequent bank withdrawals
2. Menu costs
- Costs of changing prices
- Inflation – increases menu costs that firms must bear
- It includes printing new menus, mailing new catalogs, advertising the new price, and even dealing
with customer annoyance over price changes etc.
3. Misallocation of resources from relative-price variability:

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University of Economics, HCMC MBA Program
International School of Business PS 3
- Firms don’t all raise prices at the same time, the price changes only one in a while, inflation causes
relative prices to vary more than they otherwise would.
- Distorts the allocation of resources
4. Confusion and inconvenience:
- Inflation changes the yardstick we use to measure transactions
- Complicates long-range planning and the comparison of dollar amounts over time
5. Tax distortions:
- Inflation makes nominal income grow faster than real income.
- Taxes are based on nominal income, and in case of inflation, it make the nominal interest rate. So,
inflation causes people to pay more taxes even when their real incomes don’t increase.
6. Arbitrary redistribution of wealth
- Unexpected inflation redistributes wealth among the population but not follow the rule of merit or
need.
- Inflation is especially volatile and uncertain when the average rate of inflation is high.

10. What are NX and NCO? Explain why is NX = NCO in an open economy?
- Net exports (NX) measure an imbalance between a country’s exports and its imports
- Net capital outflow (NCO) measures an imbalance between the amount of foreign assets bought by
domestic residents and the amount of domestic assets bought by foreigners

Explain why is NX = NCO in an open economy:

- Every transaction that affects one side of this equation must also affect the other side by exactly the
same amount. It means every international flow of goods and services and the international
flow of capital are two side of the same coin.

11. How is real interest rate determined in an open economy?

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University of Economics, HCMC MBA Program
International School of Business PS 3
Prefer to the market of loanable fund to determine the real interest rate in an open economy. The interest
rate in an open economy is determined by the supply and demand for loanable funds. National saving is
the source of the supply of loanable funds. Domestic investment and net capital outflow are the sources of
the demand for loanable funds. At the equilibrium interest rate, the amount that people want to save
exactly balances the amount that people want to borrow for the purpose of buying domestic capital and
foreign assets.

12. Explain theory of purchasing power parity/law of one price? How do you predict changes in nominal
exchange rate based on this theory?
Theory of purchasing power parity/law of one price is the theory of exchange rate whereby a unit of
any given currency should be able to buy the same quantity of goods in all countries. It is based on the
law of one price, This law asserts that a good must be sell for the same price in all locations.

How do you predict changes in nominal exchange rate based on this theory?

There are two implications from this theory. If purchasing power of the dollar is always the same at home
and aboard, then the real Exchange rate cannot change . And, nominal exchange rate between the
currencies of two countries must reflect the price levels in those countries (e = P*/P). Thus, we can
predict changes in nominal exchange rate based on the price levels in those countries.

13. Explain how real exchange rate is determined in an open economy? Show impact of capital flight on
an open economy?
Impact of capital flight on an open economy:

The real exchange rate is determined by the supply and demand for foreign-currency exchange. The
supply of dollars to be exchanged into foreign currency comes from net capital outflow. Because net
capital outflow does not depend on the real exchange rate, the supply curve is vertical. The demand for
dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus
increases the quantity of dollars demanded to pay for these net exports), the demand curve slopes
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University of Economics, HCMC MBA Program
International School of Business PS 3
downward. At the equilibrium real exchange rate, the number of dollars people supply to buy foreign
assets exactly balances the number of dollars people demand to buy net exports.
Impact of capital flight on an open economy:
• Capital flight: Large and sudden reduction in the demand for assets located in a country

In the case of Mexico – capital flight, when the political is instabble, people decide that Mexico is a risky
market to keep their savings there, the investors will move their capital to safe havens such as United
State, resulting in an increased in Mexican NCO. Consequently, the demand for loanable funds in Mexico
(domestic investment and net capital outflow) raise from D1 to D2, driving up the Mexican real interest
rate from r1 to r2. At the same time, in the market for foreign currency exchange, the supply of pesos rises
from S1 to S2 (panel c), it will depreciate peso from E1 to E2, so pesos becomes less valuable compared
to other currencies.
14. Describe how monetary and fiscal policies stimulate aggregate demand during a period of recessions?
 A Monetary Injection:

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University of Economics, HCMC MBA Program
International School of Business PS 3
In panel (a), an increase in the money supply shifts the Money supply curve to the right from MS1 to
MS2. Because the Money demand curve has not changed, the equilibrium interest rate reduces from r1
to r2 to balance Money supply and Money demand. The falling interest rate induce people hold
additional money.
Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of
goods and services demanded at a given price level from Y1 to Y2. The lower interest rate reduces the
cost of borrowing and return on saving. Then, the household spend more on new homes, stimulating
the demand for réidential investment. And, Firms spend more on new factories and new equipments,
stimulating business investment. As the result, the quantity of goods and services demanded at a given
price level P, rises from Y1 to Y2. Thus, in panel (b), the aggregate-demand curve shifts to the right
from AD1 to AD2
 Fiscal Policy: the setting of the level of government spending and taxation by government
policymakers.
There are two macroeconomic effects that cause the size of the shift in aggregate demand to differ
from the change in government purchases:
o Multiplier effect
o Crowding-out effect
The multiplier effect: Additional shifts in aggregate demand that result when expansionary fiscal
policy increases income and thereby increases consumer spending
Figure 4 illustrates the multiplier effect. An increase in government purchases of $20 billion can shift
the aggregate-demand curve to the right by exactly $20 billion. But when consumers répond by
increasing their spenidng, the agregate-demand củve shifts still further to AD3. This multiplier effect
arises because increases in aggregate income stimulate additional spending by consumers

Crowding-out effect: the offset in aggregate demand that results when expansionary fiscal policy
raises the interest rate and thereby reduces investment spending
Panel (a) in figure 5 shows the money market. The Money supply has not been changed, then the vertical
supply curve remain the same. When the government increases its purchases of goods and services, the
resulting increase in income raises the demand for money from MD1 to MD2, and this causes the
equilibrium interest rate to rise from r1 to r2. Panel (b) shows the effects on aggregate demand. The
increase in the interest rate, in turn, reduces the quantity of goods and services demand. In particular,
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University of Economics, HCMC MBA Program
International School of Business PS 3
because borrowing is more expensive, the demand for réidential and business investment good declines.
In other words, as the increase in government purchases increases the demand for goods and services, it
may also crowd out investment. This crowding-out effect partially off set the impact of government
purchases on agrefate demand before. The initial impact of the increase in government purchases shifts
the aggregate-demand curve from AD1 to AD2. In the end, once the crowding out take places, the
aggregate-demand curve drop back to AD3

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