Tutorial 2

KHAI SIONG GAN

ADDITIONAL QUESTION 1 (CALCULATIONS)

The economy of Country X has the following information:

Autonomous consumption is $70. Investment is $250, government expenditure $150,

autonomous taxes $60, exports $60, imports $10. (All information is expressed in billions of
dollars.)
The marginal propensity to consume is 0.7. The income tax rate and import rate is 0.2 and 0.05
respectively.
With detailed workings, determine or calculate the following.

a. Consumption function

b. Aggregate Expenditure function

c. Equilibrium real income

d. The federal budget deficit/ surplus

e. The autonomous expenditure multiplier

f. Assume the full employment level of output is $ 950 billion, what is the inflation or
recession gap equals to?

g. How much spending should the country X government increase or decrease by to

reduce or eliminate the output gap?

h. Recalculate the budget as a result of the changes in (g) and identify again if it is a
budget surplus or budget deficit. Has the budget surplus or deficit increased or
fallen?

Answers:

a. C = $ 28 b + 0.56 Y
b. AE = $ 478 b + 0.51 Y
c. Y = $ 975.51 b
d. (T+tY)-(G+TR) = [60+0.2 (975.51)]-(150) = $ 105.102 b (Surplus)
e. 𝛼 = 2.04

f. ΔY = Yf – Y = 950 – 975.51 = - $ 25.51 b (Y > Yf ; Inflation Gap)

g. ΔY = α x ΔG ; - 25.51 = 2.04 x ΔG ; ΔG = - $ 12.51 b (Decrease)

h. $ 150 b - $ 12.51 b = $ 137.49 b

(T+tY)-(G+TR) = [60+0.2 (950)] – (137.49) = $ 112.51 b (Surplus)
--- Surplus has increased by $ 7.408 b. ---

8
 KHAI SIONG GAN

 Effects: Shifting MS curve rightward,  It leads to an increase in Consumption

causing surplus (MS>MD)
 Lower IR – Lower OC of holding bonds,
Demand for old bonds ↑, Bond prices ↑, 
Asset demand for money ↑
and Investment, shifting the AD curve
rightward.
Explanations of real wealth, inter-
temporal and international effects in
moving the point to new equilibrium, full
employment position.

Additional question:
Evaluate the subsequent impacts of the monetary policy above on money demand. Support
your answer with relevant diagrams.
 Impacts of the expansionary monetary policy above – An increase in RGDP, as well as
price level. Higher AD associated with stronger spending confidence.
 This increases the volume of expenditure.
 Money demand for transaction increases, MD shifts rightwards (diagram needed).
 MD > MS (Shortage) – People short of money will sell bonds/ assets.
 Asset demand for money (money demand for speculation) ↓
 Resolves at higher IR.

5. What is Bank Negara's OPR cut and its impact on Malaysians? What are the effects on
employment, economic growth and inflation?

 Bank Negara's OPR (Overnight Policy Rate) is the interest rate at which banks in Malaysia
can borrow and lend to each other overnight. The OPR cut refers to the reduction in this
interest rate by Bank Negara Malaysia.
 When Bank Negara Malaysia cuts the OPR, it aims to stimulate economic activity by
encouraging banks to lend more money to businesses and individuals, as borrowing
becomes cheaper. This can lead to increased spending, investment, and economic growth.
 For borrowers, the OPR cut can lead to lower interest rates on loans, including home loans,
car loans, and personal loans. This can make it easier for individuals to manage their debt
and potentially take on new loans.
 For savers, an OPR cut can lead to lower interest rates on savings accounts, fixed deposits,
and other investment products. This can reduce the amount of interest earned on savings
and may lead to a shift in investment strategies.
 Regarding its impact on employment, an OPR cut may lead to increased economic activity,
which in turn can create more job opportunities. This is because businesses may expand
their operations or invest more, which can result in the creation of new jobs.
 The impact of an OPR cut on inflation is less clear-cut. Lower interest rates can lead to
increased borrowing and spending, which can potentially lead to higher prices for goods
and services. However, if economic growth remains modest, inflation may not necessarily
rise significantly.

9
 KHAI SIONG GAN

ADDITIONAL QUESTIONS
1. Critically discuss how monetary policy might be used by government in a time of inflation?
Support your answer with money market and AD-AS diagram. (10 marks)
 Mirror the answers of Question 4 above (Tutorial 8), and change it to Contractionary
(Tightening Monetary Policy). Supportive diagrams as below.

2. “The central bank of Malaysia has an easy task, if want to increase real GDP by RM300
million. The bank must increase the money supply by that amount.”
Discuss whether there is any truth in this statement? (10 marks)
“A preview of upcoming chapter- Inflation and Exchange Rate”
* Incorrect statement
Suggested Points:
 Incorrect
* An increase in the MS does not affect the real GDP directly, and certainly not dollar-
statement
 An increase in the MS does not affect the real GDP directly, and certainly not dollar-
for-dollar.
for-dollar.
* This will also result in the risk of having high inflation.
 This will also result in the risk of having high inflation.
* An increase in the MS increases real GDP by lowering IR, which reduces the cost of
 An
borrowing increase
and in the spending
increases MS increases real GDP by lowering IR, which reduces the cost of
borrowing and increases spending.
* When  interest
When interest
ratesrates
areare lower,
lower, households are
households aremore
morelikely to buy
likely new assets,
to buy and firmsand firms
new assets,
are more are more
likely to likely to purchase
purchase new new capital.
capital. ThisThis results in
results in more
more outputs to be
outputs toproduced by
be produced by
firms, increasing real GDP
firms, increasing real GDP in the end. in the end.

 Lower
* Lower interest
interest ratesrates
alsoalso leadto
lead to aa lower
lowerforeign
foreignexchange rate, which
exchange rate, reduces the prices the
which reduces
of exports and raises the prices of imports, thereby increasing net exports.
prices of exports and raises the prices of imports, thereby increasing net exports.
 As the exact size of these effects is uncertain, the CB task is much more difficult than
* As the exact size of these effects is uncertain, the CB task is much more difficult than
the statement suggests.
the statement suggests.

10
 KHAI SIONG GAN

ADDITIONAL QUESTIONS

1. Why a central bank can agree to its currency to fall indefinitely, but it cannot agree to its
currency to rise indefinitely. (4m)
 Cheaper exports, increasing its competitiveness as compared to foreign goods.
 Improving current account position (less deficit).
 No central bank has an infinite amount of foreign currency reserves, so it cannot buy
its currency (to revalue) indefinitely.

2. Explain two causes of balance of payment deficits. (4m)

 Refer to notes.

3. Propose and evaluate two initiatives/ solutions that could mitigate balance of trade deficit.
(4m)
 Contractionary FP
 Raising IR
 Trade barriers
 Do nothing (if the country is using floating ER system, as it can be self-correcting).

4. If the value of MYR is overvalued against the USD, state the implications for Malaysia’s
employment level and country’s income. (4m)
 Higherimports,
-Higher hampering
imports, hampering thethe growth
growth of products,
of local local products,lower
lower employment level.
 Lower country’s
employment levelincome due to lower NX (High M, and low X)
-Lower
 Arguablecountry's
– but if income
those are due to lower
imported NX( High
raw materials withMgood
andquality,
low X)then the impacts
-Arguable-but if those
may be favorable areextent.
to some imported raw materials with good quality,
then the impacts may be favourable to some extent
5. Some American economists argued that higher interest rates would, unusually, improve
America’s economic growth. Explain why it might be said that this link between interest
rate and economic growth is unusual.
-Unusual,because
Unusual – because lower
lower interest
interestrate reduces
rate costs cost
reduces of borrowing, which encourages
of borrowing, which
higher borrowing, spending and less saving, which can
encourages higher borrowing,spending and less saving,which can stimulate the economy.
stimulate
However,theit may be the reverse in US, as higher IR may attract hot money flows (capital
economy
flows) to take
-However, advantage
it may of higher
be reserve returns from
in US,as highersaving in USattract
IR may financialhot
institutions.
money
flows (capital flows) to take advantage of higher returns from saving in
US financial institutions

9
 KHAI SIONG GAN

Initial: Start at full employment:

 Current situation – Full Employment (RGDP = Potential GDP)

 Effect of an increase in fuel costs: Shift of SAS curve leftward
 Consequences: Shortage, an increase in the price level

How shortage is resolved (The Process):

 Movement along AD curve (Real wealth and two substitution effects)

 Movement along SAS curve (Incentive effect)

 Shortage is resolved. Conclude: New Position – Recession Gap (RGDP < Potential GDP).
An increase in price level associated with a fall in RGDP – Stagflation

ADDITIONAL QUESTIONS (Revision and Applications)

Questions to ponder upon:

6.

JAKARTA, June 29 (Reuters) - Indonesia's annual inflation rate likely stayed stubbornly high
in June, a Reuters poll showed, as increased consumption during festivities surrounding the
Muslim fasting month of Ramadan pushed up prices, and in turn inflation.

(The Times of India, June 2017) (Jakarta)

Based on the statement, determine the possible type of inflation in the economy. Explain the
impact of the increase in consumption during festivities on Jakarta’s economy using AD/AS
model with the assumption that the economy is currently having inflationary gap.

Suggested Points:

5
 KHAI SIONG GAN

Type of Inflation

 Demand-pull inflation, as it is caused by an increase in AD, not matched by equivalent

increase in AS, due to an increase in consumption during festivities surrounding the
Muslim fasting month of Ramadan.

Initial: Start at full employment:

 Current situation – Inflationary Gap (RGDP > Potential GDP)

 Effect of an increase in Consumption: Shift of AD curve rightward
 Consequences: Shortage, an increase in the price level

How shortage is resolved (The Process):

 Movement along AD curve (Real wealth and two substitution effects)

 Movement along SAS curve (Incentive effect)

 Shortage is resolved. Conclude: New Position – Further Inflationary Gap (RGDP >
Potential GDP), further increase in price level.

7. With appropriate diagrams, briefly explain how central bank controls inflation through an
open market operation. (4 marks)
 Through the sale of gov bonds in OMO to reduce MS, raising IR, less lending.
 Higher cost of borrowing reduces consumption and investment, reducing AD, controlling
demand-pull inflation.

6
 KHAI SIONG GAN

8. Analyse two reasons why central bank usually refuses to print money to support the
economy.
 Risk of inflation – demand-pull inflation, due to rising AD. High inflation creates
uncertainty. Periods of high inflation discourage firms from investing and can lead to lower
economic growth.
 Risk of public losing confidence in the value of in their own currency, resorting to barter
trade.
 Not effective – What used to cost $1 now costs $10, nothing fundamental or real has
changed. It is as if someone overnight added a zero to every dollar bill; that per se, changes
nothing. Just as giving every student 10 extra points on a test change nothing fundamentally.

9. Discuss whether inflation harms everyone in an economy. (8 marks)

Harms:
 Consumers – Lower purchasing power, buying less products.
 Lenders – IR is not rising in line with inflation rate.
 Unskilled workers – Wages rise by less than inflation rate, due to weak bargaining power.
 Taxpayers – Paying more in taxes, if the tax rates are not adjusted in line with inflation.
 Exporters – Less price competitive to foreigners.

Benefits (if it’s creeping inflation):

 Producers – Incentive to expand production, due to higher price that can be charged.
 Borrowers – Paying back less in real terms.
 Skilled workers – Able to ask for wages increase by more than inflation rate, due to stronger
bargaining power.

10. "An increase in the money supply at full employment will create an inflation gap." Explain
this view of Keynes with an appropriate diagram? (10 marks)
 Using either “MS and AD/AS curves”, or “AE and AD/AS curves”.

7
 KHAI SIONG GAN

Lower fuel prices – reduces transportation costs – shifting SAS rightwards.

Diagram (1 mark). Explain the shift in SAS (2 marks). Explain movement along AD to
reach the new equilibrium (3 marks) and movement along SAS to reach the new
equilibrium (1 mark)

ADDITIONAL QUESTIONS (Revision and Applications)

1. Briefly describe four government aids that can boost economic growth. (4 marks)
Better healthcare and education that improves human capital.
Research and development to innovate new physical capital.
Investment in technological advancement.
Introducing property rights and enforcement of rule of law.

2. Explain two benefits of encouraging investments in rural areas. (4 marks)

 To promote employment opportunities, reducing poverty and rural-urban disparities.
 To stimulate economy activity and rural development, improving standard of living.
 Increased business opportunities, by tapping into the abundant natural resources
(agricultural land/ forests) in rural areas, promoting economic growth and
environmental sustainability (organic farming/ forest conservation).
 Improved infrastructure. This includes improvements to roads, bridges, and other
transportation systems, which can improve access to markets and make it easier for
people to travel to and from rural areas. Additionally, investments in water and
sanitation systems can improve public health and hygiene.
 Social benefits and promoting social cohesion. This includes improved access to
healthcare, education, and other social services. Investments in education and training
programs can help to develop a skilled workforce, while investments in healthcare
facilities can improve public health outcomes and reduce healthcare disparities.

3. Explain two factors which influence the level of investment in a country. (4 marks)
 Changes in consumers’ demand.
 Changes in consumers’ income.
 Availability of finance.
 Interest rate.
 Pace of technological advancement.
 Corporate tax rates.
 Expected rate of returns of investments.
 Costs of capital goods.

Each point must be explained.

14
 KHAI SIONG GAN

4. Explain two government’s appropriate measures to reduce country’s unemployment

problem? (4 marks)
 Provision of training and specialist courses, to equip people with new skills.
 provide training education
Provision of more jobs for the unemployed, by having more development projects.
-

 Encourage local industries to create new employment opportunities, by giving financial

-

reducing imports
assistance/ tax rebates for the hiring of workers.
 Reducing imports, by imposing trade restrictions, to encourage domestic production.

5. “Government economic policy should be aimed at the needs of citizens – employment,

health, education, and good environment. It should not concentrate on the balance of
payments and gross domestic product”.

Discuss whether there is any truth in this statement? (10 marks)

It isGovernment macroeconomics policy objectives included: should be aimed at

true that
government economy policy
needs of  citizens but its incorrect that
Full employment (0.5 m)
,
government should not concentrate
 & LowGDPand stable
bas inflation
when (0.5m) the
increasing rapidly
the BoP GDP is will
on

 A satisfactory balance of payments position (0.5m) country ,

and will lead to higher level

relatively
low level of
experience  Sustainable unemployment
economic growth (0.5m)
. This
 Avoidance of exchange
us to rate fluctuations of health and education
will enable improve the (0.5m)
of income
 Economic stability (0.5m).
quality
provision .

Any 4 points * 0.5 = 2 marks

WhenThe
country
a discussion points:
is
experiencing
a
surplus on its BOP,
employment levels
be high bes of the level of
will also
 It is high policy
true that government economic
demand for domestic product.
should be aimed at the needs of citizens, but
its incorrect to assume that government should not concentrate on the balance of
payments and gross domestic product because when GDP is increasing rapidly, thethe
A BOP surplus will also lead to an
appreciation of the currency which will enable
country will experience relatively low level of unemployment and will lead to higher
The
citizens of
level
a
country to
of income. Thisimported
buy goods
will enable us to& improve
services. the appreciation
quality of health the education
of and
exchange
rate will provision. (2m) cost push inflation low
help to keep .

 When a country is experiencing a surplus on its balance of payments, employment

levels will also be high because of the high level of demand for domestic products (2m).
Nevertheless it can of
 A balance
,
bepayments that it
argued surplus important
willisalso lead to antoappreciation
ensure citizens
of the currency
are
which with
equipped
will enable the citizens of before
a country to buy
to imported goods
to and
the services (2m).for
Theproduction
good health and education first ,
able contribute
appreciation of the exchange rate will help to keep cost push
labour force
(imported) inflation low.
,

but not to omit the macro-objectives of

(2m).
BOP
stability
&
higher GDP.

 Nevertheless, it can be argued that it is important to ensure citizens are equipped with
good health and education first, before able to contribute to the labour force for
production, but not to omit the macro-objectives of BOP stability and higher GDP.

THE END

15