Tutorial 1:

Short Answer Questions

1. In Figure 1.1 we observe a strong upward trend in GDP per capita overtime, as well as sharp
fluctuations during certain periods. Use the concepts of short run and long run outlined in the
chapter to explain why these two concepts may coexist.

The strong upward trend in per capita GDP is due to the accumulation of inputs (e.g. machinery) and
improvements in technology in the very long-run. With more capital and more sophisticated technology,
output increases and therefore consumers have a higher standard of living (through consumption of more
goods and services).

However, panel (b) in Figure 1.1 shows that the path of output is not always smooth. Short-run
fluctuations in output can be explained using demand and sometimes supply shocks. This occurs because,
unlike the long-run, it is the level of aggregate demand that determines the output in the short-run.

2. The aggregate supply curve is drawn differently in Figures 1.2, 1.4 and 1.5. What do the different
shapes of the supply curve suggest about the relationship between price and output:

a) in the long run?

The vertical aggregate supply in the long-run suggests there is no relationship between price and
output in the long run. This is because in the long run, the level of output is determined not by price,
but by the productive capacity of the economy (supply-side factors).

b) in the short run?

In the short run the aggregate supply curve is flat. The underlying assumption in the short run is that
the level of output does not affect prices in the short run. This means that the short run supply curve
pegs the price level at the point where supply curve hits the vertical axis. Therefore, a demand shock
in the short run does not affect prices.

c) in the medium run?

In the medium run (the period of transition from the short run and the long run) the aggregate
supply curve is upward sloping. This upward slope suggests a positive relationship between price and
aggregate supply because as the price level increases the quantity of goods and services firms are
willing to supply will increase.

3. Compare the New Classical and New Keynesian views on the speed at which markets adjust when
subjected to economic shocks.

The New Classical School believes markets adjust rapidly to changing conditions. Its adherents see the
world as one in which individuals act rationally in their self-interest. This school includes Robert Barro and
Nobel laureates Robert Lucas Jr and Edward Prescott.

On the other hand, the New Keynesian School do not believe markets clear all the time and seek to
understand and explain why markets can fail. They provide a number of reasons to explain price rigidity
including information problems and institutional arrangements. Important economists from this school
include Ben Bernanke and Gregory Mankiw.
4. How will the following events affect GDP and why?
a) A cyclone destroys part of Sydney.
b) You sell your old macroeconomics textbook to another student.
c) You sell your holdings of BHP Billiton shares.
d) Your local car dealership decides to reduce its inventory by offering price reductions.
e) An unemployed worker gets an increase in unemployment benefits.

a) When a hurricane destroys property, wealth is affected, not income (or GDP). However, if a
significant amount of the capital stock is destroyed, then less can be produced later, leading to a
decrease in GDP. On the other hand, the rebuilding of destroyed property means that increased
economic activity will take place, leading to an increase in GDP.

b) The sale of your old textbook will not constitute an official market transaction (since you probably
will not report your income to the ATO). In addition, the textbook has already been used and is not
currently produced. Therefore GDP will not be affected.

c) The sale of existing stock holdings is a transfer of wealth and, as such, does not affect GDP. Any fees
that you may have to pay your broker for his or her services, however, constitute payment for
services rendered. GDP will increase by that amount.

d) Inventory changes are counted as part of investment. A reduction in business inventories will lower
the level of investment (I) and thus GDP. However, the sales of the cars count as consumption (C) if
consumers buy them, or investment (I) if firms buy them. Thus the net effect on GDP depends on the
difference between the cost of the cars to the dealership and the sales price of the cars, that is, the
value added.

e) Transfer payments that do not arise from productive activity are not counted in GDP. Thus GDP will
not be affected when benefits are paid. (Only later, when these payments are spent, will
consumption increase.)

5. Briefly describe the advantages and disadvantages of using the CPI, the PPI and the GDP-deflator as
economic indicators.

The consumer price index (CPI) measures the average price increase of a fixed market basket of goods
and services purchased by an average urban wage earner. Not all goods and services are reflected in this
market basket, and substitution among these goods is not possible so the CPI is not a perfect measure for
inflation. However, the CPI is easily available on a monthly basis and is fairly reliable.

The producer price index (PPI) measures the average price increase of a fixed market basket of
intermediate goods up to the retail stage, but it does not include services or interest payments. The PPI is
relatively easily available on a monthly basis and it is used to show future price trends. One has to be
careful to avoid double-counting, since the PPI deals with intermediate goods. The PPI does not
necessarily correspond with the CPI, since firms can't always shift higher producer prices onto consumers.

The GDP-deflator is probably the most useful price index for macroeconomists since it measures the
average price increase of all goods and services currently produced in this country. It does not include
import goods, used goods or interest payments, and early estimates are often unreliable and have to be
revised repeatedly. However, the GDP-deflator is the most complete of the price indexes.
Tutorial 2:

Short Answer Questions

1. Explain why downward movements in nominal wages still caused a rise in costs for a firm in
Australia at the start of the Great Depression.

Deflation is the rate at which the price level falls. Australia was already experiencing deflation prior to
the start of the Great Depression. However, downward movements in nominal wages were not
enough to offset the increase in the real wage due to deflation. Hence, firms' costs increased. This
problem was exacerbated when domestic and international stock markets collapsed. Prices
plummeted further and real wage costs spiralled out of control. This of course led to an increase in
the rate of unemployment.

2. What are 'beggar-thy-neighbour' strategies and how can they make a bad situation worse?

The origin of this term is derived from its resulting economic impact, making a beggar out other
nations. The aim of a beggar-thy-neighbour policy is to increase the demand for your nation's exports,
while reducing your reliance on imported goods. This can be achieved by devaluing the nation's
currency. Of course this will make exports to other nations cheaper and imports more expensive.
Therefore it is a trade policy that utilises currency devaluations and protective barriers such as tariffs
and quotas to alleviate a nation's economic difficulties at the expense of other countries. While the
policy may help stabilise the economy of a country repair it will harm the country's trading partners.
The Great Depression is an example of when beggar-thy-neighbour policies were enacted around the
world. Although the Great Depression was initially caused by the collapse of the international
financial system it was made worse by these types of policies. In effect they were attempting to
'export' unemployment by improving one country's trade position and hence demand for its goods at
the expense of its trading partners. If all countries adopt this approach the volume of world trade
declines and causes a contractionary influence on the world economy.

3. Explain how monetary policy in Australia from 1929 to 1933 helped worsen the depression.

The money supply declined nearly 20 per cent from 1929 to 1933. The fall in the money supply was in
part due to the failure of smaller banks. However, fear that there could be a repeat of more
widespread banking failures that had occurred in the 1890 economic downturn added to the
problem. The banks that failed did not have enough reserves to cover customer withdrawals. Their
failure therefore reduced the money supply. Depositors lost confidence in the monetary system. The
remaining banks responded by increasing their reserve holdings relative to deposits. The money
multiplier lost its strength and this sharply contracted the money stock. The monetary authority at
this time lay with private banks. The central monetary authority, which was the Commonwealth Bank,
took very few steps to offset the fall in the money supply. In the early stages of the depression it did
not undertake a program of open market purchases and generally did very little to prevent the
collapse of the financial system. It was not until 1933 that expansionary money supply was enacted
and from then on it took until the end of the decade to stabilise the financial system.

4. Discuss the reasons put forward to suggest why there was less economic volatility during the Great
Moderation period (1982–2007).

Prior to the economic turmoil sparked by the GFC many economies including the US and Australia
enjoyed a period of very stable economic activity. Economic volatility declined so significantly that
economists began to talk of the 'death of the business cycle' and coined the term the Great
Moderation to describe the event. A substantial decline in both demand shocks and supply shocks
was suggested as the reason. The improvement in economic institutions and economic policy are also
 included in the reasons for increased stability. Globalisation and plain good luck have been posited as
well to explain the decrease in economic volatility. Unfortunately, the death-knell for the business
cycle was premature. The Great Moderation did not last and was replaced with the 'Great Recession'
of 2007–2009.

5. What possible policy solutions and institutional changes have been suggested to stimulate the
Japanese economy?

It has been argued that the Bank of Japan should announce a target inflation rate above zero and
increase money growth until such an inflation rate is reached. If such a policy were successful, it might
also tend to raise private consumption. An additional advantage of a policy of high monetary growth
is that it might be possible to monetise some of the Government's budget deficits and so reduce the
size of the government debt to GDP ratio. However, much more than standard policy response is
needed in order for Japan to recover from recession. The structural and institutional problems must
also be rectified. In particular, the poor position of Japan's banks must be solved. The large number of
bad loans, along with continued exposure to the market due to banks' equity holdings, makes many
analysts pessimistic about viability of many of Japan's banks.

Tutorial 3:

Short Answer Questions

1. Briefly explain why the AS curve is upward-sloping in the intermediate run.

An upward-sloping AS curve assumes that wage and price adjustments are slow and uncoordinated.
This can be explained most easily by the existence of wage contracts and imperfect competition.
Because of wage contracts, wages cannot be changed easily and since the contracts tend to be
staggered, they cannot be changed all at once. In an imperfectly competitive market structure, firms
are reluctant to change their prices since they cannot accurately predict the reactions of their
competitors. Therefore, wages and prices will adjust only slowly. (Chapter 4 provides more elaborate
explanations for this.)

2. Briefly discuss why the AD curve is downward-sloping.

In the AD–AS framework, we assume that nominal money supply (M) is constant unless it is changed
by the central bank's monetary policy (which would result in a shift in the AD curve). Therefore, if the
price level increases, then real money (M/P) decreases, driving interest rates (i) up and lowering the
level of investment spending (I). This means that total output demanded (Y) will decrease. A fuller
answer may include that lower real money balances (M/P) result in less real wealth, leading to a
lower level of consumption (C) due to the wealth effect. This means that total output demanded (Y)
will decrease. A higher domestic price level (P) also means that domestic goods will become less
competitive in world markets. This will stimulate imports while reducing exports, leading to a
reduction in net exports (NX), and a decrease in total output demanded (Y).

3. 'In the classical aggregate supply curve model, the economy is always at the full-employment level
of output and the unemployment rate is always zero.' Comment on this statement.

The classical aggregate supply curve model implies a vertical AS curve at the full-employment level of
output. However, this does not mean that the unemployment rate is zero. There is always some
friction in the labour market, which means that there is always some (frictional) unemployment as
workers switch jobs, and there is always some structural mismatch, which means that the types of
labour offered does not match up with the requirements of the employment opportunities on offer.
 The (positive) amount of unemployment at the full-employment level of output is called the natural
rate of unemployment. Chapter 4 discusses the factors underlying the natural rate of unemployment
in more detail. An exact value for the natural rate has not been established for Australia (or
elsewhere) but it has been estimated to be roughly between 5.5% and 7.5% (with a very large
confidence interval around such estimates).

4. Assume a technological advance leads to lower production costs. Show the effect of such an event
on national income, unemployment, inflation and interest rates with the help of an AD–AS diagram,
assuming completely flexible wage rates.

A decrease in production costs shifts the AS curve to the right. The price level decreases, leading to a
higher level of income and lower interest rates. Since wages are completely flexible, the AS curve is
vertical and we are always at full-employment (this is the classical case). This implies that the
unemployment rate stays at the natural rate, but output goes up since workers are now more
productive.

1.2. Cost of prod. == > AS  Ex.S. == > P real ms  i  I Y

Effect: Y UR  P  i

5. 'The real impact of demand management policy is

largely determined by the flexibility of wages and prices.' Comment on this statement.

If wages and prices are completely flexible, then the economy will always be at the full-employment
level of output, independent of the price level. In other words, we have the classical case of a vertical
(long-run) AS curve. In this case, a shift in the AD curve will affect only the price level (and the nominal
wage level) but not the level of output (or employment). However, if wages and prices are completely
inflexible, then we have the (horizontal) Keynesian aggregate supply curve. In this case, any shift of
the AD curve will have a large effect on the level of output but will not affect the price level. Only in
the intermediate run, when we have an upward-sloping AS curve, will the level of output and the
price level both be affected by a shift in the AD curve. More flexibility in wages and prices implies a
steeper the AS curve. Therefore the effect of a shift in the AD curve will be smaller on output and
larger on the price level.

Tutorial 4:

Short Answer Questions

1. What are the main differences between the original expectations-augmented Phillips curve and the
one built on rational expectations?

The expectations-augmented Phillips curve predicts that inflation will rise above the expected level
when unemployment drops below its natural rate. However, if people know that this is going to
happen, why don't they immediately adjust to it? And if people immediately adjusted to it, wouldn't
this imply that anticipated monetary policy would be ineffective to cause any deviation from the full-
employment level of output? In reality, however, even if people have rational expectations, they may
not be able to adjust immediately. One reason is that wage contracts often set wages for an extended
time period. Similarly, prices cannot always be changed right away and the costs of changing prices
 may outweigh the benefits. A further argument is that even rational people make forecasting
mistakes and learn only slowly.

In other words, the location of the expectations-augmented Phillips curve is determined by the level
of expected inflation, which is set by recent historical experience. A shift in this curve caused by
changing inflationary expectations occurs only gradually. The rational expectations model, on the
other hand, assumes that the Phillips curve shifts almost instantaneously as new information about
the near future becomes available.

2. Briefly state the reason for the slow adjustment of wages to changes in aggregate demand.

The reasons for the slow adjustment of nominal wages can be explained in several ways. One
explanation is that workers have imperfect information, that is, they do not immediately realise
whether a change in their nominal wage is the result of an increase in prices or in the real wage they
receive for the work they provide. Another explanation is that coordination problems exist, that is,
different firms within an economy are unsure about the behaviour of their competitors and thus they
only reluctantly change wages or prices. The efficiency wage theory, on the other hand, argues that
firms pay above market-clearing wages to motivate their workers to work harder. Firms are also
reluctant to change wages due to the perceived cost of doing so. Another argument is that wage
contracts tend to be long-term, so real wages tend to fluctuate over the length of the contract and
output adjusts only slowly to price changes. Finally, the insider–outsider model argues that firms
negotiate only with their employees but not the unemployed. Since a turnover of the labour force is
costly to firms, they are willing to offer above market-clearing wages to the currently employed rather
than hiring the unemployed who may be willing to work for less. These various explanations are not
mutually exclusive, and they all imply that the AS curve is positively sloped, that is, that a change in
aggregate demand will affect both output and prices in the short run.

3. 'If everyone in this economy had rational expectations, then wages would be flexible and
unemployment could not occur.' Comment on this statement.

The new Keynesian models argue that even if people have rational expectations, socially undesirable
outcomes may still occur due to imperfect competition and the existence of wage contracts. Prices
may not change freely, since firms in imperfectly competitive markets are reluctant to change them,
due to the menu costs involved. Nominal wages are set by contracts over a period of time, so the
economy may adjust only slowly to a decrease in aggregate demand. Thus a rate of unemployment
higher than the natural rate can exist over an extended period of time.

4. Briefly explain why there seems to be so much interest in finding ways to shift the upward-sloping
aggregate supply curve to the right.

Shifting the upward-sloping AS curve to the right seems to be the only way to offset the effects of an
adverse supply shock without any negative side effects. An adverse supply shock, such as an increase
in oil prices, causes a simultaneous increase in unemployment and inflation, and policy makers have
only two options for demand–management policies. Expansionary fiscal or monetary policy will help
to achieve full employment faster but will raise the price level, while restrictive fiscal or monetary
policy will reduce inflationary pressure but increase unemployment. Therefore, any policy that would
shift the upward-sloping AS curve back to the right seems preferable, since it might bring the
economy back to the original equilibrium by simultaneously lowering inflation and unemployment.

5. Use an AD–AS framework to show the effect of monetary restriction on the level of output, prices
and the interest rate in the medium and the long run.
A decrease in nominal money supply will increase interest rates, leading to a decrease in investment
spending. This will shift the AD curve to the left, creating an excess supply of goods and services.
 Therefore the price level will decrease and real money balances will increase. A new equilibrium will
be achieved at the intersection of the new AD curve and the upward-sloping AS curve at an output
level that is below the full-employment level. In the long run, higher unemployment will cause
downward pressure on wages. As the cost of production decreases, the upward-sloping AS curve will
keep shifting to the right until a new long-run equilibrium is established at the full-employment level
of output, that is, where the new AD curve intersects the long-run vertical AS curve at Y* . At this
point, real output, the real interest rate, real money balances and the real wage rate will be back at
their original level. Nominal money supply, the price level and the nominal wage rate will all have
decreased proportionally.

A simplified adjustment can be shown as follows:

1––>2: Ms down  i up  I down  Y down ==> the AD curve shifts left ==> excess supply  P down
 real ms up  i down  I up  Y up

(The first line describes a policy change, that is, a shift in the AD curve; the second line describes the
price adjustment, that is, a movement along the AD curve.)

Short-run effect: Y down, i up, P down

2—>3: Since Y < Y* ==> downwards pressure on nominal wages ==> cost of production down ==> the
short run AS curve shifts right ==> excess supply of goods  P down  real ms up  i down  I up
 Y up (This process continues until Y = Y* )

Long-run effect: Y stays at Y*, i remains the same, P down.

Note: Even though only one shift of the short-run AS curve to the new long-run equilibrium is shown
here, this shift is actually a combination of many shifts.

6. Assume oil prices decline. What kind of monetary policy should the central bank undertake if its
goal is to stabilise the level of output while keeping inflation low? Show with the help of an AD–AS
diagram and briefly explain the adjustment process.

1––>2: As oil prices decline, the cost of production decreases and the upward-sloping AS curve shifts
to the right, causing excess supply of goods. Thus the price level decreases, real money balances
increase and the interest rate declines.
 2––>3: A decrease in money supply will increase the interest rate, decrease private spending and shift
the AD curve to the left. This means that prices will decrease even further and the level of output will
decline. (We assume, for simplicity, that it goes back to the full-employment level Y*, so no long-run
adjustment is needed.) Overall, the level of output has remained at its full-employment level but the
level of prices and the interest rate have decreased.

Tutorial 5:

Short Answer Questions

1. Explain at least two monetary policy rules a central bank could implement. Briefly explain why the
AS-curve is upward sloping in the intermediate run.

First, the central bank could allow the money supply to grow at a constant rate. If it was felt that large
fluctuations in the economy were caused by irregular money supply changes then this rule may
prevent these fluctuations. Second, an inflation target rule could be implemented. The central bank
would announce an inflation rate and alter the money supply when the actual inflation rate deviated
from this target. A third example of a rule is the Taylor rule, which sets interest rates on the basis of
deviations from target inflation and GDP and their actual level.

2. Use the information in Chapter 5 to answer the question: should policy makers attempt to stabilise
the economy?

The chapter explains there clearly are occasions during which active monetary and fiscal actions
should be taken to stabilise the economy. These are situations in which the economy has been
affected by major disturbances. However, as also mentioned in the chapter there are others who are
sceptical about policy makers having the ability to stabilise the economy. These people point out the
lags involved as a significant hindrance to policy implementation. For them a passive approach to
policy making is preferred. This would involve following rules to prevent time inconsistency problems
arising.

3. Why is fine-tuning difficult to achieve through fiscal policy?

Fiscal policy is perhaps more suited to use during a major economic disturbance such as the Global
Financial Crisis or the Great Depression. It can be argued that fiscal policy is inappropriate when
attempting to fine-tune the economy in 'normal times' because of its side effects. This is because
activist fiscal policies have the potential to distort choices made by consumers, workers and firms. A
change to taxation policy is a good example. As well, a fiscal policy that involves a budget deficit has
the potential not only to increase government debt but also increase interest rates and act as a
disincentive to invest. It is also much slower to introduce changes in fiscal policy because of the large
inside lags. This means it is likely to be much harder to make lots of small changes in policy in
response to developments observed in the economic data, such as GDP or the unemployment rate.
Hence it is often argued that monetary policy is better used for fine tuning the economy.
 4. Why is inflation targeting considered to be at the opposite end of the spectrum to real GDP
targeting?

Real GDP targeting is the use of monetary and fiscal policies to achieve a particular rate of real GDP
growth. Inflation targeting can be seen as being at the opposite end of the spectrum because it uses
fiscal and monetary policy to achieve a particular rate of inflation. This approach gives up on the idea
of reaching a primary target of a certain level of real GDP growth and instead focuses on the
secondary target of inflation. This approach to policy has gained support in recent years and has been
adopted by up to 20 countries including Australia.

5. ‘Credibility is extremely important in the conduct of monetary policy.’ Comment on this statement
and relate your answer to the concept of dynamic inconsistency.

Assume there is a supply shock and the central bank has to decide whether to keep unemployment
low by implementing expansionary monetary policy or to concentrate on keeping inflation under
control. The dynamic inconsistency approach suggests that the central bank should refrain from a
policy response that may look appropriate in the short run but will prove unproductive in the long
run. If the central bank always chooses to accommodate a supply shock, people will come to expect
such a reaction and will incorporate the assumption of a higher inflation rate in their wage demands.
But if the central bank consistently tries to keep inflation under control (even though it may cause
some unemployment in the short run), people will lower their inflationary expectations. The central
bank will keep its reputation as an inflation fighter, and the economy will adjust back to full
employment fairly rapidly.

Tutorial 6:

Short Answer Questions

1. Briefly distinguish between these two concepts: decreasing returns to scale and the law of
diminishing marginal returns.

Decreasing returns to scale occur when a proportional increase in all inputs leads to a less-than-
proportional increase in output. The law of diminishing marginal returns states that the marginal
product of each unit of input will decline as the amount of that input is increased, while all other
inputs constant are held constant. In other words, if we only increase one of several inputs, output
will increase but at a decreasing rate.

2. Assume a Cobb-Douglas aggregate production function in which labour's share of income is 80%
and capital's share of income is 20%. By how much will real GDP in this economy grow if labour
grows at 2.5%, the capital stock grows at 1.5% and total factor productivity increases by 2.1%?

The growth of output can be calculated as the sum of the growth in labour times the labour share
plus the growth of capital times the capital share plus the change in total factor productivity, that is:
Y/Y = (1 – )(N/N) + (K/K) + A/A, where 1 –  is the share of labour (N) and  is the share of
capital (K), and A/A is the change in total factor productivity. Therefore, we can calculate total
output growth as:
Y/Y = (0.8)(2.5%) + (0.2)(1.5%) + 2.1% = 2.0% + 0.3% + 2.1% = 4.4%.

3. Assume an economy in which the level of technology and the stock of capital are fixed. If there is a
sudden increase in the labour force due to immigration, how would the standard of living be
 affected? Would it make a difference if the increase in the labour force were instead caused by a
higher labour force participation rate of women?

If the increase in the labour force were entirely due to an influx of foreigners, then the population
would increase and living standards would decrease, since per-capita income would decrease.
However, if the increase in the labour force were due to an increase in the labour force participation
of women, then income per capita would increase since the overall population would not increase.
Therefore there would be an increase in living standards.

4. 'A higher population growth is always desirable since it will lead to higher living standards.'
Comment on this statement with the help of a diagram derived from the neoclassical growth
model.

If the rate of population growth (n) increases, the capital stock will grow at a lower rate than
population. Since the country has to feed its people, not enough will be saved and invested to keep
the capital–labour ratio (k) at its original level. Therefore, the capital–labour ratio (k) decreases until a
new steady state is reached. In other words, the investment requirement, that is, the (n + d)k line gets
steeper as population growth (n) increases. The (n + d)k line will now intersect the sy-curve at a lower
steady-state capital–labour ratio (k). This implies a lower level of output per capita (y), and therefore
a lower living standard. Thus the statement is wrong.

5. 'If Australia can increase its national savings

rate, it can achieve a higher long-term growth rate.' Comment on this statement with the help of a
diagram derived from the neoclassical growth model.

If the savings rate increases, then the sy-curve shifts up and we get a new intersection with the (n +
d)k line at a higher steady state capital–labour ratio and a higher level of output per capita. In other
words, as the level of savings and investment increases, the labour force will be supplied with more
capital until a new and higher optimal capital–labour ratio (k) and output per capita level (y) is
reached. Thus, the growth rate of real output will increase only temporarily. But, in the long run,
while the level of output per capita is higher, the growth rate of real output will again be equal to the
population growth (n).
 6. Can a poor country ever catch up with a rich country if both have the same population growth?
Explain your answer.

Over the long run, the growth rate of output is determined by the rate of population growth and the
rate of technological progress. In the short run, a nation's growth rate can be affected by investment
in machinery, infrastructure and human capital. It is impossible to predict for sure whether lower-
income countries can ever succeed in catching up with the standard of living of higher-income
countries. On balance, empirical evidence suggests slow 'conditional convergence', that is, that the
positive impact of a higher level of investment spending is only transitory, leading to a higher level of
income per capita but not a higher growth rate. Countries will converge to steady states, depending
on the share of investment to GDP, the share of government spending to GDP and the rate of
investment in human capital. However, the process of such convergence is extremely slow. There is
also some evidence to suggest the emergence of 'convergence clubs'—particular groupings of
countries with common features for whom convergence seems to be occurring quite strongly.

Tutorial 7:

Short Answer Questions

1. Suppose we have a one-sector model with a variable rate of population growth (see Fig. 7.3 in the
textbook).

(a) What does the investment requirement line look like for this model?
(b) Characterize the set of equilibrium, being sure to discuss their stability or lack thereof. Does
output in any of these equilibria have non-zero per capita growth?
 (c) Suppose your country is in a ‘poverty trap’—at the equilibrium with the very lowest level of
output per person. What could the country do to move towards a point with higher income?

2. Assume the aggregate production function is of the following form: Y = aK. At what capital– labour
ratio (k) can a steady-state equilibrium be reached?
From the production function Y = aK, it follows that y = Y/N = a(K/N) = ak. Therefore, the savings
function is sy = s(ak) and has a constant slope sa > (n + d). There will never be an intersection between
the savings function and the investment requirement and thus a steady-state equilibrium cannot be
reached.
3. 'The endogenous growth model predicts conditional convergence.' Comment on this statement.

This statement is false. Conditional convergence is the notion that countries with different savings
rates but the same rate of population growth and access to the same technology will achieve the
same long-term growth rate even though they may achieve a different standard of living. This is
contrary to the endogenous growth model, which predicts that there is a positive correlation between
savings rates and growth rates across countries.

4. 'The Asian Tigers achieved phenomenal economic growth from 1966–1990 by devoting a large share
of GDP to investment and by relying on laissez-faire economics.' Comment on this statement.

The Asian Tigers (Hong Kong, Singapore, South Korea and Taiwan) experienced a high rate of
economic growth by increasing their savings rate so more could be invested. In addition, however,
they increased their labour forces and concentrated on improving the education of their people.
While Hong Kong relied largely on laissez-faire economics, there was significant government
involvement in Singapore, where many investment projects were directed by the government.

5. Assume the government wants to increase the long-term growth rate of the economy and considers
the policy options listed below. In your opinion, which of these policies will be successful in
stimulating long-term growth and why?
a) Expansionary monetary policy
b) An increase in government spending
c) Tax credits to stimulate new research and development
d) Policies to improve education
e) Policies to control population growth

a) Expansionary monetary policy may affect real output in the short run and the rate of inflation in
the long run, however it does not affect the long-term growth rate. By affecting saving and
investment, it may affect the level of GDP per capita but not the growth rate of GDP.

b) An increase in government spending may have some short-run effects on real output, but it will
not affect the long-term growth rate of GDP. Only increases in spending affecting either the level
of education (human capital), the level research and development or investment spending
(physical capital) may potentially affect economic growth in the long run.

c) Investment tax credits are designed to create incentives to undertake new research and
development which may, in turn, lead to a higher rate of technological progress. Such a policy
may potentially affect economic growth in the long run.

d) Policies that support education will lead to an increase in human capital and this, in turn, will
affect the long-term growth rate. However, this is likely to be a very slow process.

e) Policies designed to affect the population growth rate will affect the steady-state level of growth.
For example, in developing countries that have rapid rates of population growth, most of the
available resources are needed to feed and educate people. This leaves only limited resources for
investment in new capital equipment that would allow for an increase in output per capita and a
higher standard of living.
Tutorial 8:

Short Answer Questions

1. 'An increase in the marginal propensity to save increases the impact of one additional dollar in
income on consumption.' Comment on this statement. In your answer discuss the effect of such a
change in the MPS on the size of the expenditure multiplier.

The fact that the marginal propensity to save (1 – c) has risen implies that the marginal propensity to
consume (c) has fallen. This means that now one extra dollar in income earned will affect
consumption by less than before the reduction in the MPC. When the MPC is high, one extra dollar in
income raises consumption by more than when the MPC is low. If the MPS is larger, then the
expenditure multiplier will be larger, since the expenditure multiplier is defined as 1/( 1– c).

2. Using a simple model of the expenditure sector without any government involvement, explain the
paradox of thrift that asserts that a desire to save may not lead to an increase in actual saving.
The paradox of thrift occurs because the desire to increase saving leads to a lower consumption level.
But a lower level of spending sends the economy into a recession and we get a new equilibrium at a
lower level of output. In the end, the increase in autonomous saving is exactly offset by the decrease
in induced saving due to the lower income level. In other words, the economy is in equilibrium when S
= Io. Since the level of autonomous investment (Io) has not changed, the level of saving at the new
equilibrium income level must also equal Io.

This can also be derived mathematically. Since an increase in desired saving is equivalent to a
decrease in desired consumption, that is, Co = –So, the effect on equilibrium income is:

Y = [1/(1 – c)](Co) = [1/(1 – c)](–So).

Therefore the overall effect on total saving is:

S = s(Y) + So = [s/(1 – c)](–So) + So = 0, since s = 1 – c

3. 'When aggregate demand falls below the current output level, an unintended inventory
accumulation occurs and the economy is no longer in an equilibrium.' Comment on this statement.
If aggregate demand falls below the equilibrium output level, production exceeds desired spending.
When firms see an unwanted accumulation in their inventories, they respond by reducing production.
The level of output falls and eventually reaches a level at which total output equals desired spending.
In other words, the economy eventually reaches a new equilibrium at a lower value of output.

4. Assume the following model of the expenditure sector:

AD = C + I + G + NX
C = 420 + (4/5)YD
YD = Y – TA + TR
TA = (1/6)Y
TRo = 100
Io = 160
Go = 180
NXo = – 40

a) Assume the government would like to increase the equilibrium level of income (Y) to the full-
employment level Y* = 2700. By how much should government purchases (G) be changed?
 b) Assume we want to reach Y* = 2700 by changing government transfer payments (TR) instead.
By how much should TR be changed?

c) Assume you increase both government purchases (G) and taxes (TA) by the same lump sum of
G = TAo = + 300. Would this change in fiscal policy be sufficient to reach the full-employment
level of output at Y* = 2700? Why or why not?

d) Briefly explain how a decrease in the marginal propensity to save would affect the size of the
expenditure multiplier

a) AD = C + I + G + NX = 420 + (4/5)[Y – (1/6)Y + 100] + 160 + 180 – 40 = 720 + (4/5)(5/6)Y + 80 =

800 + (2/3)Y From Y = Sp ==> Y = 800 + (2/3)Y ==> (1/3)Y = 800 ==>Y = 3*800 = 2400 ==> the
expenditure multiplier is  = 3 From Y = (Ao) ==> 300 = 3(Ao) ==> (Ao) = 100 Thus
government purchases should be changed by G = Ao = 100.

b) Since Ao = 100 and Ao = c(TRo) ==>100 = (4/5)(TRo) ==> TRo = 125.

c) This is a model with income taxes, so the balanced budget theorem does not apply in its
strictest form, which states that an increase in government purchases and taxes by a certain
amount increases national income by that same amount, leaving the budget surplus unchanged.
Here total tax revenue actually increases by more than 100, since taxes are initially increased by a
lump sum of 100, but then income taxes also change due to the change in income. Thus income
does not increase by Y = 300, as we can see below: Y = (G) + [(–c)(TAo) = 3*300 + 3*[–
(4/5)300] = 900 – 720 = 180 This change in fiscal policy will increase income by only Y = 180,
from Y0 = 2400 to Y1 = 2580, and we will be unable to reach Y* = 2700.
d) If the marginal propensity to save decreases, people spend a larger portion of their additional
disposable income; that is, the MPC and the slope of the [C + I + G + NX] line increase. This will
lead to an increase in the expenditure multiplier and equilibrium income.

5. Explain why income taxation and unemployment benefits are considered automatic stabilisers.

Income taxes and unemployment benefits are often called automatic stabilisers because they reduce
the amount by which output changes as a result of a change in aggregate demand. These stabilisers
are a part of the structure of the economy and therefore work without any actual government
intervention; for example, when output declines and unemployment increases. If we had no
unemployment benefits, people out of work would not receive any disposable income and then
consumption would drop significantly. But since unemployed workers get unemployment benefits,
consumption will not decrease as much. Therefore, aggregate demand may not be reduced by as
much as it would have without these automatic stabilisers.

6. Is the size of the actual budget surplus always a good measure for determining fiscal policy? What
about the size of the full-employment budget surplus?

The actual budget surplus has a cyclical and a structural component. The cyclical component of the
budget surplus changes with changes in the level of income whether or not any fiscal policy measure
has been implemented. This implies that the actual budget surplus also changes with changes in
income and is therefore not a very good measure for assessing fiscal policy. The structural (full-
employment) budget surplus is calculated under the assumption that the economy is at full-
employment. It therefore changes only with a change in fiscal policy and is a much better measure for
fiscal policy than the actual budget surplus. One should keep in mind, however, that the balanced
budget theorem implies that the government can stimulate national income by an equivalent and
 simultaneous increase in taxes and government purchases, thereby affecting the actual or the full-
employment budget surplus.

Tutorial 9:

Short Answer Questions

1. 'A decrease in the marginal propensity to save implies that the IS curve will become steeper.' True
or false? Explain your answer.

False. A decrease in the marginal propensity to save (s = 1 – c) is equivalent to an increase in the

marginal propensity to consume (c), which, in turn, implies an increase in the expenditure multiplier
(). But with a larger expenditure multiplier, any increase in investment spending due to a decrease in
the interest rate will lead to a larger increase in income. Therefore the IS curve will become flatter
and not steeper.

2. 'If the Reserve Bank keeps the supply of money constant, then the money supply curve is vertical,
which implies a vertical LM curve.' True or false? Explain your answer.
False. Equilibrium in the money sector implies that real money supply is equal to real money demand,
that is:

M/P = L(i,Y) = kY – hi

This implies that any increase in income (Y) will increase the demand for money. To bring the money
sector back into equilibrium, interest rates (i) have to rise simultaneously to bring the quantity of
money demanded back to the original level (equal to the fixed supply of money). Therefore, to keep
the money sector in equilibrium, an increase in income is associated with an increase in the interest
rate and the LM curve must be upward-sloping.

3. 'Restrictive monetary policy reduces consumption and investment.' Comment on this statement.

A reduction in money supply raises interest rates, which will, in turn, have a negative effect on the
level of investment spending. The level of consumption may also decrease as it becomes more costly
to finance expenditures by borrowing money. But even if it is assumed that consumption is not
affected by changes in the interest rate, consumption will still decrease since restrictive monetary
policy will reduce national income and therefore private spending.

4. 'If the demand for money becomes more sensitive to changes in income, then the LM curve
becomes flatter.' Comment on this statement.

An increase in income will lead to a rise in money demand for a given fixed money supply. In turn the
excess demand for money that is generated means that interest rates will have to rise to maintain
money market equilibrium. So, for a given increase in income, the more sensitive money demand to
income, the greater will be the excess money demand induced and hence the larger will the rise in
interest rates have to be to choke off this excess money demand. A larger rise in interest rates implies
a steeper (not a flatter) LM curve.
5. Assume the following IS–LM model:
Expenditure sector: Money sector:
Sp = C + I + G + NX
M = 700
C = 100 + (4/5)YD
P=2
YD = Y – TA
L = (1/3)Y + 200 – 10i
TA = (1/4)Y
I = 300 – 20i
G=120

a) Derive the equilibrium values of consumption (C) and money demand (L).

b) How much of investment (I) will be crowded out if the government increases its purchases by =
160 and nominal money supply (M) remains unchanged?

c) By how much will the equilibrium level of income (Y) and the interest rate (i) change, if nominal
money supply is also increased to M' = 1100?
Tutorial 10:

Short Answer Questions

1. 'Expansionary fiscal policy is more effective when it is financed by borrowing from the public than
when it is monetised.' True or false? Explain your answer.

False. If the government finances an increase in its spending by selling bonds to the public, no change
in the supply of money will occur, and the IS curve will shift without a corresponding shift in the LM
curve. On the other hand, if an increase in the budget deficit is monetised, then money supply will
increase, as the central bank buys government bonds from the public. Therefore, the LM curve will
also shift to the right, leading to lower interest rates than in the first case. Less crowding out will
occur and the overall effect on income will be greater—at least in the IS–LM model, that is, the short
run. In the long run, when prices are allowed to be flexible, then crowding out cannot be avoided by
monetising the debt, since an increase in the price level will lead to lower real money balances and
therefore higher interest rates.

2. 'Crowding out is complete in the liquidity trap.' True or false? Why?

False. In the liquidity trap the public is prepared to hold whatever money is supplied at any given
interest rate. This implies that the LM curve is horizontal. If government spending rises, the IS curve
will shift to the right. Income will rise but interest rates will not increase. This means that there will be
no crowding out.

3. Assume the government wants to increase investment but keep income constant. What policy mix
will help reach this goal?

Ease monetary policy and tighten fiscal policy. Lower interest rates increase investment while higher
taxes will offset the impact greater investment has on income.

4. Assume investment is very interest-inelastic and money demand is very interest-elastic. With the
help of an IS–LM diagram, explain the effect of a cut in the income tax rate (t) on investment (I),
money demand (L) and the budget surplus (BS) and briefly explain the adjustment process.

Investment is interest-inelastic so the IS curve is steep; money demand is interest-elastic so the LM

curve is flat. An income tax cut will shift the IS curve to the right and make it flatter. Income and the
interest rate will increase. Since the LM curve is flat, the interest rate will not increase by much, so
investment will decrease only a little. The budget deficit will increase due to the tax cut. Higher
income will lead to more money demand but a higher interest rate will lead to lower money demand.
Overall, money demand will remain constant, since money supply hasn't changed. The adjustment
process can be described as follows:

t   C   Y (  L  i  I  Y )

Overall effect: Y and i

5. Assume money demand is very interest-inelastic and investment is very interest-elastic. Explain
how the level of savings (S), money demand (L) and investment (I) would be affected if the
government increased transfer payments.

If money demand is very interest-inelastic, the LM curve is very steep, and if investment is very
interest-elastic, the IS curve is very flat. With a steep LM curve and a flat IS curve, fiscal policy is not
very effective, since most of it is crowded out. An increase in government transfer payments (TR)
shifts the IS curve to the right and income and the interest rate increase. Since income has increased,
saving has increased and since the interest rate has increased, investment has decreased. In the end,
money demand cannot be affected since money supply has not changed. The increase in income
increases money demand, but the increase in the interest rate brings it back to its original level; that
is, in equilibrium with money supply. The adjustment process that takes place is as follows:

TR   Y  (  L   i   I   Y  )

Overall effect: Y  i 

Since i increases a lot a lot, the effect on I is large, as is the offsetting effect (the crowding out effect)
on output (Y). This means that the overall effect on Y is small.