Exam 2017, answers PDF

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SAMPLE PAPER 2017 ANSWERSPART ONE1 C2 D3 D3 B5 C6 C7 A8 D9 D10 C11 B12 C13 C14 C15 C16 D17 D18 B19 C20 B(i) £420 million(ii) £180 million(iii) + £45 million(iv)The equilibrium level of income is originally £600 million.The multiplier is 1/(1-0) = 3.So an increase in investment of £30 million increas...

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SAMPLE PAPER 2017 ANSWERS PART ONE 1 2 3 3 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

C D D B C C A D D C B C C C C D D B C B

Question 21 (i)

£420 million

(ii)

£180 million

(iii)

+ £45 million

(iv) The equilibrium level of income is originally £600 million. The multiplier is 1/(1-0.7) = 3.333 So an increase in investment of £30 million increases income by 3.33 x £30 million = £100 million so new equilibrium level of income is £700 million.

(v) £600 million

Question 22

(i) With a contractionary open market operation the central bank sells Treasury bills in the money market. The result of the operation is that the banks and public holds less cash and more Treasury bills while the Central bank holds more cash and less Treasury bills. Hence the effect of the operation is to reduce the narrow money supply, the increase in the amount of Treasury bills reduces the price of Treasury bills and therefore constitutes a rise in the short term rate of interest.

The original position is rate of interest r1 and the price of Treasury Bills P1. The central bank wishes to raise the short term interest rate to slowdown the economy. It will sell Treasury bills in the financial markets increasing supply from TS1 to TS2 pushing down the price of Treasury bills from P1 to P2. The private sector will now hold less money and more Treasury bills. The money supply decreases from MS1 to MS2, to clear the money market the rate of interest needs to rise from r1 to r2.

(ii) The formula for the money multiplier is: Money multiplier = 1 + c c+r (iii) The broad money supply rises by 9 per cent as well.

Question 23

(i) We need taxes to be £200 million so national income must be £200/0.25 = £800 million to have a balanced budget. (ii) The budget would be in deficit by £50 million Tax would be 0.25 x 600 = £150 million less expenditure = £200 million Deficit = £50 million (iii) Y = 0.8 (1 - t)Y + G + 100 Given Y = £900 million at full employment 900 = 0.8 [900 - 0.25 (900)] + G + 100 implies G = 260 Therefore government expenditure needs to be £260 million

Question 24

According to classical free market economists involuntary unemployment results from trade unions keeping the real wages w2 above the equilibrium real wage w1. This results in a labour force of size N5 while the demand for labour is only N3. The result is unemployment equal to N3 N5 of which N3 N4 is involuntary and N4 N5 is voluntary. The solution to such involuntary unemployment is to weaken trade unions so that the real wage can be forced down to its equilibrium level w1.

Question 25 Diagram parts (i) to (iii)

Question 26 (i) S = - 200 + 0.2 Y = £200 million (ii) Y = 200 + 0.8 Y + 300 = £2500 million (iii) Y = 200 + 0.8Y + 500 Y = 3500 so C = 200 + 0.8 Y = 200 + 0.8 (3500) = £3000 million (iv) dY =

1 £100 million 1 - MPC

Where MPC is the marginal propensity to consume so that: dY =

1 £100 million 1 - 0.8

So national income would rise by £500 million

Question 27 (i)

(X-M) = (S-I) + (T-G)

(ii) Closed economy multiplier is 1 1-c(1-t)

Open economy multiplier is 1 1-c(1-t)+m

(iii) The current account multiplier is: dCA =

-m dG 1-c(1-t)+m

Question 28

(i)

Initial equilibrium is at interest rate r1 and income level Y1. The government then decides to increase government expenditure and finance this by bond sales to the public. The effect of the increased government expenditure is to raise aggregate demand and shift the IS curve to the right from IS1 to IS2. However the increased income and increased bond sales will have the effect of raising money demand and by lowering the price of bonds raises the rate of interest so as to keep money demand equal to money supply. Final equilibrium is obtained at the interest rate r2 and output level Y2. Hence, in principle a fiscal expansion can achieve the full employment level of output.

(ii) The National Debt of a country is the outstanding stock of government bonds in the market. The higher a country's National Debt the higher the stock of bonds available on the market and, other things being equal, the higher the interest rate. Apart from this, governments with a high National Debt tend to be distrusted by the financial markets. The markets may attach a higher risk to countries with high National Debts for fear that the government may ultimately redeem the debt by printing money which could lead to inflation. This extra inflation risk will tend to be priced into the rate at which the government can borrow.

Question 29 (i) Demand-pull inflation is an inflation that results from an initial increase in aggregate demand. Demand-pull inflation may begin with any factor that increases aggregate demand:

Cost-push inflation is an inflation that results from an initial increase in costs.

Examples of demand pull inflation include: 1. Increase in the quantity of money and lower interest rates 2. An increase in government expenditures or tax cuts 3. Changes in consumer and investment demand 4. An increase in export demand due for example to global economic g

Examples of cost push inflation include: 1. An increase in the money wage rate 2. An increase in the money price of a raw materials, such as oil and commodities. 3. A depreciation of the exchange rate which raises import costs

(ii)

With rational expectations economic agents are forward looking when determining their wage rises. This means that when aggregate demand rises from AD1 to AD2 due to an expansionary monetary policy, wages immediately change as economic agents forecast the eventual price level P3. As such prices and wages rise by the same amount so real wages are unchanged and there is no incentive for firms to take on more workers or expand output. Since wages and prices adjust fully to the increases in aggregate demand both the long run and short run aggregate supply curves are vertical at the initial level of output.

Question 30 Crowding out occurs when increased government expenditure leads to lower private sector consumption and investment, that is, the government expenditure crowds out the private sector. To the extent that crowing out occurs there will be less of a boost to aggregate demand. At one extreme some economists argue there is 100% crowding out while others argue that the crowing out effects are likely to be more limited. However many economists believe that there are significant “Crowding out” effects that will limit the effectiveness of a fiscal expansion. 1) If the government has a large fiscal deficit it will have to raise the money by selling bonds onto the financial markets, the more bonds it sells the more it will have to raise the coupon or rate of interest to attract new buyers. The rise in long term interest rates will then hit private sector consumption and investment. 2) The government could of course finance increased expenditures by raising taxes such as income and corporate taxes or indirect taxes such as VAT but if it does so this will have the effect of curtailing private sector consumption and investment. 3) If the government decides to finance the increased fiscal expenditure by selling bonds and widening the fiscal deficit it is quite possible that economic agents will conclude that the higher fiscal deficits today will mean higher taxes in the future. As such they might save more today so as not to suffer when the higher taxes come in the future – this is known as the “Barro effect”. If the increased savings equals the increased government expenditure we have what is known as Ricardian equivalence. 4) Large fiscal deficits might upset the financial markets raising long term interest rates and the cost of raising capital. 5) There may be adverse supply side effects on the economy of increased government taxes to finance increased government expenditure on the labour market which lower the incentive to work and if they drive up employers costs directly reduce labour demand. 6) In an open economy it is possible that an expansionary fiscal policy by raising the domestic interest rate might lead to a sharp appreciation of the currency which can hit exports (since they become more costly in terms of the foreign currency) and raise the price of imports (since they become more expensive in terms of the domestic currency). This will mean a slowing down of aggregate demand so to some extent offsetting the effects of the increased government expenditure....