Macro Lab 01 Question Answer Pack PDF

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Loughborough University School of Business and Economics

BSA022 Macroeconomics for Financial Studies

Lab 1 Question & Answer Pack

Lecturer: Dr. Jon Seaton Email: [email protected] Room BE 2.87 (Sir Richard Morris Building)

Summary The labs are important to your learning as feedback. We will go through a number of questions ‘together’ – in some senses this is exam practice in that you have to work out the answers to these question on the spot. So revise your notes/textbook well before these sessions. However we will work through the answers together and FULL answers are provided in this pack. This means you can check through the answers afterwards and reflect on your learning. If you find that you are struggling during these sessions despite reading well then as a matter of urgency you should come to see me to discuss/resolve these issues. Do not leave it to one week before the exams! My office hours are : Monday & Friday 8:20am to 12:50pm (I’m normally around from 8am-4pm most days of the week)

There are three sections to this pack Lab questions These are the questions you are expected to answer during these labs. They are designed to help you understand specific models of and issues with the economy typically asking about model construction, changes or shifts in curves and your policy conclusions/interpretations. There may be some mathematics involved, but nothing too complex.

Lab answers Full answers are provided and these are the answers that will appear on the slides of my power point presentation. If you do not understand these answers come to see me or email and I will seek to make them clearer. Any changes/improvements to this pack will be put on LEARN.

Revision questions To help test your understanding for each lecture and prepare you for the final exam. These questions may be used in labs, at my discretion, and you should make sure you have a good idea of how you would answer these should that happen. A good understanding of the lecture and relevant reading material will help. We may also have time in lectures, particularly the revision lecture, to discuss these in much more detail. I will not be formally providing answers to these as you should be able to figure them out from the lecture/text, but will be happy to discuss them in free lecture/lab time. I would suggest very strongly that you take time to discuss and compare notes on these with your colleagues on the course.

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Lab Questions To complement lectures 1. Introduction & Overview to Macroeconomics 2: The Roots of Modern Macroeconomics 1. What does macroeconomics study? a) Product demand functions. b) Consumption patterns of individual consumers. c) The interaction of economic aggregates. d) The behaviour of the government. e) Business decisions. 2. The Macroeconomics we look at in the course will a) explain exactly how the economy works. b) use economic models to help us understand how the real economy works. c) be able to explain individual behaviour. d) be a case study analysis of the work of Gordon Brown & George Osborne. e) use computable general equilibrium models (20 equations). 3. Which is NOT part of Macro policy? a) Stabilizing Money supply b) Supply side policy c) Government expenditure d) Regulation of Utilities 4. What happens in the AD/AS model if G rises? a) AD shifts to the right, P rises, Y rises. b) AD shifts to the right, P rises, Y falls. c) AD shifts to the right, P falls, Y rises. d) AD shifts to the right, P falls, Y falls. e) AD shifts to the left.

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5. Which macroeconomic variables affect Aggregate Demand and Supply in the Macro market? Why is this so different to demand and supply of the ‘Micro’ world you looked at in the last semester? _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________

6. What is the circular flow of income?

_______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________

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7. Define GDP at market prices and draw the circular flow diagram for an economy with ... a) No government, or external sector

_______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ b) An external sector but no Government

_______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ 4

c) Both an external and government sector

_______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________

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8. The following table shows domestic expenditure and GDP in three consecutive years : Year 1 £m

Year 2 £m

Year 3 £m

GDP

500

600

700

Government expenditure

200

250

200

Consumers’ expenditure

300

300

250

50

200

200

Investment

In which year(s) did the country have a balance of payments deficit? a) b) c) d)

Years 1, 2 and 3 Years 1 and 2 Years 2 and 3 Year 1 only

_______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ Hint: You should be able to fill in the table below knowing the relationship GDP = C + I + G +X-IM year 1 2 3

GDP

C

I

G

C+I+G

X-IM

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9. Consider the rather abstract looking aggregate supply curve in the diagram below

It comprises two sections, the first part (A) is completely horizontal, the second (B) is vertical. a) Given your understanding of the arguments put forward by the extreme left and right wing economists how would you interpret these sections? _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ b) Given your understanding of the time up to and including the great recession interpret changes in the UK economy using this graph? _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________

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Answers 1. What does macroeconomics study? a) Product demand functions. b) Consumption patterns of individual consumers. c) The interaction of economic aggregates. d) The behaviour of the government. e) Business decisions. Answer: Hopefully you found this one pretty obvious, the answer is ‘c’. Macro deals with the ‘big stuff’ of economics, so yes it looks at the economic aggregates like total unemployment, economic growth, money supply, total tax revenue and government spending as well as aggregate price indices such at average wages, CPI/RPI and key high impact variables such as the setting of the interest rate (which the Bank of England sets via the monetary policy committee). So individual decisions of consumers and businesses are not the focus of macro, neither are prices and quantities sold of individual goods and services. That said, there are grey areas and numerous researchers in micro and macro who break these traditional so-called boundaries every so often. 2. The Macroeconomics we look at in the course will a) explain exactly how the economy works. b) use economic models to help us understand how the real economy works. c) be able to explain individual behaviour. d) be a case study analysis of the work of Gordon Brown & George Osborne. e) use computable general equilibrium models (20 equations). Answer: I wish we could explain how the economy exactly works and a case study analysis would possibly be interesting though limited (we do discuss some issues though), but what we are doing is ‘b’ putting together some reasonable explanations of how the economic aggregates interact to try to describe the ‘real world’. ‘e’ is an interesting answer, economists do often try to model the whole economy in big simultaneous equation models (both equilibrium and disequilibrium approaches) but this is way ahead of what we hope to do, which is to get a fairly simple explanation of the main components of the economy that we can interpret fairly easily. 3. Which is NOT part of Macro policy? a) Stabilizing Money supply b) Supply side policy c) Government expenditure d) Regulation of Utilities Answer: Well stabilizing money supply is one of the roles of the Bank of England, they print money and also have to look after our inflation policy and try to maintain some control over exchange rates. Money supply is an economic aggregate – even though they still don’t know what it is yet! (more on that later in the course). Supply side policy is also a macro issue. Essentially its about how we might be able to shift the aggregate supply curve (in the AD/AS diagram). Government expenditure is 8

another key economic aggregate as we will see it is one component of Fiscal policy – but like so many other macro policy tools its use is fraught with controversy – but that makes things interesting! The non-Macro variable is of course ‘d’ the regulation of utilities, that’s typically viewed as a micro topic linked to the failure of markets. Some might argue that for modern macroeconomics – specifically supply side economics – the functioning of markets is a part of macro policy debate.

4. What happens in the AD/AS model if G rises? a) AD shifts to the right, P rises, Y rises. b) AD shifts to the right, P rises, Y falls. c) AD shifts to the right, P falls, Y rises. d) AD shifts to the right, P falls, Y falls. e) AD shifts to the left. Answer: G, or government expenditure, is a ‘demand side’ item or variable. If the government decides to spend more then aggregate demand (AD) in the economy will increase. This can be shown on diagram A as the shift in the AD curve to the right. So we can exclude option ‘e’. Diagram A – Demand shift Price Level (P)

AD(2) AD(1) Output (Y)

So for each level of prices P, demand has risen. What does this mean for the whole economy? In order to answer this we need to include the supply curve.

Diagram B (below), shows our initial equilibrium at P(1), Y(1) where the AD(1) and AS curves intersect. This looks remarkably like traditional micro demand and supply (but the underlying economics is different).

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Diagram B – Original equilibrium Price Level (P)

AS

P(1)

AD(1) Y(1)

Output (Y)

Diagram C – Change and new equilibrium

Price Level (P)

AS

P(2) P(1) AD(2) AD(1) Y(1) Y(2)

Output (Y)

Diagram C imposes the demand curve change caused by the impact of the rise in government expenditure G. The AS curve is stationary – it is not directly impacted by G, so the new equilibrium appears at the new intersection point Y(2), (P(2). You will notice that we move up the supply curve and thus the shape of this curve has a very real impact on our final conclusions. However, with a fairly normal (upward sloping) supply curve the increase in aggregate demand leads to a rise in output/income (from Y(1) to Y(2), but at a cost of an increase in the price level from P(1) to P(2). Presumably this price increase is somehow related to the capacity in the economy and firms’ speed of adjustment to increased demand. If firms are quick to adjust – by perhaps investing quickly in new equipment and have a readily available (cheap) 10

pool of workers to draw on, then the price change will be minimal. If there are supply constraints then clearly the price rise may be much steeper (we cover the detail of this later in the course). In conclusion as G rises, AD shifts to the right and both P and Y rise. So the answer is ‘a’. 5. Which macroeconomic variables affect Aggregate Demand and Supply in the Macro market? Why is this so different to demand and supply of the ‘Micro’ world you looked at in the last semester?

Answer This is very important as the whole course is designed to assess the different component parts of AD/AS and see how they work together. See figure below. Price Level (P)

AD=C+I+G+X-IM & Money demand and supply Note C also embodies Savings and taxation

AS Labour market demand and supply UK plc production function

P(1)

AD(1) Y(1)

Output (Y)

Aggregate demand, in the models we look at, is affected by Domestic Consumption, Savings, Investment, Government expenditure, Taxes, Exports and Imports. Money demand and supply also contribute to the changes in AD with interest rates being at the heart of changes in investment and is also a price value set by the money market. Aggregate supply is determined by the interaction of a UK production function and the labour demand and supply curves. Obviously macro is affected by macro (aggregate) variables whilst micro looks at individuals, groups or industries. Furthermore, Macro AD and AS curves actually contain demand and supply curves within them, AD contains money demand and supply, whilst AS contains the labour market demand and supply curves. In micro demand and supply are typically defined in isolation by consumers and producers separately. These ideas change depending on whether we look at the long or short run. 11

6. What is the circular flow of income? Well the answer is in the name, its about income flows and they tend to be – circular!

The Circular Flow of Income Domestic Households

In the economy each year goods and services are made, sold and bought we represent this this simple diagram

Total income generated

Payments for goods and services

Domestic Producers

As the very very simple picture above shows – stripped down to its essentials the economy can be represented as just the money flows from consumers to firms (expenditures/revenues) and money flows from firms to workers (wages or factor incomes). As you can see we do not show the flows of goods and services – only the MONEY! This is also one of the simplest diagrams, as there is no government or financial sector as well as no external sector. So we have ignored taxes, government expenditure, savings, investment, imports and exports. This is a little like a Robinson Crusoe Economy. Here Robinson might pay Friday (his companion) to make the evening meal. Friday in turn pays Robinson to milk the goats in the morning. They both take it in turn to be householder and producer. But in such a small economy with just two people it does seem a pretty odd arrangement to pay each other, they could just take on duties without payment. If that is so, why is it that we do not operate in the same way? I lecture to you out of a sense of duty, you pass food to me for the same reason. Truth is our modern economy with so many complex products and activities needs ‘money’ to drive through economic transactions rather than depending on a sense of duty or barter which are far less efficient methods of economic transaction.

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5. AE=C+I+G+X-IM

Firms

+I

4. C+G+X-IM

Financial sector +G

+X

Government -S -T

3. C+X-IM

2. C-IM or Cd

External sector

-IM Consumers

1. C

Here, above, is a rather more complex version of our familiar circular flow diagram which includes the three important players we ignored, government, the external and financial sectors. I’ve drawn it this way to show how we build up the final AE (Aggregate expenditure equation) at the end at stage 5. This equation, AE=C+I+G+X-IM, is extremely important and unlike all the other material we will show you is the TRUTH and cannot be wrong! Much of our later work, even the maths, describes human or economic behaviour, usually we call them ‘behavioural equations’, this AE equation is an IDENTITY – and must be true. We start off with the household, they have an income (the factor payments from firms) from which they pay out taxes (-T) to the government whilst they save (-S) with the financial institutions (banks). They also decide how much to consume, C, in total. Part of this consumption is in the form of imports (-IM) which is a flow of money out of our country. In total, then, the flow of money out of our (active) economy is T+S+IM=W these are, W, the withdrawals (this is why we signed them negatively). Now of course the savings and taxes are still in the UK economy but they are not ‘flowing’ they have become a stock – held by the banks and government. Note that the withdrawals can be contrasted with the three injections J=G+I+X which we will discuss below.

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Back to the flows, at stage 1, emerging from the household then is their flow of total consumption C, but the import component is lost to foreign good consumption, so domestic expenditure by our consumers (domestic consumption Cd) becomes Cd=C-IM at stage 2. However, foreign consumers buy goods and services from the UK in the form of exports, these expenditures add to UK total expenditure so we now have an increased flow of C+X-IM at stage 3, that is domestic consumption plus export revenues. The Government does not just hoard its tax revenue, it spends (often more than it raises!) in the form of government expenditures G. These add to aggregate demands and our expenditure flow increases at stage 4 by G to C+G+X-IM. Finally at stage 5 the financial sector uses consumer’s savings by turning them into loans for firms to use in investing in capital goods, that is, they buy computers, machinery tractors etc. These expenditures are classified as Investment expenditure (I) which we can also add to our expenditure flow to give our total ...