Problem 1: Most common mistakes and guidelines

Macroeconomics

Mock Exam – 2

Problem 1: Most common mistakes and guidelines

1. Suppose the economy of country A is in a long run equilibrium. (42 points)

(a) On a correctly labeled aggregate demand and aggregate supply graph show (2 points)

(i) Real output

(ii) Price level

Some students lost points due to not drawing SRAS (-0.5 points), others didn’t show LRAS (-1 point).

(b) Assume there is a recession in country B which is the main trading partner of country A. Define (2 points) and explain the effect of this recession on the country’s A (2 points)

(i) Aggregate demand (2 points)

(ii) Equilibrium level of output (2 points)

(iii) Equilibrium price level (2 points)

Show the changes on the graph from point (a) (2 points)

First you were required to define what is meant by recession. The most typical mistake not mentioning at all that recession implies low output (Y<Y*).Therefore in country B income decreased, thus ability of country B to import from A decreases.

Many concentrated only on the price effect under the recession, which may take place of course, BUT the crucial thing in recession is lower level of output. If IMb decreased then EXa decreased, thus NXa declines. Next common confusion: NX is part of Aggregate demand NOT of Aggregate supply. Therefore ADa decreases.

To get full grades for (ii) and (iii) it was not sufficient just to say they decrease and address me to the graph. Graph is there to illustrate to economic phenomena, but NOT a phenomenon in itself. The correct explanation can be expressed as follows: as aggregate demand decreases, producers decrease their level of production (movement along SRAS), moreover decrease of AD at initial price level cause excess supply, thus to arrive to equilibrium both price and output decrease.

Standard AD-AS graph with shift of AD to the left.

(c) Country A’s government decides to cure the situation, described in point (b), using fiscal policy.

(i) What fiscal policy action in your opinion would be most effective? (2 points) Explain why. (4 points)

(ii) Use a correctly labeled loanable funds market (2 points) and show the impact of the action, you identified in point (c), on the interest rate (2 points).

As country A is in recession, then EXPANSIONARY FISCAL POLICY should be used (2 points). Then you were expected to compare and contrast different tools of fiscal policy. Surprisingly some students still confuse tools of fiscal policy and monetary policy, thus they were suggesting to use OPEN MARKET OPERATIONS, WHICH ARE A TOOL OF MONETARY POLICY.

Tools of fiscal policy: government expenditures, transfers and taxes. You needed to choose one, and explain why. Government expenditures increase is the most effective tool of fiscal expansion. Full grade was given for stating different multipliers (maths expressions) and explaining their meaning, i.e. in case of taxes or transfers part of change in income is taken to savings, thus lower final effect on aggregate output as compared to the government expenditures increase.

Loanable funds: 2 points for correct graph and 2 points for the explanation: two possibilities either demand for loanable funds increases or supply of loananble funds decreases. In either case equilibrium interest rate increases.

(d) Explain the effect of the change in the interest rate, identified in point (c), on

(i) Investment in country A (2 points)

(ii) Long run economic growth. (4 points)

Investments: Graph – 1 point; explanation – 1 point: not simply stating there is an inverse relationship between Investments and interest rate, you were expected to say why there is such a relationship. Namely increase in interest rate makes loans for firms more expensive and some projects become unprofitable to realize. (Crowding out of private investments due to fiscal expansion).

One of typical mistakes was that some of you confused internal investments in country A and investments of foreigners into country A financial assets.

Long-run economic growth: Graph (PPF shifting in and/or LRAS shifting left) – 2 points. Explanation 2 points: lower investments => lower capital stock => decline of growth.

(e) What would be the impact of the change in the interest rate, identified in point (c), on

(iii) The capital account in the country A’s balance of payments (4 points)

(iv) The international value of its currency (4 points)

Capital account: increase of interest rate => more profitable country A financial assets attract foreign investments into economy => Inflow of funds from abroad => capital account deficit decreases or surplus increases.

International value of currency: Graph – 2 points; Explanation – 2 points. Demand for local currency increases as foreigners need more currency to invest in country A financial assets. As Demand for currency grows there is upward pressure on currency exchange rate, which results in currency appreciation.

(f) Explain the effect of the change, described in point (e) on the competitiveness of the country A’s goods in the world markets. (6 points)

Currency appreciation (nominal exchange rate increases) combined with an increase of prices (due to fiscal expansion) make country A currency more expensive in real terms. Real currency appreciation. Thus for 1 unit of currency country A residents may buy more units of foreign goods, on the other hand 1 unit of foreign currency can buy less country A goods. Therefore competitiveness of country A on goods market decreases. Thus imports will increase due to their relative cheapness in real terms and exports will decrease. NX decreases. (Crowding out of NX due to fiscal expansion)

Problem 2: Guidelines

Suppose the economy is at the full employment with an unemployment rate of 5%. Show the situation on the correctly labeled AD-AS and the Phillips curve graphs.

Надо было нарисовать 2 графика:

1)AD/AS: AD, SRAS и LRAS должны пересекаться в одной точке, соответствующей Y*

2)Phillips curves: LRPC должна быть вертикальной и пересекать SRPC в точке, где u=u*=5%, а inflation = 7% (А НЕ НОЛЬ!)

(a) Assume that as a result of the unexpected open market operation of the central bank inflation decreases from 7% to 4%.

Там не было вопроса, так что не требовалось и ответа J Опечатка J

(b) Define this action of the central bank and explain its affect on the monetary base and the money supply. Which of them – the monetary base or the money supply – would experience the greater change? Why?

Central Bank’s action: contractionary monetary policy: CB sold bonds in the open market.

Effect on monetary base:

1) currency in circulation decreases, as public pays for bonds with cash;

2) banks’ reserves decrease for two reasons: first, banks themselves buy bonds and thus run down reserves and second, public withdraws deposits from banks in order to buy bonds, which also reduces bank’s reserves available for lending.

MB = C + R, hence it decreases.

Effect on money supply: M = C + D(eposits). C and D decrease (see above), hence money supply decreases.

Money supply would experience a greater change, because of multiplier effect.

Типичные ошибки:

1) Путаница в причинно-следственной связи. Центробанк провел монетарную политику, в результате чего сократилось предложение денег, в результате чего

уменьшилась инфляция, А НЕ НАОБОРОТ! Просто мы догадались о том, какая была политика, по ее эффекту на инфляцию.

2) Не надо было анализировать, что происходит c real money balances. Вопрос был про nominal money supply.

3) Не может money supply уменьшиться меньше, чем monetary base, потому что monetary base – часть money supply. И действия Центробанка оказывают не «прямой эффект» на money supply, как некоторые писали, а именно через monetary base (см. выше).

(c) Analyse (using all the appropriate graphs and intuition), what would happen to aggregate demand?

Money supply decreases => interest rate rises (show this on the money market graph, with quantity of money on the horizontal axis and NOT real money balances. Татьяна Юрьевна была права, в оригинальных ответах к АРТ, не МИЭФовских, действительно так).

As interest rate rises, fewer projects become profitable, so investment decreases (show this in the investment/interest rate graph).

Since investment is a component of Aggregate Expenditures and thus AD (is VERY importan to say this: I’ve checked with API scoring guidelines), AD decreases (AD/AS graph).

Типичные ошибки:

1) Путаница в причинно-следственной связи. Спрос упал, поэтому выросла безработица, А НЕ НАОБОРОТ!

(d) How the nominal interest rate in this economy would be affected?

You were expected to refer to Fischer effect: as inflation decreases, nominal interest rate falls, because it’s a sum of real interest rate and inflation.

Типичные ошибки:

Некоторые писали, что nominal interest rate вырастет, ссылаясь на анализ денежного рынка в пункте (б). Нельзя сказать, что это совсем неправильно, просто в данном вопросе имелся в виду эффект от падения совокупного спроса, который произошел в предыдущем пункте, а не от монетарной политики.

Правильным мог бы считаться ответ, в котором сказано, что наблюдаются два противоположных эффекта на nominal interest rate: эффект от снижения предложения денег (в сторону увеличения) и эффект от снижения инфляции (в сторону уменьшения). Однако в этом случае важно обратить внимание, что на рынке денег, если мы откладываем по оси Х номинальное количество денег, то ставка процента на оси Y тоже будет номинальная, а не реальная.

(e) Who would win and who loose from the change in the rate of inflation, described in point (a)?

Winners from unexpected inflation: lenders (they get a higher than expected real interest rate), workers (their wages fixed in contracts have higher purchasing power), people getting fixed income (their income has higher purchasing power) and savers (the real value of their wealth increases).

Losers: borrowers and employeRs, i.e. firms (their situation is exactly opposite).

Типичные ошибки:

1)Многие писали только про savers and borrowers, про workers and firms – реже, про fixed income receivers еще реже, про savers вообще почти никто не вспомнил.

2)Многие перечислили только winners и ни слова про losers, или наоборот.

3)Нужны были хотя бы краткие объяснения

4)Некоторые написали эффекты с точностью до наоборот.

(f) What would happen as a result of the action undertaken by the central bank to

(i) the short run and the long run aggregate supply curves

First, there will be a movement along SRAS to the left. Later, when inflationary expectations are adjusted downwards and nominal wages decrease, SRAS will shift down (to the right). At the end, a new equilibrium will be achieved at a lower point on LRAS (which doesn’t shift).

Show this on a graph.

(ii) the short run and the long run Phillips curves.

First, there will be a movement along SRPC to the right. Later, when inflationary expectations are adjusted downwards and nominal wages decrease, SRPC will shift down (to the left). At the end, a new equilibrium will be achieved at a lower point on LRPC (which doesn’t shift).

Show this on a graph.

Типичные ошибки:

1)Многие забыли про первый эффект (движение вдоль кривой), сразу пошли дальше. 2)Перемещение вдоль долгосрочной кривой не может произойти, если краткосрочная при этом не сдвинется!

3)Долгосрочные кривые, вообще говоря, не сдвигаются в результате политик. В APT с этим путаница, поэтому давайте так: писать про сдвиг LRAS только в случае, если напрямую спрашивают про capital stock, PPF и т.д. В противном случае – не надо.

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