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EC1002 Introduction to Economics

Question 1

perfectly competitive firm?

(a) The part of the short-run marginal cost curve above short-run average fixed

cost.

(b) The part of the short-run marginal cost curve above short-run average variable

cost.

(c) The part of the short-run marginal cost curve about short-run average total

cost.

(d) The whole short-run marginal cost curve.

Statement (a) is incorrect. Fixed costs cannot be avoided in the short run, so these should not

affect the firms decision to produce or not.

Statement (b) is correct. First, if the firm produces output, the profit-maximizing supply of

output is where price is equal to marginal cost because the firm is perfectly competitive and takes

the market price as given. Second, for it to be in the interests of the firm to operate in the short

run, the price it receives must at least cover its short-run average variable cost because these

costs could be avoided by shutting down production. Therefore, the supply curve of the firm is

the portion of the short-run marginal cost curve above the short-run average variable cost curve.

Statement (c) is incorrect. Total costs include fixed costs, which cannot be avoided in the short

run. Only variable costs affect supply decisions in the short run.

Statement (d) is incorrect. The firm has the option of shutting down production and reducing

variable costs to zero. If it produces, it must therefore receive a price in excess of its short-run

average variable costs to justify producing any output. Its supply curve cannot therefore be the

whole of the short-run marginal cost curve.

Question 2

the incidence of the tax is correct?

(a) If demand is perfectly price elastic then the demand price rises and the tax

burden falls only on the seller.

1

EC1002 Introduction to Economics

(b) If supply is perfectly price elastic then the supply price is unchanged and the

tax burden falls only on the buyer.

(c) If demand is perfectly price elastic then the supply price rises and tax burden

falls only on the seller.

(d) If supply is perfectly price elastic then the supply price falls and the tax burden

falls only on the buyer.

Statement (a) is incorrect. If the demand curve is perfectly price elastic (horizontal) then the

demand price will not adjust when the tax is introduced.

Statement (b) is correct. Suppose the supply curve is perfectly price elastic (horizontal). This

shifts upwards by an amount equal to the tax. The demand price rises by exactly as much as the

tax, and since the difference between the demand price and supply price is the tax, it follows that

the supply price is unchanged. With no change in the supply price and a rise in the demand

price, the burden of the tax (the incidence) falls only on the buyer.

Statement (c) is incorrect. If the demand curve is perfectly price elastic (horizontal) then the

supply price will fall when the tax is introduced. The supply curve shifts upwards because of the

tax. The difference between the demand price and supply price is equal to the tax. Since the

demand price does not change owing to the demand curve being horizontal, the supply price

must fall.

Statement (d) is incorrect. If the supply curve is perfectly price elastic (horizontal) then the

supply price will not change following the imposition of the tax.

Question 3

(b) A public good is efficiently provided when everyones marginal utility from the

good is equal to the marginal cost of the good.

(c) A public good is non-rivalrous, but excludable.

(d) A public good is efficiently provided when the sum of everyones marginal

utilities from the good is equal to the marginal cost of the good.

Non-rivalrous means that one persons enjoyment of the good is not affected by others

benefitting from the good.

Statement (b) is incorrect. Since a public good is non-rivalrous, the marginal social benefit is

greater than the marginal benefit any individual derives from the good. Equating an individuals

marginal benefit to the marginal cost would lead to underprovision of the public good.

Statement (c) is incorrect. A public good is both non-excludable and non-rivalrous. It is not

practical to exclude any particular individual or individuals from being able to enjoy the

provision of the public good.

Statement (d) is correct. Since the public good is non-rivalrous, the marginal social benefit is the

sum of everyones marginal utility from the good (as each individuals enjoyment of the good

does not detract from that of others). Efficiency requires that this sum is equated to the

marginal cost of providing the good.

2

Examiners commentaries 2017

Question 4

Which of the following statements about a labour market with a monopsonist firm is

not correct?

(a) Less labour is hired than if the firm were perfectly competitive and took the

wage as given.

(b) Workers would like to supply more labour at the monopsony wage.

(c) The firm pays a wage below the marginal product of labour.

(d) The marginal product of labour is diminishing for the firm.

Statement (a) is correct. The monopsonist hires labour up to the point where the marginal cost

of labour (MCL) is equal to the marginal product of labour (assuming it is perfectly competitive

in the goods market). But the MCL is greater than the wage, so a firm that were perfectly

competitive in the labour market (taking the wage as given) would hire a greater amount of

labour up to the point where the wage is equal to the marginal product of labour.

Statement (b) is incorrect. Workers choose how much labour to supply for each wage, and the

monopsonist takes this into account when choosing how much labour to hire. But workers are

happy with the amount of labour they are supplying at the prevailing wage.

Statement (c) is correct. Since the firm takes into account that more hiring requires higher

wages, the marginal cost of labour is greater than the wage. Profit maximization requires the

marginal cost of labour is equal to the marginal product of labour, hence the wage is below the

marginal product of labour.

Statement (d) is correct. The marginal product of labour is diminishing, though this is not

special to the case of monopsony.

Question 5

(a) A natural monopoly is a market with barriers to entry that cannot be overcome

by potential entrants.

(b) A natural monopoly produces a product for which there are no substitutes.

(c) A natural monopoly has a long-run average cost curve that is always

diminishing.

(d) A natural monopoly produces where marginal revenue is greater than marginal

cost.

Statement (a) is incorrect. A natural monopoly does not require explicit barriers to entry to be

in place. The cost advantage enjoyed by a larger firm in a natural monopoly situation is itself a

deterrent to new entry.

Statement (b) is incorrect. The downward-sloping demand curve faced by the natural monopolist

may reflect consumers substituting towards other goods. This has nothing to do with the concept

of natural monopoly.

Statement (c) is correct. In this case, the larger the firm, the lower its average costs. The more a

firm expands, the greater its cost advantage becomes, and thus it is not possible to sustain

competition in the market.

3

EC1002 Introduction to Economics

Statement (d) is incorrect. The condition for profit maximization for a natural monopolist

remains the usual marginal revenue equal to marginal cost for monopolists.

Question 6

A car maker produces 10,000 cars in a year, which have price $10,000, though 2000

of these cars remain unsold at the end of the year. The car maker pays its workers

$40m and spends a total of $30m on buying parts needed to make the cars from

other firms. It spends $5m on new robots to use next year, and must pay interest

$2m on its debts. Which of the following statements is correct?

(b) The car makers value added is $65m.

(c) The car makers value added is $70m.

(d) The car makers value added is $23m.

Statement (a) is incorrect. This number might be obtained by subtracting wages $40m from

actual sales of $80m. This is wrong because value of the unsold cars should be included (this is

inventory investment, which counts as part of final demand). It is also wrong because wages are

subtracted. Payments to factors of production are part of value added and should not be

subtracted.

Statement (b) is incorrect. This number might be obtained by subtracting the $30m cost of the

car parts and the $5m cost of the new robots from the value of the cars produced ($100m). This

is wrong because the spending on robots is part of investment (a component of final demand). It

is not an intermediate input, and should not be subtracted when calculating value added.

Statement (c) is correct. The sales of the car maker are $80m, and the value of the unsold cars is

$20m. The value of the goods produced is thus $100m. Value added is obtained by subtracting

spending of $30m on intermediate goods (car parts) to leave $70m.

Statement (d) is incorrect. This number might be obtained by subtracting wages of $40m, the

$30m cost of the car parts, the $5m cost of the new robots, and the $2m of interest from the

$100m value of output produced. This is wrong because only the cost of the intermediate inputs

(the car parts) should be subtracted to obtain value added.

Question 7

The government increases its spending by $1bn and raises taxes by $1bn. According

to the IS/LM model, which of the following statements is correct?

(a) Output rises by exactly $1bn and the interest rate is higher.

(b) Output rises by less than $1bn and the interest rate is higher.

(c) Output rises by more than $1bn and the interest rate is higher.

(d) There is no effect on either output or the interest rate.

Statement (a) is incorrect. If the interest rate was higher, investment demand would fall. If

income increased by $1bn and taxes increased by the same amount, there would be no change in

disposable income and therefore no change in consumption. As government spending is $1bn

higher, investment is lower, and consumption is unchanged, aggregate demand and output must

have risen by less than $1bn.

4

Examiners commentaries 2017

Statement (b) is correct. The balanced-budget increase in government spending shifts the IS

curve to right by exactly $1bn (with no multiplier effect because taxes rise with government

spending, so disposable income does not increase). The intersection with the LM curve is at a

higher interest rate, and the increase in output must be smaller than the horizontal shift of the

IS curve (equal to $1bn). This is because of the crowding out of investment spending by the

higher interest rate.

Statement (c) is incorrect. Output cannot rise by more than $1bn using the logic above.

Statement (d) is incorrect. The IS curve shifts to the right, so there must be some effect on

output and the interest rate.

Question 8

(a) There is a paradox of thrift because an increase in desired saving leads to lower

income and lower consumption.

(b) There is a paradox of thrift because an increase in desired saving leads to higher

income and lower consumption.

(c) There is a paradox of thrift because saving is not equal to investment.

(d) There is a paradox of thrift because lending to the government does not boost

investment.

Statement (a) is correct. Saving more (thrift) can be have a paradoxical effect because a

reduction in aggregate demand from less consumption can reduce income (see the IS-LM model).

This is paradoxical because saving is usually thought to improve the financial position of a

household, but if it leads to lower income for the economy as a whole, this might not be the case.

Statement (b) is incorrect. What is described in this case is not paradoxical. Instead, this might

describe the process through which greater saving leads to greater capital accumulation and

higher income in the long run, with consumption falling in the short run.

Statement (c) is incorrect. In equilibrium in a closed economy, national saving must always be

equal to investment.

Statement (d) is incorrect. Lending more to the government may not boost investment (the

government might be borrowing to pay for public services today, rather than to finance

infrastructure investment), but this has nothing to do with the paradox of thrift.

Question 9

(a) The central bank can increase the money supply by selling bonds.

(b) The central bank can decrease the money supply by lowering its discount rate.

(c) The central bank can decrease the monetary base by increasing reserve

requirements.

(d) The central bank can increase the money supply by an unsterilized purchase of

foreign exchange reserves.

5

EC1002 Introduction to Economics

Statement (a) is incorrect because an open-market sale of bonds by the central bank would

actually reduce the money supply (athe payment of money from commercial banks to the central

bank reduces the amount of money in circulation).

Statement (b) is incorrect because a lower discount rate encourages commercial banks to seek

greater discount-window loans from the central bank. When commercial banks borrow more

from the central bank, this increases the money supply.

Statement (c) is incorrect because changing reserve requirements does not itself change the

monetary base (the sum of currency and reserves). Reserve requirements may change the money

multiplier (the ratio of the broad money supply to the monetary base) if they are binding.

Statement (d) is correct. When the central bank buys foreign assets (reserves), it pays using

domestic currency, which increase the supply of money in circulation. If the purchase is

unsterilized, the central bank does not offset its effects on the money supply by selling bonds and

absorbing the extra money created.

Question 10

(a) If the domestic interest rate is equal to the foreign interest rate then the

financial account of the balance of payments must be zero.

(b) If the domestic interest rate is above the foreign interest rate then the financial

account of the balance of payments must be negative.

(c) If the domestic interest rate is different from the foreign interest rate then the

financial account of the balance of payments is zero.

(d) If the domestic interest rate is equal to the foreign interest rate then the

financial account of the balance of payments might be negative.

Statement (a) is incorrect because investors would be indifferent between domestic and foreign

assets if the interest rates are same, but this does not mean that the financial account of the

balance of payments must be zero. If a positive or negative financial account is needed to finance

a negative or positive current account balance then this is consistent with perfect capital

mobility because investors do not mind whether they obtain domestic or foreign assets.

Statement (b) is incorrect because if the domestic interest rate is higher than the foreign interest

rate, investors prefer to hold domestic rather than foreign assets. Purchases of domestic assets by

foreigner or sales of foreign assets by domestic residents contribute to a positive financial

account. With perfect capital mobility, these capital flows would be large, so the financial

account would be unambiguously positive.

Statement (c) is incorrect because if there is a difference between the domestic and foreign

interest rates, there will be large capital flows in one direction under perfect capital mobility.

The financial account cannot be zero in this case.

Statement (d) is correct for the reasons explained above. With domestic and foreign interest

rates the same, investors are indifferent between domestic and foreign assets, so the financial

account might be negative (but being positive or zero would also be consistent with perfect

capital mobility).

6

Examiners commentaries 2017

Answer one of the following two long questions (30 marks each). It is essential that you explain your

answers.

Question 11

A consumer has preferences over two goods, coconuts and fish. The consumer

prefers more of each good to less, and has a diminishing marginal rate of

substitution between the two goods.

(a) [4 marks] Draw a diagram showing indifference curves and the budget

constraint of the consumer (with coconuts on the horizontal axis and fish on the

vertical axis). Show how the consumers optimal consumption choice is found in

the diagram.

(b) [12 marks] The price of coconuts rises. Draw diagrams showing how the change

in consumption of coconuts can be broken down into income and substitution

effects in each of the following three cases:

i. Coconuts are a normal good;

ii. Coconuts are a Giffen good;

iii. Coconuts are an inferior good, but not a Giffen good.

(c) [8 marks] Now suppose the consumer is a farmer whose income comes only from

selling a fixed supply of coconuts. This means that when the price of coconuts

increases by x%, the consumers income also increases by x%. Assuming that

coconuts are a normal good, will the consumer necessarily consume fewer

coconuts? Explain your answer by illustrating income and substitution effects in

a diagram.

(d) [6 marks] The theory of labour supply is based on a trade-off between two

goods, leisure and consumption. Explain the similarity between this decision

and the consumption choice problem in part (c). What is the role of income and

substitution effects in understanding the effect of higher wages on labour

supply?

(a) The indifference curves are downward sloping because the consumer prefers more of each

good to less. The indifference curves have a concave shape because the marginal rate of

substitution between the goods (the absolute value of the gradient of an indifference curve)

is diminishing [1 mark for drawing indifference curves correctly].

Fish

Indifference curves

Budget constraint

Coconuts

C

The consumers choices are limited by a budget constraint. This is a downward-sloping

straight line, and the absolute value of the gradient is equal to the relative price of the two

goods [1 mark for drawing budget constraint correctly]. The optimal consumption

choice for the consumer is on the highest indifference curve that can be reached along the

budget constraint. Geometrically, this is where an indifference curve is tangent to the

7

EC1002 Introduction to Economics

budget constraint, because the indifference curve does not cut the budget line in this case (if

it did, there must be a higher indifference curve that can be reached along the budget line)

[2 marks for correctly illustrating optimal choice].

(b) An increase in the price of coconuts makes the budget line steeper [1 mark] and pivots it

around the point where it intersects the vertical axis (the consumer could continue to buy

the same amount of fish if no coconuts were consumed before) [1 mark].

The response of the consumer can be broken down into substitution and income effects. The

substitution effect is the response to the relative price change were the consumer also to face

a hypothetical lump-sum transfer that leaves the consumer as well off as before. This

captures the incentives provided by the relative price change to adjust the chosen

consumption bundle. The income effect is the response to removing the hypothetical

transfer, holding constant the relative price. This captures the effect of the price change

making the consumer worse off or better off.

The substitution effect is found by considering a hypothetical budget line with the same

higher gradient as the new budget line, but tangent to the original indifference curve. This

is parallel to the new budget line, but not in the same position owing to the presence of a

hypothetical transfer of income [1 mark for drawing this budget line correctly]. The

tangency point would be the optimal consumption choice when faced with this budget line.

Consumption of coconuts must be lower, so the substitution effect is unambiguously

negative [1 mark].

The income effect is found by removing the hypothetical transfer, which means considering

the parallel shift of the hypothetical budget line to its true position. This is an inward shift

[1 mark]. The consumers response to this depends on whether coconuts are a normal or an

inferior good [1 mark].

i. If coconuts are a normal good, the income effect of a inward shift of the budget line is

negative [1 mark]. Both substitution and income effects point to a reduction in

consumption of coconuts, so demand for coconuts is unambiguously lower [1 mark].

Fish

SE

IE

Coconuts

ii. Now suppose coconuts are a Giffen good. This requires that coconuts are also an inferior

good. For an inferior good, an inwards shift of the budget line leads to an increase in

consumption of that good. The income effect is positive in this case, which goes against

the substitution effect. The case of a Giffen good is where the income effect actually

outweighs the substitution effect and demand for coconuts rises [2 marks].

8

Examiners commentaries 2017

Fish

SE

IE

Coconuts

iii. The final case is where coconuts are an inferior good, but not a Giffen good. The income

effect is positive, but does not outweigh the substitution effect [1 mark]. The demand

for coconuts declines, but not by as much when coconuts were a normal good [1 mark].

Coconuts are an inferior good

Fish

SE

IE

Coconuts

(c) In this case, the consumer is a farmer who derives income from selling a fixed supply of

coconuts. When the price of coconuts rises by x%, the income of the farmer rises by the

same percentage. The effect of the price increase is to raise the gradient of the budget line

as before [1 mark]. But now, the associated rise in income shifts the budget line outwards

[1 mark]. Since income increases in proportion to the price of coconuts, the amount of

coconuts that can be consumed if no fish is bought is unaffected by the price increase. The

new budget line is effectively a pivot of the old budget line around the point where it

intersects the horizontal axis [1 mark]. The horizontal coordinate of this point is the

supply of coconuts available to the farmer.

Fish

SE

IE

Coconuts

9

EC1002 Introduction to Economics

The substitution effect is obtained using the same method as before. The rise in the price of

coconuts implies a negative substitution effect on consumption of coconuts [1 mark].

Differently from before, the new budget line is reached by an outward shift of the budget

line used to calculate the substitution effect [1 mark]. This is because a rise in the price of

coconuts puts a seller of coconuts in a better position. Assuming coconuts are a normal

good, this positive income effect increases consumption of coconuts and goes against the

substitution effect [1 mark]. It is possible that the farmers consumption of coconuts rises

when the price increases, even though coconuts are a normal good [2 marks].

(d) The theory of labour supply has the consumer choosing leisure and consumption of a general

basket of goods [1 mark]. This choice can be analysed using the indifference curve and

budget constraint diagram. Suppose that leisure is on the horizontal axis and consumption

on the vertical axis. The consumer has a certain amount of time that can be used either for

leisure or for work. Each unit of time spent working results in the consumer earning wage

income. The resulting budget constraint is a downward-sloping line with gradient equal to

the (real) wage (in absolute value) [1 mark]. The budget line meets the horizontal axis at

the total amount of time the consumer has available [1 mark].

A change in the wage has an exactly analogous effect on the budget line as in the analysis of

the coconut-producing farmer from part (c) [1 mark]. The higher wage has a negative

substitution effect on leisure and a positive income effect (assuming leisure is a normal

good) [1 mark]. The wage is essentially the market price of leisure, and a rise in the wage

can be analysed in the same way as the rise in the price of the good produced by the farmer

[1 mark].

Question 12

A monopolist can produce a good with a constant marginal cost of 1. There are two

groups of customers. The first group would buy an amount Q = 7 P at price P .

The second group would buy an amount Q = 6.5 0.5P at price P .

(a) [6 marks] Suppose the monopolist can set a price paid only by those in the first

group of customers. Find the profit-maximizing value of this price and the

quantity sold to the first group.

(b) [7 marks] Suppose the monopolist can practise price discrimination and charge a

different price to the customers in the second group. Find the profit-maximizing

value of this price and the quantity sold to the second group.

(c) [10 marks] Now suppose the monopolist cannot practise price discrimination

and must charge one price for all customers. Write down the total demand

function faced by the monopolist and calculate the profit-maximizing price and

total quantity sold.

(d) [7 marks] How much extra profit does the monopolist gain by being able to

practise price discrimination? Explain why it is in the interests of the

monopolist to charge different prices to the two groups of customers.

In this question, marginal costs are constant, M C = 1, which implies total costs are T C = Q.

(a) The first group of customers has demand function Q1 = 7 P1 if they are charged a price

P1 . The inverse demand function is P1 = 7 Q1 , which gives the price P1 that must be

charged if the monopolist is to sell an amount Q1 to this group. Total revenue is therefore

equal to T R1 = P1 Q1 = (7 Q1 )Q1 , and the total costs of producing output to be sold to

the first group is T C1 = Q1 . The monopolists profits from selling to the first group of

customers (as a function of the quantity sold Q1 ) are [3 marks]:

1 = (7 Q1 )Q1 Q1 = 6Q1 Q21

The profit-maximizing quantity is obtained by differentiating profits 1 with respect to Q1

and setting this to zero [2 marks]:

1 6

= 6 2Q1 = 0 Q1 = =3

Q1 2

10

Examiners commentaries 2017

The profit-maximizing price is found by substituting this quantity into the inverse demand

function: P1 = 7 3 = 4 [1 mark].

(b) It is assumed the monopolist can charge a different price P2 to the second group of

customers without affecting demand from the first group (because the market can be

segmented) [1 mark]. The demand function of the second group is Q2 = 6.5 0.5P2 .

Multiplying both sides by 2 yields 2Q2 = 13 P2 , and hence the inverse demand function is

P2 = 13 2Q2 . Total revenue from selling to the second group is therefore

T R2 = P2 Q2 = (13 2Q2 )Q2 , and total costs are T C2 = Q2 . The monopolists profits from

selling to the second group of customers are [3 marks]:

2 = (13 2Q2 )Q2 Q2 = 12Q2 2Q22

The profit-maximizing quantity is obtained by differentiating profits 2 with respect to Q2

and setting this to zero [2 marks]:

2 12

= 12 4Q1 = 0 Q1 = =3

Q2 4

The profit-maximizing price is found by substituting this quantity into the inverse demand

function: P1 = 13 2 3 = 7 [1 mark]. This price is greater than the profit-maximizing

price for the first group of customers.

(c) If the markets cannot be segmented then the monopolist can only charge one price P to all

customers. The total amount Q sold is the sum of demand from the two groups, that is,

Q = Q1 + Q2 . The total demand function is [4 marks]:

Q = (7 P ) + (6.5 0.5P ) = 13.5 1.5P

Multiplying both sides by 2 yields 2Q = 27 3P , and hence 3P = 27 2Q. The inverse

demand function is thus P = 9 2Q/3. Total revenue and total costs are

T R = (9 2Q/3)Q and T C = Q, which imply that profits from selling to both groups at a

common price are [3 marks]:

2Q2

= (9 2Q/3)Q Q = 8Q

3

The profit-maximizing quantity is obtained by differentiating profits with respect to Q

and setting this to zero [2 marks]:

4Q 83 24

=8 =0 Q= = =6

Q 3 4 4

The profit-maximizing price is found by substituting this quantity into the inverse demand

function: P = 9 2 6/3 = 9 4 = 5 [1 mark]. This price lies between the prices 4 and 7

charged to the two groups of customers separately in parts (a) and (b).

(d) The monopolists total sales when it practises price discrimination are the sum of Q1 and Q2

from parts (a) and (b), thus Q = 3 + 3 = 6. It turns out that this is the same as the total

quantity sold Q = 6 when a common price must be charged to both groups. Total costs are

therefore the same in both cases, and any difference in profits comes from differences in total

revenue. Total revenue with a common price is T R = 5 6 = 30. Total revenues from the

two groups charged the different prices from parts (a) and (b) are T R1 = 4 3 = 12 and

T R2 = 7 3 = 21, that is, 12 + 21 = 33 in total. The difference in total revenues, and thus

in profits, is 33 30 = 3 [4 marks]. This is the gain to the monopolist from being able to

practise (third-degree) price discrimination between the two groups of customers.

Intuitively, the gains from price discrimination come from the two groups of customers

having different price sensitivities. A unit increase in price lowers demand from the first

group by one unit, but only by half a unit for the second group. Therefore, it is possible to

sell an extra unit to the first group with a smaller price reduction and what would be

required to sell this extra unit to the second group. This means that if the prices paid by

the two groups were the same, the first group would have a higher marginal revenue than

the second group. It then makes sense to sell more to the first group at a lower price and

less to the second group at a higher price [3 marks].

11

EC1002 Introduction to Economics

Answer one of the following two long questions (30 marks each). It is essential that you explain your

answers.

Question 13

(a) [6 marks] Explain why inflation has a positive effect on aggregate supply in the

short run, and a negative effect on aggregate demand.

(b) [8 marks] Suppose the economy is hit by a negative demand shock and the

central bank would like to stabilize both output and inflation. What is the best

action the central bank can take, and what are the consequences for the

nominal and real interest rates?

supply shock and the central bank would like to stabilize output. What action

should the central bank take, and what are the consequences for the nominal

and real interest rates? Can the central bank also stabilize inflation? Explain.

(d) [8 marks] If the negative supply shock is permanent, would loosening monetary

policy help to stabilize output in the long run? What would be the

consequences of the shock and the policy response for inflation and for nominal

and real interest rates?

(a) In the short run, the growth rate of nominal wages has already been set and will not be

revised until the next round of wage negotiations. Any increase in the inflation rate

therefore results in a real wage which is lower than it otherwise would be. A lower real wage

provides an incentive for firms to increase demand for labour (it is optimal to demand labour

up to the point where the real wage is equal to the diminishing marginal product of labour).

If wages have been set such that desired labour supply is greater than labour demand then

workers will be willing to supply additional labour at the new lower real wage. This increase

in employment leads firms to produce more output, increasing aggregate supply [3 marks].

SAS

AD

Y

On the demand side, an increase in inflation is assumed to lead the central bank to raise the

nominal interest rate more than one-for-one with the rise in inflation. The Fisher equation

(real interest rate equals nominal interest rate minus inflation) implies that this action

should raise the real interest rate, which has a negative effect on investment demand. This

demonstrates a negative relationship between inflation and aggregate demand [3 marks].

(b) The occurrence of a negative demand shock shifts the AD curve to the left [1 mark]. This

would reduce both output and inflation in the absence of any shift in the monetary policy

stance.

12

Examiners commentaries 2017

SAS

AD1

AD2

Y

Y1

Suppose the central bank cares about both output and inflation. Loosening the stance of

monetary policy would shift the AD curve back to the right, raising both output and

inflation. Therefore, the central bank achieves its goals of stabilizing both output and

inflation if it loosens its policy stance to the point where this completely offsets the shock to

aggregate demand and returns the AD curve to its original position [3 marks]. Note that

monetary policy is able to stabilize both output and inflation when the economy is hit by

demand shocks [1 mark].

If monetary policy is to maintain an unchanged level of demand following a negative shock,

it must reduce the real interest rate to compensate [2 marks]. Since there is no change in

inflation if this stabilization policy is effective, the nominal interest rate must also fall by the

same amount because inflation remains unchanged [1 mark].

(c) A temporary negative supply shock shifts the SAS curve to the left [1 mark]. Since it is

temporary, it does not affect inflation expectations. In the absence of a change in the

monetary policy stance, output would fall and inflation would rise. If the central bank

would like to stabilize output then a looser monetary policy stance is needed. This shifts the

AD curve to the right, and it is possible to offset the effects of the shock on output if the

size of the AD shift to the right is equal to the size of the SAS shift to the left [2 marks].

SAS2

2 SAS1

AD2

AD1

Y

Y1

Since output remains the same and there has been no demand shock, the real interest rate

must remain unchanged [2 marks]. The rise in inflation and the stable real rate mean that

the nominal interest rate must rise [1 marks]. Although monetary policy has been

loosened, the rise in inflation triggers an increase in the nominal interest rate. But alongside

the initial monetary easing, this is only sufficient to match the increase in inflation, leaving

the real interest rate unchanged.

Note that it is impossible to use monetary policy to stabilize both inflation and output in

this case. The aggregate supply curve has shifted, but monetary policy only directly affects

demand. Consequently, a better performance for inflation can only be obtained at the cost

of a worse performance for output [2 marks].

13

EC1002 Introduction to Economics

(d) The aggregate supply curve is vertical in the long run [1 mark]. This is because errors in

forecasting inflation should not persist in the long run, which means that the actual real

wage is determined through wage negotiations rather than the realized rate of inflation.

Since the aggregate supply curve is vertical, a looser monetary policy does not help to

stabilize output [2 marks], which is independent of monetary policy in the long run. The

only effect of the looser monetary policy is a further rise in inflation [2 marks].

AS2 AS1

AD2

AD1

Y

Y2 Y1

Since the level of output falls with supply, demand must also be lower in equilibrium. This

requires a higher real interest rate [2 marks]. With a rise in both inflation and the real

interest rate, the nominal interest rate must rise unambiguously [1 mark].

Question 14

Output Y is produced using capital K and labour L with constant returns to scale

and diminishing returns to capital and labour individually. The production function

is Y = f (K, L), capital depreciates at rate , the population grows at rate n, and the

saving rate is s.

(a) [6 marks] Use a diagram to show the economy has a steady state for capital per

person k and output per person y. Explain.

(b) [8 marks] There is an increase in the saving rate. Explain why this does not lead

to permanently higher growth in output per person. If there is no permanent

effect on growth, would it ever make sense for an economy to save more?

(c) [8 marks] There is an increase in population growth. Since the marginal product

of labour is diminishing, will there be a permanent decline in the growth rate of

output per person? Explain.

(d) [8 marks] The economy now experiences permanent (labour-augmenting)

technical progress at rate t. What will be the steady-state growth rates of

capital per person and output per person in this case? Since capital per person

is increasing, is the marginal product of capital declining over time? Explain.

(a) The change in the capital stock is K = I K, where I = sY is investment. This implies

the growth rate of the capital stock is:

K Y

=s

K K

Capital per worker and output per worker are defined by k = K/L and y = Y /L, and hence

Y = yL and K = kL. It follows that Y /K = y/k. Using the constant returns to scale

property of the production function Y = f (K, L):

f (K, L) K L

y= =f , = f (k, 1) = F (k)

L L L

14

Examiners commentaries 2017

K F (k)

=s

K k

There is a steady state for capital per person k = K/L when K and L are growing at the

same rate. The growth rate of L is n, therefore a steady state is reached when:

F (k)

s =n

k

which is equivalent to sF (k) = ( + n)k. The left-hand side is investment per person

i = sy = sF (k). The right-hand side is the amount that needs to be invested per person to

ensure capital per person remains stable (both to replace worn-out capital and to add new

capital to keep up with growth in the population). When the left-hand side is greater than

the right-hand side, k is growing, when the right-hand side is greater, k is declining, and

when the equation holds exactly, k is stable.

y

y

( + n)k

i = sy

k

k

Geometrically, the right-hand side is an upward-sloping straight line with gradient + n

passing through the origin [1 mark for depreciation line]. The left-hand side scales down

the per-worker production function F (k) using the saving rate s. Since the marginal

product of capital is positive but diminishing, this function is increasing and concave [2

marks for saving line]. The two lines cross at some positive level of capital per person,

and this is the steady state for k. Since y = F (k), once k reaches a steady state, so does

output per person y [3 marks for steady state].

(b) An increase in the saving rate shifts the investment per person line upwards [1 mark]. This

now intersects ( + n)k at a higher value of capital per person k2 [1 mark]. At the initial

value of capital per person k1 , investment per person exceeds the amount needed to

maintain a stable value of the ratio k, which now begins to rise over time. However, this

process comes to a halt once k2 is reached, and this point constitutes the new steady state

of the economy [1 mark]. Corresponding to this is a new higher steady state for output per

person y2 . This is greater than the initial y1 , so there is growth, but that growth does not

continue once the new steady state is reached [1 mark]. There is no effect on long-run

growth in output per person, which is zero.

y2 y

y1

( + n)k

i = s2 y

i = s1 y

k

k1 k2

15

EC1002 Introduction to Economics

Intuitively, diminishing marginal returns to capital place a limit on how long growth can

continue through capital accumulation. A higher saving rate allows for more capital

accumulation, but eventually the extra capital adds so little to output and thus investment

that the extra investment is just sufficient to cover what is needed to maintain a stable level

of capital per person. This why a steady state is eventually reached and why increasing the

saving rate has no effect on long-run growth [2 marks].

Even though the saving rate does not affect long-run growth, this does not mean that there

is nothing to be gained by saving more. The new steady state features a permanently higher

level of output per person. While some of this extra output will be needed to maintain the

higher capital stock, the amount available for consumption might increase. If permanently

higher consumption can be sustained by saving more, this might be argument for increasing

the saving rate [2 marks], though it would depend on whether the short-to-medium term

sacrifice is worth the long-run benefit. Note that it is possible even long-run consumption

might decline if too much is saved.

(c) A rise in population growth n increases the gradient of the line ( + n)k [1 mark]. The

pivoting of this line to the left results in a new intersection point with the investment per

person line at a lower level of capital per person. This, and the corresponding lower level of

output per person, is the new steady state of the economy [2 marks].

y1 y

y2 ( + n2 )k

( + n1 )k

i = sy

k

k2 k1

There is negative growth in output per person for a transitional period until the new steady

state is reached. However, once that steady state is reached, output per person is stable, so

its growth rate has returned to its initial value: zero [2 marks].

Intuitively, the diminishing marginal product of labour combined with faster population

growth might suggest output per person (the average product of labour) is continually

falling. This does not happen because the capital stock grows at a faster rate in the new

steady state. As capital and labour are increasing at the same rate in the steady state, the

diminishing marginal product of labour is not relevant. Instead, constant returns to scale

applies, and output also rises at the same rate as capital and labour, leaving output per

person stable. How is it possible to increase the growth rate of the capital stock without a

higher saving rate? This is achieved by having a lower level of capital per worker, which

means that during the transitional period, capital grows at a slower rate than the

population. Consequently, the marginal product of capital increases, which means that the

marginal unit of capital produces more output. With no increase in the depreciation rate,

this extra output can be used to invest in new capital for the additional workers [3 marks].

(d) In this case, the production function is Y = f (K, LE), where E is labour-augmenting

technology, which grows at rate t. Defining k = K/LE and y = Y /LE to be capital and

output per efficiency units of labour [1 mark], the argument for the existence of a steady

state for k and y works in the same way as part (a). The only difference is that LE grows at

rate n + t, rather than n (the growth rate of L alone), so n must be replaced by n + t [1

mark]. This increases the gradient of the straight line representing the amount of

investment needed to ensure a stable value of capital per efficiency unit of labour, but

otherwise the diagram from part (a) is the same [1 mark].

16

Examiners commentaries 2017

y

y

( + n + t)k

i = sy

k

k

Capital per person K/L is equal to E multiplied by capital per efficiency units of labour

k = K/LE, and output per person Y /L is equal to E multiplied by y = Y /LE. Since there

is a steady state for k and y, it follows that capital and output per person must grow at the

same rate as E, that is, at rate t [2 marks].

In the absence of labour-augmenting technological progress, an increase in capital per

person would lead to a decline in the marginal product of capital. However, with

labour-augmenting technological progress, the marginal product of capital is equal to F 0 (k),

where k = K/LE. As capital per efficiency units of labour is stable, the marginal product of

capital does not decline. Intuitively, growth in technology boosts the marginal product of

capital, and offsets the decline resulting from growth in capital per person [3 marks].

17

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