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14. The equation of exchange says that

A. the velocity of circulation of money is constant.

B. nominal income will increase at the same rate as money supply.
C. the economy is producing at the full employment level.
D. None of the above.

For Questions 15 and 16, consider the following balance sheet of a banking system.

Assets ($) Liabilities ($)

Reserves 3 000 Deposits 12 000
Loans 4 000
Investment 5 000

Suppose the banking system has $600 excess reserves, the public does not hold any
cash and deposits all cash into the banking system.

15. Suppose the central bank sells $500 worth of government bonds to the
commercial banks, the money supply in the economy will

A. decrease by $500.
B. decrease by $2 500.
C. remain unchanged.
D. increase by $500.

16. Suppose a customer withdraws $2 000 cash from a commercial bank by

cheque. What would be the maximum possible amount of deposits in the
whole banking system ?

A. $2 000
B. $5 000
C. $7 000
D. $10 000

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20. Suppose country X can produce either 200 units of clothing or 400 units of
food with all its resources while country Y can produce 150 units of clothing
or 275 units of food with all its resources, we can conclude that

A. country X has absolute advantage in the production of both

goods.
B. country X has comparative advantage in the production of food.
C. country X has both absolute and comparative advantages in the
production of clothing.
D. Both A and B are correct.

21. A major difference between a quota and a tariff on imports lies in their effects
on

A. the price of imports.

B. the quantity of imports.
C. domestic production of import substitutes.
D. wealth redistribution.

22. In an economy, suppose the government budget is in balance while the trade
account is in deficit. We can conclude that

A. the sum of government spending and exports is greater than the

sum of taxation and imports.
B. the sum of investment spending and exports is greater than the
sum of savings and imports.
C. the sum of government spending and investment spending is
greater than the sum of taxation and savings.
D. None of the above.

23. Which of the following statements is true for a country with a balance of
payments surplus under a fixed exchange rate regime ?

A. There will be a rise in the interest rate in the country.

B. There will be an appreciation in the value of its currency.
C. Its currency is under-valued at the existing exchange rate.
D. None of the above.

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28. Suppose Hong Kong has switched to a floating exchange rate system. The
effective exchange rate index for the Hong Kong dollar will if the
value of the US dollar rises against other currencies.

A. rise
B. fall
C. remain constant
D. be indeterminate

29. Under which of the following situations will an expansionary fiscal policy
have NO crowding out effect ?

A. Investment is not perfectly interest elastic.

B. Money demand is perfectly income elastic.
C. The economy has attained full employment.
D. The economy is in a state of liquidity trap.

30. Which of the following is NOT a problem in using the consumer price index as
an indicator of the inflation rate ?

A. It uses a fixed basket of goods.

B. It assumes the quality of goods remains unchanged.
C. It includes only final goods.
D. It includes imported goods.

END OF SECTION A

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Section B (40 marks)

1. (a) What is so ‘natural’ about the natural rate of unemployment ? (6 marks)

(b) When then can unemployment be regarded as an ‘unnatural’ phenomenon ?

(4 marks)

2. Consider an economy with unemployment. Suppose the fiscal budget was

initially balanced. The government decides to cut lump-sum taxes in order to
increase output and employment in the economy. In each of the following
cases, state whether the government can successfully achieve its objective.
Explain your answers using the IS-LM model.

(a) a tax cut compensated by a balanced budget cut in government expenditure

(5 marks)

(b) a tax cut compensated by a monetary expansion with no change in other

fiscal variables (5 marks)

3. (a) In the elementary Keynesian model, equilibrium in the goods market first
determines output; then equilibrium in the money market determines the
interest rate. In other words, the equilibrium level of income can be
determined by ignoring money market conditions. One message from the
IS-LM model is that interest rate and output are determined simultaneously
by equilibrium conditions in both the goods market and the money market.

The difference between the two models above lies in their assumptions
about the investment function. Explain. (5 marks)

(b) Explain why equilibrium in the elementary Keynesian model, which

represents equilibrium in the goods market, can also be represented by a
vertical IS curve in the IS-LM model. In what way can the elementary
Keynesian model be regarded as a special case of the IS-LM model ?
(5 marks)

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6. In principle, country A can peg its currency ($A) to a basket of foreign currencies
(say, $C and $D from countries C and D). Let us consider a new currency (call it
$B, ‘B’ for basket) each unit of which consists of one unit of $C and one unit of
$D. (Loosely, we can write $B 1 = $C 1 + $D 1.)

Suppose country A decides to fix the exchange rate between $A and $B while
allowing $A to float against $C and $D. On the other hand, countries C and D
both adopt a floating rate regime.

(a) Suppose, in the foreign exchange market, the equilibrium values of the
exchange rate between $A and $C is $A 1 = $C 2 and that between $A and $D
is $A 1 = $D 1.5.

(i) Find the market value of $B 1 in terms of $A. (2 marks)

(ii) Suppose the central bank in country A has fixed the exchange rate
between $A and $B at $A 1 = $B 1. Is $A over-valued or under-valued
in terms of $B ? (2 marks)

(b) Under what conditions can the fixed exchange rate regime adopted by
country A be sustained even in face of wild fluctuations in the foreign
exchange market ? Based on your answer, suggest a reason why it may
make more sense to peg a currency against a basket of currencies rather
than a single currency. (5 marks)

(c) We have assumed for simplicity that country A pegs $A against a basket of
only two currencies ($C and $D) and that these two currencies receive
equal weights in the basket. Why, in practice, may it be more sensible

(i) to include more currencies in the basket ?

(ii) to assign unequal weights to the various currencies in the basket ?

(4 marks)

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7. Consider an unfunded social security system in a closed economy with
unemployment. The system involves a redistribution of income from young
people to old people, i.e., the ‘young’ is taxed and the tax proceeds are
distributed to the ‘old’ as transfer payments.

There are 400 young people and 100 old people in the population. All the old
people have retired and their pre-transfer income is zero. The consumption
functions and disposable incomes of these two groups of people are given as
follows :

c1 = 10 + 0.75yd1 where c1 = consumption of each young person

c2 = 20 + 0.9yd2 c2 = consumption of each old person
d
y 1 = y1 – t yd1 = disposable income of each young person
d
y 2 = tr yd2 = disposable income of each old person
y1 = pre-tax income of each young person
t = taxes paid by each young person
tr = transfer payments received by each old
person

(a) Give one reason why the marginal propensity to consume of the old may be
higher than that of the young. (3 marks)

(b) Suppose the social security tax is the only tax in the economy and there is
no government spending. Suppose further that these taxes and transfers are
lump sums.

(i) Use the balanced budget condition to find tr given t = 100. (2 marks)

(ii) Based on your answer to (b) (i), find the aggregate consumption, C,
(i.e., sum of consumption over both the young and old people) as a
function of y1. Then, divide this (pseudo) aggregate consumption
function by the total population to obtain per capita consumption, c.
Find c as a function of y1. (3 marks)

(iii) Suppose there is no such social security system in the economy.

Find c as a function of y1. (2 marks)

(c) Use the elementary closed economy Keynesian model with no investment
to explain the effect of the above social security system on the aggregate
consumption, aggregate output, and aggregate saving of the economy.
(4 marks)
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 1999 Economics Paper II

Question No. Key Question No. Key

1. B 26. A
2. A 27. D
3. A 28. D
4. C 29. D
5. B 30. D

6. C
7. B
8. A
9. C
10. B

11. A
12. A
13. D
14. D
15. C

16. B
17. D
18. C
19. B
20. B

21. D
22. C
23. C
24. A
25. C

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 NUMERICAL ANSWERS

6. (a) (i) $A 1 = $B 6/7

7. (b) (i) 400

(ii) c = 24 + 0.6y1

(iii) c = 12 + 0.6y1

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