UNIVERSITY OF PRETORIA

FACULTY OF ECONOMIC AND MANAGEMENT SCIENCES

DEPARTMENT OF ECONOMICS
ECONOMICS 234 SEMESTER TEST AUGUST 2022
Examiner: Prof MC Breitenbach Time: 90 Minutes
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ANSWER ALL QUESTIONS CLEARLY AND CONCISELY
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1. How do the long‐run and the short‐run model fit together? What is the purpose of each
model? (3)
2. Give two reasons why Okun’s Law is useful when explaining the short‐run model? (2)
3. Looking at the Figure of the Philips Curve below, explain briefly how the two economies
depicted here respond differently to a boom and a slump. (3)

4. What is the definition of short‐run output (Ỹ) as used in the short‐run model? Write down an
equation to support your answer. (3)
5. Suppose short‐run output over the next four years is +1%, 0%, ‐1% and ‐2%. According to
Okun’s law, what unemployment rates can we expect to see in this economy? (Hint: The
natural rate of unemployment is 5% and Okun’s coefficient on short‐run output is ‐ ). (4)
6. Why does the IS curve slope downward? (2)
7. Suppose the parameters of the IS curve are = 0, = .9, ̅ = 2% and the real interest rate
R = 2%. Explain what happens to short‐run output in each of the following scenarios by
considering them separately:
a. The real interest rate rises from 2% to 4%.
b. The real interest rate falls from 2% to 1%.
c. c increases by 1%.
d. g decreases by 2%.
e. im decreases by 2%. (5)
8. From the algebraic expression of short run output, briefly describe the conditions under which
the short‐run output gap (Ỹ) will be zero. (5)
9. The South African Reserve Bank (SARB) conducts monetary policy by setting the repo rate,
which is the nominal interest rate. Explain how it ends up affecting the real interest rate
represented by the MP curve in the short‐run model (use the appropriate equation and
assumption). (5)
10. What is the Phillips curve? What role does it play in the short‐run model? Explain the role
played by each term in the Phillips curve equation. (6)
11. With the goal of stabilising output, explain why and how you would change the interest rate
in response to the following shocks. Show the effects on the economy in the short run using
 the IS‐MP model. Assume that in all cases, Ỹ starts off at zero before the news arrives (in each
answer, describe the impact of the shock and then the policy and its impact – no graphs are
needed).
a. Consumers become pessimistic about the state of the economy and future productivity
growth.
b. Improvements in information technology increase productivity and therefore raises the
marginal product of capital.
c. The war in Ukraine leads to an unexpected increase in the demand by Europeans for
domestically produced South African goods.
d. South Africans develop an appetite for new Chinese cars and sharply increase imports from
China.
e. Severe flooding on the South Coast of KZN destroys many houses and buildings as well as
warehouses with billions of rand worth of stock.
f. A housing bubble bursts, so that housing prices fall sharply and new home sales drop to a 20‐
year low. (12)

Suggested Answers:

1. The short‐run model is used to explain fluctuations in output around potential output√. The
long‐run model explains the level and growth in potential output√. In order to understand the
size and sign of short‐run output, long‐run output has to be known. √
2. Okun’s law is handy because typical voters care about unemployment rates more than they
care about the GDP numbers√. Our model focuses on short‐run GDP, but we can speak to the
person on the street by running our model through Okun’s law. Also, since unemployment
rates tend to fall a year or so after GDP starts to rise, one can use today’s GDP growth to
forecast√ changes in the unemployment rate over the next year.
3. In the steep (solid) economy, a boom causes a sharp rise in inflation√, while a bust causes a
fast drop in inflation√. Changes in inflation happen more slowly in the flat (dashed) economy√.
4. , √that is short run output is the difference between actual and potential output
√expressed as a percentage of potential output. √

OR for 2 marks: Actual output is the sum of the long run trend and short‐run fluctuations, i.e.
= +

5. 4.5%,√ 5%,√ 5.5%√, and 6√%, respectively.

6. It’s because a fall in interest rates √encourages businesses and homebuyers to borrow more
to purchase more investment goods. √
7. a) short run output falls by 1,8%√; b) short run output rises by 0,9%√; c) Short run output rises
by 1%√; d) short run output falls by 2%√; e) short run output rises by 2%√.DIRECTION OF
CHANGE IN SHORT RUN OUTPUT SHOULD BE CORRECT TO GET THE MARK.
8. ̅ : √ When = 0, in other words there are no demand shock√s and when
the real interest rate is equal to the MPC; √ where ̅ , √ IS equation reduces to
0 √because the C + I + G + EX – M = t √and the share parameters add up to 1; as we saw,
in IS equation, 1 , therefore = 0. √p 292. ANY 5 MARKS.
9. Assumption: Sticky inflation, √ in other words inflation changes very slowly and for our
purposes is fixed √when nominal interest rate changes; Fisher equation: ᴨ . √If
 SARB changes the nominal interest rate, the real interest rate will change by the same amount
√using the Fisher equation because of sticky inflation. √
10. The Phillips curve tells us that the level of short‐run output impacts the inflation rate: √
booms raise inflation above what people expected, and busts do the opposite. √ Reading
from left to right, actual inflation (π) depends on people’s inflation expectations (πe), √and
on “demand conditions,” √that is, how much ( ̅ ) √a short‐run boom or bust ( ) causes firms
to speed up or slow down their price increases. √
11.

(a) This means IS shifts left. √The SARB should respond by cutting rates (pushing MP down) √ to
put Ỹ back to zero.

(b) The IS curve shifts right. √ The SARB should respond by raising the nominal interest rate (raising
MP) √until the corresponding real interest rate again equals the marginal product of capital. This
is the same as raising MP until Ỹ equals zero again.

(c) IS shifts to the right. √The SARB should raise MP √until Ỹ is back to zero.

(d) IS shifts left. √This means fewer consumer goods will be made in South Africa. The SARB should
cut MP √until Ỹ is back to zero.

(e) Same as (b). This raises the marginal product of capital (capital is scarce, so it’s worth more).
This shifts the IS curve to the right. √That means you need to raise the MP curve √if you want to
head back to your (now lower) potential GDP.

(f) The IS curve shifts left. √The SARB should shift MP down, √cutting interest rates.

TOTAL 50