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    Oxford Economics - Skills and Practice

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    emaadyesyes

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    of 198
    Ue a Economics FOR THE |B DIPLOMA ener ty OXFORD SECTION 1 Microeconomics Demand foes = Non-prige factars attacting demand can be referred to 25 ‘shift factors’ bacause itthay change than the demand curve shifts {to the right or to the left). the price of the good changes then there is no shift of the demand curve, only a movement along it from one paint ta another. = Avoid using the expressions ‘shifts up’ or ‘shifts down when describing changes in market conditions, Itmay lead you to errars. so Pree —— 02 on i Tan Four Example 2 Explain how the demand for gi fluenced by an increase in the price of guitars. ar strings cauld be = Whan drawing a shift in a demand curve, many like {to draw arrows that shew tha directian of change. It may be a good idea to draw your arrows ‘parallal to the O-anis fike this Por like this 4—) to avoid having them point up or dovrn This way you will remomber that an increase in demand maans that at sch price the quantity demanded has increased. Risky prestice Pic 0 m1 0 Danity Figure 1.2 Example 3 Explain how an ageing populatian could affect the demand far false teeth, Pic pero Price pero ie te area age of rena creases demand fer fase beth na wee vets uneasy sing Si demeceect bre be be » a ‘Searing por wrth at Chandy pr pe Figure 1a Figure 14 10 SECTION 1 Microeconomics Price discrimination emus = Afirm must have some monapely powerto price discriminate. It must also be able to prevent resale of the good from one market ta the otter and. for some reason, cansumers in one market must be prepared to pay mora (in other words price elasticities of demand across markets must differ) om If afirm sells in market A at a price that is 18 higher than the price in markt 8, because it costs the firm 108 more to market the product in market B, then this is nata case of price diserimination, The price ratios in the two markets must differ from ratios of production costs or pravision casts in the twa markots to qualify as price disérimination, Example 39 Rewrite the following statements and fill in the blanks by using the terms provided below. Some terms may be used more than once or not at all monopoly power marginal cost higher pricing fewer ability ongumer profits perlectiy inelastic Price discrimination ix 2 (1) policy that many firms aften adopt to further inercase their (2) imply, they manage to appropriate part of the (3) surplus by charging different prices to different consumers. Consumers with a greater willingness and {4)___ te pay will be charged mare as they face (5) substitutes or have a (6) income. In cither case, their demand will be more price (7) : ‘The price-diseriminating firm must enjoy some degree of 18) defined as the ability of some firms to set price above (9) This ceally just means that (10) competitive firms cannot adopt stich a policy, (1) pricing, (2) profits, (3) comsumer, (4) ability, (5) fener, (6) higher, (7) inelastic, (8) monopoly poner, (9) marginal. cost, (10) perfectly Explain using examples the conditions that naad to be satisfied fora fir to be able to practise price discrimination successfull, lusting its pricing decision ‘with an spacopeiate diagram. fre all consumars shways necessarily worse ott when such a pricing policy is adopted by arm? Thetearetwo papular diagrams used to dlustrato price discrimination ‘Occam's rego isa line of reasonina that suggests you uso the siemptost imothod that drives the pale heme In thus casa isthe back-to-back dsgram, where We assume for simplicity that marginal costs are constant. Drawing two demand fand MB) Hear curves vetth differant slopes Wal load you to (he desited fesul that In third dates brice dlscrimunation the highest price i charged in the market with the relatively maleate demand. 21 activity Economic activity ‘= ‘Domestic’ refers to tha boundarias of a country ‘whereas ‘national refers to the nationality of the foctars of praduction. ‘The difference between GOP and GNI is that GNI includes incomes earned abrosd by pationals ofthe country while it excludes incomes earned damestically by foreign factors (which ae paid abroad), ‘= A’nominal variable Isuch os nominal GOP} refers te a veriable without having isolated or adjusted for changing prices so ftis measured at current prices But a ‘real’ variable [such a8 real GDP} refers 10 4 variable measured at constant prices of some base. ‘yearreal GOP end real GNP focus on the volume and nat the value ef putput produced. Example 1 Why for ourput)? We cannst evaluate the performance of if we awe no m portant to measure national income economy se this year compared. with last year er five years ge ent oF ceramic activity, We cannot compare the performance of one at a. point in time me. perind if We de not knows Few bal output and. income howe behaved. ( performance has bean judged. unsatisfactory Oran poticy makers wil reed measurements to devise and. implement policies to improve performance and. atso to later _indge the. effectiveness of Geir policy choices or over National income statistics therefore help in evaluating ccenemic performace through kine, across countries as well as Wn devising ard evalating pelicues h hak the term ‘performance! is radher may be misleading. For example, uf based. on he OF GDP figures it is determined that an ccanany has grown rapidly over the past decade, The level of overall macroeconomic Per capita means per person, so to arrive ata ‘per ‘capita’ figure just divide thatfigure by the jon of the country. For example, per capita artived at by simply dividing ral GDP of a ‘country by its total population, = ‘Green GOP" refers to output after factoring in the detrimental effect of the praduetion pracess on the ‘environment. Specifically: green GDP = GOP — cost of natural resauree depletion —cost of environmental depletion. 1S Ub safe to conclude that ibs performance has improved? Whab of Bhs increase in eutput and incomes WAS come ab a ternble. ervirirmnental eost? Green GOP stabisties may Help in such assessments a3 the environmental cest is accounted. for un such statistic, Skill, such statistics are aggregates and. eray nob reveal important inforwadion 2 they have ta be used. wih extra care, Example 2 Rewrite the following statements and fill in the blanks by using the terms provided below: base value incomes living standards firms boundaries real circular flow non-marketed householis goods and services constant prices nominal output green factors of production final land, labour, capital rent, wages, interest ond entrepreneurship and profits 101 N E p a 4 re) ® Q ° 3 ° 2 ° a ‘The inner circle of the (1) diagram illustrates the economic links berween @ and (3) . There is a flow of (4) from households to firms and, in the opposite direction, a flow of bs) from firms to households. ‘These are considered (6) flows whereas in the opposite direction there is a money flow which refers to the (7) paid by firms to households far use of the factors supplied. The factors of production include {8} and their rewards or payments are the sum of (9) GDP is a measure of the toral (10) economy in a year. More specifically it is the a) ofall (12) ___goods and services produced within the (13) of an economy over a period of time, typically a year. 4) GDP measures output at current prices, ic, the price prevailing each year. Real GDP measures surput valued at (15) + ive, the prices prevailing during the (16) year, If che deleterious effect of many production processes on the enviranment is accounted for then we will arrive at an estimate of 7) cpp. Using national income statistics co make inferences about {18} is fraught with problems. For example, subsistence agriculture in developing nations and, more generally, (19) ‘output is not included even though these are income-generating activities, (1 base, (2) households, (3) firms, (4) factor of production, (5) goods and services, (6) real, (7) incomes, (8) lard., Labour, capital and. entrepreneurship, (9) rent, wages, interest. and profits, C10} output, (11) value, (12) final, (13) boundaries, (14) nominal, (15) constant prices, (76) base, (17) green, (18) tivng, (19) non-marketed ofan ‘Example 3 National income figures are often used to compare living standards across countries and through time, Explain the problems associated with this Practice. Bear un mind. first of alt that uf ary such gbtempt ie made i is better te tse GNI rather than GDP Figures, a GNI frcuses on incomes earned. by the rationals of a country white GDP focuses on subput produced inside the country, But such a Figure: must be divided by the population bo adjust for the size of the counts, And., if comparisons sare. made through time, then real and not nominal figures: must be used. te adjust for changing prices The major argument in favour of using per capita, income as a measure Of living standards is that iF ik is higher ib implies that people command mere ‘subpul, and wore output is considered. better than ess output If per capita income ie used 25 a measure of living stardards we should bear these. points on enand ww Ibis just an average income figure providing va information on its distribstion ia Ik reveals wating about ibs cemposizion, m It does not ancude the value oF leisure. m it dees wet include won-marketed. output, such As the output and. income of a parent helping vis or her child with homeworle, or of subsistence agricultural oxtput in a developing country, mw It does not include, pavalied market activity that, goes uwrecorded. m It does not accouné for pollution and. other negative externalities that the prodaction process often creates These ave jast some of the mast important issues ‘wo be aware of when national income statistics are used to assess lining standards ® Calculations © To calculate nominal GDP from expenditure © data you just nced to add together consumption, investment, government expenditure and net exports or: nominal GDP = C + 1+ G + (X— My = To calculate GNP/GNI you will be given (or you will have computed) GDP values, and then you just need to add ner factor (or property) incame from abroad which is the difference between income earned abroad minus income paid abroad. Remember that, in GDP, ‘domestic’ refers to whatever econamic activity takes place inside the borders of a country, whereas, in GNI, ‘national’ focuses ‘on the nationality of the factors of production involved irrespective of where the activity takes place. So ance we have GDP figures we need to add incomes that domestic factors earned abroad (say, profits and wages) but subtract incomes that foreign factors earned domestically (again, for example, profits and. wages). The difference is mostly a result of so-called multinational corporations and is a large amount for only a few countries. = Tocalculate real GDP from nominal GDP data you need te divide che nominal GDP data by the price index for that year and multiply your result by 10, A price index is an average of the prices of goods and services expressed as an index number, ic. as a pure mumber without units of measurement, & year (period) is chosen as the base (reference) year and the value af the index in all other ycars is expressed as a percentage of that in the base year {period}. Typically, to calculate real GDP we use the so-called GDP deflator as the price index of choice (sce more on the GDP deflator later} Calculate nominal GDP from the expenditure approach. Nowinal GDP can be calculated. from expenditure. data. using the relationship: vominal GPP = C+1+6+(K—M) So: varinal GP 35.86 + 6.52 + 22.82 + (8.6 — 9.8) ‘Se. biduon Example 5 Assume that there are oaly two counteies in the world, Fictionland and Fairyland, In 2011 there were a number of active Fairyland-owned. corporations in Fictionland as well as many Fictianland-owned corporations operating, successfully in Fairyland. If Fairyland-owned factors earned $1.3 billion in Fictionland whereas Fictionland-owned factors earned $1.1 billion in Fairyland, caleulate Fictionland's GNP/GNI for 2011 (given that its GDP was estimated at $64.1 billion}. What will the relationship beeween Fairyland’s GDP and GNP/GNI be and why? To calculate Fictionland’s GNP/GN! we reed. to add wet factor (or property) income frem abroad to its GDP figure. Tris is equal to income earmed. abroad. ($1.1 billion) miras income paid. abroad. ($1.5 bition) 11-13 = — $6.2 billion. It follows that in 2011 Fictioniand’s GNP/GMI was: 4.10.2 = $65.9 billion, Since there are. Orly two countries in the wort it folltms that net factor income for Fairyland was Positive 50 its GNP/GNI was higher (by $6.2. billion) than whatever its GOP was. Example 6 ‘The table below provides nominal GDP figures for Freedmania between 2007 and 2011 as well as the price index for cach year (2008 is the hase year). Example 4 Calculate the level of real GDP of Freedmania. ‘The following data refer to Fictionfand in 2011, Consumption expenditures [Cl 3586 2007 455 970 Investment expenditures 652 2008 493 100) * [Government expandituees (6) 7282 2008 513 1083 : Export revanwas {i} a6 2010 B04 1074 2 [impart expenditures IM) 38 201 et 104 _ SECTION 2 Macroeconomics To calculate real GDP from nominal GDP figures you need to divide nominal GDP by a price index and multiply the result by 100, Year Caleuiatan — | Reak GDP CF wierd {2808 prices} Explain why, if GDP of country A is double that of 2007 46.71 country B. itis poten ally very misleading to conclude shat Tiving standards in country A are twice as high as ving a aie stendards-in county B 2009 52.06 Game 2010 56.24 Explain why itis increasingly important for countries to zen 56.40 measure green GOP alongside conventional GOP. Ea The following data represent the GDP of a country at current prices in milions ef euros and a comprehensive price index fa price deflator) amaa_[ et [aor ‘ome zaie_[ ea vase! | W6AQ0 | TeestS | 2A vara | u9a18 725679 | 20% woo] 103.12 | 19340 | 10392 zat | 103.12 103.20 | 10120 ‘= Tho short-term thictuatian of real GDP around its trend path is Bo careful labolting or racing labols roferred to-a5 the business ortrade cycle. The longctorm trend is often Jat tusiness cycte diagrams 11 shea referred to as the potential GDP of a country. a big difference whether the vertical ‘oan tnesuures the lel of eal GDF or theporceniage change i rel GDP The Example 7 horizontal axi¢ measures time “ (nero) ‘Match each term or concept with the appropriate definition or Get uscmare bettas explanation, raceutian I grawth decrensoe (but 1 Long-term trend a The maximum GDP recorded immediately] contre: to Be restive thers na 2 Retvewion before a downturn starts navans a ailoees ait 3 Expansion b When real GDP increases 4 Trough ¢ The real GDP recorded immediately before hak recovery begins Potential GDP @ When real GDP falls for at least two consecutive quarters G, ds @, ©, Gb), G0, (5, oF 104 Example Answer the following questions based on the business cyele diagram below. eal oP yore 21 1 Technically when can we say that a recession starts? ‘An ccohomy is in recession if rea GDP decreases. A popular definition requires that this dcp in cutput is at least. for tho consecutive quarters; in reality, calling a particular economic situation a recession is a much more complicated issue that experts decide, On the. diagram, real GDP starts to fall immediately after time t1 arc tine 47 2 Which points are known as ‘peaks’? Peaks are shown at Points B and H, which are immediately before real GDP starts to fall 3. On the above diagram where ean one say that growth is slowing down? ‘As long a5 growth is positive % means that real GOP is rising, A slowdonin refers to decreasing bud positive growth rakes so polis immediabely before a peak ave good. candidates, such as points A and G (bear un mind. that on alierabive defirtion of a vecessizn is Uhab it is when growth is belain the long-term trend. rade), 4 Which levels of real GDP are equal to this economy's patential output? ‘These are ary poonts on the long-term trend lire such ast, J and $- Which point is known as the trough of the cycle? Poort: E would. be called the trough as ik represents the lowest level of real GDP immediately before it starts be increase. 6 What about points C, D-and F? ‘At point € (time period 42) the econemy is stilt ‘operating above its long-term trent but econcerie ackivity is shrinking, whereas af point D it is below its pobential and. shrinking. At point F (time. period 45) the economy continues to operate. below its potential but economic. activity is picking up 7 Mowe define as natural unemployment the unemployment that exists when output is at is potential rate, then what can be said about unemployment at points (A, B, C) and (D, E, F) cof the business cycle? When output is greater than its potential rabe (points A, B and C) then achisl unemployment must be below its matural vate, white when the ‘economy is operating below its potential rate (points B, £ and. F) then actual unemployment. is above its natural rate. Use the diagram below to determine whether the falloerng statemants are true or false "al GF) Figure 22 1. Ecanomie growth is slowing down between time 11 and time %2 ‘The economy is inrecession after time 12 Real GOP is lower at time 12 than at time t1 ‘The economy wasin recession in tima 14, Real GDF was lower at time t8 than it was at time 2 Recovary begins after time 18 Aggregate demand es = Aggregate demand {AO} is not negatively slaped for the same reason that the demend for, say, pizza negatively sloped: the price af pizza rises then all other goods became relatively cheaper sa buyers -will substitute other goods for pizza. If all prices are rising fie. tha general price levetis increasing! such a substitution effect is nat possible. AD slopes downwards because of the ‘wit’ alfacts: wealth, interast rate and trade affects, = Often there is contusion because AD is the sum af 41+ +NX which is the sama as GOP measured from the expenditure approach, The erueial difference is that GDP is actual output that has been Example 1 Explain how each of the following enteies may affect AD, Assume that the ceteris paribus clause halds. 1) Household and firm debe levels rise significantly. This means that what households and. firms owe tn banks and, ather lending institutions has increased. Such a. development may force. btn Wnousehoids and firms to cut down on. theur spending, The decrease in C and. | walk tend te decrease AD and. shift it bo the left 2. Households become more optimistic. Consumer confidence is a major driving force of household expenditures. Optimise and a positive. outlook tend. to induce greaer spending, especially on duratles such as cars, furvabiire ard, appluances, AD will tend, to increas shift to the right, and 3 The exchange rate appreciates. The exchange rate is the price of a. cxrrency expressed. in terms of another currency. For 0 = $146, more expensive (say, £1.00 Lf the euro hecemes $1.50) then eurozone products will become mare. the USK and. US goods ‘An appreciation wll therefore tend to decrease nek exports, and. 50 AD, shifting i to the left example, heaper in the. eurozone 108 2 5 2 Aggregate demand and aggregate supply Praduesd within an economy, while AD shows the planned level of spending st different possible ‘average price levels by households, firms, the ‘Uovernment and the rest of the warld on comestic ‘output. The key ward is ‘planned’ ‘As is the ease with any function there can be no shift of AD when eithor of the variables represented ‘on the two axes changes, Changes in tha price la will lead to a movement slong the AD curve whi shanges in national income cannat initiate an ‘ease or decrease in AD. Once some other ‘non-incoms factor induces a change in any of the somponents of AD, then AD wil shift ‘The government decides to overhaul all infrastructure such as highways and bridges. This is tantamount to saying that government: expenditure, a. component of AD, increa: this would increase AD and shifl ib to the right ‘The central bank decreases interest rates, The central bank of a country iss responsible for conducting monetary policy, onchaing deanging interest rates. The onkerest rate can be thowght the cost of borrowing (or the reward. for if the cenbrol bank decreases interest hen cheaper borrowing will induce more spending, leading shift to Use right. an increase in AD and. Houscholds demand mare money to make the same transactions as a result of a highee price level and the resulting increase in the interest rate lowers their spending, This wilk mob shift AD as ik is the average price tevel (represented. on the. vertical. avis of tee AD diagram) that initiates Ue. change in spending. What is described above is the interest rate effect, one of the three reasons, together with the. wealth and trade effects, responsible for the negative slope of AD. in any disgram, changes in the level of whatever variables are -4 of the diagram carwat shift the function dlustrated. measured. on the two ax 7A major trading parmer resorts to increased Example 2 levels of trade protection, Define the term consumption expenditures, Bricfly Trade. protection is a. term that refers to explain three important factors that may affect policies which air to bisck imports from entering their level, 4. country. The iparts oF a major trading The term refers to spending by households on partner are a country’s exports 50 mhab the durable and ron-durable goods as well as on statement is really saying is Urat he. country's services, Interest rates, the extent of househetd, exports will decrease. This Will decrease AD indebtedness and. the degree of consumer and. shift it to the left as exports ave a. confidence are. major factors influencing capper oF 5 consumptign expenditures, 8 Personal taxation increases. Interest rates determine. the: cost of borranirg from If the government increases personal. taxation banks as well as the size of the: reward for saving then disposable income, defined as national (defied. as income vot consumed). An increase in tncome tess direct taxes, will decrease, This interest rakes makes ib more expensive to borrow and. will force households to cut down on their more, attractive. to sawe. Bath effects will tend ta spending. AD will. tend to decrease, shifting to lower hausehold. spending. the ae Ifa household has in the past barrewed. heavily to 9 Our major trading partner enters a severe finance spending sprees on goods and. services, recession, then « big proportion of its monthly income: will. emapersrie idee wat operons: have to he used to repay barks for the capital ard interest on these loans. This will mean that luring which ecoramic activity shrinks, ic. real _ less income will remain to spend on current output GDP and. 0 incomes decrease. If, for seme reason, that is the case for cur trading parler Even if interest rates are low anda household is then its spending wil decrease. Part of its wot in Large debb, individuals will thine twice spendirg was on our goods and services. Sone — before they spend, es oatopancive domestic goods and services sold abvond are urabieg, when they feel insecure and. pessimistic counbry's exports then the recession of our about the future. I people are Laid off or made trading partner will tend to decrease ow AD, yedundiand and. unemployment is rising, even Ure shitting it to the Left. This chain of events is ones lucky enough to have « jp will cut down on referred to as the international transmission their spending as a. vesull of the vising mechanism of the business cycle. ppcertsli 10 Expectations concerning continued growth increase share prices and so household wealth. Hore, increased. wealth is a result af optimism concerning the future path of the econamy Consumption will tend. to increase and so will AD, shifting ib te the right. 11 Real wealth decreases as a result of a rising price level. Here, id ie Bre Hse ah te average price level hak & respansitle for whe chaige in reat wealth so there will be we shift in AD but erly a. mavement along as people will tand. to cub exe an tei 4 Explain three important factors that may affect the level of Define the tarm investment axpenditures, Explain three level, Provide important factors that may affect th examales to ilustrata yaur answer. Bee Explain two important factors that may affect the level af (ernment expenditures. Provide exampis to iustate. your answer ret experts of a country, Provide examples to illustrate your answer, Aggregate supply ‘Aggregate supply (AS) is not real GDP. AS shows how much firms planning to offer at different average price levals par period of tim ‘= [tis the ‘stickiness’ af money (nominall wagos that is responsible for short run AS sloping wpwerd “& According to the monetarist or new class sumed flexibility of maney wa output. ‘am The Keynesian model is effectively a shart run model af national there is no guarantee that money wages and incame determination ices would adjust to restore full employment. Example 3 Explain factors that may cause the short run AS curve to shift. Across the board, changes in the praduction costs of the firms of a country will shift its short un AS. Mast. importantly this includes changes in the Level of money wages. But ary factor that changes production costs will have the same effect, fur ‘example, changes in the prices for imported. raw materials or a change. in VAT or ie subsidies, Temporary (adverse or positive) non ectnémic, factors may also create. supply shocks. natural disaster (a. hurricane, a. tsunami or an earthquake) could decrease AS at least temporarily Until destroyed infrastructure ard capital is rebuilt. A bumper crop year for an economy with a large primary sector could. increase short run S. ‘As long as there is no change in the quantity or ality of avaikable factors of production, of technology or of the institutional framework, supply-side changes affect only short mun AS. Changes in the quantity ard. quality of avaiable resources, in technology or in the institutional Framenork affect Une long run but alsa the short run AS curves. rapective itis the ‘and prites that's responsible for long run AS being vertical at the level of potential (full employment] unemployment in the Keynesian AS ‘modal. dofine patenial oatpata lilo ta ‘he ofthe vertical phird) section of tho Xoynostan AS curve inthis wagthe Reynasian deed fll employment belog ‘wall boyond which output cannct Increase can co-exit withthe Idea that there: always some unemployment in an economy (natural wemployinent) tris a mistake to write ahour the Tong run Keynesian AS" curve Remember that according to Keynes. in the long run we are all ead’ gn the distinction ts meaningless it suffices tore the "Keynesian AS curve, ‘Example 4 Explain why the monetarist or new classical long run AS (LRAS) curve is vertical at the level of potential (full employment} outpur. Potential cutput is defined as the Level of output tat an economy would preduce if all prices and. money (nominal) wages were flevible, Assume an ‘economy in Long rtun equilibrium decoded, sau, at point Al on the diagram below, where tre average price level is Pi and real eutpub is af its potential level Yp. If for some reason te average. price level increases te Pz, Haen the ecenemy pill move along the. short wuss AS shown as SRAST because of the. assumption thak money wages are Fixed, in ‘the short run, Firms will witness Inver costs as the real wage (he ratio of the money wage over the price level) is mer, Output will increase to ', above. the: potential output: level. Yp (point Az), Jverage price ‘ene MS ny + aS fe “y fas Pi | Real outzul/ ad weceme (Y) Figure 23 In the long run though, money wages will also: irerease. ta match (hy assumption} the. rise in prices. The higher money wages will shuft short un AS to the left until ik reaches SRASZ, sp that the real wage as well as firms! profitability return to their previous level. Consequently, veal output Ul return do Tp: farms Fave vo reason to pradisce, more when money wages have visen as mich as prices, Cuiput will vemain ab is potential Level but the price: Level mill be higher at P2 (point AS). Average re lever (PD ast skase ak sit ince. (0 Figure 24 Now! let's see what happens if, symmetrically, the average price level drops: start from a point on the (RAS, sag point At, where tre. economy is producing the potential output Yp and the: average price level is PI, If the average price level falls to Pz. then the economy will move alarg the short rien AS carve SRASI because of the assumption Bhat money wages are fixed in he short run, Firms wil witness increased costs as the real wage. (tne ratio of the money wage over the price Level} is higher. Outpst will decrease to Y', below the potential output Level Yp (point AZ) tn the long run thowgh, money wages will also decrease to match {by assumption) the decrease in prices. The lower money ronges wil shift short run AS to the right uni ib reaches SRASZ, so that the real wage as well as firms’ profitability retwm to Yheir proviows level. Consequently, real output will return to Yp: firms will produce more uoham money wages have. dropped. as much os prices Qutpul will return to ite potential Level bub tre. awerage price level will be lower ak PZ. This means thak ary deviation from potential output, twill be: temporary. The assumed flexibility of money wages guarantees Unak te economy will return to its potenbual sutput. LRAS is vertical at the potential level of outpub as the. latter is independent of the: level oF prices. Example 5 Explain the horizontal section of the typical Keynesian AS curve making explicit reference to the dawnward ‘stickiness’ of maney wages, According to Bre (extreme) Keynesian model, money wages de vot adjust downwards (because of Labour unions, combracts, minimum wage Laws, ec.) to lower the real wage rate for firms, so fires are forced. to Lower ovlput. As Long as money wages do mot adjust, the economy can get stack ak a lower outpat than its potential output with unemployment therefore higher than nakural. Example 6 Explain the role of ‘borlenecks” in the production process while explaining the rising seetion of the typical Keynesian AS curve. ‘The meaning of ‘botttenecks’ is instrumental. in explaining Be rising section (the secard. seckion) in Kegresian AS. After some level of total output, as real GDP continses to increase, wages mill start to increase because of ‘bottlenecks’: unemplayment: wil have decreased to such levels that firms can only find workers by offenng higher wages. Picture how the neck of a batile becomes narrower 36 that Less Liquid. cam #éw throught ib However, Uf production costs increase then firms will be willing to offer more. output only at higher prices, So the average price level rises. & direct relationship has been established between the average price level and. the level. of real output of an economy, This is region 2 (Lhe positively stoped. section) of the Keynesian AS curve, 11 Explain how the demand curve for holidays aroad cauld ba influenced by: a higher income lovels Iban incroaso in tho pric of aitline tickats discounts atfered by domestic hates Explain how tha demand curve for bicyclas could be orca by: fan increase i thelr price is this a ‘shift’ factor 2 sigrisicantincraase in the pric af helmets increased lave of pollution Reverie the fllowing staternents and filin the blanks by using the terms provided balaw, Same terms may be used ‘mora than ance or nat at al decrease increase demand substitutes: ‘complements right lett inferior normal shift movement along ‘An increase in the price of watarmeloas will lad to a decrease inf} __ On a diagracn this implies that there will be a (2) _ ofthe demand curve W Coca Cola Co. dacides to increase the arice of Cava Cola ‘than tha demand for Papsi will probly (3) and shift tothe as tho two products are considered (51 Simple demand functions ‘The law of demand requires that the price of a good and the quantity demanded per period, ceteris paribus, are inversely related. In other words, if the price increases then quantity demanded is expected to decrease and vice versa. Denoting price by P and quantity demanded by (Qd, a demand function of the form Qd =a bP is che simplest form that keeps the requirement that the two variables, price and quantity demanded, are inversely related. Lsosmeemmemante ang 33 Explain how the demand curve foc coftes could be influenced by 42 medical reports stating that mederata cates drinking ‘may have certain hoalth bane! bb a sharp increase in the price of sugar © afallin te price of tea Dernand for used ears wil whan incomes increase if consumers start ioaking into better substitutes, such as neve cars. n this case, used cars are consiarad a (goods and their demand curve will sbifto the i) W pizzaand hamburgers become ‘mone exponsive thom demand for soft drinks will probably @) as Soft drinks and fast fond are (bss es Hf ganernment announces tat in five mnths itwillincrease the tak on heat ail then one may softy assuene thatthe demend for eating fl will nw (11) and, thus, the demand cure shifts the (12) It the price of ‘ik ineraases then quantity cdemanriod il (131 50,07 gram, thei na (14), best only a (181 ‘the demand curve, This is guaranteed by che minus sign of the second term, the coefficient of price, In other words, the coefficient of price must be a negative number so that the law of demand holds. This coefficient is referced to as the slope af the demand function, ‘The functional form Qd = a — bP is an example of a linear (a straight line} function, che only form you are required to know. Ir will always be a straight line, so if you draw it you will be able to plor it using your ruler Examples of such linear demand functions include: Qd = 100 - 2P Qd = 60 —4P Qd = 5000 ~ 25P fe ‘SECTION 2 Macroeconomics eres Eeplain tree factors that may ierease the long aun AS of Explain why the monetaristaraew classical persaectie an economy employing the monetarist or newrelassical considers labour unions, government regulation in labour approach, Would thase facts also shift the Keynesian AS matiets and lack of competition in praduet markets as -eurve to the right? Use appropriate diagrams 4 Mustrata imaedmenrs 1a full employment ‘your answer, Poor labeling in AD/AS diograms is the biggest source of errors on macra questions in exam Keep thes#ips x rand, nber = Long run equilibrium in the monotarist o new classical model will always be at the potential (full employment} level of output. Atthat Dens. eut cornare:fulyIabal the level of real output, on diagram, AD intersects SRAS and LRAS. piss peta cto |= Short run equiliarium output in the monetanist or new classical madel and abe ergo ax Teal ouput? can be either below or above the economy's potential (full aoe (rem OS Simeraeeed employment] output, but only temporarily. The assumed flexibility of eee Ifyou label the vertical axis with ‘money wages will guarantee that the economy will return ta its long Dee Ceara run potential output. of dicta ao boved ‘= Inthe Keynesian mode|, the economy can get stuck ats level of thay wereimoro‘ssuse-candidatia output below potential (full employment} output as wages and prices kis diokr aval rmsd are assumed to be ‘sticky’ downwards: insufficient AD will force a ferveting that ey are analvoins decrease in output and a rise in unemployment with no automatic movemente inthe general (average) adjustment mechanism present io resiore full employment, There is » price level, need for government intervention. td labelingthehortontalusina theleter'@.Gncragain. candidates a= Whether discussing the menotarist or new classical approach, of in Ser Malet ‘the Keynesian approach, if equiliarium reat output is belaw the SE eaun iecgeaaeges potantial (full employment} level of output then the aconomy ithe vesienwasaboatthe rarket, experiences a recessionary (dafiationsry) gap, while f equilibrium for sey. cora. Using the label “YF? real output is greater than the potential (full employment lavel of ‘ts preferable for perhaps ‘real GDF’. output then the economy experiences an inflationary gay (Pera tebe empetaby Toth a il a descriptive labels) will help you flap loused on amacro analysis Example 7 Explain, using appropriate diagrams, how full employment equilibrium is restored if a ‘At ts lave ot meteical sophistication there ore plenty of i ‘arey'areas mvmacro. This te nawotdable You ris deal wth recessionary (deflationary) penis within the Bene ares Te eee ae monetarist or new classical model here nchde te lls Assume an ecenamy in long run equiibriae For the Keyneslana real output is demand-detormined reducing the potentiat (full empleyment) level of aulecarams ean getstuck a lower han fullemplermert bebernseck secon Sure on level of equllibrn. Wages ara ‘sticky downwards 2 ee eee ee eee eee there is no automatic mechanism avedlable to restor® full iustrated, on Figure 2.5 at point at, the employment Inersasing AD oan Incresse output tovecrds intersection ef ADI with SRASI on the CRAS curve. Fall salen Leb AD, for some reasen, decrease te ADZ, The For the monetarists or new classic school, real output Eons ine a lan economy ts whatever Re resourens. technology and average price leiel decreases te P’ bub since, in inetutional ranwore pect produce prices and short run, maney wages are assumed fixed, wages are Hexic fe wl gravkade towards Gus potertel the real wage has Wcreased and forced. firms to evel of output Increases in AD may increase output only riee cakes fl Gas cae temporarily fin the shart rt) unt money wages adit ee wee oe heey, al andthe conor retursto ts potent. Iongrun equilibrium less at 1", The economy will lave moved along with higher price level SRASI to point a! A recessionary (deflationary) gap will result, equal ta the line. segment Y'Yp 110 Real rutputt incemne (eh Figure 25 th the Long rum, money wages will adjust and decrease to match the decrease in the average. price level. The decrease in money wages increases the: short ran AS shifting the curve to the, right to SBAS2. The real wage rate will therefore: decrease providing the incentive. to firms to increase production so dat potential (full emplaygent) output is restored. The ecerony will again ford. itselt in long run equilibriut at point az wisi a Loner average price level P2 and, veal GDP a ibs pobevdial. level. A recessionary (deflationary) gap cannot persist in Ure Long run within Une monelarish or new classical, model. Example 8 Explain, using appropriate diagrams, how an economy ean get stuck below the full employment level of output within the Keynesian model, Assume that AD is at AD' as illustrated in Figure 2.6, The economy is operating below its maximum or ‘walt’ level of output, Yu. Mone wages and. prices are ‘sticky! downwards within the Keynesian wortd. so there is mo aukomatic mechanism present to Onluce firms 4o increase output and remove the recessionary (deflationary) gap, which is equal to the line seqment for Y"Yw) The decrease in AD has forced Firms to adjust nly output, Reak oatanké income (43 Figure 26 For the Keynesian model, the drwing force. in an econemy is effective demand. which we: call AD. If AAD is insiefficiont to generate fall employrent, then the economy is stuck ab an equilibria Level. of ouljut such as Y". It follows from this perspectine thab Bhere is a role fer the government as a may, defines AD Airey Ahn ‘tiger rs hovel Of govervinent spending G or, dndirectiy, tnreugh the mavipalabion oF taxes (which could. influence consumption and. investment. expendibsres) Note that in the. diagram above, of AD increases and shifis to tne right (as « result, say, of government intervertion} then ik is nob necessary for the. average price level to increase. The reason is that within this extreme version of the Keynesian model (with « horizontal AS segment), an equilibrium along the flak segment. implies depression-like conditions in the ecoremy with extremely high umempliyment. and. urder-ulilized, capacity. Output can expand without ary increase in wages or other rescurce prices, and so without farms raising their prices. This is true up to Ure point where ‘totllerecks’ appear, in which case botit real cutput and the average price level will be: rising. The doser to Yw the economy is operating, the greater the effeck af a further increase, of AD on the average price, Level. Note that in this extreme version of the Keynesian model, Bre more. conbemporany. idea of potential outpat, where prices and. wages are flexible and Some. normal or natural. unemployment exists, is not accommodated. Exainple 9 Determine whether the following statements are true or false, Explain your answers. 1. Within the monetatist or new classical perspective long run equilibrium will always bee restored. True, The assumed. feritdity of money (raminst) wages guarantees that cutput returns t» its potential Level 2 Within the Keynesian (extreme) model an increase in AD will always increase prices. False. The existence of very significant Levels of unemployment when an vconamy is in & deep recession (depression) uwplies that an werease fn veal cutput can be achieved. without prices vasing if, for some reason, AD starts to increase. 3. The Keynesian model assumes that money ‘wages may increase but they are ‘sticky? downwards. Truc. This is also known as the ‘ratchet: effect. Ib is this donwnneands ‘stickuness) in money wages tab prevenis autoralic restoration oF full erspleyment. the time period is greater than one year we are in the long run, False. The contemporary distinction bebueen the. short mun and the tong ran in macro rests on whether money (nominal} wages are or are not flesible. If they are flexible and they can match any change in Ure: average price. level then we are in the tong ran & The (extreme) Keynesian concept of full employment differs from the monetarist or new classical idea of porential ourput where the LRAS is vertical and where some unemployment persists, Truc. The Keyrasian madel made vo distinction betwean the short run and. the long ren. Within the Keyresian model the idea of full emplaymers, can be thought of as a. ‘wall!, oF a ‘maximum level of output. The concept of a ‘natural’ rate of unemployment was artroduced mach later (in 4968) by Milton Friedman. It was originally defired as the equilibrium rate of unemployment, Ge. the ove that would. prevail when money wages adjested. and equilibrium mas restored. in the Latour market, To accommodate. the. more, contemporary idea. that some unemployment will always be present (norma oF malural unemployment) one, can include. Ure, potential level of cutnut bo the left of the sasinrcen Level of cutput in tre rising section of the. Keyesian AS curve. ‘Example 10 Rewrite the following statements and fill in the blanks by using the terms provided below. Some terms may be used more than once or not at alll ‘The Keynesian AS curve consists of (ay = ype, 50 MPC, decreases, then (1 — MPC.) increases, and the fraction + — pg, deeresees, IE makes sense since. the less is spent on domestic goods, the less remains inside the circular flow, 2. The multiplier effect is exaggerated as the additional rounds of extra spending are conducted using the same money. Money has not increased. False. Using the example of dollars as the currency, we should. not focus on the dollar bills craslating but on the economic activity created. If the government sperds $100 on me fo build « birdhouse. for a schock and. | then spend. $80 from my $100 extra income an you to give me a haircut, then the same dallar bills may have been used bat national oulput has increased. by one birdhouse plus one huircut, 3. An increase in government spending may have minimal effect on national income if individuals realize that the extra government spending now means higher future taxes. True, If individuals ore sufficientiy foruard looking (strictly speaking, a number of aulditional assumplions are. alse weeded) then hey way increase. their saxings row (a. leakage) tb be able to meet the higher taxes that will be needed. in the future to pay off the current increase in goverrmert spending, Calculate the value ofthe aitiplier if Example 13 In an economy the government is planning te spend an extra $200 billion, What will national income be equal to if the marginal propensity to withdraw is 0.59 and current equilibrium income is $1.2 trillion? 3 The multiplier & és given by the equation k = aap. Substituting onta this equation the value of MPW gields & muléiplier equal to 1.7 Ik follows that since AY AY © £AG, then AY = Nabignal income wik increase by $140 bitlan. Thus the rei equilibrium rational income will be the inibal cone (ine. $1.2. tilen) plas SHO bilion: $1.34 triion, ‘Example 14 Assume that in an economy MPM = 0.1) MPS = 0.2 and taxes are given by the equation ‘T = 0.2Y, If the equilibrium level of national income is originally at $85 billion and exports shrink by $4 billion, calculate the new level of equilibrium income. Since taxes are a. fixed. proportion of income. fie. the average tax rate 1 is constant and equal t0 0.2), ib follows Hab the marginal tax rate (NRT) is also constant and equal t8 0.2. Thess the MEW (the sum cf Be marginal withdrawals) is (0.1 + 0.2 4 0.2) = 05, kN. or, in this case, 0.7 & 200 = $14 bition, The multiplier & is then equal to gle = 2. Since AY ay = 2 x (=4) WAX, cb foltows that $8 bution ‘The news level of national oncome is $8.0 billion tess, or $85 — $B = $77 billion. 1 income has increased by $120 billion follaviing an increase in private sector investment by $50 billion 2 income decreases by $20 billion when tha governrnent cuts its sparing from $62.5 lion to £54.5 billion. 3. the marginal propensity tm witha is 0.88, 4 the marginal pronensity to consurne i a closed aconariy without governmant intervention is 0.85, eee eee TE Alewrite the following statemants ar fillin the blangs by using the terms provided below. Same terms may be used more than once or nt all temporary short run AS. inflationary ‘equitbeium full employment money or nominal vartical ‘Within the mronetarst or new classical perspective, the long run AS is a at the potential oplgut level and ary deviation of ch ‘output from the patential ull employment evel will onty be 8 and a result of fxgd ta) ‘wagesin the short fun, When mariey wages change, te (5). Shifts al eg the -econemy return to its long run 16} equilibrium Revessionary and 47] ___ap5 cannot persis into the long run within this framework See CCaloulate te size of the necessary inerease in government spending 1 to close an $850 million sacessianary gap if the marginal propensity ta import 15 0.19, $20 is taken away as taxas fram avery extra $100-2amed and the marginal proponsity ta save is B11 2 to increase income from $1 $6 trillion to’$1.66 tilin given an estimated value for the muttiplier af 32. F ifincomeis 1.6% below the full employment lavel estimated at $620 billion, the multiplier is astimated at 2.B and she goal is to reach full emplayrnent, mae Caleulata te change in national income, 1 ina closed eesnomy if injections inewease by $12 bilioa, the marginal propensity to save is 0.26 and govemment taxes income at a Rat rate of 15% 2 iW export wevenues increase by $6 bilion in an econamy where MPM = 0.12. taxes ate 14 % af income and the savings rate is 24% if te multiplier is estimated a 1.7 and the govemmen of $350 billion ‘Assutne a closéd economy. Calculate the sits of the marginal proparsity ta ‘consume if an increasa by the government of expenditures by $122 billion was responsible far national income incraasing fram $0,860 bilion to $1,104 trillion 15 Low unemployment Genes = Low unemployment (ore high le macroecanomic policy goals as unemployment 2 5 3 Macroeconomic objectives 1 of employment) is one of the a costly phenomenan forthe economy as well as for individuals and society. Example 1 Determine whether the following. statements are true or false, Explain your answers, 1 To deal with cyclical unemployment, demand- side policies are typically employed. Trae. Since cyclical unemployment is & result of onsuffcient AD (and. is also kemon as demand, deficient or Keynesian unemplayment) it is apected that policy makers will try te increase AD te Lower cyclical unemployment. Laker, ib will be sean that these demand-side policies include fiscal policy, wherety the government tres: te iwerease AD by wcreasing its expenditures G or by decreasing taxes T, and also monetary policy, whorety (hupally) the contrat bank ties to averease AD by lowering interest rakes ror by pamping mare maney inka the economy 2 ‘There is not much that can be dane for the seasonally unemployed. True. Constenction workers in Bie winter in areas here. lemperabares drop to sub-zero Levels. (auch as in New England in the USA) are. regularly winemplayed, for several weeks and, callect uremplayment benefits. Some. are highly skilled. workers 50 it makes no sense for them to seek altemakive employment. as clerks at a food. store That is why monthly unemployment statistics are. ‘veasonally adjusted? which just means Heat the fect of seasonal unemploywent is isctated. from the date. For seasnally unemployed. unskilied bvorkers, unemplagment may decrease if better and faster information abcut job availabilities is open to them, 3. Structural unemployment will decrease if the government increases its expenditures. False. Struchsral unemployment may decrease only through = underventionist supply-side measures (such as providing rebraining, assisting relocation of 116 individuals to areas with job vacancies they ‘car, fll or providing tax: bredkes to firms willing te move to dreds with high regional ‘arempleyent) ~ market oriented. supply-side. policies (S5Ps) that aim to wake the Labour market mare flexible (such as lowering the Level of unemployment benefits, waking it easier for firms to dismiss workers so that they become willing to hire workers when the Susiness outlock is good. instead. of trying to rely only on their existing labour force, or abclishing minimam wage lans and collective bargaining processes) Example 2 Rewrite the following statements and fill in the blanks by using the terms provided below. Iabour costs collective searching fire natural stopped discouraged tax, permanent hire structural employed decrease technological rigidiry moving, increases accept skills mismatch unemplayment benefits security retraining part-time An individual is considered unemployed if he or she is actively (1) for a job buc cannoe find one. Ie follows that (2) workers who have been unemployed for so long that they have (3) leaking fora job are not included in official unemployment statistics. In addition, (4) workers are also-excluded from official statistics as they are gainfully (3 Fi As a result of unemployment, government spending (6) because most governments pay (7) to eligible unemployed individuals, At the same time, high unemployment will, ceteris paribus, lead to lower 18) revenues for the government as the unemployed have lost their wage income and tend ta spend less, High unemployment benefits may (9) the probability that an unemployed worker will {10} a job offer. Job a) and labour protection laws may also be responsible for increased level af unemployment as firms hesitate im an wprurn to 112) new workers fearing that it will be difficult to (131 them if things turn sur for the firm. (14) bargaining adds to labour: market (15) as ‘wages cannor differ and change to clear labour markers. These facrors tend to increase 116) unemployment and consequently (17) unemployment. Perhaps more importantly, structural unemployment is a result of a (18) between the {19} the unemployed possess and the skills in demand in the labour market, Some jobs may have disappeared because of (20) advancements while other jobs may have disappeared because of firms (21) Isewhere in the country oF abroad in search of lower (22) . These (23) lecreases in the demand {or certain skills imply that only through (24) of these workers will they be able to find work again. (1) searching, (2) discouraged, (3) stopped, (A) part-time, (5} employed, (6) increases, (1) unemployment benefits, (8) tax, (9) decrease, (OF accept, (11) security, (12) hire, (13) dismiss, CH) collective, (15) rigidity, (16) structsoral, (17) natural, (18) mismatch, (19) skills, (20) technological, (21) moving, (22) labour costs, (23) permarent, (24) refraining Example 3 ‘The following data refer to Lalaland in 2010, 1.627.077 1.182.000 55% Population aged 15-64 years | abou foe Unemployment rate Calculate the number af unemployed in Lalaland, ‘The unemployment rage ls tie number of the unemployed as a. propertion of the labour force. The statistics provided above abou the size of the general population of individuals bebween 1S avd G4 years old is irrelevant to this probiem Stlving the: uneimplayment rate equation = Tambor of unemployed emer rte = eta mm for the number of unemployed we get: Number OF unemployed. 192,000 0.055 = 65,560 individuals uremployed. Remember that to express @ percentage as a. decimal you move. the decimal point two positions to the left, s0 Haat 5.5% = 9,055, Example 4 ‘The labour force of the Armania Republic in 2011 ‘was 2.95 milion, af which 182,900 individuals were without a job but actively searching for one, Calculate the rate of unemployment in Armania for 2011, This is again a matter of substituting the vonibers. Care shouldbe taken in that the Labour ores ie given in millions: you have to wove the dzcimal, six positions to the right 20 it becomes 2,950,000 individuats, The equation used to compute. Ure rate of unemployment i ttrempioyment rade = TUMPEE OF Substituting yields 182,906 aa 062. is SECTION 2 Macroeconomics Exaiiplo 5 Unemployment in Fairyland in 2010 was at 5.2% with a labour force of 62.44 million, Caleulate the number of unemployed. Remember to express the unemployment rate as & decimal: 5.2% = 0.052 (moving the decimal two positions to the Lefel Appiaing the equation Unemployment. rate: = e248 = G.052 X G2.4¢ = 3.24688 widlion 0.052 (G.25 million or 3,246,886 undividuals) x= $$ Determine whether the following statements are tue ar false Explain your answers. Use a éiagram to iustrate if possible. 1 Paticy makers aim at lowering unemployment o ax-iose to.0% as possible. 22 Structural unemaloyment tends to be of a short-term nature, 3 Some fricona! unemploymer is unavoidable, 4 Official unemployment statistics tend to both Rewrite the following sistements and fil in the blanks by using the terms pravided below, Some wars may be used more than onee or nat at all, money taxes interest rates tificiant frictional seasonal short information increases durable sticky Iebour recession confidence consumption higher eyolical government agoregate ——inwastment «PEIN demand expencitures Unemployment that is a result oF people ming between jobs 's referred to as (1h This type of unemployment isof a(2h tem basis and-can decrease if labour tmarkot parepants nad fastoraccds wo batter labour mat related (3) ‘On the other hand, unemployment because of the weather, for examale among construction ‘workers during wery old ints, is Known #5 4) By Using an appropriate diacram explain structural unemployment ard evaluate policies that may be adopted te lower it. ‘Maintaining unemplayment ata knw levels considered an importante macraeconomic objective Wb? i itpossiblet die the unemployment rate to rer0? 118 |. overestimate and underestimate true unemployment ) =z __——cx~ 5. Funemployment decreases then the production possibilities curve of a country will shift owtwards 16 The LRAS curve af an economy will shift to the rightit ‘yclical unemployment decreases, 7 The LRAS curve atin economy will sift to the ightit ‘imuetural and tretional unemployment decreases. ‘unemployment and typically nat much can be dane about it ‘Unemplayment resulting fram ineutficier (3) is town asdemand @) 0 ae m_ __unemployment. This type of ‘uremploymentie) _ inal veal GOP then is decreasing. Demand for (10) ‘inms decreases but because (11) _ wages are 42) ‘Sownavards, excess supply of labour rosults, L2_unamplaymant. The deaper the racegsian the (3) this type of unemployment wil ‘Governments try ta prop up aogregate damand 0 lower ceyelical unamplayrant. Policy makers may inereasa ij or lawar (15) ‘Canal bans also decrease |16)_ induce highar 117) Fhousehods on (18) ‘ponds such as cars or apnliances and higher (13) expenditures by ferns ‘on-capital gots. Thare is no guarantee that these policies will ‘work if consumer and business (20) levels are vary low. expeactitaras by a Soon) Explain the different types.of unemployment and policies that may ke employad to reduce each. Whar difficulties, arise in addressing the problem of unemployment? Eo Discuss the possible consequences of unemployment economic, personal and soc! ca Low and stable rate of inflation ‘= Low inflation is a macrosconomic goal because inflation is costly ait = rodistributes ineame haphazardly = increases uncertainty lowering investment and therefore growth erodes the competitiveness of exports distorts the signalling power of relative price changes increasing allacative inefficiency. ‘= Inflation exists when prices are rising. ‘= Disinflation exists whan prices continue to rise but ata slower rate (for example ifthe inflation rate decreased trom 4.6 % to 26% and prices continued to iherease but by 36% instaad of by 4.6%). ‘= Doflation is when prices on average are decreasing (or example there is a negative inflation rate), = Tocalculate the CPI: = determine the basket of poods ti of each goad consumed) calculate the cost of buying this basket each year divide the cost of buying the basket in yeart by the eost of buying the same basker/n the base year and multiply by 100 the quantity Example 6 2.5 Macroeconomic angled Me Intlation is considered ‘demand pull itis @ result ‘of AD Fising too fast, and ‘¢ost push’ if itis a result ‘of increased production costs across the board. No enaiteruchat the cause a inflation, the firstline of attacking itis fF policy makers to mexoase interest rates to choke off AD [which is known as-Ught monetary policy! as well as 1 lower government ‘expenditures and raise taxes {known as cantractionary fiscal policy. SSPS.that ai to ineraase AS aré alsa ‘employed buthave-4 more longterm horizon, ‘Tho consumer price index (CPI) is used to track the ost of a fixed basket of gaods bought by the typical onsumer in some base pariod [yea Inflation in year tis the wercemtage increase in the CPI, ie. in the cost of buying this basket compared with year tt 1} ‘To calculate the inflation rate of yeart, calculate the percentage change inthe CP! between year t and year tt ‘March cach term or concept with the appropriate definition ar explanation Demand pull inflation a Underlying (core) inflation Stagilation Disinflation Phillips curve (short run} Deflation Waweene Structural and frictional unemployment 8 Consumer price index 9 Phillips curve (long run} 10 Inflation 11 Natural rate of unemployment h ‘The natural rate of unemployment consists mostly of these types ‘of unemployment b Suggests that an inverse relationship between inflation and unemployment exists Inflation that is mostly a result of AD increasing ‘The unemployment that persists in the long rum when prices and wages are flexible, the economy is producing at its potential output level and the labour market is in equilibrium € A sustained increase in the average price level ¥ Suggests that there is no inverse relationship between unemployment and inflation When the average price level continues tor rise but at a slower rates the inflation rate remains positive but a becomes a smaller number ‘The coexistence of rising inflation and stagnating output; when both inflation and unemployment are rising 119 _ SECTION 1 Microeconomics Finding the P and Qd intercepts of a linear demand function To find the P intercept for a demand funetion, Ta find the Qa intereept for a demand function, set Qd = 0 and solve for P. set P = and solve for Qd Example 4 Example 5 Let the demand curve be of the form Let the demand curve be of the form Qa = 200 ~ 2P Qa = 700 ~ s0P. To find the P intercept we set Qd = “To find the P intercept we set Qa 0 = 200 ~ 2P 0 = 700 ~ oP 2P = 200 SOP = 700 200 _ 700, Ee, an) P= 100 Pai ‘To find the Qd intercept we set P = 0: ‘To find the Qd intercept we set P Qd = 200 Qd = 700 Find the P and the Od interceats for the fellowing demand functions. = O¢= 100-2 b Oe = 60 —aP Finding the quantity demanded at different prices In many exercises you will need to find the quantity In the third column yau see if the price is $10 demanded at a particular price. For example, you then the quantity demanded will be may be asked to calculate a firm’s revenues at a 140 — (7 * 10) = 70 units. particular price. To do that you will need ta calculate the quantity demanded at that price. The process is very simple. You just need to substitute the valuc for price P inte the demand function. In the fourth column you see if the price is $40 then the quantity demanded will be 40 — (2% 40) =—40 units ‘This makes no sense, so a dash is placed in the In the second column of the table in Exercise 5 cell. Always remember that prices and quantities you sce that if the price (say, in dollars) is $2 have to be non-negative numbers, then the quantity demanded will be 320 — (8 ¥ 2) = 320 — 16 = 304 units (say, loaves of bread). Copy the following table and, carefully, till in the empty ceils. ad =220-aP | Od= 140-7 Pisi ad Od a a iz 3 ho. iE} [a 2 ia weighted index of che prices of the goods and services that the typical consumer purchases where the weights arc fixed and ceflect the spending on cach goad expressed as a proportion of total spending, j, When the average price level decreases; negative inflation k Inflation after excluding food and energy prices C1, oD, C2, WD, 3, HD, Hy gy (5, 8D, GH C1 oy CH, (9, A, C10, €), (14, 4 Example 7 Determine whether the following statements are true or false. Explain your answers. 1. Core inflation focuses only on price changes of the basic goods consumers buy, False. Core (also referred to as underlying inflation) is based. on a CPI Unt typically excludes food. and energy even though bob are very basic to consumers. The. reason for excluding food. and. energy is Unat prices of both fare. volatile in the shert ran. When food. and. energy are removed we strip aniay these. short run movements and. thes get a better pichure. of the Long ran inflation rake faced. by households 2. Cost-push inflation is very costly as not only are prices rising bur ourpur may be declining, Trae. You can visualize Unie by ether locking ab an AD/AS. diagram wiln AS shefting left. or (HL only) Uorough «short ran Pralips: carve diagram where the Phillips carve shifts outwarcks. 3. By reducing inflation and achieving price stabilicy, lower unemployment may be achieved in the long run (ceteris paribus), True. (wflation, especially nigh and, volatile inflation, wereases uncertainty for businesses sand higher uncertainty dampens investment spending. If low and. stable inflation is sichiaved. then ove can in general expect higher investment rates and thus higher growth whieh is aszeciated with move jeb creation. 4 Inflarion and unemployment are inversely related. False. For the statement to be considered, true it has to be qualified by adding ‘an the shart run’. In the short non there is a trade-off hetieen the tne variables (Wustrated. by te short ran Phillips curve) bat this trade-off disappears in the long run Uf prices and wages fare. flesible a the veal age wil adjust to tks equiubrum level and the economy wil rebar to its potential (full employment) Levet of output (the verkicad tong run Phillips curve at he vadural rate of unerepleyenent), 5 Since deflation refers to decreasing prices it follows that deflation is desirable, False. Deflation is a greater eit than inflation as the experience. of Japan has clearly ustrated.. Deflation is typically a. result of chrovically weak and. decreasing AD. Consumers postpone purchases and. firms are forced. to Farther reduce prices creating a. vicious circle; veal debt (money debt divided. by the average peice level) of Meusehotds and firms uncreases, loniering their ability and. willingress to bombo and. spend, bares accumulate dad. loans Which Wwealens their position; te. lower spending in dhe, economy Uncreases uveriplayment; lastly, merebary policy cannot be used. de Lower urterest rates as vomaal diterest rakes canmol become negative. Exampl Explain the meaning of Friedman's phrase ‘Inflation is the one form of taxation thar can be imposed without legislation,” One of the costs of unflation is that: it redistributes income. This phrase refers to a, redistribution of income from taxpayers to the government as 4 result of taxpayers’ incomes moving up Une tax brackoks Assume that Chandler's money income (say, bis salary) increased by 10% while prices also increased. dy 10%. In veal terms, i.e. in teres of purchasing power (what Chandler can buy with bis money income) nothing has changed: his real income is constant. But if this increase in romival. income pushes hin into a higher income tax bracket (mith a. higher marginal tax rake ~ see laler) then his tax dbligation to the goverrment wilt have risen faster than fris income and than prices. Effeckively his veal tax ebigation will have increased. a more purchasing gower is trarsferred. away from Chandier to the goverment. The goverrment. creased. its revenues without having to introduce mew or higher taxes ( Examples ‘The fallowing table has the prices in curos af three goods in an economy. mio]

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