### AS` Section A: Question 1

```EC 100
Summer Mock
1
General Exam Tips
1. Never leave a question blank. Writing anything
(sensible) will get some marks.
2. More (accurate) detail = more points.
– Give the relevant equations e.g. C=a+b(Y-T)
– When discussing policies, remember multiplier
effects (& give equations!)
3. Read the question carefully – e.g. Does it
specify which graphs to use?
2
Section A: Question 1
• You observe that output is above fullemployment output. Politicians are arguing about
the possible reasons. One party claims that this is
due to a drop in world oil prices. The other party
claims that this is due to an increase in consumer
spending. Using aggregate supply-aggregate
demand graphs, explain (a) how each of the
above reasons could cause an increase in output,
and (b) what evidence you could use to
determine which one of these had occurred.
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Section A: Question 1
• Effects of oil price shock in AS-AD diagram?
AS
AS‘
P0
P1
G1 > G 0
YA YB
4
Section A: Question 1
• Effects of increase in consumer spending shock in AS-AD diagram?
Suppose autonomous consumption, i.e. the intercept of the
consumption function increases, so we have an upward shift of the
consumption function independent of Y.
AS
P1
P0
YA
YC
C1 > C 0
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Section A: Question 1
• Evidence for which scenario is right?
– Price levels
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Section A: Question 2
• Suppose the government decides to decrease
taxes in an effort to increase consumer
spending and investment in the economy. Will
this plan succeed in accomplishing both goals?
How the composition of aggregate demand
affected?
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Section A: Question 2
•  =  +   −  so tax cut directly increases
C
•  = 0 − g(r)
• Composition of Aggregate Demand:
Y = C+ I + G
• So what happens? …
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Section A: Question 2
• Crowding out
lower T
Lower T shifts out
IS curve, inducing
increase in Y and r
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Section A: Question 2
• The tax cut increases C, which shifts IS curve to
the right
• The interest rate increases…which reduces
investment
• Lower taxes have crowded out investment
• So:
– The plan did not succeed in accomplishing both goals
– The composition of Aggregate Demand shifts towards
consumption and away from investment
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Section A: Question 3
• What are the net capital outflow and the
trade balance? Explain how they are related.
• First, define (or explain) each term.
– Trade balance = exports – imports (of goods and
services)
– Net capital outflows = capital outflows – capital
inflows
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Section A: Question 3
• What are the net capital outflow and the
trade balance? Explain how they are related.
• Next, how are they related?
– The trade balance and capital flows are always
equal. This means the balance of payments is
always balanced.
– If you have a positive trade balance
(exports>imports), you have net capital outflows.
– If you have a negative trade balance
(exports<imports), you have net capital inflows.
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Section A: Question 3
• What are the net capital outflow and the
trade balance? Explain how they are related.
• Why?
– The intuitive case is when you have a negative
trade balance, hence net capital inflows. This is
the case for UK and USA.
– The UK imports more than it exports. So how does
it pay for this? The answer is through net capital
inflows – foreigners purchasing UK assets… e.g.
housing:
13
http://blogs.wsj.com/moneybeat/2014/03/10/britain-filling-a-hole-with-realestate/
Britons have a huge demand for foreign goods—
on a broad measure the country imports far
more than it exports. So where does the U.K. find
the money to buy all this stuff?
Increasingly, an examination of fund-flow data
shows the answer is property. Foreigners
snapping up U.K. real estate have become a vital
source of cash. Simply put, the U.K. is selling
Belgravia to buy BMWs and swapping Islington
for iPods.
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Section A: Question 3
• What are the net capital outflow and the trade
balance? Explain how they are related.
– Other countries (e.g. China) have a positive trade
balance, hence net capital outflows.
– Intuition: China is accumulating foreign income (e.g.
£) by exporting so much to the UK. China can spend
this on UK assets (e.g. housing), which would be a
capital outflow.
– The fundamental reason there is this identity between
the trade surplus and net capital flows is that every
single transaction involves an exchange in two
directions: goods or services go in one direction,
capital goes in the other direction (to pay for it).
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Section A: Question 3
• What are the net capital outflow and the trade balance? Explain
how they are related.
• When China’s economy runs a trade surplus, someone in China is
exporting more than she is importing.
• The trade surplus thus generated is paid for from foreign sources,
say, US dollars. If the exporter just held on to those US dollars, then
she has invested abroad, i.e., on net she has sent capital abroad. T
• There is, thus, a net capital outflow.
• If, however, she handed over those US dollars to the Chinese state
authorities in exchange for Chinese RMB, it is then the state
authorities that have, on net, sent capital abroad.
• The fundamental reason there is this identity between the trade
surplus and net capital outflows is that every single transaction
involves an exchange in two directions: on the one hand, goods or
services are handed over in one direction, from China to the US; on
the other hand, currency or some
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Section A: Question 4
• What will happen to the trade balance and the real
exchange rate of a small open economy when the
government purchases increase, such as during a war?
war or a global war?
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Section A: Question 4
• First, define/explain the RER:
i.e. it is the nominal exchange rate adjusted for
relative prices (both pieces of information useful,
imagine a shopping trip to New York…)
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Section A: Question 4
• Government purchases (G) increase…
• Shifts IS curve to the right…
• Domestic (UK) interest rate rises above world
interest rate…
• Hence demand for £ increases, as UK assets
give a high return…
• Hence the nominal ER appreciates.
• The real ER also definitely appreciates, as the
increase in G increases domestic prices.
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Section A: Question 4
– Now UK goods are more expensive relative to
other countries’ (e.g. Germany).
– Hence exports fall and imports increase…
– So the trade balance falls/worsens.
(Aside: this is what we would expect from the
balance of payments: we have capital inflows due to
the increase in interest rate, so trade balance falls).
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Section A: Question 4
• Local vs global war?
– If it’s a global war then the interest rate rises in all
countries.
– So demand for £ will be much less affected.
– Hence RER and trade balance will be less affected.
(Aside: we are ignoring the fact that most wars,
especially global wars, completely destroy trade
between countries and economic activity in
general!)
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Section B: Question 5
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Section B: Question 5
– Such a question is a present. You just need to work out the steps of
the IS/LM – AS/AD model suggested here.
– Give details. Include the equations for Consumption, Investment,
Money Supply Multipler etc.
(1) On the IS side: Consumers cut consumption and business reduced
investment. The IS curve shifts left.
•
Can also show this on the Keynesian cross diagram; this is as if the Planned
Expenditure curve shifted downwards.
(2) On the LM side: heightened risks clogged lending and banks held
significant excess reserves; the money multiplier falls, hence
reducing money supply.
•
•
Due to a lack of confidence in the financial system, demand for money/cash
also increased.
Both of these factors contributed to an upward shift of the LM curve.
(3) Trace this out in an IS/LM graph and show its implications for the AD
curve in the AS-AD curve graph.
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Section B: Question 5
What is the right macroeconomic policy to bring the economy back to
full employment?
(1)
There are a host of possible policies (including “do nothing” – the economy
reverts to full employment…eventually)
You will get most marks for suggesting a number of policies and showing
(with explanations) how they affect the AS-AD and IS-LM diagrams
Some policies include (all of which were pursued by the UK and other
governments):
(2)
(3)
•
•
•
•
•
•
•
•
Fiscal: increase government spending (e.g. infrastructure projects such as HS2).
This has a multiplier effect of course (give the equation).
Fiscal: cut taxes (combined with the above, this means the government is
running a large deficit)
Monetary: increase the money supply!
Monetary: unconventional monetary policies – e.g. quantitative easing – to
“sidestep” the money multiplier problem caused by banks not lending enough
Combination of fiscal and accomodating monetary policy is the most
expansionary (because there is less crowding out than using fiscal alone)
Others: guarantee savings, so that money demand does not increase
Others: try to increase aggregate supply (e.g. by removing business regulations,
liberalising labour markets)
Others: …
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Section B: Question 6
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