The test is closed-notes and consists of 6 questions, of which 2 can be chosen for credit. Only 2 questions can be answered.
Link to Macro Economic Glossary (scroll down the glossary page to get to MacoEcon)
Topics:
Tutorial 1: Question: What determines Supply and Demand?
The Price of a certain good affects it's supply and demand as shown by the Supply and Demand curves.
The price of other goods can affect the price of a good, and the way in which it affects it is determined by these factors:
Factors affecting Demand:
1) Demand curve shift due to substitute's price. Substitute goods experience opposite demand shift.
2) Demand curve shift due to complement's price. Complementary goods experience same demand shift.
3) Demand curve shift due to Consumer income increase/decrease.
3a) Inferior good's demand curve shifts up and right as Consumer income decreases.
3b) normal good's demand curve shifts up and right as Consumer income increases.
4) Demand curve shift due to Consumer's taste
Factors affecting Supply:
1) Price of a good, leading to movement along the Supply Curve.
2) Supply curve shift due to the Price of inputs used to create the good/service.
3) Supply curve shift due to changes in technology.
4) Supply curve shift due to changes in Government Regulation.
Examples:
Market for New Cars:
How do the following market changes affect equilibrium car price?
1) Consumer Income Decrease: Cars are a normal good. Therefore a decrease in consumer income has a corresponding decrease in the demand curve. The equilibrium price would decrease as a result.
2) Bus Fare price decrease: Bus Fares are a substitute good for New Cars because a consumer's choice to take the bus replaces the need to buy a new car. Therefore, a decrease in bus fares will lead to an increase in Bus demand, and a corresponding decrease in New Car demand. This will lead to a lower equilibrium price.
3) Car Plant Worker's Wage Rate Decrease: Lower costs of production represent lower input costs of supplying cars to the consumer. The supply curve shifts upward and a higher equilibrium price results.
4) Gas price increase: Gas is a complementary good for new cars, assuming that the new cars run on gasoline. Therefore a rise in gas prices would be accompanied by lower demand for gas and a lower demand for new cars that use gas. The demand curve shifts downward, and the new equilibrium price is lower.
5) 2nd Hand Car price decrease: 2nd Hand Cars are a substitute good for New Cars, and therefore a decrease in 2nd Hand Car price would be accompanied by an increase in 2nd Hand Car demand. The New Car Demand Curve would shift down and left, leading to a lower equilibrium price.
Housing and Car Market:
If consumer's incomes increased, how would prices and quantities change for housing and cars?
1) What causes the supply curve to be very steep in the case of housing?
Holding other factors constant:
demand curve: quantity (or quantity/year) demanded versus price.
supply curve: quantity (or quantity/year) supplied versus price.
equilibrium reached when supply and demand curves intersect.
Supply and Demand:
http://afs.berkeley.edu/~pberck/EnvEcon/supply.htm
Tutorial 2: The Circular Flow of Income
1) Identify the individual components of a nation's GDP.
GDP=Y=Cp+Ip+Gp+Xp-Zp
2) What condition is necessary for the economy to be at equilibrium?
AD=Y, or Aggregate Demand is equal to output.
In an open economy, AD=Cp+Ip+Gp+Xp-Zp
Graphically, this condition occurs when a given AD curve intersects a 45 degree line drawn on a graph of Y vs. AD.
3) How would flooding in the UK affect UK GDP?
Increase in Gp as the government fixes the damage. Gp is an autonomous expenditure, and would cause AD to shift up.
Increase in c, the marginal propensity to consume, because goods were destroyed and now have to be replaced. This would cause the AD curve to change slope, although the effect would be temporary due to the temporary nature of the calamity.
Typically, governments seek to stabilize output in order to keep GDP at a "full employment level". Even when an economy is operating at potential output, there is still a "natural rate of unemployment" which simply means that the wage being paid is not sufficient for some % of workers to seek a job. (These workers don't need to work to survive, and can opt out of the employment market.)
4) How do increases in Autonomous Expenditure affect Aggregate Demand?
An increase in Ca,Gp,Ip or Xp cause an upward shift in the AD curve. These are autonomous expenditures and are not affected by the level of income/output in an economy.
A decrease in Ca, Gp, Ip or Xp cause a downward shift in the AD curve. Take the example of decreased investment Ip during a given year. Holding all other expenditures constant and assuming that c, t and z were also constant, the reduction in Ip would account for the entire reduction in AD. Now look to the next year. AD from the previous year becomes the "Initial Output" for this year. Because Cp=Ca+c(1-t)Y, the amount of Consumer expenditure in the following year would be less due to the total AD reduction from the previous year. Imports would also be less because they depend output Y as well. (Zp=z*Y). Assuming that c,t and z were held constant, the amount spent by consumers and imported would be reduced by a factor of (Y-(reduction in Ip) )/Y
Because consumer spending by households and import spending by the economy depends on output (Y), any autonomous change in output affects AD for the current cycle, and this affects output for the next cycle. Because every succeeding year depends on the previous year's AD as it's initial input, the chain of events leads to drifting in output over time based on the change in planned consumption, planned investment, planned government expenditure, or planned exports. If the balance is not adequately maintained by the government, economies can drift downward as less expenditure leads to less and less demand ad finitum.
What causes GDP to change when autonomous investment changes? (ie: what is the mechanism for this change?)
- Firms experience an "unplanned reduction" (or increase) in stocks
Tutorial 3: Output Multiplier:
- What would cause a rise in GDP in a 4 sector economy?
- Increase in planned consumer spending Cp
- Cp could increase due to Ca increasing
- Cp could also increase due to c (Marginal Propensity to Consume) increasing
- Cp could also increase due to t (tax rate) decreasing
- Increase in planned government spending Gp
- Increase in planned exports Xp
- Increase in planned investment by firms, Ip
- Decrease in z, the marginal propensity to import
Other items would cause the AD curve to shift upwards, but retain the same slope.
2. What is the Output Multiplier?
Limitation of the Output Multiplier: Only tracks changes related to Autonomous Expenditure.
3. GDP falls. How is Government Tax Income affected? How is the Govt. Budget affected?
NTp=t*Y
This means that Planned Net Taxes equals the net tax rate times output Y.
If Y decreases, and the tax rate remains the same, then tax income decreases proportionally with Y.
The government budget is: Budget surplus (shortfall)=NTp-Gp
If NTp is less than Government Expenditure Gp, then there is a negative balance, and a budget shortfall.
4. In a 4 sector economy, Gp falls, but NTp fall by the same amount. What would happen to Y?
Y would decrease.
5. What is the Tax Output Multiplier?
The Tax Output Multiplier is a way to track the change in Output due to tax increases or decreases.
The formula is:
-c*Y/(1-c(1-t))
The way to use it is:
Change in Y = (change in tax rate, including sign) * Tax output multiplier
6. How is AD affected by the dramatic fall in US house prices?
- In the short term, because many house owners are "under-water", meaning that they owe more than their house is worth, Cp decreases because they are subject to the same high payments as before (due to US loan conditions) but are subject to more stressful economic conditions. Many homeowners lost their jobs, and were unable to make payments leading to a glut of houses on the market.
- Gp increase
- Because houses are now less expensive, demand for houses may increase. However, because of the high default rate on home mortgages, many homes were taken from their owners and are sitting on bank's balance sheets. This rapid increase in supply led to a corresponding plummeting of prices and many homes remain unsold to date.
By controlling the treasury bond interest rate, the central bank is able to control the supply of money in the economy. Referring to the picture below, if there is an excess supply of money at bond rate r2, the central bank lowers bond interest rates which have the effect of making bonds less attractive to investors, who now get a lower interest rate. This encourages investors to buy bonds because
http://edwardmcphail.com/intromacro/lecture14/lecture14.html
When i>ie the quantity of money supplied exceeds the quantity of money demanded so
people buy bonds in order to decrease their money holdings. This drives up the price of bonds and causes a decrease in i.
What happens if prices levels increase? This causes a shift in the demand curve for money as shown below. Ld moves to Ld'
Comparing the multiplier formulas for open vs. closed economies:
- Open economy: m=1/(1*c(1-t)+z) where c and z are the marginal propensity to consume and import respectively.
- Closed economy, z=0 and m=1/(1*c(1-t)) a larger multiplier because the denominator is smaller.
2) What happens to imports when GDP (Y) rises?
z*Y=Zp, planned imports. As Y increases so does Z.
3) Why should M4 increase when M0 is increased? Does this actually happen?
This does happen, although the multiplier is not as large as governments are targeting.
Open market operations involve buying bonds from commercial banks for cash, thereby increasing M0. M0*m=M4, so the hope is that the multiplier will be large enough to substantially increase M4. What banks do with the money however is not solely determined by the government. If it isn't lended to the extent expected, m will be smaller and the amount of M4 created will be less.
During the crisis of 2008, banks faced liquidity problems, and they hoarded the cash on their balance sheets to ensure that they could pay depositors and this is one reason that m was not as large as the government had hoped.
4) How did US subprime mortgage markets affect bank reserves, even if the banks in question were not themselves mortgage lenders?
The default rate of mortgages led to a banking scare, which led commercial deposit customers to withdraw money at an unexpected rate. Cash reserves in banks plummeted and they were forced to turn to the federal reserve, the US central bank.
5) How did banks respond to a fall in their reserves?
Banks cut back on high-risk loans (such as sub primes that started the scare)
6) Describe the opportunity cost of money.
A person will hold cash at the expense of the opportunity to make a return on those funds in the bond market. When real interest rates are high there is not enough demand for cash and people turn to bonds. Bond demand goes up and this causes interest rates to fall until they reach an equilibrium. At this point money supply Ls and money demand Ld are equal. Graphically, this represents the intersection between the money supply curve (a vertical line) and money demand ( a line sloping downward and to the right. When interest rates are high, the quantity demanded of money is very small because bonds will minimize the opportunity cost of holding cash. When interest rates are low the quantity demanded of money is larger because their is less opportunity cost.
7) Describe the Paradox of Thrift:
During times of recession (economy is contracting), if everyone tries to save more money, aggregate demand will fall because consumer spending Cp depends on income. Cp is defined as any income that consumers choose to spend, and if they instead save (Sp) the ultimate effect is a reduction in output until expenditure by the government, consumer or firms (Ip) is resumed.
Because output falls as a whole, savings as a percentage of output also falls, and therefore the paradox is that in attempting to save, less savings is realized.
8) What affects the demand for money:
Money is useful for:
- transaction demand
- asset demand
- unexpected expenditure demand
Investment demand changes based on interest rates, with more investment projects becoming feasible as the cost of financing decreases.
Tutorial 6: Inflation
1) Describe the Repo market and monetary control
A reverse repo is what happens if you buy a bond from the bank an they agree to repurchase it from you at a fixed date for a certain price. From the bank's perspective, this is a repo, because they are doing the repurchasing.
If you sell a repo to the bank, you are effectively taking out a loan because you agree to pay the bank a certain amount on a certain date.
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