Economics Flashcards

Question 1

Q

Microeconomics

Factor Market

Answer

A

As opposed to goods market, a market for factors of production such as labour, capital or raw materials.

Demand for the factors is derived demand since it derives from the ability to produce goods for a goods market.

Question 2

Q

Microeconomics

Aggregate Demand/Supply

Answer

A

The total amount of demand or supply at a given price level across the whole market (i.e. all buyers or suppliers).

Question 3

Q

Microeconomics

Market Equilibrium

Unstable Equilibrium

Answer

A

Market equilibrium is the point at which demand and supply clears in the market. Markets generally tend towards equilibrium as sellers adjust price and quantity available to satisfy the demand in the market.

An unstable equilibrium is when an external shock to the market equilibrium does not stabilise back to equilibrium.

Question 4

Q

Microeconomics

Consumer Surplus

Answer

A

The area below the demand curve but above the market price of the goods (top left triangle).

The buyers in this area were willing to pay above the market price, the area represents the total amount they were willing to pay less what they actually paid (market price) collectively.

Reflects the gain to buyers of the market exchange.

Question 5

Q

Microeconomics

Producer Surplus

Answer

A

The area above the supply curve line and below the market price.

Represents the revenue achieved above marginal cost (the price at which 1 unit will be supplied to the market, i.e. intersection with y axis) by all suppliers due to market price being above the marginal cost of the goods.

Question 6

Q

Microeconomics

Total Surplus

What is it?

When is it maximised?

Answer

A

The sum of consumer and producer surplus.

Maximised at market equilibrium where market price = marginal value to consumer = marginal cost to producer.

Question 7

Q

Microeconomics

Utility Theory

Definition of Utility

Utility Theory

Answer

A

The total satisfaction received by a person from consuming a good or service.

Utility theory is a quantitive model of consumer preferences, represented by an ordinal function U = f(Qx₁, Qx₂, …, Qx_n)

Ordinal means it provides a ranking not a value (as in cardinal functions). The function shows the relationship between utility and every possible bundle of goods.

Question 8

Q

Microeconomics

Axioms of Utility Theory

Answer

A

Completeness: A person can compare any two bundles A & B such that either A>B (ie A is preferred to B), A=B or A

Transitivity: If A>B and B>C then A>C.

Nonsatiation: If A has more than B of all positive factors then A is preferred to B.

Question 9

Q

Microeconomics

Indifference Curves

Answer

A

Show combinations of amounts of two goods which provide the same amount of utility.

Question 10

Q

Microeconomics

Indifference Curves

Features

Which curves are better?

Shape of each curve and reason

Number of curves in existence

Answer

A

More goods always preferred to less so curves to north-east of chart are better.

The value of a good reduces as more is consumed, which causes the convex shape of the curve. The slope of the curve is the marginal rate of substitution.

Indifference curves are everywhere dense (can draw one through any point) and will never cross.

Question 11

Q

Microeconomics

Opportunity Set

Answer

A

A consumer buys X items of good x at price P_x, and Y of good y at P_y. If they have income of M then X * P_x + Y * P_y <= M is their budget constraint. A graph of this is a downward sloping diagonal line showing the combination of x and y within budget.

So the opportunity set is the set of combinations of goods they can buy given the budget constraint.

Companies have production opportunity sets and investment opportunity sets which show possible combinations of 2 goods to produce or 2 investments to make.

Question 12

Q

Microeconomics

Maximising Consumer Utility

Using opportunity sets and indifference curves to maximise utility

Answer

A

Choose the point on the budget line which lies on the furthest out (ie highest utility) indifference curve.

Question 13

Q

Microeconomics

Effect of consumer equilibrium of price changes

(in the 2-product substitution model)

Name and define the two “effects” of a price change

Answer

A

Substitution Effect: If the price of one good decreases the slope of the budget line changes so (typically) more of this good will now be purchased relative to the alternative.

Income Effect: In addition the “real income” of the consumer has increased, therefore higher utility can be achieved (although this could lead to lower consumption of an “inferior” good.

Question 14

Q

Microeconomics

Effects of price change on consumer equilibrium

(in the 2 product substitution model)

For a normal good, what does price change (fall in price of one good) look like on chart?

Which part of increase in quantity of that product is income effect and which is substitution effect?

Answer

A

Price of product B has fallen.

Draw a dotted line parallel to the new budget line going through the original indifference curve. Increase in Q_B is substitution effect. The rest of the increase is income effect.

Question 15

Q

Microeconomics

Effects of price change on consumer equilibrium

(for 2 product substitution model)

For an inferior good, what does the change in price look like on the chart?

Answer

A

For inferior goods the substitution effect leads to an an increase in quantity, but the income effect is negative. The substitution effect is the larger of the two.

Question 16

Q

Microeconomics

Effects of price change on consumer equilibrium

(for 2 product substitution model)

For an Giffen good, what does the change in price look like on the chart?

Answer

A

For an inferior good with a price decrease, if the income effect outweighs the substitution effect it is called a Giffen good. This is rarely the case.

Question 17

Q

Microeconomics

Effects of price change on consumer equilibrium

Type of good for which price increase = quantity increase

Answer

A

Veblen Good

Question 18

Q

Microeconomics

Effects of price change on consumer equilibrium

Behaviour of Substitutes and Complements

If price of product B falls, quantity demanded of product B usually increases, but what about product A?

Answer

A

If A and B are complements then the quantity of A demanded will also increase.

However if they are substitutes, then fewer of quantity A will be purchased, the consumer will “switch” from A to B.

Question 19

Q

Microeconomics

Accounting Profit

Answer

A

Accounting Profit = Total Revenue - Total Accounting Costs

Question 20

Q

Microeconomics

Economic Profit

Answer

A

Economic Profit = Total Revenue - Total Opportunity Costs

Same as accounting profit but considers additional opportunity costs of resources used.

For an entrepreneur this could include their salary if they worked instead of running the business.

For a corporation this is the required return on equity capital.

Question 21

Q

Microeconomics

Normal Profit

Answer

A

This is the accounting profit earned when economic profit is zero.

AP = EP + NP

Alternatively this is the total implicit opportunity cost.

Alternatively it is the normal amount of profit expected to be achieved from the resources available (eg required return on equity for a corporation).

Question 22

Q

Microeconomics

Economic Rent

Definition

Effect of elastic/inelastic supply

Answer

A

This is the income received by an owner of a factor of production ABOVE the opportunity cost.

Inelastic supply ⇒ Income mostly economic rent

Elastic supply ⇒ Income mostly opportunity cost

Question 23

Q

Microeconomics

Marginal Revenue

Definition

Perfect/Imperfect competition

Answer

A

The change in TOTAL revenue from selling 1 extra unit.

In perfect competition firms are price takers, every unit sold at market price (P) so MR = P.

In imperfect competition (ie monopoly) an extra unit sold requires a price decrease, so extra revenue from the unit is offset by lost revenue on all other units sold. As such TR is maximised at the quantity where MR = 0.

Question 24

Q

Microeconomics

Chart of costs vs quantity produced

Marginal Cost, Average Variable Cost,

Average Fixed Cost, Average Total Cost

Answer

A

Note: MC always crosses AVC at its lowest point

MC falls at first due to economies of scale but eventually increases due to diminishing returns.

Question 25

Q

Microeconomics

Maximal Profit in perfect competition

Answer

A

In perfect competition the market price (P) is fixed.

Therefore maximal profit (may be negative) is achieved when marginal cost (MC) = P.

Keep on producing and selling more until the marginal cost per unit exceeds the market price.

Question 26

Q

Microeconomics

Shutdown point

Answer

A

Production should be temporarily suspended when revenue just covers variable costs, equivalent to P = AVC.

Note P < AVC slightly in this chart.

Question 27

Q

Microeconomics

Long run average total cost curve

Answer

A

Red line is small factory, green is medium factory etc.

In the very long term curve smooths out connecting the troughs of each individual curve.

Question 28

Q

Microeconomics

Minimum Efficient Scale

Answer

A

At low production levels there are economies of scale, whilst at very high levels there are diseconomies of scale.

In the middle there is a range of output with the lowest average total cost, where there are constant returns to scale.

The lowest output quantity in that range is the minimum efficient scale, ie minimum output amount to reach lowest possible ATC per unit.

Question 29

Q

Microeconomics

Profit Maximisation

Goal of each firm is what?

Answer

A

To maximise economic profit. That is total revenue less total costs including normal profit.

Question 30

Q

Microeconomics

Economic Profit in Perfect Competition

How much economic profit is made if a firm maximises its profits in perfect competition?

Answer

A

For some of the microeconomic analysis perfect competition is assumed (ie the price is always equal to market price at all output levels).

In the case of perfect competition, if a firm maximises its profits it will be earning the normal profit. IE in perfect competition no economic profit can be earned.

Question 31

Q

Microeconomics

Long-run industry supply curve

Where production cost per unit is constant regardless of industry output (“constant costs of production”)

Answer

A

The normal supply and demand lines are for the short term. If demand shifts from D₁ to D₂ the price shifts to P₂ and firms make +VE economic profit in the short term.

This economic profit attracts new competitors however, and over time a new short term supply curve S₂ develops.

If costs of production (across the industry) are constant against output the long term supply curve will be too.

Question 32

Q

Microeconomics

Long-run industry supply curve

In the case where costs per unit across the industry increase with industry output (“increasing costs of production”)

Answer

A

In the short term as demand increases from D₁ to D₂ the price increases to P₂ and economic profit is achieved.

As new firms enter the new short term supply curve S2 will be at a higher price per unit due to the increasing costs of production, and P₃ will be above P₁.

As such the long run supply curve will be upward sloping.

Question 33

Q

Microeconomics

Productivity

What are total product, marginal product, average product?

Answer

A

Production levels in # units as a function of the amount of a certain input used.

For example marginal product of labour is the number of extra goods produced if one extra person is hired, and average product of labour is the average number of units produced per employee.

Question 34

Q

Microeconomics

Productivity

What is Marginal Revenue Product (MRP)?

How is profit maximised (in terms of level of production input)?

Answer

A

Marginal Revenue Product (MRP) is the amount of revenue produced by one extra unit of input, equal to marginal product * marginal revenue (MP * MR).

To maximise profits choose the level of input such that MRP = Cost per unit of input.

Since MC = cost per unit of input / MP, this is equivalent to the usual condition MR = MC.

Question 35

Q

Microeconomics

Perfect Competition

4 features

Answer

A

Firms are price takers
Demand curve is horizontal, so infinite demand at the market price, no extra sales from reducing price, zero sales above the market price
All firms products are homogenous
Low barriers to entry

Question 36

Q

Microeconomics

Monopolistic Competition

Description

AKA

Long term profits

Answer

A

NOT the same as a monopoly
AKA competitive price-searcher market
Lots of firms, low barriers to entry, competing on quality, price and marketing

Max profit at MR=MC. Economic profits attract new entrants pushing demand curve to the left, reducing economic profits. Therefore zero economic profits in the long run.

Question 37

Q

Microeconomics

Oligopy

What are the three pricing strategies?

Answer

A

Pricing Interdependence (competition will match price reductions but ignore price increases)
Cournot Model (each firm determines ouput level assuming competitors will not respond, market heads to an equilibrium)
Nash Equilibrium (game theory)

Question 38

Q

Microeconomics

Oligopy

Pricing Interdependence

Demand and MR chart

Answer

A

Assumes that competitors match price reductions but ignore price increases.

Results in a kinked demand curve. Note that marginal cost changes in a range as shown have no effect on output since marginal revenue is discontinuous at that level.

Question 39

Q

Microeconomics

Oligopy

Cournot Model

Resulting price (compared to monopoly & perfect competition)

Answer

A

The assumption is that competing firms will not respond to your output decisions.

Instead the industry reaches equilibrium over time. Equilibrium can be calculated in a simple 2 company market using formulae.

The result is a price somewhere between a monopoly and perfect competition, heading towards the perfect competition level as the number of competitors increases.

Question 40

Q

Microeconomics

Oligopy: Collusion

What are profit prospects with zero collusion

Answer

A

Without any collusion an oligopy ends up like perfect competition, with price driven down to marginal cost and zero economic profit being made.

Collusion allows firms to increase profit by holding prices at a higher level.

Question 41

Q

Microeconomics

Oligopy

Dominant firm pricing

Answer

A

This is the case where there is one monopoly like firm and several competing firms. The left chart shows supply curve for the 10 small firms. The dominant firm effectively sets the market price.

At $1.50 the small firms can satisfy all demand, but at $1 there is residual demand which creates the demand curve for the dominant firm. Thus the dominant firm sets price and output based on it’s MC and the resultant MR curve.

Question 42

Q

Microeconomics

Regulating Monopolies

Average Cost Pricing

Answer

A

Government forces the monopoly to sell at its long-run average cost.

From the usual situation of setting MR=MC (P₀) the price is reduced to P₁ where the firm will only make normal profits.

Question 43

Q

Microeconomics

Price discrimination

Describe the three degrees of price discrimination

Answer

A

First degree: Each customer is charged the price they are willing to pay. Consumer surplus is nil, producer surplus is maximised. Output levels are the same as in perfect competition.

Second degree: Price varies on quantity purchased. Consumers put themselves into consumption groups to maximise their consumer surplus.

Third degree: Consumers segregated by demographic or other traits. Prices determined by the demands of each group.

Question 44

Q

Microeconomics

Price Discrimination

How profits are affected and maximised

Answer

A

Compared to normal monopolistic situation output can be increased since profitable demand of price-sensitive consumers can be satisfied.

Each set of consumers has a different demand curve, thus a different MR curve. The firm solves MC = MR for each set of consumers and achieves higher profits than without discrimination.

Key is different elasticity of demand of different consumers, increase prices for consumers with low elasticity and drop it for those with high elasticity.

Question 45

Q

Microeconomics

Identifying the market structure

N-firm concentration measure

Answer

A

Simply the percentage of the market output generated by the N largest firms in an industry.

Question 46

Q

Microeconomics

Identifying the market structure

Herfindahl-Hirschman Index (HHI)

The “moderate” range for the index

Answer

A

For the n biggest producers in an industry,

H = M₁² + M₂² + M₃² + … + M_n²

Where M_i² is the market share of th i^th biggest producer. 0.1 to 0.18 is the moderately competitive range (below is competitive, above is uncompetitive).

If all firms have an equal share H = 1/n. So if H=0.28, the structure is equivalent to 1/0.28 = 3.57 equal size firms.

Question 47

Q

Macroeconomics

GDP

Answer

A

5 properties:

Market Value of
Domestically produced (inc. by foreigners)
Final goods and services
During a specific time period

Question 48

Q

Macroeconomics

GDP Inclusions

Government production?

Household production?

Underground economy?

Answer

A

Government and household production is estimated and included in GDP.

The underground economy can be substantial but is excluded.

Question 49

Q

Macroeconomics

GDP Deflator

Answer

A

A price index (like CPI) for goods and services which are included in GDP. Base of 100 (currently in 1992).

Broader than CPI, also includes capital goods, and goods purchased by government and businesses.

Question 50

Q

Macroeconomics

GDP measurement

Expenditure Approach

Answer

A

Sum of the following items, C+I+G+(X-M)

C: Consumption (personal) expenditure
I: Investments expenditure (private) - expenditure on inventories and capital goods by private sector which will result in future productive capacity
G: Government (public) consumption and gross investment
X-M: Net exports (exports less imports)

Question 51

Q

Macroeconomics

GDP Calculation

Income approach

Answer

A

Sum of income payments to resource suppliers and other costs of producing goods.

Largest component is employment costs, others are rent, self-employment income, profits and interest.

Question 52

Q

Macroeconomics

GDP Components

Consumption (function of what?)

Marginal Propensity to Consume (MPC)

Answer

A

Consumption (C) refers to personal consumption, and is a function of disposable income. Therefore increases as income (Y) increases and/or taxes decrease.

MPC = 1 - MPS (marginal propensity to save) is the % of additional disosable income that goes into consumption (as opposed to savings).

Question 53

Q

Macroeconomics

GDP Expenditure

Personal consmption function of?

Investments spending function of?

Government spending function of?

Net exports function of?

Answer

A

C: Function of income (Y) and MPC

I: Function of interest rates (i) and income/output level

G: Government deficit (G-T) depends on income (Y)

X-M: Depends on relative income and prices between countries

Question 54

Q

Macroeconomics

IS Curve

Formula

Answer

A

S = I + (G - T) + (X - M)

S is personal savings

I is total investment

(G-T) is the government deficit

(X-M) is net exports

Put another way, 3 uses of savings are private investment, funding the government deficit and improving the trade deficit.

Question 55

Q

Macroeconomics

IS Curve

What is the relationship between interest rates and income?

Effect on IS curve of change in government purchases

Answer

A

The IS curve describes points at which the market for goods and services clears.

High interest rates discourage investment (stick money in gilts instead) therefore reduce income.

A non-IR shift such as change in government expenditure shifts the IS curve, a change in interest rates results in a movement up or down the IS curve.

Question 56

Q

Macroeconomics

LM Curve

What is it, explain the relationship

Answer

A

Describes combinations of interest rates and income at which money demand and money supply clear.

As income (Y) increases demand for money increases (since people are richer) however money supply is constant. In order to clear supply and demand rates must rise to reduce demand for money (since money pays no interest).

Question 57

Q

Macroecnomics

Quantity Theory of Money

Formula

Answer

A

MV = PY

Where M is amount of money in the economy and V is the velocity of money.

P is price level and Y is income (volume of transactions).

Transaction produces the LM curve, balance of money supply and money demand.

Question 58

Q

Macroeconomics

Aggregate Demand Curve

How is it produced?

Answer

A

Aggregate demand curve is produced by the combination of the IS curve and the LM curve.

Question 59

Q

Macroeconomic

Aggregate Demand Curve

Explain the relationship

Answer

A

A fall in price levels has the following effects:

Increase in wealth of people holding money
Reduction in the real interest rate
Domestic goods cheaper than foreign goods

Which all have the effect of increasing the demand for domestic goods and services.

Question 60

Q

Macroeconomics

Aggregate Supply

Function of which factors

Answer

A

Aggregate quantity of goods and services supplied given by:

Y = F(L, K, T)

Where L = labour, K = capital and T = technological level.

Question 61

Q

Macroeconomics

Short-term aggregate supply

Chart and explanation

Answer

A

In the short-term some prices are fixed due to longer term agreements (eg rent, wages) therefore an increase in prices leads increases profit margin so producers increase output.

Question 62

Q

Macroeconomics

Long-run aggregate supply

Chart and explanation

Answer

A

In the long term aggregate supply is vertical, ie amount supplied by the market is unaffected by price level.

Y = F(L, K, T), people adjust behaviour based on price levels, output depends on availability of resources (L,K,T) in the economy.

Question 63

Q

Macroeconomics

Long-term aggregate supply/demand Equilibrium

Chart

Answer

A

The real level of GDP and price level in an economy are determined by the balancing of aggregate demand and supply charts.

Question 64

Q

Macroeconomics

Factors which shift aggregate demand

How do changes in these factors increase AD?

(impact on C, I, G or X)

Real wealth, optimism about the future, high capacity utilisation, expanding fiscal policy, money supply, interest rates, FX rate, global economy.

Answer

A

Function of C, I, G and X.

Increase in real wealth increases C
Higher optimism increases C and I
High capacity utilisation increases I
Higher gov borrowing increases G and increases C due to lower taxes
Increased money supply increases C
Lower rates increase C and I
Falling FX rate increases X
Global economy growth increases X

Answer 65

A

Short term aggregate supply increased by:

Reduction in resource prices
Reduction in expected inflation (high inflation motivates firms to hold on to goods now for sale in the future)
Lower taxes (or higher subsidies)
Favourable FX rates against importers

Answer 66

A

In the long term output is a function of L, K and T.

Therefore an increase in LRAS is caused by increases in availability of resources or an increase in the technological level.

Answer 67

A

In the short term this occurs when short-run aggregate supply (SAS) and aggregate demand coincide. If GDP is below equilibrium firms increase prices and production (and the opposite).

Long-run equilibrium occurs when GDP is equal to the potential GDP, denominated by Y_f.

Answer 68

A

Economic growth involves LAS shifting to the right, caused by increased availability of resources or technological advancements.

Inflation occurs due to growth in the quantity of money and shows up as a shift right in the AD curve. This is faster than economic growth therefore prices increase.

Answer 69

A

Below full employment equilibrium occurs when real GDP falls below potential GDP due to resources not being fully utilised. The difference between real GDP and potential GDP is the recessionary gap.

SAS and AD are in equilibrium but LAS is not.

Answer 70

A

Above full employment equilibrium occurs where real GDP rises above potential GDP. The GDP difference is the inflationary gap.

SAS and AD are in equilibrium but LAS is not.

Answer 71

A

Short term AD increase shifts the AD curve to the right, causing price increases and consequently an increase in short term supply (which is unsustainable in long run) and therefore an increase in output and thus GDP.

Answer 72

A

A short term supply shock (eg drought) is a cause.

Shifts SAS to the left which increases prices and reduces GDP, this is stagflation.

Answer 73

A

Basically same as the function for aggregate supply, Y = F(L, K, T).

However technology can be expressed as a multiple A, so Y = A*F(L, K).

L and K have positive marginal products with diminishing returns, Y scales with A for a given level of inputs L and K.

Answer 74

A

This is the process of one economy catching up with another one. Countries with lower levels of capital have a higher marginal product of capital therefore attract investment and therefore grow faster.

Answer 75

A

L, HC, K, T, NR

Labour supply is the quantity of the work force
Human capital measures quality of the work force
Physical capital results from savings and investment
Technology
Natural resources

Answer 76

A

Labor productivity is the amount of real GDP produced by one hour of labour. Growth of this depends on physical capital, human capital and technology.

Potential GDP = Hours worked * labour productivity

Potential growth = LR labour force growth * LR labour productivity growth

Answer 77

A

Neoclassical & Austrian Schools

Self-correcting economy

Business cycles are caused by governments trying to increase GDP and employment.

If Y is below Y^N (natural real GDP) firms cut wages and prices, increase them if Y>Y^N, and Y heads to Y^N. Thus no business cycle.

Answer 78

A

Keynesian School

No self correction - changes in output and employment restore equilibrium, not prices

Expectations drive aggregate demand, which is the driving force of the economy.

Wages and prices are sticky (esp. on downside) so SAS is horizontal

Thus a fiscal policy response is required to restore equilibrium.

Answer 79

A

Monetarist School

Economy is self-regulating and will operate at full employment if monetary policy keeps pace of money growth steady. Quantity of money is the most significant influence on AD.

Answer 80

A

Government policy is ineffective.

Answer 81

A

Real business cycle theory

Real shocks to the economy are the cause of business cycles.

Adverse cost shocks lead to recession as workers spend less time working as it is less profitable
Favourable cost shocks lead to a boom as it becomes advantageous to increase production

Government policy intervention is not required as it will exacerbate the cyle and delay convergence.

Answer 82

A

Neo-Keynesian School

Assumes that prices of goods don’t change on a daily basis as the cost of changing prices outweighs the benefits of changing. Thus markets do not reach equilibrium quickly.

Answer 83

A

Percentage of the labour force who are unemployed, where labour force excludes children (<16 yrs), students, household workers, retirees and disabled.

Split into long-term unemployed (do not have required skills or live too far from jobs) and frictionally unemployed who are between jobs.

Answer 84

A

Unemployment is a lagging indicator because:

Data is compiled after the event
Firms are slow to respond by firing or hiring workers due to the costs involved and time taken

Answer 85

A

Underemployment is a measure of labour utilisation in the economy. It considers how well labour is being utilised in terms of skills, experience and availability to work.

Answer 86

A

Lasperyres index

Uses the same basket of commodities over time, which gives a meaningful comparison over time but doesn’t reflect changes in buying patterns over time.

Answer 87

A

Paasche index

A price index which uses the current composition of the basket, so changes the composition over time. Makes it more up to date but less comparable.

Tends to understate inflation.

Answer 88

A

Fisher index

Geometric mean of the Lasperyres and Paasche index types.

Answer 89

A

Inflation is caused not only by raising prices, in the long-run if quantity of money grows faster than GDP inflation will result.

Otherwise main causes are:

Aggregate demand increase (cost-push inflation)
Aggregate supply decrease (demand-pull inflation)

Answer 90

A

The result of decreased aggregate supply and increased costs of production, costs are passed on when firms are running at full production capacity.

NAIRU/NARU: Rate of employment where wage inflation is stable

ULC: Total compensation per worker divided by output per worker

Answer 91

A

The result of aggregate demand overtaking aggregate supply. This could be the result of acceleration in monetary supply in the long term, or increases in government purchases or weaking FX rates in the short term.

Answer 92

A

Types of indicator: Leading (eg stock market), lagging or coincident.

The diffusion index measures the breadth of movement in an index by indicating how many components are rising/falling. Tends to be a leading indicator.

However the lead time has been highly variable and several false alarms have occured.

Answer 93

A

Central bank activities controlling the supply of money in the economy.

Answer 94

A

The use of government spending, tax and borrowing to achieve economic goals.

Answer 95

A

Maximum employment
Stable prices
Moderate long term interest rates

Answer 96

A

When a bank is forced to hold a certain percentage of reserves to back up its total deposits.

The reserves held to meet this requirement are “required reserves”.

Answer 97

A

Inverse of the required reserve rate, this is the multiplier applied to a change in the monetary base to find out the final impact on money supply.

If you put $1k on deposit with Bank 1, they hold 20% (reserve rate example) on reserve and lend out the rest to person B (effectively creating $800 of money and increasing the monetary supply).

Person B puts their $800 on deposit with Bank 2 who hold $160 on deposit and lend out $640. Process goes on until 5*$1000 has been created by the initial $1000.

Answer 98

A

M1: Cash, checking accounts, travellers cheques

M2: M1 + savings, short term deposits and retail money funds

M1 is based on the idea of money as a medium of exchange, M2 on the idea of money as a medium of exchange and store of value.

Answer 99

A

Money Supply (M) * Velocity of Money (V)

=

Price (P) * Real Output (Y)

Quantity Theory of Money therefore states that a change in money supply will cause a proportional change in price level, since V and Y are unaffected by monetary supply.

Velocity of money is the average number of times a dollar is used to purchase final goods or services in a year.

Answer 100

A

Money supply is unaffected by interest rates as it is set by the central bank. Money demand is inverse to interest rates.

If rates rise, demand for money falls as people seek to invest in bonds instead, pushing up bond prices and pushing interest rates back to equilibrium (and other way around).

Answer 101

A

R_nom = R_real + R_inflation + risk premium

A nominal interest rate made up of:

A required rate of return
Compensation for inflation
A premium to compensate for uncertainty

Answer 102

A

Issue currency
Set monetary policy
Governments bank and bank of banks
Lender of last resort to banking sector
Regulate payments system
Regulate banking system

Answer 103

A

Expansionary: Acting to increase the supply of money in the economy

Restrictive: Acting to reduce the supply of money in the economy

Answer 104

A

Open Market operations
Central bank policy interest rate
Reserve requirements

Answer 105

A

This involves trading in open market securities by the central bank. For example buying government securities from commercial banks will increase the money supply.

Answer 106

A

Commercial banks may need to borrow funds from the central bank overnight in order to meet reserve requirements, this is done at the repo rate (discount rate in US).

Increasing this rate discourages banks from cutting reserves tight and decreases monetary supply (restrictive).

In the US most such borrowing is done in the federal funds market (at the fed funds rate) between banks, but rate is obviously closely linked to the discount rate.

Answer 107

A

Increasing the reserve rate will decrease the amount banks can invest in interest earning assets and thus decrease money supply. This option is rarely used however since it is disruptive and can have a big impact on money supply.

Answer 108

A

If interest rates are decreased:

Short term IRs fall as they are closely linked, as do long term rates
FX rate falls due to IR differential
Money demand increases as bond returns fall and money supply increases as bonds become less attractive relative to deposits
Expenditure and investment increase due to low cost of money, net exports increase due to FX
Real GDP and inflation therefore rise.

Answer 109

A

ICrT

Independence: Two types, goal independence and instrument independence. Mostly they get given goals by government, but have independence to achieve it their own way.
Credibility
Transparency

Answer 110

A

Expansionary: Decrease interest rates in order to increase the money supply.
Contractionary: Increase interest rates in order to decrease the money supply.

The neutral rate of interest is the rate that encourages growth at its long term trend rate, the theoretical target of the central bank.

Neutral rate = Trend Growth + Inflation Target

Answer 111

A

These are shocks that cause inflation to spike upwards.

Demand shocks caused by an unexpected increase in demand is responded to with contractionary monetary policy.

Supply shocks however (such as oil prices rising due to supply shortages) may be made worse by contractionary monetary policy.

Answer 112

A

They can’t control the amount of money that households and corporations put on deposit with banks
They can’t control the amount of credit extended by banks

Answer 113

A

This is the purchase by the central bank of financial assets in order to inject money into the economy.

Seperate to the more general use of buying and selling government bonds to meet target interest rate.

Can be over effective and cause hyper-inflation or under effective if banks hold the money instead of lending it.

Answer 114

A

This is when budget deficits funded via borrowing in capital markets, lead to higher interest rates, which results in a reduction in private investment.

This could outweight the positive impact on aggregate demand of increased government spending.

Answer 115

A

Expenditure multiplier is the ratio of the change in equilbrium output brought about by an independent change in one of investment, consumption, government spending or net exports.

Answer 116

A

The magnification effect of a change in the expenditure llevel of the government on aggregate demand. This comes about because government expenditure is a component of aggregate demand and also has the effect of increasing consumption.

Answer 117

A

The tax multiplier is the magnification effect of a change in taxes on aggregate demand. Higher taxes reduce personal income and therefore personal consumption. Thus aggregate demand and GDP fall.

Answer 118

A

The government purchases and tax multiplier together create the fiscal multiplier:

1 / (1 - c (1 - t))

Where c is the MPC (marginal propencity to consume) and t is the tax rate.

This is the ratio by which output increases as a result of an increase in government spending. Note that if tax is 100% or MPC is zero then this is 1. Higher MPC and lower tax magnifies the effect.

Answer 119

A

The effect of a simultaneous increase in taxes and increase in goverment expenditure on output.

A $1 increase in government expenditure increases aggregate demand by at least $1, whilst a $1 increase in taxes reduces consumption by less than $1. Therefore the net effect is increased output.

Answer 120

A

This is the theoretical surplus or deficit which would occur if the economy were at full employment and GDP were equal to potential GDP.

Answer 121

A

Economic policy is either automatic (responds automatically to economic conditions) or discretionary.

Income taxes and transfer payments (welfare) are examples of automatic stabilisers. In a downturn people earn less income, therefore pay less tax and claim higher benefits. This leads to a budget deficit which is expansionary.

Answer 122

A

Recognition Lag - Time between when policy action is required and when policy makers realise it is required.
Action Lag - Time taken for policy makers to come up with a response and put it into action.
Impact Lag - The time taken for the action taken to have an impact on economic output.

Answer 123

A

GDP is the total market value of all domestically produced final goods and services.

GNP however is the MV of final goods and services produced by a countries citizens, whether at home or abroad.

Answer 124

A

Benefits

Results in lower prices and higher domestic consumption of foreign goods, higher prices and lower domestic consumption of domestic goods
Residents of each nation to concentrate on their specialisms
Greater product variety
Economies of scale
Efficient allocation of resources

Costs

May lead to loss of jobs in developed countries
Greater income inequality

Answer 125

A

This is the ability of one country to produce a certain good at a lower opportunity cost than other countries can produce it. It leads to an expansion of total output if countries specialise based on their comparative advantage.

Note that even if there is no absolute advantage (country A can make either 1 fish or 1/2 a loaf compared to 2 fish or 3 loaves in country B), there can still be comparative advantage.

In this situation they can specialise in producing fish to enable country B to specialise in loaves. They can exchange fish for loaves at 1:1 ratio and both countries will have more production.

Answer 126

A

Adam Smith - law of absolute advantage, each country produces goods it can produce most of for same level of resources/time
Ricardian Model - Labour is the only production factor, advantages based on technological abilities
Heckscher-Olin Model - Resource availability is the only production factor, advantages based on factors of production available

Answer 127

A

Small countries can’t affect the price of internationally traded goods, therefore always lead to net welfare losses due to distortion of production and consumption, and inefficient allocation of resources.

Large countries decisions do affect prices of goods, therefore trade barriers can generate a welfare gain within a country, although the net global welfare impact will be negative.

Answer 128

A

Normal international price is P_w, with domestic supply at Q_d1 and imports of Q₁ - Q_d1.

Tariff of amount t increases price to P_w+t, with T the additional tax revenue of the government, S the additional revenue of domestic producers and U and V being a deadweight loss of economic efficiency.

Answer 129

A

Import quota set at Q₂-Q_d2 below the natural level of Q₁-Q_d1.

S is the additional revenue received by domestic producers. T is additional revenue achieved by the selected importers within the quota. This encourages rent-seeking behaviour by foreign producers (ie lobbying to get permission to supply).

Answer 130

A

A VER is when a country agrees with another to restrict its exports of a certain product. The effect is very similar to a quota, however it is imposed by the exporting country rather than the importing country.

Answer 131

A

An export subsidy encourages exports of goods and discourages domestic sales. It costs the government instead of generating revenue and increases the amount traded (unlike other trade barriers).

The distortion creates a welfare loss for the country, more so for larger countries because increased exports push down international prices of its specialist good and damage the countries terms of trade.

Answer 132

A

Free Trade Area - No internal trade restrictions, each country sets its own external terms.

Customs Union - External trade terms set together.

Common Market - Also free movement of factors of production within the area.

Economic Union - Also common economic policies

Monetary Union - Common currency

Answer 133

A

Benefits include greater domestic competition and allowing residents of different countries to capitalise on differences by borrowing and lending internationally.

Costs are complicating economic policy or being a source of economic instability.

Restrictions can maintain the balance of payments, control FX rates, preserve savings for domestic use and protect local industry.

Include prevention of foreign investment, tax on income earned by foreigners and caps on capital flow sizes.

Answer 134

A

Accounting entries for foreign transactions in a countries currency, debits (outflow of your currency) and credits (inflow).

Current Account - From trade in goods and services

Capital Account - International capital (non-financial) such as investment

Financial Account - Financial asset movements (bonds, stocks, foreign reserves. Often included within capital account.

Answer 135

A

The consequence is that all foreign transactions in a countries currency must balance. So if a US citizen buys foreign goods for $100 (debit current account), the $100 may be deposited in a US bank accounts (credit capital account).

Or it could be exchanged for Rupees with an Indian bank who can then lend it to a customer to buy US goods (credit current account) or purchase US government bonds (credit financial account).

A current account deficit in a country means it is a net importer, spending more than it is producing, thus investing more than it is saving.

Answer 136

A

IMF - Mission is to ensure stability of the international monetary system, they keep country specific market risk and global systematic risk under control.

World Bank - Helps developing countries fight poverty and enhance environmentally sound economic growth.

WTO - Regulates global cross border trade. Creates international trading rules and fosters free trade.

Answer 137

A

FX rates quotes as: Price Currency / Base Currency

In direct quotation the local currency is the price currency. So in the US they say €:$ = 1.25 meaning €1 costs $1.25. Notation €:$ = $ per € (FC:DC = DC/FC)

Indirect quotation is used in some markets like UK, £:$ = 1.65. Notation £:$ = $ per £ (DC:FC = FC/DC)

To summarise, direct quotation tells you how much the foreign currency costs, indirect tells you what the domestic currency is worth.

Answer 138

A

Quoted as a percentage of the ask

BO Spread % = (Ask - Bid) / Ask

Answer 139

A

If forward rate > spot rate then

Base currency is at a premium

Price currency is at a discount

Answer 140

A

Credibly fixed FX rate against all currencies
All currencies fully convertible
All countries have fully independent monetary policy

However these 3 aims are not consistent and FX rates can only be fixed by restricting ability to convert or sacrificing monetary policy independence.

Answer 141

A

In a flexible FX regime the market is allowed to set FX rates based on supply and demand. The FX rate reflects economic conditions at the time, but it can be very volatile.

Fixed FX rates are achieved by fixing your rate to somebody else and accepting their monetary policy as your own.

Answer 142

A

Dollarisation: Use the dollar as your currency
Monetary Union: eg Euro

Answer 143

A

The monetary authority is required to maintain a fixed FX rate with a foreign currency.

It must maintain sufficient foreign reserves for all holders of its domestic currency to convert to the foreign currency (so only issues new currency when it gains extra reserves).

Gain currency stability but lose monetary policy control.

Answer 144

A

Fixed Parity is also known as Pegged Rates.

The country tries to keep its FX rate at a certain level but has no legal obligation to do so (unlike currency board system).

Answer 145

A

In the long run depreciating currency makes imports more expensive and exports more attractive so your countries current account deficit improves.

In the short term imports and exports are unaffected though, and the price effect leads to a deterioration in the balance of payments initially - leading to the J curve.

Answer 146

A

Regarding the effect of depreciation of your currency on the balance of payments.

This states that for depreciation to improve the balance of payments, the sum of demand elasticity of imports and demand elasticity of exports needs to be greater than unity.

Answer 147

A

The main assumption is that prices remain constant and changes in real domestic income are emphasized, making this a real-income theory of the balance of payments.

Absorption is the total goods and services taken off the market, equal to consumption plus investment.

Supply side requires idle resources for effective depreciation.

Demand side requires the Marshall-Lerner condition.

Answer 148

A

High inflation means your currency trades at a discount in forward market

Answer 149

A

This is A in the equation:

Y= A * F(L,K)

for GDP output

Answer 150

A

Only the short run since it evens out in the long run, but in the short run where you are in the cycle is important.

Answer 151

A

Positively correlated.

Budget deficit leads to high interest rates (crowding out effect) thus foreign capital inflows.

Then your currency appreciates and exports become less competitive.

Hence trade deficit worsens also.

Answer 152

A

A fall in the rate of inflation (inflation may still be positive)

Answer 153

A

Quantity demanded refers to the point on the demand curve. So a change in quantity demanded is the result of a price change and a movement along the demand curve.

Demand refers to the quantity demanded at a range of price points however, i.e. a change in some feature other than price (such as popularity of the product) resulting in a shift in the demand curve itself.

Answer 154

A

normal product: -ve

cross for substitute: +ve

cross for complement: -ve

Answer 155

A

1

Because although the dollar value doesn’t change, the quantity purchased changes by the inverse of the price change.

Answer 156

A

Decrease the price of customers with a low slope (0.1) which equates to a high elasticity of demand. A small price fall for them increases demand a lot.

Increase the price of cusotmers with a steep slope (2.0) which equates to a lower elasticity of demand. The price change for them has a smaller effect on demand.

Remember that a horiztonal demand curve means an incredibly small reduction in prices can lead to an infinite increase in demand.

Answer 157

A

Supply shock
Unanticipated reduction in aggregate demand

Answer 158

A

Based on the annual deficit/surplus as a percentage of gdp.

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