Macroeconomics exam questions Flashcards
What is a market-clearing model? When is it appropriate to assume that markets clear?
A market-clearing model is one in which prices adjust to equilibrate supply and demand. In this model there are no shortages or surpluses arising from too much or too little demand.
In the short run, prices are sticky, but in the long run prices are flexible and adjust to equate demand and supply, e.g. A labour contract might only be able to be renegotiated after 5 years to bring it in line with equilibrium pricing levels.
Therefore, it is appropriate to assume that markets clear in the long run, but not in the short run.
What is microeconomics?
Microeconomics is the study of how individual firms and households make decisions, and how they interact with one another.
Microeconomic models are based on the principle of optimisation: firms decide how much to produce to maximise profits, and households maximise the utility of their purchases within their budget constraints.
What is macroeconomics?
Macroeconomics is the study of the whole economy (not only a part of it, like a household or a firm). It handles issues such as output, employment, fiscal and monetary policy and inflation for the entire country, or region.
How are microeconomics and macroeconomics related?
Because economy-wide events arise from the interaction of many households and many firms, macroeconomics and microeconomics are inextricably linked.
When we study the economy as a whole, we must consider the decisions of individual economic actors.
Because aggregate variables are the sum of the variables describing many individual decisions, macroeconomic theory rests on a microeconomic foundation.
What is the difference between stock and flow variables? Are there any links between them? Use examples to explain your answer.
A stock is a quantity measured at a point in time, e.g. the balance on your credit card statement.
A flow is a quantity measured per unit of time, e.g. the amount of new purchases on your credit card in the last month.
They are linked in the sense that flows accumulate to form a stock, as in the example above.
Further example: the yearly government budget deficit is a flow. These budget deficits accumulate to form Government debt at a point of time, which is a stock.
What is the difference between GDP and GNP?
The difference between GDP and GNP boils down to location and ownership (domestic v foreign) of the factors of production (capital, land and labour)
What is the GDP?
GDP = Market value of all final goods and services produced by domestically-located factors of production, regardless of which nation’s factors of production they are produced by.
What is the GNP?
GNP = Market value of all final goods and services produced by the nation’s factors of production in a given period of time, regardless of where they are located –> includes all labour and capital working or invested in other countries.
Why are there differences in GDP and GNP in some countries?
GNP = GDP + factor payments from abroad (our workers abroad) - factor payments to abroad (foreign owners here).
Factor payments include: wages, profits, rent, interest & dividends on assets.
Differences occur when the income generated by nationals working abroad and domestically owned capital invested abroad does not equal the income generated by foreign workers and foreign capital invested in the country.
Suppose a woman marries her butler. After that he continues to wait on her as before (but not as an employee). How does the marriage affect GDP? How should it affect GDP?
Before she marries him, the income that the butler receives for his services is included in the GDP computation. After she marries him, he no longer receives a wage. The value of his services are therefore not computed in the GDP, so the GDP reduces.
The husband however continues to provide the same services, and GDP is the total market value of all goods and services produced domestically. As the market value of his services does not change by his change in marriage status, his marrage should really not affect the GDP.
What is the difference between nominal and real GDP?
GDP is the market value of all final goods and services produced in an economy.
Nominal GDP measures this value using current prices = current price * this year’s quantity
Real GDP measures this value using the prices of a base year = base year price * this year’s quantity. Real GDP is therefore inflation adjusted.
Could provide an example.
Is there a difference between the GDP deflator and the CPI?
Yes:
- Goods and services bought by firms and govt: GDP deflator included, CPI excluded
- Imported consumer goods and services: GDP deflator excluded, CPI included
- Basket of goods: GDP deflator changes every year, CPI fixed basket - changes every 5 years or so.
Why is it possible that the CPI may overstate inflation?
- Substitution bias: uses fixed weights, so can’t reflect consumer’s ability to substitute with goods whose relative prices have fallen
- Introduction of new goods: Introduction of new goods makes consumers better off and increases the real value of the dollar. BUT it doesn’t reduce CPI, as CPI uses fixed weights.
- Unmeasured changes in quality: Quality improvements increase the value of the dollar but are often not fully measured. The Bureau of Labor and Statistics tries to account for some improvement in quality, but cannot capture all quality improvements.
What makes the demand for the economy’s output of goods and services equal the supply? (Use a classical model!)
Using the classical model:
Assume flexible prices (long-run) and a closed economy (zero net export). So Y = C + I + G
Supply side: Y is a function of Capital K and Labor L. The economy as a fixed amount of labour and a fixed amount of capital, which are factors of production. Therefore, Y is also fixed. Y̅ = F (K̅, L̅)
Demand side: Y = C + I + G
C = C (Y̅ - T), so C depends on disposable income (total income minus tax)
I = I (r) Investment depends on the real interest rate r
G and T are fixed by public policy, so G= G̅, T = T̅ fixed.
Therefore: Y̅ = C (Y̅ - T̅) + I(r) + G̅
So in the long run the real interest rate r and therefore investment I will adjust to equate demand for the economy’s output of goods and services with supply.
Explain the consequences of an increasing budget deficit by using a classical loanable funds market model
The loanable funds market model considers:
- national savings S = supply of loanable funs, and
- desired investment I = demand for loanable funds. I = I(r); the amount of investment depends on the real interest rate.
National savings S = private savings of households and firms (Y - T - C) + public savings (T - G) = Y - C - G
Assmptions: Y is fixed by a fixed supply of capital and labour (Y = f(K,L)), T and G are fixed through public policy, and as C = C(Y - T), C is fixed too.
–> national savings are fixed.
Equilibrium: I(r) = S fixed
Graph: x axis = S, I; y-axis = r. S is vertical, I(r) slopes down. Shift S to the left.
An increase in the budget deficit will reduce national savings S, which causes the real interest rate to rise, which reduces the level of investment. Increasing the Government deficit therefore crowds out investment in the long run.
The government reduces the tax on capital income. What is the effect on investment? Explain your answers by using a classical loanable funds model.
The loanable funds market model considers:
- national savings S = supply of loanable funs, and
- desired investment I = demand for loanable funds. I = I(r); the amount of investment depends on the real interest rate.
National savings = private savings (of households and firms) + public savings (government).
- Private savings: Y - T - C
- Public savings: T - G
- National savings: S = Y - C - G
Assmptions: Y is fixed by a fixed supply of capital and labour (Y = f(K,L)), T and G are fixed through public policy, and as C = C(Y - T), C is fixed too.
–> national savings are fixed.
Equilibrium: I(r) = S fixed
Graph: x axis = S, I; y-axis = r. S is vertical, I(r) slopes down. Shift S to the left.
A decrease in taxes will increase disposable income, increasing consumption and leading to lower savings. This will increase the real interest rate and decrease investment.
↓ T⇒ ↑ C ⇒ ↓ S ⇒ ↑ r ⇒ ↓ I
What is money?
Money is the stock of assets that can be readily used to make transactions
Explain the function of money.
Money has three functions:
- Store of value - a way to transfer purchasing power from the present to teh future; I can spend what I earn tomorrow.
- Unit of account - provides the terms in which prices are quoted and debts are recorded.
- Medium of exchange - what we use to buy goods and services - we are confident sellers will accept money in payment.
Explain the types of money
There are two main types of money:
- Fiat money: money with no intrinsic value, e.g. paper currency.
- Commodity money: money with intrinsic value, e.g. gold coins. Gold can be used for various purposes - jewelry, dental fillings etc, as well as for transactions.
When does money lose its function?
Hyperinflation causes money to lose its function. This is because money ceases to be a valid store of value. This can lead to sellers not accepting money in payment leading to a barter economy. Money therefore loses its functions as a medium of exchange and a unit of account too.
The Central Bank increases money supply. What is the impact on inflation, if the velocity of money and real output is constant?
According to the quantity theory of money: MV = PY.
In growth rates, the quantity equation is:
∆M/M + ∆V/V = ∆P/P + ∆Y/Y
Assuming constant velocity and constant real output, ∆V/V = 0, and ∆Y/Y = 0.
Further, ∆P/P is inflation, so equals π.
Therefore, ∆M/M = π
This implies that increasing the money suppy increases inflation by the same percent. So if the Central Bank increases the money supply by x%, the inflation rate increases by x%.
What is the velocity of money?
The velocity of money is the rate at which money circulates in the economy. In other words, velocity tells us the number of times the average currency unit changes hands in a give period of time.
How can you calculate the velocity of money? What does it depend on?
MV = T
where M = money supply, V = transaction velocity of money, and T = value of all transactions in the economy. This is an identity.
As T is difficult to measure, nominal GDP is used as a proxy, where Y is real GDP and P is inflation. The equation becomes:
MV = PY, where V is the income velocity of money.
M/P = Y/v, so money demand = kY where k = 1/v.
Therefore, when people hold lots of money relative to their incomes, money changes hands infrequently, so the velocity of money is small. Velocity of money is determined by the demand for real money balances.
In the county of Wiknam, the velocity of money is constant. Real GDP grows by 5%, the money stock grows by 14%, and the nominal interest rate is 11%. What is the real interest rate?
Using the quantity equation: ∆M/M + ∆V/V = ∆P/P + ∆Y/Y. Velocity is constant, so ∆V/V = 0. ∆M/M = 14%, ∆Y/Y = 5% ∆P/P = π, which is inflation. 14% + 0 = π + 5%, so π = 9%
From fisher’s equation r = i - π, where r = real interest rate, i = nominal interest rate and π = inflation:
r = 11% - 9% = 2%.
Therefore, the real interest rate is 2%.
The Central Bank announces that it will increase the supply of money. What is the impact on inflation even if the Central Bank does not execute its announcement? Explain your answer in the framework of the classical theory.
From the quantity theory of money, MV = PY. Assuming velocity V is constant and output Y is fixed by the fixed supply of capital and labour in the economy, ∆M/M = ∆P/P. This means if the money suppy M were to increase, we would expect an equal increase in inflation (∆P/P).
Based on classical theory, the supply of real money balances M/P = the demand for real money balances L(i, Y), where M = money supply, P = price level, i = nominal interest rate and Y = output. Demand for real money balances depends on the nominal interest rate, because the nominal interest rate is the opportunity cost of holding real money balances.
The nominal interest rate i is set before the real inflation rate is known. Therefore, the nominal interest rate ex ante i = desired real interest rate r + expected inflation rate Eπ. If Eπ increases, then i increases by the same amount.
Therefore, M/P = L(r + Eπ, Y). So if Eπ increases, the demand for real money balances L(r + Eπ, Y) falls. If M stays constant, P must therefore increase.
By definition, an increase in the price level P is an increase in inflation. Therefore, the announcement will increase inflation even if the Central Bank does not execute its announcement.
