ME2016Q3 (Lars)

Question 1

ADWhat is the difference between GDP and GNP?

Answer 1

GNP adds/subtracts whether Danes receive more income from their overseas investments than foreign nationals receive from their investments in Denmark.

GNP = GDP + net transfers received

Question 2

What is an intermediate good?

Answer 2

a good used in the production of another good

Question 3

What are the three ways to measure GDP?

Answer 3

• GDP is the FINAL value of the goods and services produced in the economy during a given period (production side)
• GDP is the sum of VALUE ADDED in the economy during a given period (production side: Sum of value of production – intermediate goods)
• GDP is the SUM OF INCOMES in the economy during a given period (income side. The income must equal output; GDP = wages + profits (and other income such as taxes)).

Question 4

What is the difference between nominal and real GDP?

Answer 4

Nominal GDP: current prices

Real GDP: constant prices (Real GDP in chained 2005 dollars are used in the US)

Unless stated differently GDP equals GDP in real prices and Y = the year

Question 5

How do you measure the unemployment rate?

Answer 5

Unemployment rate = U/L (unemployed/labor force)

L = employed persons (N) + unemployed persons (U)

U = unemployed AND looking for a job

Question 6

How do you measure labor force participation?

Answer 6

labor force/population

Participation rate determines whether people are actually looking for a job and therefore counted as a part of the labor force or not.

Question 7

How do you measure employment rate?

Answer 7

employed/population

Question 8

What is the GDP deflator?

Answer 8

The GDP deflator is an index number due to a certain year (often 2005 in the US)

Nominal GDP/Real GDP = $Y_t/Yt

The GDP deflator gives the average price of output PRODUCED and not products sold

The rate of growth of nominal GDP is equal to the rate of inflation plus the rate of growth of real GDP

Question 9

What is CPI?

Answer 9

Consumer Price Index (CPI) gives the average price of goods and services PURCHASED, can also be used to compute the inflation rate

Question 10

What is the difference between CPI and the GDP deflator?

Answer 10

GDP deflator is for goods PRODUCED

CPI is for goods purchased/SOLD. Thus, it also includes imported goods whereas the GDP deflator only includes domestic goods.

Question 11

What does Okun’s Law predict?

Answer 11

That when output growth is high, unemployment rate will decrease

Question 12

What does the Philips curve predict?

Answer 12

when unemployment becomes very low, the economy is likely to overheat, and that this will lead to upward pressure on inflation

Question 13

What are procyclical, countercyclical and asyclical variables in relation to GDP?

Answer 13

Procyclical: a variable that follows GDP (employment rate, inflation, import, financial variables, investment, real consumer spending)

Countercyclical: a variable that is negatively correlated with GDP (unemployment rate)

Asyclical: a variable that is not correlated with GDP (exports could be an example depending on the size of the domestic market and how that market’s growth affects foreign markets)

Question 14

What are Investments in economics?

Answer 14

The purchase of new capital goods, such as (new) machines, (new) buildings, or (new) houses.

Buying shares, gold etc. “financial investment” is used

Question 15

What is inventory investment and how is it calculated?

Answer 15

Inventory investment = production – sales (can be positive or negative depending on demand in society)

Question 16

What determines C?

Answer 16

C = C₀+C₁Y^D (Y^D= Y-T)

C₀ = is autonoumous spending (not affected by Y)

C₁ = is the propensity to consume

In our course we assume that the C-line is linear and thus that C₁ is constant and thus independent of income (y)

Question 17

Should production = demand?

Answer 17

Production does NOT need to equal demand in a market because of firms’ inventories (they can supply from their inventories or if the demand is low produce more than the demand and increase their inventory)

Question 18

What is a multiplier?

Answer 18

A multiplier is a number that gives the increase in Y when an exogenous variable increases by 1. Be aware that the multiplier might differ from one exogenous to another in the same economy.

Question 19

What are the two types of money?

Answer 19

Currency (bills, coins

Checkable deposits (bank deposits)

Together this is M1

Question 20

Write up money supply = money demand and explain how the interest rate affect money demand

Answer 20

M^S=M^D

M = $Y L(i) ==> In terms of dollar

M/P = Y*L(i) ==> in terms of goods

i has a negative effect on money demand meaning that an increase in i will decrease money demand. People will hold on to their money.

++ Note that in IS-LM we use REAL money supply and REAL money demand

Question 21

What are the central bank’s assets and liabilities and what are normal banks’?

Answer 21

Question 22

What is the money multiplier?

Answer 22

The money multiplier: 1/(c+θ(1-c)) ==> is larger than 1 meaning that increases in H leads to more than one-to-one increases in money supply

• θ = amount of reserves as a percentage of deposits (by law minimum 10 %)
• c = currency
• The lower c and θ, the larger the multiplier

Supply of money: M^s= 1/(c+θ(1-c)) H^s

• The formula tells us how M^s is affected by changes in H^s (central bank money)

Demand for money: M^D = $Y*L(i)

Question 23

Instead of supply and demand of the central bank money being equal we can look at:

Answer 23

• Supply and demand for bank reserves
• The overall supply and the overall demand of money

Question 24

What is investment (I) influenced by?

Answer 24

I = I(Y,i)

Y has a positive effect and i has a negative effect

Question 25

Why is the LM curve upward sloping?

Answer 25

Equilibrium in financial markets implies that, for a given real money supply, an increase in the level of income, which increases the demand for money, leads to an increase in the interest rate. This relation is represented by the upward-sloping LM curve.

Question 26

ISLM: visualize an increase in T

Answer 26

Question 27

ISLM: visualize an increase in G

Answer 27

Question 28

ISLM: visualize an increase in money supply

Answer 28

Question 29

ISLM: visualize a decrease in money supply

Answer 29

Question 30

ISLM: visualize an increase in Y

Answer 30

Question 31

ISLM: visualize an increase in i

Answer 31

Question 32

Why can’t changes of fiscal/monetary policy not be seen immediately in the economy?

Answer 32

• Consumers are likely to take some time to adjust their consumption following a change in disposable income. 

• Firms are likely to take some time to adjust investment spending following a change in their sales. 

• Firms are likely to take some time to adjust investment spending following a change in the interest rate. 

• Firms are likely to take some time to adjust production following a change in their sales. 


Question 33

What is a liquidity trap?

Answer 33

A liquidity trap is when the interest rate is equal to zero

The central bank can increase liquidity—that is, increase the money supply. But this liquidity falls into a trap: The additional money is willingly held by people at an unchanged interest rate, namely zero. If, at this zero interest rate, the demand for goods is still too low, then there is nothing further conventional monetary policy can do to increase output.

Question 34

Why does fiscal expansions have a limit?

Answer 34

Fiscal policy also has its limits since a government cannot run with large budget deficits for a longer period.

At some point lenders will start misbelieving in the country’s ability to pay back its loans and will thus start increase the interest rate. Thus, countries with too large debt are in risk of running into a spiral where the debt is constantly increasing due to rents.

Question 35

How is the goods market, financial markets and factor markets affected by openness?

Answer 35

• Goods market: consumers can choose between domestic or foreign products but there are still quotas and tariffs
• Financial markets: the ability to trade foreign assets. Many countries still have capital control of both the domestic population’s investments overseas and foreign investors in their own country
• Factor markets: possibility of producing overseas and workers can move between borders and work in different locations

Question 36

How can export exceed GDP?

Answer 36

This is due to import of intermediate goods to produce the goods exported.

Example:

Export: 100, Import: 90, NX = 10

C = 10, I = 10, G = 10

Y = 40 < exports = 100

Question 37

What is the nominal exchange rate?

Answer 37

The price of the domestic currency in terms of foreign currency (it can also be the other way around. The foreign currency in terms of the domestic currency)

1 DKK = 0.13 Euro

(1 Euro = DKK 7.45)

Question 38

What is the real exchange rate and how do you calculate it?

Answer 38

The price of domestic goods in terms of foreign goods, denoted by ∈. The real exchange rate determines your choice between consuming domestic or foreign goods.

∈ = EP/(P^* (the foreign price))

When increasing, domestic goods are becoming more expensive relative to foreign goods and NX decrease (Marshall-Lerner)

Selling bike at P = 4000 DKK ⇒ exchanging into euros and get 520 euros ⇒ go to Germany where the price of a new bike is 260 euros (P^*). Thus EP/P^* = 520/260=2. or (4000x0.13)/260 = 2.

Question 39

What is the balance of payment? (current account balance)

Answer 39

The balance of payment is a record of all payments or monetary transactions between a particular country and the rest of the world during a specific time period.

It is taking both trade flows and financial flows into account.

Question 40

What are the components of the balance of payments? (current account balance)

Answer 40

Current account balance:

• Import and export
• Net income: Income of financial assets for domestic and population foreign population (income received – income paid; salaries, income from financial investments, dividends etc.)
• Net transfers received (negative for developed countries; it is donor money for emerging markets) aids, donations, workers’ remittances

The capital account:

• Value of assets (foreigners lending money to the country)
• Buying assets overseas
• Net capital flows/capital account balance

Statistical discrepancy

The current account and the capital account are mirrors of each other and should equal. However, because of statistical difficulties Statistical discrepancy occurs (the difference between current account balance and the capital account balance).

Question 41

What is the uncovered interest parity condition and how what is the equation?

Answer 41

Uncovered interest parity, or interest parity for short, is an arbitrage condition stating that the expected rates of return in terms of domestic currency on domestic bonds and foreign bonds must be equal.

i = i^* - ((E^e-E)/E)

If E^e < E then ((E^e-E)/E) will be negative (<0) and i will have to by larger than i^*

Or: E = (1+i)/(1+i*) * E^e

• If domestic interest rate, i increases, E increase
• If foreign interest rate, i* increases, E decreases
• If E^e increases, E increases

Question 42

What is NX and the quation for it?

Answer 42

NX = net exports which is exports - imports

NX = X(Y^*, ∈) - IM(Y, ∈)

+ - + +

∈ is negative for X (higher real exchange rate, less export because the domestic goods are more expensive for foreigners)

IM/∈ ==> converting the imported goods into the values of those goods in terms of domestic prices and currency

NX decreases as Y increase

DD(domestic demand), AA(domestic demand for domestic goods), ZZ(domestic demand for domestic goods + exports)

Question 43

What is the full equation of the IS-relation in an open economy?

Answer 43

Y = C + I + G + NX

Y = C₀+C₁(Y-T) + I(Y, r) + G + X((Y^*, ∈)1) - IM 1/∈((Y, ∈)

r instead of i ==> REAL interest rate

Y = C₀+C₁(Y-T) + I(Y, i) + G + NX(Y, Y*, ∈)

An increase in the interest rate will

1) Decrease Invesment
2) Decrease NX through the appreciation of the currency making domestic goods more expensive (decrease in X and increase in IM)

Question 44

What happens to the multiplier in an open economy if a decrease in the marginal propensity to import occurs?

Answer 44

The multiplier will increase if a reduction in the marginal propensity to import occurs.

Question 45

What will happen to NX if C, I or G increases in an open economy?

Answer 45

In an open economy, an increase in domestic demand (by changing C, I or G) has a smaller effect on domestic output than in a closed economy because some of the increased demand will be used on foreign goods. Thus, the increased domestic demand will lead to an increased trade deficit.

Thus an expansionary fiscal policy will decrease NX.

Question 46

What happens to NX if Y* increases?

Answer 46

Increase in foreign demand leads to an improved trade balance because exports increase more than the increase in import as a result of the increased domestic income.

Unfortunately we do not control Y^*.

Question 47

What is the Marshall Lerner condition?

Answer 47

The Marshall Lerner condition says that when:

E decreases==> ∈ decreases (EP/P*) ⇒ increase in exports + decrease in import (over time; J-curve - the time-frame is ignored with the Marshall-Lerner condition)

Z= C + I + G + X (Y*, ∈) - IM (Y, ∈) ∙1/∈

Quantity effects: X up, IM down (Z increases)

Price effect: (1/∈) increases (Z decreases)

Question 48

What is the affect of a depreciation in an open economy?

Answer 48

First

• Depreciation will first lead to an even bigger trade deficit. Over time it will be improved. Thus we have J-curve (typical delay time is 6-12 months but it can take years)
• Prices will change first (1/∈)
• Then quantities in import and export will change
• Net exports and output will be improved

Depreciation leads to a shift in demand, both foreign and domestic, toward domestic goods. This shift in demand leads, in turn, to both an increase in domestic output and an improvement in the trade balance.

Question 49

How can you improve your trade balance while keeping Y constant?

Answer 49

• Depreciation of the currency to increase exports and improve the trade balance
• Lower domestic demand by decreasing government spending (G)

Question 50

How does currencies adjust an economy’s trade deficit?

Answer 50

• Imports larger than exports
• Large purchases of foreign currency (to pay imports)
• Value of the domestic currency goes down (nominal exchange rate): depreciation
• Thus, exports will increase + imports decrease è demand increase è output increase è multiplier effect.
• Increase in output and improvements of the trade balance

Question 51

What happens when i increases in a closed and in an open economy?

Answer 51

Closed economy:

i increase==>I decrease==>Z decrease==>Y decrease

Open economy:

i increase==>I decrease==>Z decrease==>Y decrease

and

i increase==>E increase==> NX decrease ==>Z decrease==>Y decrease

Question 52

What is the effect of an increase in G on C, I, G and NX in an open economy?

Answer 52

G increases

C increases as Y(income) increases (multiplier effect of increase in G)

Interest rate increases: I decreases + second effect: E increase = appreciation ==> i will have to decrease and thus I is ambiguous

Due to appreciation NX will decrease (cheaper to import, more expensive for foreigners to buy domestic goods (export))

Question 53

What is the effect of a monetary contraction in an open economy? (effect on C, I, G, NX)

Answer 53

G is constant

C will decrease as Y(income) decreases

i increases so I decrease + i increase forcing an appreciation which will …

NX decreases due to the appreciation

Question 54

What is the main implication of a fixed exchange rate system regarding policy?

Answer 54

Under fixed exchange rates, the central bank gives up monetary policy as a policy instrument. With a fixed exchange rate, the domestic interest rate must be equal to the foreign interest rate. And the money supply must adjust so as to maintain the interest rate.

Fixing ⇒ Expected E = E and i= i*

Question 55

When will a fiscal expansion increase Y most; fixed of flexible exchange rate regime?

Answer 55

Fixed exchange regime because fiscal policies ALWAYS will be accomodated by monetary policy to maintain the interest rate so that i = i^*

Question 56

What is labor supply and labor demand?

Answer 56

Labor supply: total hours that workers wish to work for a given real wage rate

Labor demand: quantity of labor (in hours) that is demanded by firms for any given real wage rate

Question 57

What is a reservation wage?

Answer 57

The wage that would make a worker indifferent between working and being unemployed

Question 58

What are the three main non-competitive features of the labor market?

Answer 58

• Collective bargaining: wages bargained by labor unions
  
  • Unions have higher bargaining power than the individual
  • A general rule of thumb: the more skills that are needed to do a job, the more bargaining there will be (McDonalds is take it or leave it)
• Individual bargaining power: this depends on
  
  • Cost of replacing for the company
  • How hard it would be for the employee to find another job if quitting Firms derive bargaining power if it is hard to find a new job (matching frictions)
• Efficiency wages:
  
  • Companies seeing morale and commitment as essential pay higher wages
  • High employee satisfaction equals higher productivity
  • Low unemployment equals higher wages

Question 59

What affects the wage level? (the equation and its components)

Answer 59

W = P^e F(u,z)

W/P = F(u,z)

• Proportional with P^e (assumption)
• Increased u = lower nominal wages (W)
• Increase in z = increase in W
  
  • Unemployment insurance (increases nominal wages at any given unemployment rate)
  • Minimum wages
  • Employment protection: the more expensive it is to lay off workers, the higher bargaining power an employee will have and thus higher nominal wages

Question 60

What is the wage-setting and price-setting relations and how does these affect the natural level of unemployment, u_n?

Answer 60

Wage-setting relation (WS): W/P = F(u,z)

• W = P^e * F(z, u)
  
  • Wages will be higher, the lower the unemployment and the higher the exprected prices, P^e
  • z = other favtors such as unemployment benefits etc.

Price-setting relation (PS): W/P = 1/1+m

• P = (1+m) W
  
  • ​Firms set higher prices, the higher the cost (wages)
  • (1+m) is other factors that affect prices

At the equilibirum we have U_n

Question 61

Why does u not need to equal u_n?

Answer 61

In general, the actual price level may turn out to be different from the price level expected by wage setters. Therefore, the unemployment rate need not be equal to the natural rate of unemployment.

Question 62

What happens to Y_n as U_n increases?

Answer 62

If u_n increases, Y_n will decrease

Question 63

What happens to U_n and Y_n when a new law makes monopolies and cartels illegal?

Answer 63

This will decrease firm’s markups, m

Decreasing m will shift PS up and thus u_n down and Y_n up

AS curve will shift down and P will decrease and Y increase

Question 64

What happens to Un and Yn when the government increases the minimum wage?

Answer 64

An increase in the minimum wage, will increase z and thus increase wages moving the WS relation to the right.

Conclusively, u_n will increase and y_n will decrease

AS curve will shift up and P will increase and Y decrease

Question 65

What happens to Un and Yn if the government chooses to save money by cutting in unemployment benefits?

Answer 65

Cutting in unemployment benefits will decrease z and shift the WS-relation to the left.

Thus, u_n will decrease and y_n will increase

AS curve will shift down and P will decrease and Y increase

Question 66

What is the AS relation and how does its components affect prices?

Answer 66

P=P^e (1+m) F(Y, z)

• When Y increases, N increases, u decreases and thus P increases (positive effect)
• As markup increases, P will increase (positive)
• As Z increases, P will increase (positive)
• P^e has a one-for-one effect on P. If prices are expected to increase, they will increase (through nominal wage increases, which increase costs and thus increases prices)

Question 67

What is the AD relation and how does its components affect output?

Answer 67

Y = Y(M/P, G, T)

• M/P has a positive effect. Increase in M/P (real money supply) will increase Y
• G has a positive effect. Increase in G, increases Y
• T has a negative effect. Increase in T will decrease Y.

Any variable other than the price level that shifts either the IS curve or the LM curve also shifts the aggregate demand relation.

Question 68

Does Y need to equal Y_n?

Answer 68

Not in the short run as P won’t neccesarily be equal to P^e. In the medium run prices will be adjusted and P will equal P^e and Y = Y_n

P^e from the AS relation will adjust over time

Question 69

Visualize and explain the effects of a monetary expansion in a closed economy on the IS-LM and AS-AD diagrams

Answer 69

Short run + First stage of the medium run: Money supply increases; The monetary expansion shifts the LM and thus AD curve to the right giving a higher Y in the short run (ISLM: from A to B + B to A’ because of the lower unemployment that leads to higher wages and higher prices – when prices increase, the real money supply M^s/P will decrease and LM will shift a bit up and output goes down), and AS-AD from A to A’)

Second stage medium run: A’ to A” in AS-AD. Prices have already increased in the first stage. Thus, expected prices will go up and the AS-curve will shift (nominal wages increase, prices increase and then real money supply M^s/P decrease (interest rate increase, output decrease) and as a consequence unemployment will increase.

Question 70

Visualize and explain the effects of a fiscal contraction in a closed economy on the IS-LM and AS-AD diagrams

Answer 70

Short run and first stage of medium run:

• Decreased G ==> IS curve will shift to the left to IS’. The interest rate will decrease to get money demand up to money supply (this is all A To B partially offsetting the negative effect on output because I increase).
• The AD curve will shift leftward (A to B (B is not marked) and B to A’ ==> decrease in prices which make real money supply M^S/P increase and thus LM curve will shift down to LM’ (and output increase a bit + interest rate decrease a bit

Second stage medium run: (always a change in expectations)

• Prices are lower than the expected and thus expected prices will go down and AS-curve will shift down (AS to AS”) and we will get from A’ to A”
• From A’ to A” prices decrease and the real money supply M^S/P increase even more and we will see LM’ shift to LM”.

Question 71

Visualize and explain the effects of expansionary fiscal policy decreasing taxes in a closed economy on the IS-LM and AS-AD diagrams

Answer 71

Short run: Decrease in T will shift IS curve right to IS’ and AD right to AD’ causing increased interest rate, increased Y and increased prices

First stage medium run: The increase in Y, lower unemployment rate and higher prices will be partially offset by a decrease in M^s/P shifting LM to LM’ and AD’ to AD’’

Second stage medium run: At A”: P > P^e. Thus, in the second stage medium run price expectations will change until P = P^e and Y = Y_n. As prices increase, M^s/P will decrease and LM’ will shift up to LM” and the AS-relation (with P^e) will shift up to AS’. The new equilibrium points will be A’’’. We conclude that interest rate has increased, prices have increased and that output, Y is the same.

Composition of GDP:

C will have increased due to lower T, I will have decreased due to higher interest rate and G is the same.

Question 72

AS is the same in an open economy but how does AD differ from a closed to an open economy?

Answer 72

AD in closed economy:

P increases, M/P decreases, LM shifts leftwards, interest rate increases, money demand decreases, investment decreases, output decreases (AD is downward sloping).

AD in an open economy: Two effects

1. P increases, M/P decreases, LM shifts leftwards, interest rate increases, money demand decreases, investment decreases, output decreases (AD is downward sloping).
2. Price level increase ==> Real appreciation (EP/P^*) ==> NX decreases (Marshall Lerner condition) ==> Output decreases

Effect 2 is ONLY IN FLEXIBLE EXCHANGE RATE SYSTEMS Because in fixed exchange rate regimes money supply will be increased if prices increase to keep the ratio M^s/P constant and interest rate, Investment + Output constant.

Question 73

AS-AD in open economy with flexible exchange rates. Visiualize and explain a fiscal expansion on AS-AD

Answer 73

• G increase or T decrease ⇒ IS shift to the right (output increases, the interest and the nominal exchange rate increases (E= (1+i)/(1+i^* ) E^e), decreasing investment and NX which partially offset the initial increase in output.
• In AS-AD the AD curve shifts rightwards (output is higher for a given price level) ⇒ A to A’ A’ to C ⇒ P increases ⇒ M/P will change and shift LM curve up, interest rate increases, investment decreases and Y decreases.
• Second effect (exchange rate) P increases, ∈ (EP/P*) increase, NX decrease (Marshall-Lerner), IS left ⇒ Y decrease

When working with AS-AD in open economy you are not supposed to draw IS-LM because it will get too messy due to many stages (you might have to do it in short-run only though)

Question 74

AS-AD in open economy with flexible exchange rates. Visiualize and explain a monetary expansion on AS-AD

Answer 74

• M/P increases ⇒ LM shift to the right ⇒ Y increase, interest rate decreases, I increases, NX increases
• AD curve shifts right (from A to A’)
• Output increases, unemployment decreases, nominal wages increase, p increase and y will decrease.
• In IS-LM ⇒
  
  • 1) Increase in P will decrease M/P and LM will shift left
  • 2) Increase in P will lead to real appreciation and decrease in NX and IS will shift leftward
  • In AS-AD we move from A’ to C.

When working with AS-AD in open economy you are not supposed to draw IS-LM because it will get too messy due to many stages (you might have to do it in short-run only though)

Question 75

AS-AD in open economy with fixed exchange rates. Visiualize and explain a monetary expansion on AS-AD

Answer 75

Not possible

Monetary policy cannot be used since a change of LM will change the interest rate that will lead to a change in the nominal exchange rate.

Question 76

AS-AD in open economy with fixed exchange rates. Visiualize and explain a fiscal expansion on AS-AD

Answer 76

When doing so, the central bank will have to do monetary expansion at the same time, otherwise the interest rate will not stay constant and currency will appreciate.

• Both IS (increasing interest rate and output) and LM (decreasing interest rate and increasing output) will shift right. A to A’
• From A’ to C ⇒ Prices increase, Money supply and M/P will be constant
• ⇒ P increase, ∈ increase, NX decrease, IS shifts left + LM left (contractionary monetary policy to keep M/P constant and interest rate constant) and Y decrease.

When working with AS-AD in open economy you are not supposed to draw IS-LM because it will get too messy due to many stages (you might have to do it in short-run only though)

Question 77

Assume Y < Y_n. How do we get back to Y_n without using monetary and fiscal policies?

Answer 77

Expectations in prices will change and the AS curve will shift.

• First, as prices go down, real money supply increases: similar to an expansionary monetary policy (only for flexible exchange rate regime)
• Second, as prices go down, the real exchange rate depreciates and this leads to an increase in net exports

Question 78

Why must investment equal savings?

Answer 78

What firms want to invest must be equal to what people and the government want to save

Equilibrium in a market is either stated as:
Production = demand, or
Investment = savings (private + public savings)

Y = C + I + G
Y – T = C + I + G – T (subtracting T from both sides)
Y – T – C + T – G = I (isolating I)
Spri + Spub = I.

You can see the IS relation as:
i ==> I (planned investment) ==> Y

Y ==> S ==> I

Question 79

What is the simple equation of the current acount balance and what does a current account surplus imply?

Answer 79

CA = S + (T - G) - I

NX = S - I

Current account surplus: Savings > Investment

Current account deficit: Savings < Investment

Question 80

What will happen to the exchange rate in an open economy when making a monetary expansion?

Answer 80

Monetary expansion will decrease the interest rate and thus make it less attractive to invest in the domestic country. Thus, the demand for domestic currency will fall and the currency will have a real depreciation (EP/P*)

Question 81

What will happen to the exchange rate in an open economy when making a fiscal expansion?

Answer 81

Fiscal expansion will increase the interest rate and thus make it more attractive to invest in the domestic country. Thus, the demand for domestic currency will increase and the currency will have a real appreciation (EP/P*)

Question 82

What are the three power rules that you have to remember by heart?

Answer 82

1/x² ==> rewrite as x^-2

(x^1/2)^2/3 ==> x^1/2*2/3 ==> x^1/3

3x^1/2 = x^2/3 ==> 3 = x^2/3-1/2 ==> 3 = x^1/6

Question 83

What is the effect of an increase in G on G, C, NX, and I?

Answer 83

• G increases
• C increases as Y(income) increases (multiplier effect of increase in G)
• Interest rate increases: I decreases + second effect: Y has increased and I will increase so I is ambiguous
• Due to appreciation NX will decrease (cheaper to import, more expensive for foreigners to buy domestic goods (export))

Y = C0+C1(Y-T) + I(Y, i) + G + X((Y*, ∈)1/E) - IM((Y, ∈)1/E)

This explains ∈ ==> E = ((1+i)/(1+i*))*Ee

Question 84

What is the effect of a monetary contraction in an open economy? (Effect on C, I, G, NX)

Answer 84

• G is constant
• C will decrease as Y(income) decreases
• i increases so I decrease + Y decrease and will decrease I even more
• NX decreases due to the appreciation (higher interest rate will make E appreciate)

Y = C0+C1(Y-T) + I(Y, i) + G + X((Y*, ∈)1/E) - IM((Y, ∈)1/E)

This explains ∈ ==> E = ((1+i)/(1+i*))*Ee

Question 85

What is the intuition behind the slope of the IS curve? How would the IS curve be affected by an increase in the sensitivity of investment to changes in the interest rate?

Answer 85

IS curve: i↑, I↓, Y↓: the IS curve is downward sloping

If the sensitivity of investment to changes in the interest rate increases, it means that an increase in the interest rate will lead to a large decrease in investment, and therefore in output. The IS curve is flatter the higher this sensitivity.

Question 86

ØWould a decrease in reserves have a larger or smaller effect on output if investment were very sensitive to changes in the interest rate?

Answer 86

Decrease in reserves: money supply increases, LM shifts rightwards.

In order to maintain the equilibrium on the money market, the interest rate decreases. This has a positive effect on investment and output, and this positive effect is larger when investment is very sensitive to variations in the interest rate.

Question 87

For this question, assume that there is a simultaneous tax increase and monetary expansion. In a flexible exchange rate regime, we know with certainty that

a) the exchange rate and output would both increase.
b) the exchange rate would increase and output would decrease.
c) the exchange rate would decrease.
d) the exchange rate would decrease and output would increase.
e) none of the above

Answer 87

c) the exchange rate would decrease.

Question 88

In an open economy, which of the following would tend to make the multiplier smaller?

a) an increase in the marginal propensity to consume
b) an increase in the marginal propensity to save
c) a reduction in taxes
d) a reduction in government spending
e) a decrease in the propensity to import (sensitivity of imports to changes in domestic

income)

Answer 88

b) an increase in the marginal propensity to save

Question 89

In an open economy, the equilibrium on the goods market is characterized by:

a) savings equal investment
b) output equals consumption
c) net exports equal savings minus investment
d) taxes equal government spendings
e) both (b) and (c)

Answer 89

c) net exports equal savings minus investment

Question 90

Suppose that, due to the effects of a military conflict that has ended, a country experiences a large reduction in its capital stock. Assume no other effects of this event on the economy. Which of the following will tend to occur as the economy adjusts to this situation?

a) a relatively low growth rate for some time
b) a relative high growth rate for some time
c) zero growth for some time, followed by a gradually increasing growth rate
d) positive growth, followed by negative growth, and then zero growth
e) none of the above

Answer 90

b) a relative high growth rate for some time

Question 91

For this question, assume that policy makers are pursuing a fixed exchange rate regime and that output is initially at its natural level. A devaluation causes which of the following in the medium run?

a) an increase in the interest rate b) an increase in investment
c) a decrease in the price level d) an increase in net exports

e) none of the above

Answer 91

e) none of the above

Question 92

How can a country with flexible exchange rate regime reduce its trade deficit?

Answer 92

Expansionary monetary policy to achieve both a lower interest rate and a decrease in the exchange rate—a depreciation. 


Question 93

How can a country with fixed exchange rate regime reduce its trade deficit?

Answer 93

It cannot use fiscal or monetary policies to do so since E is fixed and i = i*.

Only opportunity in the short run would be to devaluate the currency but this wil be risky in case the financial market will fear an additional devaluation afterwards.

A devaluation leads to a real depreciation that pushes net exports up. The aggregate demand curve shifts rightwards (output is higher for a given price level). We go from A to A’ (not in the graph).

Output goes up, unemployment goes down. Workers bargain for higher nominal wages. Prices go up.

Increase in prices will cause an appreciation which will decrease NX and thus partially offset the increase in Y (we move from A’ to C)

Question 94

If output is below Y_n for an economy with fixed exchange rates, how will it get back to its natural level of output in the medium run?

Answer 94

As long as output is below the natural level of output, the price level de- creases. The decrease in the price level over time leads to a steady real depreciation (EP/P*). This real depreciation then leads to an increase in output until output has returned to its natural level (foreign price level assumed to be constant)

Question 95

What are the two options of a country faced by expectations of currency devaluation?

Answer 95

• Give in and devalue (or exit the fixed exchange rate system)
• Fight and maintain the parity at cost of a very high interest rate and a potential recession (risk of exhausting all the foreign reserves and being obliged to devalue at some point)
  
  • i = i* - ((E^e-E)/E)

Question 96

There is wide agreement among economists that flexible exchange regimes generally dominate fixed exchange rate regimes, except in two cases - what are these?

Answer 96

• When a group of countries is highly integrated and forms an optimal currency area. (You can think of a common currency for a group of countries as an extreme form of fixed exchange rates among this group of countries.) For countries to form an optimal currency area, they must either face largely similar shocks, or there must be high labor mobility across these countries. 

• When a central bank cannot be trusted to follow a responsible monetary policy under flexible exchange rates. In this case, a strong form of fixed exchange rates, such as dollarization or a currency board, provides a way of tying the hands of the central bank. 


Question 97

What is the Malthusian trap?

Answer 97

Malthusian trap: using all output growth on population growth and thus no growth in output per capita

Question 98

What is the idea of the Solow model? (The steps)

Answer 98

K ==> Y (Income/output) ==> Savings/Investment ==> K (back to the beginning and going round in circles)

Question 99

What are the three limiting assumptions of chapter 11?

Answer 99

In chapter 11 we assume that: (to clearly see capital accumulation)

• N is constant (and thus population size, unemployment rate and participation rate also constant) è thus output per worker, output per capita and output itself all move proportionately
• No technological progress
• savings are only private savings. S = I. We assume that private savings, S is proportional to income so I = sY

Question 100

What is the steady-state and how is it found graphically?

Answer 100

Steady state: The state in which output per worker and capital per worker are no longer changing is called the steady state of the economy.

k_t+1 - k_t = f(k_t ) -δk_t

_==>

Where sf(k_t ) -δk_t = 0 = the steady state denoted by k^*

sf(k) = sy = i

Graphically the steady state is found where the depreciation-line (chapter 11) or required investment line (chapter 12) is crossing the investment line.

Investment per worker has the same shape as the production function (output per worker) but is lower by the factor s (the saving rate).

Question 101

How does the saving rate affect output growth per worker and the steady state and how does an increase in the saving rate look graphically?

Answer 101

• No affect in the long run (in the long run, the growth rate of output is equal to zero, no matter what the saving rate is – it will be at its steady state).
• The saving rate determines the level of output per worker in the long run. Other things being equal, countries with a higher saving rate will achieve higher output per worker in the long run.
• An increase in the saving rate will lead to higher growth of output per worker for some time, but not forever (the steady state level increases) and the investment-curve rotates up.

The saving rate affects the level of output per person—but not its rate of growth ==> growth rate is determined by technological progress

Question 102

What is the concept of the golden rule?

Answer 102

The golden rule level so s, s_GR (k/n)_GR is the value of steady-state k/n that maximises consumption per person, c/n.

In steady state, C/N is equal to Y/N - δK/N

• For s between zero and sG (G for golden rule), a higher saving rate leads to higher capital per worker, higher output per worker, and higher consumption per worker.
• For s larger than sG , increases in the saving rate still lead to higher values of capital per worker and output per worker; but they now lead to lower values of consumption per worker ==> This is because the increase in output is more than offset by the increase in depreciation due to the larger capital stock.
• C = (1-s)Y (if S = 1 ==> consumption will be zero). If s is high consumption will be lower but investment, capital, and output high (pushes consumption up

Question 103

How do you find the optimal saving rate?

Answer 103

The optimal saving rate that maximizes C at the steady state differs from exercise to exercise. To find the optimal s, you will have to write up C* as a function of k* and then figure out what k* is.

1. Express C^* as a function of s
2. Take the deriviative of C^*with respect to s
3. Set the deriviative equal to 0 and solve for s to get the golden rule value of s (optimization-problem and thus setting equal to zero)

The golden saving rate is where the difference/gap between f(k*) and k* is biggest.

Question 104

Why is the state of technology important?

Answer 104

The state of technology tells us how much output can be produced from given amounts of capital and labor at any time. 


Y = F(K, AN)

Question 105

What is AN?

Answer 105

AN = effective labor; doubling A (technologic state) we only need half N to produce the same Y and (if A doubles we can also think of it as we are now having twice as many workers, N).

Question 106

What are the main difference between chapter 11 and 12?

Answer 106

Conclusions in the two chapter are the same despite that output can grow forever in chapter 12 due to technologic progress.

In chapter 12 we are focusing on output per effective worker Y/AN and capital per effective worker (K/AN) in stead of output per worker Y/N and capital per worker K/N.

Question 107

What are the components of the required investment line, I^r?

Answer 107

The straight line is now equal to not only the depreciation rate but also the increase in effective workers (from technological progress), which is equal to:

g_A (technological progress) + g_N (population growth)

I/AN (or i^r) = (δ + g_A + g_N) K/AN

Question 108

What happens when g_N increases?

Answer 108

The steady state decreases because the required investment line becomes steeper (an increase in break-even investment).

Question 109

What happens when g_A decreases?

Answer 109

The steady state increases because the required investment line becomes flatter (a decrease in break-even investment).

Question 110

What is the growth rate of capital and output equal to in its steady state?

Answer 110

See picture

Said differently, the steady state is characterized by the growth rate of output being equal to the growth rate of capital, itself being equal to the sum of the growth rate of population and the rate of technological progress.

This is called balanced growth: capital, output and effective labor (AN) grow at the same rate g_N + g_A

At the same time output per worker and capital per worker grow at the same rate: g_A

Steady state = Long run = Balanced growth

Question 111

What are the characteristics of balanced growth?

Answer 111

Balanced growth = long run = steady state

In steady state, output per effective worker and capital per effective worker are constant. Put another way, output per worker and capital per worker grow at the rate of technological progress.

Put yet another way, output and capital grow at the same rate as effective labor, and therefore at a rate equal to the growth rate of the number of workers plus the rate of technological progress. When the economy is in steady state, it is said to be on a balanced growth path.

Question 112

How do you achieve a higher technological progress?

Answer 112

• Investments in R&D
• Fertility of research: Understood as number of ideas generated by the R&D investment ==> this is related to the education level (human capital)
• Appropriability of research results: If companies can profit from the research results (patents). If not investments in R&D will be low. If not, the fertility of research in the industry will be low. If one company develops a good product, will another company develop an even better just after?

Question 113

Which of these countries in the table below has not yet reached their steady-state and how do we know?

Answer 113

Capital per worker (K/AN) and output per worker (Y/AN) grow at a rate that is higher than g_A for France, United Kingdom and United States. This output growth rate is higher the further the economy is from its steady state + this also depends on the savings rate (an increase in the savings rate leads to a temporary increase in the growth rate)

It looks like Japan is above their steady state.

Question 114

What are the four math-rules from Claes?

Answer 114

√x = x^0.5

x^ax^b = x^ab

x^a/x^b = x^a-b

(x^a)^b = x^ab

Question 115

What is the steady state condition in per worker terms?

Answer 115

k_t+1-k_t = sy - δk_{t (per worker terms)}

Then we know that

0 = sy - δk_t

sy = i = sf(k)

_{y = is the value that we will have calculated in the exercise and should therefore be replaced. After this you can sovle for k* and hereafter solve for y* and c*.}

Question 116

What does neutrality of money mean and why is fiscal policies not neutral in the medium run?

Answer 116

The neutrality of money in the medium-run means that:

• Monetary policies are neutral in the sense that in the medium run it does not affect i or the composition of Y.
• Fiscal policies does not affect the level of Y in the medium run either, but it does affect the composition of Y because the interest rate differs from its starting point (which is not the case with monetary policies).

Question 117

What would be the effects of a devaluation for a country with fixed exchange rate regime? (assuming we are below Yn)

Answer 117

• A devaluation leads to a real depreciation that pushes net exports up. The aggregate demand curve shifts rightwards (output is higher for a given price level). We go from A to A’.
• Output goes up, unemployment goes down. Workers bargain for higher nominal wages. Prices go up.
• This has an effect on the IS-LM graph.
  
  • an increase in prices leads to a real appreciation and to a decrease in net exports: IS shifts leftwards.

As a result, output decreases: in the AS-AD graph, we move along the new AD curve from A’ to C.

Remember there is an increased risk of an exchange rate crisis related to the use of devaluations.

Question 118

What is an exchange rate crisis and what are the two possible solutions?

Answer 118

An exchange rate crisis starts if the financial market believe a currency is overvalued or soon will be devalued.

i_t = i*_t - (E^e_t+1-E_t)/E_t

If E^e is lower than E, investors will require a higher domestic interest rate, i.

This higher i, will decrease I (and C because it is more expensive to borrow) and thus decrease Y.

Solutions:

• 1) Try to maintain the the parity by setting a higher interest rate with the risk of creating/worsening a recession. Furthermore there is a risk of selling out all foreign reserves and thus being forced to devalue or to exit the fixed exchange rate system.
• 2) Give in and devalue (or exit the fixed exchange rate system)

Question 119

What is the relation between S=I and NX?

Answer 119

If Savings > Investment = trade surplus (lending money out, net creditor)

If Savings < Investment = Trade deficit (borrowing money, net debtor)

Question 120

Why does an equal increase in G and T increase Y?(Balanced budget)

Answer 120

Goods market closed economy:

1/1-c1 (c₀- c₁t₀ + G)

Delta Y/Delta T = (1/1-c1)* -c1

Delta Y/Delta G = (1/1-c1)

1/1-c1 - (1/1-c1)*-c1 = 1-c1/1-c1 = 1

Thus, G and T are not macroeconomically neutral. Y can be affected while still remaining a balanced budget.

Question 121

What are the equations of the IS and LM curves in an open economy taking both the goods market and the two money markets (bonds, exchange rate) into account?

Answer 121

LM: M^s/P (= M^d/P) = F(Y, i)

IS: Y = C(Y-T) + I(Y, r) + G + NX(Y, Y*, ((1+i)/(1+i^*)*E^e)

IS: Y = C(Y-T) + I(Y, r) + G + NX(Y, Y*, ∈)

DUE TO SIMPLIFICATIONS of P^e=P and real interest rate = interest rate:

IS: Y = C(Y-T) + I(Y, i) + G + NX(Y, Y*, E)

Positive vs. negative effects of NX:

• Y Negative
• Y* Positive
• E or ∈: Negative

Question 122

What are the three steps in finding the golden rule saving rate?

Answer 122

1) Express c* as a function of s
2) Take the deriviative of c* with respect to s
3) Set the deriviative equal to 0 and solve for s to get the golden rule value of s.

Question 123

What is the paradox of thrift?

Answer 123

The paradox of thrift states the fact that following an increase in C₀, G (or another exogenous variable), which may be thought of as a desire to decrease savings, s may actually end up unaffected.

Why?

S will be unaffected in cases where I is independent of income. Ex. if I = b₀ or if I = b0 + b₁Y where b₀ = 200 and b₁ = 0

However, even though the nominal amount of savings haven’t changed, savings RELATIVE to income (y), which will have increased, will have changed.

Question 124

What is the idea of the J-curve?

Answer 124

The J-curve states the fact that in the real world, NX will increase if ∈ decreases (Marshall-Lerner condition). However, according to the J-curve this will not happen immediately.

In the beginning a devaluation of E (∈ decreases) will decrease NC since the quantities don’t change immediately. Thus, in the beginning import is becoming more expensive but the quantities of both X and IM is the same.

Over time, quantities will adjust and import will decrease as P* has increased and X will increase as ∈ has decreased.

The process takes some time (aprox. 3-9 months)

Question 125

What determines nominal money supply?

Answer 125

Nominal money supply is a question of how much money citizens hold in bank deposits and currency.

It is an exogenous vairable determined by the central bank. If the central bank wants to decrease money supply, they will SELL bonds to get currency that they can put back into the central bank cellar and thus take the money out of the system.

Question 126

What are the three assumptions we take regarding the foreign exchange market?

Answer 126

1) All trade of foreign currency is made with the aim of traing bongs (financial assets) and thus not goods/services.
2) There are no restrictions on trading currency and bonds between countries ==> Perfect capital mobility
3) Financial investors care ONLY about the expected return (therefore not risk and other factors).

Question 127

What is the interest parity condition in flexible and fixed exchange rate systems?

Answer 127

• Fixed: We assume E^e = E and thus i = i*
  
  • You can of course always devalue or change to a flexible exchange system.
• Floating: NO reason to assume E^e = E. E^e will typically be different than E and thus the full UIP becomes important: i = i* - (E^e-E)/E
  
  • 1+i = (1+i*) E/E^e

Question 128

What is an automatic stabilizer?

Answer 128

An automatic stabilizer is making the effect on Y of a change in an exogenous variable smaller.

Examples:

• Income-dependent taxes
• Income-dependent import

Question 129

Why is the AD-curve downward sloping?

Answer 129

• P increase, M^s/P decrease, i increase, I decrease, Z decrease, Y decrease (+multiplier)
• P increase, M^s/P decrease, i increase ==> capital inflow, E increase, EP/P* increase, NX decrease, Z decrease, Y decrease (+ multiplier

The increase in the price level leads to a decrease in the real money stock. This monetary contraction leads to an increase in the interest rate, which leads in turn to a lower demand for goods and lower output.

Question 130

Why is the AS-curve upward sloping?

Answer 130

Y increase, N increase, u decrease, W increase, cost increase, P increase

Question 131

What is the relevant vocabulary regarding E and EP/P*?

Answer 131

Regarding E:

• Appreciation (changes in a free flowing currency market)
• Depreciation (changes in a free flowing currency market)
• Revaluation (when having fixed exchange rate systems)
• Devaluation (when having fixed exchange rate systems)

Regarding EP/P*

• Real appreciation
• Real depreciation

Question 132

What does the following equation say?

CA = S + (T-G) - I

Answer 132

Current account balance = Savings (Private) + Public - Investment

If Savings (private + public) > Investment = current account surplus and net creditor

If Savings (private + public) < Investment = current account deficit and net debtor

Question 133

What is the full IS and LM equations with the Mundell-Flemming model (open economy + foreign exchange rate market) and what happens regarding the IS-cruve when the interest rate increases?

Answer 133

IS: Y = C(Y-T) + I(Y, i) + G + NX(Y, Y*, ((1+i)/(1+i*)E^e)

LM: M/P = Y * L(i)

• The first effect, which was already present in a closed economy, is the direct effect on investment: A higher interest rate leads to a decrease in investment, a decrease in the demand for domestic goods, and a decrease in output.
• The second effect, which is only present in the open economy, is the effect through the exchange rate: An increase in the domestic interest rate leads to an increase in the exchange rate—an appreciation. The appreciation, which makes domestic goods more expensive relative to foreign goods, leads to a decrease in net exports, and therefore to a decrease in the demand for domestic goods and a decrease in output.

Question 134

What is the AD equation in an open economy with FIXED exchange rates, why has it changed and how does increases in P now affect output?

Answer 134

AD: Y = (EP/P*, G, T)

negative, positive, negative

M/P has been removed and replaced with EP/P*:

Under fixed exchange rates, the central bank gives up monetary policy as a policy instrument. This is why the money stock no longer appears in the aggregate demand relation.

EP/P* is added because we now work in an OPEN economy whereas the “traditional” AD curve is for a closed economy.

Increase in P’s affect on output:

• Closed economy: Increase in P, decreased M/P and increased the interest rate (decreasing M^d)
• Open economy with fixed exchange rates: Increase in P, increases real exchange rate (EP/P*) and thus makes domestic goods more expensive and thus decreases NX ==> Y ==> Multiplier
  
  • NB: in the short run the real exchange rate (EP/P*) is fixed, but in the medium run the real exchange rate will change due changes in prices

Question 135

What is required investment in chapter 12?

Answer 135

I^r = (δ + g_A + g_N) K/AN

δ = Depreciation rate

g_A = rate of technological progress

g_N = population growth (we assume ratio of employment to population to be constant)

g_A + g_N = Growth in effective labor

Question 136

With what growth rate does Y grow with in the steady-state? (chapter 12)

Answer 136

Y/AN and K/AN is constant in its steady state

Thus, Y must grow with the same ratio as AN, which grow with g_A + g_N ==> The same goes for K

Question 137

What does output per person grow with in the steady state? (chapter 12)

Answer 137

Output per PERSON grows with a rate of g_A (the technological progress) ==> output grows at the rate of g_{N +} g_A. Subtracting population growth g_N we get that output per PERSON grows at g_A.

Output per effective WORKER grows with a rate of 0.

Question 138

What are the determinants of growth in the long run? (chapter 12)

Answer 138

• R&D
• Fertility of research:
  
  • Understood as number of ideas generated by the R&D investment è this is related to the education level (human capital)
• Appropriability of research results
  
  • If companies can profit from the research results. If not investments in R&D will be low è patents, the fertility of research in the industry (if one company develops a good product, will another company develop an even better just after?),

Question 139

How do you find k* and what is k*?

Answer 139

k* is the steady state level og capital per worker (K/N).

To find k* there are three steps:

1) Rewrite the production function into per worker terms (dividing by N)
2) Write down the steady state condition: k_t+1 - k_t = sy - δk or equvialently: k_t+1 - k_t = sf(k) - δk (because sf(k) = sy = i)
3) Set the change (left side) of the equation equal to 0 and solve for k*.

When you have found k* you can find y* by plugging k* into the equation Y/N found in the beginning and c* = (1-c)y (if the saving rate is given).

Question 140

If the production function is equal to Y = K^1/3 N^2/3 then we know what?

Answer 140

k* = (s/δ)^3/2 ==> Inverse of N^x/y

y* = k^1/3 ==> Simply lower-case k^x/y instead of K^x/y

c* = (1 - s) y ==> c* = (1 - s) k^1/3

s_GR = 1/3 ==> From K^x/y

Question 141

When will we move along the IPC curve and when will we move along?

Answer 141

Rotation: Change in E^e_(fear) + Devalue/Revalue

Move along: Change in i