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EC 100 Summer Mock

EC 100 Summer Mock. General Exam Tips. Never leave a question blank. Writing anything (sensible) will get some marks. More (accurate) detail = more points. Give the relevant equations e.g. C=a+b(Y-T) When discussing policies, remember multiplier effects (& give equations!)

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EC 100 Summer Mock

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  1. EC 100Summer Mock

  2. General Exam Tips • Never leave a question blank. Writing anything (sensible) will get some marks. • More (accurate) detail = more points. • Give the relevant equations e.g. C=a+b(Y-T) • When discussing policies, remember multiplier effects (& give equations!) • Read the question carefully – e.g. Does it specify which graphs to use?

  3. Section A: Question 1 • You observe that output is above full-employment output. Politicians are arguing about the possible reasons. One party claims that this is due to a drop in world oil prices. The other party claims that this is due to an increase in consumer spending. Using aggregate supply-aggregate demand graphs, explain (a) how each of the above reasons could cause an increase in output, and (b) what evidence you could use to determine which one of these had occurred.

  4. Section A: Question 1 • Effects of oil price shock in AS-AD diagram? AS AS‘ P0 P1 AD G1 > G0 YA YB

  5. Section A: Question 1 • Effects of increase in consumer spending shock in AS-AD diagram? Suppose autonomous consumption, i.e. the intercept of the consumption function increases, so we have an upward shift of the consumption function independent of Y. AS P1 P0 AD(C1) C1 > C0 AD(C0) YA YC

  6. Section A: Question 1 • Evidence for which scenario is right? • Price levels

  7. Section A: Question 2 • Suppose the government decides to decrease taxes in an effort to increase consumer spending and investment in the economy. Will this plan succeed in accomplishing both goals? How the composition of aggregate demand affected?

  8. Section A: Question 2 • so tax cut directly increases C • Composition of Aggregate Demand: Y = C+ I + G • So what happens? …

  9. Section A: Question 2 • Crowding out lower T Lower T shifts out IS curve, inducing increase in Y and r

  10. Section A: Question 2 • The tax cut increases C, which shifts IS curve to the right • The interest rate increases…which reduces investment • Lower taxes have crowded out investment • So: • The plan did not succeed in accomplishing both goals • The composition of Aggregate Demand shifts towards consumption and away from investment

  11. Section A: Question 3 • What are the net capital outflow and the trade balance? Explain how they are related. • First, define (or explain) each term. • Trade balance = exports – imports (of goods and services) • Net capital outflows = capital outflows – capital inflows

  12. Section A: Question 3 • What are the net capital outflow and the trade balance? Explain how they are related. • Next, how are they related? • The trade balance and capital flows are always equal. This means the balance of payments is always balanced. • If you have a positive trade balance (exports>imports), you have net capital outflows. • If you have a negative trade balance (exports<imports), you have net capital inflows.

  13. Section A: Question 3 • What are the net capital outflow and the trade balance? Explain how they are related. • Why? • The intuitive case is when you have a negative trade balance, hence net capital inflows. This is the case for UK and USA. • The UK imports more than it exports. So how does it pay for this? The answer is through net capital inflows – foreigners purchasing UK assets… e.g. housing:

  14. http://blogs.wsj.com/moneybeat/2014/03/10/britain-filling-a-hole-with-real-estate/http://blogs.wsj.com/moneybeat/2014/03/10/britain-filling-a-hole-with-real-estate/ Britons have a huge demand for foreign goods—on a broad measure the country imports far more than it exports. So where does the U.K. find the money to buy all this stuff? Increasingly, an examination of fund-flow data shows the answer is property. Foreigners snapping up U.K. real estate have become a vital source of cash. Simply put, the U.K. is selling Belgravia to buy BMWs and swapping Islington for iPods.

  15. Section A: Question 3 • What are the net capital outflow and the trade balance? Explain how they are related. • Other countries (e.g. China) have a positive trade balance, hence net capital outflows. • Intuition: China is accumulating foreign income (e.g. £) by exporting so much to the UK. China can spend this on UK assets (e.g. housing), which would be a capital outflow. • The fundamental reason there is this identity between the trade surplus and net capital flows is that every single transaction involves an exchange in two directions: goods or services go in one direction, capital goes in the other direction (to pay for it).

  16. Section A: Question 3 • What are the net capital outflow and the trade balance? Explain how they are related. • When China’s economy runs a trade surplus, someone in China is exporting more than she is importing. • The trade surplus thus generated is paid for from foreign sources, say, US dollars. If the exporter just held on to those US dollars, then she has invested abroad, i.e., on net she has sent capital abroad. T • There is, thus, a net capital outflow. • If, however, she handed over those US dollars to the Chinese state authorities in exchange for Chinese RMB, it is then the state authorities that have, on net, sent capital abroad. • The fundamental reason there is this identity between the trade surplus and net capital outflows is that every single transaction involves an exchange in two directions: on the one hand, goods or services are handed over in one direction, from China to the US; on the other hand, currency or some

  17. Section A: Question 4 • What will happen to the trade balance and the real exchange rate of a small open economy when the government purchases increase, such as during a war? Does your answer depend on whether this is a local war or a global war?

  18. Section A: Question 4 • First, define/explain the RER: i.e. it is the nominal exchange rate adjusted for relative prices (both pieces of information useful, imagine a shopping trip to New York…)

  19. Section A: Question 4 • Government purchases (G) increase… • Shifts IS curve to the right… • Domestic (UK) interest rate rises above world interest rate… • Hence demand for £ increases, as UK assets give a high return… • Hence the nominal ER appreciates. • The real ER also definitely appreciates, as the increase in G increases domestic prices.

  20. Section A: Question 4 • What about the trade balance? • Now UK goods are more expensive relative to other countries’ (e.g. Germany). • Hence exports fall and imports increase… • So the trade balance falls/worsens. (Aside: this is what we would expect from the balance of payments: we have capital inflows due to the increase in interest rate, so trade balance falls).

  21. Section A: Question 4 • Local vs global war? • If it’s a global war then the interest rate rises in all countries. • So demand for £ will be much less affected. • Hence RER and trade balance will be less affected. (Aside: we are ignoring the fact that most wars, especially global wars, completely destroy trade between countries and economic activity in general!)

  22. SectionB: Question5

  23. Section B: Question 5 • Such a question is a present. You just need to work out the steps of the IS/LM – AS/AD model suggested here. • Give details. Include the equations for Consumption, Investment, Money Supply Multipler etc. • On the IS side: Consumers cut consumption and business reduced investment. The IS curve shifts left. • Can also show this on the Keynesian cross diagram; this is as if the Planned Expenditure curve shifted downwards. • On the LM side: heightened risks clogged lending and banks held significant excess reserves; the money multiplier falls, hence reducing money supply. • Due to a lack of confidence in the financial system, demand for money/cash also increased. • Both of these factors contributed to an upward shift of the LM curve. • Trace this out in an IS/LM graph and show its implications for the AD curve in the AS-AD curve graph.

  24. Section B: Question 5 What is the right macroeconomic policy to bring the economy back to full employment? • There are a host of possible policies (including “do nothing” – the economy reverts to full employment…eventually) • You will get most marks for suggesting a number of policies and showing (with explanations) how they affect the AS-AD and IS-LM diagrams • Some policies include (all of which were pursued by the UK and other governments): • Fiscal: increase government spending (e.g. infrastructure projects such as HS2). This has a multiplier effect of course(give the equation). • Fiscal: cut taxes (combined with the above, this means the government is running a large deficit) • Monetary: increase the money supply! • Monetary: unconventional monetary policies – e.g. quantitative easing – to “sidestep” the money multiplier problem caused by banks not lending enough • Combination of fiscal and accomodating monetary policy is the most expansionary (because there is less crowding out than using fiscal alone) • Others: guarantee savings, so that money demand does not increase • Others: try to increase aggregate supply (e.g. by removing business regulations, liberalisinglabour markets) • Others: …

  25. SectionB: Question6

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