FEEDBACK TUTORIAL LETTER

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1 FEEDBACK TUTORIAL LETTER 2 ND SEMESTER 2016 ASSIGNMENT 2 INTERMEDIATE MACRO-ECONOMICS IMA612S 1

2 ASSIGNMENT 2 Please note that in order to have completed this assignment you should have worked through the textbook as well as the supplementary material available on the COLL website, in addition to the Study Guide. Correct answers are in italics: QUESTION 1 [20 marks, 2 marks per question] The Monetarist and Keynesian views on Money. For each of the following questions, select the one correct answer, from a-d. 1. According to classical economists, what is the main purpose of holding money? a) As a medium of exchange b) For precautionary purposes c) For speculation purposes d) To earn interest Explanation: According to both classical (monetarist) economists and Keynesian economists, money is held primarily as a medium of exchange, i.e. for transactions. Where classical economists and Keynesian economists differ is that classical economists believed that money was also held as an alternative way of holding wealth by households. In contrast, Keynesian economists believe that money is also held for precautionary purposes (in case of emergencies) and for speculative purposes (in order to invest in profitable opportunities when these arise). 2. According to the Quantity Theory of Money, if the number of transactions is 200, and the consumer price index is (CPI) is 105, what is the total money value of transactions in the economy? a) 21,000 b) 2,100 c) 2,10 d) Cannot say Explanation: According to the Quantity Theory of Money, if the number of transactions in an economy is fixed and independent of the money supply, then the total value of transactions will be equal to PT, where P = the general price level of goods and services purchased, which is the same as the consumer price index, and T = the number of transactions. So the total money value of transactions = PT = 200(105) =

3 3. According to the Quantity Theory of Money, if money supply is 1000, velocity of circulation of money is 5, and the number of transactions is 2000, what is the general price level prevailing in the economy? a) 1.5 b) 2.5 c) 3.5 d) 4.5 Explanation: According to the Quantity Theory of Money, if the number of transactions in an economy is fixed and independent of the money supply, then the total value of transactions will be equal to PT, where P = the general price level of goods and services purchased and T = the number of transactions. The amount of money required to pay for the transactions will depend on the velocity of circulation of money. The total volume of transactions will be equal to MV, where M = the money supply and V = the velocity of circulation of money. The Classical economists assumed the existence of full employment in an economy and T was accordingly known and fixed. They also assumed that the velocity of circulation of money, the number of times that one unit of currency turns over in order to pay for goods and services in a given period of time, was also fixed. So the Quantity Theory of Money leads to the identity: MV =PT. MV must be exactly equal to PT as the two sides of the equation measure the same thing, as PT = money spent / money demand and MV = money supply. From the identity, MV = PT, we can determine that P = MV / T. So from the information above, P = 1000 (5) / 2000 = What, according to the Quantity Theory of Money, will occur if there is a rise in inflation? a) The number of transactions increases, the money supply or the velocity of circulation increases b) The number of transactions decreases, the money supply or the velocity of circulation increases c) The number of transactions decreases, the money supply or the velocity of circulation decreases d) Cannot say Explanation: According to the Quantity Theory of Money, the identity MV = PT. So if P, the general price of goods and services purchased, in other words, inflation, rises, then in order for the identity to remain equal, either T the number of transactions will decrease, or M, the money supply or V the velocity of circulation increases (assuming V and T can vary). This is shown simply as: ( )M( )V = P( )T, where P causes the change and M, V or T can vary. 5. Refer to the Quantity Theory of Money identity; MV= PT. If all else stays equal, what will happen to inflation if the money supply increases? 3

4 a) Inflation will increase b) Inflation will decrease c) Inflation will stay the same d) Cannot say Explanation: According to the Quantity Theory of Money, the identity MV = PT, where M = money supply, P = price level / inflation, T= the number of transactions and V = the velocity of circulation of money. If M increases and V and T are fixed / stay equal, then P, the price level or in other words inflation, will increase. This is shown where: MV = PT (where V and T are assumed fixed). This is the crux of the Quantity Theory of Money, which states that inflation in an economy (where V and T are assumed to be fixed) is directly and positively related to the money supply, i.e. an increase in the money supply, where V and T are fixed, will result in an increase in inflation. 6. Why would the sale of government bonds to the public decrease the money supply in the economy? a) Inflation would increase b) Inflation would decrease c) The public swops cash for bonds d) The government swops cash for bonds Explanation: Using monetary policy, the central bank of a country can influence the interest rate in the economy by increasing / decreasing the money supply in the economy. One way the central bank does this is through the sale and purchase of government bonds (a government bond is a debt security where the government pays the bond holder periodic interest payments dependent on the term of the bond and the face value at the maturity date. The bond holder is effectively lending the central bank money). If the government or central bank sells bonds to the public, then the public is giving them their money in exchange for a bond, and in this way the money supply / cash in the economy decreases. 7. According the definition of money, M 1 is? a) Bank notes and coins b) Bank notes, coins and current accounts c) Bank notes, coins, current accounts and savings accounts d) Bank notes, coins, current accounts, savings accounts and fixed deposits Explanation: According to the definition of money, M1 is defined as narrow money or all highly liquid money (liquidity refers to how quickly money can be converted to cash). So narrow money, M1 includes all cash (bank notes and coins), as well as all money held in current accounts at the bank, as the money in current accounts can be withdrawn in cash from the bank at any time. 4

5 Broad money (M2), includes all bank notes and coins, current accounts and it also includes savings accounts, fixed deposits and other accounts (e.g. investment accounts) that are not as liquid as money in current accounts (e.g. it may take some time to convert money in a fixed deposit account to cash; think of 30 Day Notice accounts at the bank, where you have to give 30 days notice before you can withdraw the cash). 8. If consumers have expectations that the interest rate will go up in the future, they will? a) Buy bonds now b) Save now to buy bonds when interest rates go up c) Save now to buy bonds when interest rates go down d) Sell bonds now Explanation: If consumers expect that interest rates will go up in the future, that means that bonds will have a higher yield (give a greater return) in the future. In anticipation of this expected higher return, consumers will save money now in order to buy bonds in the future once the interest rate has gone up (this is the basis of Keynes' speculative motive for holding money). 9. The Keynesian view on money differs from the Monetarist view, in that it states? a) An increase in the money supply will cause a decrease in interest rate and an immediate increase in inflation b) An increase in the money supply will cause a decrease in interest rate and an increase in inflation in the long-term c) An increase in the money supply will cause a decrease in interest rate and an immediate decrease in inflation d) An increase in the money supply will cause a decrease in interest rate and a decrease in inflation in the long-term Explanation: The main difference between Keynes' theory of the money market and the monetarists' theory of the money market is the effect of the money supply in the economy. Keynes believed that the interest rate in the economy was determined where money demand equals money supply (equilibrium in the money market). If money supply increases, then the 'price' of money, the interest rate, would decrease. If the interest rate decreased, then the return consumers would earn from savings at the market rate decreased, thus consumers would choose to spend more than to save. Likewise, if the interest rate decreased, the cost of investment faced by businesses decreased, so businesses would spend more. Thus with a lower interest rate, consumption and investment would increase. This increase in spending would over time result in an increase in the general price level and thus inflation in the long-run. Monetarists on the other hand believed in the Quantity Theory of Money, whereby assuming that the velocity of circulation 5

6 of money and the number of transactions remained fixed, an increase in the money supply would result in an immediate increase in the general price level, or inflation. 10. According to the Keynesian view on money, an increase in the interest rate will result in? a) Lower consumer spending, lower investment and thus lower inflation b) Higher consumer spending, higher investment and thus higher inflation c) Lower consumer spending, lower investment and thus higher inflation d) Higher consumer spending, higher investment and thus lower inflation Explanation: According to the Keynesian view of money, an increase in the interest rate means that for consumers, there is a higher return to saving, and thus they will save more and consume less. For businesses, the cost of financing investments on credit becomes higher, and thus they will tend to invest less. Thus according to Keynes, an increased interest rate results in a slowdown in spending (think of the IS: LM Model, at a higher interest rate, the equilibrium level of income / output is less). This slowdown in consumer spending and investment means that over time inflation slows down as well. QUESTION 2 [10 marks] a) Explain the crowding-out effect (5) The crowding out effect is an economic theory stipulating that rises in public sector spending (an expansionary fiscal policy) drives down or even eliminates private sector spending. This phenomenon is explained as follows: Financing required by the government to pay for growth of public spending has the effect of raising taxes (if financed through tax revenues) or, if government finances increased spending through debt; drives up the demand for debt and subsequently the interest rate. Higher taxes and / or higher interest rates squeezes the profitability of private firms and raises their investment costs, which results in lower private sector investment. The argument leads to the conclusion that excessive growth in public spending crowds out private investment spending. 6

7 b) Give a real-life example of a potential crowding-out effect in Namibia (5) An example could be government spending on new construction (e.g. a new parliament). This could increase the cost of financing for private sector construction, where government finances this construction through debt, increasing the market demand for funds and thus driving up the interest rate. The government construction projects may also make use of limited construction resources in the country (such as skilled labour, land, water and power) which could result in the private sector facing higher costs for these resources. Any other valid example of public spending and potential crowding-out effect would be considered. QUESTION 3 [10 marks] In 2009, US President Barack Obama launched the US$ 787 billion economic stimulus package in response to the depressed US economy. Its three categories of spending were: US$ 288 billion in tax cuts, US$ 224 billion in extended unemployment benefits, education and health care and US$ 275 billion spent on job creation using federal contracts, grants and loans. a) State if this economic stimulus package was a fiscal or monetary policy initiative (3 marks) This is a fiscal policy initiative, as it entails government spending and taxes (in contrast, monetary policy initiatives involve the interest rate, inflation and the exchange rate). b) State if you think President Obama was following a Keynesian or Monetarist view on the economy, and give one reason why you say this? (3 marks) Obama was following a Keynesian view on the economy, as the Keynesian model shows that increased government spending and reduced taxes can increase / stimulate economic growth. Again, think of the IS: LM Model, where increased government spending and reduced taxes shifts the IS curve to the right to a new higher equilibrium output / income level. Monetarists on the other hand believed that government spending would depress / reduce economic growth (through the crowding-out effect). Note for this question you needed to provide a valid reason as to why you thought Obama was following a Keynesian approach that related to the information provided in the question. c) State what you think will be the outcome of this economic stimulus package on national income and unemployment? (4 marks) We can approach this simply by considering the Keynesian Model of aggregate demand: AD = C + I + G + X - M ( )AD = C + a + b ( Y - T) + I + G + X - M 7

8 So, an increase in government spending (G) and a decrease in taxes (T) would result in an increase in aggregate demand (AD), which is national income. Thus we expect to see a rise in national income. The stimulus package also entailed direct spending on increased job creation, so we would expect to see lower unemployment. In summary, the effects are; higher national income and lower unemployment. QUESTION 4 [40 marks] Consider the following short-run model of closed economy Good Market: C= Yd I = 50-5r G = 200; T = 100 Money Market: M = 1000 P = 20 L(Y,r) = Y r a) State the IS and LM equations (5) The IS equation is: IS: Y = C+ I + G Bringing together the variables from the Goods Market: IS : Y = Yd r +200 Note that consumption is dependent on disposable income (income less tax), so: IS : Y = (Y - 100) r Now, simply the above: Y = Y r Y = Y - 5r Take all the Y terms to the left-hand side Y Y = 330-5r Note the change in sign of 0.2Y when we take it across 0.8 Y = r Divide through by 0.8 Y = r The LM equation is determined by Md (money demand) = Ms (money supply) So Y-r = M/P Bringing together the variables from the Money Market: Y-r = 1000 / 20 Y - r = 50 Take the r to the right-hand side to get it into the same format as the IS equation. Y = 50 + r b) Find the short-run equilibrium interest rate and output level (10) 8

9 We know the short-run equilibrium is found where both the Goods Market and the Money Market is in equilibrium. This is found where IS = LM. So we equate these two equations. IS = LM From (a) : IS = r and LM =50 + r So we solve for Y and r by equating r = 50 +r First solve for r: = 6.25 r + r Combine like terms, and take note of the changing signs when you move the terms across = 7.25 r r = / = 50 So the equilibrium interest rate is 50%. Now we can find Ye, by plugging in the re. Using the IS equation: Ye = (50) = 100 Let's check this answer by plugging into the LM equation: Ye = = 100. So, Ye = 100 and re = 50. c) Represent the short-run equilibrium interest rate and output level graphically (5) We need to make use of the IS: LM graph. This graph has interest rate on the vertical axis and income / output on the horizontal axis. The LM curve is upward sloping as the higher the level of income, the higher the demand for real money balances, and thus the higher the equilibrium interest rate. The IS curve is downward sloping as higher interest rates means lower investment and consumption, and thus lower income / output. The IS: LM graph is shown as: 9

10 Figure 1: IS: LM graph Note to fully label your graph, including the axes, the curves and the equilibrium interest rate and level of output. d) Explain the effect on the equilibrium interest rate and output level if there was a decrease in the real money supply, and show this effect graphically? (10) Let us use the theory of liquidity preference to understand how monetary policy shifts the LM curve. Suppose that the Bank of Namibia decreases the money supply from M1 to M2, which causes the supply of real money balances to fall from M1/P to M2/P. Holding constant the amount of income and thus the demand curve for real money balances, we see that a reduction in the supply of real money balances raises the interest rate that equilibrates the money market. Decrease in real money supply results a higher interest rate, and thus the LM curve shifts upward. There is no effect on the IS curve. This is shown graphically as follows: 10

11 Figure 2: Effect of decrease in money supply: The LM curve shifts upwards from LM1 to LM2. The interest rate increases from r1 to r2 and the level of output decreases from Y1 to Y2 (Note that the question asked for the effect on the interest rate and the output level). Note: You needed to show this effect on the interest rate and output using the IS: LM graph (and not the Md / Ms graph). e) Explain the effect on the equilibrium interest rate and output level if there was an increase in (autonomous) government spending, and show this effect graphically? (10) Using the IS equation, IS: Y = C + I + G, an increase in government spending will increase output (Y). An Increase in government spending shifts the IS curve outward (to the right) - an increase in government spending raises planned expenditure, and thus output. There is no effect on the LM curve. This is shown graphically as follows: 11

12 Figure 3: Effect of increase in government spending The IS curve shifts rightwards from IS1 to IS2. The interest rate increases from r1 to r2 and the level of output increases from Y1 to Y2 (Note that the question asked for the effect on the interest rate and the output level). Note: You needed to show this effect on the interest rate and output using the IS: LM graph (and not the planned expenditure graph). QUESTION 5 [20 marks] a) Explain the difference between economic growth and economic development, and give an example of how each are measured? (10) Economic growth can be defined as an increase in a country s productive capacity, identifiable by sustained rise in real national income over a period of years. Economic growth is measured by an increase in Gross Domestic Product or Gross National Product within a country over time. Economic development is a much broader definition than economic growth. Whereas economic growth looks at the quantitative measure of the economy, economic development looks at both quantitative and qualitative measures. A country is enjoying economic development when it is experiencing economic growth, and at the same time is undergoing major structural changes in its economy, like a shift from agriculture to manufacturing, and / or improving the citizens' welfare and the infrastructure in the country. One of the measures of economic development is an increase in GDP per capita over time or the stage of the economy (i.e. shifting from primarily agriculture to diversifying the economy to include manufacturing 12

13 and professional services). There are a number of other measures of economic development, such as the life expectancy of a country (where a more developed country has better healthcare and thus a higher life expectancy) and the literacy rate of the country (where a more developed country has a better education system and thus a more literate population). To summarize, economic growth measures only the increase in the country's GDP and says nothing about the distribution of income in the country, whereas economic development looks at the economic welfare of the citizens of the county. Note for this question you needed to compare economic growth and economic development. b) The main determinants of economic growth are growth in the labour force, growth in capital stock and technical progress. For each of these determinants, provide an action that the government can take to stimulate growth (10) Actions government can take to stimulate growth in the labour force: Enhancing international migration through improving visa requirements / tax laws. Increasing the participation rate in the labour force through job creation schemes or reducing income taxes. We would have considered other government policies for increasing population if they were valid. Actions government can take to stimulate growth in the Capital stock: Government policy of subsidising companies investments in capital. Government policy of lower taxes for investment spending of businesses. We would have considered other government policies for increasing capital stock if they were valid. Actions government can take to stimulate growth in the Technical progress: Government investment in Research and Development. Government policy of subsidising or reducing taxes on companies spending on Research and Development. We would have considered other government policies for increasing technical progress they were valid. Note: For this question, you needed to have provided a specific action that government could take to stimulate growth in the labour force, capital stock or technical progress (it would not have been enough to merely define these terms). -END OF FEEDBACK TUTORIAL LETTER- 13