ME2016Q3 (Lars) Flashcards

Question 1

Q

ADWhat is the difference between GDP and GNP?

Answer

A

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

Q

What is an intermediate good?

Answer

A

a good used in the production of another good

Question 3

Q

What are the three ways to measure GDP?

Answer

A

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

Q

What is the difference between nominal and real GDP?

Answer

A

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

Q

How do you measure the unemployment rate?

Answer

A

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

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

U = unemployed AND looking for a job

Question 6

Q

How do you measure labor force participation?

Answer

A

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

Q

How do you measure employment rate?

Answer

A

employed/population

Question 8

Q

What is the GDP deflator?

Answer

A

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

Q

What is CPI?

Answer

A

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

Question 10

Q

What is the difference between CPI and the GDP deflator?

Answer

A

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

Q

What does Okun’s Law predict?

Answer

A

That when output growth is high, unemployment rate will decrease

Question 12

Q

What does the Philips curve predict?

Answer

A

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

Question 13

Q

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

Answer

A

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

Q

What are Investments in economics?

Answer

A

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

Q

What is inventory investment and how is it calculated?

Answer

A

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

Question 16

Q

What determines C?

Answer

A

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

Q

Should production = demand?

Answer

A

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

Q

What is a multiplier?

Answer

A

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

Q

What are the two types of money?

Answer

A

Currency (bills, coins

Checkable deposits (bank deposits)

Together this is M1

Question 20

Q

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

Answer

A

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

Q

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

Question 22

Q

What is the money multiplier?

Answer

A

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

Q

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

Answer

A

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

Question 24

Q

What is investment (I) influenced by?

Answer

A

I = I(Y,i)

Y has a positive effect and i has a negative effect

Question 25

Q

Why is the LM curve upward sloping?

Answer

A

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

Q

ISLM: visualize an increase in T

Question 27

Q

ISLM: visualize an increase in G

Question 28

Q

ISLM: visualize an increase in money supply

Question 29

Q

ISLM: visualize a decrease in money supply

Question 30

Q

ISLM: visualize an increase in Y

Question 31

Q

ISLM: visualize an increase in i

Question 32

Q

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

Answer

A

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

Q

What is a liquidity trap?

Answer

A

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

Q

Why does fiscal expansions have a limit?

Answer

A

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

Q

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

Answer

A

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

Q

How can export exceed GDP?

Answer

A

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

Q

What is the nominal exchange rate?

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Q

What is NX and the quation for it?

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Question 45

Q

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

Answer

A

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

Q

What happens to NX if Y* increases?

Answer

A

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

Q

What is the Marshall Lerner condition?

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Question 50

Q

How does currencies adjust an economy’s trade deficit?

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Question 56

Q

What is labor supply and labor demand?

Answer

A

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

Q

What is a reservation wage?

Answer

A

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

Question 58

Q

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

Answer

A

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

Q

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

Answer

A

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

Q

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

Answer

A

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

Q

Why does u not need to equal u_n?

Answer

A

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

Q

What happens to Y_n as U_n increases?

Answer

A

If u_n increases, Y_n will decrease

Question 63

Q

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

Answer

A

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

Q

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

Answer

A

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

Answer 58

A

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

Answer 59

A

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)

Answer 60

A

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.

Answer 61

A

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

Answer 62

A

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.

Answer 63

A

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”.

Answer 64

A

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.

Answer 65

A

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

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

Answer 66

A

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)

Answer 67

A

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)

Answer 68

A

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.

Answer 69

A

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)

Answer 70

A

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

Answer 71

A

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

Answer 72

A

CA = S + (T - G) - I

NX = S - I

Current account surplus: Savings > Investment

Current account deficit: Savings < Investment

Answer 73

A

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*)

Answer 74

A

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*)

Answer 75

A

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

Answer 76

A

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

Answer 77

A

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

Answer 78

A

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.

Answer 79

A

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.

Answer 80

A

c) the exchange rate would decrease.

Answer 81

A

b) an increase in the marginal propensity to save

Answer 82

A

c) net exports equal savings minus investment

Answer 83

A

b) a relative high growth rate for some time

Answer 84

A

e) none of the above

Answer 85

A

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

Answer 86

A

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)

Answer 87

A

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)

Answer 88

A

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)

Answer 89

A

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.

Answer 90

A

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

Answer 91

A

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

Answer 92

A

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

Answer 93

A

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).

Answer 94

A

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

Answer 95

A

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

Answer 96

A

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.

Express C^* as a function of s
Take the deriviative of C^*with respect to s
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.

Answer 97

A

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)

Answer 98

A

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).

Answer 99

A

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.

Answer 100

A

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

Answer 101

A

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

Answer 102

A

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

Answer 103

A

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

Answer 104

A

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.

Answer 105

A

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?

Answer 106

A

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.

Answer 107

A

√x = x^0.5

x^ax^b = x^ab

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

(x^a)^b = x^ab

Answer 108

A

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*.}

Answer 109

A

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).

Answer 110

A

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.

Answer 111

A

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)

Answer 112

A

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

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

Answer 113

A

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.

Answer 114

A

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

Answer 115

A

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.

Answer 116

A

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 = b₀or 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.

Answer 117

A

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)

Answer 118

A

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.

Answer 119

A

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).

Answer 120

A

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

Answer 121

A

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

Examples:

Income-dependent taxes
Income-dependent import

Answer 122

A

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.

Answer 123

A

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

Answer 124

A

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

Answer 125

A

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

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

If Savings (private + public)

Answer 126

A

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.

Answer 127

A

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

Answer 128

A

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

Answer 129

A

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

Answer 130

A

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.

Answer 131

A

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?),

Answer 132

A

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).

Answer 133

A

k* = (s/δ)^3/2 ==> Inverse of N^x/y

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

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

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

Answer 134

A

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

Move along: Change in i

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