The Macro Economy

Question 1

What does the interaction between aggregate demand and aggregate supply indicate?

Answer 1

Level of activity in an economy.

Question 2

Where does demand for an economy’s product come from?

Answer 2

From households, firms and government within the country AND from households, firms and governments in other countries.

Question 3

Explain aggregate demand.

Answer 3

The total spending on an economy’s goods and services at a given price level in a given time period.

1. Consumption: Also known as consumer expenditure. It consists of spending by households on goods and services.
2. Investment: Spending by private sector firms on capital goods.
3. Government Spending: Government spending on goods and services.
4. Net Exports: Difference between the value of exports of goods and services and the value of imports of goods and services.

Question 4

Explain aggregate demand curve.

Answer 4

(Shaped like demand curve but is bent down… inverse relation between price level and real GDP.)

A rise in the price level will cause a contraction in the aggregate demand and a fall in price level will result in extension of aggregate demand.

The prices of most products are changing in the same direction.

Question 5

What happens when price changes?

Answer 5

When price changes (rise):

1. Wealth Effect: A rise in the price level will reduce the amount of goods and services that people’s wealth can buy.

The purchasing power of savings held in the form of bank accounts and other financial assets will fall.

2. International Effect: A rise in price levels will reduce the demand for net exports as exports will become less price competitive and imports will become more price competitive.
3. Interest Effect: A rise in price levels will increase demand for money to pay higher prices. This, in turn will increase the interest rate. A higher interest rate will usually result in a reduction in consumption and investment.

Question 6

Explain shifts in aggregate demand curve.

Answer 6

(A change in price causes movement along the A.D curve.)

Any non-price influence causes A.D to change, which shifts the curve.

An increase in A.D will shift the A.D curve to the right… and vice versa.

Question 7

What increases aggregate demand?

Answer 7

Consumption:
- Rise in consumer confidence.
- Cut in income tax.
- Increase in wealth.
- Rise in money supply.
- Increase in population.

Investment:
- Rise in business confidence.
- Cut in corporation tax.
- Advances in tech.

Govt Spending:
- Desire to stimulate economic activity.
- Desire to win political support.

Net Exports:
- A fall in exchange rate.
- Rise quality of domestically produced products.
- Increase in incomes abroad.

Question 8

Define aggregate supply and it’s types.

Answer 8

The total output (real GDP) that producers in an economy are willing and able to supply at a given price level in a given time period.

Short-Run A.S: The output that will be supplied in a period of time when the prices of factors of production (inputs, resources) have not had time to adjust to changes in aggregate demand and price level.

Long-Run A.S: The output that will be supplied in the time period when the prices of factors of production have fully adjusted to change in aggregate demand and price level.

Question 9

Explain short-run aggregate supply curve and the reasons for it.

Answer 9

(Shaped like supply curve but bent downwards…)

As price level rises, producers are willing and able to supply more goods and services.

Reasons for this +ve relationship:

• Profit effect: as the price level (price of goods and services) rises/increases, the price of factors of production such as wages do not change. As the price level rises, the gap between output and input prices widens and the amount of profit increases.
• Cost effect: although the wage rates and raw material costs remain unchanged in the short-run. Average costs may rise as output increases. (Overtime payments will have to be paid and costs will be involved in recruiting more.) Producers will require higher prices to cover any extra costs involved in producing a higher output.
• Misinterpretation effect: producers may confuse changes in the price level with changes in relative prices. They may think that the demand for their product has increased. As a result they will be encouraged to produce more.

Question 10

What causes a shift in short-run aggregate supply curve?

Answer 10

1. Change in price of factors of production: A rise in wage rates, not matched by an increase in labor productivity and/or rise in raw material costs will decrease SRAS, left shift.
2. A change in taxes of firms: A reduction in corporation or indirect tax will cause an increase in SRAS.
3. A change in factor productivity/ quality of resources: A rise in labor/capital productivity will increase SRAS.
4. A change in quantity of resources: In the short-run, supply side costs (natural disasters) will change SRAS. Does not affect long-run.

Question 11

Explain long-run aggregate supply curve.

Answer 11

Relationship between real GDP and changes in price level when there has been time for input prices to adjust to changes in aggregate demand.

Keynesian: (Hook Graph) Government intervention is needed to achieve full employment. Output can be raised without increasing the price level.

New Classical Economist: (Graph parallel to y-axes.) In the long-run, the economy will operate at full capacity.

Question 12

What causes a shift in LRAS curve?

Answer 12

Causes of shift are a change in quality and/or quantity of resources.

• Net Immigration: Increase in size of labor force if immigrants are of working age.
• Increase in retirement age.
• More women entering labor force.
• Net Investment: If gross investment exceeds depreciation (replacement of worn out capital goods) there will be addition to capital stock.
• Discovery of new resources such as oil fields or mines.
• Land Reclamation.
• Improved education / training will improve labor productivity.
• Advancement in technology.

Question 13

Explain the interaction of AG and AS.

Answer 13

Growth of economy if both right-shift.

If price level is below equilibrium, excess demand will push it back to equilibrium.

If above, some goods and services will not sell and firms will have to cut prices.

Question 14

Explain inflation and it’s types.

Answer 14

On average, prices are rising at a particular rate.

Inflation is a sustained increase in an economy’s price level.

Creeping Rate: (1-3%) A low-rate of inflation. Considered to be good for an economy as it encourages business activity.

Hyper Inflation: An exceptionally high rate of inflation, which may result in people losing confidence in currency.

Question 15

How is inflation measured?

Answer 15

(Price Level = Living Costs)

Consumer Price Index: Average change in prices of a representative basket of products purchased by households.

1. Selecting a base year where nothing unusual has occurred. Given a value of 100. This is changed on a regular basis.
2. Carrying out a survey to find people’s spending patterns. Households are asked to keep a record of what they buy. The products are placed into separate categories.
3. Attaching weights to different categories: % of total expenditure spent on a category determines it’s weight.
4. Finding out price changes of retail outlets, gas companies, etc.
5. Multiplying weights with price changes gives change in consumer price index.

Question 16

Define money values and real values.

Answer 16

Money values are values at the prices operating at the time.

Real values are values adjusted for inflation. (By multiplying money values by price index in current year and divided by price index of base year.)

Question 17

What are the causes of inflation.

Answer 17

• Cost Push Inflation: Inflation caused by increases in costs of production. (Wages may increase more than labor productivity.)
• Demand Pull Inflation: Inflation caused by an increase in aggregate demand not matched by an increase in aggregate supply. (Consumer boom, rise in govt. spending, increase in net exports, increase in investment.)
• Monetarist Approach: Inflation caused by excess growth in money supply

Question 18

What are the consequences of inflation?

Answer 18

• A reduction in net exports: Inflation may reduce the international competitiveness of a country’s products which will decrease export revenue and increase import expenditure.
• An unplanned redistribution of income: Some gain and some lose as a result of inflation. (If interest rates do not rise in line with inflation, borrowers will gain and lenders will lose as borrowers will pay back less in real terms.)
• Menu costs: Costs involving the changing of prices on catalogues, price tags, bar codes and advertisements. This affect firms and involve staff time which is unpopular with customers.
• Shoe leather costs: These are costs involving moving money from one financial institute to another in search of the highest rate of interest. The time and effort it takes to minimize effect / impact of inflation on finances.
• Fiscal Drag: Bracket Creep. When income levels corresponding to different tax rates are not adjusted in line with inflation. As a result, people and firms are dragged into higher tax brackets. This is also a cost of inefficient tax system.
• Discouragement of investment: Unanticipated inflation can cause uncertainty, and makes it harder for firms to plan ahead. This discourages investment and stops economic growth.
• Inflationary noise: Money Illusion. When inflation causes consumers and firms to confuse price signals. Inflation makes it difficult to asses what is happening to relative prices. It can result in consumers and firms making the wrong decisions. A firm may take higher prices as a result of increased demand rather than inflation and raise output. This results in misallocation of resources.
• Inflation may generate further inflation as consumers, workers and firms will come to expect prices to rise. As a result they may act in ways which will cause inflation. Workers may press for higher wages, consumers purchase products in fear of prices rising further, firms may raise prices to cover expected higher costs.

Question 19

What are the benefits of inflation?

Answer 19

• Stimulating output: Low and stable inflation rate caused by increasing demand may make firms optimistic about the future. In addition, if prices rise by more than costs, profits will increase, which will provide funds for investment.
• Reduces burden of debt: Interest rates do not tend to rise in line with inflation, this may cause real interest rates to fall or become negative. Those who have borrowed money will have to pay back less in real terms. A reduction in debt burden may stimulate consumer expenditure, which could lead to higher output and employment.
• Prevent some unemployment: Firms in difficulties may have to reduce their costs to survive. With zero inflation, firms may cut their labor force to reduce expenditure on wages. But with inflation, they could keep wages constant or not increase them in line with inflation, paying less real money for wages and cutting costs this way.

Question 20

What are the factors affecting consequences of inflation?

Answer 20

• It’s cause. Demand pull inflation is less likely to be harmful than cost push inflation. Because one is associated with rising output and the other with falling output.
• It’s rate. A high rate will cause more damage than a low rate, especially if the high rate develops into hyper-inflation which leads to households and firms to lose faith in currency and may bring down govt.
• Whether the rate is accelerating or stable. An accelerating or fluctuating inflation rate will discourage firms from investing due to uncertainty.
• Whether the rate is the one that has been expected. Unanticipated inflation will also create uncertainty and cause consumers to be discouraged from spending / investing.
• How the rate compares with that of other countries. If the rate is below that of other countries, it’s products may become more price competitive.

Question 21

Explain deflation and disinflation.

Answer 21

Deflation is a sustained fall in the price level. Sometimes taken to mean lower economic activity as a result of government policy designed to reduce aggregate demand. It results in a rise of value of money, with each currency unit having greater purchasing power. (-3%)

Disinflation a fall in the inflation rate. (From 6% to 8%) The price level is still rising, but at a slower rate.

Question 22

Causes and consequences of deflation.

Answer 22

Increased burden of debt.

Increased real rate of interest.

Menu costs.

The effects of deflation are heavily influenced by the cause of deflation.

Good deflation is caused by an increase in aggregate supply. Advances in technology, may create new methods of production. Output and employment may rise and the international competitiveness of the country’s products may increase.

Bad deflation is caused by a fall in aggregate demand. In this case output falls, which causes higher unemployment. This runs the risk of becoming a deflationary spiral. Consumers may delay purchases, expecting prices to fall in the future. Firms may not invest, seeing lower demand and cut off workers. This will further reduce demand.

Question 23

What are the balance of payments?

Answer 23

“Changes in a country’s price levels can affect it’s balance of payments which in turn, can affect its exchange rate.”

A country’s balance of payments is a record of all of the economic transactions between residents of that country and residents in other countries.

Money coming into the country creates credit items and money going out of the country gives rise to debit items.

Question 24

Name the components of the balance of payments.

Answer 24

Current Account

Capital Account

Financial Account

Question 25

Explain current account.

Answer 25

• Trade in goods. Exports and imports of goods. Exports give rise to credit items and imports give rise to debit items. The trade in goods balance is the revenue earned from exports of goods minus expenditure on imports of goods. Trade in goods balance is also called balance of trade. (Visible balance, merchandise balance) A surplus is when export revenue is greater than import expenditure.
• Trade in services. Exports and imports of services. ‘Invisibles’ such as shipping, tourism, banking and insurance. A trade in services deficit occurs when revenue from the exports of services is less than expenditure on imports of services.
• Income. Income from the profits, interest and dividends earned on direct investment abroad and foreign exchange earnings on investment in the country. Credit and Debit items.
• Current transfers. Payments made and receipts received for which there is no corresponding exchange of an actual good or service. Payments to and receipts from international organizations and foreign aid. Transfers by private individuals are also included in this part of current account. (Worker’s remittances)

Question 26

Explain capital account.

Answer 26

(A relatively small part of B.O.P for most countries.)

Government debt forgiveness, money bought in and taken out of the country’s by migrants, the sale and purchase of copyrights, patents, trademarks.

A record of capital transfers, and the acquisition and disposal of non-produced, non-financial assets.

Question 27

Explain financial account.

Answer 27

(A significant part of B.O.P.)

Large movement of funds into and out of the country.

1. Direct Investment:
   Debit Items: Building a factory or taking over a firm in another country.
   Credit Items: Setting up a new plant or the takeover of a firm in the country by a foreign entity.
2. Portfolio Investment: Purchase and sale of govt. bonds and shares that do not involve legal control of a firm.
3. Other Investment: Shorter-term movements of financial investment including bank loans and inter-govt loans.
4. Reserve Assets: Gold, foreign exchange reserves, special drawing rights and the changes in a country’s reserve position in the IMF.

Reserves are kept to settle international debts and to influence the value of the foreign exchange rates.

Reduction to reserves are credit items, because selling reserves leads to getting more currency… and vice versa.

Transfer of financial assets between the country and the rest of the world.

Question 28

Explain the causes of current account deficit.

Answer 28

• A growing domestic economy: Firms may use imports as well as divert resources from exports in order to increase output. This is not considered to be a problem.
  A growing economy is likely to attract foreign direct investment which will make up for current account deficit with a financial account surplus. It is also usually short-term and self-correcting. Growing firms are even more likely to sell both abroad and locally. So export revenue may rise to correct / match import expenditure.
• Declining economic activity in trading partners: Relatively short-term and self-correcting. Another country’s import expenditure on a country’s products may fall or rise slowly. (Due to recession or slower economic growth.) A cyclic deficit, change in economic cycle of domestic economy or economy of trading partners.
• Structural Problems: If it lasts over the long-run, it is a concern. A structural problem can be caused by overvalued exchange rate, high inflation rate and / or low labor or capital productivity. This is not self-correcting.

Question 29

Explain the consequences of financial account deficit.

Answer 29

Not necessarily a problem, especially as it will give a rise to an inflow of profits, interest and dividends in future years. It may also be short-term resulting from money flowing out of the country in search of higher interest rates and currencies that may rise in value.

It is more of a concern if it results from a long-term lack of confidence in a country’s economic prospects. A capital flight may occur. Foreign owners with firms and shares sell in large quantities. Reduces tax revenue and employment, may cause recession.

Question 30

What are the consequences of current account deficit and surplus?

Answer 30

A deficit allows residents to consume more products than a country produces. A country living beyond it’s means. The country will have to finance it’s deficits by attracting investment or borrowing. This will involve outflow of money in the future in the form of investment income.

An increase in C.A deficit may also reduce aggregate demand, slow down economic growth and cause unemployment.

A surplus (saving more than spending) means that the residents of a country are not enjoying as high of a standard of living as possible. High demand + additional money supply may generate inflationary pressure. (+ Pressure on a country to change it’s policies.)

Question 31

What are exchange rates? Give an example.

Answer 31

The price of one domestic currency in terms of a foreign currency. (Bilateral exchange rate.)

A country trades with many other countries. It’s currency may rise in value against one country while falling against another.

For example, $1 may be 100rs. A 500rs product sell for $5 in the U.S. A rise in Pakistan’s foreign exchange rate against the U.S dollar would lower the price of Pakistan’s imports in terms of rupees and increase it’s price of exports in terms of U.S dollars.

Question 32

What is a trade weighted exchange rate?

Answer 32

A measure, in index form of a currency against a basket of currencies. In calculation, the countries are given a weightage according to the relative importance of the countries in the country’s trade. This gives a general change in the country’s foreign exchange rate. (Also known as multinational exchange rate.)

Question 33

What are real exchange rates?

Answer 33

A currency’s value in terms of it’s purchasing power. Price changes and exchange rates are used to assess changes in competitiveness of a country’s products in global market. (Price of domestic products in terms of foreign products.)

Real exchange rate: (nominal exchange rate * domestic price index) / foreign exchange rate.

*Real exchange rate may rise as a result of increased rate of inflation.

Question 34

In what ways are foreign exchange rates determined?

Answer 34

Floating, Fixed, Managed float.

Question 35

Explain floating exchange rate along with it’s advantages and disadvantages.

Answer 35

Floating exchange rate is determined by market forces of demand and supply. Buying and selling of currency in the foreign exchange market.

Currency traders buy domestic currencies to enable their customers to:
- Purchase goods and services from the country.
- Invest in the country.
- Make profit if the currency’s value rises in the future.

Operating on a floating exchange rate will in theory restore balance to current account of the B.O.P.

In this case, exchange rate may fluctuate significantly. This will make it difficult to estimate how much will be earned from exports and spent on imports. It may discourage trade and investment.

This will also remove pressure on govt. to maintain price stability. A govt. may use floating exchange falling to restore any loss in international competitiveness from inflation. However, that may increase inflationary pressure, because price of imported products will increase.

There is no guarantee that floating exchange rate will eliminate a current account surplus or deficit because the value of exchange rate may be pushed up despite a current account deficit if speculators are buying a currency while expecting it to rise in value.

Question 36

Explain a fixed exchange rate. Without mentioning adv or disadv.

Answer 36

Is set by govt. and maintained by the central bank. The central bank will maintain rate by intervening at the foreign exchange market and / or changing the rate of interest.

Such a measure may attract hot money flows: Flows of money moved around a world to take advantage of changes in interest rates and exchange rates.

It is easier to maintain a fixed exchange rate if the rate is set close to the long-run equilibrium value of the currency. This is because it will only have to offset short-run and relatively small fluctuations.

Question 37

What happens if the exchange rate is overvalued?

Answer 37

The central bank may run out of reserves trying to keep it at a level which does not reflect market value.

Question 38

What are the advantages and disadvantages of fixed exchange rate?

Answer 38

To keep fixed exchange rate, reserves are needed. These reserves could be used for other purposes, so this has an opportunity cost. The govt. may also sacrifice other policy objectives to maintain the fixed rate.
An increase in interest rate to maintain fixed exchange rate may reduce aggregate demand and increase unemployment.

Overtime the market pressures could mean that the fixed exchange rate has to be changed. Reduction is known as devaluation, and an increase is revaluation.

A fixed exchange rate does create certainty, which can promote international trade and investment. Foreign firms will know exactly how much they will earn.
It also puts pressure on govt. to keep inflation rates low, so that a loss of price competitiveness does not put downward pressure on exchange rate.

Question 39

Explain managed float.

Answer 39

This contains features of a floating exchange rate system and a fixed exchange rate system. Usually involves govt. allowing the exchange rate to be determined by market forces within a given band. (Upper and lower limit…)

If exchange rate is within limits, no action will be taken.
If demand for the currency were to rise up, the central bank would sell the domestic currency to increase it’s supply. This will keep the exchange rate within the desired band.

Question 40

What are the factors underlying changes in foreign exchange rates?

Answer 40

• Changes in demand for and supply of a currency will cause a change in the price of the currency if it’s floating or put upwards or downwards pressure on it if fixed / managed float.
• Demand of currency will rise if higher value of exports is being sold. (Foreigners may buy more of the currency if they wish to purchase shares in the country’s firms due to improving economic prospects.)
• Foreigners will also buy the currency if they want to open bank account in the country due to higher interest rates.
• Foreign firms will purchase large sums of the currency in order to setup branches in the country. (Due to rise in labor productivity.)
• If foreigners speculate that the value of currency will rise, they will purchase it to make a profit.
• An increase in supply will cause a fall / put downwards pressure in a currency’s value.

More of the currency may be sold to purchase other currencies in order to:
- undertake foreign travel…
- purchase more of the country’s govt. bonds…
- setup firms abroad in anticipation of the currency’s value falling.

The value of a fixed or managed floating exchange rate may be changed by the pressure of market forces. Govt. may decide that the currency is undervalued because it keeps having to sell the currency to maintain it’s value. (Revaluation)

A govt. may also decide to alter a fixed / managed exchange rate in order to achieve macroeconomic aims such as:
- devaluing a currency below it’s long-run equilibrium level to gain a competitive advantage and improve current account.
- may set high exchange rate to reduce inflationary pressure.

Question 41

What are the effects of a depreciation / devaluation on domestic and external economy?

Answer 41

A fall in the value of exchange rates will make exports cheaper and imports more expensive in terms of foreign currencies.
This will enable firms to sell more both domestically and abroad.
Domestic consumers are more likely to purchase locally produced products instead of the more expensive imports.
Foreigners are more likely to purchase the exports because they are cheaper.

A rise in net exports will increase aggregate demand, result in higher output and lower unemployment.

This may give rise to inflationary pressure. As economy approaches full capacity, resources will become scarce which will increase prices. Imported products that are purchased will be more expensive and count in the country’s consumer price index. Cost of production will increase due to an increase in cost of imported raw material. Domestic firms will have less competitive pressure to keep prices low.

If demand for exports and imports is price elastic, a fall in exchange rate will result in a rise of export revenue and fall in import expenditure. This reduces current account deficit.

Question 42

What is depreciation?

Answer 42

Decrease in international price of currency caused by market forces.

Question 43

What is devaluation?

Answer 43

Decision by govt. to lower the international price of a currency.

Question 44

Explain the marshall-lerner condition.

Answer 44

The requirement that for a fall in exchange rate to decrease current account deficit, the sum of PEDs of exports imports must be greater than one.

The greater the combined PED is, the smaller a change in foreign exchange rate is needed to increase current account position.

If the combined PED is less than one, a revaluation of the exchange rate will be the more appropriate policy strategy.

Question 45

Explain the J-curve effect.

Answer 45

A fall in exchange rate will worsen the current account position before it starts to improve it.

In the short-term, demand for imports and exports will be relatively inelastic. (Takes time to register that prices have changed and to search for an alternate.)

In the long-term, demand becomes more elastic and current account position moves from deficit to surplus.

Question 46

What is appreciation?

Answer 46

Increase in international price of a currency caused by market forces.

Question 47

What is revaluation?

Answer 47

Decision by govt. to raise the international price of it’s currency.

Question 48

What are the effects of appreciation / revaluation of exchange rate?

Answer 48

Will make exports more expensive in terms of foreign currencies and import cheaper in terms of domestic currency.

Fall in demand of domestic products, will lead to lower aggregate demand which will give a rise to unemployment and slow down economic growth.

However, it’s main impact is causing a reduction in inflationary pressure, if the economy is operating closer to or at maximum capacity.

Higher exchange rate may also reduce inflationary pressure, by shifting aggregate supply curve to the right because of lower imported raw material costs.

The price of imported products will fall, which will increase competitive pressure on domestic firms to restrict prices in order to maintain sales at home and abroad.

Higher exchange rate may increase current account deficit or reduce a surplus but the outcome mainly depends on price elasticities of exports and imports. (Marshall-lerner condition and j-curve effect in reverse.)