Theory and problems agoutput/bcyc/mfpol

Question 1

Calculate and explain gross deomestic product (GDP) using expenditure and income approaches

Answer 1

GDP is the total market value of the goods and services produced in a country within a certain time period. GDP includes only purchases of newly produced goods and services.

Under the expenditure approach, GDP is calculated by summing the amounts spend on goods and services produced during the period

Under the income approach, GDP is calculated by summing the amounts earned by households and companies during that period (inluding wage income, interest income, and business profits)

Approaches should be equal

Question 2

Compare the sum-of-value added and value-of-final-output methods of calculateing GDP.

Answer 2

Sum-of-value-added method is the calculation of GDP by summing the additions to value created at each stage of production and distribution

Value-of-final-output method is the calculation of GDP under the expenditure approach (summing all the values of all final goods and services produced).

Question 3

Compare nominal and real GDP and calculate and interpret the GDP deflator

Answer 3

Nomial GDP is the total value of all goods and services produced by an economy, valued at current market prices (expenditures approach)

Real GDP measure the output of the economy using prices from a base year, removing the effect of changes in prices so that inflation is not counted as economic growth

GDP deflator is a price index that can be used to convert nominal GDP into real GDP, taking out the effects of changes in the overall price level

Question 4

GDP in 20X2 is $1.80 billion at 20X2 prices and $1.65 billion when calculated using 20X1 prices. Calculate the GDP deflatory using 20X1 as the base period.

Answer 4

GDP deflator = 1.80 / 1.65 * 100 = 109.1 reflecting a 9.1% increase in the price level

Question 5

Nominal GDP was $213 billion in 20X6 and $150 billion in 20X1. The 20X6 GDP deflator relative to the base year 20X1 is 122.3. Calculate real GDP for 20X6 and the compound annual real growth rate of economic output from 20X1 to 20X6.

Answer 5

Real GDP 20X6 = $213 / 1.223 = $174.16

Noting that real and nominal GDP are the same for the base year, the compound real annual growth rate of economic output over the 5-year period is:

(174.16/150)^1/5 -1 = 3.03%

Question 6

Compare GDP, national income, personal income, and personal disposable income

Answer 6

The four components of GDP are consumption, spending, business investment, government spending, and net exports. GDP = C+I+G+(X-M)

National income is the income received by all factors of production used in the creation of the final output

Personal income is the pretax income received by households

Personal disposable income is personal income after taxes

Question 7

Explain the fundamental relationship among saving, investment, the fiscal balance, and the balance trade

Answer 7

If you make the expenditure and income approach to calculating GDP (they should be equal) you get

C+I+G+(X-M) = C+S+T

Rearrange and solve for S (household and business savings)

S = I+(G-T) + (X-M)

Fiscal balance is G-T (government expenditures less net taxes, if positive this is a deficit)

Trade balance is X-M (exports less imports, if positive trade surplus)

Saving and investment is S-I (private savings less private investment)

Question 8

Explain the IS curve

Answer 8

The IS curve (investment and savings) plots the combinations of income and real interest rates for which aggregate output and income equal planned expenditures

Question 9

Explai the LM curve

Answer 9

The LM curve (liquidity money) shows the combination of GDP or real income (Y) and real interest rate (r) that keep the quantity of real money demanded equal to the quantity of real money supplied

Quantity theory of money is required

MV =PY

where M=money supply; V=velocity of money in transactions; P= price level; Y= real GDP

Real money supply is M/P, this is held constant

1/V is a fraction of real incomes

Y is real interest rate

Question 10

Explain the IS and LM curves and how they combine to generate the aggregate demand curve

Answer 10

The aggregate demand curve shows the relationship between the quantity of real output demanded (which equal real income) and the price level.

Nominal money supply (M) is held constant, and changes in the real money supply are due to changes in the price level (P)

Curve slopes downward because higher price levels (holding money supply constant) reduce real wealth, increase real interest rates, and make domestically produced goods more expensive compared to goods produced abroad, all of which reduce the quantity of domestic out demanded.

Question 11

Define the aggregate supply curve

Answer 11

The aggregate supply (AS) describes the relationship between the price level and quantity of real GDP supplied, when all other factors are kept constant. It represents the amount of output that firms will produce at different price levels.

Question 12

Explain the aggregate supply curve in the short run and long run

Answer 12

The aggregate supply curve (AS) describes the relationship between the price level and the quantity of real GDP supplied, when all other factors are kept constant

In the very short run (VSRAS) we assume wages, input cots, and prices are fixed so that producers can increase or decrease output without affecting prices. VSRAS is perfectly elastic.

In long run (LRAS), we assume all prices can vary so the the curve is perfectly inelastic

In the short run (SRAS) we assume output prices will change proportionally to the price level but that at least some in put prices are sticky (don’t change in the short run), so the result is an upward sloping SRAS curve

Question 13

Explain the causes of movements along and shift in aggregate demand curves

Answer 13

The aggregate demand curve (AD) reflects the total level of expenditures in an economy by consumers, businesses, govenments, and foreigners.

Change in price level is represented as a movement along the AD curve not a shift

A shift in the AD curve can result from a change in any of GDP = C+I+G+net X

• 1. Increase in consumers’ wealth*, income saved is less and spending increases, increasing AD
• 2. Business expectations*, when future sales are optimisitc, increase spending into plant and equipment, increases AD
• 3. Consumer expectations of future income,* save less and spend more, AD increases
• 4. High capacity utlization*, when companies produce at a high % of capacity, more investment into plant and equipment, AD increases
• 5. Expansion of monetary policy,* money supply grows and banks lend more, interest rates decrease, investment in plant and equipment as well as consumer spending increaeses, AD increases
• 6. Expansionary fiscal policy*, decreasing government budget surplus i.e. cut taxes increases govenment spending, AD increases
• 7. Exchange rates,* decrease in value of currency, increase exports decrease imports, AD increases
• 8. Global economic growth,* GDP growth in other countries increases imports, AD increases

Question 14

Explain the causes of movements along and shift in aggregate supply curves in the short-run

Answer 14

Short-run aggregate supply curve (SRAS) reflects the relationship between output and the price level when wages and other input prices are held constant

In addition to changes in potetntial GDP (shift in long-run AS), the following can change the SRAS)

• 1. Labour productivity,* holding wage constant, labour productivity increases, unit costs decrease, and out put will increase as a result, SRAS increases
• 2. Input prices,* when decreaed (i.e. wages) output increases, SRAS increases
• 3. Expectation of future output prices,* when companies expect an increase in output prices, production increases, SRAS inceases
• 4. Taxes and government subsidies,* a decrease in tax or increase in subsidies will decrease costs of production, output will increase, SRAS increases
• 5. Exchange rates,* appreciation of currency will decrease cost of imports such as production inputs, production costs decrease, SRAS increases

Question 15

Explain the causes of movements along and shift in aggregate supply curves in the long-run

Answer 15

The long-run aggregate supply curve (LRAS) is perfectly inelastic (vertical), changes in factors that affect the real output will f_ull employment_ with shift the LRAS curve.

Include

1. Increase in supply and quality of labour, increaese productivity, LRAS increases
2. Increase in the supply of natural resources, LRAS increases
3. Increase in the stock of physical capital, increase potential output and LRAS
4. Technology, increase labour productivity and real output, LRAS increases

Question 16

Describe how fluctuation in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle

Answer 16

Equilibrium in the short-run is at P 110, if it is at 115, excess supply over aggregate dmeand for a good, sometimes termed recessionary gap. Firms will see a build up of inventory and will decrease production and prices

If at P 110, there is excess aggregate demand over supply, inflationary gap

Figure: Long-run equilibrium of real output

Question 17

Explain how a short run macroeconomic equilibrium may occur at a level above or below full employment

Answer 17

In the figure, the economy is in short-run equilibrium but not long-run equilibrium

Below full employment, the difference between real GDP (GDP1) and full-employment GDP (GDP*) is call a recessionary gap or output gap; this creates downward pressure on wages and input prices, P decreases

The opposite situation, above full employment will cause upward pressure on prices and inflation, P increases

Question 18

Analyze the effect of combined changes in aggregate supply and demand on the economy

Answer 18

If aggregate demand increases relative to LRAS, out put and prices increase in the short-run, and in the ,ong-run, resource prices (espcially wages) increase, decreasing short-run aggregate supply and increasing prices further until output returns to the full employment level on the long-run aggregate supply curve (Figure)

A decrease in aggregate demand relative to the LRAS, reduces the price level and output initially, followed by decreases in resouce prices that increase short-run aggregate demand, which decreases the price level further and increases output to its long run equilibrium level

One example of combined changes is stagflation; high unemployment and increasing inflation

Question 19

Describe the sources, measurement, and sustainability of economic growth

Answer 19

Sources of economic growth include:

1. Labor supply; labour force 16 or older who are working or unemployed. Affected by population growth, immigration
2. Human capital; education and skill level of a country’s labour force
3. Physical capital stock; this is increased by high rate of investment in physical capital
4. Technology; to increase productivity
5. Natural resources; raw material inputs

Measurement of economic growth includes:

potential GDP = aggregate hours worked * labour productivity

OR growth in potential GDP = growth in labour force + growth in labour productivity

Sustainability of economic growth is the rate of increase in the economy’s productive capacity

Question 20

Describe the production function approach to analyzing the sources of economic growth

Answer 20

Production function describes the relationship between labour (L), capital stock (K), and productivity (A)

Y = A * f(l,K)

(Y) is aggregate economic output

(A), total factor productivity cannot be explained by the increases in labour and capital (i.e. technological advances)

(Y/L) is output per worker

(K/L) is physical capital per worker

We assumer the production function exhibits diminishing marginal productivity for each input, so productivity gains are also necessary for economic growth

Question 21

Distinguish between input growth and growth of total factor productivity as componenets of economic growth

Answer 21

In developed countries, where a high level of capital per worker is available and capital inputs experience diminishing marginal productivity, technological advances that increase total factor productivity are the main source of sustainable economic growth

Question 22

Describe the business cycle and its phases

Answer 22

The business cycle is characterized by fluctuations in economic activity, mainly GDP and rate of unemployment

expansion, peak, recession/contraction, trough

Question 23

Explain the typical patterns of:

resource use fluctuation,

housing sector activity,

and external trade sector activity,

as an economy moves through the business cycle

Answer 23

Resource use fluctuation

Inventory to sales ratios typically increase late in expansions when sales slow and decrease near the end of contractions when sales begin to accelerate. Firms decrease or incresase production to restore their inventory-sales ratios to their desired levels.

Firms adjust their utilization of current employees. Firms are slow to lay off employees early in contractions and slow to add employees early in expansions.

Firms use thier physical capital more intensively during expansions (invest more) and less intensively during contractions (deferring maintenance)

Housing sector activity

The level of activity in the housing sector is affected by mortgage rates, demographic changes, the ratio of income to housing prices, and investment or speculative demand for homes resulting from recent price trends

External trade sector activity

Domestic imports tend to rise with increases in GDP growth and domestic currency appreciation, while increases in foreign incomes and domestic currency depreciation tend to increase domestic export volumes

Question 24

Describe the theories of a business cycle:

Neoclassical

Keynesian economists

Monetarists

Austrian-school

Real business cycle

Answer 24

Neoclassical economists believe the business cycles are temporary and driven by changes in technology, and that rapid adjustments of wages and other input prices cause the economy to move to full-employment equilibrium

Keynesian economists believe excessive optimism or pessimism among business managers causes business cycles and that contractions can persit because wages are slow to move downward. New Keynesians believe input prices other than wages are slow to move downward.

Monetarists believe inappropriate changes in the rate of money supply growth cause business cycles, and that money supply growth should be maintained at a moderate and predictable rate to suport the growth of real GDP

Austrian-school economists believe business cycles are initiated by government intervention that drives interest to artificially low levels

Real business cycle theory holds that business cycles can be explained by utility-maximizing actors responding to real economic forces such as external shocks and changes in technology, and that policy makers should not intervene in business cycles

Question 25

Describe types of unemployment and measures of unemployment

Answer 25

3 categories: **Frictional unemployment**; results from the time lag necessary to match employees who seek work with employers needing their skills **Structural unemployment**; is cuased by long-run changes in the economy that eliminate some jobs while generating others for which unemployed workers are not qualified **Cyclical unemployment;** is caused by changes in the general level of economic activity (is positive when economy is operating at less than full capacity) Measures: **Unemployment rate** is the % of labour force that is unemployed; does not include *voluntarily unemployed* **Underemployed** is a person who is working pt but would like ft or higher salary **Participation ratio** is the % of working-age population who are either employed or actively seeking employment. This may be affected by the number of discouraged workers during economy expansion or recessions

Question 26

Explain **inflation, hyperinflation, disinflation,** and **deflation**

Answer 26

**Inflation**; is a persistent increase in the price level over time; prices of almost all goods and services are increasing **Hyperinflation;** inflation that accelerates out of control **Disinflation;** is an inflation rate that decreases over time but remains above zero **Deflation** is a persistently decreasing price level (i.e.deep recessions)

Question 27

Explain the construction of **indices used to measure inflation**

Answer 27

**The consumer price index (CPI)** is the best-knkown indicator of U.S. inflation. CPI basket represents the purchasing patterns of a typical urban household. **Price index for personal consumption expenditures** is an alternative measure of consumer price inflation. Businesses rather than consumers are surveyed. **GDP deflator** is also used widely to measure inflation Headline inflation referes to price indexes for all goods Core inflation excludes food and energy

Question 28

The following table shows price information for a simplified basket of goods Calculate the change in the price index for this basket from the base period to current period

Answer 28

Quantity \* price in base period Total cost of basket = 2,500 Quanitty \* current price Total cost of basket = 2,900 price index = 2,900 / 2,500 \* 100 = 116 The price index is up 116/100 - 1 = 16% over the period

Question 29

Compare inflation measures, including their use and limitations _Laspeyres price index_ _Passche price index _ _A Fisher price index_

Answer 29

_Laspeyres price index_ is based on the cost of a specific basket of goods and services that represents actual consumption in a base period. New goods, quality improvements, and consumers' substitution of lower-priced goods for higher-priced goods over time cause a Laspeyres index to biased upward. _Passche price index_ uses current consumption weights for the basket of goods and services for both periods and thereby reduces substitution bias. _A Fisher price index_ is the geometric mean of a Laspeyres and a Paasche. Biase can be removed by *hedonic pricing*

Question 30

Distinguish between **cost-push** and **demand-pull** inflation

Answer 30

**Cost push** results from a decrease in aggregate supply, while **demand-pull** inflation results from an increase in aggregate demand Aggregate supply can decrease if there is an increase in the real price of a factor of production i.e. labour or energy Aggregate demand would with an increase in money supply or government spending The impact on output is the key difference between the two to decrease GDP or increase GDP The non-accelerating inflation rate of unemployment (NAIRU) represents the unemployment rate below which upward pressure on wages is likely to develop Wage demands reflect inflation expectations

Question 31

Describe **economic indicators**, including their uses and limitations Give examples

Answer 31

3 types of economic indicators: l**eading** (change before peak or trough), **coincident** (same time), **lagging** (after) A limitation of using economic indicators to predict business cycles is that their relationships with business cycle are inexact and can vary over time

Question 32

Identify the past, current, or expected future business cycle phase of an economy based on economic indicators

Answer 32

Commercial and industrial lons and the CPI for services are lagging indicators. Industrial production and personal income are coincident indicators. These indicators suggest the business cycle has been in the contraction phase. Building permits and orders for nondefense capital goods are leading indicators. Increases in both of these in the latest two months suggest an economic expansion may be emerging Taken together, these data indicate that the business cycle may be at or past its trough. This conclusion would be supported if the index of leading indicators and most of its other components are also increasing.

Question 33

Compare **monetary** and **fiscal policy**

Answer 33

**Fiscal policy** refers to a governments' use of spending and taxation to incluence economic activity **Monetary policy** refers to the central bank's actions that affect the quantity of money and credit in an economy in order to influence economic acitivty. It is either expansionary or contractionary Both are used by policy makers to maintain stable prices and producing positive economic growth. Fiscal policy can be used as a tool for redistribution of income and wealth

Question 34

Define functions and definitions of **money**

Answer 34

3 primary functions: * medium of exchange or means of payment * unit of account * store of value _Narrow money_ is the amount of notes and coins in circulation in an economy plyus balances in checkable bank deposits _Broad money_ includes narrow money plys any amount available in liquid assets, which can be used to make purchases

Question 35

Explain the _money creation process_

Answer 35

In the fractional reserve system, new money created is a multiple of new excess reserves available for lending by banks. The potential multiplier is equal to the reciprocal of the reserve requirement and therefore is inversely related to the reserve requirement money created = new deposit / reserve requirement money multiplier = 1 / reserve requirment

Question 36

What is the relationship of money and the price level?

Answer 36

**Quantity theory of money** states that the quantity of money is some proportion of the total spending in an economy and implies the quantity equation of exchange money supply \* velocity = price \* real output (MV = PY) Monetarist believe that velocity an real output change slowly (constant). So if money supply increases, price does propotionatley Holding V and Y constant (not affected by M and P) is known as *money neutrality*

Question 37

Describe the theories of the **demand for** and **supply of** money

Answer 37

**Demand for money** is the amount of weath that households and firms in an economy choose to hold in the form of money. There are 3 reasons: * *Transaction demand:* as GDP increases, so do transactions and the demand for money * *Precautionary demand:* money held for unforseen needs, higher for larger firms, increases with the size of the economy * *Speculative market:* money that is available to take advantage of investment opportunties, is inversely related to returns available in the market **Supply of money** is determined by the central bank and is independent of the interest rate (this account for the veritcal inelastic) supply curve - an increase in money supply, households will buy more securities increasing security prices and decreasing the interest rate (and v.v)

Question 38

Describe the **Fisher effect**

Answer 38

The **Fisher effect** states that the nominal interest rate is simply the sum of the real interest rate and expected inflation - real rates are relatively stable and changes in interest rates are driven by changes in expected inflation. This is consistent with money neutrality

Question 39

Describe the roles and objectives of central banks

Answer 39

Key roles include: * sole supplier of currency * banker to the government and other banks * regulator and supervisor of payments system (risk and reserve requirements) * lender of last resort * holder of gold and foreign exchange reserves * conductor of monetary policy Primary objectives include: * control inflation (US 2-3%) * stability in exchange rates * full employment * sustainable positive economic growth * moderate long-term interest rates

Question 40

Contrast the costs of expected and unexpected inflation

Answer 40

_High inflation_, even when it is perfectly anticipated, imposes costs on th eeconomy as people reduce cash balances because of the higher opportunity cost of holding cash _Unexpected inflation_, has more significant costs because the information value of price changes, can make economic cycles worse, and shifts wealth from lenders to borrowers. Uncertainty about the future rate of inflation increases risk, resulting in decreased business investment

Question 41

Describe the _implementation_ of monetary policy

Answer 41

Monetary policy is implmented using 3 main policy tools: * policy rate (used to lend funds to member banks in shortfalls) * discount rate (US) * refinancing rate (ECB) * 2-week repo rate (UK) * reserve requirements (increase will decrease funds available which will increase interest rates and v.v.) * open market operations (buying and selling of securities by the central bank) Decreasing the policy rate, decreasing reserve requirements, and making open market purchases of securities are all expansionary

Question 42

Describe the _qualities_ of effective central banks to succed in its inflation targeting policies

Answer 42

3 essential qualities: 1. independence (from politicians) * political party has incentives to boost economy and jobs at end of term * *operational independence*, central bank determines policy rate * *target idependence,* central bank defines how inflation is computed, set level, and time 2. Credibility (should follow through on stated intentions) 3. Transparency * should disclose the state of economic environment by issueing inlation reports

Question 43

Explain the relationships between monetary policy and economic growth, inflation, interest, and exchange rates (**transmission mechanism**)

Answer 43

Central banks manipulation of short-term rates can affect real variables (economic growth and inflation rate) through a **transmission mechanism** if in recession: * central bank buys securities, which increases bank reserves * _interbank lending rate decreases_, bank more willing to lend each other reserves * longer term interest rates decrease * Increase in business investment into plant and equipment * consumer spending increases * depreciation in currency increaes exports * Increase in consumption, investment, and net exports increases aggregate demand * Increase in aggregate demand increases **inflation, employment, and real GDP** Transmission mechanism for the decrease in interbank lending rates affects four things 1. Market rates decrease 2. Asset prices increases (lower discount rates for NPV) 3. Firms and individuals their expectations for economic growth 4. Domesitc currency depreciates

Question 44

Constrast the use of inflation, interest rate, and exchange rate targeting by central banks

Answer 44

Most central banks set target inflation rates, typically 2-3%, rather than targeting interest rates (which was once common) When inflation is expected to rise above the target band, the money supply is decreased to reduce economic activity (and v.v) Developing economies sometimes target a stable exchange rate for their currency relative to that of a developed economy, selling their currency when above the target and v.v

Question 45

Determine whether a monetary policy is expansionary or contractionary

Answer 45

A **contractionary** policy is associated with a decrease in the growth rate while **expansionary** policy increases its growth rate a **neutral interest rate** = real trend rate of economic growth + inflation. This is the growth rate of the money supply that neither increases nor decreases the economic growth rate

Question 46

Describe the limitations of monetary policy

Answer 46

Reasons the monetary policy may not work as intended: * monetary policy changes may affect inflation expectations to such an extent that long-term interest rates move opposite to short-term interest rates * individuals may be willing to hold greater cash balances without a change in short-termm rates (**liquidity trap**) * Banks may be unwilling to lend greater amounts, even when they have increased excess reserves * Short-term rates cannot be reduced below zero * Developing economies face unique challenges in utilizing monetary policy due to undeveloped financial markets, rapid financial innovation, and the lack of credibility of monetary authority

Question 47

Describe the roles and objectives of fiscal policy

Answer 47

**Fiscal policy** refers to a government's use of spending and taxation to meet macroeconomic goals **Objectives** include: * influencing the level of economic activity and aggregate demand * redistributing wealth and income among segments of the population * allocating resources among economic agents and sectors in the economy Keynesian economists believe that fiscal policy through its effect on aggregate demand should be used to stim economic growth when operating at less than full employment Monetarists believe that fiscal stimulus is only temporary and monetary policy should be used to change inflationary pressures (but not used to influence aggregate demand)

Question 48

Describe the tools of fiscal policy, including their advantages and disadvantages

Answer 48

Fiscal policy tools include spending tools and revenue tools Spending tools (most effective for increasing aggregate demand) * transfer payments e.g. social security and unemployment insurance beneftis (not included in GDP) * current spending (of goods and services) * capital spending (on infrastrucutre) Revenue tools * direct taxes (levied on income or wealth) * indirect taxes (levied on goods and services Advantages of fiscal policy tools * social policies, such as discourage tobacco use, can be implemented very quickly via indirect taxes * quick implementation of indirect taxes also means that government revenues can be increased without significant additional costs Disadvantages * direct taxes and transfer payments take time to implement, delaying the impact of sical policy * capital spending also takes a long time to implement, the economy may have recovered by the time its impact is felt

Question 49

What is a f**iscal multiplier**, **balanced budget multiplier**, and **ricardian equivalence**

Answer 49

**Fiscal multiplier** The effect government spending has on aggregate dmeand because those whose incomes increase from increased government spending will in turn increase their spending, which increases the incomes and spending of others fiscal multiplier = 1 / 1-MPC(1-t) marginal propensity to consume **Balanced budget multiplier** The effect on aggregate demand that increasing taxes has. balanced budget multiplier = 100(MPC)\*fiscal multiplier **Ricardian equivalence** When taxpayers reduce current consumption and increase current saving by just enough to repay the principal and interest on the debt the government issued to fund the increased deficit

Question 50

Describe the arguments for and against being concerned with the size of a fiscal deficit (relative to GDP)

Answer 50

Debt ratio is the ratio of aggregate debt to GDP **Arguements for:** * Higher deficit leads to higher future taxes, which leads to disincentives to work and entrepreneurship, leads to l_ower long-term economic growth_ * If markets lose confidence in the government, investors may not be willing to refinance debt, could lead to government defaulting (forigen debt) or printing money (domestic debt) which leads to _high inflation_ * Crowding out effect; increased interest rates from increased government borrowing which decreases private sector borrowing **Arguments against:** * if debt is primarily held by domestic citizens, the scale of the problem is over stated * if debt is used to finance productive capital investments, future economic gains will be sufficient to repay debts * fiscal defecits may prompt needed tax reform * deficits would not patter if private sector savins in anticipation of future tax liabilities just offsets government deficits (ricardian equivilance holds) * if the economy is operating at less than full capacity, deficits do not divert capital away from productive assets and can aid in increasing GDP and employment

Question 51

Explain the implementation of fiscal policy and the difficulties of implementation

Answer 51

Fiscal policy is implemented by government changes in taxing and spending policies. Delays in realizing the effects of fiscal policy changes limit their usefulness. Delays can be caused by: * recognition lag; policy makers may not immediately recognize when fiscal policy changes are needed * action lag; governments take time to enact needed fiscal policy changes * impact lag; fiscal policy changes take time to affect economic activity

Question 52

Determine whether a fiscal policy is expansionsary or contractionary

Answer 52

An increase in surplus is indicative of a contractionary fiscal policy and an increase in deficit is indicative of an expansionary fiscal policy

Question 53

Explain the interaction of monetary and fiscal policy

Answer 53

4 scenarios: 1. Expansionary fiscal and monetary policy * highly expansionary * interest rates will usually be lower * private and public sectors will both expand 2. Contractionary fiscal and monetary policy * aggregate demand and GDP will be lower * interest rates would be high due to tight monetary policy * private and public sectors will contract 3. Expansionary fiscal policy and contractionary monetary policy * aggregate demand will likely be higher (fiscal policy) * interest rates will be higher (increased gov't borrowing and tight monetary policy) * gov't spending as a proportion of GDP will increase 4. Contractionary fiscal and expansionary monetary * interest rates will fall (decreased gov't borrowing and expansion of money supply) * increase in private consumption and output * gov't spending as a proportion of GDP will decrease (fiscal policy) * private sector will grow (result from lower interest rates) For all types of fiscal stimulus, effects are greater when combined with expansionary monetary policy

Question 54

Compare gross domestic product and **gross national product**

Answer 54

Gross domestic product over a period (a year) is the total value of goods and services produced within a country's boarders **Gross national product** is the total value of goods and services produced by the labour and capital of a country's citizens Difference due to * non-citizen incomes of foreigners working within a country * income of citizens who work in other countries * income of foreign capital invested within a country * income of capital supplied by its citizens to foreign countries The income of citizens working abroad is included in GNP but not GDP GDP is more closely related to economic activity within a country and so to its employment and growth

Question 55

Describe the benefits and costs of international trade

Answer 55

**Benefits:** * specilize in the production of an export and benefit from economies of scale * greater product variety * more competition * efficient allocation of resources **Costs:** * losses to domestic industries that lose business to foreign competition * unemployment may increase in the short term, however overall gains are thought to exceed costs so that winners could compensate losers

Question 56

Distinguish between comparative advantage and absolute advantage

Answer 56

**Absolute advantage**; country can produce a good at a *lower cost* in terms of resources than another country **Comparative advantage**; country can produce a good at a *lower opportunity cost* than another country As long as opportunity costs differ, two countries can both benefit from trade

Question 57

Explain the **Ricardian and Heckscher - Ohlin models** of trade and the source(s) of comparative advantage in each model

Answer 57

**Ricardian model** of trade has only _one_ factor of production - labour. The source of differences in labour productivity are due to *differences in technology* **Heckscher and Ohlin** model of trade has _two_ factors of production - capital and labour. The souce of comparative advantage is the *differences in the relative amounts of each factor* the countries possess

Question 58

Compare **types of trade and capital restricition** and their economic implications

Answer 58

Types of trade restricitons: * **tariffs**: taxes on imported good collected by the government * **quotas:** limits on the amount of imports allowed over some period * **export subsidies:** gov't payments to firm that export goods * **minimum domestic content:** requirement that some percentage of product content must be from the domestic country * **voluntary export restraint:** restriciton of amount exported to avoid tariffs or quotas imposed by trading partner Economic implications of trade restrictions for importing country: * reduce imports * increase price * decrease consumer surplus * increase domestic quantity supplied * increase producer surplus Export subsidies decrease export prices and benefit importing countreis at the expense of the exporting gov't All decrease national welfare except for tariffs and quotas because for a country that imports a large amount of the good, setting a quota or tariff could reduce the world price for the good

Question 59

Explain motivations for and advantages of **trading blocs, common markets, and economic unions**

Answer 59

Trade agreements, which increase economic welfare by facilitating trade among member countries, take the following forms: * free trade area (NAFTA): all barriers to the import and export of goods and services among member countries are removed * custom union: member countries *also* adopt a common set of trade restrictions with non-members * common market: member countries also remove all barriers to the movement of laour and capital goods among members * economic union: member countries also establish common institutions and economic policy for the union * monetary union (EU): member countries also adopt a single currency

Question 60

Describe the **balance of payments accounts** including their components

Answer 60

Balance of payments refers to the fact that increases in a country's assets and decreases in its liabilites must balance with decreases in its assets and increases in its liabilities. Includes the current account, captial account, and financial account Current accout: * includes imports and exports of mechandise and services * foreign income from dividens on stock holdings and interest of debt securities * unilateral transfers such as money received from those working abroad Capital account * includes debt forgiveness * assets that migrants bring to or take away from a country * transfer of funds for the purchase or sale of fixed assets * purchases of non-financial assets (patents etc.) Financial account * includes government-owned assets abroad (gold, foreign currencies) * direct foreign investment and claims against foreign banks * foreign-owned assets * domestic gov't and corporate securities, direct invetment in domestic country and currency Overall, any surplys (deficit) in the current account must be offset by a deficit (surplus) in the capital and financial accounts

Question 61

Explain how decisions by consumers, firms, and governments affect the balance of payments

Answer 61

In equilibrium, we have the relationship exports-imports = private savings + gov't savings - domestic investment When total savings is less than domestic investment, exports must be less than imports so that there is a deficit in the current account; requires foreign investment in domestic capital

Question 62

Describe functions and objectives of the international organizations that facilitate trade, including the **World Bank**, the **International Monetary Fund,** and the **World Trade Organization**

Answer 62

The World Bank * provides low-interest laons, interest-free credits, and grants to developing countries * provides resources and knowledge and helps form private/public partnerhips * overall goal is to fight poverty International Monetary fund * facilitates trade by promoting international monetary cooperations and exchage rate stability * assists in setting up international payments systems * makes resources available to member countries with balance of payments problems World Trade Organization * goal of ensuring that trade flows freely and works smoothly * focus on instituting, interpreting, and enforing a number of multilateral trade agreements that detail global trade policies

Question 63

Define an **exchange rate** and distinguish between **nominal and real exchange rates** an **spot and forward exchange rates**

Answer 63

**Exchange rate** (*d/f domestic per foreign*) is the price or cost of units of one currency in terms of another **Nominal exchange rate** is just the price currency per base currency **Real exchange rate** measures changes in relative purchasing power over time real exchange rate (d/f) = nominal exchange rate (d/f) (CPI_foreign/CIP_domestic) **Spot exchange rate** is the currecny exchange rate for immediate delivery (2 days after trade) **Forward exchange rate** is a currency exchange rate for an exchange to be done in the future (30,60,90 days etc.)

Question 64

At a base period, the CPIs of the US and UK are both 100, and the exchange rate is $1.70/£. Three years later, the exchange rate is $1.60/£, and the CPI has risen to 110 in the US and 112 in the UK. What is the real exchange rate?

Answer 64

real exchange rate (d/f) = nominal exchange rate (d/f) (CPIforeign/CIPdomestic) $160/£ \* 112/110 = $1.629/£ means the US goods and services that cost $1.70 at the base period now cost only $1.629 (in real terms) if purchased in the hUK and the real exchange rate, $/£ has fallen

Question 65

Describe the **functions of and participants** in the foreign exchange market

Answer 65

The market for foreign exchange (FX) is the largest financial market in terms of the value of daily transactions and has a variety of participants, including * multinational banks (the sell side) * corporations * investment fund managers * hedge fund managers * investors * governments * and central banks (buy side) hedgers - decrease FX risk speculators - increase FX risk

Question 66

Calculate and interpret the percentage change in a currency relative to another currency

Answer 66

Given USD/EUR has changed from 1.42 to 1.39 percentage change is 1.39/1.42 - 1 = -0.0211 Correct to EUR has depreciated by 2.11% relative to USD Cannot say USD has appreciated by 2.11% Must convert EUR/USD 1/1.42 = 0.7042 and 1/1.39 = 0.7194 EUR/USD 0.7194/0.7042 - 1 = 2.16% It is correct to say USD has appreciated 2.16% relative to EUR **Can correcly calculate the percentage change of the base currency only**

Question 67

Calculate and interpret **currency cross-rates**

Answer 67

The **cross rate** is the exchange rate between two currencies implied by their exchange rates with a common third currency. Necessary when there is no active FX market in the currency pair.

Question 68

The spot exchange rate between the Swiss frac (CHF) and the USD is CHF/USD = 1.7799, and the spot exchange rate between the New Zealand dollar (NZD) and the US dollar is NZD/USD = 2.2529. Calculate the CHF/NZD spot rate.

Answer 68

(CHF/USD) / (NZD/USD) = 1.7799 / 2.2529 = 0.7900

Question 69

The AUD/EUR spot exchange rate is 0.7313 with the 1-year forward rate quoted at +3.5 points. What is the 1-year forward AUD/EUR exchange rate? The AUD/EUR spot rate is quoted at 0.7313 and the 120-day forward exchange rate is given as -0.062%. What is the 120-day forward AUD/EUR exchange rate?

Answer 69

The forward exchange rate is 0.7313 + 0.00035 = 0.73165 The forward exchange rate is 0.7313(1-0.00062) = 0.7308

Question 70

Explain the arbitrage relationship between spot rates, forward rates and interest rates

Answer 70

If a forward exchange rate does not correctly reflect the difference between the interest rates for two currencies, an arbitrage opportunity for a riskless profit exists. In this case, borrowing one currency, converting it to the otehr currency at the spot rate, investing the proceeds for the period, and converting the end-of-period amount back to the borrowed currency at the forward rate will produce more than enough to pay off the initial loan, with the reminader being a riskless profit on the arbitrage transaction.

Question 71

Consider two currencies, the ABE and the DUB. The spot ABE/DUB exchange rate is 4.5671, the 1-year riskless ABE rate is 5%, and the 1-year riskless DUB rate is 3%. What is the forward exchange rate that will prevent arbitrage profits.

Answer 71

forward / spot = (1+ interest rate_domestic) / (1 + interest rate_foreign) Rearrange forward = spot (1+I_ABE / 1 + I_DUB) = 4.5671(1.05/1.03) = 4.6558(ABE/DUB) Note the forward rate is greater than spot rate by 4.6558/4.5671 - 1 = 1.94%. This is approx equal to interest rate differential 5-3 = 2% The currency with the higher interest rate should depreciate over time by the amount of the interest rate differential

Question 72

Describe exchange rate regimes * formal dollarization* * monetary union* * currency board arrangement* * conventional fixed peg arrangement* * pegged exchange rates * * crawling peg* * management of exchange rates within crawling bands* * managed floating exchange rates* * independently floating *

Answer 72

Exchange rate regimes for countries that do not have their own currency: * with *formal dollarization*, a country uses the currency of another country * in a *monetary union*, several countries use a common currency Exchange rate regimes for countries that have their own currency: * a *currency board arrangement* is an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate * in a *conventional fixed peg arrangement,* a country pegs its currency within margins of ±1% versus another country * pegged exchange rates within horizontal bands or a target zone, the permitted fluctuations in currency value relative to another currency or basket of currencies are wider (e.g. ±2%) * *crawling peg,* the exchange rate is adjusted periodically, typically to adjust for higher inflation versus the currency used in the peg * *management of exchange rates within crawling bands*, the width of the bands that identify permissible exchange rates is increased over time * *managed floating exchange rates*, the monetary authority attempts to influence the exchange rates in response to specific indicators, such as the balance of payments, inflation rates, or unemployment without any specific target exchange rate * *independently floating,* the exchange rate is market-determined

Question 73

Explain the impact of exchage rates on countries international trade and capital flows *elasticties approach and absorption approach*

Answer 73

2 approaches, **elasticities approach** (total value of exports and imports) **and absorption approach** (capital flows) keep in mind: X - M = (S-I) + (T-G) **Elasticities** (ε) of export and import demand must meet the Marshall-Lerner condition for a depreciation of domestic currency to reduce an existing trade deficit W_Xε_X = W_M(ε_M-1) \> 0 W is proportion of export and imports ε is price elasticity of demand for exports and imports Under the **absorption approach**, national income must increase relative to national expenditure in order to decrease a trade deficit. This can also be viewed as a requirement that national saving must increase relative to domestic investment in order to decrease a trade deficit