ECON 100 Tutorial: Week 19

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ECON 100 Tutorial Week 19

• www.lancaster.ac.uk/postgrad/murphys4/
• s.murphy5_at_lancaster.ac.uk
• office hours 300PM to 445PM tuesdays LUMS C85

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Question 1

• Use AD-AS analysis to show how each of the events
  below will affect the equilibrium price level and
  real output in an economy in the short run when
  the aggregate supply curve is i) upward-sloping
  to the right and
• ii) a crude Keynesian curve.
• In each case, draw the appropriate diagram.
• a) Government spending increases
• b) The nominal money supply increases
• c) Workers expect inflation to rise and negotiate
  higher money wages today
• d) New technology increases the productivity of
  workers
• e) Consumers expect the economy to go into
  recession.

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Question 1(a) Government spending increases

• Use AD-AS analysis to show how this will affect
  the equilibrium price level and real output in an
  economy in the short run when the aggregate
  supply curve is i) upward-sloping to the right
  and ii) a crude Keynesian curve. Draw the
  appropriate diagram.
• Increased government spending shifts the AD curve
  to the right. The Keynesian AS curve is an L on
  its back
•  For i) both real output and the price level
  rise. See diagram below. For ii), the answer
  depends on the position of the AD curve relative
  to potential (full employment) output. Where the
  AS curve is horizontal (AD1) , real output rises
  and the price level is unchanged at AD2. Where AS
  is vertical at potential output (AD3) then real
  output is unchanged but the price level rises at
  AD4.

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Question 1(b) The nominal money supply increases

• Use AD-AS analysis to show how this will affect
  the equilibrium price level and real output in an
  economy in the short run when the aggregate
  supply curve is i) upward-sloping to the right
  and ii) a crude Keynesian curve. Draw the
  appropriate diagram.
• The outcomes are as in a) for both i) and ii).
  Expansionary fiscal and monetary policies have
  the same effects in the AD-AS framework.

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Question 1(c) Workers expect inflation to
rise and negotiate higher money wages today

• Use AD-AS analysis to show how this will affect
  the equilibrium price level and real output in an
  economy in the short run when the aggregate
  supply curve is i) upward-sloping to the right
  and ii) a crude Keynesian curve. Draw the
  appropriate diagram.
• For i), higher wages raise costs for firms and so
  the SRAS curve in i) shifts upwards. The price
  level is then higher and real output is lower.
  The economy is experiencing stagflation.
• For ii), the AS curve shifts upwards along the
  horizontal section. The price level therefore
  rises and real output falls. Along the vertical
  section of the curve the price level rises and
  real output is unaffected if aggregate demand is
  at AD3. At AD2 the price level rises and real
  output falls as at AD1

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Question 1(d) New technology increases the
productivity of workers

• Use AD-AS analysis to show how this will affect
  the equilibrium price level and real output in an
  economy in the short run when the aggregate
  supply curve is i) upward-sloping to the right
  and ii) a crude Keynesian curve. Draw the
  appropriate diagram.
• For i), technical progress shifts the SRAS
  downwards as costs fall. The price level in the
  economy falls and real output rises.
•  
• For ii), if the AS curve shifts down along its
  horizontal section and the AD curve cuts this
  part of the AS curve, the price level falls and
  real output rises.
•  
• Potential output also rises with technical
  progress so the vertical section of the curve
  would shift to the right in the long run. If the
  AD curve cuts this part of the AS curve, in the
  long run the price level will fall and output
  would rise. In the short run, however, neither
  the price level nor real output would change with
  this AD curve.

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Question 1(e) Consumers expect the economy to go
into recession.

• Use AD-AS analysis to show how this will affect
  the equilibrium price level and real output in an
  economy in the short run when the aggregate
  supply curve is i) upward-sloping to the right
  and ii) a crude Keynesian curve. Draw the
  appropriate diagram.
• The AD curve shifts to the left as consumers
  reduce consumption. The effects are the reverse
  of those in a) and b) for i) both the price
  level and real output fall.
•  
• For ii), along the horizontal section of the AS
  curve
• real output falls but the price level is
  unchanged
• (AD2 falls to AD1). Along the vertical section,
• the price level falls (AD4 falls to AD3).
•  
• It is possible that if AD falls far enough, real
  output will fall as well. For example if AD fell
  from AD3 to AD2 in the diagram below. If the AD
  curve is still on the vertical part of the AS
  curve, however, real output is unaffected.

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Question 2

• Show the effect on the slope of the aggregate
  demand curve of the following changes
•  
• a) A fall in the interest elasticity of demand
  for money
• b) A fall in the marginal propensity to consume
• c) An increase in the interest elasticity of
  demand for investment.
• Hint Bear in mind how the AD curve can be
  derived from changes in the money market caused
  by changes in the price level and the IS-LM
  model.

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Question 2(a)

• Show the effect on the slope of the aggregate
  demand curve of A fall in the interest elasticity
  of demand for money
• Hint Bear in mind how the AD curve can be
  derived from changes in the money market caused
  by changes in the price level and the IS-LM
  model.
• A lower interest elasticity of demand for money
  means a steeper liquidity preference (demand for
  money) curve.
•  
• If the price level now rises, the change in the
  real money supply that this brings about causes
  interest rates to increase more in the money
  market given the steeper liquidity preference
  curve. This means a bigger fall in investment and
  so a bigger fall in AD and real output. For this
  reason, the AD curve is now flatter.
•  
• It is possible to show the same effect with a
  price fall.

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Question 2(b)

• Show the effect on the slope of the aggregate
  demand curve of A fall in the marginal propensity
  to consume
• If the marginal propensity to consume falls, the
  slope of the AD curve in the Keynesian cross
  diagram is flatter. This means that when interest
  rates changes following a change in the price
  level, the change in investment that results does
  not affect the AD curve as much. The AD curve is
  therefore steeper.

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Question 2(c)

• Show the effect on the slope of the aggregate
  demand curve of An increase in the interest
  elasticity of demand for investment
• Hint Bear in mind how the AD curve can be
  derived from changes in the money market caused
  by changes in the price level and the IS-LM
  model.
• Investment responds more to changes in interest
  rates caused by a change in the price level as
  the marginal efficiency of investment curve is
  flatter. AD therefore responds more to the
  associated change in price level and so the AD
  curve is flatter.
• Taken together, the three concepts in a), b) and
  c) are key determinants of the slope of the AD
  curve.

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Question 3

• In the United States, the collapse of a housing
  market bubble and the ensuing financial crisis
  led to the steepest drop in real GDP and the
  largest increase in the unemployment rate since
  the Great Depression. The fallout from these
  events on credit availability, balance sheets,
  and confidence continues to weigh on aggregate
  demand, restraining the pace of recovery in the
  housing market, firms willingness to hire and
  invest, and spending by consumers and state and
  local governments. In addition, these demand
  effects have probably diminished the productive
  capacity of the economy.
• Reifschneider D, Wascher W and Wilcox D (2013),
  Aggregate Supply in the United States Recent
  Developments and Implications for the Conduct of
  Monetary Policy, Paper presented at the 14th
  Jacques Polak Annual Research Conference, Hosted
  by the International Monetary Fund, Washington,
  DC-November 78, 2013
•  
• a) Show using AD-AS analysis how the authors
  think the US economy responded to the financial
  crisis of 2008.
• b) How did demand effects diminish the
  productive capacity of the economy?

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Question 3(a)

• In the United States, the collapse of a housing
  market bubble and the ensuing financial crisis
  led to the steepest drop in real GDP and the
  largest increase in the unemployment rate since
  the Great Depression. The fallout from these
  events on credit availability, balance sheets,
  and confidence continues to weigh on aggregate
  demand, restraining the pace of recovery in the
  housing market, firms willingness to hire and
  invest, and spending by consumers and state and
  local governments. In addition, these demand
  effects have probably diminished the productive
  capacity of the economy.
• Show using AD-AS analysis how the authors think
  the US economy responded to the financial crisis
  of 2008.
• The paper shows how the concepts of aggregate
  demand, aggregate supply and potential output are
  used by economists to think about the effect of
  events on the economy.
• What happened in 2008 in the US (and other
  economies worldwide) was that aggregate demand
  fell markedly as a result of the global financial
  crisis. In AD-AS analysis this is represented by
  a shift to the left of the AD curve. AD-AS
  analysis suggests, therefore, that this shock to
  the economy would reduce real output and the
  price level in the short run. And that is what
  happened in the US. Similar effects took place in
  other economies that included negative inflation
  rates for a short while at least. In the US,
  inflation on some measures was negative in most
  months throughout the period from March to
  December 2009 just as AD-AS analysis suggests
  would happen.
•  
• The response of the US economy at the time also
  suggests that the short run aggregate supply
  curve in the US is upward-sloping to the right
  and not vertical as in the New Classical School.
  That said, there is something called the Lucas
  short run aggregate supply curve that allows for
  the possibility of unanticipated demand shocks to
  the economy causing the aggregate supply curve to
  slope upwards in the short run. The financial
  crisis would be, of course, a very good example
  of such a shock as very few actually saw it
  coming.

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Question 3(b)

• In the United States, the collapse of a housing
  market bubble and the ensuing financial crisis
  led to the steepest drop in real GDP and the
  largest increase in the unemployment rate since
  the Great Depression. The fallout from these
  events on credit availability, balance sheets,
  and confidence continues to weigh on aggregate
  demand, restraining the pace of recovery in the
  housing market, firms willingness to hire and
  invest, and spending by consumers and state and
  local governments. In addition, these demand
  effects have probably diminished the productive
  capacity of the economy.
• How did demand effects diminish the productive
  capacity of the economy?
• It has been suggested (not just by these authors)
  that potential output was affected by the demand
  shock the economy experienced in late 2008 and
  into 2009.
•  
• Faced with the huge (and in modern times
  unprecedented) falls in demand at the time, firms
  cut back markedly on investment. (This would, by
  the way, suggest an accelerator effect at work.)
  The capital stock, a key determinant of an
  economy's potential output, therefore fell. Given
  the continuing nature of the crisis over the
  years since 2009, and its effect on demand and
  government spending, the curb on investment has
  arguably reduced the quality of the capital stock
  over time as the latest capital goods are not
  brought into use. These would have incorporated
  incremental technical improvements as well as new
  technology that maintain trend growth in
  potential output over time. In addition, a
  declining quality of capital stock could reduce
  worker productivity through having to use older
  capital.
•  
• A shift to the left of the LRAS curve (or at
  least a smaller shift to the right) resulting
  from these effects puts further downward pressure
  on output and raises the prospect of higher
  inflation as demand recovers. Draw the diagram to
  show this effect at work. In total, there would
  be long term as well as short-term consequences
  for the economy as future economic growth, and so
  real output, are reduced.

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Question 4

• Which of the curves show that supply is perfectly
  elastic up to potential output YN?
•  
• a) I only
• b) I and II only
• c) I and III only
• d) None of them

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Question 5

• Which of the curves show that there is a ratchet
  effect?
• a) I only
• b) I and II
• c) II only
• d) III only

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Question 6

• Which of the curves show that when output is at
  YN an increase in aggregate demand will raise
  both the price level and income in the economy?
•  
• a) II only
• b) II and III only
• c) I and III only
• d) None of them

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Question 7

• Which of the curves show that curing an
  inflationary gap will always reduce prices?
•  
• a) II only
• b) III only
• c) I and II only
• d) All of them

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Question 1a)

• Using the concept of the circular flow of income,
  show why national income in an economy must equal
  both national spending and national output.
• National income is the income received by
  households from firms in the circular flow. This
  equals the amount of spending that households
  undertake, so National Income is equivalent to
  National Expenditure.
• The value of what firms produce (National Output)
  is the same as the cost of the goods. These costs
  are the costs of the factor of production that
  households provide to the firms for which they
  receive income. And so National Output and
  National Income are equivalent to one another.
• Through these equalities, National Expenditure
  and National Output must also be the same.
• The identity is used in the National Income
  statistics.

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Question 1b)

• Explain, with the help of a suitable diagram,
  what is meant by an inflationary gap.
• Inflationary gap is the difference in expenditure
  due to a level of output greater than full output

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Question 1c)

• The marginal propensity to consume in an economy
  is 0.6. What is the value of the multiplier?
• If full employment income in this economy is
  1500 billion and current equilibrium income
  1300 billion, by how much would the government
  in this economy need to raise its own spending to
  achieve full employment?
• The multiplier is 2.5 (1/1 0.6).
•  
• Change in spending required is 200/2.5 80
  billion.

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Question 1d i and ii)

• Households in an economy have a constant income
  over their working life of 30,000. Working lives
  start at the age of 20 and last 40 years. After
  that, retirement lasts 20 years. Households also
  have an initial endowment of wealth from
  inheritance of 100,000, which they receive at
  the age of 20. Assuming the interest rate is
  zero, what does the life cycle hypothesis suggest
  are
• i) the current consumption of households
  throughout their expected lives?
• Total income is 1,200,000. They also have
  100,000 inherited wealth. This gives total
  wealth as 1,300,000. Consumption per year will
  be 1,300,000/60 21,666.67.
• ii) household savings throughout their working
  lives?
• Savings will be 30,000 minus consumption of
  21,666.67 8,333.33

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Question 1d iii)

• the difficulties for governments in conducting
  fiscal and monetary policy? Illustrate your
  answer to this question with reference to your
  answers to i) and ii).
• The problems for the government are that in
  applying these policies they will not get the
  same effect on consumption and therefore
  aggregate demand from temporary changes in G, T,
  the money supply or interest rates. Households
  will simply spread the benefit over the remaining
  years of expected life. The marginal propensity
  to consume is therefore much lower in the short
  run for temporary changes in income as is the
  value of the multiplier which depends upon the
  size of the MPC. To close a deflationary gap, for
  example, would require bigger adjustments in
  government spending.
•  
• In referring to the earlier answers students
  could use a change in income due to a change in
  government policy giving, say, a one-off rise in
  income of 1,000. They would then recalculate the
  new permanent income and consumption. From this
  they can show the marginal propensity to consume
  out of the change in income, which will be
  relatively low.

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Question 1e)

• Briefly explain, using appropriate economic
  analysis, whether or not you think the marginal
  propensity to consume of rich households is the
  same as that of poor households.
• In the simple Keynesian consumption function, the
  marginal propensity to consume is often presented
  as constant. In this case, the marginal
  propensity to consume of all households is the
  same. This does not have to be the case, however.
•  
• As income rises the marginal utility of
  consumption of rich households could be expected
  to fall, a lesson learned from microeconomics.
  Rich households might as a result be less likely
  to consume changes in income than poor
  households. Poor households, in contrast, would
  have many more consumption possibilities when
  income increased and so a higher marginal
  propensity to consume.
•  
• Also, rich households might be more prepared to
  save when income increases. Under the permanent
  income hypothesis where transitory shocks to
  income are thought to be positive for this group
  and lead to current income exceeding permanent
  income, the marginal propensity to save out of
  income from these positive transitory shocks is
  like to be high.
•  
• Poor households on the other hand face the
  opposite situation of negative transitory shocks
  and would therefore be more likely to consume in
  the face of a transitory fall in income. Their
  marginal propensity to consume would, therefore,
  be higher.
•  
• On the other hand, the permanent income
  hypothesis suggests that the average propensity
  to consume of all households tends in the long
  run to be the same. It does not decline with
  income as the Keynesian consumption function
  suggests. This result was the basis for the
  Lorenz paradox, which could be mentioned here. A
  constant average propensity to consume would
  imply the same marginal propensity to consume for
  all households.

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Question 2a)

• Show, using appropriate diagrams, what would you
  expect to be the effect of a rise in interest
  rates on
• i) the level of investment by firms in an economy
• identify the marginal efficiency of capital or
  investment schedule.

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Question 2a)

• Show, using appropriate diagrams, what would you
  expect to be the effect of a rise in interest
  rates on
• ii) the demand for bank loans
• provide the demand curve for bank loans

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Question 2a)

• Show, using appropriate diagrams, what would you
  expect to be the effect of a rise in interest
  rates on
• iii) the demand for money?
• the liquidity preference curve is required.

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Question 2b)

• A firm expects the revenues each year from
  investing in a new machine to be as follows
• Year 1 2 3 4
• 20,000 25,000 25,000 15,000
• At the end of year 4 the machine will be
  scrapped.
• The cost of the machine today is 78,000. The
  firm uses a discount rate of 4. Explain why you
  think the firm should or should not buy the
  machine.
• At a discount rate of 4 the present values are
• Year Present Value
• 1 20,000/1.04 19,230.77
• 2 25,000/1.042 23,113.91
• 3 25,000/1.043 22,224.91
• 4 15,000/1.044 12,882.06
• The sum of these present values is 77,391.65.
• This means that on a cost-benefit basis the firm
  would not buy the machine.

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Question 2b)

• A firm expects the revenues each year from
  investing in a new machine to be as follows
• Year 1 2 3 4
• 20,000 25,000 25,000 15,000
• At the end of year 4 the machine will be
  scrapped.
• Does your decision change if interest rates fall
  and the discount rate is now 3?
• At a discount rate of 3 the present values
  become
•  
• Year Present Value
• 1 20,000/1.03 19,417.48
• 2 25,000/1.032 23,564.90
• 3 25,000/1.033 22,878.54
• 4 15,000/1.034 13,327.31
• The sum of these present values is 79,188.22.
• This means that the firm would now buy the
  machine.

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Question 2c)

• Briefly explain why debit cards are not money.
• Debit cards are used by consumers to assure a
  seller of a good that the customer has the funds
  in her or his bank account to settle the debt
  with the seller. Without the funds in the bank, a
  debit card is worthless. It is the bank account
  (deposit) therefore that is the money which
  settles the debt and not the card.
• As with cheques, debit cards are the way a
  customer instructs their bank to transfer funds
  from their bank account to that of the seller.

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Question 2d)

• Suppose there is an increase in autonomous
  investment in an economy. What does IS-LM
  analysis suggest might happen to interest rates
  and income in this economy if the economy is in a
  liquidity trap? Illustrate your answer with an
  appropriate diagram.
•  
• If the economy is in a liquidity trap then it is
  possible that the increase in investment by
  shifting the IS curve to the right will increase
  income while leaving interest rates unchanged
  (IS1 to IS2 below). It is also possible, however,
  that if the shift to the right is large enough
  (to IS3 below) then the IS curve moves to the
  upward-sloping part of the LM curve. Interest
  rates then rise along with income as a result of
  investment rising.
• Both these points can be illustrated on a diagram
  like the one below showing IS curves and an LM
  curve illustrating a liquidity trap at a low
  interest rate r.

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Question 2d)

• If the economy is in a liquidity trap then it is
  possible that the increase in investment by
  shifting the IS curve to the right will increase
  income while leaving interest rates unchanged
  (IS1 to IS2 below). It is also possible, however,
  that if the shift to the right is large enough
  (to IS3 below) then the IS curve moves to the
  upward-sloping part of the LM curve. Interest
  rates then rise along with income as a result of
  investment rising.

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Question 2 e i)

• An aggregate supply curve is perfectly elastic up
  to the full-employment level of output (Yf) and
  then perfectly inelastic at Yf. Aggregate demand
  is currently equal to Yf.
• Illustrate this situation on a suitable diagram.
• This is situation AD1 or AD2

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Question 2 e ii)

• Using relevant diagrams show the effect of an
  increase in autonomous consumption on the price
  level, income, and the interest rate in this
  economy.
• If autonomous consumption rises the AD curve
  shifts to the right from, for example, AD2 to
  AD1. On the AS-AD diagram, the price level will
  rise and income will remain at Yf.
•  

On an IS-LM diagram, with the normally-sloped
curves, the rise in autonomous consumption will
cause the IS curve to shift to the right. At the
same time, the LM curve will shift to the left as
the rise in price level identified on the AD-AS
diagram causes the real money supply to fall. The
interest rate will therefore rise while leaving
income unchanged, as on the AD-AS diagram.   The
IS-LM diagram should show both curves shifting
and the new intersection at the same level of Y
but with a higher r.
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Question 2 e ii)

• Using relevant diagrams show the effect of an
  increase in autonomous consumption on the price
  level, income, and the interest rate in this
  economy.
• If autonomous consumption rises the AD curve
  shifts to the right from, for example, AD2 to
  AD1. On the AS-AD diagram, the price level will
  rise and income will remain at Yf.
•  

On an IS-LM diagram, with the normally-sloped
curves, the rise in autonomous consumption will
cause the IS curve to shift to the right. At the
same time, the LM curve will shift to the left as
the rise in price level identified on the AD-AS
diagram causes the real money supply to fall. The
interest rate will therefore rise while leaving
income unchanged, as on the AD-AS diagram.   The
IS-LM diagram should show both curves shifting
and the new intersection at the same level of Y
but with a higher r.
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Question 3

• a)i) 23/2 23 8
• ii) X2/X-1 X3
• iii) (X3)2/X6 X6 /X6 X0 1
• iv) Log101 0
• b) Y 6 X2
• dy/dx 2x
• c) C100.8Y
• i) dC/dY mpc 0.8
• ii) C/Y apc (100/Y) 0.8
• iii) impact of Y on APC using derivative is
• d(C/Y)/dy -100/Y2, so the impact is negative

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Question
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Next Week (week 19)

• Well go over these worksheet questions in the
  tutorial.
• Also, we can address any questions from the exam
  that you might have.