ECON2000 2009 Macro Test 2 Solution by monkey6

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									ECON2000 2009 Macro Test 2 Solution
ECONOMICS IIA (ECON 2000/7) MARCH 2009 TEST Duration: Instructions: 1 hour Section A: Multiple Choice Questions Answer all questions on the MCQ card provided. Four (4) marks will be allocated for a correct answer, minus one (– 1) for an incorrect answer and zero (0) if no choice is made. Please fill in all necessary details on your MCQ card, especially student number! Section B: Problem/Essay-Type Questions Answer ALL questions in your answer book. Read all questions before answering any. Use neat and well-labelled diagrams where appropriate. Specify the equation and show all calculations where appropriate. Weightings: Section A Section B 30% 70% MACROECONOMICS PAPER II

ECON2000 2009 Macro Test 2 Solution
SECTION A

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1) In relation to efficiency wages, which of the following are correct: a) Regardless of workers’ bargaining power, firms may want to pay workers more than the reservation wage b) The objective of paying an efficiency wage is to decrease worker turnover and increase productivity c) Workers are more likely to receive efficiency wages in a ‘sclerotic’ labour market d) Efficiency wage theories do not suggest that wages depend on both the nature of a job and on labour market conditions e) (a) and (b) are correct 2) In the labour market, the natural rate of unemployment is the unemployment rate a) consistent with the level output determined by the intersection of the short run aggregate supply and demand curves b) that the economy converges towards in the short run c) equal to the natural level of employment as a proportion of the labour force d) that requires the real wage chosen in wage setting be equal to the nominal wage implied by price setting e) consistent with the level output where prices equal expected prices 3) Given that the IS curve is downward sloping and the LM curve is upward sloping. Which of the following effects are incorrect in the IS-LM model in the short run: a) An increase in government spending always leads to a decrease investment spending by increasing money demand b) An increase in taxes decreases output and decreases the interest rate c) A decrease in the nominal money supply for a given price level, lowers output and increases the interest rate d) An increase in government spending has less impact on the interest rate when the interest sensitivity of money demand is high e) All of the above are incorrect in the short run IS-LM model

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ECON2000 2009 Macro Test 2 Solution

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4) In the AS-AD model, assuming the economy is initially in medium run equilibrium, which of the following occurs in response to an expansion in the nominal money supply: a) In the short run, prices and the interest rate fall but output is unchanged due to the increases in prices that leave the real money supply unchanged b) In the short run, prices and output fall but the interest rate is unchanged due to the increases in prices that leave the real money supply unchanged c) In the medium run, prices, output and the interest rate fall d) In the medium run, prices, output and the interest rate are unchanged e) In the short run, prices and output rise but the interest rate falls 5) If the financial market is in equilibrium at an interest rate equal to 10% then: a) At an interest rate of 15%, the return on bonds would lead the public to hold too little money and an excess supply of money would result b) At an interest rate of 5%, the return on bonds would lead the public to hold too much money and an excess demand for money would result c) At an interest rate of 15%, the return on bonds would lead the public to hold too much money and an excess demand for money would result d) At an interest rate of 5%, there would be an excess demand for bonds e) Both (a) and (b) are correct 6) Which of the following are true of the IS-LM model: a) The positive slope of the LM curve is due to the increase in money demand that results from an increase in output b) The negative slope of the IS curve is due to the decline in prices that results from a downward revision of price expectations c) The positive slope of the LM curve is due to the decrease in money demand that results from an increase in output d) The positive slope of the LM curve is due to the decrease in money demand that must be achieved through an increase in the interest rate when output contracts. e) Both (a) and (d) are correct 7) Assuming the economy is initially in medium run equilibrium, which of the following occurs in response to an expansion in government spending: a) In the short run, prices and the interest rate rise but output is unchanged due to the increases in prices that leaves the real money supply unchanged b) In the short run, prices and output rise but the interest rate is unchanged due to the increases in prices that leaves the real money supply unchanged c) In the short run, prices and output rise and the LM curve shifts upward d) In the medium run, prices and output are unchanged but the interest rate rises e) In the short run, prices and output rise and the LM curve shifts downward 3

ECON2000 2009 Macro Test 2 Solution

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MCQ SOLUTIONS: 1E 2E 3A 4E 5E 6A 7C

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ECON2000 2009 Macro Test 2 Solution
SECTION B Question 1

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Suppose South Africa is currently in medium run equilibrium. The recent global financial crisis is expected to lead to lower global aggregate demand. As a precautionary measure (i.e. before any negative shock to aggregate demand has occurred) the National Treasury embarks on a reduction in taxes for a given level of government expenditure. a) Explain and illustrate using appropriate diagrams the effect of a reduction in taxes in the short run in the IS-LM model. In words, note the changes that occur in the financial market as the economy adjusts to equilibrium. [7] b) Explain and illustrate using appropriate diagrams the effect of a reduction in taxes in the short run in the AD-AS model. [6] c) Suppose instead of the National Treasury reducing taxes, they increase government spending by an amount equal to the reduction in taxes. Would the IS curve in the short run shift by the same amount? Explain. [3] d) We have discussed two possible ways in which expansionary fiscal policy can be conducted. The effect of increasing the budget deficit leads to an increase in output and may lead to an increase or decrease in investment in the short run. Briefly discuss an alternative policy change that would a result in a certain increase in investment and output in the short run. (No diagrams required) [4] TOTAL MARKS [20]

Solution to Question 1 a) The reduction in taxes shifts the IS curve to the to the right from IS0 to IS1 The equilibrium income increases from Y0 to Y1 . The increase in income stimulates money demand and hence money demand increases. The interest rate increases so as to offset the increase in money demand and hence maintain financial market equilibrium. The economy moves up along the LM curve from point A to point B. Please refer to Figure 1 for the shifts in the curves. for the correct shift and 1 mark for a correctly labeled diagram.

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ECON2000 2009 Macro Test 2 Solution
Figure 1

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b) The reduction in taxes leads to higher disposable income. The higher disposable income leads raised consumption and a higher level of aggregate demand for a given price level, hence the AD curve shifts to the right from AD0 to AD1 . The rightward shift of the AD curve causes the economy to move up the AS curve from point A to point B . The movement up the AS curve induces a higher level of real output and an increase in the price level . AWARD THIS MARK IF CORRECTLY INDICATED IN DIAGRAM Please refer to Figure 2 for the shifts in the curves. for the correct shift and 1 mark for a correctly labeled diagram. (1/2 mark) for correctly labeling Pe=P0 and (1/2 mark) for correctly labeling Y0=Yn

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ECON2000 2009 Macro Test 2 Solution
Figure 2

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c) No, the IS curve would not shift by the same amount. The effect of taxes is quantitatively smaller in comparison to government spending on shifts in the IS curve . This occurs because the tax multiplier is quantitatively smaller than the government spending multiplier. OR This occurs because the direct affect of a change in taxes influences spending through disposable income and thus some of this is absorbed through increased savings .

d) Expansionary monetary policy . The increase in real money supply shifts the LM curve downwards, reducing the interest rate and increase output. The reduction in the interest rate and increase in output, results in an increase in investment.

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ECON2000 2009 Macro Test 2 Solution
Question 2 Suppose that the mark-up of goods prices over marginal cost is 5% and F (u, z )  0.5  0.5u  z where z = 0.5. Round-off to two decimal places in all calculations.

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i. If current prices are equal to expected prices, what is the equilibrium real wage? [2] The real wage is determined by the price setting relation = 1/(1.05) = 0.95 ii. What is the natural rate of unemployment? Illustrate your findings. In equilibrium: [5]

F ( un , z ) 

1 (1   ) 1  0.95 (1  0.05)

0.5  0.5un  0.5  1  0.5un  un  1  0.95  10% 0.5

Real Wage W/P

0.95

PS

WS Unemployment Rate, u

un =10%

iii. Suppose that due to a recent legal judgement patent laws are repealed. How will this affect the competitive environment? How will this change affect µ? [2]

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ECON2000 2009 Macro Test 2 Solution

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The repeal of patent laws will promote competition in the market for goods whose production was exclusively undertaken by patent holders , this decreases the mark-up µ. iv. Based on your answer in (iii) increase or decrease µ by 0.02. Illustrate the affect on the labour market equilibrium and explain the adjustment to the new equilibrium natural rate of unemployment and indicate its new value. [show all calculations] [11] In the new equilibrium: 1  0.5un  1  0.97 (1  0.03) 1  0.97 un   6% 0.5

The decrease in µ shifts the price setting schedule up . This results in a higher real wage consistent with price setting. The real wage consistent with wage setting (0.95) is below that consistent with price setting (0.97) at the unemployment rate of 10%. This implies that the lower current real wage (0.95) results in lower labour costs for firms and induces firms to increase the level of employment . The increase in employment leads to a decrease in the unemployment rate which increases wage demands through the wage setting relation F(u,z) thus moving the economy up the wage setting relation until equilibrium is restored at un=6%. Real Wage W/P

0.97 0.95

PS1 PS0

WS Unemployment Rate, u

un1 =6%

un0 =10%

TOTAL MARKS [20] 9


								
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