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SOLUTIONS Devaluation


  • pg 1
      Chapter 17: Extensions and Applications in Macroeconomic Policy
      Date: 18 September 2006

      Question 1
      a) What relationship does the Phillips curve postulate?                             (2)

         It shows a relationship between inflation and unemployment. In the short-run it shows
         a negative relationship. In the long-run we have a vertical Philips curve.

      b) What is the mechanism behind the Phillips curve?                                 (3)

         An increase in aggregate demand raises the price level and output. More output
         requires more employment, and hence lower unemployment.

      Question 2
      What is stagflation and what causes it?                                             (2)

         Stagflation is a simultaneous rise in unemployment and inflation, the opposite of what
         the Phillips curve postulates. It is causes by an adverse supply shock such as a
         sudden increase in the price of oil.

      Question 3
      What is the natural rate hypothesis and what does it say about the Phillips curve? (2)

         It states that at the natural rate of unemployment ( i.e. when there is full employment),
         any rate of inflation is possible, and as such the fundamental trade- off behind the
         Phillips curve is wrong.

      Question 4
      a) What is the difference between adaptive and rational expectations?               (2)

         Adaptive expectations theory holds that agents create their expectations of the future
         based on past values and events. Rational expectations theory holds that agents use
         all available information (past and present) in order to forecast the variable and tend
         to have zero expected error.

      b) What are the weaknesses of the adaptive expectations theory?                     (2)

 i.      It assumes that economic agents base their expectations on past information only. In
         reality people also use current information.
ii.      The systematic errors made by individuals under the adaptive expectations wrongly
         suggest that they do not learn from past experience.

iii.      The theory does not explain how adjustment coefficient      in the model is chosen.
iv.       Model of adaptive expectations never attain equilibrium, they only move towards it

       Question 5
       a) What is the founding tenet of supply-siders?                                    (2)

          They hold that tax rates almost completely determine economic behaviour, and that
          tax reduction will boost growth.

       b) What are the two different tax types levied in an economy?                      (2)

          Direct: taxes are levied directly on wealth and income.
          Indirect: taxes are levied on most goods and services that are consumed, such as in
          the case of VAT.

       c) What is the Laffer curve?                                                       (2)

          The Laffer curve postulates a relationship between tax revenue and tax rates whereby
          tax rates above a certain level will result in less tax revenue because of more tax
          evasion and reduced transfers.

       d) Explain the shape of the Laffer curve                                           (6)

          It has three critical points: the origin where tax rate is zero, the optimal taxe rate
          where the tax revenue is maximized, and the point where the tax rate is 100%. When
          tax is zero or 100% tax revenue is zero. Between 0% and 100% there is a rate where
          tax revenue is maximized. Below the optimal tax rate an increase in tax increases the
          tax revenue. Above the optimal tax rate an increase in tax rate will reduce tax

       Question 6
       The following table shows the tax rates and corresponding revenue collect an economy.
       Tax Rate                                      Tax Revenue ( Rands in Billion )
       0                                             0
       20                                            40
       40                                            80
       60                                            70
       80                                            30
       100                                           0

       a) Draw a diagram of this economy‟s Laffer curve.                                  (5)


b) What is the optimal tax rate?                                                  (3)

Optimal tax rate is equal to 40%

c) Explain what would happen if the tax rate is increased when we are starting from a
   point where the tax rate is above the optimal tax rate.                        (4)

Tax revenue falls. Explain why. (See pages 404-405)

d) Explain what would happen if the tax rate is increased when we are starting from a
   point where the tax rate is below the optimal tax rate.                        (4)

Tax revenue increase. Explain why. (See pages 404-405)

Question 7
A tax cut boosts the tax revenue for the government. Discuss.                     (12)

Base your discussion on the Laffer curve

Question 8
What are the two definitions of economic growth?                                  (2)

   It is an increase in real GDP occurring over a specific time period, or an increase in
   real GDP per capita occurring over a specific time period.

Multiple Choice Questions

1) The Phillips curve postulates a relationship between:
   a) price level and the unemployment rate.
   b) inflation and the unemployment rate.
   c) exchange rate and interest rates.
   d) tax rates and tax revenue.

2) Stagflation is when:
   a) prices and wages rise because of a slowdown in the economy.
   b) whe re there is both rising inflation and unemployment.
   c) where inflation rises inexplicably.
   d) where unemployment rises because of oil price hikes.

3) The natural rate hypothesis states that:
   a) there is a natural rate of unemployme nt.
   b) there is a natural rate of inflation.
   c) there is a natural rate of inflation to unemployment.
   d) there is a natural rate of exchange rates.

4) The full employment rate of unemployment is also known as:
   a) the NAIRU.
   b) the Phelps-Friedman rate of unemployment.
   c) cyclical unemployment.
   d) adaptive rate of unemployment.

5) Rational expectations forecasts:
   a) are always perfect.
   b) have a forecast error of zero.
   c) always under-predict.
   d) always over-predict.

6) If last year‟s inflation was 5%, its forecast was 7%, and the coefficient of expectation
   is 0.5, then next year‟s adaptive expectation of inflation is:
   a) 6%.
   b) 5%.
   c) 7%.
   d) 3.5%.

7) Rational expectation theorists say that the Phillips curve:
   a) holds only in the long run.
   b) holds only in the long run under certain conditions.
   c) does not hold in the long or short run.
   d) holds in the short run but not the long run.

8) According to Keynes:
   a) wages are perfectly flexible.
   b) government intervention was the cause of the Great Depression.
   c) wages are sticky - downward.
   d) the market self- corrects.

9) The Laffer curve postulates that:
   a) there is always a negative relationship between tax rates and tax revenue.
   b) there is always a positive relationship between tax rates and tax revenue.
   c) at certain rates cutting the tax rate will result in higher tax revenue.
   d) there is an inverse relationship between inflation and unemployment.

10) If a country is on the negative slope of the Laffer curve then:
    a) raising taxes will result in higher tax revenue.
    b) cutting taxes will result in highe r tax revenue.
    c) cutting or raising tax rates will reduce tax revenue.
    d) raising inflation will cause a drop in unemployment.

Chapter 18: Money and Banking
Date: 02 October 2006

Question 1
a) Identify and explain three different functions of money.                      (3)

   Medium of exchange
   Unit of account
   Store of value

b) What is meant by “M1”, “M2”, “M3”.                                            (3)

   M1: narrow definition of money supply. In SA, notes and coins in circulation plus
   demand deposits.
   M2: broader definition of money supply. In SA, M2 = M1 + long tem deposits.
   M3: broadest definition of money. In SA, M3 = M2 + long term deposits.

c) It is relatively easy to understand why people would accept payment in the form of
   gold. But why do people also accept pieces of paper, in the form of currency notes
   and cheque, as money? In what circumstances would a shopkeeper, for example not
   accept currency notes as payment for goods.                                   (6)

   Individuals accept pieces of paper as money because other individuals accept the
   pieces of paper as money. I trust paper money because you trust paper money. A
   shopkeer accepts my paper money because she knows it can be spent in another shop,
   or she knows my cheque can be deposited ion bank account. This convention of
   having confidence in paper money is reinforced through its designation as legal

   However shopkeepers in the UK are unlikely to accept payment in Rands, Zambian
   Kwacha, Ghanaian cedi or Zimbabwean dollar.

Question 2
In the financial market what is a bond?                                          (2)

A bond is an IOU. It is an agreement between the issuer of the bond (the borrower) and
the buyer of the bond (lender) with terms on the interest rate payments as well as the
maturity of the loan when the borrower agrees to have paid the loan plus the interest.
Government and corporations issue bonds to raise money.

Question 3
Identify and explain the factors that determine the demand for money. Draw a graph of
the money demand curve.                                                          (6)

Explain transaction and asset demand for money. Draw the two curves and then
aggregate them to come with the money demand function.

Question 4
Draw a diagram of the money market and explain the effect of each of the following on
the equilibrium interest rate.

a) A fall in money supply                                                           (2)
   This shifts money supply to the left, increasing interest rates.
b) A rise in money demand                                                           (2)
   This shifst the money demand curve up increasing interest rates.
c) An increase in people‟s desire, given an interest rate, to hold bonds
   instead of money.                                                                (2)
   This shifts the money demand downwards reducing interest rates.
d) A rise in people‟s income.                                                       (2)
   This shifts the money demand up increasing interest rates.

Question 5
What is fiat money?                                                            (2)
   Fiat money is money that is not backed by any precious commodity such as gold.

Question 6
What is the money multiplier and how is it defined?                             (4)
   The money multiplier is the factor of change in the money supply when the money
   aggregate changes. It is defined as 1 divided by the required reserve ratio.

Question 7
What are the two types of demand for money?                                      (2)
   There is the transaction demand for money because money is used to buy goods and
   services. This demand varies directly with the money value of goods and services in
   the economy. The asset demand for money is when money is used as a store of value.
   This demand varies inversely with the interest rates.

Question 8
Explain the quantity theory of money.                                               (3)
   It states that there is a direct relationship between money and its velocity on one
   hand, and the price level and level of transactions on the other.

Question 9
Explain how the banking system creates money using the following balance sheet. Make
sure you explain the money multiplier.

         City Bank
Assets                Liabilities

Cash   2 500          Capital stock 2 500                                        (15)

See pages 430–432.

Multiple Choice Section

1) Tony promises to pay Bongi R500 in a year‟s time. Here, what function of money is
   being used?
   a) medium of exchange
   b) store of value
   c) standard of deferred payme nt
   d) unit of account

2) Fiat money is money that:
   a) originated with the Italian traders.
   b) is worth exactly what the metal it is made of is worth.
   c) is not backed by any precious money.
   d) is issued by an international lender such as the World Ba nk.

3) A fractionally backed currency system is one where:
   a) many different banks produce and hold the money base.
   b) money was issued for more than the worth of the metal that backed it.
   c) the money is backed by many different types of metals.
   d) the money is made up of coins and notes.

4) M2 is M1 plus:
   a) savings and deposits up to medium te rm in length.
   b) savings and deposits up to long term in length.
   c) all other financial assets.
   d) cheque deposits.
5) Assume ABSA bank has an entry in its liability side for R35 million. Who does that
   money belong to?
   a) all owne rs of the bank
   b) the Reserve Bank
   c) its depositors
   d) ABSA

6) If FNB has total deposits of R40 million and the SARB sets the required reserves at
   20%, how much money can it lend out?
   a) R40 million
   b) R32 million
   c) none
   d) R48 million

7) If the reserve ratio is 20%, what is the monetary multiplier?
   a) 5
   b) 4
   c) 20
   d) 1.25

8) If ABSA has total deposits of R40 million and the reserve ratio is 20%, what is the
   total amount that the money supply can increase by if ABSA lends out all the money
   that it can?
   a) R200 million
   b) R42 million
   c) R40 million
   d) R160 million
9) In the quantity theory of money, where MV = PT:
   a) M stands for the manufacturing index.
   b) PT stands for private transfers.
   c) money supply is indirectly related to price level.
   d) velocity is directly related to the level of transactions.

10) The demand for money because it is used to buy goods and services is known as:
    a) exchange medium demand.
    b) velocity demand.
    c) transaction de mand.
    d) market demand.

Chapter 19: Macroeconomic Policy Issues
Date: 9 October 2006

Question 1
a) What is fiscal policy?                                                             (2)
   Fiscal policy is the government’s decisions and actions regarding taxes and

b) What is the difference between discretionary and non-discretionary fiscal
   policy?                                                                              (4)
   Discretionary policy is the deliberate attempt by the government to alter economic
   conditions by manipulating government expenditure and/or taxes. Non-discretionary
   fiscal policy refers to the existence of automatic stabilizers built in to existing fiscal

c) What are the three different classes of taxes?                                   (3)
   Proportional taxes: where the tax is proportional to the level of income, i.e. the
   percentage tax paid does not change.
   Progressive taxes: where the percentage tax paid varies directly with the level of

   Regressive taxes: where the percentage tax paid varies inversely with the level of

Question 2
a) How is a deficit financed?                                                    (3)
   It is financed through domestic and foreign borrowing, by moneterizing the deficit
   (printing money) and by privatizing state industries.

b) When is deficit financing good and when is it bad?                             (4)
   A country can borrow to invest in capital expenditure because that will give a return
   which can pay back the borrowed money, whereas governments should not borrow to
   finance current expenditure such as wages, as these do not earn a return.

Question 3
a) What are the tools of monetary policy?                                         (6)
   reserve ratio requirements, credit ceilings, foreign exchange control regulations,
   deposit rate control and the terms and conditions of hire-purchase and lease

b) What are open market operations?                                            (2)
   They are when the Central Bank alters the money base by entering the market
   through buying and selling bonds.

Question 4
a) What is the difference between a revaluation/devaluation and an
   appreciation/depreciation?                                                  (2)
   A revaluation/devaluation is when the governments adjusts a fixed exchange rate peg,
   whereas an appreciation/depreciation is when the market moves and a new
   equilibrium market value is achieved.

b) What is the difference between a fixed exchange rate, a floating exchange
   rate and a managed float?                                                      (2)
   With a fixed exchange rate the government pegs the exchange rate at a certain rate
   and intervenes in the market to keep that peg. A floating exchange rate is when the
   market sets the exchange rate entirely. A managed float is a mix of the two, where the
   government lets the exchange rate float within a small band.

(Take your time to explain questions 5 and 6 to students. This may
be confusing to some).
Question 5
Use a diagram to explain what happens when the Central Bank attempts to peg the
exchange rate above the equilibrium market rate.                                (10)
See pages 460–461.

Question 6
Use diagrams to show the process whereby an increase in the money supplied by the
Reserve Bank leads to an increase in real GDP.                                 (10)
See page 457.

Multiple Choice Questions
1) Discretionary fiscal policy refers to fiscal policy that:
   a) needs the finance minister‟s signature to become law.
   b) is dependant on certain events happening in an economy.
   c) is delibe rate policy set by government to change economic activity.
   d) is dependant on local provinces to enact.

2) Crowding out occurs when:
   a) government spending drives up the interest rate and reduces private
   b) government businesses and regulations reduce the private sector‟s involvement in
      the economy.
   c) the private sector takes on all the profitable opportunities in an economy.
   d) the government drives up the wages of workers to such an extent that private
      firms are harmed.

3) The primary deficit refers to:
   a) the excess of government expenditure over tax revenue.
   b) the excess of planned tax revenue and actual revenue.
   c) the excess of government expenditure over tax revenue less interest
   d) government expenditure and planned government spending.

4) Which way of financing the deficit will be more likely to produce inflation?
   a) domestic borrowing
   b) foreign borrowing
   c) privatisation
   d) monetizing the deficit

5) What method will not lead to a decrease in government borrowing?
   a) fiscal restructuring
   b) privatisation
   c) increasing VAT
   d) expanding the social welfare project

6) Which of the following is not a tool of monetary policy?
   a) setting the reserve requirement ratio
   b) setting the repo
   c) changing foreign exchange regulations
   d) cutting back on education spending

7) If the Central Bank of China announces that the yuan will trade from tomorrow
   onwards at 5 to the dollar instead of the current 3 to the dollar, this is known as:
   a) revaluation.
   b) devaluation.
   c) depreciation.
   d) appreciation.

8) If the rand moves in the market from R6.20 to the dollar to R3.50 to the dollar, there
   has been a:
   a) revaluation.
   b) devaluation.
   c) depreciation.
   d) appreciation.

9) The term „open market operations‟ refers to:
   a) the government borrowing money in foreign markets.
   b) the Central Bank changing the reserve ratio.
   c) the Central Bank intervening in the foreign exchange market.
   d) when the Central Bank alters the money base by buying and selling bonds.

10) If a bank goes to the Reserve Bank because it is near bankruptcy and the Reserve
    Bank gives it money, then the Reserve Bank is acting as a:
    a) bank regulator.
    b) bank supervisor.
    c) lende r of last resort.
    d) bank controller.

Chapter 12: International Trade
Date: 16 October 2006

NB: Tell students not to worry about Comparative advantage. We went as far as defining
the term. So ignore questions 6 in the MCQ section.

Question 1
a) What is the difference between a tariff and a quota?                               (2)
   A tariff is a tax on imports to raise their prices; a quota is a restriction on how much
   can be imported.

b) Other than tariffs and quotas, what other ways can governments use to restrict
   trade?                                                                         (4)
   exchange controls, local content requirements, embargoes, subsidies, administration
   barriers, preferential buying policies and orderly market transactions

c) What is the infant industry argument for protecting local industries?          (2)
   It is that small companies in a country can compete with foreign companies but need
   to get experience and critical mass before they can compete effectively and so are
   protected for a short period.

d) What is dumping?                                                                (2)
   Dumping is the practice of selling a product in a foreign country at a lower price
   than in the country where the product is produced.

Question 2
1) What are the different sources of trade?                                        (4)
   Climate, natural resources, local labour and skills, different consumer tastes.

Question 3
2) What is the division of labour and specialization?                             (2)
   It is when the production process is split, with each worker only producing a certain
   section of it repeatedly and hence becoming specialized in that process.

Question 4
3) What is absolute cost advantage                                                 (2)

A country has an absolute advantage in the production of a good if it can efficiently
produce the good than the other country. It may be using less labour to produce a given
unit of good than the other country.

Question 5
4) What are the two types of tariffs?                                                (2)
   There are specific tariffs where a specific amount is set irrespective of the price
   amount of the import and an ad valorem tariff which is a set percentage of the price
   of a product.

Long Questions
Question 1
Outline the reasons put forward for why countries should protect their local
industries and restrict trade.                                                     (6)
    See pages 295–300.

 Question 2
Draw a diagram and explain either verbally or mathematically the gains that
can be achieved through trade.                                                     (12)
    See page 290.

Question 3
Explain with the aid of a diagram the economic effect of an import tariff. In your
answer explain the distributional impacts of import tariffs on                     (15)

a)   local consumption,
b)   domestic production,
c)   imports,
d)   government revenue,
e)   importers.
     See page 298.

Multiple Choice Questions
1) The division of labour refers to:
   a) why women and men have clearly different work in traditional economies.
   b) why certain countries produce cheap goods and others more complicated goods.
   c) how certain processes of a production routine are divided amongst workers.
   d) how a family unit divides its energy into raising and affording children.

2) The value at which one currency is traded for another currency is known as:
   a) terms of trade.
   b) exchange rate.
   c) purchasing price parity.
   d) absolute advantage.

3) In 1982 the French government required all Japanese video recorders to be
   individually cleared at a tiny customs house run solely by one old man before they
   could be sold in France. This obviously slowed down imports to only a handful a day.
   This is an example of:
   a) an import quota.
   b) voluntary export restriction.
   c) a non-tariff barrier.
   d) an export quota.

4) The African Growth and Opportunity Act (AGOA) became law in the US in 2000. It
   allows South Africa and other African countries to export more to America by
   reducing US tariffs on African goods. AGOA would thus benefit:
   a) SA consumers and US producers.
   b) SA consumers and SA producers.
   c) SA produce rs and US consume rs.
   d) US producers, but harm SA consumers.

5) South Africa began to expand its trade with the international community after 1994
   a) ensure military self sufficiency.
   b) improve the competitiveness of SA business.
   c) improve the world‟s view of South Africa as a newly democratic state.
   d) increase our money supply.

Consider the following table, which represents the quantity of output that can be
produced per labourer in each country, and then answer the next two questions, 9 and 10.

Country                               Computers                    Apples (Kg)
USA                                      5                            100
SA                                       2                            120

6) According to the trade theory of comparative advantage:
   a) the USA has an absolute advantage in both computers and apples but will
      specialize in the production of computers.
   b) SA has a absolute advantage in both computers and apples but will specialize in
      the production of apples.
   c) SA has an absolute advantage in apples and will specialize in the production of
   d) there is no basis for international trade in this example between SA and the

7) Which of the following terms of trade options are not possible if there is to be
   mutually beneficial trade:
   a) 1 computer = 23 apples
   b) 1 apple = 0.03 computers
   c) 1 computer = 15 apples
   d) 1 apple = 0.04 computers

Consider the following diagram and answer the question 11




          R6                                                         World price

                       100            180 250

8) If the government decides to impose a R2 import tariff on the this product, the new
   level of imports will be:
   a) 75 units.
   b) 100 units.
   c) 123.33 units.
   d) 150 units.

9) If an investor purchases a US Bond for R55 000, that money will be reflected in:

   a)   the current account.
   b)   the capital account.
   c)   the financial account.
   d)   the unrecorded transactions.

10) If two countries form a free trade area then:
   a) there are no tariffs and quotas between them but each has its own external
   b) as above, but with a common external tariff set.
   c) as above, but with no barriers to labour or capital area.
   d) as above, but with monetary and fiscal unification.


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