ECON 100 Tutorial: Week 19 office hours: 3:00PM to 4:45PM tuesdays LUMS C85.

ECON 100 Tutorial: Week 19 www.lancaster.ac.uk/postgrad/murphys4/ s.murphy5@lancaster.ac.uk office hours: 3:00PM to 4:45PM tuesdays LUMS C85

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.

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 (AD 1 ), real output rises and the price level is unchanged at AD 2. Where AS is vertical at potential output (AD 3 ) then real output is unchanged but the price level rises at AD 4. i)

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.

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 AD 3. At AD 2 the price level rises and real output falls as at AD 1

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.

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 (AD 2 falls to AD 1 ). Along the vertical section, the price level falls (AD 4 falls to AD 3 ). It is possible that if AD falls far enough, real output will fall as well. For example if AD fell from AD 3 to AD 2 in the diagram below. If the AD curve is still on the vertical part of the AS curve, however, real output is unaffected.

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.

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.

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.

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.

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 7–8, 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?

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.

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.

Question 4 Which of the curves show that supply is perfectly elastic up to potential output Y N ? a)I only b)I and II only c)I and III only d)None of them

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

Question 6 Which of the curves show that when output is at Y N 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

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

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.

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

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.

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

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.

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.

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.

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

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.

Question 2b) A firm expects the revenues each year from investing in a new machine to be as follows: Year1234 20,000 25,00025,00015,000 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: YearPresent Value 120,000/1.04 = £19,230.77 225,000/1.04 2 = £23,113.91 325,000/1.04 3 = £22,224.91 415,000/1.04 4 = £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.

Question 2b) A firm expects the revenues each year from investing in a new machine to be as follows: Year1234 20,000 25,00025,00015,000 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: YearPresent Value 120,000/1.03 = £19,417.48 225,000/1.03 2 = £23,564.90 325,000/1.03 3 = £22,878.54 415,000/1.03 4 = £13,327.31 The sum of these present values is £79,188.22. This means that the firm would now buy the machine.

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.

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 (IS 1 to IS 2 below). It is also possible, however, that if the shift to the right is large enough (to IS 3 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*.

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 (IS 1 to IS 2 below). It is also possible, however, that if the shift to the right is large enough (to IS 3 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.

Question 2 e i) An aggregate supply curve is perfectly elastic up to the full- employment level of output (Y f ) and then perfectly inelastic at Y f. Aggregate demand is currently equal to Y f. i)Illustrate this situation on a suitable diagram. This is situation AD1 or AD2

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 Y f. 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.

Question 3 a)i)2 3 /2= 2 3 = 8 ii)X 2 /X -1 =X 3 iii)(X 3 ) 2 /X 6 = X 6 /X 6 =X 0 = 1 iv)Log 10 1 = 0 b) Y = 6+ X 2 dy/dx = 2x c) C=100+.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/Y 2, so the impact is negative

Question

Next Week (week 19) We’ll go over these worksheet questions in the tutorial. Also, we can address any questions from the exam that you might have.

ECON 100 Tutorial: Week 19 office hours: 3:00PM to 4:45PM tuesdays LUMS C85.

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ECON 100 Tutorial: Week 19 office hours: 3:00PM to 4:45PM tuesdays LUMS C85.

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