• Internal Code :
  • Subject Code : ECON1010
  • University :
  • Subject Name : Economics

Principles of Economics

Question 1: True, False, or Uncertain

Explain whether each of the following statement is true, false, or uncertain. Start your answer by selecting one of the three statements – “True”, “False” and “Uncertain” and then provide arguments to justify your selection (be brief and concise in less than 100 words). You need to make assumption clear, reasonable, and explicit if making any. The quality and logic of arguments determine your marks. (4 marks each)

a) Nominal interest rates are always higher than real interest rates.

Answer True

The long-term period of load recollection must be considered, in that case, the real interest rate is adjusted in accordance to the expected rate of inflation over the span of repayment. So, real interest rate is approximately the nominal interest rate minus the inflation rate.

b) If the lockdown measure due to a further spread of COVID-19 pandemic is extended to international flows of goods and services across the Australian border, saving in the national income account must be equal to the investment in Australia.

Answer True

If the lockdown measure due to a further spread of COVID-19 pandemic is extended to international flows of goods and services across the Australian border, it means that all exports and imports have been stopped. This is the case of a closed economy. In a closed economy it is assumed that all the savings are equal to investments. (S=I). For a firm to invest, it needs savings to be able to finance the investment. Although, it does not happen this way practically.

c) The price of cars produced in Australia sold to consumers in the United States (US) goes up. This means that GDP deflator and the CPI rise in the US.

Answer True

It is the cost price index that measures the inflation. Whereas GDP deflator also detects the differences between nominal and real GDP levels. Consumers of United States are purchasing cars from Australia, which implies that consumers were getting the cars produced in Australia at cheaper rates than the US produced cars. Due to rise in prices of cars produced by Australia, it could be concluded that United states is undergoing inflationary period. It further implies the rise of the GDP deflator.

d) An increase in the money multiplier (M) and a decrease in the reserve ratio (R) occur during the financial crisis.

Answer True

During a crisis, banks tend to adjust the reserve requirements to loosen the money supply so that the liquidity of money can be increased among the citizens. This implies that, they can change the rules from requiring banks to hold 20% of their money to only 10% or up to 30% depending on their desires for the economy. (MCMAHON, 2011).

Question 2: Covid-19 in The Macroeconomy

Starting with the long-run equilibrium in the aggregate demand and supply (AD-AS) model. Consider the macroeconomic effects of the lockdown measures due to COVID-19. In each part of your answer, please be brief and concise in less than 100 words. You need to make assumption clear, reasonable, and explicit if making any. The quality and logic of arguments determine your marks.

a) Explain this development in the AD-AS framework in words.

Answer An AD-AS framework is an economic model that explains the interaction of total output in a market to the general price level that prevails. It is based on the theory of John Maynard Keynes that represents the relation between aggregate demand and aggregate supply. The Aggregate demand curve is derived from the equilibrium achieved in the IS-LM equilibrium income at the varying potential level of prices. AD shows the combinations of price level to that of the output at which the goods market is at equilibrium. Similarly, AS is derived by the finding the supply by firms at similar demand levels. The AS-AD then represent the general equilibrium. (Academy, 2020).

b) Show Part a) using AD-AS figure. Ensure to include short-run supply curve (SRAS), long-run supply curve (LRAS) and aggregate demand (AD) and to label the X-axis and Y-axis of the figure. Also, mark the equilibrium price and quantity before and after the lockdown.

Answer

Source:https://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/macro-changes-in-the-ad-as-model-in-the-short-run/a/how-the-ad-as-model-incorporates-growth-unemployment-and-inflation-cnx

In the above image we see that the short run equilibrium is at E0 (suppose, pre COVID 19), when the demand is at AD0. Once the crisis is hit, the money supply is loosened by the central bank to help sustain the demand in the economy. The demand curve shifts to AD1, making the new equilibrium at E1 to help increase in GDP after the COVID 19 crisis. But this at the same time leads to an increase in the price level too. (Academy, 2020).

c) Fiscal and monetary policy measures can be taken as the response to the development in part a). Explain the policy measures in writing. Diagrammatic representation of the effects of these policies not required.

Answer The IS-LM approach uses both fiscal and monetary measures to reach the equilibrium at various levels, as both the policies impact the aggregate demand and aggregate supply. At the same time, both policies cause the factors influencing the demand and supply to shift.

The fiscal policy impacts AD through changes in government spending, taxation, leading to the change in the purchasing power of an individual. If the purchasing power is high, AD would be high a device versa. Monetary policy impacts the supply of an economy by influencing the inflation and interest rates. These impact exports, employment, etc. (Hall, 2019).

d) What are the possible long run impacts of the recommended policy measures in part (c)? Explain the impact in writing. Diagrammatic representation not required.

Answer In the long run, both the policies, in the way implemented, can show how the economy expands or contracts. An expansionary fiscal policy of government is usually formulated in an inaction to any financial shock that country faces. The government investments prevent any negative shift in the aggregate demand of the economy, which in long run helps in stabilising the industries, increasing employment, etc.

Similarly, an expansionary monetary policy involves the central bank implementing various measure of CLR, SLR, OMO, repo and reverse repo rates to increase the money supply and lead to lowering of interest rates. (Hall, 2019).

e) Continue the long run, the government starts to register the budget surplus after having paid off the large budget deficits incurred as the policy measured in part c). What happens to the quantities of saving and investment and (real) interest rates with this development? Explain in writing. Diagrammatic representation not required (Hint: try to explain the step by step).

Answer The higher fiscal deficit to counter the problems of economy, and the fiscal measures taken by the government to increase the aggregate demand in the economy helps in increasing the private savings in the long run. These savings can lead to higher amount of private investments in the economy.

At the same time, when the government has paid off the deficit and enters the surplus budget, it can also increase the level of government’s investment in the economy. Increased amount of investment (minus the inflationary effects) lead to a faster development of the economy. (OpenTextbook, 2020).

Question 3: Short Answers on Principles of Economics

For each short answer, the word limit is 100 words. You need to make assumption clear, reasonable, and explicit if making any. The quality and logic of arguments determine your marks. (4 marks each)

a) Donald Trump promised a more aggressive fiscal policy with a large increase in spending and significant tax cuts leading to a much larger government (budget) deficit. The US economy was at near the full employment (the unemployment rate in the US was low below 5%), what do you expect will be the response of the US Central Bank in terms of changes to the cash rate? Explain.

Answer As evident in the question, President Trump is trying to implement an expansionary fiscal policy to increase the liquidity, raise the level of employment, and most importantly sustain the aggregate demand in the economy. The US Central Bank, to support this expansionary measure, would itself deploy the expansionary measures too. The cash rate would supposedly be lowered so that the interest rates go down and loans become cheaper. This would help the businesses to procure loans create supply in correspondence to the AD. (IG, 2020).

b) The Central Bank of New Zealand has a higher inflation target than the Reserve Bank of Australia. Does this tend to depreciate or appreciate the New Zealand dollar against the Australian dollar? Explain

Answer Inflation target is a part of monetary policy where the central bank of a country has a target set for the level of inflationary rate to be achieved. The inflation rate of Central Bank of New Zealand is higher than the inflation rate of Australia. This would mean that if the exchange rates adjusted, the Australian dollar would be expensive against the New Zealand dollar, depreciating the New Zealand dollar as against the Australian dollar.

c) What are the reasons for increasing convergence between emerging economies (defined as countries with lower GDP per capita but growing rapidly) and advanced economies (countries with high GDP per capita but lower growth)? Explain.

Answer The economic convergence, often referred as a catch-up effect is based on the hypothesis that the poorer economies tend to grow at a faster rate than already developed economies. The major reasons for increasing convergence between the emerging and developed economies is untapped resources.

  • The developed economies tend to have already exploited their available resources while emerging ones have a plenty of resources to exploit.
  • Countries with high GDP generally are already experiencing diminishing returns on their investments much more than countries with middle and lower levels of GDP. Hence, the growth rate and productivity are relatively smaller.

d) You have successfully secured the mortgage of worth in $1,000,000 from the Bank to purchase a house. After the contract has been written, inflation in the economy turned out to lower than what was expected. Who gained and lost from this development? Explain.

Answer The lender would be a gainer in this situation. The amount of actual inflation is lower than the anticipated one, which means that the nominal interest rate that was set by factoring in the level of inflation in mind, is yielding more. For example, the rate of return by considering the inflation was set at 8% while actual inflation was only 5%. This means that the lender is gaining extra 3% and at the same time the borrower is losing that.

e) The government (and the central bank) has an easier job of dealing with the macroeconomic impacts of consumers and investors being pessimistic about the future of the economy than the period of stagflation. Do you agree? Explain

Answer Yes, I agree. In stagflation the level of unemployment is already rising with the level of inflation. One must consider the external factors that would affect the economy in unexpected ways (example: COVID 19). If the government and central bank already have pessimistic view, it is highly likely that they would implement rigorous expansionary measures. This would in turn help the economy deal with unforeseen external negative effects too.

References for Principles of Economics

Academy, K. (2020). How the AD/AS model incorporates growth, unemployment, and inflation. Retrieved from Khan Academy: https://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/macro-changes-in-the-ad-as-model-in-the-short-run/a/how-the-ad-as-model-incorporates-growth-unemployment-and-inflation-cnx

Hall, M. (2019). How Do Fiscal and Monetary Policies Affect Aggregate Demand? Retrieved from Investopedia: https://www.investopedia.com/ask/answers/040315/how-do-fiscal-and-monetary-policies-affect-aggregate-demand.asp

(2020). Cash rate definition. Retrieved from IG.com: https://www.ig.com/au/glossary-trading-terms/cash-rate-definition

MCMAHON, T. (2011). Money Moultiplier. Retrieved from Inflation Data: https://inflationdata.com/articles/2011/09/17/money-multiplier/

OpenTextbook. (2020). HOW GOVERNMENT BORROWING AFFECTS PRIVATE SAVING. Retrieved from Open textbook: https://opentextbc.ca/principlesofeconomics/chapter/31-3-how-government-borrowing-affects-private-saving/

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