ECON 100 Tutorial: Week 24

Extra slides for exam revision

Ayesha Alia.ali11@lancaster.ac.uk

Office Hours: Tuesday 2:00-3:00, LUMS C85

Revision: True/FalseQuestions 1 – 25 from Last Year’s Week 24 Tutorial Worksheet

1. Interest paid to domestic holders of National Debt is included in the National Income Accounts. False (taxpayers are effectively paying themselves interest)

2. The amount of money, which economic agents in the aggregate actually hold at any given moment, is necessarily equal to the amount supplied. True

3. The amount of money, which economic agents in the aggregate actually hold at any given moment, is equal to the amount they demand to hold. False

4. If the amount of money held by individuals exceeds the amount they demand to hold, Keynesian liquidity preference theory suggests that they spend it on bonds. True (and bond prices rise, implying that interest rates fall)

5. If the amount of money held by individuals exceeds the amount they demand to hold, Friedman’s monetarist theory (neo-quantity theory) suggests that they spend it on bonds. False (answer is ‘goods and services, including imports, so that prices rise generally - inflation) 6. In a world of fixed exchange rates and the absence of foreign exchange controls, it would be impossible for a nation to pursue an independent monetary policy. True (If you fix the price, the amount supplied must be commensurate with that price.)

7. Under the gold standard mechanism, gold imports make it more difficult to export goods and services. True (with an inflow of money, domestic prices rise)

8. Those who feel better off if earnings and prices increase by (say) 10% suffer ‘money illusion’. True

9. The original Phillips curve: an inverse relationship between real wages and unemployment. False

10. The expectations augmented Phillips curve hypothesis is that an inverse relationship between percentage wage increases and unemployment exists only where inflation is unanticipated. True

11. Fiscal policy determines the magnitude of the PSBR. True

12. An increase in the gold and forex reserves shows as a positive entry on the capital account. False (import of gold) 13. Individuals hold money for speculative purposes if they think bond prices will fall. True

14. The quantity theory of money states that an increase in the money supply will ultimately cause a proportional increase in the general level of prices. True

15. When the PSBR is increased, the money supply must also increase.False (bond sales could accommodate the deficit)

16. When the PSBR is increased, the national debt must also increase. True

17. The quantity theory of money implies that the velocity of circulation changes to accommodate changes in the money supply. False

18. Quantity theorists believe that money is an important determinant of the level of real income. False

19. Inflation is an upward prices adjustment to accommodate a higher real resource costs. False

20. Inflation is currency debasement. True

21. Keynes said that ‘inflation is always and everywhere a monetary phenomenon’. False (Friedman said this)

22. Keynes’s speculative demand for money reflects the view that, in a severe depression, monetary expansion is more likely to raise bond prices than other prices. True

23. The speculative demand for money is the need to have money to make speculative purchases. False

23. If residents of Eire bought petrol in Northern Ireland this would show in respectively as a negative entry on Eire’s capital account and a positive entry on the UK’s capital account. False (Eire: current account import/capital account export; UK, vice versa)

24. The demand to hold money is inversely related to the rate of interest because when the interest rate is low people borrow money to buy goods. False 25. The natural rate of unemployment is that rate which is consistent with ‘neutral’ money. True

Exam 4• Things to review:• Past Exams (questions 30 – 40 approximately)

• http://www.lancs.ac.uk/sbs/registry/Exams/PastPapers/PastPapers.htm• Lecture slides and/or recordings• Tutorial Worksheet Problems that relate to class Lectures.• Reading material

Past Exam Questions2013, 2012, 2011, and

2010Note: Solutions are not available to tutors.

Answers presented here are subject to error.

The hypothesis of the expectations-augmented Phillips curve holds that:

a) employment contracts fully accommodate the rate of price inflationb) job-seekers never make systematic errorsc) wage settlements are partially determined by the expected rate of price

inflationd) reservation wages are determined by minimum wage legislation

2010 Exam Q32

a) monetary policy is the exogenous variable, that causes variations in unemployment b) trade union activity is the exogenous variable, that causes variations in unemployment c) unemployment is the exogenous variable, that causes variations in inflation d) monetary policy is the exogenous variable, used to counter variations in unemployment

2013 Exam Q33

Which of the following statement is true? With the expectations-augmented interpretation of the Phillips curve, Milton Friedman assumes that

Expectations Augmented Phillips Curve• Initially, unemployment and inflation are at

point A. • Expansionist monetary policy would

increase consumption, shifting to point B along the Phillips curve• Unemployment is reduced but there is a trade

off; inflation.

• After a short period, agents will associate expansionist policies with inflation and will push for higher wages. (Gerry: Price-wage spiral)

• This will stop the consumption stimulus and also de-incentivise hiring. Agents will shift their expectations curves to point C.

The natural rate of unemployment is the level of unemployment that is consistent with:

a) a high rate of inflationb) low rate of inflationc) an absence of monetary disturbanced) an absence of involuntary unemployment

2010 Exam Q33

See Lecture 52 Natural rate of unemployment (NRU) NAIRU

Theoretical starting point -Perfect competition -Imperfect competition

Origins of deviation -solely in labour market rigidities

-in labour market rigidities;-supply-side inflation

Inflationist mechanism -monetary policies -monetary policies;-supply-side inflation

Type of unemployment-voluntary (therefore NRU can be assimilated to level of full

employment)-voluntary;

-involuntary

Uniqueness of equilibrium -unique -multiple equilibriums when considering open economies

The hypothesis of rational expectations contends that individuals:

a) do not make systematic errors b) anticipate future prices accuratelyc) adapt slowly to the rate of inflationd) only make rational errors

2010 Exam Q34

Rational Expectations:

• Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random.

Identify the missing word(s): Goodhart’s Law states ‘that any ____I____ will tend to collapse once pressure is placed upon it for control purposes.’

a) monetary targetb) observed statistical regularityc) fiscal budgetary stanced) structured investment

2010 Exam Q35

Goodhart’s Law

• Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.• (Goodhart's original 1975 formulation, reprinted on p. 116 in

Goodhart 1981[2])

Suppose that national income (measured in 1990 prices) is £1000 billion. Suppose further that prices have doubled since 1990 and that the typical unit of money circulates around the economy 20 times per year. What is the money supply?

a) £50 billionb) £100 billionc) £150 billiond) £200 billion

2010 Exam Q36

MV = QP

We know that: V = 20Q = 1000P = 2

So, solving for M:MV=PQM = QP/V

M = 1000*2/20 M = 100

  

The general structure:

BoP ≡ X - M + IOU (loan/credit) ≡ 0

BoP ≡ current account + capital account ≡ 0

income-expenditure ∆wealth ≡ 0

(deficit) (wealth falls) - + (exporting assets or writing an IOU)

(surplus) (wealth rises) + - (importing assets or receiving an IOU)

Balance of International Payments Accounts

NB: the current account surplus is matched by a a ‘capital outflow’

If the LM curve is vertical, then:

a) full crowding out occursb) fiscal policy will be infinitely effectivec) monetary policy will not workd) supply side policies will be unavailable

2010 Exam Q38

‘Crowding out’ occurs if new public expenditure

a) is insufficient to maintain social services b) creates excess demand and over-full employment c) attracts an influx of economic migrants d) diverts expenditure from existing productive activities

2013 Exam Q31

Vertical LM curve• If the demand for money is not related to the

interest rate, as the vertical LM curve implies, then there is unique level of income at which the money market is in equilibrium.• Thus, with vertical LM curve, an increase in

government spending (which shifts the IS curve) cannot change the equilibrium income and only raises the equilibrium interest rates.• If government spending is higher and the

output is unchanged, there must be an offsetting reduction in private spending.• In this case, the increase in interest rates crowds out

an amount of private spending equal to increase in government spending. • Thus, there is full crowding out if LM is vertical.

With Keynes’s speculative/asset demand to hold money, speculation is in respect of a likely change in:

(a) the inflation rate (b) the exchange rates (c) bond prices (d) equity prices

2012 Exam Q31

UK National Debt comprises:

(a) the sum of trade deficits over past years (b) sterling currency notes and coins in circulation, plus commercial bank deposits (c) outstanding loans to the state, excluding sterling currency notes and coins in circulation (d) outstanding loans to the state, including sterling currency notes and coins in circulation

2012 Exam Q32

As defined in Keynes’s General Theory, ‘involuntary unemployment’ relates to individuals whose employment prospects would be raised by:

(a) a rise in the price of wage goods (i.e., a rise in the cost of living) (b) a fall in the price of wage goods (i.e., a fall in the cost of living) (c) greater trade union participation (d) a shift to capital-intensive production methods

2012 Exam Q33

As defined in Keynes’s General Theory, ‘involuntary unemployment’ relates to individuals whose employment prospects would be raised by

a) a rise in the price of wage goods (i.e., a rise in the cost of living) b) a fall in the price of wage goods (i.e., a fall in the cost of living) c) greater trade union participation d) a shift to capital-intensive production methods

2013 Exam Q30

Keynes on involuntary unemployment• “Clearly we do not mean by ‘involuntary’ unemployment the mere existence of

an unexhausted capacity to work. An eight-hour day does not constitute unemployment because it is not beyond human capacity to work ten hours. Nor should we regard as ‘involuntary’ unemployment the withdrawal of their labour by a body of workers because they do not choose to work for less than a certain real reward. Furthermore, it will be convenient to exclude ‘frictional’ unemployment from our definition of ‘involuntary’ unemployment. My definition is, therefore, as follows: Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods [i.e., consumer goods] relatively to the money-wage [i.e., nominal wage], both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.”

If a UK resident citizen buys a BMW car from Germany and the car exporter uses the payment to buy UK government bonds, which of the following statements would be true?

(a) UK net exports fall and net capital exports fall (b) UK net exports rise and net capital exports rise (c) UK net exports fall and net capital exports rise (d) UK net exports rise and net capital exports fall

2012 Exam Q34

Net Exports

• If a UK resident citizen buys a BMW car from Germany• This is a German export and UK import of a tangible good

• The car exporter uses the payment to buy UK government bonds• This is a German import and UK export of a capital good

The original Phillips curve identified a robust correlation between:

(a) unemployment and the rate of change of real wage rates (b) unemployment and the rate of change of money wage rates (c) wage levels and unemployment (d) wage levels and inflation

2012 Exam Q35

Indicate which one of the following statements is true. With the original interpretation of the Phillips curve, A.W. Phillips assumes that

a) wage bargaining is the exogenous variable, that causes variations in money wages b) the business cycle (as reflected in the unemployment rate) is the exogenous variable, that causes variations in increases in money wages c) the real wage is the exogenous variable, that causes variations in inflation d) inflation is the exogenous variable, that causes variations in unemployment

2013 Exam Q32

Phillips Curve

• Inflation is a change in money wages

According to Friedman’s re-interpretation of the Phillips Curve, if inflationary expectations rise, the Phillips curve:

a) shifts down b) shifts up c) becomes flatter d) becomes steeper

2011 Exam Q32

Expectations Augmented Phillips Curve• Initially, unemployment and inflation are

at point A. • Expansionist monetary policy would

increase consumption, shifting to point B along the Phillips curve• Unemployment is reduced but there is a

trade off; inflation.

• After a short period, agents will associate expansionist policies with inflation and will push for higher wages.

• This will stop the consumption stimulus and also de-incentivise hiring. Agents will shift their expectations curves to point C.

If job seekers under-estimate the rate of inflation, the duration of the job-search:

(a) shortens, so that unemployment tends to rise (b) lengthens, so that unemployment tends to fall (c) shortens, so that unemployment tends to fall (d) lengthens, so that unemployment tends to rise

2012 Exam Q36

If job seekers under-estimate the rate of inflation• Then they will over-estimate the value of an offered wage contract• And will accept a lower real wage• And thus will have a shorter period of unemployment

Fiscal monetarists argue that inflation is a consequence of excessive growth in:

(a) revenue from taxation (b) national debt(c) the money supply (d) national output

2012 Exam Q37

Fiscal monetarists argue that inflation is a consequence of excessive growth in

a) revenue from taxation b) sovereign debt c) the money supply d) national output

2013 Exam Q36

The Taylor Rule is a representation of monetary policy whereby the short-term nominal interest rate is varied systematically with respect to:

(a) the trade deficit and the value of sterling (b) employment and the cost of living (c) inflation and the ‘output gap’ (d) tax revenues and the level of government borrowing

2012 Exam Q38

Taylor rule

The Taylor rule equation is written as:

rt = r* + π* + w(πt – π*) + (1 – w)(yt – y*)/y*where:

rt is the central bank discount rate y is the GDP

πt is the inflation rate y* is the potential GDPπ* is the inflation rate target w is the policy parameter

Define r as the real rate of interest and let r* be the rate consistent with long run equilibrium in the economy. Further, define π as the rate of inflation and π* as the target rate of inflation. Then r = r* + α(π – π*) is:

a) an LM curveb) a Taylor rulec) a DSGE modeld) incomprehensible

2010 Exam Q39

By the Taylor Rule, nominal interest rates are raised whenever:

a) inflation falls b) the output gap widens c) the output gap closes d) the inflation target is raised

2011 Exam Q36

By the ‘Lucas critique’, economic forecasts are:

(a) always unreliable (b) most reliable when economic policy is stable (c) most unreliable when a change in economic policy is implemented (d) most unreliable when inflation is accelerating

2012 Exam Q39

According to the ‘Lucas critique’, economic forecasts are

a) always unreliable b) most reliable when economic policy is stable c) most unreliable when a change in economic policy is implemented d) most unreliable when inflation is accelerating

2013 Exam Q38

Policy instruments and objectivesTheory of Economic Policy (Lecture 57 Slide 42)

New Classical Economics – the Lucas critique

Economic forecasts are most unreliable when they are most needed; i.e., when a change in economic policy is to be implemented

Even if individuals’ expectations could be forecast in the context of current policy structures, that ‘success’ is undermined when that policy structure changes

New policy implies a new context in which decisions are taken: so individuals’ reactions are affected

Behavioural adjustments to changes in policy structures emasculate macroeconomic forecasting and (with it) aggregate demand management

Robert Lucas (1937 - )

Nobel Prize 1995 …

‘for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy’

When the Bank of England undertakes quantitative easing:

(a) long-term government bonds (gilts) are bought using newly created money (b) the composition of the national debt is altered (c) the volume of the national debt remains constant (d) all of the above

2012 Exam Q40

Quantitative easing is a process whereby a central bank:

a) sells long-term government bonds b) purchases long-term government bonds c) sells short-term government bonds d) purchases short-term government bonds

2011 Exam Q35

What is quantitative easing?• Expansionary monetary policy usually involves the central bank buying

short-term government bonds in order to lower short-term market interest rates. If they keep doing this, it will eventually stop working – that is when the economy is falls into a liquidity trap. • A liquidity trap can occur when short-term interest rates are either at, or

close to, zero, so that normal monetary policy can no longer lower interest rates.

(Zero is the lower bound on interest rates – meaning they can’t be

lower than zero – meaning bonds have to give at least a zero return.) • This is when central banks use quantitative easing.• Quantitative easing is when central banks purchase long-term assets

(including bonds, gilts, real estate) in an attempt to lower the long-term interest rate and increase money supply.

Which of the following is not a function of the Bank of England?

a) lender of last resortb) supplier of moneyc) acting as a store of valued) determining the official interest rate

2010 Exam Q40

For UK international payments, the ‘balance for official financing’ is the value of:

a) net exports including ‘invisibles’ b) foreign exchange reserves c) net UK borrowing from foreign central banks d) foreign exchange bought/sold to maintain the exchange value of sterling

2011 Exam Q38

The balance of international payments is

a) a corollary of the government’s overseas borrowing b) a measure of an economy’s indebtedness c) the overseas aid budget of a nation state d) an accountancy identity

2013 Exam Q34

In the context of the balance of international payments, a residual for ‘official financing’ indicates the extent to which the monetary authority

a) sells domestic currency to increase holdings of foreign exchange reserves b) sells foreign exchange reserves to support the value of the domestic currency c) allows the international value of its currency to be determined by market forces d) is taking advantage of a trade surplus to build its foreign exchange reserves

2013 Exam Q39

  

The general structure:

BoP ≡ X - M + IOU (loan/credit) ≡ 0

BoP ≡ current account + capital account ≡ 0

BoP ≡ X - M + ‘invisibles’ + DLT + DST + Dforex ≡ 0

BoP ≡ { balance for official financing } + Dforex ≡ 0

Balance of International Payments Accounts (Lecture 61 Slide 35)

balance for official financing: the amount taken from (or absorbed by) official forex reserves in order to stabilise the international value of domestic currency

(exports of gold and/or forex to

support £)

With the Keynesian (liquidity preference) theory the interest rate is determined by:

a) the asset demand to hold money b) the speculative demand to hold money c) expectations relating to future bond prices d) all of the above

2011 Exam Q37

A nation with a fixed exchange rate cannot insulate itself from world inflation because, if initially its domestic inflation rate is lower than elsewhere:

a) economic recession forces domestic prices up b) domestic goods become less competitive and cost-push inflation raises domestic prices c) domestic goods become more competitive which tends to increase money in domestic circulation d) none of the above

2011 Exam Q39

Under a fixed exchange rate

• Low domestic inflation will cause the price of goods to rise more slowly than in other countries• So other countries will seek to buy goods from the low inflation

country• This will increase the amount of capital in the low inflation country• This will put upward pressure on the low inflation country’s currency

‘Ricardo equivalence’: borrowing by the state is equivalent to ... I ... (whether currently or else deferred by borrowing). Robert Barro set Ricardo equivalence within the context of Keynesian macroeconomics, where the implication is that ... II ... government expenditure gives no boost to aggregate demand, since it is offset by ... III ... to meet ... IV .... In order: missing words are:

I II III IV a) raising taxation tax-financed spending living costs b) reducing taxation IMF-financed depreciation borrowing costs c) raising taxation High default an exchange rate

target d) raising taxation bond-financed saving future tax demands

2013 Exam Q35

The ‘Bank Rate’ (the key short-term rate set by the Bank of England) is the repo rate. A repo is a repurchase agreement whereby

a) a commercial bank sells the central bank a security, with an agreement to repurchase that security, on a given date, at a higher price. b) a commercial bank sells the central bank a security, with an agreement to repurchase that security, on a given date, at a lower price. c) the central bank sells a commercial bank a security, with an agreement to repurchase that security, on a given date, at a higher price. d) the central bank sells a commercial bank a security, with an agreement to repurchase that security, on a given date, at a lower price.

2013 Exam Q37

A structural fiscal deficit exists when sovereign net borrowing is a) negative even as an economy is producing at full capacity b) positive even as an economy is producing at full capacity c) rising even when austerity measures are in place d) negative even as an economy is producing at full employment

2013 Exam Q40