1. Consider a macro economy was initially at equilibrium level of real GDP.

Using an aggregate demand and aggregate supply diagram or model of the economy,

graphically illustrate and discuss the short run and long run effects of the following events

upon the economy: 

(a) The Central Bank within the economy lifts interest rates.

When central banks lifts up the interest rate, people find it more lucrative to keep money

in tied in banks, bonds and securities. This is because the opportunity cost of keeping

money in hand is high. As people keep more money in banks, they are left with lesser

money for consumption purpose. As a result aggregate demand falls and thus prices fall

in short run. Economy produces a lesser amount at this new lower price. Although in long

run, interest rate falls as the supply of funds (savings) is greater than the demand for

funds (investment). As interest rate falls, people prefer keeping money in hand and thus

demand rises. Economy reaches its initial level equilibrium in the long run.

(b) There is an increase in private domestic investment spending.

An increase in private domestic investment savings reduces the disposable income of

people in the economy. As a result, aggregate demand falls leading to fall in equilibrium

output and price level. Although in the long run the increased supply of savings causes

interest rate to fall and fall in savings follows. Savings fall until economy reaches its

initial level. Long run equilibrium is restored at the initial price and output level.

(c) An increase in international oil prices

An increase in international oil prices may have different effects on the economy

depending upon the fact if the country is an exporter or importer of oil.

 If the country is an importer of oil, an increase in its price causes countries imports’

worth to rise. This might overshadow the exports of the economy and economy might

face unfavorable terms of trade in short run. The consequence of this would be fall in

aggregate demand and thus fall in price. This fall in aggregate demand prevails even in

the long run as oil is used as raw material in production of many goods, so an increase in

its price would cause an increase in the price of many other goods. Government cannot

even reduce its consumption by a large amount to counter balance the increase in value of

imports, because it is an essential raw material. As a result, its supply falls as well and is

more than the fall in demand causing higher prices. Thus, economy suffers with lower

output and increased prices in long run.

Another scenario is the one where the country is an exporter of oil. An increase in the

price of oil would raise the total value of exports and thus the economy faces favorable

terms of trade. Its aggregate demand increases and thus its prices increase as well. Even

in the long run, economy has higher output and price, but this is lower than increased

output and prices faced by the economy in short run. As during this period other

economies adjusts their demand accordingly, which might cause a small reduction in

exports and hence equilibrium price and quantity.

(d) An appreciation in the foreign exchange rate of the economy’s currency

An appreciation in the foreign exchange rate makes exports of the economy expensive for

rest of the world, so the export demand falls. Export being a component of aggregate

demand, aggregate demand falls. There is another side of the coin as well, appreciation of

domestic currency makes import cheaper, and thus imports would rise. Overall picture

remains the same economy is worse off with unfavorable balance of trade, lower demand
 and lower equilibrium price and output. Although in the long run, fall in prices makes

domestic goods a lucrative option, and thus demand for domestic goods rise and foreign

goods fall, this causes prices to move up the scale alongwith the output level. Long run

equilibrium gets restored at the initial level.

(e) A fall in real estate prices in the capital cities of the country

A fall in real estate prices in the capital cities of the country, leads to fall in the total

wealth. Fall in wealth, may cause fall in consumption spending as people save more in

order to secure more income for future. Fall in consumption would cause fall in aggregate

demand, equilibrium price and quantity. This effect would sustain in long run.

(f) The country’s main exports fall in price while the goods the country imports from

abroad rise in price

An increase in the import price of the country would cause amount of imports to fall,

until unless the increase is very large there would be fall in overall imports and thus

increase aggregate demand of the economy. Felling prices of export demand makes our

exports an attractive option for rest of the world leading to an increase in exports and

hence aggregate demand, thus in the short run economy produces a larger equilibrium

output at a higher price. Although as time passes increase in income induces increase in

demand of both foreign as well as domestic goods. If the increase in demand for domestic

good is greater than increase in foreign good’s demand, economy stays at a higher

equilibrium and price. (The long run equilibrium price and output is though lower than

the short run equilibrium output and price as, increase in import demand does induce a

fall in aggregate demand and price)

2. Why are quarterly movements in a country‘s GDP measure so important? What is it

called, when a country has two successive negative quarters of economic growth? (LAGS)

(1 mark)

Quarterly movements in GDP of an economy is important as it helps the government analyze if

the policies implemented by him are working in the right direction or not; and if they are

producing desired result. Generally, such targets are inflation or unemployment rate or growth

rate of the economy. Government takes appropriate measure if the economy is not moving in the

desired direction, in order to stimulate growth in the relevant variables. When an economy faces

two successive negative quarters of growth it is said that the economy is facing recession.

3. Why does market based economic system needs monitoring or is, in fact, a market

system self-stabilizing? (1 Mark)

Market based economic systems is an economic system which rely on privately owned

enterprises and allows minimalistic level of government intervention. Such an economy does not

need monitoring it is self-stabilizing. This is because the economy runs on the principle that

supply creates its own demand and assumes that wages and prices are not sticky. Therefore, any

change in demand would cause change in price and supply (and the other way around) until

equilibrium is restored in the economy. This is the self-stabilizing mechanism.

4. Currently Australian consumers are paying off their debts and not spending. Using the

simple Keynesian model assesses the implications for equilibrium GDP and the level of

savings of an increase in the savings function. Conversely, what would happen to

equilibrium income if there were a sustained rise in private investment spending? (2

Marks)

As most of the people in the Australian economy are using the money to pay off their debts, this

would cause a reduction in their expenditure on consumption and thus cause a fall in aggregate

demand. Even in the money market, people are taking out money from bank to pay off the debts

leading to a fall in the reserves of the banks. Therefore, the banks decide to increase the interest.

Thus, even in the long run, people would prefer to keep money tied with the financial

institutions, as the opportunity cost of spending is high. Thus, the economy faces a sustained fall

in equilibrium output and demand.

Investment spending is a component of aggregate demand. Thus, a sustained increase in the

private spending cause aggregate demand to rise and thus an increase in equilibrium output and

prices in short run.

In the long run, Increase in investment spending also causes the interest rate to rise and thus an

increase in the total savings of the economy, which in turn causes aggregate demand to fall, as

consumption has reduced. Nevertheless, this effect can be seen in long run. Thus in long run

economy returns to initial level of equilibrium output and prices.

5. State the difference between: -uncertainty and risk. -between the interest rate and the

exchange rate - between the supply side shocks and demand side shocks -between a trade

deficit and net foreign debt (2 marks)

Certainty means the probability with which the event takes place is one. Uncertainty is when the

probability of the occurrence of the event is less than1, i.e., there is chance that the event might

not occur. An activity involves risk if its occurrence may cause some sort of loss or negative
impact. The difference between uncertainty and risk is that uncertainty does not talk about the

type of impact which occurrence of event imposes, which risk does.

6. Assuming that the money market is initially in equilibrium, trace through the effects of a

rise in the money supply on the money market on the interest rate and also on output,

employment and the price level. (2 marks)

A rise in the money supply cause a wedge in the money market, as supply of money is greater

than the demand for money, interest rate rises. When interest rate rises people are induced to

save more, as the opportunity cost of spending money for consumption purpose has increased.

An increase in saving causes consumption and hence aggregate demand to fall. Fall in aggregate

demand leads to lower equilibrium level of output and prices. Fall in demand is followed by fall

in supply to eliminate the excess supply. As and when the producers realize this, they cut down

on production and thus the number of people employed. As a result, unemployment increases at

this new level of equilibrium.

7. Why do professional and market economists monitor a whole number of economic and

business indicators? What are they trying to achieve in doing this? (2 marks)

Economic indicators are like statistic, it tells about the condition of the economy. Consumer

price index and GDP are few examples of economic indicators. These indicators tell us about the

present condition of the economy, and bring us face to face with how economy has performed in

the past. By analyzing these indicators, the professional and market economist gets assistance

while making future decisions and policies for the economy. There are two type of these

indicators: leading indicators which change before the economy as a whole does (expectations of
consumer index) and lagging indicators which change after the economy has gone through

transition (unemployment). Economists use these indicators to protect the economy from entry

into depression or recession.

8. Why is a depreciation of a country currency not necessarily a bad thing? Why is a

country’s appreciation of its currency on the foreign exchange market not necessarily a

good thing? (2 marks)

Depreciation of a country’s currency makes country’s export a lucrative option for rest of the

world. Therefore, country’s export demand and thus aggregate demand rises. An increase in

aggregate demand causes equilibrium output and price levels of the economy in short run. Thus,

the economy is better off in the short run. Though depreciation of the domestic currency does

affect the economy negatively as well; as the imports now become expensive and it might cause

fall in aggregate demand. However, till the time the impact of exports is greater than the impact

of imports; economy is better off.

Appreciation of an economy may not always be a good thing as it makes our imports cheaper

and exports expensive. A cheaper import can induce people to demand more imported goods,

and if the value of imports increases by such an extent that it overshadows the total value of

exports, then it would lead to fall in aggregate demand and thus short run equilibrium quantity

and price. However, this would happen only if the amount of imports increases by a huge

amount.

9. The central bank decided to implement an expansionary policy action. What would you

expect to happen to the nominal interest rate, the real interest rate and the money supply?
Under what economic circumstances would this type of policy action be appropriate? (2

marks)

An expansionary policy action is taken to induce people to demand more of goods and services,

so that aggregate demand rises and the economy moves out of the slump. Expansionary policy

taken by central bank means an increase in the money supply. When money supply is increased,

in the goods market consumption increases as people have more money in hand. Increase in

consumption induces aggregate demand to increase and thus in short run we have higher level of

equilibrium output and price level. On the other hand, in the money market, in long run interest

rate is increased to induce people to save more. Thus in long run people save more and consume

less leading to a fall in consumption and fall in aggregate demand thereafter. So economy

reaches its initial level of equilibrium in long run.

10. Why under flexible exchange rates does a nation not have to worry too much about a

balance of payments deficit? What other specific advantages do flexible exchange rates give

to the operation of economic policy with specific regard to the effectiveness of fiscal policy

and monetary policy? (3 marks)

Under a flexible exchange rate, market is self-stabilizing. If there is any imbalance in the market,

exchange rates adjust to bring back the economy into equilibrium. This happens because

exchange rate is flexible; there is no stickiness (limits attached to it). Thus government

intervention is not required to correct any sort of imbalance in the economy. As flexible

exchange if free to adjust itself it ensures that, the current account is always balanced. In

addition, as the government is not required to control the value of currency, every time when

there is an appreciation or depreciation, it may not maintain high level of reserves.

In case of a fiscal policy, flexible exchange rate works very efficiently. When government

decreases taxes, people demand more of both domestic as well as foreign goods. This is because

the disposable income of the people have increased, thus they have more money to spend. As

import demand rises, demand for foreign currency rises given its supply causing the exchange

rate to depreciate. When exchange rate depreciates, export of the country increases, leading to

increase in the aggregate demand and thus equilibrium price and quantity increases. Thus the

expansionary fiscal policy has very effective in case of a flexible exchange rate.