Macroeconomics Tutorial 1 Aggregate demand, supply, national output and inflation

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The circular flow of income shows the flow of incomes between firms and households. False. The circular flow of income shows the flow of inputs, outputs and incomes between households and firms, not just incomes. See section 9.3 of Begg and Ward. Each of the following are leakages from the circular flow of income: consumption, savings, taxation and imports. False. Consumption is not a leakage but savings, taxation and imports are. See section 9.3 of Begg and Ward. Total expenditure is equal to consumption plus investment plus government spending plus net exports. True. Total expenditure is simply the sum of all spending inside the economy, adjusted for spending in the UK on imported products. See section 9.3, sub-heading Total Expenditure, in Begg and Ward. Aggregate demand is negatively related to the rate of inflation. True. The higher the rate of inflation, the higher the interest rate that is needed to bring inflation under control. Higher interest rates reduce the level of borrowings and therefore reduce the level of funds available to purchase products and services. See section 9.4 of Begg and Ward. Under full wage adjustment to price increases, aggregate supply is perfectly elastic. False. Under full wage adjustment to prices, real wages remain constant. Employment remains constant and the aggregate willingness to supply remains constant. Hence, aggregate supply is perfectly inelastic. See section 9.4 and Figure 9.7 of Begg and Ward. Aggregate supply is negatively related to the rate of inflation. False. The important issue for aggregate supply is whether or not a bout of inflation leads to nominal or real changes in relative wages and prices. See Section 9.4 in Begg and Ward. If imports grow faster than exports, aggregate demand falls. True. If imports grow faster than exports, net exports fall and aggregate demand falls too. See Section 9.4 in Begg and Ward.

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8. Which of the following will lead to cost push inflation? a) b) c) d) e) An increase in real wage rates An increase in investments by firms AD (aggregate demand) shifts rightwards An increase in government spending on health services A fall in the value of the against the Euro this would make imports more expensive An increase in exports from the UK to the rest of the world AD shifts rightwards

Answer: A 9. The Table below contains the UK retail price index for the years 1993 to 2003. First change the base year, so that 1998 = 100 and then calculate the rate of inflation from 1994 onwards.

We can calculate the new index as follows: Let RPI 1998=100 (by assumption)

RPI1987,t RPI1998,t = *100 RPI1987,1998 RPI1998,t - RPI1998,t-1 INFLATIONRATE = *100 RPI1987,t-1

Year 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Retail Price Index 1987 = 100 138.4 141.6 145.4 149.3 152.9 156.2 158.9 161.3 163.7 166 168.9 Retail Price Index 1998 = 100 (138.4/156.2)*100=88.6 (141.6/156.2)*100=90.7 (145.4/156.2)*100=93.1 95.6 97.9 100.0 101.7 103.3 104.8 106.3 108.1 ((90.788.6)/88.6)*100=2.3 ((93.190.7)/90.7)*100=2.7 2.7 2.4 2.2 1.7 1.5 1.5 1.4 1.7 Rate of Inflation

10. Which one of the following represents a correct interpretation of the Table above? A) Prices are falling but inflation is rising. B) Prices are falling and inflation is falling. C) Prices are rising but inflation is falling D) Prices are rising but inflation is rising Answer: C 11. Suppose expected inflation for next year is 2.5%. If you are currently earning 28,000 a year, what should your nominal wage be next year if you want to keep your real wage constant? A) 28700 B) 28800 C) 29000 D) 25000 Answer: A Nominal wages must increase by the same rate as inflation, hence: 28000x(1+0.025)=28700. 12. Suppose expected inflation for next year is 2.5%. and the current tax allowance is 6475. What should the tax allowance be next year to avoid the problem of fiscal drag? A) around 6636 B) around 6453 C) around 6565 D) around 4578 Answer: A Assuming nominal wages grow by the inflation rate of 2.5%, tax allowance must also grow by 2.5%. Hence next years tax allowance should be 6475*(1+0.025)=6636.875.