ECON 100 Tutorial: Week 19

www.lancaster.ac.uk/postgrad/alia10/a.ali11@lancaster.ac.uk

office hours: 3:45PM to 4:45PM tuesdays LUMS C85

Agenda• Today’s tutorial: Go over Exam questions & solutions.• Check Moodle for next week’s tutorial worksheet and

work through it before next week’s class.

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.

7 marks

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-employment-level output

5 marks

Question 1c)The marginal propensity to consume in an economy is 0.6. What is the value of the multiplier?

Multiplier = 1 / (1 – MPC)The multiplier is 2.5 = (1/[1 – 0.6]).

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?

Change in spending required = inflationary gap amt./multiplier

Change in spending required is 200/2.5 = £80 billion.

5 marks

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

2 marks for each part

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 short answer:Because short-run and long-run MPC’s are different from each other.

Coskeran’s solution: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.

5 marks

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.

Coskeran’s solution: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.

8 marks

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 economyidentify the marginal efficiency of capital or investment schedule.

5 marks total, for all three parts

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 loansprovide 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:Year 1 2 3 4

20,000 25,000 25,000 15,000At 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:Year Present Value1 20,000/1.04 = £19,230.772 25,000/1.042 = £23,113.913 25,000/1.043 = £22,224.914 15,000/1.044 = £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.

5 marks

Question 2b)A firm expects the revenues each year from investing in a new machine to be as follows:Year 1 2 3 4

20,000 25,000 25,000 15,000At 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: Year Present Value1 20,000/1.03 = £19,417.482 25,000/1.032 = £23,564.903 25,000/1.033 = £22,878.544 15,000/1.034 = £13,327.31

The sum of these present values is £79,188.22.This means that the firm would now buy the machine.

3 marks

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.

5 marks

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.

7 marks

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 (IS1 to IS2 below).

It is also possible, however, that if the shift to the right is large enough (to IS3 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 2 e i)An aggregate supply curve is perfectly elastic up to the full-employment level of output (Yf) and then perfectly inelastic at Yf. Aggregate demand is currently equal to Yf. i) Illustrate this situation on a suitable diagram.This is situation AD1 or AD2

3 marks

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.

The IS-LM diagram should show both curves shifting and the new intersection at the same level of Y but with a higher r.

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 Yf.

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.

5 marks

Question 3a)i) 23/2= 23 = 8ii) X2/X-1 =X3

iii) (X3)2/X6 = X6 /X6 =X0 = 1iv) Log101 = 0

b) Y = 6+ X2

dy/dx = 2x

c) C=100+.8Yi) dC/dY = mpc = 0.8ii) C/Y = apc = (100/Y) + 0.8iii) impact of Y on APC using derivative is: d(C/Y)/dy = -100/Y2, so the impact is negative

3 marks for each part in a) and b)6 marks for each part in c)

Next Week (week 20)We’ll go over the tutorial worksheet – should be available on Moodle this week.