Question 1 (i) Identify and briefly explain the main features of the business cycle.

(2 marks) The business cycle is a model that represents the fluctuations in the economy; the trough, expansions, peaks and contractions. An expansion is a period of rising GDP and a contraction is a period of declining GDP. In moving between periods of expansion and contraction, the economy will experience peaks and troughs. A peak is the beginning of a contraction, the high point of economic activity prior to downturn. A trough is the end of a contraction, the low point of economic activity prior to recovery. Thus a contraction can be seen as the period in which the economy is moving from a peak to a trough, and an expansion is the period in which the economy is moving from a trough to a peak. (ii) Explain the concepts of (a) potential output and (b) the output gap. (3 marks) Potential output expressed as y*, is the amount of output (real GDP) that an economy can produce when using its resources, such as capital and labor, at normal rates. Potential output is different to maximum output as capital and labor can be utilized at greaterthan-normal rates, for a time, a countrys actual output can exceed its potential output. Potential output is not a fixed number but grows over time, reflecting increases in both the amounts of available capital and labor and their productivity. A nations actual output can expand and contract due to changes in the countrys potential output, and changes in the utilization rate of labor and capital. At any point in time, the difference between potential output and actual output is called the output gap, which can be expressed as y-y*. A positive output gap is known as an expansionary gap, when actual output is above potential output and resources are being utilized at above-normal rates. A negative output gap, known as a contractionary gap, is when actual output is below potential, and resources are not being utilized fully. (iii) Explain the concept of Okuns law. Discuss the implications of Okuns law for policymakers? (5 marks) Okuns law states that each extra percentage point of cyclical unemployment is associated with about 1.6 percentage point (for Australia) increase in the output gap, measured in relation to potential output. Okuns law can be written as y-y*/y*= -B(u-u*). So for example, if cyclical unemployment is equal to 2% of the labor force, the contractionary gap will be 3.2% of potential GDP. Using an example, we can examine the usage of Okuns law and the implications. In June 2XXX, Australia had a total unemployment rate of 10.5% and a natural unemployment rate of 8.5% meaning that cyclical unemployment was 2%. Thus the output gap for June 2XXX according to the Okuns law would be 1.6 x 2%, which is 3.2% of potential GDP. Since potential GDP in June 2XXX was $142 000 million (measured in 2XX-2/2XXX-1 prices), the output gap in that quarter should have been 3.2% x $142 000 million or $4544 million. Thus the output losses sustained in recessions, calculated according to Okuns law, can be quite significant. Assuming that the June 2XXX was a recession and the population of Australia was 14 million, the output loss per adult person in that quarter equaled the total output gap of $4544 million divided by 14 million people, roughly $325 per adult, in 2XXX-2/2XXX-1 prices.

This calculation implies that output gaps and cyclical unemployment may have significant costsa conclusion that justifies the concern that the public and policy-makers have about contractions and recessions. Policy-makers view both contractionary gaps and expansionary gaps as problematic. When there is a contractionary gap, capital and labor resources are not being fully utilized and output and employment are below normal levels. Okuns law implies that there is a correlation between contractionary gaps and cyclical unemployment; thus policy makers need to ensure reduced levels of cyclical unemployment during recessions in order to decrease the output gap. A prolonged expansionary gap is problematic because when faced with a demand for their products that significantly exceeds their normal capacity, firms tend to raise prices; hence an expansionary gap results in increased inflation, which reduced the efficiency of the economy in the longer run.

Question 2 (i) Discuss the role played by fixed (or sticky) prices in the Keynesian model of income determination. Briefly explain what would happen if prices were fully flexible in the short-run. (2 marks) The Keynesian model is built on the key assumption that firms do not respond to every change in the demand for their products by changing their prices. Instead, they typically set a fixed price for some period; then meet the demand at the price. By meeting the demand, the firm produces just enough to satisfy their customers at the prices that have been set. Firms do not normally change their prices frequently, because doing so would be costly. Economics refer to the costs of changing prices as menu costs. Menu costs may also include other kinds of costs such as market survey, information gathering, etc. If prices were fully flexible in the short-run, there would be no menu costs and the firms would be able to perfectly price discriminate charging each customer their highest reservation price as long as it is above the marginal cost of production. Furthermore, if prices were fully flexible there would then be a distinction between real and nominal values such as GDP as the short-run is no longer immune to price changes. (ii) Explain the concept of Planned Aggregate Expenditure (PAE). How does PAE differ from Actual Expenditure? (2 marks) Actual aggregate expenditure refers to the total spending by households, firms, the government and the rest of the world and can be expressed as: AE= C + I + G + NX. Planned aggregate expenditure is the total planned spending on final goods and services. Planned spending could easily differ from actual spending, the most important case is that of a firm that sells either less or more of its product than expected. If a firms actual sales are less than expected so that part of what it planned to sell remains in the warehouse, the firms actual investment is now larger than the planned investment, denoted IP due to the unsold inventory, I> IP. If a firm sells more than planned, it will add less to its inventory and so actual investment would be lower than planned investment, I< IP. However, for households, the government, and the foreign market, we may reasonably assume that actual spending and planned spending are the same.

Thus, PAE differ from actual expenditure due to the difference in planned investment, IP, and actual investments, I, and can be expressed in the following equation: PAE= C + IP+ G + NX.

(iii) Use the Keynesian aggregate expenditure model and appropriate diagrams to explain the following: The paradox of thrift The paradox of thrift describes the implications of the Keynesian models concerns regarding the macroeconomic effects of increased savings. The model shows that an attempt by the community to increase saving will fail, and the economy, overall, will be worse off as a result of that attempt. Increased saving or thriftiness by the community means that people increase their savings at each and every level of income. The economy will be in equilibrium when savings equals investment. So we introduce an initial equilibrium of IP. Suppose there is an increase in incentive to save, this will result in an upward shift of the saving function S to S.

It can be seen that the level of saving still remains the same at the new saving function of S, however here we have a new equilibrium with a lower GDP than previously because we increased savings, hence the paradox of thrift.

The effect on equilibrium GDP of an exogenous increase in exports. (6 marks) In the event of an exogenous increase in exports with the new export level denoted as X1 and the old X0, the PAE will increase at a constant level of X1- X0, and will thus shift upwards. The level of planned injection would also increase by a constant level of X1- X0 and meet the withdrawal function at a higher point. Hence, there would be a new higher level of equilibrium GDP denoted Ye1.

Question 3 (i) Explain what is meant by the multiplier? Why, in general, does a one dollar change in exogenous expenditure produce a larger change in short-run output? (3 marks) The multiplier is the effect of a one-unit increase in exogenous expenditure on short-run equilibrium output, so a multiplier of 5 means that for each one-unit change in exogenous expenditure leads to a 5-unit change in short-run equilibrium output in the same direction. In general a one dollar change in exogenous expenditure produces a larger change in short-run output because it initiates a chain effect of losses/gains. For example, a decrease/increase in consumer spending would reduce/increase the sales of consumer goods directly; however it also reduces/increases the incomes of workers and owners in the industries that produce the consumer goods. As incomes the spending levels of the workers and owners decrease/increase and other producers in the economy also suffer/benefit, resulting in a chain of reduced/increased spending. Thus because of the successive rounds of declines/increases in spending and income may lead to a decrease/increase in PAE, and output that is significantly greater than the change in spending that started the process. (ii) Explain the role played by the marginal propensity to import in determining the size of the multiplier. Other things equal, how does an increase in the marginal propensity to import affect the size of the multiplier? (3 marks) The marginal propensity to import, m, represents the percentage of income sent overseas which is money that therefore does not reach the domestic producers and is not multiplied.

However, the money is still included under consumption, c, and so in order to calculate a correct multiplier it must be subtracted from the consumption. Hence the expression for the multiplier for a four-sector model is:

Multiplier =

1 (1 [( c m)(1 t )])

If the MPM increases, then the denominator in the multiplier will decrease as c-m would decrease. Another interpretation is that if a significantly large proportion of income is spent on imports so that M is relatively high, then any change in income earned domestically will have a smaller effect on domestic expenditure compared to the situation in which the marginal propensity to import is small. Thus, when M is high the multiplier is smaller as less is spent on domestic expenditure.

(iii) Use a diagram to illustrate the concept of short-run equilibrium in the Keynesian aggregate expenditure model. Suppose the economy is initially not in equilibrium, explain the process by which the economy adjusts to equilibrium. (4 marks) Equilibrium in the economy occurs when injections (investment) =withdrawals (savings), this coincides with the point where the economys savings function intersects the economys investment function.

Suppose the economys current level of GDP is Y, a level that is greater than the level of GDP associated with equilibrium, Ye, hence savings is larger than planned investments. The expenditure plans of households and firms fall short of the amount that is actually being produced so firms will not be able to sell all that they make, resulting in excess supply. As the economy is operating in short-run, prices do not change so the situation cannot resolve itself by a decrease in price. Firms therefore cannot sell all they produce and result in an increased inventory of unsold stock, which results in increased costs. Typically to avoid some of the costs, the firm would decrease production, resulting in a drop in the economys GDP. As income is derived from GDP, and that savings are related to income, we also find that savings fall. Planned investment does not change as planned investment expenditure is unaffected by changes in GDP. Similarly, in the scenario where planned aggregate expenditure exceeded output, firms would not have made their investment plans on the basis of having to meet these high levels. Firm would run down their inventories to meet the demand coming from households and firms. In the long-run, firms would have to boost production and so the amount of output produced in aggregate in the economy rises to meet the higher level of planned aggregate expenditure, and equilibrium is achieved.

Question 4 (i) What are the main instruments of fiscal policy? Explain how each might be used to close an expansionary output gap. (4 marks) Fiscal policy refers to decisions about government spending and decisions about taxes and transfer payments. Keynes felt that changes in government purchases were probably the most effective tool for reducing or eliminating output gaps. Government purchases of goods and services are part of the planned aggregate expenditure and thus directly affect total spending. If output gaps are caused by too much or too little spending, then the government can help to guide the economy toward full employment by changing its own level of spending.

Changes in the level of taxes or transfers can also be used to affect planned aggregate expenditure and thus eliminate output gaps. Unlike changes in government purchases, changes in taxes or transfer do not affect planned spending directly but rather work by changing disposable income in the private sector. For example, a 10-unit increase in planned investment moved the economy from an initial situation with no output gap to a situation with an expansionary gap. The 10-unit increase in planned investment is a 10-unit increase in exogenous expenditure, which will lead to an even greater increase in short-run equilibrium output. To offset to 10-unit increase in exogenous expenditure by means of fiscal policy, the government can reduce its purchases by 10 units. Under the assumption of the basic Keynesian model, government purchase are simply given and do not depend on output so government purchases are part of total exogenous expenditure, and changes in government purchases change exogenous expenditure one-for-one. Alternatively, it could raise taxes or cut transfers to reduce consumption spending. Assume the economy has a MPC=0.8, to reduce consumption spending by 10 units at each level of output, the government will need to increase taxes or reduce transfers by 12.5units. At each level of output, a 12.5 unit tax increase will reduce disposable income by 12.5 units and cause consumer to reduce their spending by 0.8 x 12.5=10 units, as needed to eliminate the expansionary output gap.

(ii) Explain what is meant by the government budget constraint. Indicate how it provides a link between fiscal policy and public debt. (3 marks) Government budget constraint is the term given to the concept that government spending in any period has to be financial either by raising taxes or by government borrowing. This term is quite literal in that the government is limited to only two sources of financing. The spending activities of the government are comprised of government expenditure, and transfer payments. The government has three means at its disposal to finance this expenditure. Firstly, it can raise taxes. Secondly, it can borrow money. When the government borrows money, it issues a security. Thirdly the government can print money to finance expenditure; however this will lead to very high rates of inflation and is not actively used. Thus if the government experiences a budget deficit, that is when spending exceeds the available finance, it is highly probable that it will increase public debt in order to finance the expenditure. The outstanding stock of government borrowing is called public debt. Public debt equals the sum of all past deficits less any surpluses. (iii) Explain the difference between discretionary fiscal policy and automatic stabilizers. Which one of these will be the main influence on the size of the structural budget deficit? Explain. (3 marks) Discretionary fiscal policy refers to deliberate changes in the level of government spending, transfer payments or in tax rates. To be useful as a stabilization tool, discretionary changes in fiscal policy need to be implemented in a timely manner. However, most changes in fiscal policy are only made on an annual basis in a Governments Budget.

This is the main difference between discretionary fiscal policy and automatic stabilizers. Automatic stabilizers refer to provisions in the law that imply automatic increases in government spending or decreases in taxes when real output declines. Taxes and transfer payments for example, respond automatically to output gaps: when GDP declines, income tax collection fall because income tax is a percentage of taxable income which would also fall, while unemployment and other welfare benefits rise. These changes do not require any explicit action by the government. Structural deficit issues can only be addressed by explicit and direct government policies: reducing spending, increasing the tax base, and/or increasing tax rates. It can be described as long-term in nature hence needing government action to remove it. Thus, it can be seen that discretionary fiscal policy would be the main influence on the size of the structural budget deficit, as discretionary fiscal policy equated with structural changes in the budget whilst automatic stabilisers drive cyclical changes.

Questions 5 A government is considering its fiscal policy response to a decline in exogenous desired expenditure by households and firms which has produced a large contractionary output gap. (i) Two alternative policies are under consideration: An increase in government spending of $20 billion, or A one-time cash payment to all households, which also has a total value of $20 billion Use the 4-sector Keynesian aggregate expenditure model to explain which of these policies will have the largest effect on planned aggregate expenditure and on the level of output. (4 marks)

PAE [C (c m)T I P G X ] (c m)(1 t )Y

An increase in government spending of $20 billion would have the largest effect on PAE compared to a one-time cash payment to all households. A one-time cash payment to all households with a total value of $20 billion would be equivalent to an increase in income before tax of all households, denoted Y, by $20 billion/number of households. However, this would not necessarily increase planned aggregate spending by $20 billion or greater than $20 billion due to the operation of the multiplier. As shown through the equation of PAE, the economys level of PAE depends not on T by on c T , the exogenous tax multiplied by the marginal propensity to consume. The remaining portion would be saved and therefore would have no effect on planned aggregate expenditure. Thus, a government spending of $20 billion would have the largest effect on PAE and the largest level of output.

(ii) Suppose the government is concerned about the size of the budget deficit. It decides to increase government spending by $20 billion, but at the same time to increase exogenous taxes by $20 billion. Will this policy have any effect on the level of output? Explain your answer. (3 marks) In this policy, the amount of increase government spending and the increase in exogenous taxes are both $20 billion, thus we can assume

G T

Hence this is an example of the balanced budget multiplier (BBM); the short run effect of equilibrium GDP of an equal change in government expenditure and net tax. Using the BBM formula:

1 Y [C (c m)T I P G X ] (1 [( c m)(1 t )])

e

Y e

1 [(c m)T G ] (1 [( c m)(1 t )])

Y e

1 (c m) G (1 [( c m)(1 t )])

c,m, and t, all have to be between 0 and 1. In the 4-sector model, BBM is positive but less than one in value. Thus the result is an increase in the economys equilibrium level of GDP; however it will be less than $20 billion. This can also be examined theoretically; $20 billion is taken away from income and $20 billion is spent by the government. Assuming the MPC=0.8, the government has effectively taken away $16 billion in consumption and $4 billion in savings that would not have been spent and added $20 billion in expenditure, thus increasing the level of output in this example by $4 billion.

(iii) Briefly indicate any complications or issues with fiscal policy that are not accounted for by the Keynesian aggregate expenditure model. (3 marks) Fiscal policy has three complications which need to be examined, supply-siders, deficits, and inflexibility. In making fiscal policy, government officials should take into account not only the need to stabilize planned aggregate expenditure but also the likely effects of government spending, taxes, and transfers on the economys productive capacity. A second consideration for fiscal policy-makers is the need to avoid large and persistent budget deficits. Sustained government deficits can be harmful because they reduce national saving, which in turn reduces investment in new capital goods which is an important source of long-run economic growth. Finally, the third issue with fiscal policy is that it is not always flexible enough to be useful for stabilization. Changes in government spending or taxes must usually go through a lengthy legislative process which reduces the ability of fiscal policy to respond in a timely way to economic conditions.

Question 6 (i) Money can be defined by its functions. In the following cases explain whether or not something is money, and which of the functions of money that it satisfies. - Credit-card account with a $5,000 limit - A BHP-Billiton share - A Transaction Account with the Commonwealth Bank with a $2000 balance (3 marks) Money is any asset that can be used in making purchases. For something to be classified as money it must satisfy three criteria, medium of exchange, unit of account and store of value. Medium of exchange means that an asset can be used in purchasing goods and services. The second function unit of account means that the asset is the basic measure of economic value. The final criteria store of value means that the asset is a means of holding wealth. Hence, the credit-card account is not money as it only meets a medium of exchange, the BHPBilliton share has store of value only and so is not money. Only the Transaction Account is money as it meets all three criteria. (ii) Explain the assumptions and implications of the quantity theory of money. (3 marks) The quantity theory of money is an extension of the quantity equation which states that the nominal value of expenditure in the economy must be equivalent to the stock of money multiplied by its velocity of circulation.

The quantity theory of money is expressed as where M is the money supply, V is the velocity, P is the price level, and Y is the output. It assumes that velocity and output are fixed numbers, which is not the case, and in doing so, proves that changes in M cause (proportional) changes in P. The quantity theory of money implies that if the quantity of goods and services y is approximately constant and assuming that V is also constant, an increase in the supply of money will lead people to bid up the prices of the available goods and services. Thus high rates of money growth will tend to be associated with high rates of inflation.

M V P Y

(iii) Explain what is meant by open-market-operations. Briefly explain how the RBA uses open-marketoperations to influence the cash rate. (4 marks) Open-market purchase is the purchase of government bonds from the public by the Reserve Bank for the purpose of increasing the balances in banks exchange settlement accounts. Open-market sale is the sale by the RBA of government bonds to the public for the purpose of reducing the balances in banks exchange settlement accounts. Open-market operations is the thus both open-market purchases and sales. Open market operations provide a means by which the RBA can influence the overall level of cash (exchange settlement funds). They also provide the means by which the RBA is able to ensure the overnight cash rate is equal to its target rate. The RBA affects the level of interest rates in the economy by first affecting the supply of reserves which Australias commercial banks hold in special accounts, known as exchange settlement accounts (ESA).

ESAs are accounts kept by the commercial banks with the RBA which are used to manage the flow of funds between commercial banks generated by the commercial activities of their customers. If the RBA wants to raise the level of bank reserve and thus lower cash rate, it would purchase financial assets from commercial banks. These purchases are paid for by the RBA crediting the exchange settlement accounts of the selling bank, leading to an increase in bank reserves called open-market purchase. To reduce bank reserves and increase cash rate, the RBA would sell some of the financial assets that it holds usually to the banks. This will lead to a transfer of reserves from the commercial banks to the RBA, and the RBA retires these reserves from circulation, this is known as open-market sale.