UKEA 1033 May 2017

UNIVERSITI TUNKU ABDUL RAHMAN

ACADEMIC YEAR 2017/2018

TUTORIAL QUESTIONS AND ANSWERS

UKEA 1033 Macroeconomics I

WEEK 1: Tutorial 1 (Overview of the basic concepts of macroeconomics)

 Tutor introduction to students.

 Tutor goes through Unit Plan.
 Tutor explain course syllabus and course requirement.
 Tutor explains and clarify assignment requirement.
 Tutor clarifies any queries that students arise.
 Appointment of class representative.
 Tutor continues with the discussion on topic 1.

Question1:

a) During a given year, the following activities occur:

 A gold mining company pays its workers $400,000 to mine 150 pounds of
gold. The gold is then sold to a jewelry manufacturer for $500,000.
 The jewelry manufacturer pays its workers $450,000 to make gold necklaces,
which the manufacturer sells directly to consumers for $1,500,000.

i. Using the “production of final goods” approach, what GDP in this economy?
ii. Using the “value added” approach, what is GDP?
iii. Using the income approach, what is GDP?

b) An economy produces three goods: cars, computers, and oranges. Quantities and
prices per unit for years 2010 and 2011 are as follows:

2010 2011
Quantit Quantit
  y Price y Price
$2,00 $3,00
Cars 10 0 12 0
Computer $1,00
i. What is s 4 0 6 $500 nominal GDP in
2010 and Oranges 1000 $1 1000 $1 in 2011? By what
percentage does nominal GDP
change from 2010 to 2011?
ii. Using the prices for 2010 as the set of common prices, what is real GDP in 2010 and
in 2011? By what percentage does real GDP change from 2010 to 2011?
iii. Using the prices for 2011 as the set of common prices, what is real GDP in 2010and
2011? By what percentage does real GDP change from 2010 to 2011?

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iv. Why are the two output growth rates constructed in (b) and (c) different? Which one
is correct?
c) Use the prices for 2006 as the set of common prices to compute real GDP in 2006 and
in 2007.

i. Compute the GDP deflator for 2006 and for 2007, and the rate of inflation from 2006
to 2007.
ii. Use the prices for 2007 as the set of common prices to compute real GDP in 2006 and
in 2007. Compute the GDP deflator for 2006 and for 2007 and the rate of inflation
from 2006 to 2007.
iii. Why are the two rates of inflation different? Which one is correct?

Question 2:

a) A man employed as a general manager earns $48,000 a year and gives his wife, who
does not have a job, $12,000 a year for housekeeping. He is redeployed as an assistant
manager earning $36,000 a year. His wife takes a job as a teacher earning $24,000 a
year and agrees to have a $6,000 cut in the housekeeping allowance. They sold their
car and earned $10,000. Their son has his pocket money reduced from $1200 to $960
per year. At the same time, their daughter registers as unemployed and receives
$3,600 benefit per year. Calculate the changes in national income.

b) Explain the effects of the size of underground economy on unemployment rate.

Question 3:

a) Explain the difference between the GDP deflator and the CPI.

b) Suppose that the only good you purchase is a loaf of bread and that at the beginning
of the year, the price of a loaf of bread is RM2. Suppose you lend RM1000 for one
year at an interest rate of 5%. At the end of the year, a loaf of bread costs RM2.08.
What is the real rate of interest you earned on your loan?

Question 4:

a) Suppose that the investors buying the ABC firm’s bond expect a 2% inflation rate for
the year. Given this expectation, the nominal interest rate is 6%. The year after the
investors purchase the bond, the inflation rate turns out to be 6%, rather than the 2 %
that had been expected. Who gains and who loses from the unexpectedly high
inflation rate?

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b) For each of the following, indicate if the person would be classified as employed,
unemployed, or not in the labour force.

i. A 70-year-old man who is on pension help his daughter in her business.

ii. A 20-year-old college student who is out of school for the summer and is looking
for a job.

iii. A 30-year-old woman with a PH.D in history who has not been able to find a
teaching position and is driving a cab for 30 hours a week

iv. A 40-year-old steel worker who isn’t working and has given up searching for a job.

Question 5:

a) Suppose you are measuring annual Malaysia GDP by adding up the final value of all
goods and services produced in the economy. Determine the effect of each of the
following transactions on GDP:

i. You buy RM100 worth of fish from a fisherman, which you cook and eat at home.

ii. A seafood restaurant buys RM100 worth of fish from a fisherman.

iii. Singapore government buys new cars from Proton for RM200 million.

iv. John sells his car to Siti for RM80,000.

b)Explain the difference between GDP and GNP.

c) Refer to the following table, calculate the growth rate.

Year Nominal GDP (RM billion) Deflator index Growth rate
1 550 140 -
2 560 135
3 576 120
4 586 117
5 604 108

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Week 1: Tutorial 2 (The Goods Market)

Question 1:

Suppose that the economy is characterized by the following behavioral equations:

C = 180+0.8YD
I = 160
G = 160
T = 120

Answer the following questions:

a) Calculate the equilibrium GDP (Y), Yd and C.
b) Assume that G is now equal to 136. Solve for equilibrium output.
c) Assume that G is equal to 136, so output is given by your answer to (b). compute
private plus public saving. Is the sum of private and public saving equal to
investment? Explain.

Question 2:

Suppose the economy is characterised by the following set of equations

C = 200 + 0.7 Yd
Yd = Y - T
I = 100
G = 200
T = 200
Where C is consumption, Yd is disposable income, T is lump sum taxes, Y is GDP, I is
investment and G is government spending.

a) Calculate the equilibrium level of income in this economy. Illustrate it in your ZZ

graph.
b) What is the value of the multiplier?
c) The government decides that income is too low and wishes to expand the economy by
cutting lump sum taxes to 100. Calculate the new equilibrium level of income.
d) The government is now concerned about the rising level of government debt so cuts
government spending by 100 units. What happens to the equilibrium level of income?
Comment on your findings.

Question 3

a) The government wishes to undertake a program of public works costing RM5 billion
but must balance its budget. If the current level of GDP is RM100 billion, would the
government be correct to raise the tax rate by 5%? Explain your answer.

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b) Discuss and explain what effect an increase in the marginal propensity to consume
has on the size of the multiplier.
c) Use the ZZ-Y model to illustrate the effects of an increase in investment on the
economy. Also, explain what effect this increase in investment has on the economy.
Question 4:

Discuss what is meant by the paradox of saving.

Question 5:

Given that the MPC = 0.75 and that RM10,000 million of real GDP is currently being
demanded.

a) Explain the meaning of multiplier effect. What is the value of the multiplier?
b) How much should the government increase in their spending to increase the real
GDP to RM15,000 million?
c) If government chooses to reduce tax (reducing the same amount as the increase
in government spending), what will happen to the multiplier and real GDP?
d) Refer to (b) and (c), if government is only allowed to choose only one
alternative between increasing in government spending or reducing taxation to
increase the real GDP, what will be the government’s decision? Explain the
rationale of the government’s decision.
e) Explain the relationship between multiplier and the slope of the consumption.
Illustrate your answer using ZZ-Y model.

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Week 2: Tutorial 3 (Financial Markets)

Question 1:

a) A bond promises to pay £250 in one year’s time.

i. What will the interest rate on the bond at current market prices RM185, RM200
and RM230 respectively?
ii. What is the price of the bond at interest rates of 5%, 7.5% and 10%?
iii. What is the relationship between bond prices and interest rates?

b) Explain how the following will affect the equilibrium level of interest.
i. a large increase in the cost of using ATMs.
ii. a requirement for all banks to deposit a proportion of their reserves in a non-
interest bearing account at the central bank.
iii. the government runs a substantial budget surplus and repurchases bonds from
the private sector.
iv. a fall in consumer confidence.

Question 2:

Suppose that money demand is given by

a) if the income level if Y=1000, and the interest rate is r-10%, what is the demand for
money?
b) What is the equilibrium level of interest rates when the supply of money is equal to
200?
c) What happens to the equilibrium rate of interest following and increase in the money
supply of 400?
d) What happens to the equilibrium rate of interest following an increase in income to
1500?

Question 3:

The money multiplier

Suppose the following assumptions hold:

 The public holds no currency
 The ratio of reserves to deposits is 0.1
 The demand for money is given by
d
M = $Y(0.8-4i)
Initially, the monetary base is $100 billion and nominal income is $5 trillion.

a) What is the demand for central bank money?

b) Find the equilibrium interest rate by setting the demand for central bank money equal

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to the supply of central bank money.

c) What is the overall supply of money?
d) What is the impact on the interest rate if central bank money is increased to $300
billion?

Question 4:

What is ‘bank runs’? What can be done to avoid bank runs? Provide your discussion with
relevant examples.

Question 5:
The following table shows the changes in deposits, reserves, and loans of 4 banks as a result
of a $100,000 initial deposit in bank No.1. Assume all banks are loaned up. Answer the
following questions:

New Deposit Required Reserve Loans

Bank No.1 $100,000.00 $5,000.00 $95,000.00
Bank No.2 $ 95,000.00 $4,750.00 $90,250.00
Bank No.3 $ 90,250.00 $4,512.50 $85,737.00
Bank No.4 $ 85,737.50 $4,286.90 $81,450.63

a) What is the required reserve ratio?

b) What is the money multiplier in this economy?
c) How much money will be created out of the initial $100,000 deposit?
d) If the required reserve ratio were changed to 12%, total loans of Bank.No2
will change to?
e) Define the money multiplier. Suppose there are $10 million in excess reserves
in the banking system and the required reserve ratio is 10% by how much
could the money supply expand by assuming that the banking system is
closed?

Week 2: Tutorial 4 (Goods and Financial Markets: The IS-LM Model)

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Question 1:
Compare the effect of changes (increase) in money demand and changes (increase) in money
supply to the LM curve. Derive the LM curve from the money market.

Question 2:
Consider the following IS-LM model:

C = 200+0.25YD T = 200
I = 150+0.25Y-1000i (M/P)d = 2Y-8000i
G = 250 M/P = 1600

a) Derive the IS relation.

b) Derive the LM relation.
c) Solve for equilibrium real output.
d) Solve for the equilibrium interest rate.
e) Solve for the equilibrium values of C and I.
f) Now suppose that the money supply increases to M/P =1840. Solve for Y, i, C, and I,
and describe in words the effects of an expansionary monetary policy.
g) Set M/P equal to its initial value of 1600. Now suppose that government spending
increases to G = 400. Summarize the effects of an expansionary fiscal policy on Y, i,
and C, and I.

Question 3:

Consider the following IS-LM model:

H S
( )
P
=2 , 000
d
C=1 ,000+0. 6Y D CU
=c=0 . 4
I=200+0 . 2Y −4 ,000 i Md
T =250 M d
G=300 ( )
P
=Y −3 ,000 i
Required reserved ratio = 0.1

a) Derive IS and LM relation.

b) Find the real output and interest rate when the economy reaches its equilibrium.
c) Suppose that money supply increases to 2,500. Solve for Y and i.
d) Explain the situation in (d) using appropriate graph.

Question 4:

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a) Based on your understanding of the IS-LM model, graphically illustrate and explain
what effect an increase in consumer confidence will have on output, the interest rate,
and investment.

b) Policy mixes
Suggest a policy mix to achieve the following objectives:
i. Increase Y while keeping i constant.
ii. Decrease the fiscal deficit while keeping Y constant. What happens to i and
investment?

Question 5:

Answer the following questions based on the information given.

C=650+0 .1 Y D
I=400+0 .3Y −600 i
T=500
G=200
H s
()
P
=260
c=0 .4
M d
( )
P
=Y −1,000 i

θ=0 .2

a) Derive IS relation.
b) Derive LM relation.
c) Find the equilibrium output and interest rate.
d) Explain with the aid of IS-LM diagram the effect of an increase in the government
spending to the economy.
e) What action should the government takes in order to remain interest rate unchanged
after the incident that happened in (d)? Use appropriate diagram to support your
answer.

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Week 3: Tutorial 5 (The Labor Market)

Question 1:

a) The natural rate of unemployment

Suppose that the firm’s markup over costs is 5%, and the wage-setting equation is W =
P(1-u), where u is the unemployment rate.

i. What is the real wage as determined by the price-setting equation?

ii. What is the natural rate of unemployment?
iii. Suppose that the markup of prices over costs increases to 10%. What happens to the
natural rate of unemployment? Explain the logic behind the answer.

b) Bargaining power and wage determination

Even in the absence of collective bargaining, workers do have some bargaining that
allows them to receive wages higher than their reservation wage. Each worker’s
bargaining power depends both on the nature of his job and on the economy-wide labor
market condition. Let’s consider each factor in turn.

i. Compare the job of a delivery person and a computer network administrator. In which
of these jobs does a worker have more bargaining power? Why?
ii. For any given job, how do labor market conditions affect the worker’s bargaining
power? Which labor market variable would you look at to assess labor market
conditions?

c) Assume the following: The non-institutional civilian population is 200 million, of

which 100 million are employed and 8 million are unemployed. Base on the data
above,
i. Determine the unemployment rate.
ii. Determine the labor force participation rate.
iii. Determine the non-employment rate.

Question 2:

a) First, explain what the WS relation represents. Second, explain why it has its
particular shape.
b) First, explain what the PS relation represents. Second, explain why it has its
particular shape

Question 3:

a) Explain what effect a change in the unemployment rate has on the real wage based on:
(1) the WS relation; and (2) the PS relation.
b) Explain what the natural rate of unemployment is.

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c) Graphically illustrate (using WS and PS relations) and explain the effects of a

decrease in unemployment benefits on the equilibrium real wage, the natural rate of
unemployment, the natural level of employment, and the natural level of output.

Question 4:

a) Explain why nominal wages are a function of the expected price level.
b) Explain how an increase in the unemployment rate will affect bargaining power and
nominal wages

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Week 3: Tutorial 6 (Putting All Markets Together: The AS-AD Model)

Question 1:

a) Define the aggregate supply curve. Explain why the aggregate supply curve has its
particular shape.
b) Define the aggregate demand curve. Explain why the aggregate demand curve has its
particular shape.

Question 2:

a) Explain what effect an increase in the money supply has on the aggregate demand
curve.
b) Explain how changes in each of the following variables affect the aggregate price
level: (1) the expected price level; (2) output; (3) the mark up; and (4) the minimum
wage.

Question 3:

When output exceeds the natural level of output, explain what adjustments will occur in the
labor market and discuss what effect they will have on output and the price level.

Question 4:

In an AD-AS diagram, show what happens to output and the price level in the short run and
the medium run when there is a decrease in investment.

Question 5:

Assume that the economy starts at the natural level of output. Now suppose there is a decline
in business confidence, so that investment demand falls for a given interest rate.
a) In an AD-AS diagram, show what happens to output and the price level in the short
run and the medium run.
b) What happens to the unemployment rate in the short run and the medium run?

Question 6:

Base on your understanding of the AD-AS and the IS-LM model, graphically illustrate and
explain what effect a reduction in the money supply will have on the economy. In your
graphs, clearly illustrate the short-run and medium-run equilibra. Assume that before
changes, the economy was at the natural level of output.

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Week 4: Tutorial 8 (The Natural Rate of Unemployment and the Phillips Curve)

Question 1:

a) Based on the ‘early incarnation’ of the Phillips curve, explain what effect a reduction
in the unemployment rate will have on the inflation rate.
b) What are the two reasons why the original Phillips curve vanished? Explain.
c) Write down the expressions for the original Phillips curve and the expectations-
augmented Phillips curve (or the modified, or accelerationist Phillips curve). Explain
how the original Phillips curve differs from the expectations-augmented Phillips
curve.

Question 2:

a) Based on your understanding of the Phillips curve, explain what happens to actual
inflation (relative to expected inflation) when the actual unemployment rate is either
above or below the natural rate of unemployment.
b) Based on your understanding of the Phillips curve, is it possible for the
unemployment rate to increase while inflation increases? Explain.

Question 3:

Explain why Phillips curve is different from the mutated Phillips curve.

Question 4:
a) Derive and explain the relationship between inflation and natural rate of
unemployment.

Question 5:

a) Based on your understanding of the Phillips curve, is it possible for the

unemployment rate to increase while inflation increases? Explain.
b) Explain what is meant by the "wage-price" spiral.
c) Briefly comment on the predictions of economists Milton Friedman and Edmund
Phelps about the ability to exploit a trade-off between inflation and unemployment.

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Week 4: Tutorial 8 (Inflation, Activity, and Nominal Money Growth)

Question 1:

The estimated Okun’s law for the United States is given by

ut – ut-1 = -0.4(gyt – 3%)

a) What growth rate of output leads to an increase in the unemployment rate of 1%

per year? How can the unemployment rate increase even though the growth rate of
output is positive?
b) What rate of growth of output do we need if we want to decrease unemployment
by two percentage points over the next four years?
c) Suppose that we experience a second baby boom. How do you expect Okun’s law
to change if the rate of growth of the labor force increases by two percentage
points?

Question 2:

Suppose that the economy can be described by the following three equations:
ut – ut-1 = -0.4(gyt – 3%) Okun’s law
π t −π t−1 = -(u – 5%) Phillips curve
t

g =g - t
π Aggregate demand
yt mt
a) What is the natural rate of unemployment for this economy?
b) Assume that at t=0, the economy is in the medium-run equilibrium. What are
u0 and π 0 if we have the nominal growth rate of money ḡm =11%?

Suppose that the central bank decides to tighten monetary policy in the following
way: It decides to decrease real money growth relative to trend by 2.5% in Year 1,
and to increase it relative to trend by 2.5% in Year 2, and remain at 3% thereafter.
c) Calculate the values of (g m−π ), g y , u , π , and gm for all the periods until the
new medium-run equilibrium is reached.
d) When would be the economy return to the medium-run equilibrium? Explain.

Question 3:

Explain what is meant by the Lucas critique and discuss how the credibility of monetary
policy affects how the economy adjusts to a monetary policy action that attempts to reduce
the inflation rate.

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Question 4:

Explain how the staggering of wage decisions can limit how quickly disinflation can occur
without causing an increase in unemployment.

Question 5:

a) What are the two reasons why the rate of growth of output has to be at least equal
to the normal growth rate of output to prevent the unemployment rate from rising?
Explain.
b) Output growth that is 1% above normal causes only a 0.4% reduction in the
unemployment rate rather than a 1% reduction in the unemployment rate. What
are the two reasons why unemployment does not fall by the same 1%? Explain.

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Week 6: Tutorial 9 (Openness in Goods and Financial Markets)

Question 1:

a) Explain how the following situations affect the Malaysian balance of payments.
i. A Malaysian contractor provides its consulting services to a company in Italy.
ii. Malaysia investors decide to buy 100 shares of a company listed in Japan.

iii. European investors decide to build a large manufacturing facility in Malaysia.

iv. More tourists visit Malaysia due to the “Visit Malaysia 2007”.
v. Interest payments to overseas investors.

b) Explain the components in Balance of Payment and provide each of the components
with appropriate examples.

Question 2:

Consider two bonds, one issued in euros in Germany, one issued in dollars in the United
States. Assume that both government securities are one-year bonds – paying the face value of
the bond one year from now. The exchange rate, E, stands at 1 dollar = 1.05 euros.

The face values and prices on the two bonds are given by

Face
    Value Price
United 1-year
States bond $10,000 $9,615.38
1-year €
Germany bond € 13,333 12,698.10
The symbol € represents the euro

a) Compute the nominal interest rate on each of the bonds.

b) Compute the expected exchange rate next year consistent with uncovered interest
parity.
c) If you expect the dollar to depreciate relative to the Euro, which bond should you
buy?
d) Assume you are an U.S. investor. You exchange dollars for euros and purchase the
German bond. One year from now it turns out E is actually 1.11 (1 dollar = 1.11
euros). What is your realized rate of return in dollars compared to the realized rate of
return you would have made had you held the U.S. bond?

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Question 3:

a) Explain the concept of Uncovered Interest Parity (UIP).

b) Malaysian tourists are thinking of visiting Vietnam with Ringgit (RM)
currency strengthened in September 2009. Although the prices of goods in Vietnam
have increase, they can buy more Vietnam Dong (VND) per Ringgit (RM). Does this
imply that their trip will be cheaper?

Question 4:

a) Suppose the interest parity condition holds. Also assume that the one-year interest
rate in the United States is 6% and that the one-year interest rate in Canada is 6%.
What does this imply about the current versus future expected exchange rate (for the
U.S. and Canadian dollars)? Explain.
b) Explain why a comparison between the interest rates on domestic and foreign bonds
might provide misleading information about which bonds yield the highest expected
returns.
c) Assuming that the interest parity condition holds, what type of information is
contained in interest rate differentials between domestic and foreign bonds? Explain.

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Week 6: Tutorial 10 (The Goods Market in an Open Economy)

Question 1:

a) Explain the difference between: (1) the demand for domestic goods; and (2) the
domestic demand for goods.
b) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect a
reduction in government spending will have on output, exports, imports, and net
exports. Clearly label all curves and clearly label the initial and final equilibria.

Question 2:

Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect a reduction in
foreign output (Y*) will have on the domestic economy. Clearly label all curves and clearly
label the initial and final equilibria.

Question 3:

Assuming the Marshall-Lerner condition holds and using the ZZ/Y and NX graphs, illustrate
graphically and explain what effect a real depreciation will have on the domestic economy.
Clearly label the initial and final equilibria.

Question 4:

Suppose a country is experiencing a recession and trade surplus. Further assume that the
policy makers’ goals are to achieve full employment output and balanced trade. Given this
information, what type of exchange rate and / or fiscal policy can be used to achieve
simultaneously these two goals? Explain.

Question 5:

Explain what the J-curve is and why it occurs.

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Week 7: Tutorial 11 (Output, the Interest Rate, and the Exchange Rate)

Question 1:

a) Suppose the domestic and foreign interest rates are initially equal to 5%. Now
suppose the domestic interest rate rises to 8%. Explain what effect this will have on
the exchange rate.
b) Consider a monetary expansion in an economy operating under flexible exchange
rates. Discuss the effects on consumption, investment, and net exports.

Question 2:

Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,
graphically illustrate and explain what effect a reduction in foreign output (Y*) will have
on the domestic economy. In your graphs, clearly label all curves and equilibria.

Question 3:

Assume the exchange rate is fixed. Using the IS-LM-IP model, graphically illustrate and
explain what effect a reduction in government spending will have on domestic economy. In
your graphs, clearly label all curves and equilibria.

Question 4:

Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that the
foreign interest rate falls. Discuss what policy makers must do to maintain the pegged
exchange rate. Also discuss what effect this will have on domestic output and net exports.

Question 5:

Consider the following IS-LM model in an open economy:

C =400+0.25YD
I = 300+0.25Y-1,000r
G =500
2
IM = 0.1Y ε +100 ε
X = 0.02Y*-110 ε
T = 200
Y* = 10,000
Md = PY-8,000i
MS = 1,600
i* = 5%

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Suppose that P = P* = 1 and there is no inflation, π e=π =0 .

Assume that the exchange rate is fixed. Calculate the equilibrium Y, i, and ε .

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Week 7: Tutorial 12 (Exchange Rate Regimes)

Question 1:

a) Suppose output is below the natural level of output. In a fixed exchange rate regime,
explain the two ways the economy can return to the natural level of output.
b) Assume a country is in a fixed exchange rate regime. Explain what factors might
cause individuals to expect that a country will have an exchange rate adjustment.

Question 2:

Suppose the economy is operating below the natural level of output. Discuss the arguments
for and against using devaluation in such a situation.

Question 3:

Suppose financial markets believe that there is a 50% chance country with a fixed exchange
rate wants to devaluate its currency by 5% a month from now (note that there is a 50%
chance the country will not devalue). If the central bank wants to hold the existing parity,
what does it need to do?

Question 4:

Given the following information:

C=540+0. 4(Y −T )
I=200+0. 2Y −2500 r
IM=0. 1Yε+20 ε 2 W=P e ( z−2u)
X =0.036 Y∗−80ε P=(1+μ)W
T =100 z=1
G=100 μ=0 .25
Y∗¿10, 000 Y =N
M s =1,300 L=2 ,000
d
M =PY −5 ,000 i π=0 .068
(a) Derive AS and AD relation.
(b) Find the Yn, P, i, un, ε and r. Assume that TB= 0 when economy reaches medium run
equilibrium.
(c) Derive AS and AD relation.

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