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Tutorial Solutions ECW2730 2013

Measuring Macroeconomic Data
Aggregate Production and Productivity

Chapter 2 – problem 2 & 3
Chapter 3 – review question 2 & 3
Chapter 5 - review question 5 & 7, problem 4

Money and Inflation
Saving and Investment in Closed and Open
Economies

Chapter 4 – review question 1, 4, 7 & 8
Problem 6

The Sources of Growth and the Solow Model

Chapter 6 – Problem 1, 2, 5, 6, & 7

Driver of Growth: Technology, Policy and
Institutions

Chapter 7 - review question 1-6
Problem 6 & 7
Chapter 8 – Problem 1, 4, 5 & 8

Business Cycles: An Introduction
The IS Curve
Fiscal Policy and the Government Budget
Monetary Policy and Aggregate Demand

Chapter 9 - review question 1, 2, 7, 8, 9
Problem 1, 4
Chapter 17 – Problem 1 & 4
Chapter 10 - review question 1-4
Problem 1 & 4
Chapter 11 - review question 1-3, 6-8

Aggregate Supply and the Philips Curve
The Aggregate Demand and Supply Model

Macroeconomics Policy and Aggregate Demand
and Supply Analysis

Chapter 12 - review question 1-3, 6-10

Chapter 13 - review question 5, 7, 9, 12,
Problem 7 & 9

The Financial System and Economic Growth

Chapter 14 - review question 1, 2, 4, 6,
Problem 2, 8-10

Exchange Rates and International Economic
Policy

Chapter 18 - review question 2, 3, 6, 7, 8-10
Problem 2

Note: Selected solutions are taken from “Instructors Manual for Macroeconomics, Mishkin©
2012, Pearson Publishers. They are for private study purposes only and should not be used
for any other purpose.
Tute 1, Week2
Chapter 2

2013

2. a. According to the production approach, which measures GDP by adding the value
added from each firm, GDP will increase in this case. This is interpreted as good news, as this
measure is intended to measure economic activity.
b. We cannot say that both countries are better off for sure. We can say that economic
activity has increased in both countries, but GDP cannot measure, by definition,
many important aspects of human welfare (including our perceptions about the
environment). Theoretically, it is possible that the impact of pollution is so negative
that it actually decreases the quality of life in these countries. We can say for sure
that the inhabitants of Utopia will benefit more from this increase in economic
activity than the inhabitants of Pandora, who value their environment twice as much.
Since individual preferences about issues like environmental protection are
inherently difficult to measure, these considerations are often left out of the
discussion and most policymakers focus only on the GDP measure when evaluating
alternative policies.
c. In this alternative scenario, inhabitants of Utopia will not benefit as much from the
increased economic activity if it undermines one of their fundamental values: a more
equal income distribution. As before, it might even be the case that inhabitants of
Pandora will suffer a lot from observing a more skewed income distribution, but they
will always benefit more from this situation than their counterparts in Utopia.
Measuring GDP: The Expenditure Approach
3.
a. A household purchase of a home built in 1985 will not affect GDP because only
currently produced goods and services are considered by the GDP measure. Counting
previously produced goods will overestimate GDP, as these goods were already counted the
year they were produced.
b.
A household purchase of a newly built dishwasher will count towards GDP and will
be included in consumption expenditure (as durable goods expenditure).
c.
A farmer’s purchase of a new tractor will be included in GDP as private investment,
since the farmer is adding to his or her machinery stock. This transaction will be considered
fixed investment.
d.
An individual receipt of any type of transfer from the government (including tax
credits) is not included in GDP, since this transaction is not meant to pay for any currently
produced good or service.

e. A U.S. Department of Defense purchase of equipment could be considered
government consumption or government investment. In this case, however, the
helicopters are manufactured in another country and therefore this transaction will
not affect GDP.
Chapter 3
2. Total factor productivity measures the productivity of all inputs. It is the average output
produced by one unit of capital together with one unit of labor. Labor productivity
measures the average output produced by one unit of labor. Labor productivity increases if
increases in capital lead to the production of more output with the same amount of labor,
even though total factor productivity does not change in this case. Labor productivity is
more easily measured, but total factor productivity is a better indicator of how
productive capital and labor are together.
3. The Cobb-Douglas production function is Y = AK0.3L0.7, where Y = output, A =total factor
productivity, K = capital, L = labor, and the exponents are the shares of national income
received by capital (0.3 or 30%) and labor (0.7 or 70%). Total factor productivity cannot
be measured directly, but can be estimated as A = Y/(K 0.3L 0.7).
Chapter 5
5.
The equation of exchange is derived from the definition of velocity as the average
number of times per year that a dollar is spent to buy the total output produced in the
economy. Total spending is
P  Y and the quantity of money available to spend is M, so velocity V = (P  Y)/M. This
definition of velocity is converted into the equation of exchange by multiplying both sides by
M to get M  V P  Y, which states that the quantity of money multiplied by the number of
times this money is spent in a given year must equal the average price level times real GDP.
Since multiplying real GDP by the price level gives nominal GDP, the equation of exchange
says that total spending to buy goods and services equals nominal GDP.
7.
Based on the relationship that the percentage change in a product of two variables is
approximately equal to the sum of the percentage change in each variable, the equation of
exchange, M  V = P  Y can be converted to % M + %V = %P + %Y. Knowing that
the percentage change is the same as the growth rate of a variable and recognizing that
inflation is the growth rate (percentage change) of the price level, the equation tells us that
inflation equals the growth rate of money plus the growth rate of velocity minus the growth
rate of output. Assuming velocity is constant yields the theory that inflation equals the growth
rate of money minus the growth rate of output. This relationship emphasizes the key role of a
central bank to limit money supply growth in order to control inflation.
Problem 4
4.
a.
To estimate annualized rates, multiply the 3 months percentage growth rate by
4 and the 6 months percentage growth rate by 2. The table below shows the results:

Period
3 months
6 months
1 year

Annualized Growth
Rate
M1
M2
5.89%
7.54%
9.49%

0.45%
2.50%
2.13%

b. As noted in Chapter 5, growth rates of M1 and M2 can be quite different. The year
2009 saw a significant increase in M1, while M2 did not increase by that much.
Another important feature is that M1 can be substantially more volatile than M2, as
observed since 1992 (see Figure 1).

Tute 2, Week 3

2013

Chapter 4 – review question 1, 4, 7 & 8 Problem 6
1. The two components of national saving (S) are private saving (SP) and government
saving (SG). Private saving is disposable income (YD, which is GDP or national income Y
minus taxes T) minus consumption expenditure (C). Government saving is taxes minus
government purchases (G). Thus, national saving S = SP + SG = Y - T - C + T - G = Y - C
- G. If national saving (a flow) is positive, national wealth (a stock) increases because the
saving is used to finance either domestic investment in capital goods or the purchase of
foreign assets. Negative national saving involves borrowing from abroad or selling
foreign assets to finance domestic investment. Saving, Investment, and Goods Market
Equilibrium in a Closed Economy
4. Crowding out refers to the decrease in investment spending that results because
government spending increases. This occurs because an increase in government spending
reduces desired saving and causes the real interest rate to increase, which results in a
decline in desired investment spending. Thus an increase in government spending
crowds out—leads to a decrease in—investment spending.
7. Both types of economies are open to trade and capital flows, but the ―small‖ economy is
so small relative to the world economy that it has no effect on the world real interest rate.
A ―large‖ open economy is large enough that changes in its desired amounts of saving
and investment do affect the world real interest rate.
8. The small open economy will have a trade surplus if the world real interest rate is above
rE, the real interest rate at which the small open economy’s desired amounts of saving
and investment would be the same. (rE would be the equilibrium real interest rate if the
economy were closed.) At the higher world real interest rate the economy’s desired
saving exceeds its desired investment; it has positive net exports—a trade surplus—and
excess saving that can be lent to foreigners (net capital outflow). However, if the world
real interest rate is below rE, then the economy will have negative net exports and a trade
deficit. Because its desired saving falls short of its desired investment, it will borrow
from the rest of the world at the world real interest rate and thus will experience net
capital inflow.
Problem
6. a. Considering Japan an open economy means that Japan’s investment equals its
national saving minus its net exports. If saving is $1.25 trillion (25% of $5 trillion)
and net exports equal $50 billion, then Japan’s investment is $1.20 trillion.
b. If Japan’s net exports equal $50 billion and its imports are valued at $650 billion,
then Japan’s exports equal $700 billion.

Tute 3, Week 4
Chapter 6 – Problem 1, 2, 5, 6, & 7

2013

Sources of Economic Growth: Growth Accounting
1. a. India’s output growth can be calculated as:

1
2
gY  4%   3%   3%  7%.
3
3
b. The contribution of productivity growth to total output growth is
India’s growth came from productivity growth in this case.

4
7

 57%. Almost 60% of

2. a. The difference in output growth rates can be explained by differences in productivity growth
rates. This is the factor that cannot be measured directly, as opposed to changes in the capital
and labor input stocks.
b. Productivity growth rates can be calculated as the difference between output growth rates
and the combined growth rates of the capital and labor input stock. Productivity growth in
country 1 is a mere 0.5% and it is 2.5% for country 2, which explains its higher output
growth rate.
5. a. According to the Solow model, an increase in the saving rate will increase the capital–labor
ratio in the United States. There will be a transition during which the U.S. economy will
move towards a new steady state. At the new steady state, U.S. residents will enjoy a higher
capital–labor ratio level, and therefore a higher output-per-worker ratio. These ratios,
however, will not increase any further. The effect of a higher saving rate, according to the
Solow model, is to increase the steady state level of output per worker. After this transition
period is over, output per worker does not increase any further.
b. In light of the previous answer, one might ask: Why not keep increasing the saving rate
forever? The answer is that increasing the saving rate means decreasing current
consumption, a quite important trade-off. This reasoning demonstrates that there is a limit to
this path to encourage economic growth.
6. If low standards of living are the reason individuals decide to have many children, then
encouraging couples to have fewer children will not have a significant effect on economic
growth. Although the concept of capital dilution is very important, there are many arguments in
favor of the hypothesis that low standards of living encourage individuals to have more children.
Some population control policies were not very successful (e.g., distribution of contraceptives). As
people saw no change in their well-being, even if they had contraceptive methods at hand, they
still decided to have many children. Some other population control methods were more coercive
(e.g., fines, sterilization, etc.) and therefore resulted in lower fertility rates. These often did not
translate to an increase in the standard of living of these societies. Most societies that saw a
decrease in their fertility rates also experienced
an increase in their standards of living either prior to or during the decrease in fertility rates.
7. There are many consequences that arise from a coercive population control method as the one
implemented by China. First, the drop in fertility rates has been so big, than the Chinese labor
force might be smaller in the future than what it is today. Second, it means that young workers in
the future will have to work extra hard to support their parents. This is a phenomenon shared by
many aging populations, even when there is not population control, but clearly the one-child
policy makes this worse. Finally, and most importantly, Chinese families that are allowed to
have only one child usually prefer to have a baby boy. This has resulted in ratios of baby boys to
baby girls of around 120 to 100, when the usual ratio is around 103 to 105 baby boys per 100 baby
girls. An interesting corollary is that in the future there will be more Chinese young boys trying to
marry fewer Chinese girls than in previous years.

Tute 4, Week 5
Chapter 7 - review question 1-6, Problem 6 & 7

2013

1. As physical objects, labor and capital inputs are rival and excludable: They can only be used in one
productive activity at a time, so that using them to produce one thing precludes their use to produce
something else, and they cannot be used by producers who have not obtained permission to do so.
Technology (ideas) differs completely in these important characteristics. Ideas can be used in more
than one productive activity at the same time, and are more likely to be nonexcludable, so that other
people can use them without permission or payment for their use. In these respects, technology has
the characteristics of public goods.
2. Government can promote productivity growth by designing policies that lead to more spending on
infrastructure, human capital, and research and development. These policies might take the form of
increased government spending in these areas or instead provide greater incentives for private
individuals and investors to undertake the increased expenditures.
3. Because of the nonexcludable nature of technology, many of the benefits of new technology will
be external. This means that private businesses who invest in R&D will not get the full benefits of the
new technology they create and therefore may not expect to earn enough profits to justify the R&D
investment necessary to develop the new technology.
4. A patent gives an inventor exclusive rights over the use of his or her invention for a specific period
of time. The inventor may use the new technology or sell or license it for others to use. When
governments grant patents this enables inventors to earn higher profits from their inventive
activities—e.g., R&D—and thus helps overcome the disincentives that otherwise spring from the
nonexcludability of technology. This should benefit society by increasing R&D spending,
technological progress, and the growth rate of per capita output.
5. Property rights protect property owners from government and others that might want to extort their
wealth. They promote economic growth by providing incentives to save and invest and allocate
capital to its most productive uses.
6. Property rights are no better than the legal system that defines, interprets, and enforces them. To
promote strong property rights a society needs an effective legal system that enforces contracts,
has adequate resources (courts and judges) to hear and decide cases within a reasonable time, and
provides access to lawyers so aggrieved parties can have their day in court.
Problem
6.

According to the graph, there is a close association between corruption and per capita income.
As the CPI value increases, indicating that corruption is less prevalent, GNI per capita also
increases. As expected, relatively richer countries exhibit higher values of the CPI. This
constitutes evidence in favor of the hypothesis that corruption and economic growth are
negatively related.
7. Unfortunately there is no clear answer for this question. There are valid arguments for both
positions. The prevalence of corruption in a society makes the enforcement of property rights
very difficult, as government officials are often bribed in exchange for preferential treatments or
concessions. Also, in a society in which most people are corrupt it often pays off to behave as a
corrupt individual, making this problem even worse. It is also true, however, that badly designed
institutions can promote corruption. This is the case when bureaucracies create positions (usually
government officials) that create the opportunity for individuals to exert some power. If you have
to pay many license fees to obtain a permit to conduct your businesses, it is probable that the
higher the number of licenses you have to obtain at different government offices, the more bribes
you will be asked to pay. This is an example of a vicious circle from which it is very difficult to
escape. Poor countries often exhibit a combination of poorly designed and enforced property
rights and corruption.

Tute 5, Week 6
Chapter 8 – Problem 1, 4, 5 & 8

2013

1. a. There are two expansions according to this graph: (1) from January 1912 to January 1913,
which lasted 12 months, and (2) from December 1914 to August 1918, which lasted 44
months, or 3 years and 8 months.
b. There are two contractions according to this graph: (1) from January 1913 to December
1914, which lasted 23 months, and (2) from August 1918 to March 1919, which lasted 7
months.
4. a. Considering only changes in real GDP, the economy reached its peak in February and
reached its trough in April.
b. The inflation rate seems to be a lagging variable. The economy reached its peak in February,
but the inflation rate kept increasing for a few more periods. Inflation began its decrease
after the economy reached its trough in April. The stock price index seems to be a leading
(by one month) indicator of the business cycle. It peaked one month before real GDP and it
reached its trough one month before (March) than real GDP (April).
5. a. Real GDP and stock prices index:

b. Unemployment and inflation rates:

c. Considering real GDP and the unemployment rate, it is not clear that the economy reached
its trough in April, since the unemployment rate kept increasing after that period. Using
other indicators, the trough would probably be determined at some date between April and
May
(when unemployment peaks).
d. By considering these four indicators, it is clear that no single indicator can be used to
determine the business cycle. The problem is that even if the timing of some variables can be
assessed, this relationship can change over time. A leading variable might predict a peak in
the next month, or the next quarter, depending on the ever changing economic environment.
8. This statement is not correct. Keynes stated that we should primarily focus on short-run
fluctuations, since it takes a long time for the economy to reach its long-run equilibrium. Waiting
for such a long time would be useless, Keynes argued, since there are policy tools that can be
used to reduce the pervasiveness of business cycle contractions. Instead of waiting for prices to
adjust, which takes a long time, Keynes argued for an approach that would make use of policy
tools to stimulate the economy. Keynes was also worried about the long-run consequences of
policy actions, however, and it is not correct to interpret his famous statement as irresponsible.

Tute 6, Week 7
Chapter 9 - review question 1, 2, 7, 8, 9 Problem 1, 4
Chapter 17 – Problem 1 & 4

2013

1. Planned expenditure is the sum of four types of spending to purchase goods and services:
consumption, planned investment, government, and net exports (exports minus imports). Keynes
emphasized this concept because he believed analyzing the determinants of planned expenditure
provided the best approach to explain why output dropped sharply during the Great Depression
despite little if any change in the economy’s capacity to produce output.
2. The consumption function states that consumer spending depends on disposable income, the real
interest rate, and other variables such as consumers’ optimism and wealth. The consumption function is
written as C  C  mpc  (Y – T) – cr. Y – T represents disposable income and mpc is the marginal
propensity to consume, the fraction of an additional dollar of disposable income that consumers will
spend to purchase goods and services; r is the real interest rate and c measures how sensitive consumers’
spending plans are to a one percentage point change in the real interest rate; and C represents
autonomous consumption, the portion of total consumer spending that is determined by variables other
than disposable income and the real interest rate. Consumer spending is positively related to autonomous
consumption and disposable income and inversely related to the real interest rate.
7. If unplanned inventory investment is positive, there is an excess supply of goods because aggregate
output exceeds planned expenditures. When this occurs, firms will cut production and aggregate
output will decline. If unplanned inventory investment is negative, there is an excess demand for
goods because planned expenditures are greater than aggregate output, firms will increase production,
and aggregate output will rise.
8. The IS curve shows the different combinations of the real interest rate and aggregate output for
which the goods market is in equilibrium with Y  C  I  G  NX. Because consumption, planned
investment, and net exports all are inversely related to the real interest rate, planned expenditures rise
as the real interest rate falls, and therefore the level of aggregate output required to satisfy goods
market equilibrium will be greater at lower real interest rates and smaller at higher real interest rates.
When the points of goods market equilibrium are plotted on a diagram that measures the real interest
rate on the vertical axis and aggregate output on the horizontal axis, the IS curve will slope downward.
9. The IS curve shifts when autonomous factors (factors that operate independently of the real interest
rate and aggregate output) cause changes in planned expenditures. When an autonomous factor
increases planned expenditures at each real interest rate, the IS curve shifts to the right because the
level of aggregate output required for goods market equilibrium rises. The IS curve shifts to the left
when an autonomous factor decreases planned expenditures at each real interest rate. The autonomous
factors are autonomous consumption, autonomous investment, autonomous net exports, taxes, and
government purchases. Increases in all these factors except taxes shift the IS curve to the right; tax
increases shift it to the left.

Chapter 17, Problems
1.a. The real exchange rate is: (16  0.75)/10  1.2, which means that U.S. wine is more expensive
that French wine (i.e., the real exchange rate is higher than 1).
b. The real exchange rate is now: (12  0.75)/10  0.9, which means that U.S. wine is less
expensive that French wine (i.e. the real exchange rate is lower than 1).
4. a.

b. Expectations of a slow recovery and low interest rates in the United States decreased the
relative expected return of the domestic asset. Therefore, the alternative asset (i.e., Brazilian
Real-denominated assets) increased its relative expected return. This resulted in a shift to the
left in the demand for the domestic asset and in a depreciation of the U.S. dollar, as noted in
the graph below.

Tute 7, Week 8

2013

Chapter 10 - review question 1-4, Problem 1 & 4
1. The real interest rate is the nominal interest rate minus the expected inflation rate. Because it
adjusts for inflation, the real interest rate indicates the reward for lending and the cost of
borrowing money in purchasing power rather than dollar terms. Because prices are sticky in the
short run, changes in the money supply have little if any short-run effect on prices and therefore
on actual and expected inflation. Hence, when a change in the Fed’s monetary policy causes the
nominal interest rate to change, the real interest also changes in the same direction. In the long
run, however, when prices are flexible, actual and expected inflation do change in response to
changes in monetary policy, leaving the real interest rate unaffected.
2. The monetary policy curve represents the relationship between the inflation rate and the real
interest rate. It slopes upward because monetary policymakers who wish to keep actual inflation and
expected inflation stable will follow the Taylor principle and respond aggressively to a given increase
in the inflation rate by raising nominal interest rates by an even greater amount so that the real interest
rate also rises.
3. An autonomous monetary policy tightening occurs when the Fed decides to raise the real interest
rate at any given inflation rate. This shifts the MP curve upward. An autonomous monetary policy
easing, a decision to lower the real interest rate at any given inflation rate, shifts the MP curve
downward.
4. The aggregate demand curve shows combinations of the inflation rate and the quantity of
aggregate output for which the goods market is in equilibrium with Y = C + I + G + NX. It slopes
downward because, as the MP curve indicates, an increase in inflation results in an increase in the real
interest rate. As the IS curve indicates, increases in the real interest rate cause consumption, planned
investment, and net exports to decline. These spending declines reduce the quantity of aggregate
output demanded and hence reduce the equilibrium quantity of aggregate output. Thus, the aggregate
demand curve slopes downward because a rise in inflation works through the increase in real interest
rates to reduce the equilibrium quantity of aggregate output.
Problem
1. a. When the inflation rate is 2%, the real interest rate is given by:
r  1.5  0.75  3  1.5  0.75  2 . For inflation rates of 3% and 4%, real interest rates are 3.75%
and 4.5% respectively.
b. See graph

4. An increase in U.S. net exports directly affects the IS curve, since planned expenditure increases
at every real interest rate. Assuming the goods market is in equilibrium, aggregate output
increases, shifting the IS curve to the right. The monetary policy curve does not shift, since net
exports are not a determinant of the monetary policy curve. The monetary policy curve
represents the monetary authorities’ willingness to set a given real interest rate in the short run
according to current inflation rates. Given the same monetary policy curve, and a new IS curve,
the aggregate demand curve shifts to the right. This means that aggregate output increases at
every inflation rate.

Tute 8, Week 9
Chapter 11 - review question 1-3, 6-8
Chapter 12 - review question 1-3, 6-10

2013

Chapter 11
1. The real interest rate is the nominal interest rate minus the expected inflation rate. Because it
adjusts for inflation, the real interest rate indicates the reward for lending and the cost of borrowing
money in purchasing power rather than dollar terms. Because prices are sticky in the short run,
changes in the money supply have little if any short-run effect on prices and therefore on actual and
expected inflation. Hence, when a change in the Fed’s monetary policy causes the nominal interest
rate to change, the real interest also changes in the same direction. In the long run, however, when
prices are flexible, actual and expected inflation do change in response to changes in monetary policy,
leaving the real interest rate unaffected.
2. The monetary policy curve represents the relationship between the inflation rate and the real
interest rate. It slopes upward because monetary policymakers who wish to keep actual inflation and
expected inflation stable will follow the Taylor principle and respond aggressively to a given increase
in the inflation rate by raising nominal interest rates by an even greater amount so that the real interest
rate also rises.
3. An autonomous monetary policy tightening occurs when the Fed decides to raise the real interest
rate at any given inflation rate. This shifts the MP curve upward. An autonomous monetary policy
easing, a decision to lower the real interest rate at any given inflation rate, shifts the MP curve
6.When the Fed tightens monetary policy by raising the real interest rate at any given inflation rate,
this means that the quantity of aggregate output demanded at any given inflation rate will be
lower, and so will the equilibrium quantity of aggregate output. This shifts the aggregate demand
curve to the left. Conversely, an autonomous easing of monetary policy lowers the real interest
rate at any given inflation rate, increases the equilibrium quantity of aggregate output, and shifts
the aggregate demand curve to the right.
7.

The demand for real money balances (M d/P) depends on the nominal interest rate i and real
income Y. Real money balances earn little or no interest; the opportunity cost of holding them is
the nominal interest rate that could be earned on bonds. The higher this interest rate, the greater
the interest earnings that people sacrifice when they hold money rather than investing in bonds.
As the nominal interest rate rises, so does the opportunity cost of holding money, and the
quantity demanded of real money balances decreases. Thus the demand for money is inversely
related to the nominal interest rate. The demand for real money balances is positively related to
real income because as income rises people make more purchases and thus demand more real
money balances to pay for these transactions. Furthermore, as income rises households also tend
to have more wealth and want to hold more financial assets, including real money balances.

8. Open market operations are purchases or sales of government securities the Fed undertakes to
change the level of bank reserves and the amount of lending that banks do. When the Fed
purchases government securities, the sellers of these securities deposit the money they receive
into the banking system, increasing banks’ reserves. With more reserves, banks can make
additional loans that increase the supply of money. When the Fed sells government securities, the
money paid for the securities is withdrawn from the banking system. Banks therefore lose
deposits and reserves and must reduce their lending, which decreases the supply of money.

Chapter 12
1. A rise in inflation causes the real interest rate to rise. This reduces planned expenditures and
lowers the level of output necessary for goods market equilibrium. The opposite occurs if
inflation falls. Therefore, goods market equilibrium will occur at lower levels of output when the
inflation rate rises and at higher levels of output when inflation falls. The downward slope of the
aggregate demand curve reflects this. The short-run aggregate supply curve slopes upward to
reflect the increase in the inflation rate that occurs when the economy’s aggregate output of
goods and services exceeds the potential output level in the short run and the decrease in
inflation that occurs when output is below potential output.
2. The following changes shift the aggregate demand curve to the right: monetary policy easing,
increase in government purchases, decrease in taxes, autonomous increase in consumption,
autonomous increase in investment, and autonomous increase net exports. The opposite changes
in these factors shift the aggregate demand curve to the left.
3. Shifts in the short-run aggregate supply curve result from changes in expected inflation, price
shocks, and persistent output gaps. None of these factors shift the long-run aggregate supply
curve because price and wage flexibility ensures that in the long run the economy produces at its
potential output level. Potential output depends not on actual or expected inflation but rather on
the capital, labor, and technology available for producing goods and services.
6.

Demand shocks are exogenous changes that cause the aggregate demand curve to shift. These
shocks stem from monetary policy easing or tightening, changes in government purchases and
taxes, and autonomous changes in consumption, investment, and net exports. Positive demand
shocks shift the aggregate demand curve to the right; negative shocks shift it to the left.

7. A positive demand shock moves the aggregate demand curve to the right and causes both
inflation and output to increase. Because this increases output relative to potential output and
expands the output gap, the rate of inflation rises. In ensuing time periods expected inflation rises
and the aggregate supply curve shifts to the left until the economy’s self-correcting mechanism
has lowered output to potential output. Thus the only long-run effect of the positive demand
shock is a rise in inflation.
8. Supply shocks are another term for the price shocks that cause shifts of the short-run Phillips
curve and therefore of the short-run aggregate supply curve. Positive supply shocks lower
inflation and shift the short-run aggregate supply curve down and to the right; negative supply
shocks increase inflation and shift the short-run aggregate supply curve up and to the left.
Temporary supply shocks shift only the short-run aggregate supply curve but permanent supply
shocks also shift the long-run aggregate supply curve.
9. The temporary negative supply shock does not affect potential output or the long-run aggregate
supply curve but shifts the short-run aggregate supply curve up and to the left. This initially
raises the inflation rate and causes short-run equilibrium output to fall below potential output.
With actual output falling relative to potential output, the output gap turns negative. This
increases unemployment relative to the natural rate of unemployment and increases the
unemployment gap, which causes inflation to begin falling. As inflation falls, expected inflation
also drops and shifts the short-run aggregate supply curve back down and to the right until longrun equilibrium is attained. Thus the short-run effects of the temporary negative supply shock are
to increase inflation and decrease output and the long-run effects are to leave both inflation and
output unchanged.

10. A permanent negative supply shock, unlike a temporary one, reduces potential output and shifts
the long-run aggregate supply curve to the left. Inflation begins to rise and output falls. Although
output has fallen, potential output also has fallen, the lower output is above the new potential
output and there is a positive output gap. This, along with increases in expected inflation, shifts
the short-run aggregate supply curve up and to the left. This continues until inflation rises
enough to eliminate the output gap and reduce output to the new potential output level. Thus a
permanent negative supply shock has short-run effects that are identical to those of a temporary
negative shock, but its long-run effects are that inflation will be permanently higher and output
permanently lower.

Tute 9, Week 10
Chapter 13 - review question 5, 7, 9, 12,
Problem 7 & 9

2013

5.Stabilization policy is conducted more frequently using monetary policy rather than fiscal policy
because implementing fiscal policy requires making changes in taxes and government spending
that take longer to deliberate and enact than monetary policy decisions do.
7.Activists see the process of price and wage adjustments that move the economy to long-run
equilibrium as working very slowly. They argue that instead of waiting for these slow
adjustments to move the economy to full employment and potential output, government policy
makers instead should implement stabilization policies. Nonactivists hold that prices and wages
adjust faster than activists believe and argue that policymaking itself is a time-consuming
process. Furthermore, policy makers are not sure of the economy’s potential output or natural
rate of unemployment and thus do not know where to move the aggregate demand curve, so
stabilization policies may do more harm than good.
9. The data lag is the time it takes to collect and process the quarterly, monthly, and other data that
tell policy makers how well or poorly the economy is performing. The recognition lag is the time
policy makers may wait for additional data to come in to be more confident of their
interpretations of economic conditions and trends. The legislative lag is the time it takes to
decide on a particular policy. This generally is not long for monetary policymakers but can be
quite long for fiscal policy makers because legislation must be passed in order to change taxes
and government purchases. The implementation lag is the time required for policy makers to
adopt a new policy once it has been approved. This lag, like the previous one, is likely to be
longer for fiscal policy than it is for monetary policy. The effectiveness lag is the time it takes a
policy to affect the economy. The combined length of these five lags can be long and variable,
making the outcome of stabilization policy actions uncertain.
12. Monetary policy makers can target any inflation rate they want to simply by implementing
autonomous monetary policy easing (to target a higher inflation rate) or tightening (to target a
lower one). However, although they can exert this control over inflation in the long run, they
have no control over real interest rates or potential output in the long run, so the classical
dichotomy and monetary neutrality hold just as they do in the classical framework.
Problems

7.

In panel (A) the short-run aggregate supply curve has a steeper slope, meaning that wages and
prices in general are more flexible (i.e., changes in output result in larger changes in the inflation
rate). This situation constitutes a stronger argument in favor of nonactivist policy, since changes
in the aggregate demand curve will result in smaller changes in output and unemployment when
the short-run aggregate supply curve is depicted as in panel (A). Alternatively, one might think
that further efforts in terms of monetary or fiscal policy are needed to affect output if prices and
wages are less flexible (as depicted by the somewhat less steep short-run aggregate supply curve
in panel B).

9.a.

b. According to the graph, Canada’s unemployment rate was below the estimated natural rate
of unemployment for the first part of the period, and then it was above the natural rate. This
suggests that Canada’s relatively high inflation rates during this period were the result of
demand-pull inflation between 1972 and 1975–76. As expected, the unemployment rate
decreased, but expectations about future high inflation rates quickly became embedded in
the economy. As a result, inflation stayed high even when the unemployment rate exceeded
its natural rate, in the second part of the period. During this second period inflation could be
described as cost-push inflation, as workers asked for higher nominal wages.

Tute 10, Week 11
Chapter 14 - review question 1, 2, 4, 6, Problem 2, 8-10

2013

1. The financial system matches savers (those who have surplus funds) with borrowers who
may have good investment opportunities but no savings of their own to invest. Without a
well-functioning financial system, savings will not be channeled from those with excess
funds to those who can make the most productive use of them. As a result, economic growth
will suffer.
2. In direct finance, borrowers get funds from savers by selling them financial instruments
(securities) such as stocks or bonds. These securities give the lenders (savers) a claim to the
borrowers’ future income or assets. With indirect finance a financial intermediary (such as a
bank, mutual fund, or pension fund) gets funds from the savers and lends them to the
borrowers, a process known as financial intermediation. Indirect finance is the most
important form of finance in all countries, but especially in developing countries where
markets for buying and selling financial instruments are poorly developed, if they exist at all.
4. Investors in financial instruments who engage in information collection face a free-rider
problem, which means other investors may be able to benefit from their information without
paying for it. Individual investors, therefore, have inadequate incentives to devote resources
to gather information about borrowers who issue securities. Financial intermediaries avoid
the free-rider problem because they make private loans to borrowers rather than buy the
securities borrowers have issued. Since they will reap all the benefits from the information
they collect, their information collection activities will be more profitable. They thus have
greater incentive to invest in information collection.
6. Developing countries likely have weaker accounting and reporting standards, so accurate
information about private firms is more difficult to come by and also more difficult to
analyze because of limited access to information technology. As a result, asymmetric
information problems are greater in developing countries and local firms therefore find it
difficult to acquire funds through selling securities in financial markets. Since banks make
private loans and have incentive to gather information to solve asymmetric information
problems, financial intermediation becomes even more important in developing countries’
financial systems than it is in developed countries.
Problems:
2.Funds were definitely not allocated to their most productive use. Funds are allocated to their most
productive use when considerations about which individual or firm should receive these funds
are based on risk and expected returns associated with the investment. The situation in which
funds are allocated based on political positions results in an inefficient allocation of funds, and as a
consequence, in an inefficient financial system. This is often the case in countries where
corruption and badly designed institutions (e.g., the legal right of a political party to nominate
state bank directors, lack
of independent press, etc.) are prevalent. These endemic problems usually affect the efficiency of
the financial system, not only directing funds to non productive uses (that often do not even pay
them back) but also crowding out funds for productive uses.

8. Although it might seem a good idea to ―copy and paste‖ regulatory frameworks that ensure the
soundness of a financial system from one country to the other, this is usually not a good idea.
Developed and developing countries have quite different financial systems. Incorporating a
system of deposit insurance will surely result in an increase in deposits at financial
intermediaries. However, without proper regulations (i.e., prudential regulation and supervision)
to limit the moral hazard problems associated with a system of deposit insurance, banks will
probably accept more risks than they would otherwise do. This is obviously not a desired
consequence. The increase in moral hazard problems will probably offset the benefit derived
from avoiding bank runs (the most immediate effect of a system of deposit insurance).
9. As more individuals and firms participate in the financial system, monetary policy becomes more
effective. When more firms and borrowers rely on financial intermediaries, monetary policy
tools have a more immediate effect on monetary aggregates. Monetary policy tools affect
financial intermediaries’ ability to create loans and therefore to increase the supply of means of
payment (i.e., money). If most individuals rely on the financial system as a source of funds, a
contractionary monetary policy will be quite effective in restricting the access to credit for most
firms or borrowers. Conversely, expansionary monetary policy will be more effective in a
country in which most individuals participate in the financial system, as opposed to situations in
which people rely on other sources of funds (e.g., family members, loan sharks, etc.) whose
behavior cannot be affected by the central bank. This gives central banks of developed countries
one more tool (or a more effective tool) to manage short-run fluctuations in the economy.
10. Microcredit programs were very effective in defining a set of incentives that helped to deal with
asymmetric information problems. As a result, microcredit loans usually exhibit higher
repayment rates (the percentage of loans that are actually repaid) than regular loans made by
financial intermediaries. Solving the adverse selection problem was never the intention of
microcredit schemes, since the target population is the extreme poor (individuals who live on
less than $1 per day) and usually owns no collateral. But making sure that the recipients of the
loans have strong incentives to pay back the loan and work hard so that their investment is a
success (i.e., dealing with the moral hazard problem) was very important. That is precisely why
poor women are usually the recipients of this type of loans: Women are often the ―head of the
household‖ in very poor families, where men often have no habit of working, along with other
problems. Creating a group of women to monitor expenditures ensures that funds are allocated to
their most productive use and helps women to achieve their goals. Microcredit programs have
been very successful in helping people abandon poverty, and spur entrepreneurship in poor
countries.

Tute 11, Week 12
Chapter 18 - review question 2, 3, 6, 7, 8-10
Problem 2

2013

2. The nominal exchange rate tells you how many euros you can buy with your dollars. The real
exchange rate tells you how cheap or expensive U.S. goods and services are relative to European
goods and services. Because of sticky prices in the short run, nominal and real exchange rates
move together, so that a change in the amount of euros per dollar means that the quantity of
European goods and services a dollar can buy also changes. When the dollar appreciates (is
worth more in terms of euros) European goods and services are less expensive for Americans to
buy, while American goods and services become more expensive to Europeans. The opposite
changes occur when the dollar depreciates (is worth less in terms of euros). Thus, U.S. goods and
services will sell better in both Europe and the United States in the short run when the dollar
depreciates. In the long run, however, prices are not sticky; therefore, real exchange rates are not
influenced by changes in nominal exchange rates in the long run.
3. The law of one price says that if two countries produce an identical good and transportation costs
and trade barriers are low, the price of the good should be identical in both countries, no matter
which currency is used to pay for it. This means that the real exchange rate will be 1.0 and the
nominal exchange rate is determined by the relative prices of the good in each country’s
currency. The theory of purchasing power parity applies the law of one price to countries’
aggregate output of goods and services by holding that in the long run exchange rates will adjust
to reflect relative national price levels between countries. (For example, if a country experiences
10% inflation, the nominal exchange rate for its currency will depreciate 10% to keep the real
exchange rate at 1.0.) PPP theory does not hold in the short run because countries do not produce
identical products and many of the goods and services they produce are not traded with other
countries.
6. Because appreciation of the domestic currency increases the real as well as the nominal exchange
rate in the short run, it makes exports more expensive and imports less expensive. This causes
net exports to decline and shifts the aggregate demand curve to the left. While the currency’s
appreciation also shifts the short-run aggregate supply curve downward, because it makes
imports less expensive and lowers the aggregate price level, this effect is typically smaller than
the impact on aggregate demand. The overall impact, therefore, is that aggregate output and the
inflation rate both decrease. Depreciation of the domestic currency has the opposite effect of
raising both inflation and output.
7. Central banks intervene in foreign exchange markets to adjust their holdings of international
reserves (foreign-currency denominated assets), influence exchange rates, or both. When a
central bank buys assets denominated in the domestic currency, it is selling some of its foreigncurrency denominated assets and so its international reserves decline. Alternatively, a central bank
that sells assets denominated in the domestic currency is buying international reserves. The
impact on exchange rates depends on whether the intervention is sterilized or unsterilized. An
unsterilized purchase of domestic currency (sale of international reserves) reduces bank reserves,
lowers the money supply, and causes the domestic interest rate to rise, so the domestic currency
appreciates. Conversely, an unsterilized sale of domestic currency (purchase of international
reserves) increases bank reserves and the money supply and reduces the domestic interest rate, so
the domestic currency depreciates. Sterilized interventions, however, do not affect exchange
rates because the central bank offsets them with open market operations that leave bank reserves
unchanged.
8. In a fixed exchange rate regime the value of one currency is pegged to another currency (called
the anchor currency) and central banks intervene in foreign exchange markets to keep the
exchange rate between the two currencies at this fixed value. In a floating exchange rate regime

there is no preset exchange rate that central banks are trying to maintain. Instead, exchange rates
are determined by supply and demand and therefore are allowed to ―float‖ up or down depending
on market forces. A managed or dirty float exchange rate regime is one in which central banks
intervene as they see fit to influence exchange rates.
9. A currency is overvalued relative to another currency if the fixed exchange rate (par value of the
currency) is higher than the equilibrium exchange rate between the two currencies in the foreign
exchange market. To keep the exchange rate from falling to the equilibrium value, the central
bank must intervene to buy domestic currency by selling its international reserves. This is a
problem because sooner or later the central bank will exhaust its international reserves and be
unable to maintain the exchange rate for its currency at the par value. When this occurs, the
currency must be devalued, which means the fixed exchange rate is reset at a lower value.
Anticipation that this may occur leads to speculative attacks on the currency in which speculators
sell large quantities of the currency and drive its equilibrium market value lower, which puts
more pressure on the central bank’s international reserve position and hastens the expected
devaluation.
10. The policy trilemma is the reality that a country or monetary union cannot simultaneously have
free capital mobility, a fixed exchange rate for its currency, and an independent monetary policy.
It can choose any two of these policies, but must give up the remaining one.

Problem:
2. a. For the law of one price to hold, the nominal exchange rate should be 5 Yuan per dollar, so
that an individual holding $2 can buy the same coffee priced at 10 Yuan in China.
b. The purchasing power parity theory predicts an appreciation of the Chinese currency, from 7
Yuan per dollar to 5 Yuan per dollar (0.143 dollar per Yuan to 0.2 dollar per Yuan).
Alternatively, we can think of this as a depreciation of the U.S. dollar (the same dollar is
exchanged for fewer units of the foreign currency).

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