Question 1. (i) Identify and briefly explain the main features of the business cycle. (2 marks) Business cycles are usually characterized by periods of transition from peak to trough and then from trough to peak. The peak of a business cycle is the high point of GDP prior to a downturn whereas a Trough is the low point economic activity prior to a recovery. The period in which the economy is moving from a peak to a trough is called a contraction and the period in which the economy is moving from a trough to peak is an Expansion.
(ii) Explain the concepts of (a) potential output and (b) the output gap. (3 marks) Potential Output (y*) or full employment output is the level of GDP an economy can produce when using its resources, such as labour and capital, at normal rates. This is not the same as maximum output. Potential output grows over time with growth in labour and capital and with growths in technology. At any point in time, the difference between the economy’s potential output and actual output is called the output gap (y – y*). A positive output gap, which occurs when actual output is higher than potential output and when resources are being utilised at above-normal rates, is called an expansionary gap. This is related to firms operating above normal capacity and can lead them to raise prices (inflationary). On the other hand, a negative output gap, which occurs when potential output exceeds actual output and when resources are not being utilised, is called a contractionary gap. This is related to capital and labour not being fully utilised (cost in terms of forgone output).
(iii) Explain the concept of Okun’s law. Discuss the implications of Okun law for policymakers. (5 marks) Okun’s law states that each extra percentage point of cyclical unemployment is associated with about a 1.6 percentage point (for Australia) increase in the output gap, measured in relation to potential output. The quantitative relationship is (y-y*)/y* = -B(u-u*). This describes how an additional percentage point of cyclical unemployment is associated with a B percentage point decline in the output gap. The output losses associated sustained in recessions, calculated according to Okun’s law, can be quite significant. Calculations using this relationship depict that output gaps and cyclical unemployment may have major costs. Therefore, we can conclude with the fact that the public and policymakers have concern in relation to contractions and recessions.
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) New Keynesians assume prices and wages are fixed or sticky, meaning that they do not change easily or quickly with alterations in supply and demand, so that quantity adjustment prevails. When prices are sticky, higher aggregate demand raises production, and this raises incomes. If prices were fully flexible in the short run, economy’s resources would be fully employed and thereby the economy would return to the natural level of real GDP. Firms would stop producing when price is lower than production cost, so there would be less competition.
(ii) Explain the concept of Planned Aggregate Expenditure (PAE). How does PAE differ from Actual Expenditure? (2 marks) Planned Aggregate Expenditure is the total planned spending on final goods and services. In equilibrium, planned expenditure and actual expenditure must equal in the economy. The difference between planned and actual expenditure is unplanned inventory investment. When firms sell fewer products than planned, stocks of inventories increase. Because of this, actual expenditure can be above or below planned expenditure.
(iii) Use the Keynesian aggregate expenditure model and appropriate diagrams to explain the following: – The paradox of thrift – The effect on equilibrium GDP of an exogenous increase in exports. (6 marks)
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 income-expenditure multiplier, or the multiplier for short, is the effect of a one-unit increase in exogenous expenditure on short-run equilibrium output. For example, a multiplier of 3 means that a 6-unit decrease in exogenous expenditure reduces short-run equilibrium output by 18 units. Therefore, a one dollar change in exogenous expenditure produce a larger change in short-run output as initial amount of expenditure leads to raised consumption spending resulting in an increase in national income greater than the initial amount of spending.
(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 is the change in imports divided by the change in disposable income. It decides the slope of the aggregate expenditures line and is part to the multiplier process. Similar to taxes, the marginal propensity to import tends to lower the size of the multiplier as demand for domestically produced final goods and services falls. An increase in the marginal propensity to import increases the value of the denominator of the equation, which then decreases the overall value of the fraction and thus the size of the multiplier.
(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)
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) Main components of Fiscal Policy: – Government expenditure: Government spending of goods and services, investment and infrastructure directly affects total spending. If too much or too little total spending causes output gaps, the government can help to guide the economy toward full employment by changing its own level of spending. – Taxes or transfer payments: In contrast, changes in tax or transfers do not affect planned spending directly. When disposable income rises households should spend more. Thus tax cut or increase in transfers should increase planned aggregate expenditure. Similarly, an increase in taxes or a cut in transfers, by lowering households’ disposable income, will tend to lower planned spending. This stimulates spending and eliminates contractionary 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 had to be financial either by raising taxes or by government borrowing.We can denote government expenditure undertaken by the government in period t by Gt and transfer payments by Qt. Therefore, the total spending activities of the government can be noted as Gt+ Qt. Also, the government has three means at its disposal to finance this expenditure: 1. Taxes available to be spent by government it time t – denoted by Tt. 2. Issued security when government borrows money – This is a financial asset that obliges the government to repay the loan, and pay interest, over some designated time period. Bt-2 is the stock of securities that the government still has owing at the end of the last period. Any new borrowing that the government undertakes in period t will be denoted as Bt – Bt-1. The stockpile of debt that accumulates when government continues borrowing money is called the public debt. 3. Interest needed to pay on government’s stock of debt – in any time t the government pays interest of rBt-1 where r is the real rate of interest. Government expenditures (purchases, transfer payments and interest payments) in any period need to be funded by taxes or by borrowing. This is the Government budget constraint summarized as below: Gt+ Qt + rBt-1 = Tt + (Bt – Bt-1).
If we rearrange this so that gross taxes are on the left-hand side, the link between fiscal policy and the stock of public debt becomes readily apparent: Gt+ Qt – Tt + rBt-1 = (Bt – Bt-1).
(iii) Explain the difference between discretionary fiscal policy and automatic stabilisers. 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. Automatic stabilizers refer to the tendency for a system of taxes and transfers, which are related to the level of income to automatically reduce the size of GDP fluctuations.