Tips for preparing for the exam

• Practice. Do the problems in the back of the book chapters. Do the problems on the book’s website. Do the problems in the study guide.

• Read the question. Read carefully.• Answer the question. Don’t answer the

question you think was asked. Answer the question that actually was asked. Most exam errors happen here. Remember to read the question.

Tips for preparing for the exam

• Be sure to answer all of the question.• Don’t put down too much. Don’t provide a

whole background of a model unless the question asks for it. If the question asks you to analyse a scenario, go straight into the scenario.

• Don’t put down too little. In an essay question, provide your reasoning and analysis. Draw a relevant graph and talk about the graph. Don’t just say “Yes.”

Final exam tip

• Don’t panic! Relax and breath. You do not need to write for 3 hours to do well in an economics exam. Often a well-ordered sentence is worth more than 2 pages of semi-coherent babbling. Stop and think about your answer.

Answers to the sample exam

Question B.1: State whether the following statements are true or false.

i) Net exports are equal to GDP – (G + I + G)– Answer: True, as in an open economy, Y = C + I +

G + NX.

ii) The marginal propensity to save (MPS) is the change in consumption divided by the change in income.

– Answer: False, the MPS is the change is savings divided by the change in income.

iii) Changes in government expenditure (G) and/or exports (X) can result in an increase in GDP through the multiplier effect.

– Answer: True, G and X are components of autonomous spending. Changes in autonomous spending will give rise to a larger change in GDP through the multiplier effect.

iv) The unemployment rate is defined as the number of unemployed divided by the total population.

– Answer: False, the unemployment rate is defined as the number of unemployed divided by the labour force.

v) The marginal propensity to consume is equal to 1 minus the marginal propensity to save.

– Answer: True, the marginal propensity to consume is the fraction of each new $1 in income that consumers will devote to new consumption. As the rest of the new $1 is saved, MPS = 1 – MPC.

vi) A recessionary gap is the amount by which aggregate expenditure exceeds the full employment level of GDP.

– Answer: False, a recessionary gap is the amount by which aggregate expenditure is short of full employment GDP.

vii) Aggregate expenditure in a closed economy is equal to (C+I+G).

– Answer: True, in a closed economy, NX = 0, so the only components of aggregate expenditure are C, I and G.

viii) The aggregate demand curve shows the relationship between real GDP and the price level.

– Answer: True, the AD curve shows the relationship between aggregate expenditure and the price level in an economy.

ix) GDP excludes second-hand goods.– Answer: True, as second-hand goods were goods

produced in a previous year. Only the services involved in the sale of the second-hand goods are goods or services produced in this year.

x) The multiplier tells us that an increase in investment by $100m will give rise to a smaller than $100m increase in GDP.

– Answer: False, the multiplier is the factor by which investment will give rise to a larger increase in GDP.

Question B. 2: Briefly explain the concept of a consumption function. Explain how changes in net wealth and the price level alter the consumption function.

– Answer: A consumption function is the relation between consumer spending and GDP in an economy. As net wealth rises, we would expect consumers to consume more, so a rise in net wealth will raise consumption spending for all levels of GDP- the consumption function shifts up.

– Answer continued: A rise in the price level will lower (the real value of) net wealth and so shift the consumption function down.

Question B.3: The reserve ratio for the banks is 25%. ABC Bank has $20,000 in deposits and $12,000 in reserves. Assume all other commercial banks are loaned up.

a) What is the value of ABC Bank’s excess liquidity?

– Answer: The ABC Bank has $20,000 in deposits, so it must retain $5,000 in reserves. So the bank has $7,000 in excess liquidity- reserves over and above that required by law.

b) What is the value of the additional loans that can be made by the commercial banking system?– Answer: As we have assumed all other banks are

loaned up, only the ABC Bank’s loans matter. So the ABC bank can loan out the $7,000 in excess cash it has.

c) What is the money multiplier?– Answer: The money multiplier is 1/R = 1/0.25 = 4.

d) By how much will total deposits expand if this bank lends all its excess reserves and there is no leakage from the banking system?– Answer: Total deposits will expand by the money

multiplier times the excess cash of the ABC bank:Change in total deposits = 4 x $7,000 = $28,000

Question B. 4: What adverse internal effects may follow from:

a) a depreciation of the exchange rate and– Answer: If the exchange rate depreciates,

then the A$ becomes cheaper relative to other currencies, so our exports become cheaper overseas and foreign imports become more expensive here. There are many possible detrimental internal effects:

• If Australian producers require a lot of foreign imports in production, this means the cost of these foreign components rises

• If Australian debt is denominated in foreign currency, then the total value of the foreign debt rises

• If the economy is already at full employment, a depreciation will increase NX and so also shift the AD curve to the right. The economy will experience a boom, and we will have inflation.

b) an appreciation of the exchange rate?– Answer: If the exchange rate appreciates,

then the A$ becomes more expensive relative to other currencies, so our exports become more expensive overseas and foreign imports become cheaper here. There are some possible detrimental internal effects:

• Australian net exports will decline.• If the economy is at full employment, an

appreciation of the exchange rate will lower NX and so shift the AD curve to the left. The economy will experience a recession, and until prices and wages adjust, we will have unemployment.

Question C.1: a) Use the AD-AS model to compare the

causes and policy implications of (i) demand-pull and (ii) cost-push inflation in both the short-run and the long-run.– Answer: Demand-pull inflation is caused by

shocks to aggregate expenditure that push aggregate demand above aggregate supply at current prices. Cost-push inflation is caused by price shocks that push aggregate supply below aggregate demand at current prices.

See graphs from earlier in this session about demand-pull and cost-push inflation.

Policy implications - demand-pull:AD > potential output at current prices. If the

government cuts back on G in times of demand-pull inflation, then the AD curve will be shifted left following the AD shock. The cut in government demand can completely negate the expansion from the shock, so we are left with no rise in prices.

Policy implications- cost-push inflation: AS < potential output at current prices. If the

government does nothing, wages and prices will fall to return the economy to potential GDP. However this usually involves an extended recession. If the government increases G when the AS shock happens, this will return the economy to the natural rate of output without an extended recession, but at higher prices.

b) In what way does the presence of cost-push inflation make demand-management policy ineffective?– Answer: Cost-push inflation makes demand-

management policy ineffective is the sense that the government response does not cancel inflation. In fact, the government response of increasing spending after the supply shock leads to more inflation. Demand-management makes the inflation worse after a supply shock.

Question C. 2:

a) Define the crowding-out effect.– Answer: In the long-run, the economy always returns

to potential GDP. The crowding-out effect for G is the idea that in the long-run, an increase in G will come at the expense of other forms of aggregate expenditure.

A particular concern is that an increase in G might increase interest rates and so reduce investment spending and so lower the long-run capital accumulation and so growth in the economy. An increase in interest rates will make the A$ more desirable for investors, appreciate the A$ and so reduce net exports- another form of crowding out.

b) Is the crowding-out effect likely to be larger during a recession or when the economy is near full employment? Use the AD-AS model to substantiate your answer.– Answer: The crowding-out effect will likely larger

when the economy is near full employment. During a recession, the economy is below potential GDP, so an increase in G can be met by increasing output. However, as output gets closer to potential output, as increase in G will result in higher output and higher prices.

Draw a diagram based on the crowding-out diagrams earlier in this session.

Question C. 3:a) Define unemployment.

– Answer: To be considered unemployed a person must be (1) not currently employed and (2) actively looking for a job.

b) Outline the causes of frictional, structural and cyclical unemployment.– Answer: To be part of frictional unemployment, a

person must have left a job to search for a new job that betters matches their skills, career path, etc. To be part of structural unemployment, a person must have left a job that was eliminated because of changes in the structure of the economy- the types of goods that we produce. To be part of cyclical unemployment, a person must have left a job that was eliminated because the economy was in a recession, but that will likely be added again after the economy returns to potential GDP.

c) What are the main policies for dealing with each type of unemployment?– Answer: To reduce frictional unemployment, the

government can reduce the costs of job search or increase the speed at which job information flows through the economy. To reduce structural unemployment, the government can ease the transition of workers out of industries that are closing down into existing or new industries. Often this will involve relocating and retraining workers. To reduce cyclical unemployment, the government can use demand-management policies to reduce the size and duration of recessions.

Question C. 4:

a) What is the relationship between savings and investment? Explain whether Australia is a high or low-saver economy.– Answer: There is no necessary link between

savings and investment in a country, as the gap between I – S can be borrowed from overseas. This borrowing will raise the level of foreign debt.

Australia has a domestic savings rate about equal to the rest of the developed world.

b) When is a country considered a ‘debtor’ or a ‘creditor’ country? Is Australia a net debtor or a creditor country to the rest of the world? Explain.– Answer: A country is considered a ‘debtor’

country if residents of the country owe more to residents of foreign countries than residents of foreign countries owe to them. If the reverse is true, the country is considered a ‘creditor’ country. Australia is a net debtor country to the rest of the world. However recent government budget surpluses have been used to drive down Australian public and foreign debt.