2.4 Assessment through the use of the news

Section A – Knowledge and Comprehension – Answer the following questions. (30 marks)

1. What is an open market operation? Show, by using graphs, how the central bank can use an open market operation in order to influence economic activity.
2. What are the three types of unemployment? What is the natural rate of unemployment?
3. What is the real exchange rate? If domestic inflation is higher than foreign inflation, but the domestic country has a fixed exchange rate, what happens to net exports in the domestic country over time? Why?

Section B – Application – Solve the following problems. (20 marks)

4. The following table lists a number of components of UK gross national product from both income and expenditure sides of the account for 1995 (figures are in £000s).

Consumer expenditures	367,853	Taxes on expenditures	83,023
Subsidies	5,878	Profits	63,912
Rent	44,092	Capital consumption	63,968
Net property income from abroad	328	Stock changes	–5,303
Government expenditures	121,899	Investment spending	95,442
Exports	135,115	Wages	387,315
Other factor incomes	1,665	Imports	140,415

1. Use the expenditure approach to compute the economy’s gross domestic product (GDP) and gross national product (GNP) and national income.
2. Use the income approach to compute the economy’s gross domestic product (GDP), gross national product (GNP) and national income.

5. A typical family living in Sandy Island consumes only apple juice, bananas and cloth. Prices in the base year are £4 a litre for apple juice, £3 a kilogram for bananas and £5 a square metre for cloth. The typical family spends £40 on apple juice, £45 on bananas and £25 on cloth. In the current year, apple juice costs £3 a litre, bananas cost £4 a kilogram and cloth costs £7 a square metre.

1. Calculate the retail price index on Sandy Island in the current year.
2. Calculate the inflation rate between the base year and the current year.
3. Was your calculation of the price index based on the Laspeyres Index or the Paasche Index? Briefly explain.
4. Are these two indexes a good measure of the price index in the economy? Briefly explain.

6. The following expressions show the relationships between variables in the goods and money markets. Fill in the gaps (dotted lines) in these ‘chain relations’ and briefly explain their meaning.

1. Central bank buys bonds → Price of bonds (P^b) … → M^S … → Interest rate (i) …
2. i ↓ → Cost of borrowing … → I … → AD … → Y …
3. Contractionary open market operation → M^S … → i … → Cost of borrowing … → I … → AD … → Y …

Section C – Application and Analysis – Solve the following problem. (10 marks)

7. In a closed economy autonomous consumption is given by c₀ = 200 and the marginal propensity to consume is c₁ = 0.8. Investment, government spending and taxes are, respectively, =300, =300, =200.

1. Determine the equilibrium level of output Y^e.
2. Draw the goods market graph showing the economy’s equilibrium.
3. Compute the government budget balance. Is it in surplus or deficit?
4. Compute the level of consumption and savings in the economy.
5. Show that in equilibrium injections equal withdrawals.
6. Show the relationship between investment and private and public saving.
7. Assume that full employment in the economy is achieved when Y^e = 4,000. How much should the government spend () in order to achieve this level of output?
8. Calculate the government spending multiplier.
9. Suppose now that taxes are endogenous and that the tax rate is t = 0.25 so that T = 0.25Y. Compute the equilibrium level of output (assume that government spending is back to =300).
10. What is the government spending multiplier in this case? Is it bigger or smaller than that you computed in h) above? Briefly explain.

Section D – Analysis and Synthesis – Solve one of the following problems. (10 marks)

8.  Suppose that a closed economy is initially operating at Y_n. Now suppose that the government increases spending in the economy so that G increases.

1. Use the AD/AS graph to illustrate the initial equilibrium, the dynamic adjustment and the medium-run equilibrium.
2. What are the initial effects of the increase in G on the price level P, real money M/P, the interest rate i, investment I and output Y?
3. What happens to the unemployment rate u and output Y relative to their natural levels during: the short run, the dynamic adjustment and the medium run?
4. When output Y is greater than its natural level Y_n, what happens to the AS curve for the next year? Explain.
5. As the AS curve shifts, what happens to the price level P, real money M/P, the interest rate i, investment spending I and output Y?
6. Does output Y return to its natural level Y_n? If so, what does this suggest about the price level P and the expected price P^e in the medium run?

9. Suppose the domestic economy is initially experiencing a trade deficit. Further assume that government officials would like to eliminate the trade deficit. By using the goods market and the net export graphs, answer the following questions.

1. What type of (domestic) policy could be pursued to eliminate the trade deficit? What effect would this policy have on output? Explain.
2. What type of exchange rate policy could be pursued to eliminate the trade deficit? What effect would this policy have on output? Explain.
3. Suppose domestic policy-makers can put pressure on foreign policy-makers to alter their fiscal policy. What type of foreign fiscal policy could be implemented to eliminate the trade deficit? What effect would this policy have on domestic and foreign output? Explain.

10. Suppose that the British government decides to adopt a fixed exchange regime so that the pound to euro exchange rate is fixed at a specific parity.

1. What are the implications of this decision for monetary policy?
2. The British government explains this policy decision as an attempt to control inflation. Comment on this policy decision. Why should a fixed exchange rate regime help in controlling inflation?
3. Suppose that after the introduction of the fixed exchange rate regime the United Kingdom experiences higher inflation than in euroland. What are the economic implications of such an inflation differential?
4. ‘By looking at the inflation differential between the UK and euroland, financial speculators can be tempted to trigger a financial crisis.’ Explain this statement.
5. Suppose that shortly after the introduction of the fixed exchange rate regime the UK economy experiences a recession. Shortly after the start of the recession there are calls for the abolition of the fixed exchange rate regime. Experts predict the possibility of a financial crisis. Explain the rationale behind these calls and predictions.

Section E – Synthesis and Evaluation – Comment on the following article. (30 marks)

‘Hopes that the UK manufacturing sector has stabilised received a further boost on Wednesday, with accelerating output and order books pushing a closely-watched survey to its highest level since December 1999.

Meanwhile, a Confederation of British Industry survey suggested the retail sector, which had been burgeoning while manufacturing slumped, appeared to be tempering itself.

The purchasing managers’ index (PMI), compiled by the Chartered Institute of Purchasing and Supply (Cips) and Reuters, rose from 50.6 in March to 53.4 last month. This was the third consecutive month that the index stayed above 50, the mark which signals growth.

Manufacturing demand rose at the fastest rate for almost two and a half years as companies reported an increased volume of new business from both domestic and foreign customers, Cips said.

Export orders rose for the second time in the past three months, and at the fastest pace for more than five years. Companies surveyed said business conditions were improving.

Although the survey added to hopes that the manufacturing sector is emerging from the months of recession, it is unlikely to change expectations that the Bank of England’s prime interest rate will remain at its 38-year low of 4 per cent until the second half of the year.

Cips said many companies thought a recovery in the US manufacturing sector had helped stimulate growth in much of Europe, with demand from the Middle and Far East, as well as Canada and the US, also up in April.

However, companies doing business with South American countries, particularly Argentina and Brazil, reported slower growth in export orders.

Seventy per cent of companies reported that sales were up in April, while 13 per cent said they were down. The plus 57 per cent balance was a significant improvement on the plus 31 per cent in March and was the highest individual monthly balance since August 1988.

… The three-month moving average, which smooths out month-to-month fluctuations, suggested sales were still slightly below the growth rates of last autumn, the CBI said.

Grocers reported the strongest annual growth since August 2001, while other retailers reported strong growth in sales of clothes, durable household goods, furniture, carpets, hardware, china and DIY products.

Last week, gross domestic product data released by the Office for National Statistics showed the UK economy stagnated for a second successive quarter in January to March, growing just 0.1 per cent in the quarter after zero growth in the quarter of 2001.

The annual rate of growth was down from 1.6 per cent in the fourth quarter of last year to 1 per cent – the lowest for almost 10 years.’ (Financial Times, 1 May 2002)

Comment on the above article and use the AD/AS model to explain the economic situation in the United Kingdom. Should the Bank of England intervene in the economy by changing the interest rate? Why? (Suggestion: before using the AD/AS model, use the aggregate demand relation to comment on the UK economy.)