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UNIT 1: THE CAPITALIST REVOLUTION

PRINCIPLES OF ECONOMICS

Practical Session N°13

José Elías Durán Roa

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A. Solution to Problem Set 12

B. Conceptual Questions Problem List 12 [Discussion]

OUTLINE

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Solution to Problems

Problem List 12

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Problem N°1

The following questions refer to Figure 15.5.

    • What would the policymaker’s indifference curves look like if the policymaker cared only about low unemployment?

a

In this case they are vertical (see diagram below), e.g. through U=3% because the policymaker cares only about unemployment, therefore willing to achieve the optimal level of unemployment at whatever inflation rate required. The indifference curve with highest utility would lie somewhat to the left of the labour supply curve since the policymaker requires a finite rate of inflation.

The policymaker prefer stable inflation to zero

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Problem N°1

Which point on the Phillips curve would that policymaker choose?

b

Since the policymaker aims for low unemployment, he will choose the point where the Phillips curve intersects her right-most indifference curve (e.g. at U=3%).

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Problem N°1

What would the policymaker’s indifference curves look like if the policymaker cared only about low inflation?

c

In this case, they are horizontal with higher utility the closer the curves are to the low inflation target; utility will fall as the horizontal lines are further above and further below the one at the low inflation target.

BLACKBOARD

Which point on the Phillips curve would this policymaker choose?

d

In this case, the policymaker would choose the point at which the Phillips curve intersects the horizontal line at the low inflation target.

What would the indifference curves look like if to be re-elected, the policymaker needed the support of pensioners more than that of working-age people?

e

Pensioners are not directly affected by unemployment and are more likely to rely on savings and accumulated wealth. Since their welfare is more likely to be affected by inflation, the policymaker’s indifference curves may be relatively flat so that inflation has a stronger effect on welfare than unemployment.

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The Swedish central bank raises the interest rate. Which, if any, of the following statements about the exchange rate (a) and about the consequences of the central bank’s decision (b) and (c) are true?

    • If a depreciation of home’s exchange rate increases its value, then the exchange rate must be defined as the number of units of home currency per one unit of foreign currency.

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    • The demand for Swedish bonds goes up and hence, the Swedish Krona depreciates in value.

    • Net exports, i.e. exports minus imports, rise because a Krona buys more units of foreign currency.

c

a

a) True, by definition.

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b) False, because to buy the now more attractive Swedish bonds (more attractive because of the higher interest rate), it is necessary to have Swedish Krona and hence the Krona will appreciate, not depreciate.

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c) False. The Krona buys more units of foreign currency but this leads to a fall in net exports because Swedish exports are now more expensive elsewhere in the world and imports from elsewhere are cheaper.

b

Other Problems N°1

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Which of the following statements regarding inflation and deflation is correct?

Other Problems N°2

 

  1. Borrowers benefit from deflation, as the value of their debt decreases in real terms.
  2. Inflation transfers wealth from lenders to borrowers .
  3. Falling prices benefit consumers and are therefore always good for the economy.
  4. Inflation makes it difficult for consumers and firms to attain the message about scarcity of resources (sent by relative prices) and is therefore always bad for the economy.

d

a

c

b

b. Borrowers benefit from inflation. Why?

  1. Falling prices certainly benefit consumers who have constant nominal income. However, if they postpone consumption in expectation of further price falls (particularly of durable goods such as cars), then this leads to a fall in aggregate demand for the economy, which could lead to further deflation

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Other Problems N°3

Consider a scenario where the Bank of England views the UK economy to be overheating and is attempting to slow the economy down using monetary policy. Which of the following statements regarding the effects of an interest rate rise is correct?

    • It leads to higher bond prices, which results in higher demand for UK bonds.
    • It leads to higher demand for GBP, which results in an appreciation of the GBP.
    • It leads to the UK exports becoming cheaper and imports becoming more expensive.
    • It has opposing effects on the UK’s aggregate demand (AD): it discourages investment, which lowers AD, but results in cheaper imports, which boosts AD.

d

a

c

b

  1. An interest rate rise does lead to higher demand for UK bonds, but due to their lower prices.
  1. New Bonds Offer Higher Yields: New bonds are issued at the higher prevailing interest rates, offering better returns.
  2. Existing Bonds Less Attractive: Existing bonds, with lower fixed interest rates, become less attractive compared to new issues.
  3. Market Adjusts Prices: To compete with new bonds, the market price of existing bonds falls, aligning their yields with current interest rates.

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Other Problems N°3

Consider a scenario where the Bank of England views the UK economy to be overheating and is attempting to slow the economy down using monetary policy. Which of the following statements regarding the effects of an interest rate rise is correct?

    • It leads to higher bond prices, which results in higher demand for UK bonds.
    • It leads to higher demand for GBP (Great British Pound), which results in an appreciation of the GBP.
    • It leads to the UK exports becoming cheaper and imports becoming more expensive.
    • It has opposing effects on the UK’s aggregate demand (AD): it discourages investment, which lowers AD, but results in cheaper imports, which boosts AD.

d

a

c

b

b. Higher interest rates attract international investors, which in turn raises demand for GBP.

  1. Higher interest rates lead to lower bond prices, resulting in higher demand for UK bonds. This in turn leads to a GBP appreciation, making UK imports cheaper and exports more expensive, which depresses aggregate demand in the UK.
  1. Cheaper imports mean greater leakages from the domestic economy. This reduces aggregate demand.

(fugas)

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Conceptual Questions

Problem List 12

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Conceptual Problem N°1

Conceptual Problem N°4

Discussion A

Discussion B

In the event of a financial crisis, would it be preferable for the government to stabilize the economy using fiscal or monetary policy?

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What are the dangers of using fiscal policy?

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Fiscal policy is usually less flexible because of the need to obtain agreement for changes in expenditure or taxes. In particular, cuts in expenditure or rises in tax might be politically difficult to introduce. Therefore, monetary policy may be quicker to react to shocks..

Fiscal policy may be problematic especially where there is the danger of sovereign credit risk (sovereign debt crisis), which may reduce a country’s ability to finance increased spending or tax cuts by issuing new bonds (i.e. by borrowing).