UNIT 1: THE CAPITALIST REVOLUTION

PRINCIPLES OF ECONOMICS

Practical Session N°10

José Elías Durán Roa

1. Problem List 9
2. Conceptual Questions Problem List 9 [Discussion]

OUTLINE

Other Problems N°3

Which of the following statements about the price-setting curve is correct?

1. The price-setting curve depicts the firms’ profit-maximising price level for different levels of economy-wide employment.
2. Firms have to pay a higher real wage when the employment rate is higher. Therefore the price-setting curve is upward-sloping.
3. At points below the price-setting curve, the firms are setting prices too high compared to their profit-maximising level.
4. The falling European competition due to Brexit would result in the UK’s price-setting curve shifting up.

a

c

d

b

Solution to Problems

Problem List 9

Problem N°1

Use the websites of two central banks of your choice to collect data on the monthly policy interest rate and the mortgage interest rate between 2000 and the most recent year available:

• Plot the two series for each country on separate line charts (so two charts in all), with the date on the horizontal axis and the interest rate on the vertical axis.

a

r

M

The banking markup in the UK was around 1.5% before 2008, and around 4% after 2008. The banking markup in the US varies more than the UK, ranging from less than 0.5% to 5% before 2008, and fluctuating at around 4% after 2008. You can refer to the economic performance of these countries during the period or competition in the banking sector or policies implemented in each country to give reasons for what is observed.

Problem N°1

• How does the banking markup (difference between the mortgage interest rate and the monthly policy interest rate) compare between the two countries? Suggest possible reasons for what you observe. You may find it helpful to research characteristics of the economies of your chosen countries.

​

b

1. Do banking markups change over time? Suggest possible reasons for what you observe.

c

In both the UK and the US, the banking markup widens after the 2008 recession. The central bank may lower the base rate during a recession to stimulate aggregate demand and discourage saving, which explains why the base rate was close to zero for both the UK and US after this period. The mortgage rates did not fall by as much during the recession and stayed low, which reflects banks’ perceptions of greater uncertainty in the economy and the likelihood of default.

Problem N°2

Use Figure 10.4 to show that the difference in current consumption at the lower and higher interest rate (at E and G), namely $23, is composed of an income effect and a substitution effect. It will be helpful to review income and substitution effects from Unit 3 before doing this. Why do the income and substitution effects work in the same direction in this example?

In this case the interest rate begins at the lower rate, giving E as the initial equilibrium. The increase in the interest rate makes it more expensive to borrow, reducing Julia’s feasible set. To isolate the income effect, the constraint line at this original interest rate can be moved down so that it is just tangential to the new indifference curve going through the final position G (shown by the dashed line going through H). Thus, the income effect of the interest rate rise is the movement from E to H, which reduces current consumption because of the implied reduction in income associated with a rise in the interest rate. The substitution effect is the remaining movement from H to G. The substitution effect also reduces current consumption because there is a substitution from the now relatively higher priced good (current consumption) towards the now relatively cheaper good (future consumption).

​

The substitution effect of a rise in the interest rate always reduces current consumption because of the shape of the indifference curves (the substitution effect is a movement along the indifference curve). The income effect also reduces current consumption in this case because the interest rate increase reduces Julia’s income and so she consumes less now and in the future.

H

Remember…

Other Problems N°1

The diagram depicts Julia’s choice of consumption in periods 1 and 2. She has no income in period 1 and an income of $100 in period 2. Based on this information, which of the following statements is correct?

1. When the interest rate is 10%, if Julia borrows $23 in period 1 then she can consume $75 in period 2.
2. When the interest rate is 10%, the marginal rate of transformation of goods from period 2 to period 1 is 0.1.
3. When the interest rate is 78%, the maximum that Julia can borrow in period 1 is $56 (rounded to the nearest dollar).
4. When the interest rate is 78%, a consumption plan of $30 in period 1 and $67 in period 2 is in Julia’s feasible set.

b

a

c

d

Other Problems N°2

The diagram depicts Julia’s indifference curve for consumption in periods 1 and 2. Based on this information, which of the following statements is correct?

1. At consumption choice A, Julia values an extra unit of consumption in period 2 by 1.5 times the value of an extra unit of consumption in period 1.
2. Julia is impatient at all points on the indifference curve.
3. If Julia had less pure impatience, then her indifference curve would be steeper at A.
4. If Julia did not experience diminishing marginal returns to consumption and had no impatience, then her indifference curves would be straight lines with slope exactly equal to -1.

b

a

c

d

Which of the following statements about the banking system is correct?

1. The policy rate is the rate at which the central bank lends in the money market.
2. The policy rate is determined by the supply and demand of the money market.
3. The bank lending rate is the rate at which the central bank lends to commercial banks.
4. The spread (markup) represents how the central bank’s money is distributed amongst the commercial banks.

b

a

c

d

Other Problems N°4

Conceptual Questions

Problem List 9

Conceptual Problem N°1

Conceptual Problem N°2

Discussion A

Discussion B

Consider an individual’s income over his or her lifetime from leaving school to retirement. Explain how an individual may move from a situation like Julia’s to one like Marco’s over the course of their lifetime (assume that their pure impatience remains unchanged over their lifetime).

Think about the income and substitution effects of a rise in the interest rate, as analysed in Exercise 10.2 and 10.3 in the book. Comment on whether a rise in the interest rate would be expected to reduce consumption expenditure in an economy in which a proportion of households are like Julia, and a proportion are like Marco.

Conceptual Problem N°3

Conceptual Problem N°4

Discussion A

Discussion B

Why do you think that banks tend to be more unpopular than other profit-making firms (Honda or Microsoft, for example)?

Many countries have policies that limit how much interest a moneylender can charge on a loan. What are likely to be the long-term effects of such laws?