Macro

2022 main ppr

13)Disruption to the supply of natural gas has caused a surge in energy prices in Utopia.
Although Utopia has an inflation target of 2% the current rate of inflation is 5%. The Central
Bank of Utopia forecasts a period of above-target inflation of around two years.
(a) What type of shock has affected Utopia and how has it fueled inflation? (5 marks)
The shock that has affected Utopia is a temporary supply shock, caused by the disruption to
the supply of natural gas. This has led to a surge in energy prices, which has increased the
cost of production for businesses and households, giving rise to cost-push inflation. The
higher energy prices have not only impacted inflation directly, but also indirectly through
price rises of other goods. This has led to an above-target inflation rate of 5%, which is well
above Utopia's inflation target of 2%.
The supply shock has had broad-based effects on the economy because natural gas is a
key input in many industries, including electricity generation, heating, and manufacturing. As
a result, businesses face higher production costs, which they pass on to consumers through
higher prices. The shock has fueled inflation in Utopia, pushing the rate above the target of
2%.
The Central Bank of Utopia has forecasted a period of above-target inflation for around two
years, indicating that the supply shock is expected to persist for some time. This prolonged
period of high inflation may lead to inflationary expectations and affect wage- and
price-setting behavior, altering the trade-off between inflation and output. The supply shock
may also have distributional effects, as different groups in the economy may be affected
differently by the higher energy prices.
It is important for policymakers to understand the nature and implications of the supply shock
to formulate an effective response to mitigate its impact on inflation and the economy. They
may need to consider measures such as adjusting monetary policy or implementing policies
to promote energy efficiency and reduce the economy's reliance on natural gas.

(b) Explain why the Central Bank of Utopia faces a trade-off between inflation and output
stability in the face of this shock. How is this trade-off reflected by the shape of Utopia’s
Aggregate Demand (AD) curve? (10 marks)

The Central Bank of Utopia faces a trade-off between inflation and output stability in
the face of the supply shock caused by the disruption to the supply of natural gas. To
reduce inflation, the Central Bank may need to increase interest rates, which would
make borrowing more expensive and reduce consumer and business spending. This
can lead to a decrease in aggregate demand (AD), which could result in a fall in
output and employment, potentially leading to a recession.

On the other hand, if the Central Bank chooses to prioritize output stability and
maintain current interest rates, it may help to support employment and economic
growth. However, this may lead to higher inflation, which could reduce the
purchasing power of consumers and businesses.

The trade-off between inflation and output stability is often represented by the shape
of Utopia's Aggregate Demand (AD) curve. The AD curve shows the relationship
between the level of output and the price level, assuming other factors such as
government spending and taxes remain constant. In the short run, the AD curve may
be relatively steep, indicating that a small change in output can lead to a significant
change in prices. This reflects the trade-off between inflation and output stability,
where an increase in output may lead to higher inflation, and vice versa.

In the long run, the AD curve may become flatter, indicating that changes in prices
have a smaller impact on output. This is because over the long term, prices and
wages may adjust to changes in output, leading to a smaller impact on inflation. In
this case, the trade-off between inflation and output stability is reduced, and the
Central Bank may be able to achieve both goals simultaneously.

In summary, the Central Bank of Utopia faces a trade-off between inflation and
output stability in the face of the supply shock caused by the disruption to the supply
of natural gas. The shape of Utopia's Aggregate Demand (AD) curve reflects this
trade-off, with a relatively steep curve in the short run and a flatter curve in the long
run.

Anskey ans=In the face of a temporary supply shock (SAS shifts up) it is not possible to
maintain the inflation target and keep output stable. If the Central Bank prioritises inflation
stability, then output will fall below potential output in the short-run. This would be reflected
by a shallow AD curve, or at the extreme horizontal at the inflation target. In contrast, if the
priority is to keep output stable, the Central Bank must accept inflation. This would be
reflected by a steep AD curve, or at the extreme vertical at potential output. The
downward-sloping AD curve describes a particular compromise in the way interest rates are
set. M

(c) Analyse the effect of the shock in Utopia in the short and long run using the AS–AD
framework. (8 marks)

In the short run, the supply shock leads to an increase in the price level and a
decrease in the level of output, as shown in the AS-AD framework. The aggregate
supply (AS) curve will shift leftward due to the increase in the cost of production
caused by the higher energy prices. This results in higher prices and lower output,
shown as a movement along the aggregate demand (AD) curve. Therefore, Utopia
will experience both inflation and a recession in the short run.In the long run,
however, the AS-AD framework shows that the economy will eventually return to its
natural level of output, but at a higher price level than before the supply shock. In the
long run, the AS curve will shift back to its original position, as wages and prices
adjust to the higher energy prices. The resulting equilibrium will be at a higher price
level and a lower level of output, shown as a leftward shift in the AD curve. This
means that the long-run effect of the supply shock will be primarily inflationary,
rather than a recession.
Anskey ans-This is a standard AS–AD diagram of a temporary supply shock. Here
the SAS shifts up in the short-run; inflation rises and output falls in the short-run.
This is a movement along the downward-sloping AD curve. In the long-run, the SAS
gradually restores and the economy goes back to where it has started.

(d) What type of monetary policy should the Central bank of utopia conduct to
accommodate the shock?

The central bank may be following a flexible inflation targeting or a Taylor rule
framework, which takes into account both inflation and output stabilization
objectives. This may involve accepting a period of above-target inflation, in order to
prevent a large fall in output.

Alternatively, the Central Bank of Utopia could consider other monetary policy
frameworks, such as nominal GDP targeting, to guide its policy decisions in response
to the supply shock. This would involve targeting a level of nominal GDP, rather than
just inflation, and adjusting policy instruments accordingly to achieve this target.
Nominal GDP targeting can provide more flexibility in responding to supply shocks
and can help prevent large deviations of output from potential.

In response to the supply shock, the Central Bank of Utopia may adopt a flexible
inflation targeting framework. This would involve setting an inflation target that takes
into account the expected period of above-target inflation due to the supply shock.
The central bank would then adjust monetary policy instruments, such as interest
rates, to achieve this target over the medium term.However, in the short term, the
central bank may need to accept a period of above-target inflation to prevent a large
fall in output. This is because raising interest rates to combat inflation may lead to a
decrease in output and employment in the short run, which could exacerbate the
negative effects of the supply shock.Instead, the central bank may choose to keep
interest rates low for an extended period to support output and employment, while
gradually tightening policy as the economy recovers from the supply shock. The
central bank may also communicate its commitment to keeping interest rates low for
an extended period to provide further stimulus to the economy.Overall, the flexible
inflation targeting framework can provide the Central Bank of Utopia with the
necessary flexibility to respond to the supply shock while still achieving its long-term
inflation target.
anskey-(d) The Central Bank of Utopia will have raised interest rates but not to the point of
bringing inflation back to its target. The Central Bank is not adhering to the inflation target as
inflation is expected to be above target for two years. The central bank is accepting a period
of above-target inflation, in order to prevent a large fall in output.

Demand shock:
Adjustment to demand shocks ► BVFD: read section 24.6 and complete activity 24.1.
Section 24.6 shows how, following a demand shock, the gradual adjustment of wage growth
eventually brings output to the full employment level (potential output) and demonstrates
how short-run aggregate supply curves and the vertical (long-run) aggregate supply curve fit
together. Below is a description of both positive and negative demand shocks. Starting at
point A, a positive demand shock shifts the AD curve from AD0 to AD1 , leading to a higher
output level and a higher rate of inflation at point B. In time, facing higher inflation than was
built into wage negotiations and thus experiencing a falling real wage, workers will negotiate
higher wage growth and the SAS curve will start shifting upwards to the left. The higher
wage growth will be partly passed on through higher prices, and output will fall until it is back
to the long-run equilibrium level Y* . The adjustment process for a negative demand shock
(described more fully in section 24.6) is similar just in the opposite direction, with the AD
curve shifting left from AD0 to AD2 , moving the economy into recession at a lower rate of
inflation. At point D, there is involuntary unemployment. This will put downward pressure on
future wage negotiations, resulting in lower wage growth and a shift in the SAS curve,
eventually to point E. Block 16: Aggregate demand and aggregate supply 183 AS Y* A
Inflation Output, income (GDP) AD0 ① ② ② ① AD1 AD2 SAS0 SAS1 SAS B 2 E C D π0
π1 π2 Figure 16.1 Demand shocks.

2022 ppr )In Narnia, production per worker (y) depends on capital per worker (k) such that y
= A √ k, where A > 0. Every year 20% of the capital stock depreciates, while workers in
Narnia save 10% of their income. The population is stable in Narnia, neither growing nor
shrinking.

(a) Explain what is meant by the ‘steady state’ and find capital per worker and output per
worker in Narnia’s steady state, as a function of parameter A. (10 marks)

(b) Let A = 10. If capital per worker is currently at 25, should we expect to see economic
growth in Narnia? (5 marks)

(c) Starting from a position where capital per worker is 25, technological change causes A to
rise from 10 to 20. Explain how this affects Narnia’s steady state and illustrate the change in
a diagram. Will there be economic growth in Narnia? (10 marks)
(d) How does your analysis in (c) help us understand the drivers of long run economic
growth?

2022 zone B paper

Question 13 Disruption to the supply of natural gas to Atlantis has caused a surge in energy
prices. While Atlantis has had a period of inflation around 2% for several years, the current
rate of inflation is 6%.
(a) What type of shock has affected Atlantis and how has it fueled inflation? (5 marks)
 (b) Explain what is meant by the natural rate of unemployment and explain why the long-run
Phillips curve is vertical at that rate. Why is inflation constant in the long-run equilibrium? (10
marks)
The natural rate of unemployment is the rate that prevails when employment is at its
long-run level (potential output). Equilibrium unemployment is not zero because job
separations and job hiring rates continuously occur, giving rise to people moving between
jobs etc. In the long run equilibrium unemployment is unrelated to inflation because it is
assumed nominal wages and prices are flexible and change together. Equilibrium
unemployment in the long run depends only on the real wage, which is unaffected. Inflation
is constant in the long-run equilibrium because people correctly anticipate inflation (π = π e )
and adjust nominal wages to real wages at the level required for the long-run equilibrium (Y
= Y¯ and U = U ∗ ).
(c) Analyse the effect of the shock on Atlantis using short- and long-run Phillips curves.
Explain how the Central Bank’s willingness to accommodate the shock affects inflation and
unemployment in Atlantis. (10 marks)
The rise in energy prices is an adverse temporary supply shock which shifts up the short-run
Phillips curve without affecting the LRPC. Monetary policy can fully accommodate the shock,
for example, by raising the target inflation rate in line with the shift, so that inflation rises but
unemployment remains at the long-run level. If instead interest rates were to rise, then it
would prevent inflation from rising as high as in the full-accommodation case. The fall in
aggregate demand induced by the interest rate rise would raise unemployment. This would
be reflected by a move along the higher short-run Phillips curve, giving rise to stagflation.
That is, both high inflation and high unemployment.
(d) Explain why the credibility of monetary policy is important.
The credibility of monetary policy is important because it affects inflation
expectations. If the public believes that the Central Bank is committed to achieving
its inflation target, it can influence their behavior and expectations. When people
have confidence in the Central Bank's ability to control inflation, they will adjust their
wages and prices according to the target, which helps to stabilize the economy.On
the other hand, if the public doubts the Central Bank's commitment to its target, they
may anticipate higher inflation and adjust their behavior accordingly. This can lead to
a self-fulfilling prophecy, where inflation expectations become reality and lead to
higher inflation.Therefore, the credibility of the Central Bank is crucial in anchoring
inflation expectations and achieving price stability. A credible Central Bank can help
to reduce uncertainty and promote economic growth, while a lack of credibility can
lead to volatility and instability.

Anskey answer-(d) Here candidates were expected to discuss the importance of inflationary
expectations. If people expect high inflation (i.e. do not feel that the Central Bank will meet
the inflation target), then that feeds into wages and prices etc. A Central Bank that is more
credible is more likely to be believed and influence inflation expectations, which turn out to
be true if there is perfect credibility. Many candidates correctly identified the role of
expectations and how the Central Bank’s credibility affects them. A minority argued that
Central Banks’ credibility makes international trade easier or stabilises the exchange rate,
which is not the point in this question.
2021 main ppr
Question 13)
The United Kingdom (UK) is an open economy with government. Aggregate demand is
described by Y = C + I + G + X − Z, where C denotes aggregate consumption, I denotes
investment, G denotes government expenditure, X denotes exports and Z denotes imports.
In particular: C = 50 + 0.7(Y − T ) I = 50 − 6r G = 20 T = 20 X = 60 Z = 18 + 0.2Y.

(a) Explain briefly what the IS curve represents and find its equation for the UK. (6 marks)

(b) Find the multiplier for the UK and explain its meaning. What does it depend on? (4
marks)
(c) The UK left the European Union (known as ‘Brexit’) and since 1st January 2021 trade
between the UK and the European Union has been subject to trade barriers. As a result,
suppose exports and imports change to: X = 20 Z = 8 + 0.1Y. How does this affect the UK’s
IS curve and multiplier? (6 marks)
(d) The Bank of England sets the base rate of interest in the UK. Assume it is set at r = 2.
Use the IS–LM framework to examine the effect of Brexit on the UK economy (note: there is
no need to consider the BP curve). (6 marks)

(e) The Bank of England lowered the interest rate after the Brexit referendum and again in
March 2020. Can your diagram in (d) provide a rationale for this policy response? Could a
change in government spending be used instead to restore the IS to its initial position and
the economy’s output to pre-Brexit levels? (8 marks)

Question 14) The country of Coronia has a labour force (LF) of 40 million people. Of these 3
million are unemployed (U), and the rest employed (E). The rate of job loss for those in work
is j = 0.01, whereas the hiring rate for those without jobs is h = 0.09.

(a) Explain what the natural rate of unemployment is and derive an expression for it in terms
of j and h. Find the natural rate of unemployment for Coronia. (6 marks)

(b) Is unemployment in Coronia at the natural rate? If not, will Coronia converge to the
natural rate over time? (6 marks)
(c) Many governments have introduced ‘furlough schemes’ during the coronavirus pandemic.
Through these schemes, governments pay the wages of many millions of people who are
unable to work due to lockdowns and are put on leave (are furloughed) by their employer.
How are furlough schemes likely to affect the natural rate of unemployment in these
countries during the coronavirus pandemic and after the schemes end? (6 marks)

(d) During the coronavirus pandemic many part-time employees, especially women, left the
labour force to take on home schooling responsibilities. How might this affect the current
unemployment rate? (6 marks) (e) Repeated lockdowns have had the effect or closing
restaurants, bars and shops, as well as restricting travel. How might lockdown affect
unemployment and what type of unemployment is affected?

Question 13 Taxmania is a closed economy with government. Aggregate demand is

described by Y = C + I + G, where C denotes aggregate consumption, I denotes investment
and G denotes government expenditure. Disposable income is denoted by YD; income in
Taxmania is taxed at a rate t, while the government can also deduct taxes as a lump sum T .
In particular: C = 40 + 0.8YD YD = (1 − t)Y − T I = 200 − 6r G = 360 t = 0.25 T = 0.
(a) Explain briefly what the IS curve represents and find its equation for Taxmania. (6 marks)

(b) Find the multiplier for Taxmania and explain its meaning. What does it depend on? (4
marks) (c) The central bank of Taxmania targets the real interest rate and has set r = 4. Use
the IS–LM framework to find the level of output in the economy. Show that Taxmania has a
balanced budget. (6 marks)
(d) Due to the coronavirus pandemic the government of Taxmania increases expenditure on
healthcare and vaccinations, raising government spending to G = 560. What is the effect of
this on aggregate spending in the economy? Show that Taxmania is now running a budget
deficit. (6 marks)
(e) Concerned about debt, the government of Taxmania decides to raise taxes. This can be
done by either (i) raising the income tax rate t or (ii) introducing a lump sum tax T . Under
which tax system will fiscal policy through G be more effective?

Question 14)
Suppose aggregate supply in the United Kingdom is Y = Y ∗ + 50(π − π e ), where Y
denotes output, Y ∗ denotes potential output, π denotes the inflation rate and π e denotes
the expected rate of inflation. Also Y − Y ∗ = −10(u − u ∗ ), where u denotes the
unemployment rate and u ∗ denotes the equilibrium (or natural) rate of unemployment.

(a) Find the expectations augmented short-run Phillips curve for this economy and sketch it
in a diagram, explaining its shape. Add the long-run Phillips curve to your diagram and
explain its shape. (8 marks)

(b) The Bank of England has an inflation target of 2 per cent. However, inflation in the UK
has been below target at 1 per cent due to the economic effects of the coronavirus
pandemic. Analyse the effects on unemployment, output and inflation in the short-run and
long-run if: i. the inflation target is credible ii. expectations are adaptive, so π e t = πt−1. (8
marks)
(c) Suppose the inflation rate is on target at 2 per cent. However, it is a widely held belief that
the United Kingdom’s departure from the European Union (known as ‘Brexit’) will increase
the inflation rate through higher import prices. Could such a belief be self-fulfilling? (6 marks)

(d) ‘The specific inflation target does not matter, provided it is credible.’ Do you agree with
this statement? Explain why, or why not. (8 marks)

2020 main paper

Question 13 In this question we will reflect on the Australian fires from last year. A wide part
of Australia has experienced severe fires in the last year, which made the economy much
less productive and had severe impacts on business activities.

(a) Explain why you could expect negative shifts in the aggregate demand curve following
the fires. What would you expect are the drivers of this shift? Reflect on each of the
components of the aggregate demand and comment on whether they are likely to change
due to the fires. (6 marks)
(a) Aggregate Demand (AD) is an economic measurement of the total amount of demand for
all finished goods and services produced in an economy.
Aggregate demand is expressed as the total amount of money exchanged for those goods
and services at a specific price level and point in time. Aggregate demand is
Y = A − b(r − π), with A > 0 and b > 0. This does not get us very far here so it helps to
think about an open economy and consider the aggregate demand Y = C + I + G + NX,
where C stands for consumption, I for investment, G for government expenditure (the
difference between tax revenues and government spending) and NX stands for net exports
(the difference between exports and imports).
Aggregate demand consists of all consumer goods, capital goods (factories and equipment),
exports, imports, and government spending.The severe fires in Australia are likely to result in
negative shifts in the aggregate demand curve. This is because the fires are likely to lead to
a reduction in economic activity and lower consumer and business confidence. The drivers
of this shift in aggregate demand can be analyzed by considering the components of
aggregate demand.

Consumption: The fires are likely to result in a reduction in consumption spending due to the
loss of homes, businesses, and infrastructure. Additionally, people may be less inclined to
spend money on non-essential items due to the uncertainty and anxiety caused by the fires.

Investment: The fires are also likely to lead to a reduction in investment spending.
Businesses may postpone or cancel investment projects due to the uncertainty caused by
the fires. Additionally, the destruction of infrastructure and businesses may make it more
difficult for businesses to invest.

Government spending: The government may increase its spending in response to the fires,
such as by investing in rebuilding infrastructure and providing aid to affected communities.
However, the extent of this increase in government spending will depend on the
government's response to the fires.

Net exports: The fires are unlikely to have a direct impact on net exports. However, if the
fires result in a reduction in economic activity in Australia, this could lead to a reduction in
exports due to lower demand for Australian goods and services.

In summary, the negative shift in the aggregate demand curve following the fires can be
expected due to the reduction in consumption and investment spending. The extent of the
shift in aggregate demand will depend on the government's response to the fires and the
overall impact of the fires on the economy.
 (b) Explain why you could expect negative shifts in the aggregate supply curve following the
fires. What would you expect are the drivers of this shift? Reflect on each of the components
of the aggregate supply and comment on whether they are likely to change due to the fires.
(6 marks)
(b) Aggregate supply is the total supply of goods and services produced within an economy
at a given overall price in a given period. It is represented by the aggregate supply curve,
which describes the relationship between price levels and the quantity of output that firms
are willing to provide. A shift in the aggregate supply can be attributed to many variables,
including changes in labour, technological innovations, an increase in wages, an increase in
production costs, changes in producer taxes, subsidies and changes in inflation. Here the
most likely factor to affect the aggregate supply are the costs of production, now higher
because of the factories which got burnt, and the labour force may be reduced,
Each component of the aggregate supply could be affected by the fires. Firstly, the
physical capital component could be negatively impacted as the fires could destroy
buildings, machinery, and equipment. This would result in a reduction in the stock of
capital available for production. Secondly, the human capital component could be
negatively impacted as people could be injured, displaced or suffer from health
problems as a result of the fires. This could lead to a reduction in the quality and
quantity of labour. Finally, the natural resources component could be negatively
impacted as the fires could destroy forests, vegetation and wildlife, reducing the
availability of natural resources for production.

Overall, the negative shifts in the AS curve would cause higher prices and lower
output, which would result in stagflation, where the economy faces high inflation and
low economic growth.

(c) Show the shifts discussed in parts (a) and (b) graphically. You may assume an
upward-sloping AS curve for simplicity. Can you predict what happens to real GDP and the
price level? (8 marks)
Anskey check for this
(d) The fires in Australia can also be considered a decrease in the country’s stock of capital.
You may use the Solow model to show what happens when capital decreases and what the
model predicts for the new growth rate. Are these consequences likely to happen in
practice?

Question 14
(a) Allen would like to open a business to produce a software that he thinks would be
well-received by the market. However, the investment needed to start a business is very high
and Allen could barely cover it on his own. The software is very likely to be successful and
generate profits, but it takes 2 years before profits are generated. Explain why the existence
of a financial intermediary, like a bank, makes Allen’s investment more likely. (4 marks)

(b) Banks are financial intermediaries engaged in maturity transformation. Explain what it
means for banks to engage in maturity transformation and what are the risks associated with
it for banks and depositors. How do banks make profits? (8 marks)
(c) Now assume that Allen needs to borrow £300 to produce his software, which will
generate £500 in two years. There are N savers in the economy, each endowed with £2 and
each facing a 25% chance that there will be an emergency and they will need their £2 back.
What is the minimum value of N such that a financial intermediary can solve the problem of
getting money from savers to borrowers? (6 marks)

(d) After the 2009 financial crisis, countries in the Basel Committee on Banking Supervision
have agreed to raise the mandatory reserves for banks. Explain what happens to the money
multiplier and the bank deposit multiplier if the reserve ratio is increased and what
governments need to do if they wish to maintain the previous level of broad money M.

2019 paper
Section C: Macroeconomics Candidates should answer ONE of the two following long
questions. It is essential that you explain your answers. Question 13
(a) There is some consensus that following Brexit house prices will drop in London. If prices
do fall, how are banks’ balance sheets affected? Why? How do you expect this to affect the
ability of banks to borrow from each other, depositors and financial markets? (8 marks)

(b) Does the fall in house prices affect only house owners and banks? Discuss the impact of
the price decrease on the economy. (6 marks)

(c) Now assume that the Central Bank would like to foster investments by lowering interest
rates. What happens if interest rates are already very low? Will the policy be effective? (6
marks)

(d) Some analysts suggest that there might be a bubble in the financial market. They
suggest using a policy mix to reduce the impact of the bubble. Explain why this might work
and show the appropriate shifts in the IS–LM model. Does the effectiveness of the policy mix
depend on the exchange rate regime? (10 marks)

Question 14
(a) What does the Phillips curve represent? Is there a difference between the Phillips curve
in the short-run and long-run? Explain and show it in a diagram. (6 marks)

(b) What is the impact of a short-term negative shock on output, unemployment and
inflation? Explain and draw a diagram. (6 marks)
(c) What is the relationship between the current and capital accounts in a flexible exchange
rate regime? (4 marks)
(d) What is Okun’s law? (4 marks) (e) Assume that we are in a floating exchange rate
regime. The price of oil went up, driving the economy to a much higher unemployment rate.
Use a standard IS–LM–BP model to explain what happens to income, interest rates and the
balance of payment if the central bank uses monetary policy to stabilise the economy at
potential output.

2019 paper
Question 13 (a) How can we represent the Solow model graphically? (6 marks)
(b) How does the Solow model show that the process of capital accumulation can generate
economic growth? Can growth be indefinite if savings keep increasing and there is no
technological growth and a constant population growth? (8 marks)

(c) Discuss the effects of an improvement in technology in the Solow model. Focus on its
effects on living standards in the short run and in the long run. Show this graphically. (8
marks) 28 Examiners’ commentaries 2019

(d) How does the Solow model differ from Romer’s model? What is the long-run growth rate
of output per worker in each of the models? What does this imply in terms of policy?

Question 14
(a) What does the Phillips curve represent? Is there a difference between the Phillips curve
in the short-run and long-run? Explain and show it in a diagram. (6 marks)
(b) What is the impact of a short-term negative shock on output, unemployment and
inflation? Explain and draw a diagram. (6 marks)
(c) What is the relationship between the current and capital accounts in a flexible exchange
rate regime? (4 marks) 30
(d) What is Okun’s law? (4 marks)
(e) Assume that we are in a floating exchange rate regime. The price of oil went up, driving
the economy to a much higher unemployment rate. Use a standard IS–LM–BP model to
explain what happens to income, interest rates and the balance of payment if the central
bank uses monetary policy to stabilise the economy at potential output.

Question 6
Choose the correct statement. Potential output IS:
(a) The output demanded by households as consumption and by firms as
investment.
(b) The output obtained when there is no unemployment.
(c) The output obtained by trading with other countries.
(d) The output obtained when all inputs are fully employed.
Reading for this question
See BVFD Section 16.3.
Approaching the question
(d) is correct.
The potential output is a measure of the economy’s output when all inputs are fully employed
–
this is the standard definition of it.
Question 7
The Fisher equation tells us that:
(a) Nominal interest rates are less volatile than the real ones.
(b) Real interest rates are always higher than nominal ones.
(c) Nominal interest rates can be the same as the real ones.
(d) Inflation is always positive.
22
Examiners’ commentaries 2019
Reading for this question
See BVFD Sections 20.1 and 22.2.
Approaching the question
(c) is correct.
This is the standard Fisher equation when inflation is equal to zero so that the nominal and
real
interest rates are the same.
Question 8
In a time of political stability demand for financial assets may increase and create a
bubble. In the context of the IS–LM model which of the following statements IS
NOT correct?
(a) Decreasing government spending might be an appropriate response.
(b) Income will fall because of a rightward shift in the IS curve.
(c) If there is no intervention the interest rate will be higher.
(d) The central bank can raise the interest rate to slow investments.
Reading for this question
See BVFD Section 20.1.
Approaching the question
(b) is not correct.
If demand for financial assets increases, there will be a rightward shift of the IS curve and
hence
higher income. This means that out of the statements given the only incorrect one was (b)
which
considered a fall in income – this happens whenever the IS curve shifts to the left.
Question 9
Which of the following statements IS correct?
(a) The real exchange rate cannot be equal to the nominal exchange rate.
(b) The real exchange rate depends only on the rates of inflation in the two
countries.
(c) The purchasing power parity exchange rate is the path of the nominal exchange
rate that maintains a constant real exchange rate.
(d) The purchasing power parity exchange rate can be computed by looking at the
market for one good.
Reading for this question
See BVFD Section 24.3.
23
EC1002 Introduction to economics
Approaching the question
(c) is correct.
The purchasing power parity exchange rate is computed based on the idea that regardless
of the
currency they are expressed in, real prices should be the same. This means maintaining a
constant real exchange rate through nominal prices.
Question 10
What does the convergence theory in the Solow model imply?
(a) Rich nations will stop growing.
(b) Poor nations will grow slower than rich nations.
(c) Growth will only arise if a nation is not in steady state.
(d) Poor countries will grow faster than rich countries.
Reading for this question
See BVFD Section 28.7.
Approaching the question
(d) is correct.
The convergence theory postulates that countries will eventually reach the same steady
state
output, i.e. there is convergence. This is true regardless of where countries start from as
Solow
assumes that growth is a concave function of income. Countries which start with higher
incomes
will grow less than countries which start at lower levels of income. Hence countries which
start at
lower incomes will grow faster and catch up with those which started with higher ones.

2018 paper

Question 6
Which of the following statements about the rate of inflation is correct?
(a) The numerical value of the consumer price index is the rate of inflation.
(b) The increase in the numerical value of the consumer price index is the rate of
inflation.
(c) The percentage change in the numerical value of the consumer price index is the
rate of inflation.
(d) If the rate of inflation is positive then the price of every type of good has
increased.
Reading for this question
See BVFD Section 2.2 for a discussion of price indices.
Approaching the question
(c) is correct.
6
Examiners’ commentaries 2018
Inflation is measured as the percentage rate of change of the price of a bundle of goods. You
can
think of the inflation rate as a weighted average of the percentage increases in the prices of
the
goods. As with any average the average may increase, even though some of the things
averaged
fall. Here the rate of inflation might be positive even if the prices of some goods fall.
Question 7
Which of the following statements about the balance of payments is not correct?
(a) The current account measures the difference between payments for goods
manufactured in the UK and exported, and payment for goods manufactured
outside the UK and imported by the UK. It does not include services.
(b) The capital account is the international flow of transfer payments relating to
capital items.
(c) The financial account records international purchases and sales of financial
assets.
(d) The UK has a floating exchange rate. If all transactions between the UK and
the rest of the world are correctly measured, then the UK balance of payments
is
current account + capital account + financial account = 0.
Reading for this question
See BVFD Section 24.3.
Approaching the question
(a) is not correct.
The current account includes services.
Question 8
In the simple model of national income determination investment, government
expenditure, and tax revenue, are all taken to be exogenous. A more sophisticated
model recognises that there are automatic stabilisers. Which of the following
statements about the model with automatic stabilisers is correct?
(a) Tax rates must change for automatic stabilisers to work.
(b) In the model with automatic stabilisers tax revenue automatically falls when
national income increases.
(c) In the model with automatic stabilisers government expenditure automatically
increases when national income increases.
(d) The multiplier is lower in the model with automatic stabilisers than it is in the
model without automatic stabilisers.
Reading for this question
See BVFD Section 17.5.
Approaching the question
(d) is correct.
7
EC1002 Introduction to economics
Question 9
Which of the following statements about banking crises is correct?
(a) In a solvency crisis depositors are anxious about whether a bank will be able to
repay the money they have deposited in the bank. Many depositors try to
withdraw money at the same time. The assets of the bank are greater than its
liabilities.
(b) In a liquidity crisis depositors are anxious about whether a bank will be able to
repay the money they have deposited in the bank. Many depositors try to
withdraw money at the same time. The assets of the bank are greater than its
liabilities.
(c) Central banks can resolve a solvency crisis by lending to the bank in difficulties.
(d) It is easy for central bankers to tell whether a bank has a liquidity crisis or a
solvency crisis.
Reading for this question
See BVFD Section 18.6.
Approaching the question
(b) is correct.
Question 10
Which of the following statements about the Phillips curve model with expectations
is correct?
(a) An expected high rate of inflation is associated with high levels of output and
employment.
(b) An unexpected high rate of inflation is associated with high levels of output and
employment.
(c) In the long run governments can increase real output and employment by using
monetary policy to increase the rate of inflation.
(d) In the long run there is nothing governments can do to increase real output and
employment.
Reading for this question
See BVFD Sections 22.4, 23.3.
Approaching the question
(b) is correct.
8
Examiners’ commentaries 2018

Question 13 (a) After the financial crisis in 2007–2009 many central banks reduced
the interest rate. Is this a change in fiscal policy? Is this a change in monetary policy?
(4 marks)

(a) After the financial crisis in 2007-2009, many central banks reduced interest rates
to stimulate economic growth. This is a change in monetary policy, as interest rates
are one of the key tools used by central banks to influence the economy. Fiscal
policy, on the other hand, refers to changes in government spending and taxation.

The reduction in interest rates is a monetary policy tool called "expansionary

monetary policy," which aims to boost economic activity by making it easier for
individuals and businesses to borrow and spend money. By reducing interest rates,
central banks hope to increase the money supply and encourage lending and
investment.

(b) What is the difference between a closed economy model and an open economy
model? (4 marks)

(c) Explain the derivation of the IS curve in a closed economy model. Use the IS–LM
model to analyse the effect of a fall in investment, due to a lack of confidence, on
national income if there is no change in fiscal policy and no change in the interest
rate. (10 marks)

(d) Continue to assume a closed economy. Assume now that the central bank sets
the interest rate, setting a higher interest rate when output is higher. Discuss, using
your IS–LM diagram, how monetary and fiscal policy can be used to reduce the
impact of the fall in investment on national income. (6 marks)
 (e) In June 2016 a referendum in the UK resulted in a decision that the UK should
leave the European Union. Following the referendum there was concern that firms
would reduce their investment in the UK. Monetary policy in the UK is determined by
the Bank of England, which sets the interest rate. The interest rate was cut from 0.5%
to 0.25% in August 2016. How does the fact that the UK is an open economy with a
floating exchange rate change your analysis of the effects of monetary policy?

The exchange rate can have a significant impact on the effectiveness of monetary
policy in an open economy. In the short run, a cut in the interest rate can lead to
outflows of funds as investors seek higher returns elsewhere, leading to a
depreciation of the exchange rate. This can result in higher inflationary pressures as
the cost of imports increases, potentially offsetting the expansionary effects of the
interest rate cut. However, in the long run, the exchange rate is expected to adjust to
a level that restores equilibrium in the capital markets, meaning that monetary policy
can be effective in achieving its goals. Nevertheless, the uncertainty and volatility
surrounding exchange rates in the short run make it difficult to predict the impact of
monetary policy on the economy.

Question 14 (a) Why do households hold money? What type of bank deposits are
included in the money supply? (7 marks)
(b) Contactless cards make it possible to make a payment by holding the card near a
reader, with no requirement to enter a PIN number or provide a signature. They allow
customers to make a transaction more quickly and conveniently than using cash.
However, there is a limit on the size of the transaction and some shops will not
accept cards for very small transactions. Are contactless cards a perfect substitute
for cash? What effect is the introduction of contactless cards likely to have on
holdings of cash and bank deposits? What are the risks of contactless cards? Which
sectors of the economy prefer working with cash rather than electronic payments
involving banks? (7 marks)

(c) What is a reserve requirement for a bank? What determines the reserve ratio of a
bank? If a bank has a reserve ratio of 3%, starts with zero cash, and then receives a
cash deposit of £3,000 how much can it lend? What is the effect of the lending on
the money supply in the economy? (7 marks)

(d) What is quantitative easing? Why did the Bank of England adopt a policy of
quantitative easing after the financial crisis of 2007–2009? Was the policy
successful? (9 marks)

Reading for this question See BVFD Sections 18.1, 18.3 and 19.5. Approaching the
question
(a) Households hold money as:
• a medium of exchange, i.e. for making transactions
• a unit of account, i.e. for keeping track of prices. In hyperinflations when prices
change very fast the unit of account might be another currency, for example US
dollars.
• a store of value, i.e. as an asset. A bank deposit is included in the money supply if it
can be used to make transactions.
BVFD makes a distinction between sight deposits and time deposits. (This is US
terminology, in the UK sight deposits are current accounts and time deposits are
savings accounts.) Depositors can withdraw cash instantly from a sight deposit
account, and it can be used to make payments. BVFD describes cheques as the way
of making payments. However, payments are increasingly done electronically. Sight
deposits generally pay no interest. Time deposits pay some interest but there are
restrictions on when and how much can be withdrawn and they cannot be used for
making transactions. In practice there is not a clear distinction between sight and
time deposits, in particular arrangements for automatic transfers from time to sight
deposits in effect allow time deposits to be used for transactions (although there
may be fees for this service). This is why there are several measures of money
supply depending on exactly which accounts are included. (b) Contactless cards are
a close substitute for cash and are, therefore, likely to reduce demand for cash, and
possibly increase demand for bank deposits. They are not a perfect substitute for
cash partly due to the risk of theft and fraud. The most likely short-term problem is
failure of the card reader system. It is worth carrying some cash. 18 Examiners’
commentaries 2018 Card transactions are more easily traceable than cash
transactions so the black economy works largely, but not entirely, with cash. This is a
big deal from the law enforcement point of view. (c) Some candidates struggled with
fractional reserve banking which is one of the more difficult concepts to understand
at this level. It is described in the textbook. The required ratio is: reserves deposits so
with a 3% reserve ratio and deposits of £3,000 the common sense answer is that the
bank can lend 97% of the deposit, i.e. £2,910. See BVFD Section 18.3 for a story
which is closer to reality. Suppose a bank receives a deposit of £3,000 in cash. Banks
can expand their balance sheets, simultaneously creating loans, which are assets,
and deposits in the borrower’s account, which are liabilities. The assets are then
cash + loans. The liabilities are deposits. The bank is constrained by its reserve ratio
and: reserve ratio = cash deposits which as assets = cash + loans = liabilities =
deposits: reserve ratio = cash cash + loans. Therefore, with a cash deposit of £3,000
and a reserve ratio of 3% the banks can create loans of £97,000 so the money supply
is now £97,000 + £3,000 = £100,000. (d) Quantitative easing is the purchase by a
central bank of government bonds and ‘safe’ private sector bonds. The objective was
to push up the price of bonds and hence reduce the long-run interest rate, thereby
encouraging investment and consumption. This was done in the context of the
financial crisis at which point the official interest rate was very low (close to the zero
lower bound) so there was no further scope for stimulating the economy in the
standard monetary policy way by cutting the interest rate. The UK government was
reluctant to use fiscal policy to stimulate the economy. It embarked on a policy of
austerity. The US government in contrast undertook both quantitative easing and a
boost to government expenditure. Saying whether the policy was successful requires
thinking about what would have happened if central banks had not undertaken
quantitative easing. The Bank of England calculated that the long-term interest rate
was 1% lower than it would have been otherwise. However, given the pessimism of
households and firms it is unclear how effective this was in increasing consumption
and investment above the level which they would have been in the absence of
quantitative easing.

Zone b 2018

Question 6
Which of the following statements about banking crises is correct?
(a) Central banks can resolve a solvency crisis by lending to the bank in difficulties.
(b) In a solvency crisis depositors are anxious about whether a bank will be able to
repay the money they have deposited in the bank. Many depositors try to
withdraw money at the same time. The assets of the bank are greater than its
liabilities.
(c) It is easy for central bankers to tell whether a bank has a liquidity crisis or a
solvency crisis.
(d) In a liquidity crisis depositors are anxious about whether a bank will be able to
repay the money they have deposited in the bank. Many depositors try to
withdraw money at the same time. The assets of the bank are greater than its
liabilities.
Reading for this question
See BVFD Section 18.6.
Approaching the question
(d) is correct.

Question 7
Which of the following statements about the rate of inflation is correct?
(a) If the rate of inflation is positive, then the price of every type of good has
increased.
(b) The percentage change in the numerical value of the consumer price index is the
rate of inflation.
(c) The numerical value of the consumer price index is the rate of inflation.
(d) The increase in the numerical value of the consumer price index is the rate of
inflation.
Reading for this question
See BVFD Section 2.2 for a discussion of price indices.
Approaching the question
(b) is correct.
Inflation is measured as the percentage rate of change of the price of a bundle of
goods. You can think of the inflation rate as a weighted average of the percentage
increases in the prices of the goods. As with any average the average may increase,
even though some of the things averagedfall. Here the rate of inflation might be
positive even if the prices of some goods fall.
Question 8
Which of the following statements about the balance of payments is not correct?
(a) The capital account is the international flow of transfer payments relating to
capital items.
(b) The financial account records international purchases and sales of financial
assets.
(c) The current account measures the difference between payments for goods
manufactured in the UK and exported, and payment for goods manufactured
outside the UK and imported by the UK. It does not include services.
(d) The UK has a floating exchange rate. If all transactions between the UK and
the rest of the world are correctly measured, then the UK balance of payments
Is current account + capital account + financial account = 0.
Reading for this question
See BVFD Section 24.3.
Approaching the question
(c) is not correct.
The current account includes services.
Question 9
Which of the following statements about the Phillips curve model with expectations
is correct?
(a) An unexpected high rate of inflation is associated with high levels of output and
employment.
(b) An expected high rate of inflation is associated with high levels of output and
employment.
(c) In the long run governments can increase real output and employment by using
monetary policy to increase the rate of inflation.
(d) In the long run there is nothing governments can do to increase real output and
employment.
Reading for this question
See BVFD Sections 22.4, 23.3.
Approaching the question
(a) is correct.
Question 10
In the simple model of national income determination investment, government
expenditure, and tax revenue, are all taken to be exogenous. A more sophisticated
model recognises that there are automatic stabilisers. Which of the following
statements about the model with automatic stabilisers is correct?
(a) In the model with automatic stabilisers tax revenue automatically falls when
national income increases.
(b) The multiplier is lower in the model with automatic stabilisers than it is in the
model without automatic stabilisers.
(c) Tax rates must be changed for automatic stabilisers to work.
(d) In the model with automatic stabilisers government expenditure automatically
increases when national income increases.
Reading for this question
See BVFD Section 17.5.
Approaching the question
(b) is correct.

Question 13 The USA has decided to increase government expenditure and reduce
taxes.
(a) Is this a change in fiscal policy? Is this a change in monetary policy? (4 marks)

(b) What is meant by the natural level of output? What, if any, is the relationship
between the natural level of output and the rate of inflation? (4 marks)

(c) Explain the derivation of the IS curve in a closed economy model with a
government. Assume that the interest rate is set by a central bank which sets a
higher interest rate when output is higher. Use the IS–LM model to analyse the effect
of increasing government expenditure and cutting taxes if the economy is producing
less than its natural level of output. (12 marks)

(d) How would your analysis change if the economy is producing its natural level of
output? What action would you recommend a central bank with an inflation target
take in these circumstances?

Question 14
(a) Consider the balance sheet of a nonfinancial firm. Explain the distinction
between assets and liabilities. What are inventories? Are inventories an asset or a
liability? Is a loan made to the firm by a bank an asset or a liability of the firm? (4
marks)
(b) In the balance sheet of a bank are deposits assets or liabilities? Are loans to
other firms assets or liabilities? (4 marks)
 (c) What is the required reserve ratio for a bank? If a bank has a required reserve
ratio of 5%, starts with zero cash, and then receives a deposit of £20,000 how much
can it lend? What is the effect of the lending on the quantity of money in the
economy? (5 marks)

(d) Banks earn a zero rate of interest on their cash holdings and a rate of interest
greater than zero on the amount they lend. Despite this fact banks sometimes
choose to have a higher ratio of cash to deposits to than is required by the central
bank. Why do they choose to do this? (4 marks)

(e) The Bank of England is the central bank of the UK. What does the statement that
the Bank of England is the lender of last resort in the UK mean? Why is it possible for
the Bank of England to act as the lender of last resort? (4 marks)

(f) What is quantitative easing? Why did the Bank of England adopt a policy of
quantitative easing after the financial crisis of 2007–2009? Was the policy
successful?

2017 papers
Question 6
Consider a closed economy with no government. Use notation:
• Y income
• C consumption
• I investment
• S saving.
Assume that consumption is given by C = A + cY and Y = C + I where A and c
are both positive and c is less than 1. Which of the following statements is correct?
(a) Suppose that c = 0.75. Suppose that investment increases by 100 because
investors become more optimistic. Then income increases by 500.
(b) If saving and investment are at their planned levels and S = I then the
economy is in equilibrium.
(c) If c = 0.75 then the multiplier is 0.75.
(d) If consumers become more willing to consume so c increases but I and A do not
change then income falls.
Reading for this question
See BVFD Chapter 16.4 and Mathematics box 16.
Approaching the question
(b) is correct.
In this model Y = C + I = A + cY + I, so in equilibrium:
(1 − c)Y = A + I
implying that:
Y=
A+I
(1 − c)
.
The multiplier is 1/(1 − c). If c = 0.75 then the multiplier is 4, so (c) is incorrect. If
investment
increases by 100 then output Y increases by 400, so (a) is incorrect. If c increases
then 1 − c
decreases and the multiplier 1/(1 − c) increases so equilibrium income increases,
hence (d) is
incorrect. Equilibrium requires that when consumption, saving and investment are at
their
planned levels C + I = C + S, so S = I.
Question 7
Which of the following statements is correct?
(a) The labour market is in equilibrium if demand for labour at the current wage is
equal to the size of the labour force.
(b) The labour market is in equilibrium if there is zero voluntary unemployment.
(c) The labour market is in equilibrium if demand for labour at the current wage is
equal to the number of workers willing to accept a job at the current wage.
(d) It is impossible to increase the level of equilibrium unemployment by improving
the match between the skills employers require and the skills workers have.

Approaching the question

(c) is correct.
The labour market is in equilibrium if demand for labour at the current wage is equal
to the
number of workers willing to accept a job at the current wage.
Question 8
Central banks such as the Federal Reserve in the USA and the Bank of England in
the UK operate monetary policy. Which of the following statements is not correct?
(a) Many central banks aim to control the rate of inflation. Some central banks are
concerned about both inflation and the level of unemployment.
(b) No central banks ever allows other banks to become bankrupt.
(c) Some central banks buy both government and private sector bonds.
(d) Many central banks control the interest rate but not the money supply.
Reading for this question
See BVFD Chapters 19.5, 19.6, 18.7 and 22.7.
Approaching the question
(b) is not correct.
Many central banks, including the Bank of England, have an inflation target. Although
it is not officially part of its mandate the Bank of England is in practice also
concerned about the level of unemployment. The US Federal Reserve is concerned
about both inflation and the level of Unemployment. Central banks do sometimes
allow other banks to become bankrupt. For example, the US Federal Reserve allowed
Lehman Brothers to go bankrupt in September 2008. Central banks do sometimes
buy government and private sector bonds. This is quantitative easing.The Bank of
England and the US Federal Reserve control the interest rate but not the money
supply.
Question 9
Which of the following statements is correct?
(a) The government deficit is the difference between government expenditure and
government revenue.
(b) If the government runs a deficit then national debt falls.
(c) Inflation increases the ratio of national debt to national income.
(d) If there is inflation and the government does not change tax rates then the
government deficit rises.

See BVFD Chapters 17.3.–17.6.

Approaching the question
(a) is correct. The government finances a deficit by borrowing which increases
government debt. Inflation increases nominal national income but does not increase
national debt so decreases the debt-to-national income ratio. If there is inflation and
no change in tax rates then there is an automatic fiscal stabiliser which increases tax
revenue so reduces the deficit.
Question 10
Use the aggregate supply–aggregate demand diagram to answer this question. The
government decreases taxes without changing expenditure or monetary policy.
Which of the following statements is correct?
(a) The aggregate demand curve shifts downwards.
(b) The aggregate supply curve shifts upwards.
(c) In the long run output does not change but inflation increases.
(d) In the short run output increases but inflation does not change.
Reading for this question
See BVFD Chapter 21.6 and the figure below.
Approaching the question
(c) is correct.In the short run, the aggregate demand curve shifts upwards from AD0
to AD1 with the result that income increases from Y0 to Y1 and inflation increases
from π0 to π1. In the long run, aggregate supply moves upwards to AS 1 and the
economy is back at Y0 but with a higher rate of
inflation at π2.

Question 13 (a) The IS–LM diagram has income on the horizontal axis and the
interest rate on the vertical axis. What is the LM schedule in this diagram? Why is it
upward sloping? (6 marks) (b) What is the IS schedule in the IS–LM diagram? Why is
it downward sloping? Assume the economy is closed and explain your answer
mathematically. (8 marks) (c) Use the IS–LM model to show how fiscal and
monetary policy can be used to increase output without changing the interest rate. (8
marks) (d) What are the limitations of the IS–LM model that policymakers should be
aware of ?

Question 14 (a) Explain the difference between a fixed exchange rate regime and a
floating exchange rate regime. What policy actions does a country have to follow to
maintain a fixed exchange rate? What is a dirty float? (6 marks) (b) The UK has a
floating exchange rate and capital mobility. The exchange rate between the US dollar
and the UK pound changed from $1.48 dollars per pound on June 23rd 2016 to $1.36
dollars per pound on June 24th 2016 following the vote to leave the European Union.
Did the UK pound appreciate or depreciate relative to the US dollar? Did the change in
the exchange rate make it more or less expensive for UK residents to buy goods
manufactured in the US? Does the change in the exchange rate make exporting to
the US more or less attractive for UK-based firms? What effect is the change in the
exchange rate likely to have on inflation in the UK? (8 marks) (c) 8 marks Consider an
open economy with a fixed exchange rate and perfect capital mobility. Assume that it
is impossible to devalue the currency. Suppose that inflation increases. Can the
central bank change the interest rate in order to reduce inflation? Is fiscal policy
effective in this situation? (8 marks) (d) Consider an open economy with a floating
exchange rate and perfect capital mobility. Suppose that inflation increases. Can the
central bank change the interest rate in order to reduce inflation? Is fiscal policy
effective in this situation?

Zone A 2017
(a) The aggregate demand and aggregate supply diagram has output on the
horizontal axis and inflation on the vertical axis. Explain the derivation of the
aggregate demand schedule from the IS schedule and monetary policy. Why is it
downward sloping? Explain your answer mathematically. (8 marks) (b) What causes
movements along the aggregate demand schedule? What happens to the aggregate
demand schedule if government expenditure increases and tax revenue does not
change? What happens to the aggregate demand schedule if the target inflation rate
is increased? (8 marks) (c) What is the shape of the aggregate supply curve if prices
and wages are completely flexible. What determines potential output? (6 marks) (d)
Suppose that an economy starts at a point where aggregate demand and short and
long aggregate supply are all equal. The central bank then tightens monetary policy
in order to reduce the rate of inflation. Use a diagram to discuss what happens to
aggregate demand and supply in the short and long run.
Question 14 (a) The Phillips curve diagram has unemployment on the horizontal axis
and inflation on the vertical axis. Professor Phillips of the London School of
Economics published a paper in 1958 showing a statistical relationship between
annual inflation and employment with low unemployment when inflation was high
and high unemployment when inflation was low. What do economists now believe
about the shape of the long-run Phillips curve? Why is the short-run Phillips curve
downward sloping? Where do the long- and short-run Phillips curves intersect? (6
marks) (b) What is the mathematical relationship between inflation Jr, expected
inflation Jre , actual unemployment U and equilibrium unemployment U∗ that
describes the short-run Phillips curve? What happens to the long-run and short-run
Phillips curves if expected inflation increases? Can governments in this model
reduce unemployment by increasing inflation in a predictable way? (8 marks) (c)
What are the costs of anticipated and unanticipated inflation? (8 marks) (d) Is
deflation (a negative rate of inflation) desirable?