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Macroeconomics 1 – Additional review questions – solutions

Question 1 (a)

Suppose Australian imports from Japan and China decrease significantly,

and at the same time interest rates in Australia increase

i. Will the Australian currency appreciate or depreciate?  Explain. 

The decrease in imports will result in a decrease in the supply of A$; the supply curve for the AUD will shift to the left.

Higher interest rates in Australia will increase FFI – foreign financial investment in Australia.  This will result in an increase in demand for the A$; the demand curve for the AUD will shift to the right.

The decrease in supply of the A$ and the increase in demand for the a$ will result in an appreciation of the AUD in the forex market.

(1 + 2 + 1)

ii.  Illustrate the above events in the foreign exchange rate market.

Graph illustrating shifts of both D and S curves and the new equilibrium vale of the AUD.  

(Note: graphs are not required in AT3; it is used for illustrative purposes.  Direction of shifts and new equilibrium value will be required). (2)

1 (b) Impact of the above appreciation of the A$ on:

(i) Australian net exports will decrease.

      The appreciation of the A$ will increase the prices of Australian exports.  This will result in a decrease in demand for Australian exported goods and services (including tourism, education).

Foreign buyers will have to increase the value of foreign currency required to buy an A$.

Additionally, prices of Australian imports will decrease, as Australian buyers of imports will decrease the value of A$s required to buy imports.

(ii) Due to the decrease in exports Australian RGDP growth will decrease.  NXs are a component of RGDP.

(iii) The inflation rate in Australian will tend to decrease.  The decrease in NXs will decrease aggregate demand in Australia.  This will result in a lower price level, decreasing the inflation rate.  

(iv) The decrease in aggregate demand and RGDP growth results in a decrease in demand for labour and consequently an increase in cyclical unemployment.

(2 + 0.5 + 1 + 0.5 = 4) 

Question 2

Using the exchange rate market, explain how each of the following events impact on the demand and/or supply of Australian dollars relative to the US dollar. State whether the exchange rate appreciates or depreciates as a result of each of the events.

i) The growing demand for Australian exported resources increase the price of iron-ore and other mineral exports.

· The increased demand for Australian exports and the higher value of Australian exports will increase Australian net exports;

· This will result in an increase demand for the AUD;

· The AUD will increase in value and appreciate in the forex market (relative to the USD).

(2 for explanation, 0.5 for identifying shift of AUD, 0.5 for depreciation of AUD = 3 marks)

ii) There is a decrease in interest rates in Australia while interest rates in the US increase.

· Lower interest rates in Australia relative to US interest rates will decrease foreign financial investment (financial investment in bonds, shares and bank deposits) in Australia;

· This will result in a decrease in demand for the AUD;

· The AUD will decrease in value and depreciate in the forex market (relative to the USD).

Note: alternate answer may refer or also include increase Australian financial investment in the US; this will increase the SAUD; also resulting in a depreciation of the AUD relative to the USD

(2 for explanation, 0.5 for identifying shift of AUD, 0.5 for depreciation of AUD = 3 marks)

iii) Currency speculators strongly believe that the AUD will increase in the future and at the same time higher incomes in Australia result in an increase in imports of goods and services.

· Currency speculators / traders believing the AUD will increase in value will buy the AUD.  This will increase demand for the AUD;

· An increase in demand for imports will increase the supply of the AUD.

· As a consequence of both these changes the change in the value of the AUD is ambiguous; it may rise, fall or stay the same.

(2.5 for identifying and explaining DAUD; 1 for SAUD, 0.5 for conclusion, 1 for diagram = 3 marks)

Question 3

i. If potential RGDP was $12.9 billion for 2012, is the economy facing a recessionary or inflationary gap?  What is the size of the gap?

GDP gap = 12.9 – 12.8 = $0.1 billion (or $100 million)

RECESSIONARY GAP – Potential RGDP > Actual RGDP

Recessionary gap = GDP gap / Ke

= 100 m / 2.5 = $40 million ……or $0.04 billion

ii. If the MPC for the economy is 0.6, how much government spending would be required to close the GDP Gap and in which direction?

G will have to increase by $40 million

>>>>>> Change in Y = change in G x Ke.   = $40 m x 2.5 = + $100 m

iii. If instead of using expenditure policy to close the GDP, the government decided to use tax policy, by how much will taxes need to change to close the GDP Gap and in which direction?

 Rec Gap = $100 m / Kt

= $100 / - 1.5 = - $66.67 m

Tax will have to decrease by $66.67 m

(2 + 1 + 2) = 5 marks 

(b) Assume the following information about the economy of Oceania.  The MPC = 0.75

i) Is the economy facing a recessionary gap or inflationary gap in 2017?  What is the size of the recessionary/inflationary gap? = GDP gap / Ke

RGDP is less than Potential RGDP; the economy is facing a recessionary gap.

The recessionnary gap = GDP gap / Ke.  If MPC = 0.75 then Ke = 4.

= $30 bill / 4 = $7.5 bill

ii) By how much will the government need to change its spending to close this economy’s GDP gap? 

Refer to part i) above.  The government will increase government expenditure by $7.5 billion.

(Note: if it decided to change the level of income tax revenues the govt will decrease income tax by the GDP gap / Kt = $30 b / -3 = - $10 billion.  Also note the decrease to tax in order to increase RGDP)

iii) If the government is successful in moving real GDP to its potential level in 2017, state and briefly explain whether each of the following will be higher, lower or the same as it would have been if they had taken no action:

If the government is successful in moving real GDP to its potential level in 2014, state and briefly explain whether each of the following will be higher, lower or the same as it would have been if they had taken no action:

-  Real GDP will INCREASE

-  Potential GDP will NOT CHANGE

-  The inflation rate will INCREASE

- The unemployment rate will DECREASE (as RGDP will move back to or equal Potential RGDP).

(2 + 1 + 2 = 5 marks)