EC2013 SEMESTER 2

INTERMEDIATE MACROECONOMICS

TUTORIAL 1: THE DEMAND SIDE

Please prepare your answers in advance of the tutorial.

1. What is the IS curve? Why does it slope downwards?

2. Explain what happens to the IS curve when there is (i) an increase in autonomous consumption (ii) a reduction in the interest sensitivity of investment (iii) an increase in the marginal rate of taxation.

3. Use the Keynesian cross to show the effect of a decrease in autonomous investment on the economy. Discuss the path of the economy as it adjusts to the new medium-run equilibrium. Why does the economy not continue to contract?

4. Use the Keynesian cross to illustrate the paradox of thrift. Model the change in savings behaviour as an increase in the marginal propensity to save, s1 (remember that c1 + s1 = 1). Show how a rise in investment can counteract the reduction in output associated with the rise in savings.

5. According to the permanent income hypothesis, how will the paths of borrowing and consumption change in response to:

(a) A temporary decrease in income when it occurs.

(b) A permanent decrease in income when it occurs.

(c) Are the answers different if the changes in income are unanticipated, i.e. if they are ‘news’?

Comment on the size of the marginal propensity to consume and the size of the multiplier.

6. Assuming the real interest rate is 4 per cent, calculate how, according to the PIH, consumption and borrowing would change in each of the following cases

(a) A stock market crash permanently reduces the value of an individual’s assets by 1,000.

(b) Households are told that in a year’s time, they will receive a one-off bonus of 1000. Then in one year’s time, it is not paid.

(c) Comment briefly on your results.

7. Explain the concepts of excess sensitivity and excess smoothness that arise from the empirical literature on the permanent income hypothesis. What could explain these findings?

8. What does Tobin’s q tell us firms’ investment decisions depend upon? According to Tobin’s q, when should a firm invest?

9. What is the key problem with measuring marginal q? Is there an alternative measurement that can be used instead? Is this alternative measurement likely to be an accurate proxy for marginal q?