Section A – use a Section A answer book

Answer ONE question

1       (a)     GDP per capita in Luxemburg is roughly 2.5 times the EU 28

average. Ireland’s GDP is over 1.8 times the EU 28 average   and Germany’s about 1.2.  The GDP per capita of the UK,      France and Italy are close to the EU average. What factors do we need to bear in mind in interpreting these statistics?

Answer:

To properly answer this question, we must consider the            difference between GDP and GNI. GDP includes the income of all the agents that contribute to production within a given          geographic location, irrespective of their residence and             nationality. GNI, on the contrary, considers the residence of     those that produce, irrespective of the geographic location in    which they contributed to production. GNI = GDP + incomes     earned abroad by resident entities and subtracting incomes      generated by non-resident entities with the country. Thus, GNI per capita offers a better idea of the standards of living of the   population in a country than GDP per capita does.

This distinction is particularly important as many of the workers in Luxembourg are not residents in the country: thus, a             significant portion of the income produce belongs to non-         residents. A similar issue applies to Ireland: Ireland hosts         multiple multinational firms whose profits belong to non-           residents.

In answering this question, you could also refer to differences in the price level and consumption per capita.

(b)     Imagine that the government decides to increase

unemployment benefits. How would this change both       government expenditures and consumption? Explain your answer.

Answer:

Unemployment benefits do not affect government                 expenditures. Unemployment benefits are not paid in           exchange for goods and services. They are a transfer. But   unemployment benefits might increase consumption as they are a transfer to those that have recently lost their jobs.

(70 marks)

(30 marks)

2       In 2003, the economists John T Addison and Paulino Teixeira                 (100 marks)

surveyed the early empirical literature studying the effects of             employment protection on employment (Addison, John T. and           Paulino Teixeira, “The Economics of Employment Protection,”           Journal of Labor Research, 2003, 24 (1), 85– 128.). Most of the         studies they surveyed pointed to a negative relation between             employment protection and employment. And some studies pointed  to a particularly negative relation between employment protection     and youth employment. Discuss these results in light of the effects of employment protection on the job separation and job finding              probabilities.

Answer:

Employment protection makes it costly for firms to fire the workers.    As a result, job separations tend to fall. At the same time, when         deciding to hire new workers, firms internalize the potential costs of a mismatch with a worker and how costly it would be to fire that            worker. As a result, if employment protection increases, firms would  likely open less vacancies leading to a drop in the ability of workers   to find new jobs. This simultaneous drop in job separation and job     finding probabilities has opposing effects in employment: lower job    separation tens to increase employment while lower job finding tends to decrease employment. The survey by Addison and Teixeira           suggests that the latter effect dominates the former one when            employment protection increases. This view is particularly consistent with the negative relation between employment protection and youth employment. Youth workers tend to be the outsiders: those that are  looking for jobs. On the contrary, older workers tend to be the            insiders: those already with a job. Given the drop in job separation, it is likely that older workers (insiders) can retain their jobs but it is        unlikely for younger workers (outsiders) to find jobs, leading to even  lower youth employment.

Section B – use a Section B answer book

Answer TWO questions

3       (a)    Assume that both government transfers and taxes increase

in the same amount and simultaneously there is a rise in    consumers’ confidence. Using the Keynesian Cross model, comment on the combined effect of all these disturbances  on output.

Answer:

In the Keynesian Cross model, a rise in government          transfers leads to more consumers’ disposable income     which, ceteris paribus, leads to more consumption. On the contrary, a rise in taxes reduces consumers’ disposable    income, which, ceteris paribus, leads to less consumption. They are the opposite of one another as both affect           disposable income (recall that T = taxes – government      transfers). Thus, if one increases and the other falls in the same amount, T is unchanged, and these two shocks do  not affect the economy.

We are left with the increase in consumers’ confidence. This increases autonomous expenditures, which leads to more    planned expenditure and, thus, more output in the                Keynesian Cross.

It would be important for you to add a diagram showing a shift upwards in the Desired demand (Z) line.

(b)     Using the IS-TR model, contrast the effect on output of an

increase in taxes when the economy is and is not on the zero lower bound.

Answer:

This question asks you to contrast the effects of             contractionary fiscal policy in two different contexts: zero lower bound and ‘normal’ conditions.

The zero lower bound applies when nominal interest rates are already at or close to zero. As agents would not accept an interest rate below zero, the interest rate cannot fall       further, and the Taylor rule is bounded. Thus, the TR curve is in fact horizontal in this case (at least for a certain range of output). On the contrary, in ‘normal’ conditions, the TR   curve is upward sloping.

The best way for you to show the consequences of the         contractionary fiscal policy would be to plot the two TR         curves (one upward sloping and another horizontal close to i=0). Then you plot two parallel IS curves, in which IS2 (after the contractionary fiscal policy) is to the left of the initial IS    curve. Then you contrast the intersections with the TR          curves. You should see that the fall in output is higher when the TR curve is horizontal. Intuitively, this follows from the    lack of crowding-out when the TR curve is horizontal. This   crowding-out is beneficial when there is a shift to the left in   the IS curve because the fall in the interest rate reduces the total fall in output. That, however, does not occur when the   TR curve is horizontal.

(50 marks)

(50 marks)

4       The OECD reported a drop in the average business confidence index in OECD countries in 2018. Using appropriate diagrams, answer the following questions.

(a)    Would the drop in business confidence have different

effects on output in the context of the IS-LM and AD-AS models in the short run?

Answer:

Yes, it would have. In both cases, a reduction in business    confidence leads to less investment. This corresponds to a  shift to the left in the IS curve, implying a shift to the left in    the AD curve. In the IS-LM, the fall in output is cushioned by the fall in the interest rate. But in the AD-AS model, the fall  in output is cushioned by both the fall in the interest rate      and the subsequent fall in prices as firms react to lower        demand by reducing prices. Thus, the fall in output is higher in the IS-LM than in the AD-AS model as the former             assumes prices to be fixed.

You would have to complement your analysis with two      diagrams, which should show how different is the reaction of output to the shock in the two models.

(b)    Would the drop in business confidence have different

effects on output in the short run and long run? In

answering this question, use the AD-AS model.

Answer:

Under classical assumptions, the fall in business confidence has no effect on potential (natural) output. Thus, in the long- run, output will revert to potential as firms start reacting to    lower marginal costs by gradually reducing prices. As firms  reduce prices and there is deflation, aggregate demand       increases (there is a movement along the AD curve) until     output reaches potential.

Again, you would have to use at least one diagram to complement your answer.

(60 marks)

(40 marks)