ECON1102 MACROECONOMICS Tutorial test No.2
(i) Identify and briefly explain the main features of the business cycle. (2 marks) Business cycles are usually characterized by periods of transition from peak to trough and then from trough to peak. The peak of a business cycle is the high point of GDP prior to a downturn whereas a Trough is the low point economic activity prior to a recovery. The period in which the economy is moving from a peak to a trough is called a contraction and the period in which the economy is moving from a trough to peak is an Expansion.
(ii) Explain the concepts of (a) potential output and (b) the output gap. (3 marks) Potential Output (y*) or full employment output is the level of GDP an economy can produce when using its resources, such as labour and capital, at normal rates. This is not the same as maximum output. Potential output grows over time with growth in labour and capital and with growths in technology. At any point in time, the difference between the economy’s potential output and actual output is called the output gap (y - y*). A positive output gap, which occurs when actual output is higher than potential output and when resources are being utilised at above-normal rates, is called an expansionary gap. This is related to firms operating above normal capacity and can lead them to raise prices (inflationary). On the other hand, a negative output gap, which occurs when potential output exceeds actual output and when resources are not being utilised, is called a contractionary gap. This is related to capital and labour not being fully utilised (cost in terms of forgone output).
(iii) Explain the concept of Okun’s law. Discuss the implications of Okun law for policymakers. (5 marks) Okun’s law states that each extra percentage point of cyclical unemployment is associated with about a 1.6 percentage point (for Australia) increase in the output gap, measured in relation to potential output. The quantitative relationship is (y-y*)/y* = -B(u-u*). This describes how an additional percentage point of cyclical unemployment is associated with a B percentage point decline in the output gap. The output losses associated sustained in recessions, calculated according to Okun’s law, can be quite significant. Calculations using this relationship depict that output gaps and cyclical unemployment may have major costs. Therefore, we can conclude with the fact that the public and policymakers have concern in relation to contractions and recessions.
(i) Discuss the role played by fixed (or sticky) prices in the Keynesian model of income determination. Briefly explain what would happen if prices were fully flexible in the short run. (2 marks) New Keynesians assume prices and wages are fixed or sticky, meaning that they do not change easily or quickly with alterations in supply and demand, so that quantity adjustment prevails. When prices are sticky, higher aggregate demand raises production, and this raises incomes. If prices were fully flexible in the short run, economy’s resources would be fully employed and thereby the economy would return to the natural level of real GDP. Firms would stop producing when price is lower than production cost, so there would be less competition.
(ii) Explain the concept of Planned Aggregate Expenditure (PAE). How does PAE differ from Actual Expenditure? (2 marks) Planned Aggregate Expenditure is the total planned spending on final goods and services. In equilibrium, planned expenditure and actual expenditure must equal in the economy. The difference between planned and actual expenditure is unplanned inventory investment. When firms sell fewer products than planned, stocks of inventories increase. Because of this, actual expenditure can be above or below planned expenditure.
(iii) Use the Keynesian aggregate expenditure model and appropriate diagrams to explain the following:
- The paradox of...
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