ECS1601/204/1/2016

Tutorial Letter 204/1/2016

Economics 1B

ECS1601
Semester 1
Department of Economics

IMPORTANT INFORMATION:
This tutorial letter contains a discussion of the
answers to Assignment 04.

Open Rubric

CONTENTS
1

DISCUSSION OF ASSIGNMENT 04/2016 .......................................................................................... 3

ECS1601/204
Dear Student
This tutorial letter contains the answers to the multiple-choice questions in Assignment 04, with brief
explanations where necessary. In most cases, however, we merely refer you to the prescribed textbook
and/or the study guide. If you have any questions about the answers that are provided, please discuss
them with your fellow students and your e-tutor on the e-tutor website.
All official study material sent out by the University is also available on the internet on the ECS1601 website
on myUnisa. Make sure you visit this website.
By now, you should also have been allocated to an e-tutor website (ECS1601-15-S1-XE). The X indicates
your particular e-tutor group. For example, if you are in e-tutor group 3, your e-tutor group website is
ECS1601-15-S1-3E. This e-tutor group is your learning community. You are grouped with one e-tutor and
200 fellow students and this is where you should communicate, discuss and learn from one another. Your
e-tutor provides a weekly set of slides to guide you through the learning material for that week. A quiz with
questions on the work that you should study for that week will also be provided. Discussing this with fellow
students will be a worthwhile experience from which you should benefit tremendously. Your e-tutor will
guide you to make sure that you really understand the work. Be sure to make use of this exciting
opportunity that we provide to you.
Remember that the examination is in May not too far in the future. Try to adhere to the study programme
provided in Tutorial Letter 101.
1

DISCUSSION OF ASSIGNMENT 04/2016

All references, unless otherwise indicated, are to the prescribed textbook: Mohr, P & Associates.
2015. Economics for South African students. 5th edition. Pretoria: Van Schaik.

4.1

Option [3] is correct.

An increase in the expected inflation by households will imply that they will buy as much as possible
today before inflation rises, hence consumption will increase instantaneously, which will shift the AD
curve rightward. All the other options such as an increase in saving rates, will lead to a leftward shift
of AD curve. See section 19.1, pages 362 and 363, in the subsection about the position of the AD
curve.

4.2

Option [4] is correct.

Statement (a) is incorrect Improved technology decreases production costs and the AS curve shifts
downwards. Political stability might attract investment and the change in investment will lead to a
change in aggregate demand. Statement (b) is correct because a boom in China will imply more
investments between China and South Africa, and even a change in net exports, which can move the
AD curve to the right. Statement (c) is correct since depreciation of local currency implies cheaper
exports and more expensive imports, which will increase exports and decrease imports so that net
exports increase, which is illustrated with a rightward shift of the AD curve.

4.3

Option [4] is correct.

An adverse supply shock will raise inflation and lower production; this can only be remedied by an
anti-inflationary incomes policy. Options [1] and [3] are incorrect because expansionary fiscal and
contractionary monetary policies can increase production by increasing aggregate demand, but this
will also increase the price level. Similarly, contractionary policy will decrease demand and thus
decrease the price level, but it will also decrease the level of production and income. To address both
the decline in income and the increase in the inflation, an anti-inflationary incomes policy may be
used, which balances growth in income and growth in productivity. See section 19.1 on page 366.

4.4

Option [2] is correct.

Only the wealth effect, interest rate effect and the international trade effect are responsible for the
slope of the AD curve (see section 19.1 on page 361). The substitution effect refers to the effect of a
change in the price of one good on the quantity demanded of another good that is a substitute for the
good. You learned about this in ECS1501 (see box 4-2 on page 71). It does not affect the slope of the
AD curve as it does not affect aggregate demand, but demand for specific goods.

4.5

Option [2] is correct.

The money stock and interest rates are fixed in the Keynesian model, but are variable in the
AD-AS model. Option [1] is incorrect, because prices are only fixed in the Keynesian model. Option
[3] is incorrect because interest rates are flexible in the AD-AS model, but not in the Keynesian
model. Option [4] is incorrect because it is only in Keynesian model where demand is the driving force
of economic activity and supply adjust passively. In the AD-AS model, the level of economic activity is
determined by the interaction of aggregate demand and aggregate supply. Option [5] is incorrect
because wages are fixed in the Keynesian model, but can vary in the AD-AS model. See box 19-1 on
page 360.

4.6

Option [1] is correct.

Statement (a) is correct because expansionary monetary policy, which implies a decrease in interest
rates, will lead to an increase in investment that will also lead to an increase in aggregate demand.
This can be illustrated by a rightward shift of the AD curve. Statement (b) is incorrect because a
contractionary fiscal policy, that is a decrease in government expenditure and/or an increase in tax,
will result in a leftward shift of the AD curve. Statement (c) is incorrect, as demand management
policy where taxes are increased results in a leftward shift of the AD curve as the decrease in
disposable income will result in a decrease in induced consumption. See table 19-1 on page 363.

4.7

Option [4] is correct.

Statement (a) is correct because increased productivity means more production with the same
amount of inputs and thus a rightward shift of the AS curve. An increase in production costs means
that it is now more expensive to produce the same amount of output, hence the leftward shift of the
AS curve. Statement (b) is also correct. Improved weather conditions will shift the AS curve
downwards or to the right as more output can be produced at the same cost, while lowered
productivity will cause the AS curve to shift upwards or to the left, as less output can then be
produced at the same cost. Statement (c) is incorrect because an increase in oil prices increases
production cost and thus the AS curve will shift leftwards. A wage reduction means that production is
now less expensive and thus the AS curve will shift rightwards. See table 19-2 on page 364.

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4.8

Option [1] is correct.

Statement (a) is correct. Investment forms part of autonomous expenditure and therefore a change in
investment will lead to an equal change in autonomous expenditure. This change in autonomous
expenditure leads to a greater change in level of output owing to the multiplier effect. Therefore,
statement (b) is incorrect. Statement (c) is incorrect because the fact that prices and wages are fixed
does not prohibit the multiplier effect. The multiplier effect is the result of induced consumption.

4.9

Option [4] is correct.

An increase in investment will result in an increase in aggregate demand. The increase in aggregate
demand stimulates an increase in production and thus in income, but also results in an increase in
the price level. A decrease in investment will decrease aggregate demand, income and the price
level. Therefore, options [1] and [3] are incorrect and [4] is correct. Option [2] is also incorrect. As
shown in figure 19-7, the increase in income will be smaller in the AD-AS model because prices also
change owing to the increased demand.

4.10 Option [3] is correct.

A decrease in the interest rate will increase investment, as more investment projects become viable
at the lower interest rate level. The increase in investment stimulates an increase in demand and
therefore in production, which increases income. The increase in income stimulates an increase in
consumption, which results in further increases in production and income. As production is increased,
it becomes more expensive to produce and therefore the price level also increases. Therefore options
(b), (c) and (e) are correct and the correct alternative is [3]. See section 19.2 on page 370 and 371.
4.11 Option [1] is correct.
If the investment function (see figure 17-3) is relatively inelastic, it means that a given change in the
interest rate has a relatively small effect on investment, and therefore on aggregate demand.
Monetary policy, which works via the interest rate, will therefore not be very effective to stimulate the
economy. Fiscal policy, which increases government expenditure directly, will therefore be more
effective to increase aggregate demand and thus stimulate the economy. As explained in section 19.3
where the relative effectiveness of monetary and fiscal policy is discussed, fiscal policy is generally
more effective to stimulate a depressed economy. Therefore, option [2] is not correct. Options [3] and
[4] are not correct as contractionary policy is used to dampen economic activity and not to stimulate a
depressed economy.
4.12 Option [3] is correct.
At YB the balance of payments is in equilibrium (exports is equal to imports). When the income level
increases, induced imports will increase while exports (which are autonomous) stay the same.
Therefore, an increase in income implies that imports exceed exports and that the balance of
payments deficit increases. As Y0 lies to the right of YB, there will be a current account deficit.
At Yf there will be full employment. At income level lower than Yf there will be unemployment.
Therefore, as Y0 is at an income level lower than Yf, there is unemployment at this level of income.
To increase income to levels closer to full employment, it is necessary to stimulate demand, that is, to
use expansionary policy. This will, however, increase the balance of payments deficit, as explained
5

above. Therefore, a policy dilemma exists at Y0 one economic problem (unemployment) can only be
solved by worsening another (the balance of payments deficit).
See section 19.3 and figure 19-10 on page 375.
4.13 Option [1] is correct.
The situation could be improved if expansionary demand management policies could be combined
with an inflow of foreign capital, as the inflow would make the deficit on the current account
affordable. Option [2] is incorrect because neutral policy measures imply monetary or fiscal policies
that have no effect on production and unemployment. Option [3] is incorrect because incomes
policies are used as constraints on wages and prices, and shift the AS curve downwards to the right
(see section 21.2). Therefore, such policy may decrease unemployment, but will increase the balance
of payment deficit as imports increase when the income level increases. Option [4] is incorrect since,
as explained above, there are policy measures which can improve the situation. See page 374.
4.14 Option [1] is correct.
By definition, inflation is a continuous and considerable rise in general prices. Option [2] is incorrect
because it a once-off increase in the price level is not inflation. Option [3] is incorrect since a small
increase in general prices is not inflation; it has to be a considerable increase. Option [4] is incorrect
since an increase in the price of one commodity is not inflation. Note, however, that such an increase
that influences all other prices may start an inflationary impulse. See the definition of inflation in
section 20.1 on page 382.
4.15 Option [2] is correct.
To calculate the inflation rate for 2014 using the available information:
First find the average for each year by adding the indexes for each month and dividing by 12:

Month

January
February
March
April
May
June
July
August
September
October
November
December
Total for each year
Average for each year
(Total for each year / 12)
6

Consumer price index

December 2012 = 100
2013
100,3
101,3
102,5
102,9
102,6
102,9
104,0
104,3
104,8
105,0
105,1
105,4
1 241,1

2014
105,4
106,3
107,0
107,8
107,8
108,1
109,2
109,5
109,9
110,3
110,8
110,9
1 303,0

103,425

108,583

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To calculate the inflation rate on an annual average basis for 2014:
2014 =

4.16 Option [4] is correct.

(2014) (2013)

(2013)

100 =

108,583 103,425

103,425

To calculate the implicit GDP deflator for each year, you do the following:

=
100

For 2012: (2012) =
For 2013: (2013) =

(2012)

(2012)
(2013)

(2013)

100 =
100 =

2 799 874
2 300 745
2 988 411
2 410 383

100 = 4,99%.

100 = 121,69
100 = 123,98

To calculate the inflation rate:

2013 =

4.17 Option [2] is correct.

(2013) (2012)

(2012)

2,29

121,69

100 =

123,98 121,69

121,69

100

100 = 1,88%.

Statement (a) is incorrect since it suggests that inflation distributes wealth from the young to the
elderly, which is not true; the opposite is true. Because younger people are more likely to be
borrowers while older people are more likely to have fixed nominal incomes, inflation results in wealth
being distributed from the elderly to the young. Statement (b) is correct since the government is
always a debtor and inflation benefits debtors at the expense of lenders. Bracket creeping will also
benefit the government. Statement (c) is incorrect because the rich have surplus funds, which can be
invested in high interest bearing assets during inflationary periods, while the poor usually spend their
total income and can therefore not hedge themselves against inflation by investing in assets that
provide a higher return than the inflation rate. See section 20.3 on pages 384 to 387.
4.18 Option [3] is correct.
A reduction in interest rates implies an increase in investment, which thus increases aggregate
demand and is illustrated by a rightward shift of AD curve. This can therefore be classified as a
demand-pull factor and will increase production, income and employment.
4.19 Option [2] is correct.
An upward or leftward shift of the AS curve (adverse shock) illustrates cost-push inflation, and results
in a decrease in production, income and employment (see figure 20-2). This combination of high
inflation and unemployment is referred to as stagflation (see section 20-4). Hyperinflation refers to
very high interest rates. As explained in section 20.3 and box 20-3, hyperinflation is a process were
both the aggregate demand curve and the aggregate supply curve keep on moving upwards, due to
expectations of high inflation rates.

4.20 Option [1] is correct.

Statement (a) is correct since it is the strict definition of unemployment (see section 21.1). Statement
(b) is incorrect because the broad definition includes persons who have the mere desire to find work,
which implies it includes discouraged workers. Statement (c) is incorrect because there is a difference
between the strict and broad definitions of unemployment.
4.21 Option [2] is correct.
Thabo resigned and is unemployed because he is currently looking for a better job. This forms part of
frictional unemployment. Thato is employed each year for four months, which implies that when he is
not working, he is seasonally unemployed. Thabos mother lost her job due to a recession, which
implies she is cyclically unemployed. See box 21-1 on page 403.
4.22 Option [4] is correct.
An increase in the demand for exports will increase aggregate demand, which can increase
production, income and therefore also employment. Option [1] is incorrect. A reduction in the labour
intensity of production implies that production becomes more capital intensive, implying that less
labour will be needed and that unemployment may therefore increase. Options [2] and [3] are
incorrect since increased immigration and increased population growth implies more people
competing for the same job, and this will therefore not decrease unemployment. Option [5] is incorrect
because a decrease in government spending might mean that some person in the government sector
loses his or job, which will increase unemployment. A decrease in government spending may also
decrease aggregate demand, and thus decrease production and income, which will cause an
increase in unemployment. See section 21.1 for a discussion of the policies that may reduce
employment.
4.23 Option [3] is correct.
The expanded definition of unemployment (as also explained in the textbook in section 21.1) regards
any person who has a desire to find employment as unemployed, even if that person has become
discouraged and has stopped looking for a job. Therefore, it will include more persons in the pool of
unemployed persons than the strict definition (which is used as the official rate). Statement [1] is not
correct. In the report it is stated that, according to the strict definition, unemployment increased from
20% to 24,7% this is an increase in unemployment of 4,7 percentage points, not 60%. Statement [2]
is therefore also incorrect although unemployment did not increase by 60%, it has increased.
Statement [4] is incorrect. In 2013, the unemployment rate based on the expanded definition was
35,6% while it was 31,5% in 1994, thus an increase of 4,1 percentage points from 1994 to 2013. As
these figures point to an increase in the unemployment rate, statement [5] is also incorrect.
4.24 Option [1] is correct.
The Phillips curve suggests that unemployment and inflation could be traded off against each other,
that is, a lower inflation rate could be achieved at the expense of a higher unemployment rate, and a
lower unemployment rate could be achieved at the expense of a higher inflation rate. Therefore,
options [2] and [3] are incorrect. Option [4] is incorrect an increase in demand will most likely lead to
an increase in inflation and a decrease in unemployment. Therefore, although inflation and
unemployment are not affected in the same direction by a change in aggregate demand, both figures
are affected by the change in aggregate demand. This is exactly what the Phillips curve illustrates.

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4.25 Option [1] is correct.
This phenomenon of higher inflation and higher unemployment is referred to as stagflation and it is
caused by the same factors that cause a leftward shift of the AS curve (see figure 21-3). These
factors are listed in table 19-2. Alternatives [2] to [5] will all cause a rightward shift of the AS curve,
and thus a leftward shift of the Phillips curve. Increases in wages are, however, one of the factors that
will cause a leftward shift of the AS curve, thus causing a rightward shift of the Phillips curve.
Therefore, statement [1] is correct.
4.26 The correct option is [2].
Stagflation is described in the discussion of the previous question. Hyperinflation refers to a situation
where there are extreme and rapid increases in general prices, occasionally caused by non-prudent
monetary policies or political factors. Therefore, option [1] is incorrect. Option [3] is incorrect since
demand-pull inflation results in higher levels of production, that is, a decrease in unemployment.
Option [4] is incorrect since inflation targeting is a policy designed to bring inflation under control
within a specified (usually lower) range.
4.27 Option [1] is correct.
A complete business cycle includes a trough, an upswing, a peak and a downswing (see figure 22-1).
Option [2] only has a trough and an upswing, which is an incomplete cycle. Option [3] has a peak and
a recession only, which also shows an incomplete cycle. Option [4] also includes only a trough and a
peak, which is impossible as a peak cannot be reached without an upswing phase. Option [5] is
incorrect as a complete cycle also includes a downswing, or recession, and therefore a trough has to
be reached before an upswing can begin.
4.28 Option [2] is correct.
As indicated in section 22.3, an increase in the capital stock can come about owing to capital
widening and/or capital deepening. Capital deepening refers to the situation when the amount of
capital per labourer is increased, while capital widening refers to the situation when the capital stock
is increased to accommodate an increasing labour force. Therefore, both statements [3] and [4] are
incorrect. Statement [1] is incorrect as (as stated in the textbook) capital refers to the manufactured
means of production, such as buildings, machinery, equipment and roads.
4.29 Option [5] is correct.
All other options are supply side factors (see the discussion in section 22.3), but exports affect
demand.
4.30 Option [5] is correct.
All the other factors mentioned are supply factors that may influence economic growth. However,
export is a demand factor because an increase in exports implies that there is increased production in
the domestic economy. The increase in production will lead to economic growth and relieve the
balance of payments since net exports, (X-Z) are part of it (see section 22.3).

We wish you all the best with your studies!

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