Examiners' Commentaries 2016: EC1002 Introduction To Economics

Examiners commentaries 2016

EC1002 Introduction to economics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201516. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading

references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of this course and having completed the Essential reading and activities, you should be
able to:
define the main concepts and describe the models and methods used in economic analysis
formulate problems described in everyday language in the language of economic modelling
apply and use the main economic models used in economic analysis to solve these problems
assess the potential and limitations of the models and methods used in economic analysis.
Overview
This year was the third year in which we used the new format of examination where Part I which is
made up of multiple choice questions (MCQs) and covers the entire syllabus, constitutes 50% of the
total mark while Parts II and III contain the longer questions in microeconomics and
macroeconomics, respectively. There was a significant improvement in candidates performance in
this years examination and the overall pass rate increased to 66%. This is very good news which
reflects an improvement both in the MCQ section and, by implication, the coverage of the course
material, and in answering the long questions which requires a much higher level of understanding of
the material. The mean mark on the MCQ section (as a percentage of its 50% weight in the overall
examination) increased in Zone A from 53.8% to 57%. It suggests to us that there is greater
commitment to the entire syllabus and fewer candidates decide to drop parts of the syllabus. Given
that the performance on the MCQ steadily improved (the mean mark in the first year was 49.8%),
we also conclude that candidates are becoming more comfortable with this way of testing.
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General advice
You may want to consider now your study process in stages. Firstly, you must understand each
section of the material as is presented in the basic textbooks. Secondly, you must study the subject
guide. If you manage to work your way through it, you are bound to have properly understood that
which is in the textbook. Last, but not least, you should try to answer questions from the self-study
sections in the subject guide as well as from past examination papers all by yourself, without looking
at the provided answers. Once you have done this, you should carefully compare your answer with
the provided answer in the subject guide and the Examiners commentaries. Always try to
reproduce the full and correct answer by yourself.
It was very clear from the examination scripts that those who failed could not have properly gone
through the first phase of the study process. At the same time, it was abundantly clear that the
candidates who have done well have followed all three stages of the study process. It was clear that
they were familiar with the subject guide as well as with previous years Examiners commentaries
and that their analytical skills have been considerably enhanced in the process. Consequently, it
seems that those who have done well, have done really well.
A possible explanation to candidates failure in absorbing the subject guide at the basic descriptive
level could be the false perception of its mathematical nature. There is, in fact, very little
mathematics in the subject guide and those issues, which are essential to the understanding of the
subject guides exposition, are discussed at length in the mathematical preface. Please make sure
that you read it carefully before you embark on the study of economics.
There is, we are afraid, no way around it. Economics is an abstract discipline and as such it requires
the use of logical tools. Without these tools, our ability to make sense of the vast complex world of
social interactions is considerably reduced. For the very same reason a candidate is required to take
a quantitative paper in his, or her, first year, he, or she, must have a reasonable command of those
very basic tools, which lie at the foundation of human knowledge.
This, of course, should not be misread as a call for mathematical competence. Of course, things
would be easier had we all had good mathematical skills. Given that most people do not have these
skills, we must be sure not to abandon mathematical tools altogether. It is important that candidates
recognise that the subject guides exposition is using very basic mathematical tools, all of which are
within anyones grasp. Instead of being stifled by fear, one should recognise that candidates without
any mathematical background could meet our requirements fairly quickly. A bit more effort on this
front will guarantee that at least the descriptive standards of the course will be met.
You might have noticed that in recent years the course became much more focused. This means that
instead of getting acquainted with a little bit of a lot of things, we now wish that you gain some
command on fewer things. The key difference here is between getting acquainted and gaining
command. For the former, one normally needs to know about economic concepts. Now, we want
candidates to know the concepts.
The essay-type or discursive writing is a method of exposition becoming the getting acquainted
approach. In such a format, one tends to write about things and to describe them. For the other
approach the active understanding approach one would need to resort to a more analytical form
of discourse. A form of discourse where the candidate is making a point or, to use a more
traditional word from rhetoric, where one is trying to persuade.
To think about writing in this way will help a great deal. It forces the candidate first to establish
what it is that he, or she, wishes to say. Once this has been established, the writer must find a way
of arguing the point. To make a point, as one may put it, basically means to know the answer to
the question before one starts writing. It is the impression of the examiners that many candidates
try to answer the question while writing. A question normally triggers a memory of something which
one had read in the textbook. It somehow opens the floodgates and candidates tend to write about
the subject everything they know with little reference to what the question is really about. This is
not what this course is all about. We want the candidate to identify the tools of analysis which are
relevant in each question; we want him, or her, to show us that they know what these tools are; and,
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lastly, we want candidates to be able to use the tools.
Examination questions, in this course, are written in a problem form which then requires that the
candidate will be able to establish which framework of analysis is more appropriate to deal with
different problems. In their exposition, candidates are then expected to properly present this
framework. Only then are they expected to solve the problem within this framework. All of these
are now clearly marked in the breaking up of each question into sub-questions. Although some
questions may have a general appeal, we do not seek general answers. You must think of the
examination as an exercise rather than a survey.
Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons. The Examiners commentaries suggest ways of
addressing common problems and improving your performance. One particular failing is question
spotting, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but you
need to be aware that the examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet in the section of the VLE dedicated to
each course. You should read the syllabus carefully and ensure that you cover sufficient material in
preparation for the examination. Examiners will vary the topics and questions from year to year and
may well set questions that have not appeared in past papers. Examination papers may legitimately
include questions on any topic in the syllabus. So, although past papers can be helpful during your
revision, you cannot assume that topics or specific questions that have come up in past examinations
will occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.
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Important note

references
section.
Comments on specific questions Zone A
Part B Microeconomics
Question 1
The government considers ways in which to reduce the use of roads. Currently,
people pay a lump-sum tax per period for the right to use the roads and there is no
limit on how much they can use the roads except the running costs of using a car.
The new proposal is to replace this system with a lower lump sum tax which will
allow for up to x
miles to be driven per period without additional tax. For every
additional mile, car users will have to pay a tax of t on top of the running costs.
Suppose that x measures mileage and the price of x is the price of using a car per
mile. Let y represent all other goods.
(a) Describe, using a diagram, the initial set-up and what would be the choice of
mileage by a typical individual.
(b) How would the new proposal affect the budget constraint, which the individual
is facing?
(c) Could the government achieve its objective (reducing the use of cars) without
affecting the well-being of the individual?
(d) Could individuals end-up driving more? If so, does this mean that the use of
cars is an inferior good?
Approaching the question
In this question, candidates were expected to demonstrate their understanding of consumer

choice. The story here is quite simple. The government wishes to reduce the use of cars on the
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roads. The initial situation is that people pay a lump-sum tax T (a form of a road tax) which is
independent of how much they use their car. The government proposes a change according to
which the lump-sum tax will be lower and will allow the use of up to x miles without additional
costs. However, if someone drives beyond that, there will be an additional tax of t for each
additional mile. There are running costs incurred by using the car which are given by p0x per mile.
(a) The initial set-up is as follows. We assume two goods, x, which measures the use of cars in
terms of mileage, and y, all other goods. The initial tax is T and initial prices are p0x and p0y ,
respectively.
(b) How would the change affect the budget constraint facing the individual? The new level of
lump-sum tax is now Tb < T and beyond x , the price of a mile is now p1x = p0x + t. There is
no change in the price of y. Therefore, the new budget line will be as shown below.
5
As the lump-sum tax has been reduced, the intercept with the y-axis will be at a higher
level of y. Up to x
the individual pays the same price as before for each mile used, so the
new heavy line is parallel. From x the individual will pay more for each mile and, therefore,
the slope is steeper. The intercept with the x-axis contains the x
miles plus the additional
miles which can be bought, at the new price, after paying the new lower lump-sum tax.
(c) Can the government achieve its objectives, i.e. reduced car use, without affecting the
well-being of individuals? The answer is, of course, yes, but it depends on the level of the
new lump-sum tax, the mileage allowance under the initial tax and the tax levied per mile
beyond that point. A situation where the levels are such that the government achieves its
objective is given in the following diagram.
If the individual was initially at A using his, or her, car for x0 miles per period, they will
now move to point B where they are at the same level of well-being, but where they use
their car much less, x1 < x0 .
(d) Is it possible that the policy will trigger an increase in the use of cars and would this mean
that the use of cars is an inferior good? To answer this question we have to consider two
possible situations.
The first is when the individual is normally using the car beyond the allowance of x

permitted without extra penalty under the new lump-sum tax. If they do, it means that
they are in the domain where the cost of an extra mile has now gone up. Therefore, we face
the following possibility.
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In general, it is easy to see that as the new budget line is beyond the individuals initial level
of consumption, he, or she, is likely to be made better off. It means that they experience an
increase in their real income which could lead to an increased use of the car without the
latter being an inferior good. As at A the individual is using his car beyond the allowance,
the price of the last mile has now changed. The substitution effect will take us to point C,
from where it is easy to see that the income effect will lead to an increase in demand for car
use and that it is a normal good.
The other possibility is that the individual is using the car below the allowance. This means
that effectively he, or she, is only exposed to an income effect. As income has increased,
using the car more is consistent with the good being normal.
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Question 2
A local competitive industry is supplied by local producers and by international

suppliers. The international supply is perfectly elastic. Due to fall in rents, the fixed
costs facing the local industry have fallen.
(a) Show the initial long-run equilibrium in the market. Identify the equilibrium
price, quantity, imports and local production.
(b) What will be the effect of the change on the cost functions of a representative
firm?
(c) What will happen, in the short-run, to the equilibrium price, quantity, imports
and the number of firms in the industry?
(d) What will happen in the long-run? Will there be any spillover effects on other
industries?
In this question we examine a competitive industry which faces international competition. We

assume the industry to be sufficiently small so that international supply is perfectly elastic: what
happens locally would not change the international price of the good.
The fall in local rents paid only by local producers will lead to a fall in the fixed costs which local
firms face. This is an equivalent story to a lump-sum subsidy.
(a) The initial set-up:
Local production is x0L and imports are given by x0 x0L .

(b) & (c) The effect of the change on a representative local firm will be a shift downwards of the
average cost schedule:
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We start at point A which is the initial equilibrium. Local firms supply x0L units of the good
(point A) and the rest of the market is supplied by foreign firms (imports).
A fall in fixed costs would only affect average costs, not marginal costs. A saving of dF
would reduce average costs by dF/x. Hence, for very few units of x, dF/x would be large
but as the number x increases, dF/x becomes smaller. Therefore, the new average cost
schedule would be further below the old one at lower levels of output. As we produce more,
the average gain is reduced. As decisions about quantities depend only on marginal costs,
there will be no short-run effect other than that the profits (shaded area) which firms will
now be making will have increased.
(d) The long-run effects: As firms make profits above the normal this will draw capital into the
industry and there will be an increase in the local supply of the good.
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As firms enter the industry, the supply schedule will shift to the right, therefore reducing the
amount of imports. On the face of it, this process can go on forever as what normally
restores long-run equilibrium is the corresponding fall in the price which erodes profits and
stops entry. Here, the price is given (openness) and this means that the equilibrium must be
restored by other means. Indeed, as supply increases and the flow of firms into the industry
increases, demand for labour (or capital, or both) will necessarily increase. At one stage, the
industry would become sufficiently large to have an impact on the local factor markets and
cause an increase in wages and/or returns to capital. This will shift the new average costs
function (AC dF/x) upwards so, in contrast to our earlier case, the marginal cost schedule
will shift upwards. The process will end at a point like B where profits are once again at
their normal rate.
Where exactly this process will terminate is unclear. In the above diagram it will grind to a
halt at point B and, therefore, reduce imports. However, it could have gone further:
As local production increases it will reach point B, which now reflects the intersection
between the local supply and international demand schedules. At this point, the industry
will be exporting the difference between point B and local demand at the international price.
In terms of the spill-over to other groups in society, it is clear that the consumer surplus of
the buyers of x would not be affected by the policy. However, the increase in wages which
would result from the control of local land prices suggests that the policy will filter through
to benefit all workers and owners of capital. In this sense, in spite of the fact that the direct
effect of the control was beneficial to firms, the long-run profits of the firm would be
unaffected but its stakeholders would all benefit from it as would other members of society.
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Question 3
A famous art gallery faces demand from locals, who are not willing to pay above a
certain price and whose price elasticity is high. There is also a demand from tourists
whose maximum demand price is much higher than that for locals and whose price
elasticity is much lower. Suppose too that the marginal cost of a visit is constant.
(a) Derive the demand curve facing the art gallery.

(b) Derive the marginal revenue that the art gallery will face.
(c) What would be the equilibrium price and would both locals and tourists visit
the gallery? What would be the inefficiency created in the market in each case?
(d) What are the conditions under which the marginal cost intersects with the
marginal revenue of the locals and yet, the gallery will choose to price them out
of the market?
This is a question about a monopolist who is facing a demand from two distinct groups of
consumers: tourists who are willing to pay a high price and have a low price elasticity of demand
(as the cost of visiting the museum on another occasion is very high), and locals who are not
willing to pay beyond a certain price level, say p, and whose price elasticity of demand will be
much greater (they can wait for the opportune moment to visit the museum).
(a) The demand facing the monopolist:
(b) Therefore, the marginal revenue schedule will be:
Recall that the Marginal Revenue Function is given by:

1
MR = p(x) 1 .
|xp |
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This means that the lower is the price elasticity, the lower will be the marginal revenue
schedule at any given x. The diagrams on the left and in the middle try to capture this.
One should bear in mind that with linear demands, the price elasticity will constantly
change. The reason we drew a linear demand is just for ease of exposition. The main point
to observe is that in the right-hand diagram, the marginal revenue to the left of the kink will
be the same as that of the tourists, but once the demand is made up of the two groups the
price elasticity will be greater than the price elasticity of the tourists but smaller than the
price elasticity of the locals (depending on the relative size of each group).
(c) The equilibrium price:
The question raises two issues: (i.) the equilibrium price and quantity (and, subsequently,
the deadweight loss), and (ii.) whether the two groups of consumers will visit the gallery. In
principle, we must draw a distinction here between the case where the monopolist (the art
gallery) can discriminate between the two groups and that where it cannot.
We begin with the easy case when the art gallery can discriminate between the two groups:
When the monopolist can discriminate, he would want each group of agents to pay a price
which enables aggregate profits to be maximised. By equating the marginal cost to the
marginal revenue of each group separately, the monopolist can charge them different prices.
The total profit is given by the sum of the areas between the marginal revenue and the
marginal cost schedules, less any fixed costs, in the above diagrams.
If the art gallery cannot discriminate, then there are three possible situations as illustrated
below:
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In this case, the marginal cost schedule intersects the marginal revenue schedule (which the
art gallery faces) only once. At this point, it only intersects the marginal revenue schedule
of the tourists, and it will charge the tourists their maximum willingness to pay, which is
given at point A. Would the monopolist be willing to allow more entry to the gallery? We
can clearly see that as x increases, the willingness to pay falls. The marginal cost of every
additional unit will be greater than the marginal revenue which means that the monopolist
will see a fall in profits with every additional entry.
From the point of view of the competitive benchmark, the inefficiency created by the
monopolist will be the yellow area up to the point where price equals the marginal cost
which is, of course, the efficient outcome.
The second and the third case arise when the marginal cost intersects both marginal revenue
curves:
In terms of profit maximisation, both A and B satisfy the profit-maximising principle of

being at a point where marginal cost equals marginal revenue. The question is whether the
art gallery will choose to be at B and charge the price of p1 , which means that both tourists
and locals visit the gallery, or would they choose to be at A and charge p0 , which means
that only tourists will visit the gallery (this is the subject of part (d) of the question).
At this stage, we will look first at the choice of being at B:
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In order to prefer point B we have to ask whether the monopolist would wish to offer more
visits beyond the first point where MR = MC (point x0 ). To the left of point (a) it is clear
that MR > MC everywhere. It means that the monopolist makes a profit on each additional
visit. To move beyond point (a) we can see that at first, all the way to point (c), MC > MR
which means that on this additional number of visits the monopolist will make a loss which
will, of course, reduce its profits. Therefore, if the monopolist were to move away from (a)
he would want to move to the next profit-maximising possibility at point B (or (e) where
MR = MC again). From (c) to (e) we have MR > MC which means that the monopolist is
making profits on the additional visits. Hence, if the red triangle (abc) is smaller than the
blue triangle (cde) then the monopolist will increase his profits by moving all the way from
x0 to x1 .
In such a case, the deadweight loss will be the yellow triangle which is, of course, much
smaller than in the first case where the monopolist was charging a price which only tourists
were willing to pay.
(d) The third case: when the gallery charges a high price which excludes the locals even though
the marginal cost curve intersects with the locals marginal revenue.
The reasoning here is the same as in the previous case. Up to the first intersection (point a)
MR > MC. From point (a) to point (c), MC > MR which means that the monopolist makes
losses (the red triangle abc). Continuing to allow visits until point (e) will generate
additional profits (by way of the blue triangle cde). In the previous case we said that if the
losses were less than the gain, the monopolist will charge a price allowing both tourists and
locals to visit. However, if the red triangle is greater than the blue triangle, the monopolist
will stop at point A and charge a price which only tourists are willing to pay. The
deadweight loss, of course, will be much greater than in the first case as the marginal cost is
lower.
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Part C Macroeconomics
Question 4
In a closed economy, the poor have a higher marginal propensity to consume than
the rich, and the government pursues a balanced budget approach where spending is
adjusted to the level of tax raised (there is a proportional tax system). The share of
the poor in national income is and they do not pay tax.
(a) What will be the economys multiplier?

(b) How would an increase in the rate of tax affect the economy had wages and
prices been fixed?
(c) How would your answer change had wages and prices been flexible?
(d) What would be the effects of greater deprivation, through a fall in the share of
income which goes to the poor, on your answers to (a)(c)?
An economy in which the poor have a higher marginal propensity to consume than the rich, and
in which their share in national income is , has a government which adjusts its spending to the
level of tax raised. We assume that the poor do not pay tax (but it is perfectly acceptable to
assume that everyone pays the tax).
(a) The multiplier:
C(Y ) = C0 + c1 (1 t)Y (1 ) + cp1 Y
I(r) = I0 I1 r
G(Y ) = t(1 )Y
[C0 + I(r)] + [c1 (1 t)(1 ) + cp1 ]Y = Y
1 1
Y = A(r) = A(r) .
1 [c1 (1 t)(1 ) + cp1 + t(1 )] 1M
(b) We examine the effect that an increase in the tax rate t would have on the economy had
wages and prices been fixed. It is easy to see that a change in t will only affect the multiplier:
M
= 1 c1 (1 ) = (1 )(1 c1 ) > 0.
t
In our case, the reason why the increase in tax raises aggregate demand for goods is due to
the fact that the government has a balanced budget. This means that an increase in tax will
transfer income from private consumption, where it is mitigated by the marginal propensity
to consume, to the government which has a higher marginal propensity to consume.
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The increase in the tax rate would increase aggregate demand at each level of the interest
rate. The IS schedule shifts to the right and, as the multiplier increases, it also becomes
steeper. Every change in the interest rate will have a greater impact on the equilibrium level
of national income.
(c) With flexible prices and wages:
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The increase in demand will cause an increase in prices which, in turn, will reduce the
supply of liquid assets. In the short run, the economy moves from A to B and in the long
run, when wages are re-negotiated and if workers have the correct expectations, the system
will return to its initial level of income with higher prices and a higher interest rate. There
will be crowding out of investment to fund the increase in government spending.
(d) In this section we examine the effects of an increase in the tax rate t when it is accompanied
by an increase in deprivation. By an increase in deprivation we mean that the same number
of poor command a smaller share of national income. Namely, we examine a fall in . Our
system is:
C(Y ) = C0 + c1 (1 t)Y (1 ) + cp1 Y
I(r) = I0 I1 r
G(Y ) = t(1 )Y
[C0 + I(r)] + [c1 (1 t)(1 ) + cp1 ]Y = Y
1 1
Y = A(r) = A(r) .
1 [c1 (1 t)(1 ) + cp1 + t(1 )] 1M
Clearly, affects only the multiplier, hence:

M
= cp1 c1 (1 t) t.

While the marginal propensity of the poor is greater than that of the rich, we also have to
deduct the tax rate. Had we assumed that everyone pays the tax, the sign of the above
equation would have definitely been positive (the last t would not have been there). In our
case, whether or not the sign of the equation is positive depends on the following condition:
if cp1 c1 > t(1 c1 )

(
M/ > 0
M/ 0 otherwise.
In the case of a positive relationship, the increase in deprivation (i.e. a fall in ) would
decrease the multiplier and offset the increase which would have been generated by the
increase in the tax rate t. If the effect of on the multiplier is negative, a fall in its value
would increase the multiplier and accentuate the initial effects.
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Question 5
The rise in the number of people at retirement age led the government to consider
an increase in the age of retirement. The current arrangements are that the
government offers a state pension, which is budgetary, to everyone. The government
is also committed to a balanced budget, which is funded by a proportional tax. The
marginal propensity to consume of pensioners is lower than that of the rest of the
population but their marginal propensity to import is greater (as they tend to
spend more time abroad).
(a) What would be this economys multiplier and how would the change affect it?
(b) Analyse the effect of the increase in the age of retirement on an open economy
without capital mobility and a fixed exchange rate.
(c) How would your answer change had there been perfect capital mobility with a
fixed exchange rate?
(d) How would your answer to (c) change had the exchange rate been flexible?
There are two elements to the information given in this question. Firstly, a reduction in the
number of people who qualify for retirement means that there are fewer old age pensioners. As
pensions are funded from the budget this could have amounted to a fiscal contraction (the
reduction in transfer payments increases net tax revenues, T ). However, as the government has a
balanced budget policy, the implication of an increase in T is also an increase in government
spending. The second element is the fact that old age pensioners tend to travel abroad more
than the young and that their marginal propensity to consume is smaller than that of the
younger generation. We are told that there is a proportional tax system and that the government
maintains a balanced budget policy. Let represent the share of taxes directed at pensioners.
(a) The economys multiplier will be:
C(Y ) = C0 + cy1 (1 t)Y + cp1 tY
I(r) = I0 I1 r
G(Y ) = t(1 )Y
EP E0 P0

X = X0
P P0
EP E0 P0

IM ,Y = IM0 + my1 Y + mP
1 tY
P P0
EP E0 P0

AE Y, r, = C0 + I(r) + (X0 IM0 )
P P0
+[cy1 (1 t) + cp1 t my1 mp1 t]Y = Y
EP

1
Y = A r,
P 1 [cy1 (1 t) + t(cp1 mp1 ) my1 + t(1 )]
EP

1
= A r, .
P 1M
A decrease in the number of pensioners means an increase in which is a parameter

determining the multiplier:
M
= t[(cp1 mp1 ) 1] < 0.

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Hence a fall in would cause an increase in the multiplier. The intuition is simple: there is
a transfer of money from pensioners, who would spend most of it abroad (increasing demand
for imports), to the government who would spend most of it locally.
(b) An open economy without capital mobility and a fixed exchange rate:
The decrease in was expansionary, this means that for any given level of interest rates,
there would now be equilibrium at a higher level of income. This is a shift to the right of the
IS schedule which also becomes flatter. However, a decrease in would generate a decrease
in demand for imported goods at any level of income. This means that the level of income
for which the initial demand for net exports would be off-set, is now higher. In other words,
the NX line shifts to the right.
If we start at A we can see that there will now be excess demand for local goods and a
surplus in the current account. The economy will start moving towards point B. The excess
supply of foreign currency will be met by an increase in the central banks reserves which
will lead to an increase in the supply of liquid assets. The LM schedule will hence shift
downwards (for any given level of income there will be equilibrium at a lower interest rate).
This will carry on until we reach equilibrium at point C where both output and interest
rates increase.
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(c) Perfect capital mobility and a fixed exchange rate:
The initial change in this case is simply the shift of the IS schedule to the right and it
becomes flatter (A to B). This will raise local interest rates above the international level of
return on assets and, subsequently, cause an inflow of capital (foreigners wishing to hold
local assets). This will cause an excess supply of foreign currency. In the case of a fixed
exchange rate, the excess supply of foreign currency will be absorbed by the central bank
and cause an increase in the supply of liquid assets. The LM schedule will shift downwards
and the new equilibrium will be at point C.
(d) In case of a flexible exchange rate regime:
The nominal exchange rate (E) will decrease due to the excess supply of foreign currency.
This depreciation will cause the demand for net exports to diminish. The IS schedule will
shift back to its original position at A, where there is higher government spending and less
net exports.
20
Question 6
Some foreign companies, which conduct business in an economy, pay a relatively low
level of tax in the country and distribute all their profits to their shareholders who
live outside this country. The government decides to clamp down on tax avoidance
and so raises the tax rate that these companies have to pay.
(a) Show the initial equilibrium in the real economy and in the foreign currency
market.
(b) How would government policy affect the economy in the short run?
(c) What would be the long-run implications if the exchange rate were fixed?
(d) What would be the long-run implications if the exchange rate were flexible?
In this question candidates were expected to deal with an open economy with perfect capital
mobility as the story is about foreign companies who own assets in the home economy. The
shareholders of some of these companies live abroad and earn their income from distributed
profits which are profits after tax. Tax avoidance meant that the distributed profits were
considerable.
(a) The initial set-up in the economy and in the foreign currency market is given below:
21
and in the foreign currency market:
(b) When the government clamps down on tax avoidance, assuming that this is successful, there
will be less profits available to be distributed and sent abroad to the shareholders. This
means that the demand for foreign currency will fall and the governments tax revenues will
increase. In the foreign currency market this will show in the following way:
The fall in demand for foreign currency will create an excess supply at the existing nominal
exchange rate. Point B represents the case of a fixed exchange rate regime where the excess
supply translates into an increase in the quantity of liquid assets supplied in the economy.
Point C is that of a flexible exchange rate where the nominal exchange rate will fall (an
appreciation).
In the goods market, the initial effect will be that the increase in tax revenues will reduce
22
aggregate demand if we assume that there was no change in government spending:
The fall in aggregate demand means that if nothing else happens, the economy will begin to
move towards point B where income falls as does the interest rate.
(c) In the case of a fixed exchange rate, we will have to make an adjustment for the short run as
the increase in the supply of liquid assets will accompany, if not precede, the fall in
aggregate demand which is a much slower process:
In the short run, in the case of fixed exchange rates, we will be at a point like B. As the
local interest rate is below the international interest rate it will trigger capital outflows:
23
This will lead to an increase in demand for foreign currency and subsequently a fall in the
supply of liquid assets to a level below the original one. The new equilibrium will be at
point C where there will be a fall in income.
(d) In the case of a flexible exchange rate, there will first be a fall in the nominal interest rate
which will reduce demand for net exports (hence the IS schedule will shift further to the left,
point B below):
However, the capital outflow will increase the nominal exchange rate and lead to an increase
in net exports which will shift the IS schedule to the right until a new equilibrium is formed
at point D.
24

Important note

references
section.
Comments on specific questions Zone B
Part B Microeconomics
Question 1
To improve peoples diet and reduce obesity, the government identifies a basket of
health food (measured in units of x). Individuals already consume these foods but
some in insufficient quantities. The health authorities claim that if individuals
consume x units of the health food basket they will receive what they need for their
health without risking obesity. The government provides the public with vouchers
with which they can consume up to x units of the basket at a lower price. Anyone
who has not used all their vouchers will then face an increase in their health
insurance (vouchers are not transferrable).
(a) Describe, using a diagram, the initial conditions in the space of health food
basket (x) and all other goods (including all other food items) (y).
(b) Show the effect that the scheme will have on the budget constraint.
(c) How would this affect those who under-consume health food?
(d) How would this affect those who over-consume health food?
(e) Would the government achieve its objective? Would the answer depend on
whether or not health food is considered to be an inferior good?
The question is about consumers choice. The government designs a policy which it hopes will
lead to a change in consumers behaviour. The issue here is the consumption of healthy food as
25
part of a diet which will reduce obesity and prolong life. The proposal is to offer individuals
vouchers with which they could buy healthy food at a cheaper price, but the vouchers are limited
to the consumption of x units of health food. Anyone who has not used all their allowance will
be penalised with an increase in their health insurance. This is not a simple question and one has
to follow each step carefully.
(a) The initial situation. We assume x to represent the quantities of the health food consumed
and y to represent all other goods. The prices of the two types of good before the
government proposal are given as p0x and p0y , respectively:
An individual will then choose to consume at point A.

(b) We now examine the effect of the scheme on the budget constraint.
The government announces that it will provide vouchers for up to the desired quantity of
health food (x). This means that the price of x up to x
is now lower. Beyond x , the price
will be the same as before. However, anyone consuming less than x will face an increase in
health insurance (dHI) which will, of course, reduce ones income.
For any value of x less than x, the consumer must pay an increased health insurance
premium (so the intersect of the budget line with the vertical axis is lower than before) and
pays a lower price per unit. If x is greater than x, then units of x in excess of x
can be
purchased at the original price, so the new budget line will be parallel to the old one, but
will lie above it because the cost of the first x
units was less than before, so leaving more
disposable income which can be spent on additional units.
26
(c) The case of those who under consume health food:

We expected to find the following analysis:
If we start at A we can see that this individual, who now faces cheaper health food prices
(due to the vouchers), will wish both to replace y with these goods (substitution effect A to
C) as well as to buy more when real income increases and the good is a normal good (C to
B). Notice that when the individual is at point B, he/she is no longer subject to the penalty
of additional health insurance.
27
(d) The case of those who already consume beyond the required quantity:
Individuals who consume more than the required quantity will not face the penalty of
increased health insurance. This means that as they are already at the domain of
consumption where the price they pay for the last unit is the full price (they have already
exhausted the use of vouchers), they only face an income effect. If the good is normal, they
will move from A to B.
(e) Would the government achieve its objective? The answer is yes. The obvious issue is with
those who used to consume less than the required quantity of health food. In such a case, it
is always in the interest of the individual to get to point B. If the good were to be inferior, it
would have meant a choice to the left of point C. However, such a choice (being on the
broken line) would have meant a penalty payment which would have led the individual to
the heavy line where his, or her, utility is much lower. Therefore, the policy will be very
effective in making individuals consume more health food but not in terms of raising money
for the government from the penalty.
28
Question 2
A local competitive industry is supplied by local producers and by international

suppliers. The international supply is perfectly elastic. Due to fall in rents, the fixed
costs facing the local industry have fallen.
(a) Show the initial long-run equilibrium in the market. Identify the equilibrium
price, quantity, imports and local production.
(b) What will be the effect of the change on the cost functions of a representative
firm?
(c) What will happen, in the short run, to the equilibrium price, quantity, imports
and the number of firms in the industry?
(d) What will happen in the long run? Will there be any spillover effects on other
industries?
In this question we examine a competitive industry which faces international competition. We

assume the industry to be sufficiently small so that international supply is perfectly elastic: what
happens locally would not change the international price of the good.
The fall in local rents paid only by local producers will lead to a fall in the fixed costs which local
firms face. This is an equivalent story to a lump-sum subsidy.
(a) The initial set-up:
Local production is x0L and imports are given by x0 x0L .

(b) & (c) The effect of the change on a representative local firm will be a shift downwards of the
average cost schedule:
29
We start at point A which is the initial equilibrium. Local firms supply x0L units of the good
(point A) and the rest of the market is supplied by foreign firms (imports).
A fall in fixed costs would only affect average costs, not marginal costs. A saving of dF
would reduce average costs by dF/x. Hence, for very few units of x, dF/x would be large,
but as the number x increases, dF/x becomes smaller. Therefore, the new average cost
schedule would be further below the old one at lower levels of output. As we produce more,
the average gain is reduced. As decisions about quantities depend only on marginal costs,
there will be no short-run effect other than that the profits (shaded area) which firms will
now be making will have increased.
(d) The long-run effects:
As firms make profits above normal, this will draw capital into the industry and there will
be an increase in the local supply of the good.
30
As firms enter the industry, the supply schedule will shift to the right hence reducing the
amount of imports. On the face of it, this process can go on forever as what normally
restores long-run equilibrium is the corresponding fall in the price which erodes profits and
stops entry. Here the price is given (openness) and this means that the equilibrium must be
restored by other means. Indeed, as supply increases and the flow of firms into the industry
increases, demand for labour (or capital, or both) will necessarily increase. At one stage, the
industry would become sufficiently large to have an impact on the local factor markets and
cause an increase in wages and/or returns to capital. This will shift the new average costs
function (AC dF/x) upwards so, in contrast to our earlier case, the marginal cost schedule
will shift upwards. The process will end at a point like B where profits are once again at
their normal rate.
Where exactly this process will terminate is unclear. In the above diagram it will grind to a
halt at point B and, therefore, reduce imports. However, it could have gone further:
As local production increases, it will reach point B which now reflects the intersection
between the local supply and international demand schedules. At this point, the industry
will be exporting the difference between point B and local demand at the international price.
In terms of the spill-over to other groups in society, it is clear that the consumer surplus of
the buyers of x would not be affected by the policy. However, the increase in wages which
would result from the control of local land prices suggests that the policy will filter through
to benefit all workers and owners of capital. In this sense, in spite of the fact that the direct
effect of the control was beneficial to firms, the long-run profits of the firm would be
unaffected, but its stakeholders would all benefit from it as would other members of society.
31
Question 3
Consider a monopolist with the following demand function: p(x) = a bx. Suppose
that marginal costs are constant at c. There are no fixed costs.
(a) Show diagrammatically the monopolists initial equilibrium.

(b) Identify the areas in the diagram denoting the monopolists profit and the
inefficiency it creates.
(c) If c = 10 and a = 60, what would be the equilibrium price (you need first to
derive the equilibrium price algebraically)?
(d) By how much will the equilibrium price increase if the marginal cost increased
by 20%?
(e) What will happen to the degree of monopolistic power as a result of such an
increase?
This is a question about a monopolist.
(a) Here candidates were expected to show, diagrammatically, the initial equilibrium:
32
(b) Candidates were expected to identify in the diagram the areas depicting profits and the
inefficiency created by the monopolist:
As there are no fixed costs, the profits will be the difference between total revenue and the
total costs (blue area). The yellow area denotes the deadweight loss created by the
monopolist.
(c) What would be the equilibrium price if c = 10 and a = 60?

To answer this question, one needs to derive the equilibrium price algebraically. The inverse
demand function is given by px (x) = a bx, and marginal costs are constant and given by c
(no fixed costs). Therefore, revenue will be R(x) = px (x) x, which means:
R(x) = px (x) x = ax bx2 .
Hence marginal revenue is given by MR(x) = a 2bx.

Profit maximisation requires that MR = MC, therefore:
MR(x) = MC
a 2bx = c
ac
xM
0 = .
2b
As we have explicit functions, we can now calculate from the inverse demand function the
price which people are willing to pay by substituting the equilibrium level of output for x:

ac 1 1 a+c
px (xM0 ) = a bx = a b =a a+ c= .
2b 2 2 2
Therefore, if c = 10 and a = 60, we have:
a+c 60 + 10
px (xM
0 )= = = 35.
2 2
33
(d) By how much will the equilibrium price increase if the marginal cost increased by 20%?
We now have a new level of marginal costs: c1 = 1.2c. We examine again the profit
maximisation level of output and its corresponding price:
a 1.2c
MR(x) = MC a 2bx = 1.2c xM
1 = .
2b
Hence:
a + 1.2c
p(xM
1 )= .
2
The change in the price of x, therefore, is given by:
dx = p(xM M
1 ) p(x0 ) = 0.5a + 0.6c 0.5a 0.5c = 0.1c.
Namely, while marginal costs increased by 20%, the price would rise by only 10% of the
value of the original marginal cost. Therefore, dc > dp. It is also easy to see that in this case
the deadweight loss would diminish (the proportions in the above diagram are misleading).
(e) How will this change affect the degree of monopolistic power?
The first thing we must establish is what exactly is the degree of monopolistic power. The
notion of monopolistic power is basically a measure of the ability of the monopolist to
charge above the competitive price. Hence it could easily be something like MC/p. If price
equals marginal costs, MC/p = 1 (no monopolistic power). As price increases above
marginal costs, MC/p diminishes and the degree of monopolistic power increases. In other
words, the measure MC/p is an inverse measure of monopolistic power.
There are two ways of answering the question. One is easy and relies on getting the answer
to (c) correct. The other is a more elaborate procedure based on fundamental definitions.
The first method suggests that as the equilibrium price is given by:
a+c
px =
2
the degree of monopolistic power will be given by:
MC c 2c
= = .
p (a + c)/2 a+c
34
Hence:
d(MC/p) 2(a + c) 2c 2a
= = > 0.
dc (a + c)2 (a + c)2
The increase in c will lead to an increase in MC/p, and so a fall in the degree of
monopolistic power.
The alternative method is as follows.
From the profit maximisation condition of the monopolist we know that:

1 MC 1 1
MC = p 1 + =1+ =1 .
p ||
Therefore, monopolistic power depends on the price elasticity of demand which the firm is
facing. A firm in perfect competition faces an infinitely elastic demand (|| and hence
p = MC and there is no monopolistic power). In our case, the price elasticity facing our
monopolist is:
dx p 1 p 1 a bx a
= = = =1 .
dp x dp/dx x b x bx
Therefore:
MC 1 1 1 1
=1+ =1+ =1+ =1+ .
p 1 a/bx 1 a/(b(a c))/2b 1 2a/(a c)
Hence if c rises, (a c) diminishes, 2a/(a c) increases and 1 (2a/(a c)) diminishes.

Therefore, 1/[1 (2a/(a c))] increases and so does MC/p. An increase in MC/p represents
a decrease in the degree of monopolistic power.
35
Part C Macroeconomics
Question 4
To raise productivity in the economy, the government increases the level of spending
on both higher and vocational education. Assume a closed economy and that the
increase in spending is funded by borrowing from the public. Also assume that
enlarging the circle of educated people will lead to an increase in productivity.
(a) Show the initial equilibrium of this economy when prices and wages are flexible.
(b) What would be the short-run effect of increasing the level of spending on
education during the period before the increased level of education affects
productivity?
(c) What would be the long-run effects, taking into consideration the effects of
education on productivity?
(d) Critics of the government insisted that such an increase is irresponsible and
demanded that it will be accompanied by an equivalent increase in taxation.
How would such a policy affect your answers in (b) and (c).
This is a question about an economy where the government uses its spending power to raise
productivity. The government increases public spending (funded by borrowing from the public)
to raise the level of higher education and vocational training. In so doing, we assume that the
government is successful in increasing the skill level, and hence productivity, of the labour force.
We assume a closed economy.
(a) The initial set-up when prices and wages are flexible requires that we look simultaneously at
the IS-LM model as well as the AD-AS model:
36
However, as we are dealing with the problem of productivity which will directly affect the
labour market, it will be useful to look also at its initial equilibrium:
The shaded area under the labour demand schedule corresponds to Y0 in the IS-LM-AD-AS
framework and also provides the information about the distribution of income between
wages and capital.
(b) Here we are looking at the direct effect of the policy before it bears fruit. Namely, we are
looking at the effect that the increase in spending will have on the economy in the short run
before any change in productivity materialises.
37
The increase in government spending increases G and, as it is funded by borrowing from the
public, it will lead to an increase in overall demand for consumption. This means a shift to
the right of both the IS and AD schedules because, for the same interest rate and price, we
now need greater output to achieve equilibrium. As prices are flexible and respond much
faster, this will cause a fall in the supply of liquid assets which will shift the LM schedule
upwards (a higher level of interest rates would be needed to achieve equilibrium for any
given level of income). The new equilibrium will be at point B where prices and interest
rates are higher and so also is national income and output.
(c) We now consider the long run taking into consideration that the policy was effective in
raising the productivity of the labour force.
Let us begin by looking at the IS-LM-AD-AS framework which we will then anchor in the
analysis of the labour markets. Candidates who did not conduct the labour market analysis
would have received full points if their discussion of the IS-LM-AD-AS framework was
complete.
We saw that in the short run, the economy would move from A to B reflecting the increase
in aggregate demand due to the increase in government spending and the subsequent
increase in prices which would lead to the shift upwards of the LM schedule.
In the long run, without the improvement in productivity (which would increase potential
output), the excess demand for labour at point B (on the SAS(w0 ) schedule would create
pressures for nominal wages to rise. Together with correct expectations with regard to the
pass through of the increase in wages onto prices, the SAS schedule would have moved
upwards and we would have returned to equilibrium at an even higher price. However, given
that there was an increase in productivity and hence demand for labour (recall that the
marginal product of labour is the profit-maximising demand for it), this means that at the
current level of real wages at point B, the excess demand would be even greater (see below).
Even at the original level of wages, there will now be an excess demand for labour which
means that the short-run supply, at the level of nominal wages at A and B, will be much
greater. This is denoted by the broken blue line in the bottom diagram, (SAS(w
0 )).
38
Therefore, at the given real wages at B there will now be greater pressure for nominal wages
to rise. However, as one can see from the bottom diagram above, as the SAS schedule shifts
to the right, there is now an excess supply of goods in the market and, therefore, pressure on
prices to go down:
Both the pressure on nominal wages to rise and on prices to fall will push real wages in the
same direction: upwards from B towards point C. One can clearly see that at C there is
more output than there was at A, our initial condition. This is due to the improvement in
labour productivity.
The increase in nominal wages will shift the short-run supply schedule (SAS) upwards
towards the heavy blue line in the AD-AS framework. As the economy moves from B to C
in that diagram (leading to a fall in prices due to an excess supply of goods at B), the
supply of liquid assets will recover and rise even further. Therefore, the LM schedule will
shift downwards until it meets the IS schedule at point C, at a lower level of interest rates
and a much higher level of national income.
(d) What if, instead of funding the policy by borrowing from the public, the government funded
the increase by a full increase in taxation?
If the policy were funded by an equivalent increase in taxation there would still be a fiscal
expansion. As the loss of demand for private consumption is only a fraction of a unit of
income (marginal propensity to consume is less than 1) and public spending is of the full
unit, there will be an increase in aggregate demand and both the IS and AD schedules will
shift to the right. The difference will be that the shift is going to be much smaller:
39
The move from A to B is much less pronounced than before, but as the effect on
productivity will be exactly the same, in the long run the new level of output will be exactly
the same as the one before. However, what is clearly better in this system of financing is
that the fall in interest rates will be larger on this occasion and, therefore, will ensure a
significant increase in demand for investment.
40
Question 5
The rise in the number of people at retirement age led the government to consider
an increase in the age of retirement. The current arrangements are that the
government offers a state pension, which is budgetary, to everyone. The government
is also committed to a balanced budget, which is funded by a proportional tax. The
marginal propensity to consume of pensioners is lower than that of the rest of the
population but their marginal propensity to import is greater (as they tend to
spend more time abroad).
(a) What would be this economys multiplier and how would the change affect it?
(b) Analyse the effect of the increase in the age of retirement on an open economy
without capital mobility and a fixed exchange rate.
(c) How would your answer change had there been perfect capital mobility with a
fixed exchange rate?
(d) How would your answer to (c) change had the exchange rate been flexible?
There are two elements to the information given in this question. Firstly, a reduction in the
number of people who qualify for retirement means that there are fewer old age pensioners. As
pensions are funded from the budget this could have amounted to a fiscal contraction (the
reduction in transfer payments increases net tax revenues, T ). However, as the government has a
balanced budget policy, the implication of an increase in T is also an increase in government
spending. The second element is the fact that old age pensioners tend to travel abroad more
than the young and that their marginal propensity to consume is smaller than that of the
younger generation. We are told that there is a proportional tax system and that the government
maintains a balanced budget policy. Let represent the share of taxes directed at pensioners.
(a) The economys multiplier will be:
C(Y ) = C0 + cy1 (1 t)Y + cp1 tY
I(r) = I0 I1 r
G(Y ) = t(1 )Y
EP E0 P0

X = X0
P P0
EP E0 P0

IM ,Y = IM0 + my1 Y + mP
1 tY
P P0
EP E0 P0

AE Y, r, = C0 + I(r) + (X0 IM0 )
P P0
+[cy1 (1 t) + cp1 t my1 mp1 t]Y = Y
EP

1
Y = A r,
P 1 [cy1 (1 t) + t(cp1 mp1 ) my1 + t(1 )]
EP

1
= A r, .
P 1M
A decrease in the number of pensioners means an increase in which is a parameter

determining the multiplier:
M
= t[(cp1 mp1 ) 1] < 0.

41
Hence a fall in would cause an increase in the multiplier. The intuition is simple: there is
a transfer of money from pensioners, who would spend most of it abroad (increasing demand
for imports), to the government who would spend most of it locally.
(b) An open economy without capital mobility and a fixed exchange rate:
The decrease in was expansionary, this means that for any given level of interest rates,
there would now be equilibrium at a higher level of income. This is a shift to the right of the
IS schedule which also becomes flatter. However, a decrease in would generate a decrease
in demand for imported goods at any level of income. This means that the level of income
for which the initial demand for net exports would be off-set, is now higher. In other words,
the NX line shifts to the right.
If we start at A we can see that there will now be excess demand for local goods and a
surplus in the current account. The economy will start moving towards point B. The excess
supply of foreign currency will be met by an increase in the central banks reserves which
will lead to an increase in the supply of liquid assets. The LM schedule will hence shift
downwards (for any given level of income there will be equilibrium at a lower interest rate).
This will carry on until we reach equilibrium at point C where both output and interest
rates increase.
42
(c) Perfect capital mobility and a fixed exchange rate:
The initial change in this case is simply the shift of the IS schedule to the right and it
becomes flatter (A to B). This will raise local interest rates above the international level of
return on assets and, subsequently, cause an inflow of capital (foreigners wishing to hold
local assets). This will cause an excess supply of foreign currency. In the case of a fixed
exchange rate, the excess supply of foreign currency will be absorbed by the central bank
and cause an increase in the supply of liquid assets. The LM schedule will shift downwards
and the new equilibrium will be at point C.
(d) In case of a flexible exchange rate regime:
The nominal exchange rate (E) will decrease due to the excess supply of foreign currency.
This depreciation will cause the demand for net exports to diminish. The IS schedule will
shift back to its original position at A, where there is higher government spending and less
net exports.
43
Question 6
The owners of a company, which operates mainly in another country, are regular
receivers of dividends. The government of the other country has clamped down on
tax avoidance and raised considerably the tax that the company now has to pay in
the other country.
(a) Describe the initial equilibrium, before the change, in the country where the
owners live.
(b) How would the change affect the economy in the short run if the exchange rate
was fixed?
(c) How would your answer change had the exchange rate been flexible?
(d) What will be the long run in the case of (b) and (c)?
Here we look at country A, in which the owners of firms operating in another country, B, live.
This means that these owners receive dividends on their shares in foreign currency. Now the
government of the other country B clamps down on tax avoidance. This means that those
companies now have less profits to distribute to their owners who live abroad in country A. This
is clearly a question about an open economy with perfect capital mobility.
(a) The initial set-up in the economy where the owners live is given below:
44
The initial equilibrium in the foreign currency market:
(b) When the government of country B clamps down on tax avoidance, and assuming that it is
successful, there will be less profits available to be distributed and sent to the country under
consideration where the shareholders live. This means that the supply of foreign currency
will fall:
The fall in the supply of foreign currency will create an excess demand at the existing
nominal exchange rate. Point B represents the case of a fixed exchange rate regime where
the excess demand translates into a decrease in the quantity of liquid assets supplied in the
economy. Point C represents the case of a flexible exchange rate regime where the nominal
exchange rate will rise (depreciation).
In the goods market, the initial effect will be a fall in the supply of liquid assets which will
shift the LM schedule upwards meaning that for any level of national income there will now
be equilibrium at a higher domestic interest rate:
45
The rise in the domestic interest rate will lead to a fall in the demand for domestic
investment and output will subsequently fall to Y1 . We move from A to B.
(c) If, instead, the exchange rate regime was flexible then, looking at the foreign currency
market we observe that due to the fall in the supply of foreign currency, there will be an
excess demand for foreign currency. The nominal exchange rate will increase (depreciation):
The increase in the nominal exchange rate will make exports more attractive and imports
more expensive. There will be an increase in demand for net exports, which is a component
of the IS. Therefore, the IS schedule will shift to the right and there is now an excess
demand for goods. As output increases to bridge this gap, the demand for liquid assets also
increases and subsequently there will be an increase in domestic interest rates. Therefore,
the economy will move from A to B experiencing a similar increase in domestic interest rates
as in the case of a fixed exchange rate regime, but this time coupled with an expansion of
national income.
46
(d) What will be the long-run implications in both cases?

In the short run there is movement from A to B. In both cases this led to an increase in
domestic interest rates which are then higher than the international rate. This means that
returns on assets in this country are now greater than elsewhere. This will lead to a capital
inflow as foreigners would begin buying domestic assets and, so, increasing the supply of
foreign currency.
In the case of a fixed exchange rate, this will lead to a reversal of the decline in liquid assets
until the economy goes back to its original position:
As the LM schedule shifts back to its original position, interest rates will return to their
international level. As interest rates decrease, there will be an increase in demand for
domestic investment which will, in turn, return output and national income to their original
level.
In the case of a flexible exchange rate:
47
The increase in the supply of foreign currency will lead to a decrease in the nominal
exchange rate back to its original level. Therefore, the demand for net exports will return to
its original level. The IS schedule will shift back to the left and the economy will return to
the original position.
48

Examiners' Commentaries 2016: EC1002 Introduction To Economics

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Examiners' Commentaries 2016: EC1002 Introduction To Economics

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Examiners commentaries 2016