Macroeconomics Tutorial 1

Aggregate demand, supply, national output and inflation

1. The circular flow of income shows the flow of incomes between firms and households. False. The circular flow of income shows the flow of inputs, outputs and incomes between households and firms, not just incomes. See section 9.3 of Begg and Ward.

True/False

2. Each of the following are leakages from the circular flow of income: consumption, savings, taxation and imports. False. Consumption is not a leakage but savings, taxation and imports are. See section 9.3 of Begg and Ward.

True/False

3. Total expenditure is equal to consumption plus investment plus government spending plus net exports. True. Total expenditure is simply the sum of all spending inside the economy, adjusted for spending in the UK on imported products. See section 9.3, sub-heading ‘Total Expenditure’, in Begg and Ward.

True/False

4. Aggregate demand is negatively related to the rate of inflation. True. The higher the rate of inflation, the higher the interest rate that is needed to bring inflation under control. Higher interest rates reduce the level of borrowings and therefore reduce the level of funds available to purchase products and services. See section 9.4 of Begg and Ward.

True/False

5. Under full wage adjustment to price increases, aggregate supply is perfectly elastic. False. Under full wage adjustment to prices, real wages remain constant. Employment remains constant and the aggregate willingness to supply remains constant. Hence, aggregate supply is perfectly inelastic. See section 9.4 and Figure 9.7 of Begg and Ward.

True/False

6. Aggregate supply is negatively related to the rate of inflation. False. The important issue for aggregate supply is whether or not a bout of inflation leads to nominal or real changes in relative wages and prices. See Section 9.4 in Begg and Ward.

True/False

7. If imports grow faster than exports, aggregate demand falls. True. If imports grow faster than exports, net exports fall and aggregate demand falls too. See Section 9.4 in Begg and Ward.

True/False

8. Which of the following will lead to cost push inflation?

a) An increase in real wage ratesb) An increase in investments by firms – AD (aggregate demand)

shifts rightwardsc) An increase in government spending on health servicesd) A fall in the value of the £ against the Euro – this would make

imports more expensivee) An increase in exports from the UK to the rest of the world –

AD shifts rightwards

Answer: A

9. The Table below contains the UK retail price index for the years 1993 to 2003. First change the base year, so that 1998 = 100 and then calculate the rate of inflation from 1994 onwards.

We can calculate the new index as follows:Let RPI 1998=100 (by assumption)

YearRetail Price Index

1987 = 100Retail Price Index

1998 = 100Rate of Inflation

1993 138.4 (138.4/156.2)*100=88.6

1994 141.6(141.6/156.2)*100=90.7

((90.7-88.6)/88.6)*100=2.3

1995 145.4(145.4/156.2)*100=93.1

((93.1-90.7)/90.7)*100=2.7

1996 149.3 95.6 2.71997 152.9 97.9 2.41998 156.2 100.0 2.21999 158.9 101.7 1.72000 161.3 103.3 1.52001 163.7 104.8 1.52002 166 106.3 1.42003 168.9 108.1 1.7

10. Which one of the following represents a correct interpretation of the Table above?

A) Prices are falling but inflation is rising.B) Prices are falling and inflation is falling.C) Prices are rising but inflation is fallingD) Prices are rising but inflation is rising

Answer: C

11. Suppose expected inflation for next year is 2.5%. If you are currently earning £28,000 a year, what should your nominal wage be next year if you want to keep your real wage constant?

A) 28700B) 28800C) 29000D) 25000

Answer: A Nominal wages must increase by the same rate as inflation, hence: £28000x(1+0.025)=28700.

12. Suppose expected inflation for next year is 2.5%. and the current tax allowance is £6475. What should the tax allowance be next year to avoid the problem of fiscal drag?

A) around £6636B) around £6453C) around £6565D) around £4578

Answer: A Assuming nominal wages grow by the inflation rate of 2.5%, tax allowance must also grow by 2.5%. Hence next year’s tax allowance should be £6475*(1+0.025)=£6636.875.