EC1002 Commentary 2017

Examiners’ commentaries 2017

EC1002 Introduction to economics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2016–17. 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 (2016).
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 the real world in the language of economic modelling
• apply and use the economic models to analyse these issues
• assess the potential and limitations of the models and methods used in economic analysis.
Format of the examination
This paper consists of three sections:
• Section A (40 marks): Ten multiple choice questions, each worth four marks. Candidates
must answer all questions. No explanation is needed.
• Section B (30 marks): Candidates must answer one of two questions on microeconomics. It
is essential that candidates explain their answers.
• Section C (30 marks): Candidates must answer one of two questions on macroeconomics. It
is essential that candidates explain their answers.
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Textbook
The answers make extensive reference to the textbook for the course, referred to as BVFD. The
textbook is:
• Begg, D., G. Vernasca, D. Fischer, and R. Dornbusch, Economics (2014) McGraw–Hill (11th
edition).
Key steps to improvement
When answering the long questions (Sections B and C), some candidates had problems because they
were not familiar with the material. The examiners look for clear and logical arguments which
explain the material and answer the precise question asked – putting in irrelevant material makes for
a less clear answer. Some candidates found this difficult, and it was obvious that they had not fully
understood the material.
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, but 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 might not cover all topics in the syllabus in the same depth, but you
need to be aware that 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 available on the VLE. 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
This paper consists of THREE sections:
Section A (40 marks): TEN multiple choice questions, each worth FOUR marks. Candidates must
answer all questions. No explanation is needed.
Section B (30 marks): Candidates must answer ONE of TWO questions on microeconomics. It is
essential that candidates explain their answers.
Section C (30 marks): Candidates must answer ONE of TWO questions on macroeconomics. It is
Section A
Answer all questions from this section.
Choose one answer for each question; no explanation is needed.
Note that some questions ask you to choose which statement is correct and others ask you to choose
which statement is not correct.
Question 1
You are told that the income elasticity of demand for a good is 2. Which of the
following statements is correct?
(a) If income increases by $1 then the quantity of the good demanded increases by
2.
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(b) If the price increases by 1% then the quantity of the good demanded decreases
by 2%.
(c) As income increases the proportion of income spent on the good decreases.
(d) If income increases by 1% then the quantity of the good demanded increases by
2%.
Reading for this question
See BVFD Chapter 4.1.
Approaching the question
(d) is correct.
The income elasticity of demand quantifies the sensitivity of demand (in percentage points) to a
change in income (also in percentage points).
Question 2
The figure shows a supply and demand diagram. Find the equations of the supply
and demand curves. Which of the following statements about the equilibrium price
p and quantity Q is correct?
(a) p = 6, Q = 4.
(b) p = 6, Q = 5.
(c) p = 9, Q = 6.
(d) p = 10, Q = 7.
See BVFD, Chapter 3.4 and Mathematics box 3.1.
(c) is correct, p = 9 and Q = 6.
The inverse supply function has equation pS = 3Q/2, because it is a straight line which passes
through the origin and has slope 12/8 = 3/2.
4
The inverse demand function has equation pD = 12 − Q/2, because it is a straight line, meets the
vertical axis at 12 and has slope −12/24 = −1/2.
The inverse supply and demand functions intersect when pS = pD , so:

3 1
Q = 12 − Q
2 2
which implies that Q = 6. The price is 3Q/2 = 9.
Question 3
The table shows the total revenue of a firm. Find marginal revenue at each level of
output. Which of the following statements is correct?
output revenue
1 18
2 32
3 42
4 48
5 50
6 48
(a) If marginal cost is 6 at all levels of output then the profit-maximising level of
output is 4.
(b) If marginal revenue is less than marginal cost then increasing output increases
profits.
(c) Increasing output always increases profits if marginal revenue is positive.
(d) The marginal revenue from increasing output from 3 to 4 units is 5.
See BVFD Chapter 6.6 for how to get marginal revenue from total revenue and find the
profit-maximising level of output from marginal revenue and marginal cost.
(a) is correct.
See the table below for the calculations:

output revenue marginal revenue
1 18 18
2 32 14
3 42 10
4 48 6
5 50 2
6 48 −2
Increasing output increases profits if MR > MC and decreases profits if MR < MC. Here MC = 6
so MR > MC if output Q < 4 and MR < MC if Q > 4, so Q = 4 maximises profits.
Question 4
Figures (a)–(d) show long-run average cost curves (LAC). Which of the figures
shows economies of scale at all levels of output?
5
(a) Figure a.
(b) Figure b.
(c) Figure c.
(d) Figure d.
(b) is correct.
Economies of scale means that long-run average cost falls as output rises.
Question 5
Which of the following statements is correct?
(a) If a good is public then consumption by one person does not reduce the amount
available for other people.
(b) A public good is a good that the government pays for.
(c) Congested roads carrying a large amount of traffic are public goods.
(d) A public good is a good produced by the government.
(a) is correct.
A public good is a good for which individuals cannot be excluded from using it and the use by an
individual does not reduce availability to others.
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Question 6
Consider a closed economy with no government. Use notation:
• Y income
• C consumption
• I investment
• S saving.
Assume that consumption is given by C = A + cY and Y = C + I where A and c

are both positive and c is less than 1. Which of the following statements is correct?
(a) Suppose that c = 0.75. Suppose that investment increases by 100 because
investors become more optimistic. Then income increases by 500.
(b) If saving and investment are at their planned levels and S = I then the
economy is in equilibrium.
(c) If c = 0.75 then the multiplier is 0.75.
(d) If consumers become more willing to consume so c increases but I and A do not
change then income falls.
See BVFD Chapter 16.4 and Mathematics box 16.
(b) is correct.
In this model Y = C + I = A + cY + I, so in equilibrium:
(1 − c)Y = A + I
implying that:
A+I
Y = .
(1 − c)
The multiplier is 1/(1 − c). If c = 0.75 then the multiplier is 4, so (c) is incorrect. If investment
increases by 100 then output Y increases by 400, so (a) is incorrect. If c increases then 1 − c
decreases and the multiplier 1/(1 − c) increases so equilibrium income increases, hence (d) is
incorrect. Equilibrium requires that when consumption, saving and investment are at their
planned levels C + I = C + S, so S = I.
Question 7
(a) The labour market is in equilibrium if demand for labour at the current wage is
equal to the size of the labour force.
(b) The labour market is in equilibrium if there is zero voluntary unemployment.
(c) The labour market is in equilibrium if demand for labour at the current wage is
equal to the number of workers willing to accept a job at the current wage.
(d) It is impossible to increase the level of equilibrium unemployment by improving
the match between the skills employers require and the skills workers have.
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(c) is correct.
The labour market is in equilibrium if demand for labour at the current wage is equal to the
number of workers willing to accept a job at the current wage.
Question 8
Central banks such as the Federal Reserve in the USA and the Bank of England in
the UK operate monetary policy. Which of the following statements is not correct?
(a) Many central banks aim to control the rate of inflation. Some central banks are
concerned about both inflation and the level of unemployment.
(b) No central banks ever allows other banks to become bankrupt.
(c) Some central banks buy both government and private sector bonds.
(d) Many central banks control the interest rate but not the money supply.
See BVFD Chapters 19.5, 19.6, 18.7 and 22.7.
(b) is not correct.
Many central banks, including the Bank of England, have an inflation target. Although it is not
officially part of its mandate the Bank of England is in practice also concerned about the level of
unemployment. The US Federal Reserve is concerned about both inflation and the level of
unemployment.
Central banks do sometimes allow other banks to become bankrupt. For example, the US Federal
Reserve allowed Lehman Brothers to go bankrupt in September 2008.
Central banks do sometimes buy government and private sector bonds. This is quantitative
easing.
The Bank of England and the US Federal Reserve control the interest rate but not the money
supply.
Question 9
(a) The government deficit is the difference between government expenditure and
government revenue.
(b) If the government runs a deficit then national debt falls.
(c) Inflation increases the ratio of national debt to national income.
(d) If there is inflation and the government does not change tax rates then the
government deficit rises.
8
See BVFD Chapters 17.3.–17.6.
(a) is correct.
The government finances a deficit by borrowing which increases government debt. Inflation
increases nominal national income but does not increase national debt so decreases the
debt-to-national income ratio. If there is inflation and no change in tax rates then there is an
automatic fiscal stabiliser which increases tax revenue so reduces the deficit.
Question 10
Use the aggregate supply–aggregate demand diagram to answer this question. The
government decreases taxes without changing expenditure or monetary policy.
(a) The aggregate demand curve shifts downwards.

(b) The aggregate supply curve shifts upwards.
(c) In the long run output does not change but inflation increases.
(d) In the short run output increases but inflation does not change.
See BVFD Chapter 21.6 and the figure below.
(c) is correct.
In the short run, the aggregate demand curve shifts upwards from AD0 to AD1 with the result
that income increases from Y0 to Y1 and inflation increases from π0 to π1 . In the long run,
aggregate supply moves upwards to AS 1 and the economy is back at Y0 but with a higher rate of
inflation at π2 .
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Section B: Microeconomics
Answer one of the two following long questions. It is essential that you explain your answers.
Question 11
(a) There are two firms A and B. Both firms produce the same good. QA is the
output of firm A and QB is the output of firm B. The cost to firm A of
producing QA units of output is QA . The cost to firm B of producing QB units
of output is QB . The price of the good is p. The market inverse demand
function is p = 7 − QA − QB . What is a Cournot–Nash equilibrium? Find the
industry price, the quantities that each firm produces, and the firms’ profits in
Cournot–Nash equilibrium.
(10 marks)
(b) Explain what a Stackelberg equilibrium is. Assume that firm A is the leader
and firm B the follower. Assume that the industry is in a Stackelberg
equilibrium. Find the quantity produced by firm A and the quantity produced
by firm B, the price of the good, the profits of firm A and the profits of firm B.
(8 marks)
(c) Under what conditions is a firm likely to be a leader in its industry?
(4 marks)
(d) Under what conditions is the leader able to make it impossible for a follower to
enter the industry?
(8 marks)
See BVFD Chapter 9.5, particularly Mathematics box 9.1. The Mathematics box does the
argument for a general inverse demand function p = a − b(QA + QB ), and cost function for firm
A of cQA and for firm B of cQB . Here you have a special case with a = 7, b = 1 and c = 1. You
should not memorise the details in the Mathematics box, you should remember the structure of
the argument following the steps given below.
Writing down the answer using the formulae from the Mathematics box without explanation will
get you few marks. The numbers are chosen to make the algebra easy. You will have a much
harder time if you try to write out the Mathematics box in terms of a, b and c. You can do the
mathematics by setting marginal revenue equal to marginal cost as in the Mathematics box, but
you may find it easier to go directly to profits for firm A which are a quadratic in QA with a
negative coefficient of Q2A so the first-order condition gives a maximum. Similarly, profits for firm
B are a quadratic in QB with a negative coefficient of Q2B so the first-order condition gives a
maximum.
See BVFD Chapter 9.5, particularly Mathematics box 9.2 for a discussion of Stackelberg
equilibrium.
(a) In a Cournot–Nash equilibrium each firm chooses the output that maximises its profits
given the output of the other firm.
As the cost of producing QA is QA the profits of firm A are:
πA = pQA − QA = (7 − QA − QB )QA − QA = (6 − QB )QA − Q2A .
This is a quadratic in QA with a negative coefficient of Q2A so the first-order condition gives
a maximum. We have:
∂πA
= 6 − QB − 2QA = 0.
∂QA
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Rearranging, the best response of firm A (the reaction function) to QB is:

1 1
QA = (6 − QB ) = 3 − QB .
2 2
Similarly, firm B has profits:
πB = pQB − QB = (7 − QB − QA )QB − QB = (6 − QA )QB − Q2B .
This is a quadratic in QB with a negative coefficient of Q2B so the first-order condition gives
a maximum. We have:
∂πB
= 6 − QA − 2QB = 0.
∂QB
Rearranging, the best response of firm B (the reaction function) to QA is:
1 1
QB = (6 − QA ) = 3 − QA .
2 2
In a Cournot–Nash equilibrium both firms are on their reaction functions so:
1 1
QA = 3 − QB and QB = 3 − QA
2 2
which implies that QA = QB = 2.
The price is:
p = 7 − QA − QB = 3.
The profits of firm A are:
pQA − QA = 3 × 2 − 2 = 4.
The profits of firm B are:
pQB − QB = 3 × 2 − 2 = 4.
(b) In a Stackelberg equilibrium the leader, here firm A, chooses output first. Firm B then
chooses its profit-maximising output given firm A’s output. Firm A takes firm B’s response
into account when choosing QA .
From the previous calculations firm B chooses output QB = 3 − QA /2 in response to QA .
Given this, firm A’s profits are:
πA = pQA − QA = (7 − QA − QB )QA − QA

1
= 7 − QA − 3 − QA QA − QA
2

1
= 4 − QA QA − QA
2
1
= 3QA − Q2A .
2
This is a quadratic in QA with a negative coefficient on Q2A so the first-order condition gives
a maximum. The first-order condition is:
dπA
= 3 − QA = 0
dQA
so QA = 3 and QB = 3 − QA /2 = 3/2. The price is p = 7 − QA − QB = 7 − 9/2 = 5/2.
Profits for firm A are:
5 9
πA = pQA − QA = × 3 − 3 = .
2 2
Profits for firm B are:
5 3 3 9
πB = pQB − QB = × − = .
2 2 2 4
(c) See the discussion of first-mover advantage and the Stackelberg model in BVFD Chapter 9.6.
(d) See BVFD Chapters 9.6 and 9.7.
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Question 12
(a) You are considering starting up a company. What is the economic cost of your
time? What is the opportunity cost of the money that you put into the
company? What are supernormal profits and how do they differ from
accounting profits?
(6 marks)
(b) How might the objective of a firm owned and run by one person differ from that
of a firm run by directors and owned by a large number of shareholders?
(6 marks)
(c) Suppose that a profit maximising firm in a perfectly competitive industry has
two types of cost in each year that it operates. At the start of each year there is
an upfront cost covering items such as software and legal fees which is fixed in
the sense that it does not depend on how much the firm produces. Once the
upfront cost has been paid it is not possible for the firm to get back any of the
money. There is a also a variable cost which depends on output.
Assume that the average variable cost is u-shaped. Show in a diagram the firm’s
average total cost, average variable cost and marginal cost curves. Show in your
diagram the price at which the firm makes zero economic profits when it takes
the fixed costs into account.
(10 marks)
(d) Now assume that the firm learns that next year the fixed cost will be higher but
the variable cost will be the same. How does the change the cost curves? What
effect will this have on the firm’s output this year? What is likely to happen to
the firm and the industry next year?
(8 marks)
For (a), see BVFD Chapters 1.3 and 6.2.
For (b), see BVFD Chapter 6.3.
For (c) and (d), see BVFD Chapter 7.3 on the relationship between marginal cost (MC), average
variable cost (AVC) and average total costs (ATC).
(a) The idea of opportunity cost (economic cost) is introduced in BVFD Chapter 1.3. For
people who can do two things with their time, the opportunity cost of doing one thing is the
benefit of doing the other. If there are more than two things to choose between, the
opportunity cost of one thing is the benefit of the best alternative.
In the context of the start-up the opportunity cost of your time is the maximum amount
you could make doing something else. If the best alternative is employment it is your wage.
In the context of the start-up the opportunity cost of the capital you put into the firm is the
amount you could earn on the capital doing something else – for example, putting the
money in a bank or investing in the shares of other companies.
Supernormal profits are the difference between the revenue of the firm and the opportunity
cost of inputs.
(b) If a firm is owned and run by one person she may prefer to work for herself rather than
being employed, perhaps because she can work in ways and on projects which she finds
satisfying, she may choose not to maximise profits.
In a firm run by directors and owned by a large number of shareholders, the shareholders are
assumed to be interested in maximising profits. The directors run the firm. The directors
12
will be interested in revenue rather than profit maximisation if the amount of money they
get is related to the size of the firm. There is then a conflict of interest. This conflict can be
made less serious by linking directors’ payment to profits or share value rather than size.
The other factor which may push profit maximisation is the threat of hostile takeover. This
applies only to firms whose shares are publicly traded. If another firm believes that the firm
is failing to maximise profits it may put in a hostile bid for the firm. If the bid is successful
the firm taking over is likely to sack senior management of the firm which has been taken
over. Takeovers are more common in some countries (such as the UK) than in others (such
as Germany).
(c) We have:
The horizontal axis should be labelled as q and/or output. The units on the vertical axis are
given as costs (£) in the textbook.
The average variable cost curve AVC should be shown as u-shaped as the question states.
The average total cost curve should be shown as lying everywhere above the AVC curve.
The distance between AVC and ATC is large for small q and small for large q.
The marginal cost curve must pass through the minimum of both the AVC and ATC curves.
The price at which the firm makes zero economic profits taking fixed costs into account is at
the level of minimum ATC. In the above figure this is p0 .
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(d) We have:
MC and AVC do not change. ATC shifts upwards from ATC0 to ATC1 .
The minimum of ATC1 is at the point where the ATC1 curve intersects MC. The
intersection is at a higher point than that of ATC0 and MC.
There is likely to be no effect on price and quantity this year as the fixed cost for this year is
already sunk.
However, when deciding what to do next year firms take ATC1 into account. The market
price will increase from p0 to p1 . At the higher price demand will be lower so the industry
quantity will be lower. There will be fewer firms in the market.
Section C: Macroeconomics
Question 13
(a) The IS–LM diagram has income on the horizontal axis and the interest rate on
the vertical axis. What is the LM schedule in this diagram? Why is it upward
sloping?
(6 marks)
(b) What is the IS schedule in the IS–LM diagram? Why is it downward sloping?
Assume the economy is closed and explain your answer mathematically.
(8 marks)
(c) Use the IS–LM model to show how fiscal and monetary policy can be used to
increase output without changing the interest rate.
(8 marks)
(d) What are the limitations of the IS–LM model that policymakers should be
aware of ?
(8 marks)
14
For (a), BVFD Chapter 20.2 explains why central banks have moved to setting interest rates
from controlling the money supply. Also, see BVFD Chapter 19.5, in particular Concept 19.1.
For (c), see BVFD Chapter 20.2.
For (d), BVFD Chapter 21.2 argues that in the long run output is determined by aggregate
supply. Attempts to use monetary policy beyond that level results in inflation.
(a) There are two ways to consider the LM curve. Which is appropriate depends on how the
central bank operates – either by setting the money supply or by setting the interest rate.
Traditionally central banks operated by controlling the money supply. However, now central
banks such as the Bank of England (UK), Federal Reserve (US) and European Central Bank
(Eurozone) operate by setting the interest rate. Concept box 20.1 explains how the LM
schedule can be interpreted as a description of the central bank’s interest rate policy.
Because of the widespread use of interest rate setting EC1002 Introduction to
economics no longer requires candidates to know the traditional theory of monetary policy
operated by controlling the money supply. Since the financial crisis of 2008–09, quantitative
easing has been an important part of monetary policy. This question does not require a
discussion of quantitative easing but other questions could do so.
(b) In outline the IS schedule shows the combination of interest rates and income at which the
goods market clears. At low levels of the interest rate investment and consumption are high
which results in high levels of income. At high levels of the interest rate investment and
consumption are low which results in low levels of income. Therefore, the IS schedule is
downward sloping.
For good marks you need more detail. From BVFD Chapter 17.2, in a closed economy the
relationship between income, Y , investment, I and government spending, G, is given by:
Y = C + I + G.
In equilibrium this equation holds when C, I and G are all at their planned levels. Ignoring
the effects of interest rates for now and taking government spending, G, and investment, I,
as given and working with the consumption function, where T is taxes, gives:
C = Ac + c(Y − T )
where 0 < c < 1 and Ac > 0. This implies:
Y = Ac + c(Y − T ) + I + G
(1 − c)Y = Ac + I + G − cT
Ac + I + G − cT
Y = .
(1 − c)
Now take account of the fact that investment and consumption are affected by the interest
rate, r. Both are lower at higher values of r implying that Y is decreasing in r so the IS
curve is downward sloping.
An excellent answer would do this algebraically starting with:
I = AI − dr
C = Ac − er + c(Y − T )
where AI > 0, AC > 0, d > 0 and e > 0. Hence:
Y = Ac − er + c(Y − T ) + AI − dr + G
15
so:
Ac0 − cT + AI − (d + e)r + G
Y =
(1 − c)
which is decreasing in r so the IS curve is downward sloping because d > 0, e > 0 and
0 < c < 1.
(c) We have:
The figure above is based on Figure 20.4 of BVFD.

The original position E0 is at the intersection of the downward-sloping IS0 and
upward-sloping LM0 .
Expansionary fiscal policy, cutting taxes, and/or increasing government spending shifts the
IS curve upwards from IS0 to IS1 . If there is no change in monetary policy, then the LM
curve does not change and this moves the economy from E0 to E1 so increases both income,
Y , and the interest rate, r.
Expansionary monetary policy shifts the interest rate downward for each level of income so
shifts the LM curve downward from LM0 to LM1 . The combined effect of the shifts in the IS
and LM curves moves the economy from E0 to E1 where the interest rate, r, is back at its
original level r0 and income, Y , has increased from Y0 to Y1 .
(d) IS–LM is a theory of demand which applies only if the country is below its potential level of
output. Attempts to use monetary and fiscal policies to move the economy above this level
are likely to result in inflation.
It is possible that increasing government spending will indicate to households and firms that
the economy is in a bad way so any increase in government spending is likely to result in an
offsetting fall in consumption and investment. See BVFD Case 17.1 for a discussion of
Japan in this context.
IS–LM ignores the consequences of monetary and fiscal policies for aggregate supply in the
long run. This effect is called hysteresis – see Concept box 23.2. It may operate through the
labour market. It may also be a result of low levels of investment reducing the capital stock
in the future.
The balance between government spending and taxes is also considered only as a component
of aggregate demand in the IS–LM model. However, it affects the stock of government debt.
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Question 14
(a) Explain the difference between a fixed exchange rate regime and a floating
exchange rate regime. What policy actions does a country have to follow to
maintain a fixed exchange rate? What is a dirty float?
(6 marks)
(b) The UK has a floating exchange rate and capital mobility. The exchange rate
between the US dollar and the UK pound changed from $1.48 dollars per pound
on June 23rd 2016 to $1.36 dollars per pound on June 24th 2016 following the
vote to leave the European Union.
Did the UK pound appreciate or depreciate relative to the US dollar?
Did the change in the exchange rate make it more or less expensive for UK
residents to buy goods manufactured in the US?
Does the change in the exchange rate make exporting to the US more or less
attractive for UK-based firms?
What effect is the change in the exchange rate likely to have on inflation in the
UK?
(8 marks)
(c) 8 marks Consider an open economy with a fixed exchange rate and perfect
capital mobility. Assume that it is impossible to devalue the currency. Suppose
that inflation increases. Can the central bank change the interest rate in order
to reduce inflation? Is fiscal policy effective in this situation?
(8 marks)
(d) Consider an open economy with a floating exchange rate and perfect capital
mobility. Suppose that inflation increases. Can the central bank change the
interest rate in order to reduce inflation? Is fiscal policy effective in this
situation?
(8 marks)
For (a), BVFD Chapters 24.2 and 24.3 explain the difference between fixed and floating exchange
rate regimes. Also, see BVFD Chapter 26.3.
For (d), see BVFD Chapters 25.4 and 25.5.
(a) In a fixed exchange rate regime the exchange rate is fixed by the government. The central
bank has to meet any difference between supply and demand for the currency by adjusting
foreign exchange reserves. If demand for its currency is less than supply, the central bank
has to buy domestic currency and sell foreign currency which reduces its foreign exchange
reserves. This cannot carry on indefinitely – if investors believe that the currency may be
devalued the currency becomes vulnerable to speculative attacks.
With a floating exchange rate regime the exchange rate adjusts to equate supply and
demand for the currency. The central bank does not buy or sell currency.
With a managed float (sometimes called a dirty float) there is no fixed exchange rate, but
the central bank sometimes intervenes in the currency market, largely in order to smooth
fluctuations in the exchange rate.
17
(b) The pound depreciated against the dollar. The number of pounds required to buy $1
increased from 1/1.48 = 0.68 to 1/1.36 = 0.74.
It makes it more expensive to buy goods manufactured in the US because more pounds are
needed for each dollar.
It makes it more attractive to export to the US because the price in dollars now gives more
pounds.
It is likely to increase inflation. If this were a one-off effect that had all its impact
immediately there would be an increase in the pound-price of goods that were imported, or
made from imported inputs, but then no more change. However, the change takes time to
feed through so inflation is at a higher level while that is happening. If the pound continues
to depreciate there will be a sustained higher rate of inflation.
(c) Intuitively with a fixed exchange rate and perfect capital mobility the interest rate has to be
set at a level that will maintain the exchange rate so monetary policy is not available for
controlling inflation.
Fiscal policy is more effective because with the interest rate given there is no interest rate
effect on investment and consumption.
Intuitively as the nominal interest rate is set to maintain the exchange rate, domestic
inflation with a fixed exchange rate reduces the real rate of interest so, other things equal,
increases aggregate demand. However, the other effect is on the price of imports which
become more expensive which decreases aggregate demand.
A better answer would include a model. See BVFD Mathematics box 25.1. Use notation:
• Y = aggregate demand
• r = nominal interest rate
• π = inflation
• r − π = real interest rate.
Aggregate demand is Y = A − b(r − π), with A > 0 and b > 0.
Interest rate policy is r − π = f π, with f > 0. The real interest rate is high when inflation is
high.
Hence Y = A − aπ, where a = bf .
Taking the exchange rate into account:
Y = A0 − b(r − π) − h(EP/P ∗ )
where E is the exchange rate, P is the domestic price level and P ∗ is the foreign price level.
Fiscal policy increases A0 which increases Y .
(d) Monetary policy
In an open economy changing monetary policy by increasing the interest rate has the
immediate effect of increasing capital inflows, so the exchange rate appreciates. If the
interest rate increase is expected to be temporary investors expect a depreciation of the
exchange rate, capital inflows will reverse and there will not be a persistent effect on the
exchange rate.
If the interest rate increase is expected to persist there will be an effect on the exchange
rate. The textbook argues intuitively that, in the short run, interest parity must hold. This
requires that, taking into account exchange rate changes, the return from buying a domestic
asset must be the same as that from buying a foreign asset. The return to a UK investor
from holding a UK asset is the UK interest rate. Alternatively, the UK investor can sell
pounds to get US dollars, use the dollars to buy a US asset earning the US interest rate, then
sell the dollars got from this asset to buy pounds. The assumption is that the rates of return
on the two strategies must be the same. So if the UK interest rate is persistently higher
than the US interest rate this must be offset by an appreciation of the pound relative to the
dollar which makes exporting less profitable so further reduces aggregate demand. (Note:
this argument is fine as an examination answer at EC1002 Introduction to economics
18
level. However, if you are considering making such an investment note that exchange rates
sometimes move suddenly by a large amount so the strategy outlined can be very risky.)
Therefore, monetary policy is more effective in an open economy than in a closed economy.
Fiscal policy
Suppose the government responds to the inflation with tighter fiscal policy – increasing
taxes or decreasing government spending. This reduces aggregate demand which results in a
lower interest rate so a depreciation of the exchange rate which boosts exports which
increases aggregate demand, so the two effects work in opposite directions and fiscal policy
is less effective in an open economy than in a closed economy.
19

Important note

references
section.
Comments on specific questions – Zone B
This paper consists of THREE sections:
Section A (40 marks): TEN multiple choice questions, each worth FOUR marks. Candidates must
answer all questions. No explanation is needed.
Section B (30 marks): Candidates must answer ONE of TWO questions on microeconomics. It is
Section C (30 marks): Candidates must answer ONE of TWO questions on macroeconomics. It is
Section A
Answer all questions from this section.
Choose one answer for each question; no explanation is needed.
Note that some questions ask you to choose which statement is correct and others ask you to choose
which statement is not correct.
Question 1
Figures (a)–(d) show long-run average cost curves (LAC). Which of the figures
shows economies of scale at all levels of output?
20
(a) Figure a.
(b) Figure b.
(c) Figure c.
(d) Figure d.
(a) is correct.
Economies of scale means that long-run average cost falls as output rises.
Question 2
The table shows the total revenue of a firm. Find marginal revenue at each level of
output. Which of the following statements is correct?
output revenue
1 7
2 12
3 15
4 16
5 15
6 12
(a) The marginal revenue from increasing output from 3 to 4 units is 3.

(b) Increasing output always increases profits if marginal revenue is positive.
(c) If marginal cost is 1 at all levels of output then the profit-maximising level of
output is 4.
(d) If marginal revenue is less than marginal cost then increasing output increases
profits.
21
See BVFD Chapter 6.6 for how to get marginal revenue from total revenue and find the
profit-maximising level of output from marginal revenue and marginal cost.
(c) is correct.
See the table below for the calculations:

output revenue marginal revenue
1 7 7
2 12 5
3 15 3
4 16 1
5 15 −1
6 12 −3
Increasing output increases profits if MR > MC and decreases profits if MR < MC. Here MC = 1
so MR > MC if output Q < 4 and MR < MC if Q > 4, so Q = 4 maximises profits.
Question 3
Which of the following statement is correct?
(a) Congested roads carrying a large amount of traffic are public goods.
(b) If a good is public then consumption by one person does not reduce the amount
available for other people.
(c) A public good is a good produced by the government.
(d) A public good is a good that the government pays for.
(b) is correct.
A public good is a good for which individuals cannot be excluded from using it and the use by an
individual does not reduce availability to others.
Question 4
You are told that the own price elasticity of demand for a good is −0.5. Which of
the following statements is correct?
(a) If the price increases by $1 then the quantity of the good demanded increases
by 0.5.
(b) If the price decreases by $1 then the quantity of the good demanded decreases
by 0.5.
(c) If the price increases by 1% then the quantity of the good demanded increases
by 0.5%.
22
(d) If the price increases by 1% then the quantity of the good demanded decreases
by 0.5%.
(d) is correct.
The own-price elasticity of demand quantifies the sensitivity of demand (in percentage points) to
a change in price (also in percentage points).
Question 5
The figure shows a supply and demand diagram. Find the equations of the supply
and demand curves. Which of the following statements about the equilibrium price
p and quantity Q is correct?
(a) p = 75, Q = 25.

(b) p = 60, Q = 20.
(c) p = 45, Q = 15.
(d) p = 30, Q = 10.
See BVFD, Chapter 3.4 and Mathematics box 3.1.
(b) is correct, p = 60 and Q = 20.
The inverse supply function has equation pS = 3Q, because it is a straight line which passes
through the origin and has slope 90/30 = 3.
23
The inverse demand function has equation pD = 90 − 3Q/2, because it is a straight line, meets
the vertical axis at 90 and has slope −90/60 = −3/2.
The inverse supply and demand functions intersect when pS = pD , so:
3
3Q = 90 − Q
2
which implies that Q = 20. The price is 3Q = 60.
Question 6
(a) The labour market is in equilibrium if there is zero voluntary unemployment.

(b) The labour market is in equilibrium if demand for labour at the current wage is
equal to the number of workers willing to accept a job at the current wage.
(c) The labour market is in equilibrium if demand for labour at the current wage is
equal to the size of the labour force.
(d) It is impossible to increase the level of equilibrium unemployment by improving
the match between the skills employers require and the skills workers have.
(b) is correct.
The labour market is in equilibrium if demand for labour at the current wage is equal to the
number of workers willing to accept a job at the current wage.
Question 7
Use the IS–LM diagram to answer this question. Suppose the government cuts
taxes but does not change expenditure or monetary policy. Which of the following
statement is correct?
(a) The IS curve shifts downwards.

(b) The LM curve shifts downwards.
(c) Income increases but the interest rate falls.
(d) Both income and the interest rate increase.
See BVFD Chapter 20.2 for a discussion of shifts in the IS curve, and the figure below.
24
(d) is correct.
It shifts upwards (BVFD observes that an increase in taxes shifts the IS curve down, so a
decrease in taxes shifts the IS curve up). This is a change in fiscal policy, not monetary policy, so
the LM curve does not change. The effect of the outward shift in the IS curve is to move upwards
along the upward-sloping LM curve increasing both income and the interest rate. See the figure
above where the IS curve shifts from IS0 to IS1 . There is no change in the LM curve so the effect
of the tax cut is to shift the economy from E0 to E1 , so income increases from Y0 to Y1 and the
interest rate increases from r0 to r1 .
Question 8
Consider a closed economy with no government. Use notation:
• Y income
• C consumption
• I investment
• S saving.
Assume that consumption is given by C = A + cY and Y = C + I where A and c

are both positive and c is less than 1. Which of the following statements is correct?
(a) If c = 0.80 then the multiplier is 0.80.

(b) If consumers become more willing to consume so c increases but I and A do not
change then income falls.
(c) Suppose that c = 0.80. Suppose that investment falls by 10 because investors
become less optimistic. Then income falls by 40.
(d) If saving and investment are at their planned levels and S = I then the
economy is in equilibrium.
See BVFD Chapter 16.4 and Mathematics box 16.
(d) is correct.
25
In this model Y = C + I = A + cY + I, so in equilibrium:
(1 − c)Y = A + I
implying that:
A+I
Y = .
(1 − c)
The multiplier is 1/(1 − c). If c = 0.80 then the multiplier is 5, so (a) is incorrect. If investment
decreases by 10 then output Y decreases by 50, so (c) is incorrect. If c increases then 1 − c
decreases and the multiplier 1/(1 − c) increases so equilibrium income increases, hence (b) is
incorrect. Equilibrium requires that when consumption, saving and investment are at their
planned levels C + I = C + S, so S = I.
Question 9
Central banks such as the Federal Reserve in the USA and the Bank of England in
the UK operate monetary policy. Which of the following statements is not correct?
(a) No central bank ever allows other banks to become bankrupt.

(b) Many central banks control the interest rate but not the money supply.
(c) Some central banks buy both government and private sector bonds.
(d) Many central banks aim to control the rate of inflation. Some central banks are
concerned about both inflation and the level of unemployment.
See BVFD Chapters 19.5, 19.6, 18.7 and 22.7.
(a) is not correct.
Many central banks, including the Bank of England, have an inflation target. Although it is not
officially part of its mandate the Bank of England is in practice also concerned about the level of
unemployment. The US Federal Reserve is concerned about both inflation and the level of
unemployment.
Central banks do sometimes allow other banks to become bankrupt. For example, the US Federal
Reserve allowed Lehman Brothers to go bankrupt in September 2008.
Central banks do sometimes buy government and private sector bonds. This is quantitative
easing.
The Bank of England and the US Federal Reserve control the interest rate but not the money
supply.
Question 10
The UK has a floating exchange rate and capital mobility. The exchange rate
between the US dollar and the UK pound changed from $1.48 dollars per pound on
June 23rd 2016 to $1.36 dollars per pound on June 24th 2016 following the vote to
leave the European Union. Which of the following statements is correct?
(a) The UK pound appreciated relative to the US dollar.

(b) The change in the exchange rate makes it less expensive for UK residents to
buy goods manufactured in the US.
26
(c) The change in the exchange rate makes exporting to the US more attractive for
UK based firms.
(d) The change in the exchange rate is likely to decrease the rate of inflation in the
UK.
(c) is correct.
The pound depreciated against the dollar. It makes it more expensive to buy goods
manufactured in the US because more pounds are needed for each dollar.
It makes it more attractive to export to the US because the price in dollars now gives more
pounds.
It is likely to increase inflation. If this were a one-off effect that had all its impact immediately
there would be an increase in the pound-price of goods that were imported, or made from
imported inputs, but then no more change. However, the change takes time to feed through so
inflation is at a higher level while that is happening. If the pound continues to depreciate there
will be a sustained higher rate of inflation.
27
Section B: Microeconomics
Question 11
(a) The indifference curve diagram has the quantities of two goods x and y on the
axes. Explain the meaning of the assumptions that the consumer prefers more
to less and has a diminishing marginal rate of substitution. Show in a diagram
the indifference curves of a consumer who prefers more to less and has a
diminishing marginal rate of substitution. Indicate which set of points gives
higher utility than the points on the indifference curve.
(8 marks)
(b) What does the budget line represent? If the price of good x is px , the price of
good y is py and income is M what is the equation of the budget line? Show the
budget line in a diagram. Where does the budget line meet the x-axis? Where
does the budget line meet the y-axis? What is the slope of the budget line?
What happens to the budget line if the price of good x, the price of good y and
income M all increase by 20%?
(6 marks)
(c) Show in a diagram the relationship between the indifference curve and the
budget line at the consumer’s chosen bundle. What is the relationship between
the marginal rate of substitution and the prices px and py of goods at the
consumer’s chosen bundle? Show in your diagram what happens to the budget
line and the chosen bundle if the price of good x increases while the price of
good y and the consumer’s income do not change.
(8 marks)
(d) What is a normal good? Assume both goods are normal. Show in a new
diagram the breakdown into income and substitution effects of an increase in
the price of good x with no change in the price of good y and income.
(8 marks)
For (a), see BVFD Chapter 5.1 for a discussion of tastes and utility and the representation of
tastes as indifference curves.
For (b), see BVFD Chapter 5.1 for a discussion of the budget line.
For (c), see BVFD Chapter 5.1 for a discussion of utility maximisation, tastes, price changes and
the budget line.
For (d), see BVFD Chapter 4.6 for the definition of a normal good. Chapter 5.2 shows the effect
of an increase in income if both goods are normal. Chapter 5.3 discusses income and substitution
effects.
28
(a) We have:
The consumer prefers more to less if holding consumption of one good constant and
consuming more of the other increases utility. This implies that the indifference curve is
downward sloping. Bundles of goods above the indifference curve are preferred to bundles of
goods on the indifference curve.
The marginal rate of substitution (MRS) says how many units of good y the consumer is
willing to give up to get one more unit of good x. It is the negative of the slope of the
tangent to the indifference curve. The MRS is decreasing if the consumer becomes less
willing to give up good y in order to get more of good x as the amount of good x that she
has increases.
Taken together, preferring more to less implies that indifference curves are decreasing and
getting flatter as x increases and y decreases.
(b) We have:
The budget line shows the maximum combinations of goods that the consumer can afford
given prices and income.
It has equation:
px x + py y = M
29
where px and py are the prices of goods x and y, respectively, and M is income. The budget
line is a straight line that meets the x-axis at (M/px , 0) and the y-axis at (0, M/py ). Its
slope is −px /py .
If the price of good x, the price of good y and income all increase by 20% there is no change
in the budget line. A way of seeing this geometrically is that the ratios M/px and M/py do
not change when px , py and M are all increased by 20% so the points where the line meets
the axes do not change.
(c) We have:
The consumer chooses a point at which the budget line is tangent to the indifference curve.
At the chosen bundle MRS = px /py .
When py and M do not change there is no change in the point (0, M/py ) at which the
budget line meets the vertical axis. However, if px increases then M/px decreases so the
point (M/px , 0) at which the budget line meets the horizontal axis shifts leftward. As px
increases but py does not change, px /py increases so the budget line becomes steeper. Before
px increases the consumer is at A in the figure above. After px increases the consumer is at
point B.
(d) We have:
The figure above shows the substitution effect and income effect. This requires drawing a
line that is parallel to the new steeper budget line and tangent to the original indifference
curve at the point D. This is the dashed line in the figure.
30
C to D is the substitution effect of an increase in px from px1 to px2 .

D to E is the income effect. As both goods are normal the income effect D to E also results
in a decrease in both x and y.
Question 12
(a) What is the relationship between total cost, marginal cost and average cost? If
the long-run total cost for a firm of producing output q is 2q what is the
long-run marginal cost function and what is the long-run average cost function?
(6 marks)
(b) What is perfect competition? Suppose an industry is perfectly competitive and
all firms have the same long-run cost function. What is the relationship between
the industry price, marginal cost and average cost in the long run? Explain
your answer.
(8 marks)
(c) Assume that an industry is perfectly competitive. For all firms in the industry
the long-run cost of producing output q is 2q. The demand curve for the
industry is Q = 6 − p where p is price and Q is industry output. What is the
industry price? How much does the industry sell? What profits does the
industry make?
(4 marks)
(d) What is monopoly? Assume that the industry is a monopoly which produces
output Q at total cost 2Q. As before the demand curve for the industry is
Q = 6 − p so the inverse demand curve is p = 6 − Q. Write down total revenue
as a function of Q and find the profit-maximising output and price. What
profits does the industry make? Are the consumers better or worse off with
monopoly than they are with perfect competition?
(12 marks)
For (a), see BVFD Chapter 7.6 for a discussion of the relationship between total, marginal and
average costs applied to short-run costs. Chapter 7.6 discusses total, average and marginal costs
for long-run costs. You must look at the Mathematics box. The relationship between total,
marginal and average cost functions is the same.
For (d), see BVFD Chapter 8.5 for the definition of a monopoly and Chapter 8.6 for a discussion
of the behaviour of a monopolist.
(a) Marginal cost is the extra cost of producing one more unit of output.
Average cost is the total cost divided by the quantity of output.
More mathematically marginal cost, M C(q), is the derivative of total cost T C(q) with
respect to quantity:
dT C(q)
M C(q) = .
dq
Average cost is the total cost of producing q units divided by the number of units produced.
Mathematically:
T C(q)
AC(q) = .
q
31
If the total cost T C(q) = 2q then the additional cost of going from q units to q + 1 units is
2(q + 1) − 2q = 2, so marginal cost is 2. Alternatively, using calculus:
dT C(q)
M C(q) = = 2.
dq
Average cost is:

T C(q) 2q
AC(q) = = = 2.
q q
(b) An industry is perfectly competitive if:
• there are many firms and consumers each buying or selling a small amount relative to
the market, so they are price-takers
• the good produced is homogeneous, that is all firms produce exactly the same good
• buyers have perfect information
• there is freedom of entry and exit.
See BVFD Chapter 6.6 for a discussion of why profit maximisation implies that marginal
revenue = marginal cost. Chapter 8.2 explains that for a perfectly competitive firm
marginal revenue = price, so profit maximisation implies that price = marginal cost.
The story here is that producing and selling one more unit generates extra revenue, that is
marginal revenue. However, it also generates extra cost, that is marginal cost. If marginal
revenue > marginal cost, increasing q by one unit increases profits. If marginal revenue <
marginal cost, increasing q by 1 unit reduces profit. Therefore, at the profit-maximising
point marginal revenue = marginal cost.
Alternatively, you can make the argument using calculus. A profit-maximising firm taking
prices as given chooses q to maximise:
π(q) = pq − T C(q).
(T C is the notation used in the textbook for total cost.) The first-order condition for profit
maximisation is:
dπ(q) dT C(q)
=p− = p − M C(q) = 0
dq dq
so profit maximisation implies that price = MC.
In the long run there is freedom of entry and exit. Firms leave the market if they make
losses and enter if they can make profits. Hence equilibrium in the market requires that
profits are zero, so pq − T C(q) = 0 implying that:
T C(q)
p= = AC(q).
q
(c) You can answer this question using either algebra or a diagram.
Algebra: in perfect competition in the long run p = LRM C = LRAC, so here p = 2.
The industry sells Q = 6 − p = 4.
The industry makes zero profits as p = AC.
Diagram: as all firms have a long-run cost of producing of 2q, marginal cost is 2 so the
marginal cost curve is a horizontal straight line as is the supply curve for the industry.
Industry price and quantity are determined by the intersection of supply and demand. From
the figure below the price must be 2, so quantity is determined by the demand curve,
Q = 6 − p = 6 − 2 = 4.
32
(d) A monopoly is the sole supplier of a good and does not face competition from potential
entrants.
You can find the profit-maximising Q in three ways. You only need to do one way.
i. Working with algebra: total cost is 2Q so profits are:
π(Q) = pQ − T C(Q)
= (6 − Q)Q − 2Q
= 6Q − Q2 − 2Q
= 4Q − Q2 .
The first-order condition:

dπ(Q)
= 4 − 2Q = 0
dQ
implies that Q = 2. For full marks it is essential to say something about why the
first-order condition gives a maximum. An argument you can use is that profits are a
quadratic in Q. The coefficient of Q2 is −1 which is less than 0 which implies that the
graph of the quadratic is an ‘arch’ and the first-order condition gives a maximum. A
more formal way of handling this is to observe that the function π(Q) has a negative
second derivative:
d2 π
= −2 < 0
dq 2
so is concave. If a function is concave, the first-order condition gives a maximum.
ii. As total revenue = 6Q − Q2 the derivative is marginal revenue = 6 − 2Q. MC = 2 so the
MR = MC condition implies that:
MR = 6 − 2Q = 2 = MC
so Q = 2. Again, you need to say something about why the condition MR = MC gives a
maximum. You can observe that MR is decreasing in Q so if Q < 2 then MR > MC so
increasing Q increases profits. If Q > 2 then MR < MC so increasing Q decreases profits.
Therefore, the profit maximum is where MR = MC.
iii. You can use a diagram, as below, which should show the demand curve and marginal
revenue as downward-sloping straight lines meeting the axes at the points shown in the
figure. Marginal revenue is 6 − 2Q so is a downward-sloping straight line which meets the
vertical axis at (0, 6) and has slope −2. MC as a horizontal straight line at height 2, and
MR = MC at Q = 2. Again, you need to say something about why the condition MR =
MC gives a maximum. You can observe that MR is decreasing in Q so if Q < 2 then MR
33
> MC so increasing Q increases profits. If Q > 2 then MR < MC so increasing Q

decreases profits. Therefore, the profit maximum is where MR = MC.
Whichever method is used to find Q the price is given by the inverse demand p = 6 − Q = 4.
Profits are:
π(Q) = pQ − T C(Q) = 4 × 2 − 2 × 2 = 4.
All you need to do to see whether the consumers are worse off with monopoly than they are
with perfect competition is to note that they must be because the monopoly price, 4, is
higher than the price with perfect competition, 2. See BVFD Chapter 8.7 for a detailed
discussion of the social costs of monopoly, but this is not required here.
Section C: Macroeconomics
Question 13
(a) The aggregate demand and aggregate supply diagram has output on the
horizontal axis and inflation on the vertical axis. Explain the derivation of the
aggregate demand schedule from the IS schedule and monetary policy. Why is
it downward sloping? Explain your answer mathematically.
(8 marks)
(b) What causes movements along the aggregate demand schedule? What happens
to the aggregate demand schedule if government expenditure increases and tax
revenue does not change? What happens to the aggregate demand schedule if
the target inflation rate is increased?
(8 marks)
(c) What is the shape of the aggregate supply curve if prices and wages are
completely flexible. What determines potential output?
(6 marks)
(d) Suppose that an economy starts at a point where aggregate demand and short
and long aggregate supply are all equal. The central bank then tightens
monetary policy in order to reduce the rate of inflation. Use a diagram to
discuss what happens to aggregate demand and supply in the short and long
run.
(8 marks)
34
For (a), see BVFD Chapter 21.1 and in particular Concept box 21.1. As Concept box 21.1 says,
there are many ways of modelling aggregate demand. For that reason the question tells you what
is on the axes of the diagram you should work with.
For (c), see BVFD Chapters 21.2 and 21.6.
For (d), see BVFD Chapters 21.2 and 21.3.
(a) You would get some marks for an intuitive answer to the question with no further
discussion. Monetary policy in most countries is now operated by an interest rate-setting
central bank with an inflation target. If inflation is high the central bank sets a high interest
rate. This reduces investment and consumption which makes the demand for output low. So
high levels of inflation are associated with low levels of demand.
For good marks you need to work either with algebra or a diagram. You do not have to do
both. Doing the algebra using the notation π = inflation, Y = output and r = interest rate,
the central bank sets interest rates according to the rule:
r = aπ
where a > 0 because high inflation results in a high interest rate. The IS schedule is
downward sloping and has an equation of the form r = b − cY , where c > 0 because at a
higher interest rate there is less investment so less output. Hence:
aπ = b − cY
so:
b − cY
π= (.1)
a
is the equation of the aggregate demand schedule. As a > 0 and c > 0 this is downward
sloping. It is essential for full marks that you comment on the signs of a and c.
You can also work with the diagram described in BVFD Concept box 21.1. The figure below
is based on this.
Understanding the diagram takes some work and you may find the algebra easier.
Explaining the diagram, start in the top-left part of the diagram which has inflation on the
horizontal axis and the interest rate on the vertical axis. Note that here moving left along
the horizontal axis corresponds to a higher level of inflation. The central bank sets a higher
35
level of interest rate when inflation is higher giving the upward-sloping line in this part of
the diagram.
Now look at the IS line in the top-right part of the diagram. Given the interest rate you can
read off what the output Y is.
The 45◦ line in the bottom-left part of the diagram is there simply to get the inflation rate
onto the the bottom part of the vertical axis. A higher inflation rate corresponds to a point
lower down the vertical axis.
Now draw a straight line vertically downwards from the level of output Y0 determined by
monetary policy and the IS curve. Draw a line horizontally from the interest rate on the
vertical axis. The point where these lines cross is on the aggregate demand curve in the
bottom-right part of the diagram. Starting at another inflation rate would give you another
point on the aggregate demand curve.
High inflation corresponds to lower levels of output, so if you go back to the usual diagram
you get a downward-sloping aggregate demand curve. To see this note that in the
bottom-right part of this diagram higher inflation corresponds to a point lower down the
vertical axis. Higher output corresponds to a point further to the right on the horizontal
axis. Therefore, high inflation is associated with low aggregate demand and low inflation is
associated with high aggregate demand.
(b) Which way you can do this depends on how you answered part (a). There are three
possibilities:
• intuition only, this will not give you full marks
• algebra
• diagram.
You can get full marks if you do either the algebra or the diagram correctly. You do not
need to do both.
Intuition
Movements along the aggregate demand schedule come from things that do not change the
IS schedule or monetary policy (the response function of the central bank). This requires
changes in the inflation rate for other reasons, for example depreciation of the exchange rate
which increases prices, or an increase in inflation due to a shock – weather related, for
example.
In outline an increase in government spending without a change in taxes increases aggregate
demand at each level of the interest rate, shifting out the IS curve. Hence for each level of
inflation aggregate demand is higher so the aggregate demand curve moves outwards.
Increasing the target inflation rate results in looser monetary policy, so setting a lower r at
each level of π. Moving to the IS curve this gives a higher Y at each level of π so the
aggregate demand curve shifts outwards.
Algebra
To do this you need to have established in part (a) that the equation of the aggregate
demand curve is:
b − cY
π=
a
which is decreasing in Y because a > 0 and c > 0. Therefore, the aggregate demand curve is
downward sloping. Movements along the aggregate demand curve are caused by changes in
π with no change in monetary policy (the relationship r = aπ).
If government spending increases and tax revenue does not change then b increases in the IS
curve shifting the IS curve r = b − cY upwards. The effect on aggregate demand,
π = (b − cY )/a, is to shift it outwards. Therefore, the inflation rate for each level of Y :
b − cY
π=
a
increases, so the aggregate demand curve shifts outwards.
36
If the target inflation rate is increased there is a decrease in a in the equation r = aπ which
has the effect on:
b − cY
π=
a
of increasing π. Hence the inflation rate for each level of Y increases, so the aggregate
demand curve shifts outwards.
Diagram
Movements along the aggregate demand schedule come from things that do not change the
IS schedule or monetary policy (the response function of the central bank). This requires
changes in the inflation rate for other reasons, for example depreciation of the exchange rate
which increases prices, or an increase in inflation due to a shock – weather related, for
example.
The figure shows the effect of the increase in government spending which shifts out the IS
curve implying that the aggregate demand curve also shifts outwards.
If the target inflation rate is increased then the central bank sets a lower interest rate for
each level of π so the monetary policy line in the top-left hand part of the diagram becomes
flatter. The change in monetary policy makes the central bank’s reaction function in the
top-left quadrant flatter which has the effect of giving a lower r for each level of π and so a
higher Y for each level of π, shifting the aggregate demand curve outward.
37
(c) If prices and wages are completely flexible output is always at its potential level which is
determined by the available inputs and technology. The aggregate supply curve is then
vertical. Inflation does not change relative prices so has no effect on aggregate supply.
(d) We have:
Initially all the curves intersect at (Y0 , π0 ). If the central bank tightens monetary policy it
sets a higher interest rate r and hence a lower Y for each level of inflation. In the short run
this has the effect of shifting the aggregate demand curve inwards from short run AD0 to
short run AD1. This moves the economy to (Y1 , π1 ), which is lower down the SRAS 0 curve,
so π1 < π0 and Y1 < Y0 .
In the long run the SRAS curve shifts downwards to SRAS 1 and the economy moves back
to the long-run supply curve, to (Y0 , π2 ) so in the long run the effect is to reduce the rate of
inflation but with no impact on supply.
Question 14
(a) The Phillips curve diagram has unemployment on the horizontal axis and
inflation on the vertical axis. Professor Phillips of the London School of
Economics published a paper in 1958 showing a statistical relationship between
annual inflation and employment with low unemployment when inflation was
high and high unemployment when inflation was low. What do economists now
believe about the shape of the long-run Phillips curve? Why is the short-run
Phillips curve downward sloping? Where do the long- and short-run Phillips
curves intersect?
(6 marks)
(b) What is the mathematical relationship between inflation J r, expected inflation
J r e , actual unemployment U and equilibrium unemployment U ∗ that describes
the short-run Phillips curve? What happens to the long-run and short-run
Phillips curves if expected inflation increases? Can governments in this model
reduce unemployment by increasing inflation in a predictable way?
(8 marks)
(c) What are the costs of anticipated and unanticipated inflation?
(8 marks)
(d) Is deflation (a negative rate of inflation) desirable?
(8 marks)
38
For (a), see BVFD Chapter 22.4.
For (b), see BVFD Chapter 24.4, in particular Mathematics box 22.1.
For (d), see BVFD Chapter 22.5 and in particular Case 22.1 on deflation.
(a) Economists now believe that the long-run Phillips curve is vertical. This is partly due to
what has happened since Phillips wrote his paper. Countries such as the UK have at times
experienced simultaneously high rates of unemployment and inflation. At other times there
has been low unemployment and low inflation. On a theoretical level there is a belief that in
the long run output is determined by the supply of inputs, technology, tax rates etc. It is
affected by the real wage, W/P , where W is the money wage and P is the price of goods. In
the long run the real wage adjusts to the point where there is an equilibrium level of
unemployment, sometimes called the natural rate of unemployment.
Economists believe that the short-run Phillips curve is downward sloping because nominal
(money) wages are based on expected inflation and change less frequently than prices. If
inflation is higher than expected, so the price of goods is higher than expected, the real wage
W/P is lower than expected, and so firms employ more workers. If inflation is lower than
expected, the real wage W/P is higher than expected, and so firms employ fewer workers.
The short-run and long-run Phillips curves intersect at the expected level of inflation.
(b) The mathematical relationship for the short-run Phillips curve is:
π = π e − b(U − U ∗ )
where π is the rate of inflation, π e is the expected rate of inflation, U is unemployment, U ∗

is the equilibrium level of unemployment, and the parameter b > 0.
See BVFD Chapter 24.4 for the definition of the equilibrium level of employment. It is the
level of employment associated with the natural level of output, that is the level of output
which is determined by the supply of inputs, the level of technology and the level of tax
rates etc.
In the short run the Phillips curve is downward sloping. In the long run people come to
expect the equilibrium level of employment and the level of inflation; the long-run Phillips
curve is a vertical straight line at the equilibrium level of output. See the figure below.
Governments cannot reduce unemployment by increasing inflation in a predictable way,
because people take this into account when forming inflation expectations.
The figure illustrates the situation. The economy starts at (U ∗ , π0 ) where the economy is on
both the short-run and long-run Phillips curves and inflation is at its expected level π0 .
Suppose that expected inflation rises from π0 to π1 . This shifts the short-run Phillips curve
upwards but does not change the long-run Phillips curve. Unemployment continues to
fluctuate around its equilibrium level U ∗ but inflation now fluctuates around π0 rather than
π1 .
39
(c) There are three possibilities.

• Inflation is fully anticipated and institutions adapt.
The book interprets this as meaning that real variables including relative prices, interest
rates and taxes do not change and the costs of inflation are:
∗ shoe leather costs – holding money becomes more expensive so people take costly
actions to economise on cash
∗ menu costs – the need to reprint menus, change prices.
Mobile phone banking, contactless payments and IT make these less important than in
the past.
• Inflation is fully anticipated but institutions do not adapt.
∗ Effective tax rates may change, for example if the level of income at which you start
paying tax is fixed in nominal terms it will drop in real terms.
∗ Taxation of capital is particularly difficult. The real interest rate = nominal rate −
inflation rate. Taxes on capital are typically not inflation-adjusted, so are based on
nominal returns.
• Unexpected inflation.
∗ Redistributes – generally borrowers gain (their real debts decrease) and savers lose as
their savings become less in real terms. This results in redistribution between
generations – savers are on average older than borrowers. However, this does depend
on what happens to the assets which older people hold – for example, if house prices
rise in real terms it benefits older people who have paid off their mortgages, but
makes it harder for young people to afford to buy a house.
(d) Negative rates of inflation are not desirable. This assumes that negative nominal interest
rates are not possible, that is banks cannot require savers to pay for banks to hold their
money because then people start holding cash.
Therefore:
real interest rate = nominal interest rate − inflation rate
= nominal interest rate + deflation rate
so if the nominal rate is zero and there is deflation of 4% then the real interest rate is 4%.
Therefore, monetary policy is tight which is likely to further increase deflation.
Deflation causes big problems for savers – including governments, firms and individuals. The
ratio of debt to income increases, resulting in lower spending which further increases
deflation. This is the debt deflation spiral. This was a major concern in the US in the 1930s,
and avoiding this spiral has been a concern of monetary policy post the 2007–09 financial
crisis.
40

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Examiners’ commentaries 2017

Examiners’ commentaries 2017

Information about the subject guide and the Essential reading

Format of the examination

This paper consists of three sections:

Key steps to improvement

Examination revision strategy

Examiners’ commentaries 2017

Information about the subject guide and the Essential reading

Comments on specific questions – Zone A

This paper consists of THREE sections:

Answer all questions from this section.

Choose one answer for each question; no explanation is needed.

Reading for this question

See BVFD Chapter 4.1.

Approaching the question

Reading for this question

See BVFD, Chapter 3.4 and Mathematics box 3.1.

Approaching the question

(c) is correct, p = 9 and Q = 6.

The inverse supply and demand functions intersect when pS = pD , so:

Reading for this question

Approaching the question

See the table below for the calculations:

Reading for this question

See BVFD Chapter 7.7.

Approaching the question

Which of the following statements is correct?

Reading for this question

See BVFD Chapter 14.2.

Approaching the question

Consider a closed economy with no government. Use notation:

Assume that consumption is given by C = A + cY and Y = C + I where A and c

Reading for this question

See BVFD Chapter 16.4 and Mathematics box 16.

Approaching the question

In this model Y = C + I = A + cY + I, so in equilibrium:

Which of the following statements is correct?

Reading for this question

See BVFD Chapter 23.2.

Approaching the question

Reading for this question

See BVFD Chapters 19.5, 19.6, 18.7 and 22.7.

Approaching the question

(b) is not correct.

Which of the following statements is correct?

Reading for this question

See BVFD Chapters 17.3.–17.6.

Approaching the question

(a) The aggregate demand curve shifts downwards.

Reading for this question

See BVFD Chapter 21.6 and the figure below.

Approaching the question

Reading for this question

Approaching the question

πA = pQA − QA = (7 − QA − QB )QA − QA = (6 − QB )QA − Q2A .

Rearranging, the best response of firm A (the reaction function) to QB is:

Reading for this question

For (a), see BVFD Chapters 1.3 and 6.2.

For (b), see BVFD Chapter 6.3.

Approaching the question

Reading for this question

For (b), see BVFD Chapter 17.2.

For (c), see BVFD Chapter 20.2.