200ECN Intermediate Economics

January 2017: Marking Scheme

Microeconomics Section

1. “A risk-averse decision maker prefers a sure thing to a lottery of equal

expected value, evaluates lotteries according to their expected utility, and has
a utility function that exhibits diminishing marginal utility”. Using diagrams
critically discuss these assertions.

Firstly, students are expected to explain why the expected utility theory is used to
analysis consumer behaviour in an environment of uncertainty instead of just using
the expected value, i.e. EV is only suitable if we assume that people are risk neutral.
Good answers are also expected to highlight that the expected utility theory is based
on the overall wealth of an individual.

Secondly, examples of different utility functions for a risk averse individual person
should be provided, e.g. sqrt(wealth) and ln(wealth). The more concave the utility
function is, the more risk averse a person will be. Highlight that the function is always
increasing at a diminishing rate. Excellent answers will explain the Arrow-Pratt
measure as a measure of risk aversion.

To show that a person prefers a sure thing to a lottery of equal expected value, a
numerical example and a diagram should be provided. E.g. a utility function sqrt(W)
can be assumed and then an individual has the following two options: 50% chance of
having wealth of 4000 or if the person is lucky a 50% of having a wealth of 12000.
The expected value of wealth would be 8000.

The utility the person gets from this gamble is EU(W) = 0.5 * sqrt(4000) + 0.5
sqrt(12000) = 85.4. Good answers will highlight that the measurement unit is utils.

If the person has a wealth of 8000 for sure, his utility would be 89.4, a higher utility
from before!

Good answers will also calculate the Certainty equivalent and Risk Premium and
explain the concept and will also add them to the diagram.
2. Three different ways of measuring the impact of a change in the price of a
good on consumer welfare are (i) the compensating variation of the price
change (ii) the equivalent variation of the price change and (iii) the change in
consumer surplus caused by the price change

(a) Illustrate and explain the differences between these three measures for a
price decrease. Clearly outline any assumptions you have made in your
analysis.
(b) Under what circumstances would the measures be equal? Draw a
diagram to illustrate your answer.

Firstly, good answers start with an explanation why does three measures are necessary
to measure changes in welfare of consumers and why we cannot just compare the
difference of utility functions. All three measures have to be defined. Equivalent
variation shows “How much money would you have to give a consumer, before a
price reduction, in order to have the equivalent positive impact of the price
reduction”, compensating variation on the other hand illustrates: “How much money
would you have to take away from a consumer, after a price decrease, in order to
make her just as well off as she was before the price decrease?” Consumer surplus is
defined as the difference between the willingness to pay and what consumers actually
pay. The Marshallian demand curve is used to capture the impact of price changes on
consumer surplus.

A graphical analysis using indifference curves and demand curves are required. As
you have to compare the measures, you have to derive EV and CV in the same
indifference curve diagram. Students have to explain how EV and CV can be derived
from the indifference curve diagram, i.e. for CV you have to shift the new budget
constraint back to the old indifference curve and for EV you have to shift the old
budget constraint to the new indifference curve.

Good answers also provide expenditure functions and how they can be used to derive
CV and EV. Students should highlight that EV focusses on the new and CV on the old
utility.

Students have to state what kind of good they are analysing, e.g. a normal good.
Students have to define normal goods (when income increases consumption increases)
and prove with the diagram that the good is normal (SE and IE point in the same
direction), i.e. from Q1 to Q’1 is the substitution effect and from Q’1 to Q2 is the
Income effect.

To compare both measures with the ∆ CS compensated and uncompensated demand

curves have to be derived. Those demand curves have to be derived from the
indifference curve diagram! Using appropriate labelling, students have to show that
the area of CV is smaller than the change in CS than the area of the EV.
Good answers will also say that for inferior goods EV < ∆ CS < CV. Excellent
answers will highlight that that we keep utility constant for EV and CV, for the
uncompensated (Marshallian) demand curve, utility is changing depending on the
position on the demand curve. Therefore the change in consumer surplus is only an
approximation for measuring welfare changes through price changes.

b. If there is no income effect, then CV = ∆ CS = EV. The larger the IE, the more
different those three measures will be. The IE is distorting the analysis. Therefore if
we have a large IE we cannot use the Marshallian demand curve for the welfare
analysis. Good answers will provide the Slutsky equation and show that if the budget
share of the good is small or the income elasticity is small, then the IE will be
negligible.
Good answer will also include examples.

To get full marks answers have to include indifference curve diagram for a good
without income effect. The derived compensated and uncompensated demand curve
diagram will show that all the three demand curves are the same.

General comments

- Many students mixed up CS and delta CS. Change in CS measures the impact of a
price change on welfare!
- Indifference curve diagrams were in general fine. Derivation of demand curves was
often missing or incorrectly labelled.
- Many students did not compare the three welfare measures with each other!
- Many students did not answer part b. of the question, which had a big impact on
mark.
- Only few students were able to draw a diagram for goods with no IE.
Question 3

To avoid an increasing budget deficit the Chancellor is considering different policies

to raise money. Using indifference curve analysis analyse the impact of the suggested
policies below for a person who consumes good (food) and good (all other goods).

a) Compare and contrast the impact of a quantity tax on food products and an increase
in income tax. Focus your analysis on both the utility and consumption of food.
Which policy is less harmful for the consumer. (50 marks)

b) Assume that the government introduced a quantity tax. To mitigate the impact of
the quantity tax on the poor the government considers refunding the tax paid by using
lump sum payment for poor consumers. Analyse the impact of the refund on the poor
consumer's utility. (50 marks)

(100 marks total)

3a)

The quantity tax will affect the price of good, while the income tax will affect the
maximum amount that can be consumed of both goods. Graphically, the income tax
will shift the budget constraint downwards, while the quantity tax will pivot the
budget constraint clockwise around the intercept on the -axis.

From the graphical solution it can be seen that the quantity consumed of good will
drop more under a quantity tax. The welfare loss will also be higher under a quantity
tax. The reason for this is that the quantity tax distorts prices. The geometric argument
that highlights the fact that a quantity tax yields a higher welfare loss is the following:

To find the equivalent income tax that generates the same tax revenue, the original
budget constraint will be shifted down such that it intersects the consumption bundle
that is optimal under a quantity tax. This implies that the original bundle is affordable,
but the slope is now not equal to the MRS. This implies that allocation is not optimal
anymore. So there must exist another interior solution that is affordable but yields a
higher utility.

3b)

Given that the tax is refunded, the budget constraint is shifted up such that it intersects
the old budget constraint. Given that prices are distorted in most cases there will still
be a welfare loss and the poor are not fully compensated.

The only case in which there might be a welfare gain is the case of a Giffen good.
Macroeconomics

FIRST SIT – QUESTION 4a [30 marks]

Money as a Medium of Exchange: [10 marks]
 Money is used to facilitate the exchange of goods and services.
 Explanation:
o Without money, exchange of goods and services is possible only if there is a 'double
coincidence of wants',
o with money, exchange of goods and services is possible even if there is only a 'single
coincidence of wants'.
 Example: hungry lecturer / studying butcher

Money as a Measure of Value: [10 marks]

 Money is used to express the value/price of goods and services.
 Explanation:
o Without money, if there are n goods in the economy, there will be n(n−1)/2 relative
prices.
o With money, if there are n goods in the economy, there will only be n relative prices.
 Example: 20 goods  190 prices / 19 prices.

Money as a Store of Value: [10 marks]

 Money is used to transfer purchasing power over time.
 Explanation
o Without money, many repositories of purchasing power over time tend to be illiquid
and/or risky.
o Money as a repository of purchasing power over time tends to be liquid and
(relatively) safe.
 Example: Money vs. Italian government bonds

FIRST SIT – QUESTION 4b [50 marks]

Preliminaries [10 marks]
 Downward sloping money demand curve
 because
 if interest rate i (opportunity cost of money) increases
 less money used as store of value
 less money demand
 Horizontal (or any other) money supply curve
 because central bank controls money supply.

Short-Term Effects of Quantitative Easing (“Liquidity Effect”) [15 marks]

Due to the acquisition of bonds (Quantitative Easing):
 Money supply will increase
 Because central banks buys bonds using money
 Result: interest rate will decrease
 Diagram
o Rightshift of money supply curve
o Equilibrium
 “Liquidity Effect”
Long-Term Effects of Quantitative Easing (“Income / Price Level / Expected Inflation-Effect”)
[20 marks]
Due to the increase in money supply / short-term decrease in the interest rate
 Income and Price Level will increase
 Money demand will increase
 Because of transactions motive
 Result: interest rate will increase
 Diagram
o Rightshift of money demand curve
o Equilibrium
 “Income / Price Level / Expected Inflation-Effect”

Final Outcome: [5 marks]

The final interest rate will be
 lower than the initial interest rate if
o Liquidity Effect larger than Income et al Effect
 higher than the initial interest rate if
o Liquidity Effect smaller than Income et al Effect

FIRST SIT – QUESTION 4c [20 marks]

Main Characteristics: [10 marks]
 One-off fixed repayment of the face value at maturity date n,
 No interest payment (coupon) at maturity date n,
 Face value (typically) above price (borrowed amount).

Calculation of the Price: [10 marks] To

calculate the price 𝑃, we can use
𝐹
𝑃= ,
1+𝑖
where 𝐹 denotes the face value and 𝑖 denotes the interest rate. Inserting the given data results i
2,750
𝑃= = 2,500.
1+0.1

FIRST SIT – QUESTION 5a [60 marks]

Students need to discuss effects of exchange rate volatility to exports.
A discussion of how exchange rate is determined should be provided. A graph explaining the
equilibrium points should also be provided. (20 marks)
Furthermore, the implications of exchange rate change should be analysed and a relation to exporter’s
future profits should be made.
A discussion of the different types of risk associated with producers should be provided and how these
might affect their decision to export or sell in the domestic market.
Finally the implications of the fluctuation of exchange rate to the level of exports should be explained.
(20 marks)
A use of an example to illustrate the potential effects to exports from exchange rate volatility is also
necessary. (20 marks)

FIRST SIT – QUESTION 5b [40 marks]

Calculation of M0: [10 marks]
To calculate M0, we can use
𝑀0 = 𝐶 + 𝑅,
Where 𝐶 denotes total currency in circulation and 𝑅 denotes total bank reserves. Inserting the given
data results in:
 𝑀0 = 80 + 320 = 400.

Calculation of M1: [15 marks]

To calculate M1, we can use
𝑀1 = 𝐶 + 𝐷,
Where 𝐶 denotes total currency in circulation and 𝐷 denotes total bank deposits. Solving the reserves
ratio 𝑟 = 𝑅 ⁄𝐷 for 𝐷 and inserting the result above results in:
𝑀1 = 𝐶 + 𝑅 ⁄𝑟.
Inserting the given data results in:
320
𝑀1 = 80 + = 1,680.
0.2

Calculation and Interpretation of the Money Multiplier 𝜇: [15 marks]

To calculate 𝜇, we can use
𝑀1 = 𝜇 × 𝑀0.
Inserting the above results results in: 1,680 = 𝜇 × 400 and thus
𝜇 = 4.2
Interpretation of the Money Multiplier: The money multiplier reflects the marginal effect of an increase
in the monetary base on money supply.

FIRST SIT – QUESTION 6 [100 marks]

A
A discussion of the definitions of both nominal and real exchange rate should be provided (5 marks)
Nominal exchange rate: The price of one currency in terms of another
Real exchange rate: The relative purchasing power of one currency compared with another given the
current exchange rate and price level
RER = S x P/P*
 S = nominal/spot exchange rate

 P = price index in the UK

 P* = price index in the foreign country

Students should also provide an example for both nominal and real exchange rate. (5 marks)

B
The discussion should be made around changes to both nominal and real exchange rate changes in
relation to potential affects from to exports and imports.
The discussion should be focused on both effects for the government (example rise or fall in
competiveness resulting to a rise or fall on exports) as well the purchasing of goods and services from
individual consumers. (20 marks)
An example can also be provided for potential implications to both consumers and government (10
marks)

C
Students must calculate the interest from scenario A as well as the profit. In scenario A it is clear that
the make no profit. In scenario B the amount must be borrowed from the UK exchanged using s and
invested in the us with 2 interest rate. The amount will then be exchanged using the future rate. This
will provide a larger profit.
Scenario A no profit
Scenario B
£100/1+0.001 = £99.009
99.009*1.2= $118.811
118*1.02=$121.18
121.18/1.1= £110.17
Profit of 110.17
II)
An explanation a discussion of the definition of arbitrage must be provided. Students must explain the
implications for rates of return between the two scenarios. An example must also be provided. (marks
15)
The concept of arbitrage must also be linked to the scenario outlined in I. (5 marks)

III)
The different interest rate parity conditions must be discussed along with the different formulas.
An identification of the scenario by which the individual here is operating must be provided as well as
the potential implications of a change in risk. As a result the concept of risk premia must be discussed.
(10 marks for each type of interest rate parity condition)