EC1002 Exr14 PDF

Examiners’ commentaries 2014

EC1002 Introduction to economics
Important note
This commentary reflects the examination and assessment arrangements for this course in
the academic year 2013–14. The format and structure of the examination may change in
future years, and any such changes will be publicised on the virtual learning environment
(VLE).
Information about the subject guide and the Essential reading references
Unless otherwise stated, all cross-references will be to the latest version of the subject
guide (2011). You should always attempt to use the most recent edition of any Essential
reading textbook, even if the commentary and/or online reading list and/or subject guide
refer to an earlier edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the contents list and
index of the new edition to find the relevant section.
General remarks
Learning outcomes
At the end of this course and having completed the Essential reading and activities,
you should be able to:
 define the main concepts and describe the models and methods used in economic
analysis
 formulate problems described in everyday language in the language of economic

modelling
 apply and use the main economic models used in economic analysis to solve these
problems
 assess the potential and limitations of the models and methods used in economic
analysis.
What are the Examiners looking for?

This year we saw the introduction of the new format examination. We replaced the
compulsory short questions’ sections in previous examinations (questions 1 and 5 in
Sections A and B) with a multiple-choice section which now constitutes Part I of the
examination. Part II contains the long questions which, as in previous years, allow
candidates to choose one out of three questions on micro- and macroeconomics.
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Explanations for these changes can be found on the VLE; I will only say here that,
while they do serve our purpose of allowing the entire syllabus to be tested in every
sitting, the new structure also benefits candidates by allowing a broader scope of
abilities to count towards their performance.
In the previous year, the overall failure rate on this examination paper was quite high
(about 43 to 48 per cent). This year, with the introduction of the new format, we
noticed that the overall failure rate has fallen. This, of course, is good news but
particularly because it shows that the change in format has not led to an inadvertent
reduction in standards or expectations. Multiple-choice questions, although more
helpful for candidates in that they trigger one’s memory through the availability of
correct answers, can also be quite demanding and engage candidates’ understanding
at a high level. We made sure that the type of questions that appeared in the
examination papers were balanced and aimed at both a more refined demonstration of
abilities and at high levels of understanding.
In the multiple-choice section, candidates in Zone A scored a mean of 49.8 per cent,
and 43 per cent in Zone B. This is very good and it means that, on average, Zone A
candidates had already scored about 25 points, and Zone B candidates, 21.5 per cent,
before they began answering questions in Section B. To remind you, Section A is
mainly focused on testing what we call the ‘first level of knowledge’ (as were the
compulsory sections in previous years’ examinations). This is that level at which
candidates demonstrate that they have covered the material and that they understand
the basic concepts and models covered in this course. Given that the questions in the
Part I, Section A carry 50 per cent of the mark, you can appreciate that we think that if
a candidate can demonstrate this level of knowledge across the syllabus, we believe
that such a candidate should be allowed to pass.
However, we cannot consider a candidate with this level of knowledge alone, as an

excellent one. To achieve this level of commendation, candidates have to demonstrate
that they have also acquired the second level of knowledge, which is command of the
material. What we mean by this is that candidates can encounter a problem, described
in normal daily language (like the problem the government faces in trying to persuade
the public to increase the use of public transport in Zone A, question 1, or the problem
facing the Goode family regarding the use of their garden to grow their own
vegetables in Zone B, question 1, or the problems facing artistic jewellers in Zones A
and B, question 2 and so on); select the right analytical framework (model) with
which to deal with it; translate the specifics of the problem into a known generic
framework; and then work out the implications. This level of knowledge is mainly
tested in Part II of the examination. This does not mean that candidates are not
awarded points for demonstrating Part II questions that they have the first level of
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knowledge. That is, if a candidate chooses the right framework with which to answer a
question and answers it well, even though they have not yet demonstrated their
command of the material, they will already have gained some points for showing that
they chose the right framework and that they know the generic form of this analytical
tool.
This means that if a Zone A candidate’s mean score on Part I was around 25 marks,
and a Zone B candidate’s was around 21.5 marks, it should not be too difficult for the
Zone A candidate to acquire the remaining 15 marks, or 18.5 marks for the Zone B
candidate, by demonstrating that even if they have not mastered the second level of
knowledge, they could still pass by showing in each of the long questions their
command of at least the first level of knowledge. The fact of the relatively high failure
rate – though lower than previous years – suggests that far too many candidates come
to the examination without even the first level of knowledge (that is, knowing the
concepts and the models, let alone how to use them).
It is not clear to me why this should be the case. The long questions are normally
based on the core topics of the syllabus. This means that it is unlikely that candidates
would have failed to cover them. Just choosing the right framework in the two
questions that are required to be answered, would have facilitate a pass when put
together with the mean mark gained on Part I. I must therefore conclude that the
relatively high failure rate is due to some level of guessing the answers to the multiple-
choice questions on the part of candidates. But what the final result teaches us is that
you cannot really pass this examination if you depend on guesswork.
But, as in past years, I would like to move away from failure rates and say something
about the majority of candidates who not only pass the examination but do well in it.
The reason why we are pleased with the introduction of the multiple-choice section is
mainly because it allowed for a good increase in the number of Firsts, with quite a few
candidates achieving marks in the 90s! The level of achievement of the better
candidates is simply remarkable, both in absolute and relative terms. The degree of
command which quite a few candidates demonstrate in their ability to interpret and
use the models is a sign of fantastic levels of learning. We are confident that these
achievements can be replicated by a much larger group of candidates if they have the
will to excel rather than the will just to pass.
General advice
You may want to consider your study process in stages. First, you must understand
each section of the material as it is presented in the basic textbooks. Second, you must
study the subject guide. If you manage to work your way through it, you are bound to
have properly understood the contents of the textbook. Last, but not least, you should
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try to independently answer questions from the self-study sections of the subject guide
as well as from past examination papers, without looking at the provided answers. You
should then carefully compare your answer with the provided answer in the subject
guide and the Examiners’ commentaries. Always try to reproduce the full and correct
answer by yourself. It was very clear in past examination papers that those who failed
could not have properly gone through the first phase of the study process. At the same
time, it is abundantly clear that those candidates who have done well followed all
three stages of the study process. It was clear that they were familiar with the subject
guide as well as with previous years’ Examiners' commentaries and that their analytical
skills have been considerably enhanced in the process. Consequently, it seems that
those who do well, do really well.
A possible explanation for candidates’ failure to absorb the subject guide at the basic
descriptive level could be the false perception of its mathematical nature. There is, in
fact, very little mathematics in the subject guide and those issues, which are essential
to an understanding of the subject guide’s exposition, are discussed at length in the
mathematical preface. Please make sure that you read it carefully before you embark
on the study of economics. There is, we are afraid, no way around it. Economics is an
abstract discipline and, as such, it requires the use of logical tools. Without those tools,
your ability to make sense of the vast, complex world of social interactions is
considerably reduced. For the very same reason that you are required to take a
quantitative paper in your first year, you must also have a reasonable command of
these very basic tools, which lie at the foundation of human knowledge.
This, of course, should not be misread as a call for mathematical competence. Of

course, things would be easier if we all had good mathematical skills. Given that most
people do not have those skills, we must be sure not to abandon mathematical tools
altogether. It is important that you recognise that the subject guide’s exposition is
using very basic mathematical tools, all of which are within your grasp. Instead of
being stifled by fear, you should recognise that even with no mathematical
background, you could meet our requirements fairly quickly. A bit more effort on this
front will guarantee that at least the descriptive standards of the course will be met.
You might have noticed that in recent years, the course became much more focused.
This means that instead of getting acquainted with a little bit of a lot of things, we now
wish you to gain some command of fewer things. The key difference here is between
‘getting acquainted’ and ‘gaining command’. For the former, one normally needs to
know about economic concepts. Now, we want you to know the concepts.
Essay-type or discursive writing is a method of exposition of the ‘getting acquainted’

approach. In such a format, one tends to write about things and to describe them. For
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the other approach – the active-understanding approach – one would need to resort to
a more analytical form of discourse. This is a form of discourse where candidates are
‘making a point’ or, to use a more traditional word, ‘rhetoric’, where one is trying to
persuade.
To think about writing in this way will help a great deal. It forces the candidate, first,
to establish what it is that they wish to say. Once this has been established, the writer
must find a way of arguing the point. To ‘make a point’, as one may put it, basically
means to know the answer to the question before one starts writing. It is my
impression that many candidates try to answer the question while writing. A question
normally triggers a memory of something that one has read in the textbook. It
somehow opens the floodgates and candidates tend to write down everything they
know about the subject with little reference to what the question is actually asking.
This is not what this course is all about. We want you to identify the tools of analysis
which are relevant in each question; we want you to show us that you know what
these tools are; and, lastly, we want you to be able to use the tools. Examination
questions, in this course, are written in a ‘problem’ form which then requires that you
will be able to establish which framework of analysis is more appropriate to deal with
different problems. In your exposition, you are then expected to properly present this
framework. Only then are you expected to ‘solve the problem’ within the framework.
Although some questions may have a general appeal, we do not seek general answers.
You must think of the examination as an exercise rather than a survey.
Question spotting
Many candidates are disappointed to find that their examination performance is poorer
than they expected. This can be due to a number of different reasons and the Examiners'
commentaries suggest ways of addressing common problems and improving your
performance. We want to draw your attention to one particular failing – ‘question
spotting’, that is, confining your examination preparation to a few question topics which
have come up in past papers for the course. This can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth,
but you need to be aware that Examiners are free to set questions on any aspect of the
syllabus. This means that you need to study enough of the syllabus to enable you to
answer the required number of examination questions.
The syllabus can be found in the Course information sheet in the section of the VLE
dedicated to this course. You should read the syllabus very carefully and ensure that you
cover sufficient material in preparation for the examination.
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Examiners will vary the topics and questions from year to year and may well set questions
that have not appeared in past papers – every topic on the syllabus is a legitimate
examination target. So although past papers can be helpful in 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 paper. We strongly advise you not to adopt this strategy.
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EC1002 Introduction to economics – Zone A
Important note
(VLE).
Unless otherwise stated, all cross-references will be to the latest version of the subject guide
(2011). You should always attempt to use the most recent edition of any Essential reading
textbook, even if the commentary and/or online reading list and/or subject guide refers 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.
Comments on specific questions

PART I
Section A
You have 90 minutes and you should attempt to answer ALL the questions.
Each question has FOUR possible answers (a–d). There is only ONE correct answer to each
of the questions.
Approaching the questions
I already said that the mean mark on the multiple choice section for Zone A was
49.8%. Comparing this with the mean mark on the whole paper in past year this is
clearly a better result. This means that the multiple choice section was successful in
allowing a more refined testing of students’ abilities. It also suggests that our efforts
last year in preparing students for the new form of assessment were successful and as
we said then, the form of assessment should not affect the way you learn. When you
know something, it does not matter how we ask about it, you will always know the
answer. Equally, if you do not know something, it does not matter how we ask the
question, you will still not know the answer.
We will not reproduce here the multiple-choice questions with their right answers.
There are enough questions on the VLE with which to practise your learning
interactively.
7
PART II
Section B
Answer ONE question from this section.
Question 1
To attract more people onto the public transport system, the government proposes to
reduce the price of using the system. However, to offset the losses that would be accrued to
the system, the proposal also suggests the imposition of a lump-sum tax on each individual
which will ensure that on the basis of Slutsky’s definition, no real income effect will be
experienced.
a. Describe the initial choice the individual would make assuming the x represents the use
of the public transport system and y all other goods.
b. How will the proposal affect the choices which the individual makes as well as his, or
her, well-being?
c. Will there be income or substitution effects under the definitions of both Hicks and
Slutsky?
d. Would the public transport system recover all the money that had been lost due to the
reduction in fares?
e. Will the policy be successful? Could the government have achieved its objectives with a
higher tax?
Approaching the question
In this question we examine candidates’ command of consumer choice theory. In our

case, the government proposes a scheme to influence the choices which individuals
make between the use of public transport and spending their income on other goods.
The proposal is for a unit subsidy and a lump sum tax to ensure increased use of public
transport without affecting the well-being of the public.
a. Here candidates were expected to present the framework of analysis which they
would use to deal with the problem raised in the question. We expected to find the
following set-up:
8
Io
0
py
A
y0
U0
0
px
0
py
x0 Io x -use of
px
0 Public
transport
b. We now examine the effect of the proposal on the individual. Here, there are two
basic elements. First, there is the subsidy which is given through the proposed
lower price (𝑝1 𝑥 < 𝑝0 𝑥 ). Second, there is the lump-sum tax which will ensure that
the individual stays at the same level of real income, based on Slutsky’s definition,
as he/she was before the change. In other words, the government wishes to affect
a pure substitution effect that will ensure that people use more public transport.
The overall changes are summarised in the diagram below:
y
U0
Io
0 U1
py
Io  T
0
py
A
y0
y1 B
0
px px
1
0
py py
0
x0 x1 Io Io  T Io x -Public
use of
0 1 1
px px px transport
The heavy black line represents the effect of the lower price (effective subsidy)
which the government now charges for public transport. The red heavy line
9
represents the final new budget line when we add in the lump-sum tax which,
according to Slutsky’s definition, allows people to continue buying their original
choice at A. However, as the individual now faces a different price for public
transport, the substitution effect under Slutsky would lead the individual to move
from point A to point B.
c. Here we focus on the difference between the Hicks and Slutsky definitions of real
income:
y
U0
Io
0 U1
py
Io  T
0
py
A
y0
H
yc B
y1 C
0
px px
1
0
py py
0
x0 xc H x1 Io Io  T Io x -Public
use of
0 1 1
px px px transport
Clearly, under the Hicksian definition of real income, we would have gone to
point C. This means that the move from A to C is the pure substitution effect and,
therefore, the move from C to B (which lies on the higher indifference curve)
constitutes an income effect. Under Slutsky’s definition, there will be only a
substitution effect as real income (consumption at point A) is unchanged.
d. Candidates are now being asked about the success of the government in
recapturing lost revenues.
The government will achieve its objective in terms of making individuals use more
public transport. However, the planned lump-sum tax will not really cover the
losses that could be generated by such a move. Before the change, the individual
was at point A and the following held true:
𝐼0 = 𝑝0 𝑥 ∙ 𝑥0 + 𝑝0 𝑦 ∙ 𝑦0
After the change (where 𝑝1 𝑥 = 𝑝0 𝑥 − 𝑠), when the new budget line goes through
A, the following holds true:
𝐼0 − 𝑇 = (𝑝0 𝑥 − 𝑠) ∙ 𝑥0 + 𝑝0 𝑦 ∙ 𝑦0
10
which means that 𝑇 = 𝑠 ∙ 𝑥0 so, if by offering the lower price the government’s loss
of revenue will be exactly 𝑠 ∙ 𝑥0 and the lump sum tax covers this in full, the
government will now incur extra costs because 𝑥1 > 𝑥0 .
e. Could the government be more successful if it levied a higher lump sum tax?
y
U0
Io
0 U1
py
Io  T
0
py
A
y0
H
yc B
y1 C
0
px px
1
0
py py
0
x0 xc H x1 Io I o  T2 I o  T1
1 1
Io x -Public
use of
0 px px 1
px px transport
If the tax were higher (𝑇1 < 𝑇2 ), then we could have moved to a point like C
which would have allowed the government to achieve the same objectives, but
based on the Hicksian definition of real income. In such a case, people will indeed
travel more than they did but less than they would have if the lump sum tax had
been lower (at point B).
Question 2
The Jewellery industry is competitive and made up of two types of producers: original local
artists and commercial imitators. The cost of production of jewellery is evidently higher for
the local artists than it is for the commercial imitators. The consumers, however, cannot
really tell the difference. However, without the local artists, commercial imitators will have
nothing to imitate.
a. Describe an initial set-up in which both local artists and commercial imitators supply
the market.
b. What will happen in the long run?
c. As a result of a court case, the imitators will now have to pay a fixed fee for the right
to use the local artists’ ideas. How will this affect the long run equilibrium?
11
d. If instead, the government taxed commercial imitators with a lump-sum tax, would this
be, in principle, more conducive to the increase in local artists’ market share?
In this question we examine the application of competitive market analysis. A market

for jewellery is supplied by two types of producers: commercial and local artists whose
costs of production are higher due to the fact that they design and make their own
jewellery (i.e. not through mass production). We assume that consumers cannot really
tell the difference and that the ideas of local artists are the fuel which allow
commercial producers to make their own products.
a. Here is the initial set-up of the industry when both types of producers are in the
market (assume that there are m artists and n commercial producers):
Local Artists Commercial
MCi ( w0 , r0 ) n m
MCi ( w0 , r0 ) S   MCk ( w0 , r0 )
ACi (w0 , r0 ) k 1
ACi (w0 , r0 )
A A px
0
A
D()
i i
x j j x0 x
x 0 x 0 x
Given the difference in the technology of production and subsequently the cost of
production, the initial set-up where both types of producers are in the market
must be such that the commercial producers are making profits. Though we said
that the ideas of the local artists are important for the commercial producers,
there is no need for them to pay for these ideas as, in the competitive set-up,
information is full and free.
b. In the long run, the following process will develop:
MCi (w0 , r0 ) n m
MCi ( w0 , r0 ) S   MCk ( w0 , r0 )
ACi (w0 , r0 ) k 1
ACi (w0 , r0 ) n T  m
S  MC ( w , r )
k 0 0
A A k 1
px
0
A
B B B
D()
x i1 x i 0 i j x j j x0 x x
x x 1
0 x 1
12
The profits above normal, which commercial producers make, will allow the
return above the normal market rate of return on capital which would lead to the
entry of more commercial producers. This will create excess supply in the market
which would lead to a fall in the equilibrium price until we get to the new price
which is equal to the minimum average cost of the commercial producers (the
move from A to B). Local artists will make losses and this will lead to their
departure from the market. As they do so, supply will shift to the left and price
will temporarily increase which, in turn, will attract more commercial producers
until all local artists are pushed out and we are left with only commercial
producers.
c. We are now considering how the long run process will evolve if commercial
producers were to pay local artists for imitating their products:
MCi ( w0 , r0 ) n m
MCi ( w0 , r0 ) S   MCk ( w0 , r0 )
ACi (w0 , r0 ) k 1
P
ACi ( w0 , r0 )  n T  m U
ACi (w0 , r0 )
x S  MC ( w , r )
k 0 0
A ACi ( w0 , r0 ) 
P
A 0 A k 1
x px
C C
C
D()
i i j x
x1 x 0
xi x j1
x 0 xj x0 x
1
We begin at A. Now the commercial producers pay a fee for the use of the local
artists’ idea. This fee is a lump sum fee as it is independent of how many units
they produce. It is a fixed cost for the commercial producers and equivalent to a
lump sum subsidy for the local artists. As a result, the average costs of commercial
producers increase while those of local artists decrease. If the fees are properly
designed, the minimum of the new average costs curve would be at the same price
level that would allow both types of producers to stay in the market in the long
run. Relative to point A, however, both types of producers would initially make
profits above the normal which would lead to an increase in their numbers.
d. An alternative is considered here where a lump sum tax is levied on the

commercial producers:
13
MCi ( w0 , r0 ) n m
MCi ( w0 , r0 ) S   MCk ( w0 , r0 )
ACi (w0 , r0 ) k 1
T
ACi ( w0 , r0 ) 
x
ACi (w0 , r0 )
A A 0 A
px
D()
x i i
x j j x0 x
0
x 0 x
We begin at A where originally commercial producers made profits while local
artists made no profits above the normal. If the tax is levied, it will shift the
average costs of commercial producers up and will virtually eliminate all the
profits which they had above the normal. In such a case, this will become the
long-run equilibrium as firms will neither leave nor enter and the market share of
local artists will remain unchanged. In the previous case, when commercial
producers paid fees to local artists, there were still profits above the normal for
both types of producers. This would have led to the entry of both commercial
producers and local artists. While it is not clear what exactly will happen to their
market share, their number would have increased!
Question 3
Labour contracts are such that for a given level of hourly wages, one must provide at least a
given number of hours. This means that workers will not be paid at all if they do not supply
their contracted hours. We assume that there are no other sources of income.
a. Show how this will affect the supply of labour and the well-being of workers by
comparing this to a situation where payment is not conditional on a certain minimum
of hours being provided.
b. How would a tax on wages affect the choices of labour of those who work the required
hours?
c. An employer who wishes his workers to work more, offers those who work beyond the
required hours a bonus but he is not sure whether to offer a lump-sum bonus or an
hourly-based bonus. Which of these options will yield a better result and why?
d. Would your answer to (b) be different if the worker were a workaholic (someone who
would always work more than the contracted hours)?
This is a question about the labour market and the choice of leisure. In the question we
are told that labour contracts are such that, for a given level of hourly pay, individuals
must provide at least a certain number of hours (say 𝐿̅). It means that a worker will
14
not get anything if he/she does not fulfil their part of the deal.
a. To analyse the effect that this will have on the supply of labour and on workers’
well-being, we must begin with the initial set-up:
T  0
0
Le T Le
If the real wage level is 𝜔0 and the contracted hours are: 𝐿̅ = 𝑇̅ − ̅̅̅
𝐿𝑒 then the
individual will face the above budget constraint. If the individual works less than
the required number of hours, he will get no wage at all. The question is how this
condition will affect the worker’s labour supply. For this we must consider the fact
that there is a section of the labour supply which would not be affected but two
sections which would be affected. The first one is when labour supply is upward
sloping and the second is when it is backward bending. We assume that for each
wage level, the contracted hours are not the same:
B
A
A 0 B
U1
0 U0
0
Le Le T Le L L
15
Therefore, if for the level of wages 𝜔0 the contracted hours are 𝐿̅ , then we will
have a move from A to B. Without the minimal working hours, the individual
would have chosen to work at A but, now, his utility will be maximised if he works
at B. The same would apply to different wage levels with rising contracted hours.
At a certain level of the wage rate, the individual would have chosen to work
more hours than contracted and there will be no change in the labour supply. At
the backward bending part we see the following:
D
C
1 D
U3
B
U2
A
0 A
B
U1
U0
1
0
D 1 0
Le B
Le Le T Le LD L
Le LB
In between there would be wages for which the choice of hours would exceed that
stipulated by the contract. Had all contracts adhered to the same number of
contracted hours, we would have had the following change:
C
D 1 D
B U3
A U2
0 A
B
U1
U0
1
0
1 0
Le
Le Le T Le L L
16
where the supply of labour would have moved along the broken heavy line from
the bottom and then joined the previous labour supply on the right until it moved
along the red broken line again.
b. There is now a tax levied on wages and the question is how this will affect those
who work the required number of hours. These include those who have to do this
(even though it may not have been their choice without the minimum contracted
hours) and those who would have worked these hours anyway.
A tax on wages means that the real wages will now fall from 𝜔0 to 𝜔0 (1 − 𝑡).
i. In the case of those who are, as it were, made to work the hours:
T  0
B
U0
0 (1  t ) 0 U1
Le T Le
Initially at A, these people will still be subject to the same contract and would
move to point B where they supply the same number of hours but they will
become worse off.
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ii. In the case where these hours were a choice:
T  0
A
C
U0
D
B
SE
U1
0 (1  t ) 0
Le T Le
The substitution effect would lead the individual to point C and the income
effect (in the case of leisure being a normal good) would have led him to
point D. However, at D he will not be clocking enough hours according to the
contract and he would therefore end up at point B. Unlike the previous case –
where the individual is twice affected by the contract (his original choice as
well as the choice after the tax) – this agent would only be subjected to the
effects of the contract once the tax has been levied.
c. The employer now wishes to entice his workers to work more than the required
hours.
He proposes to give them a bonus but considers two possibilities: either to pay a
bonus of, say, b per every additional hour beyond the required ones, or, to pay a
lump sum bonus of, say, K. Obviously, for the two proposals to be comparable we
must assume that the employer spends the same amount on both occasions.
18
T  0 K
T  0  b( Le  Le )
B B
 T0  K
C
U2
b A
U1
U0
0
Le
B
Le T Le
If the employer paid a bonus of b, the individual who is originally at A would
choose to move to point B where he works more but is also on a higher utility
level. If instead he was given a lump-sum bonus of K, which is the same as
̅̅̅𝑒 − 𝐿𝐵 𝑒 )), he would
the amount spent under the bonus per hour (𝐾 = 𝑏 ∙ (𝐿
end up at point C where the individual will be better off than he was at A or
would have been at B. From the employer’s perspective it is clearly better to
offer a bonus per hour worked but from the worker’s perspective, he would
rather have the lump-sum bonus.
d. The question is about whether the individual would respond differently to the
bonus if he was a workaholic.
x
T  0  b( Le  Le )
B
B
 T0  K
K
T  0 C
U2
U1
A
b
U0
0
B A C
Le Le Le L e T Le
If the agent was a workaholic he would work for more than his contracted hours
to begin with (point A). His response to the bonus per hour would be to work
19
even more (point B), while his response to a lump-sum bonus would be to work a
bit less (point C). Like the normal agent, he too would wish to have a lump sum
bonus while the employer still prefers the bonus per hour. Therefore, it is
conceivable to conclude that these types of preferences do not properly represent
the behaviour of a workaholics.
Such individuals who find themselves at B due to the introduction of the

minimum hour requirement will now move to a point like C where they will offer
much more labour than before.
Section C
Question 4
In a closed economy the marginal propensity to consume of the rich is smaller than that of
the rest of the population. There is a proportional tax rate which is higher for the rich
people than it is for the rest of the population. To improve equity the government decides
to change the tax regulation in such a way that some of those who could escape to the
lower tax rate will now be deemed higher tax rate payers.
a. What will be the economy’s multiplier before the change?
b. How will the change affect the economy if prices and wages are fixed?
c. Will your answers to (a) and (b) be different if the government has a balanced budget
policy where spending is adjusted to the level of tax revenues?
d. What will be the effect of the policy if there are flexible prices and wages in the
economy? What would happen to real wages, output and investment in this economy?
In this question we have a closed economy where the marginal propensity of the rich
to consume is smaller than that of the rest of the population and where the rich also
pay a higher tax rate.
a. To find the multiplier we need to set the scene. We assume that the share of the
rich in income is given by α:
c( y )  c0  c1 (1  t L )(1   ) y  c R1 (1  t H )    y
I ( y , r )  I 0  I 1r
G  G0
AE ( y , r )  [c0  I 0  I 1r0  G0 ]  [c1 (1  t L )(1   )  c R 1 (1  t H ) ] y
1 1
 y  A( r0 )  A( r0 )
1  [c1 (1  t L )(1   )  c 1 (1  t H ) ]
R
1 M
20
b. The government has now changed the tax regulation which means that some
people who were deemed to be in a lower tax bracket will not have to pay a
higher rate of tax. This means that the share of income which is taxed at a higher
rate will now increase. The only unclear element here is whether those who are
now deemed rich will also change their behaviour in the sense that their marginal
propensity to consume will fall. Both possibilities are acceptable, even though the
option where people do not change their behaviour just because the government
deemed them to be rich is more convincing. In the simpler case, where we assume
that people who are deemed rich by the authorities will also adjust their
perception of themselves, the change is simply an increase in the share of rich
people in the population. Namely, it is an increase in α. In such a case, we can see
that α is an argument of the multiplier alone so the effect of the change will come
through the change in M:
𝜕𝑀
= 𝑐 𝑅 1 ∙ (1 − 𝑡𝐻 ) − 𝑐1 ∙ (1 − 𝑡𝐿 ) < 0
𝜕𝛼
Clearly, as 1 − 𝑡𝐻 < 1 − 𝑡𝐿 and as 𝑐 𝑅 1 < 𝑐1 , the effect of the change in α is inverse.

This means that an increase in α would lead to a decrease in the multiplier.
If we follow the other route where we suppose that those who are deemed as rich
still perceive themselves as ordinary and continue to behave as if they are not rich,
the analysis will be somewhat different, though the conclusions would be similar.
As income is only an argument of the consumption function, we must now write a

new function where we take into consideration that a fraction of the income, say,
β, has now moved from low tax bracket to a high tax bracket:
𝑐̅(𝑦) = 𝑐0 + 𝑐1 ∙ (1 − 𝑡𝐿 )(1 − 𝛼 − 𝛽)𝑦 + 𝑐1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛽𝑦 + 𝑐 𝑅 1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛼𝑦
Clearly, the difference between the original function and the new one is given by:
𝑑𝑐 = −𝛽𝑦 ∙ 𝑐1 ∙ (1 − 𝑡𝐿 ) + 𝛽𝑦 ∙ 𝑐1 ∙ (1 − 𝑡𝐻 ) =
= 𝛽𝑦 ∙ 𝑐1 [(1 − 𝑡𝐻 ) − (1 − 𝑡𝐿 )] < 0
And as all these variables are components of the multiplier we will have a new
multiplier:
1 1
=
1 − [𝑐1 ∙ (1 − 𝑡𝐿 )(1 − 𝛼 − 𝛽) + 𝑐1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛽 + 𝑐 𝑅 1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛼] 1 − 𝑀′
where the difference between M’ and M is clearly:
𝛽𝑐1 [(1 − 𝑡𝐻 ) − (1 − 𝑡𝐿 )] < 0
As M>M’ it means that the new multiplier will be smaller whichever version of the
story one would wish to tell. This means that the IS curve shifts to the left and
21
becomes steeper.
r
LM ( M 0 , P0 )
A
r0
r1 B
IS (G, tL , tH , 0 )
IS (G, tL , tH , 1 /  )
Y
Y1 Y0
Hence the equilibrium level of income will fall and the domestic interest rate will
increase.
c. In the case of a balanced budget the initial set up will be a bit different:
c( y )  c0  c1 (1  t L )(1   ) y  c R1 (1  t H )    y
I ( y , r )  I 0  I 1r
G ( y )    y  t H  (1   ) y  t L
AE ( y , r )  [c0  I 0  I1r0 ]  [c1 (1  t L )(1   )  c R1 (1  t H )  t H  (1   )t L ] y
1 1
 y  A( r0 )  A( r0 )
1  [c1 (1  t L )(1   )  c 1 (1  t H )    t H  (1   )t L ]
R
1 M
With regard to sub-question (a), notice that the multiplier here will be greater
than in the case without a balanced budget. Also 𝐴̅ < 𝐴 means that relative to the
original position in the above diagram, the IS curve shifts to the left and becomes
flatter. You have not been asked to examine where exactly the IS will lie, but this
is something we encourage you to do by yourself. So how will the answer to (b)
change with a balanced budget?
We now follow the simple version (an increase in the share α which is
accompanied by an adjustment of behaviour):
𝜕𝑀
= 𝑐 𝑅 1 ∙ (1 − 𝑡𝐻 ) − 𝑐1 ∙ (1 − 𝑡𝐿 ) + 𝑡𝐻 − 𝑡𝐿
𝜕𝛼
While we know from the previous case that the first two elements produce a
negative outcome, the addition is positive (𝑡𝐻 − 𝑡𝐿 > 0). This means that, in
comparison to the no-balanced budget case, the effect of the policy would lead to
either a smaller fall in M or to the complete opposite: an increase in M.
22
In the second version of the story we will have the same change in the
consumption function as before but also a change in the demand for public
spending:
𝐺̅ (𝑦) = (𝛼 + 𝛽)𝑦 ∙ 𝑡𝐻 + (1 − 𝛼 − 𝛽)𝑦 ∙ 𝑡𝐿

= 𝛼 ∙ 𝑦 ∙ 𝑡𝐻 + (1 − 𝛼)𝑦 ∙ 𝑡𝐿 + 𝛽𝑦 ∙ (𝑡𝐻 − 𝑡𝐿 )
which is the old G(y) + a positive number that will lead to the following new
multiplier:
1
1 − [𝑐1 ∙ (1 − 𝑡𝐿 )(1 − 𝛼 − 𝛽) + 𝑐1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛽 + 𝑐𝑅 1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛼 + 𝛼 ∙ 𝑡𝐻 + (1 − 𝛼) ∙ 𝑡𝐿 + 𝛽 ∙ (𝑡𝐻 − 𝑡𝐿 )]
1
=
1 − 𝑀′
The difference between M’ and M is:
𝛽 ∙ (𝑡𝐻 − 𝑡𝐿 ) + 𝛽 ∙ 𝑐1 ∙ (1 − 𝑡𝐻 ) − 𝛽 ∙ 𝑐1 ∙ (1 − 𝑡𝐿 ) = 𝛽[(𝑡𝐻 − 𝑡𝐿 ) + 𝑐1 ∙ ((1 − 𝑡𝐻 ) −

(1 − 𝑡𝐿 ))]
Here, too, the answer is as ambiguous as before and the multiplier may either be
positive or of a smaller negative number in absolute value.
Therefore, relative to the case where there is no balanced budget, the effect will be:
r
LM ( M 0 , P0 )
A
r0
r1 B
IS (G, tL , tH , 0 )
IS (G, tL , tH , 1 /  )
Y
Y1 Y0
Namely, we will either move to the heavy blue broken line (between A and B) if
the multiplier is still smaller than the one before the change or to the green dotted
line (to the right of A) if the multiplier becomes bigger.
d. In this section of the question you were asked to examine the effects of the change
in policy when prices and wages are flexible.
The following diagram should have been presented (assuming that the outcome of
the policy would be to shift the IS curve to the left):
23
r
LM ( M 0 , P0 )
LM ( M 0 , P1 )
A
r0
LM ( M 0 , P2 )
r1 B
C IS (G0 , tH , tL ,  )
r2
IS (tH , tL ,  ,  )
Y
p
SAS ( w0 )
p0 A
B SAS ( w1 )
p1
p2 C
AD (G0 , tH , tL ,  , M )
AS (tH , tL ,  ,  , M )
y1 y0 Y
Clearly the fall in aggregate demand would shift IS to the left and the change in
the multiplier will make IS steeper. The same will apply to the AD curve. There is
now excess supply in the market which would lead to a fall in prices and, with it,
an increase in the supply of real balances. In turn, this will lead to a fall in the
interest rate. In the labour market real wages will increase, which will reduce the
number of people employed, and the new equilibrium will be at point B. However,
there is still an excess supply of labour in the labour market and this will lead to a
fall in nominal wages and, subsequently, to a further fall in prices. The whole
economy will then move from point B to C.
Question 5
In Woodland, export is dominated by the timber industry. A discovery of a slow-spreading

tree disease which reduces the quality of wood has hit the timber industry hard. In an
attempt to compensate for the bad news, the Central Bank decides to allow for an increase
in the amount of loans in the economy. Assume an open economy without capital mobility
and a fixed exchange rate.
a. Describe the initial equilibrium.
b. How would the discovery of the tree disease affect the equilibrium in the short and in
the long run? What will happen to domestic investment?
c. Will the Central Bank’s policy be effective?
d. How would your answer to (b) and (c) differ if the country had perfect capital mobility
and a flexible exchange rate?
24
In this question we have an economy where timber is the main export. A slow
spreading disease affects the quality of trees produced in this economy and, therefore,
would lead to a fall in exports.
a. We begin with the initial set-up of an open economy without capital mobility and
a fixed exchange rate:
E0 p *0
NX ( )0
p0
r
LM ( M 0 , P0 )
r0 A
E0 p *0
IS (G, t , )
p0
Y
Y0
b. Here we are being asked to analyse the effects of the spread of the disease alone.
In the terminology of the model, the spread of the disease and the decline in
timber quality imply that there will be a decline in demand for exports. This
means a decrease in demand for net-exports – NX – which, in turn, will reduce the
demand for domestic products and shift IS to the left of the NX=0 constraint. The
NX=0 constraint will shift to the left as there is a need for less income to generate
the imports required to offset the new autonomous net exports component of the
net-export function:
25
E0 p *0
NX ( )0
p0
r LM ( M 0 , P0 )
E0 p *0
NX ( )0
p0
r1 C
B A
r0
E0 p *0
E0 p *0
IS (G, t , )
IS (G, t , ) p0
p0
Y
Y1 Y2 Y0
The fall in exports would reduce the demand for net exports NX. This means that
at any given interest rate there is now a smaller demand for local goods: IS shifts
to the left. It also means that as initial net exports are lower, one needs a lower
level of income to offset it so as to ensure that NX=0 once again. Hence, the
NX=0 line also shifts to the left.
Here we face the question of how far to the left should the NX=0 line should
move and the answer, as always, depends on some examination of the alternative
definition of equilibrium in the goods market: the investment-savings
consideration.
Before the change, at A, the following holds as NX=0:
𝐼(𝑟0 ) = 𝑠(𝑦0 ) + 𝑡 ∙ 𝑦0 − 𝐺
After the change we look at a point like B where there is equilibrium in the goods
market (on IS). The following holds:
𝐼(𝑟0 ) = 𝑠(𝑦2 ) + 𝑡 ∙ 𝑦2 − 𝐺 − 𝑁𝑋
As 𝑠(𝑦0 ) > 𝑠(𝑦2 ) and 𝑡 ∙ 𝑦0 > 𝑡 ∙ 𝑦2 (assuming G constant) then clearly NX<0 for
the equation to hold. This means that point B must be to the right of the point
where NX=0.
In terms of the dynamics the following will be the sequence, in the short run and
in the long run, had the central bank not intervened:
26
E0 p *0
NX ( )0 LM ( M1 , P0 )
p0
r LM ( M 0 , P0 )
E0 p *0
NX ( )0
p0
r1 C
r0 A
r2 B
E0 p *0
E0 p *0
IS (G, t , )
IS (G, t , ) p0
p0
Y2 Y
Y1 Y0
We will first move along LM towards the new equilibrium at point B where the
goods market and liquid asset markets are in equilibrium. However, as there is a
deficit in the current account, this would lead to a fall in the supply of liquid assets
and a shift of LM toward point C where the final new equilibrium will be
established.
c. The central bank’s intervention:
In our story, the central bank encourages more loans to help the industry, which
suggests an increase in deposits and therefore an increase in the quantity of liquid
assets. An easy way to see this is by supposing that the policy will be implemented
through the relaxation of the reserve ratio:
1
𝐿 = 𝑅[ − 1]
𝛼
where α is the reserve ratio. However, an increase in α also means that the
quantity of liquid assets will increase:
1
𝑀 = 𝑃𝐶 + 𝑅
𝛼
where PC is cash held by the public and R the total amount of reserves in
commercial banks. This means that, in addition to the change in IS and in NX,
there will also be a change in LM but in the opposite direction.
27
E0 p *0
NX ( )0 LM ( M 2 , P0 )
p0
r LM ( M 0 , P0 )
E0 p *0
NX ( )0
p0 LM ( M1 , P0 )
r1
C
r0 A
r2 B
E0 p *0
E0 p *0
IS (G, t , )
IS (G, t , ) p0
p0
Y
Y1 Y0 Y2
The shift downwards of LM as a result of the increase in the supply of liquid assets
will lead, together with the shift to the left of IS, to a move towards an equilibrium
at point B (the fall in demand for exports is offset by the increase in demand for
investment due to the lower interest rate). However, at B, there is a deficit in the
current account (NX<0) and with a fixed exchange rate policy, this means that
the central bank will sell foreign currency in return for local currency which will
lead to a fall in the supply of liquid assets. The new equilibrium will have to be at
point C. The bank’s policy will have no long-term effect.
d. We now assume that this is an open economy with perfect capital mobility and a
flexible exchange rate regime.
The effects of the fall in exports without the intervention of the central bank will
lead to the following situation:
r LM ( M 0 , P0 )
A=C
r0  r0 * BOP
B
r1
E0 p *0 E p*
IS (G0 , t0 , )  IS (G0 , t0 , 1 0 )
p0 p0
E0 p *0
IS (G0 , t0 , )
p0
Y1 Y
Y0
The fall in demand for net exports shifts IS to the left. Excess supply will lead to a
fall in output and a fall in demand for liquid assets which will shift the equilibrium
28
from A to B. At the lower domestic interest rate there will now be an outflow of
capital as the return on foreign assets is greater than that on domestic assets. The
excess demand for foreign currency (which has already been created by the fall in
exports) will lead to an increase in the nominal exchange rate E (a depreciation)
which will increase the demand for net exports and shift IS back to its original
position at A.
In the case where the central bank encourages loans, the following picture will
emerge:
r LM ( M 0 , P0 )
LM ( M1 , P0 )
A C
r0  r0 * BOP
E1 p *0
IS (G0 , t0 , )
B p0
r1
E0 p *0
IS (G0 , t0 , )
p0
E p*
IS (G0 , t0 , 0 0 )
p0
Y
Y1 Y0 Y2
As both IS and LM shift more or less simultaneously, the initial change would be
to move from A to B. The fall in demand for exports is offset by an increase in
demand for investment. However, the very low domestic interest rate, together
with the initial fall in exports, will lead to an excess demand for foreign currency
and an increase in the nominal value of E (depreciation). This will increase
demand for net exports and lead to a new equilibrium at point C. The intervention
of the bank is effective in more than offsetting the effects of the fall in demand for
export.
Question 6
The climate in Hotland is much more pleasant than that of Stormia. The two countries,
however, signed an agreement which allows the free movement of non-working people
between them. As a result, a great number of retired people in Stormia choose to move to
warm and pleasant Hotland. Analyse the effects of this change on each of the countries
individually when:
a. There is a fixed exchange rate.
b. There is a flexible exchange rate.
29
c. How would your answer change if Hotland had to respond to the increase in house
prices by increasing the spending on public housing?
This is a fairly straightforward question where we have two countries (which are not
necessarily each other’s main trading partners) which sign a deal to allow people from
the two countries to move freely between them even though they are not allowed to
work in the other countries. In terms of the set-up, this is a question about an open
economy with perfect capital mobility. While the question did not stipulate this
explicitly, it is difficult to imagine people moving to live in another country without
being able to move their assets between the two countries. The story in the question is
such that people from Stormia move to live in Hotland. This means two things. First,
there is an increase in demand for the exports of Hotland by the people of Sotrmia
(i.e. they use their income, earned in Sotrmia, to buy goods in Hotland). Therefore,
Stormia will face a fall in demand for net exports (as their demand for imports –
Hotland’s exports – increases) while Hotland will face an increase in demand for net-
exports. Second, there will also be an increase in demand for local assets in Hotland.
a. We analyse the effects on the two countries, assuming an open economy with
perfect capital mobility and a fixed exchange rate policy:
Stormia (A) Hotland (B)
LM B (M 0 , P0 )
LM A (M1 , P0 ) A
LM (M 0 , P0 )
B LM B (M1 , P0 )
r1
c A A c
r0 r0
r1 B E0 p *0
B IS (, )
p0
E0 p *0
IS A (, ) E0 p *0
A E0 p *0 p0 IS B (, )
IS (, ) p0
p0
A B
A A A Y B
y1
B
y2
B
Y
y2 y1 y0 y0
In Stormia, the increase in demand for imports (Hotland’s goods) will lead to a
fall in demand for net exports and therefore a fall in overall demand for domestic
products. This will lead to a shift to the left of IS and a decline in demand for
liquid assets. The economy will move from A to B. Notice that we do not assume
the two countries to be each other’s main trading partners, which means that their
exchange rates are not necessarily the inverse of each other.
30
At B, the interest rate in Stormia is lower than the international return on assets
and, therefore, there will be an outflow of capital which will lead to a further
increase in the demand for foreign currency on top of the one generated by the
increase in the demand for imports. Therefore, as there is a fixed exchange rate
policy in both countries, this will lead to a fall in the supply of liquid assets and we
move to point C.
In Hotland, the effect will be the exact opposite. The increase in demand for
exports will lead to an increase in the demand for net exports and therefore a shift
to the right of IS. At the same time, there is already an excess supply of foreign
currency emanating from the purchase of assets in Hotland by residents of
Stormia. Given the fixed exchange rate, this will translate into an increase in the
supply of liquid assets which will be furthered by the excess supply of foreign
currency coming from the current account. Hence the economy is likely to move
straight from A to point C as both IS and LM shift at the same time.
b. The case of a flexible exchange rate:
Stormia (A) Hotland (B)
LM B (M 0 , P0 )
LM A (M 0 , P0 )
B
r1
A=C A=C
r0 r0
r1 B E0 p *0
B IS (, )
p0
E0 p *0
IS A (, )
p0
A E1 p *0 E0 p *0
A E0 p *0  IS (, ) IS B (, )
IS (, ) p0 p0
p0 B E1 p *0
 IS (, )
p0
A B
A A Y B
y1
B
Y
y1 y0 y0
In this case, the various excess supplies or demands for foreign currency would
translate into a change in the nominal exchange rate (again, recall that the two
countries are not necessarily each other’s main trading partner). The economies
will both return to their original point as there has been no change in the supply
or demand for liquid assets and, hence, the level of income for which the
equilibrium will be at the level of interest rates, which would not trigger inflows or
outflows of capital.
c. There is an effect on house prices in Hotland, and the government decides to

spend on public housing.
31
An increase in domestic house prices in Hotland would have some impact on the
price level index of this country. Therefore, the real exchange of this economy will
fall but so would the supply of liquid assets. In such a case, an increase in
spending on public housing would increase demand and therefore shift IS to the
right. It may, however, only offset the fall in demand for net exports due to the fall
in the real exchange rate. However, the crucial point here is that if the increase in
house prices has not been overturned by the public investment, then the new
equilibrium will have to be to the left of point A below:
LM B ( M 0 , P1 )
r LM B (M 0 , P0 )
B
r1
C A
r0  r0 * BOP
B E0 p *0
IS (, )
p0
E0 p *0
B E1 p *0 IS B (, )
IS (, ) p0
p1
B B B Y
y2 y0 y1
Therefore, with a flexible exchange rate, the increase in domestic price levels will
lead to a recession in Hotland due to the effect of the influx of people from
Stormia on domestic price levels. Had the exchange rate been fixed, the outcome
would be very similar to the outcome in (a), except that point C in that diagram
would be somewhere to the left of the point C in (a).
32

EC1002 Introduction to economics – Zone B
Important note
(VLE).
Unless otherwise stated, all cross-references will be to the latest version of the subject
guide (2011). You should always attempt to use the most recent edition of any Essential
reading textbook, even if the commentary and/or online reading list and/or subject guide
refers 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.
Comments on specific questions

PART I
Section A
You have 90 minutes and you should attempt to answer ALL the questions.
Each question has FOUR possible answers (a–d). There is only ONE correct answer to
each of the questions.
Approaching the questions
I already said that the mean mark on the multiple choice section for Zone B was 43%.
Comparing this with the mean mark on the whole paper in past year this is clearly a
better result. This means that the multiple choice section was successful in allowing a
more refined testing of students’ abilities. It also suggests that our efforts last year in
preparing students for the new form of assessment were successful and as we said
then, the form of assessment should not affect the way you learn. When you know
something, it does not matter how we ask about it, you will always know the answer.
Equally, if you do not know something, it does not matter how we ask the question,
you will still not know the answer.
We will not produce here the multiple choice questions with their right answers. You
have enough questions on the VLE with which to practise your learning interactively.
33
PART II
Section B
Question 1
Mr and Mrs Goode see an opportunity to use their own garden to grow as much as they can
of their food consumption. The plot is such that with an overall cost of 𝐶0 one can produce
up to 𝑥̅ units of food. Assume that there are only two types of goods, x (food stuff) and y
(all other goods).
a. Describe the initial choice of Mr and Mrs Goode before considering whether to make
use of their garden.
b. Suppose that the amount of food they can grow 𝑥̅ is exactly the same as the quantity of
x they chose to consume before deciding on growing their own food. Will they still
choose to use their garden to grow food in it? On what does your answer depend?
c. If they do decide to use their garden to grow food, will they also buy food from the
supermarket?
d. Suppose now that the whole neighborhood followed suit and there is now a local
market where Mr and Mrs Goode can sell their product or buy fresh food but at a
higher price than in the supermarket. Will they end up being buyers or sellers of food?
In this question we examine candidates’ command of consumer choice theory. In our

case, a couple (Mr and Mrs Goode) are considering the idea of self-sufficiency as they
can grow food in their garden. At a cost of 𝑐0 they can produce up to 𝑥̅ units of their
food consumption.
a. Here candidates were expected to present the framework of analysis which you
would use to deal with the problem raised in the question. We expected to find the
following set-up:
34
Io
0
py
A
y0
U0
0
px
0
py
x0 Io x -food stuff
0
px
b. We assume here that 𝑥0 = 𝑥̅ which means that the capacity of the garden is such
that they can produce in it exactly what they are currently consuming.
Io
0
py
I o  c0 B’
0
py
A B
I o  c0 y
0
 0
py
I o  c0 U1
C
py
0
U0
px
0 U2
0
py
x0  x x
I o  c0 x -food stuff
0
px
Given that the cost of producing food in the garden is 𝑐0 , there are three possible
outcomes to the Goodes’ decision to grow food in their garden. In the first case
(the red line or the furthest budget constraint), the level of cost is such that the
couple may end up consuming at point B where the amount of food stuff they
would wish to consume is greater than that which they produce themselves. This,
of course, is not necessarily the outcome and much of it depends on the shape of
their indifference curves. However, if food were a normal good for them, then
they would find themselves at point B. Had food been an inferior good, they could
find themselves at point B’ where they still make use of their entire produce from
the garden. In any case, at this level of cost they will use the garden to produce
food as their utility is now greater.
35
If the level of cost (𝑐0 ) is such that they can now consume as much y as before,
together with the full use of their garden, then they will stay at point A (the blue
line or the middle budget constraint). In such a case, they will be indifferent
between using or not using their garden.
If the level of cost is such that they find themselves on the green line (the lowest
budget constraint) they may move to a point like C where they make full use of
their garden but their utility will be lower. In such a case, they will not use their
garden to produce food stuff.
c. Here we are being asked whether the Goodes would still buy food from the
supermarket if they decide to grow food in their garden.
There are two possibilities to be considered. In the first one, we assume, as before,
that the amount of food the garden can produce is the same as the Goodes used to
consume before they decided to grow food in the garden. But in such a case, for
them to decide to produce food, the level of cost must be such that it corresponds
to the first case in (b – the blue line or the furthest budget constraint). In the case
where they are indifferent, they will definitely not buy in the supermarket as their
choice would still be A (in the above diagram) so that they will just consume what
they have produced.
Io
0
py
I o  c0 B’
0
py
A B
y0
U1
U0
px
0 U2
dx 0
py
x0  x x1 Io x -food stuff
I o  c0
px
0
x 0
px
In this case, we can see that if food is a normal good they would move from A to B
where the amount of food they wish to consume is now greater than what they
can produce. They will therefore buy dx in the market to complement their food
consumption. If they treated good as an inferior good and moved from A to B’
they will not buy any more food in the supermarket.
36
d. The whole neighbourhood is now producing food in their gardens and a local has
market developed where fresh food is sold for a higher price than the prices at
which these goods could be purchased in the supermarket.
The development of the local market suggests that there are local people who
prefer to pay more to buy fresh produce. For them, the supermarket is not a
substitute for fresh food. In other words, fresh food is a different commodity and
these people spend their money only on fresh food and other products. The locals
who prefer to produce their food in their gardens are of a similar persuasion.
Moreover, local producers cannot sell their goods to the supermarket, which has
its own cheaper sources. In other words, fresh food is now the new commodity x
and its price is 𝑝1 𝑥 . If all producers sold their entire produce in the market, the
prices would have come down and they would have faced more or less their
original budget constraint.
We must now reconsider all three situations which were described in section (b)
above. We shall begin with the case where the Goodes would have been
indifferent between using their garden or not. This was the case in the diagram in
(b) where the new budget constraint went through point A. When the local
market developed and the Goodes buy (or sell) their food in the local market, they
no longer shop in the supermarket:
y
I o  c0  px  x
1
0
py
Io
0
py
I o  c0 y A
0
 0
py
U1
U0
0 U2
dx px
1 px
0
0 py
py
I o  c0 Io x -food stuff
x1 x0  x x 0
px
0 px
Relative to their initial point they can now produce the quantity of food produce
they used to consume (only now it is fresh). This means that, in principle, they
could sell their produce in the local market and the new budget constraint will
have to go through point A. In spite of the fact that in the previous analysis we
said that they will be indifferent between using their garden and not using it,
37
when the local market develops they will clearly be better off producing food in
their garden. In such a case, they will move to point B which is on a higher
indifference curve and sell dx of their produce in the local market.
The second case is the one where it was clear that the Goodes would want to use
their garden to grow food. Here, however, we have two cases. The first is the case
when food is a normal good.
Io
0
py
I o  c0
0
py
C
B
y0 A
U1
U0
U2 0
dx px
0
py
x0  x x1
x
I o  c0 Io I o  c0 x -food stuff
1
px
0 x 0
px px
In the absence of a local market the Goodes would have moved from A to B where
they would use their garden to grow food as well as augment their consumption
with food purchased in the supermarket. However, given that the emergence of
the local market means that food products are now only fresh food products, the
Goodes would still use their garden as well as buy products in the local market.
They will therefore move from A to C. In principle, we can also say that if the
Goodes did not consider fresh food as a complete alternative to supermarket food,
they may have felt that B is preferred and this would have meant that they will
not take part in the local market even though they would still grow food in their
garden. The difference will then be purchased in the supermarket.
Had they treated food as an inferior good:
38
Io
0
py B
I o  c0
0
B’
py
A U1
y0
U0
U2 0
dx px
0
py
x1 x0  x x
I o  c0 Io I o  c0 x -food stuff
1
px
0 x 0
px px
They would have opted to use the garden to grow food (point B’) but, this time,
they would also join the local market where they will sell some of their products
(point B).
Lastly we have the case where they would not have used their garden had there
not been a local market.
Io
0
py
B
A
y0
I o  c0 U2
0
py C U0
0
px U1
dx py
0
x1 x0  x x
I o  c0 Io x -food stuff
I c px
0
px
0
x o 1 0
px
Originally they were at A and with the cost of using the garden to produce food
they would have found themselves at a worse position (C). However, with the
option to sell the produce in the market (the heavy blue line) they may be able to
move to a point like B where they would clearly prefer to use the garden for
growing food and sell dx in the local market.
39
Question 2
The Jewellery industry is competitive and made up of two types of producers. Original local
artists and commercial imitators. The cost of production of jewellery is evidently higher for
the local artists than it is for the commercial imitators. The consumers, however, cannot
really tell the difference. However, without the local artists, commercial imitators will have
nothing to imitate.
a. Describe an initial set-up in which both local artists and commercial imitators supply
the market.
b. What will happen in the long run?
c. As a result of a court case, the imitators will now have to pay a fixed fee for the right
to use the local artists’ ideas. How will this affect the long run equilibrium?
d. If instead, the government taxed commercial imitators with a lump-sum tax, would this
be, in principle, more conducive to the increase in local artists’ market share?
In this question we examine the application of competitive market analysis. A market

for jewellery is supplied by two types of producers: commercial and local artists whose
costs of production are higher due to the fact that they design and make their own
jewellery (i.e. not through mass production). We assume that consumers cannot really
tell the difference and that the ideas of local artists are the fuel which allow
commercial producers to make their own products.
a. Here is the initial set-up of the industry when both types of producers are in the
market (assume that there are m artists and n commercial producers):
MCi ( w0 , r0 ) n m
MCi ( w0 , r0 ) S   MCk ( w0 , r0 )
ACi (w0 , r0 ) k 1
ACi (w0 , r0 )
A A
px
0
A
D()
i i
x j j x0 x
x 0 x 0 x
Given the difference in the technology of production and subsequently the cost of
production, the initial set-up where both types of producers are in the market
must be such where the commercial producers are making profits. Though we said
that the ideas of the local artists are important for the commercial producers,
there is no need for them to pay for these ideas as in the competitive set-up
40
information is full and free.
b. In the long run, the following process will develop:
MCi ( w0 , r0 ) n m
MCi ( w0 , r0 ) S   MCk ( w0 , r0 )
ACi (w0 , r0 ) k 1
ACi (w0 , r0 ) n T  m
S  MC ( w , r )
k 0 0
A A k 1
px
0
A
B B B
D()
i i j x
x1 x 0
xi x j1 x 0 xj x0 x
1
The profits above the normal which commercial producers make, will allow the
return above the normal market rate of return on capital which would lead to the
entry of more commercial producers. This will create excess supply in the market
which would lead to a fall in the equilibrium price until we get to the new price
which is equal to the minimum average cost of the commercial producers (the
move from A to B). Local artists will make losses and this will lead to their
departure from the market. As they do so, supply will shift to the left and prices
will temporarily increase which, in turn, will attract more commercial producers
until all local artists are pushed out and we are left with only commercial
producers.
c. We are now considering how the long run process will evolve if commercial
producers were to pay local artists for imitating their products:
MCi ( w0 , r0 ) n m
MCi ( w0 , r0 ) S   MCk ( w0 , r0 )
ACi (w0 , r0 ) k 1
P
ACi ( w0 , r0 )  n T  m U
ACi (w0 , r0 )
x S  MC ( w , r )
k 0 0
A ACi ( w0 , r0 ) 
P
A 0 A k 1
x px
C C
C
D()
x i1 xi 0 x j0 x
xi x j1 xj x0 x
1
We begin at A. Now the commercial producers pay a fee for the use of the local
artists’ idea. This fee is a lump sum fee as it is independent of how many units
they produce. It is a fixed cost for the commercial producers and equivalent to a
lump sum subsidy for the local artists. As a result, the average costs of commercial
producers increase while those of local artists decrease. If the fees are properly
designed, the minimum of the new average costs curve would be at the same price
41
level which will allow both types of producers to stay in the market in the long
run. Relative to point A, however, both types of producers would initially make
profits above the normal which would lead to an increase in their numbers.
d. An alternative is considered here where a lump sum tax is levied on the

commercial producers:
MCi ( w0 , r0 ) n m
MCi ( w0 , r0 ) S   MCk ( w0 , r0 )
ACi (w0 , r0 ) k 1
T
ACi ( w0 , r0 ) 
x
ACi (w0 , r0 )
A A 0 A
px
D()
i
x j0 x
x 0
xi xj x0
We begin at A where originally commercial producers made profits while local

artists made no profits above the normal. If the tax is levied, it will shift the
average costs of commercial producers up and will virtually eliminate all the
profits which they had above the normal. In such a case, this will become the
long-run equilibrium as firms will neither leave nor enter and the market share of
local artists will remain unchanged. In the previous case, when commercial
producers paid fees to local artists, there were still profits above the norm for both
types of producers. This would have led to entry of both commercial producers
and local artists. While it is not clear what exactly will happen to their market
share, their number would have increased!
Question 3
A place of work which for technological reasons has to be located far from centres of
population is, at the moment, paying a travel allowance to cover the time which workers
spend commuting to work. The owner is now considering a change of policy and declares
that anyone who works less than a certain number of hours per day will have to pay back
their travel allowance.
a. Show how workers will make their choices before the change.
b. How will the proposal affect the total amount of work offered to the employer?
c. If all places of work adopted such a policy what would happen to the level of wages?
d. Would the amount of work offered to the employer increase if he were to offer, in
addition, an extra bonus for each hour worked beyond the one for which one is entitled
to a travel allowance?
42
This is a question about the labour market and the choice of leisure. In the question we
are told that the place of work is located away from the centre of population which
means that all workers have to spend some time to commute to work. They receive a
travel allowance to pay for their time but this is a lump-sum payment which may or
may not be the same as the wage they are being paid per hour multiplied by the
number of hours they commute. The key point here is that they cannot choose how
many hours they commute. If they do not travel to work, they will not receive the
allowance.
a. The first step is to establish the framework of analysis before the employer makes
any changes:
TA  TC A
 (T0  Le )  0
0
0
px
U0
0
TA
L0 e T0 T Le
TC
Suppose that the time it takes the agent to travel to work is 𝑇̅ − 𝑇0 . At first he has
to pay the travel cost himself (TC) which would put him in debt and he cannot use
any of the time he travels to earn any wage to offset this initial cost. Had the
employer not provided any allowance, the heavy budget line where he gets a
wage per hour would have had to start at that point. However, the employer pays
a travel allowance (TA) which, according to the above diagram, is greater than the
actual travel cost (TC). The logic of this is that the employer is also paying for the
loss of earnings due to the long journey to work but this is not a significant point
and it would have been just as well to have assumed that TA = TC.
In our case, the individual will choose to be at point A. The number of hours he, or
she, will work is therefore: 𝐿0 = 𝑇0 − 𝐿0 𝑒 and his, or her, income in units of x (a
𝑇𝐴−𝑇𝐶
composite good) would be: + (𝑇0 − 𝐿0 𝑒 ) ∙ 𝜔0 .
𝑝0 𝑥
43
b. We now consider the new scheme according to which, an individual who works
less than a certain number of hours, will not receive the travel allowance (i.e. they
will have to pay it back). If the real wage level is 𝜔0 and the minimum hours
required qualifying for the travel allowance is 𝐿̅ = 𝑇̅ − 𝐿
̅̅̅𝑒 then the individual will
face the following problem:
TA  TC A
 (T0  Le )  0
0
px
0
TA
U0
0 U1
TA
0 T0
Le Le
TC
T Le
0
The red (heavy) budget constraint is based on the new rule. If someone works less
than the required hours, that person will not receive a travel allowance (TA). Only
those who work the minimum hours required, or more, will receive the allowance
in full. This means that for those agents who used to work more than the required
hours (𝐿𝑒 < 𝐿̅𝑒 ), there will be no change but for those who worked less (like point
A), they will have to move to a point like B where more hours will be supplied.
They will also become worse off. Therefore, in terms of the hours worked for the
employer, the scheme will necessarily increase those hours.
c. This is a question about the effect that this will have on the supply schedule and
subsequently, on the equilibrium wage level:
In the previous section we saw how a worker would response to the scheme given
the wage he or she is earning. However, the labour supply depends on what an
agent would do at all levels of wages. Given the backward bending supply of
labour, it is clear that we have to consider the influence of the scheme on the
individual at different levels of wages. At a lower level of wages (upward sloping
supply), there will be levels of wage where the individual will not be offering
enough hours to acquire the travel allowance and, as a result of the scheme, they
will increase their supply of hours for a given wage level.
44
0 B
A
TA A 0 B
U1
TA U0
0
Le Le TC T Le L L
Therefore, if for the level of wages 𝜔0 the minimum qualifying hours is 𝐿̅ then we
will have a move from A to B. Without the minimal working hours requirement,
the individual would have chosen to work at A but now his utility will be
maximised if he worked at B. The same would apply for different wage levels with
rising contracted hours. At a certain level of wage, the individual would have
chosen to work more hours than contracted and there will be no change in the
labour supply. However, at the backward bending part we will see the following:
1 D 1
C D
TA
C
0
B U3
A U2
0 A
B
U1
U0
TA
1 0
TC
Le
Le Le T Le L L
In between there would be wages for which the choice of hours would exceed the
minimum required and will, therefore, not change the number of hours supplied
at these level of wages. Therefore, if we look at the labour market as a whole, we
will find that the equilibrium level of wages will fall but not necessarily the
number of hours supplied:
45
1 D 1
C D
TA
C
0
B U3
A U2
0 A
B
U1
U0
2
E
TA
D
1 0
TC
Le
L
e Le T Le L L
If before the change we were at A, the new scheme will lead to an excess supply of
hours which would lead to a fall in wages but an increase in the amount of hours
supplied relative to the original position.
d. What if the employer offered, in addition, a bonus for each hour worked beyond
the minimum required to qualify for the travel allowance?
For those who initially worked beyond the required hours, this is a simple case of
substitution and income effect. The substitution effect will push towards an
increase in the supply of hours but the income effect will push in the opposite
direction as leisure is a normal good. In such a case, it is not clear whether such
individuals would increase or decrease their supply of labour. But the answer is far
more categorical in the case of those who used to work less than the required
hours:
46
T  0
C
0  b B U1
TA
U0
TA
Le
B
Le T Le
Such individuals who find themselves at B due to the introduction of the
minimum hour requirement will now move to a point like C where they will offer
much more labour than before.
Section C
Question 4
In a closed economy the marginal propensity to consume of the rich is smaller than that of
the rest of the population. There is a proportional tax rate which is higher for the rich
people than it is for the rest of the population. To improve equity the government decides
to change the tax regulation in such a way that some of those who could escape to the
lower tax rate will now be deemed higher tax rate payers.
a. What will be the economy’s multiplier before the change?
b. How will the change affect the economy if prices and wages are fixed?
c. Will your answers to (a) and (b) be different if the government has a balanced budget
policy where spending are adjusted to the level of tax revenues?
d. What will be the effect of the policy if there are flexible prices and wages in the
economy? What would happen to real wages, output and investment in this economy?
In this question we have a closed economy where the marginal propensity of the rich
to consume is smaller than that of the rest of the population and the rich also pay a
higher tax rate.
47
a. To find the multiplier we need to set the scene. We assume that the share of the
rich in income is given by α:
c( y )  c0  c1 (1  t L )(1   ) y  c R1 (1  t H )    y
I ( y , r )  I 0  I 1r
G  G0
AE ( y , r )  [c0  I 0  I 1r0  G0 ]  [c1 (1  t L )(1   )  c R 1 (1  t H ) ] y
1 1
 y  A( r0 )  A( r0 )
1  [c1 (1  t L )(1   )  c 1 (1  t H ) ]
R
1 M
b. The government has now changed the tax regulation which meant that some
people who were deemed as low tax payers will not have to pay a higher rate of
tax. This means that the share of income which is taxed at higher rate will now
increase. The only unclear element here is whether those who are now deemed
rich will also change their behaviour in the sense that their marginal propensity to
consume will fall. Both possibilities are acceptable even though the one where
they do not change their behaviour just because the government deemed them as
rich is more convincing. In the simpler case, where we assume that people who
are deemed rich by the authorities will also adjust their perception of themselves,
the change is simply an increase in the share of rich people in the population.
Namely, it is an increase in α. In such a case, we can see that α is an
argument of the multiplier alone so the effect of the change will come
through the change in M:
𝜕𝑀
= 𝑐 𝑅 1 ∙ (1 − 𝑡𝐻 ) − 𝑐1 ∙ (1 − 𝑡𝐿 ) < 0
𝜕𝛼
Clearly, as 1 − 𝑡𝐻 < 1 − 𝑡𝐿 and as 𝑐 𝑅 1 < 𝑐1 , the effect of the change in α is inverse.
This means that an increase in α would lead to a decrease in the multiplier.
If we follow the other route where we suppose that those who were deemed as
rich still perceive themselves as ordinary and continue to behave as if they were
not rich, the analysis will be somewhat different though the conclusions would be
similar.
As income is only an argument of the consumption function, we must now write a

new function where we take into consideration that a fraction of the income, say,
β, has now moved from low tax bracket to a high tax bracket:
𝑐̅(𝑦) = 𝑐0 + 𝑐1 ∙ (1 − 𝑡𝐿 )(1 − 𝛼 − 𝛽)𝑦 + 𝑐1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛽𝑦 + 𝑐 𝑅 1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛼𝑦
Clearly, the difference between the original function and the new one is given by:
48
𝑑𝑐 = −𝛽𝑦 ∙ 𝑐1 ∙ (1 − 𝑡𝐿 ) + 𝛽𝑦 ∙ 𝑐1 ∙ (1 − 𝑡𝐻 ) =
= 𝛽𝑦 ∙ 𝑐1 [(1 − 𝑡𝐻 ) − (1 − 𝑡𝐿 )] < 0
And as all these variables are components of the multiplier we will have a new
multiplier:
1 1
=
1 − [𝑐1 ∙ (1 − 𝑡𝐿 )(1 − 𝛼 − 𝛽) + 𝑐1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛽 + 𝑐 1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛼] 1 − 𝑀′
𝑅
where the difference between M’ and M is clearly:
𝛽𝑐1 [(1 − 𝑡𝐻 ) − (1 − 𝑡𝐿 )] < 0
As M>M’ it means that the new multiplier will be smaller, whichever version of
the story one would wish to tell. This means that the IS curve shifts to the left and
becomes steeper.
r
LM ( M 0 , P0 )
A
r0
r1 B
IS (G, tL , tH , 0 )
IS (G, tL , tH , 1 /  )
Y
Y1 Y0
Hence the equilibrium level of income will fall and the domestic interest rate will
increase.
c. In the case of a balanced budget the initial set up will be a bit different:
c( y )  c0  c1 (1  t L )(1   ) y  c R1 (1  t H )    y
I ( y , r )  I 0  I 1r
G ( y )    y  t H  (1   ) y  t L
AE ( y , r )  [c0  I 0  I1r0 ]  [c1 (1  t L )(1   )  c R1 (1  t H )  t H  (1   )t L ] y
1 1
 y  A( r0 )  A( r0 )
1  [c1 (1  t L )(1   )  c 1 (1  t H )    t H  (1   )t L ]
R
1 M
With regard to sub-question (a), notice that the multiplier here will be greater
than in the case without a balanced budget. Also 𝐴̅ < 𝐴 and this means that
relative to the original position in the above diagram, the IS curve shifts to the left
and becomes flatter. You have not been asked to examine where exactly will IS lie
49
but this is something we encourage you to do by yourself. So how will the answer
to (b) change with a balanced budget?
We now follow the simple version (an increase in the share α which is
accompanied by an adjustment of behaviour):
𝜕𝑀
= 𝑐 𝑅 1 ∙ (1 − 𝑡𝐻 ) − 𝑐1 ∙ (1 − 𝑡𝐿 ) + 𝑡𝐻 − 𝑡𝐿
𝜕𝛼
While we know from the previous case that the first two elements produce a
negative outcome, the addition is positive (𝑡𝐻 − 𝑡𝐿 > 0). So it means that, in
comparison to the non-balanced budget case, the effect of the policy would lead to
either a smaller fall in M or to the complete opposite (an increase in M).
In the second version of the story we will have the same change in the
consumption function as before but also a change in the demand for public
spending:
𝐺̅ (𝑦) = (𝛼 + 𝛽)𝑦 ∙ 𝑡𝐻 + (1 − 𝛼 − 𝛽)𝑦 ∙ 𝑡𝐿

= 𝛼 ∙ 𝑦 ∙ 𝑡𝐻 + (1 − 𝛼)𝑦 ∙ 𝑡𝐿 + 𝛽𝑦 ∙ (𝑡𝐻 − 𝑡𝐿 )
which is the old G(y) + a positive number that will lead to the following new
multiplier:
1
1 − [𝑐1 ∙ (1 − 𝑡𝐿 )(1 − 𝛼 − 𝛽) + 𝑐1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛽 + 𝑐 𝑅 1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛼 + 𝛼 ∙ 𝑡𝐻 + (1 − 𝛼) ∙ 𝑡𝐿 + 𝛽 ∙ (𝑡𝐻 − 𝑡𝐿 )]
1
=
1 − 𝑀′
The difference between M’ and M is:
𝛽 ∙ (𝑡𝐻 − 𝑡𝐿 ) + 𝛽 ∙ 𝑐1 ∙ (1 − 𝑡𝐻 ) − 𝛽 ∙ 𝑐1 ∙ (1 − 𝑡𝐿 ) = 𝛽[(𝑡𝐻 − 𝑡𝐿 ) + 𝑐1 ∙
((1 − 𝑡𝐻 ) − (1 − 𝑡𝐿 ))]
Here, too, the answer is as ambiguous, as before, and the multiplier may either be
positive or of a smaller negative number in absolute value.
Therefore, relative to the case where there is no balanced budget, the effect will
be:
50
r
LM ( M 0 , P0 )
A
r0
r1 B
IS (G, tL , tH , 0 )
IS (G, tL , tH , 1 /  )
Y
Y1 Y0
Namely, we will either move to the heavy blue broken line between A and B if the
multiplier is still smaller than the one before the change or to the green dotted
line to the right of A if the multiplier becomes bigger.
d. In this section you were asked to examine the effects of the change in policy when
prices and wages are flexible.
The following diagram should have been presented assuming that the outcome of
the policy would be to shift the IS curve to the left:
r
LM ( M 0 , P0 )
LM ( M 0 , P1 )
A
r0
LM ( M 0 , P2 )
r1 B
C IS (G0 , tH , tL ,  )
r2
IS (tH , tL ,  ,  )
Y
p
SAS ( w0 )
p0 A
B SAS ( w1 )
p1
p2 C
AD (G0 , tH , tL ,  , M )
AS (tH , tL ,  ,  , M )
y1 y0 Y
Clearly the fall in aggregate demand would shift IS to the left and the change in
the multiplier will make IS steeper. The same will apply to the AD curve. There is
now excess supply in the market which would lead to a fall in prices and, with it,
an increase in the supply of real balances. In turn, this will lead to a fall in the
interest rate. In the labour market the real wage will increase, which will reduce
the number of people employed and the new equilibrium will be at point B.
51
However, there is still an excess supply of labour in the labour market and this will
lead to a fall in nominal wages and, subsequently, to a further fall in prices. The
whole economy will then move from point B to C.
Question 5
There is a deep recession in an economy’s main trading partner. The Central Bank decides to
take action to offset the potential effects of this by working towards a reduction of the
interest rate. There is no capital mobility and the exchange rate is fixed.
a. Describe the initial equilibrium.
b. How would the recession abroad affect the equilibrium in the short and in the long
run? What will happen to domestic investment?
c. Will the Central Bank’s policy be effective?
d. How would your answer to (b) and (c) differ if the country had perfect capital mobility
and a flexible exchange rate?
An economy’s main trading partner is in recession. Clearly, this will affect the demand
for the economy’s exports. The Central Bank is taking steps to reduce the interest rate.
a. We begin with the initial set-up of an open economy without capital mobility and
a fixed exchange rate:
E0 p *0
NX ( )0
p0
r
LM ( M 0 , P0 )
r0 A
E0 p *0
IS (G, t , )
p0
Y
Y0
b. How will the recession abroad affect the economy?
As we have already said, intuition suggests that this will lead to a decline in
demand for this economy’s exports. In terms of the model we portrayed in (a), the
only way that the main trading partner appears in the parameters of the model is
in the form of foreign prices (p*), which is an argument of the real exchange rate
52
𝐸∙𝑝∗
( ). As the prices in the main trading partner are falling due to the recession
𝑝
(excess supply of goods), the real exchange rate will fall too. This means that
there is less return on exports in real terms and imported goods are cheaper in
real terms. Therefore, the demand for net exports will fall. The fall in demand for
NX means both a fall in the overall demand for domestic output (IS will shift to
the left) and a shift to the left of the NX=0 constraint as the fall in net exports will
now require lower levels of income to offset its autonomous element:
E0 p *1
NX ( )0
p0
r LM ( M 0 , P0 )
E p*
NX ( 0 0 )  0
p0
r1 C
B A
r0
E0 p *0
E0 p *1
IS (G, t , )
IS (G, t , ) p0
p0
Y
Y1 Y2 Y0
The fall in exports would reduce the demand for net exports (NX). This means
that at any given interest rate there is now a smaller demand for local goods: a
shift to the left of IS. It also means that as the initial NX is lower, one needs a
lower level of income to offset it so that NX=0. Hence, the NX=0 line also shifts
to the left.
Here we face the question of how far to the left the NX=0 line should move and
the answer, as always, depends on some examination of the alternative definition
of equilibrium in the goods market: the investment-savings consideration.
Before the change, at A, the following holds as NX=0:
𝐼(𝑟0 ) = 𝑠(𝑦0 ) + 𝑡 ∙ 𝑦0 − 𝐺
After the change we look at a point like B where there is equilibrium in the goods
market (on IS). Here the following holds:
𝐼(𝑟0 ) = 𝑠(𝑦2 ) + 𝑡 ∙ 𝑦2 − 𝐺 − 𝑁𝑋
As 𝑠(𝑦0 ) > 𝑠(𝑦2 ) and 𝑡 ∙ 𝑦0 > 𝑡 ∙ 𝑦2 (assuming G is constant) then clearly NX<0
for the equation to hold. This means that point B must be to the right of the point
where NX=0.
53
In terms of the dynamics the following will be the sequence, in the short run and
in the long run, had the Central Bank not intervened:
E0 p *1
NX ( )0 LM ( M1 , P0 )
p0
r LM ( M 0 , P0 )
E0 p *0
NX ( )0
p0
r1 C
r0 A
r2 B
E0 p *0
E0 p *1
IS (G, t , )
IS (G, t , ) p0
p0
Y2 Y
Y1 Y0
We will first move along the LM curve towards the new equilibrium at point B
where the goods market and liquid asset markets are in equilibrium. However, as
there is a deficit in the current account, this would lead to a fall in the supply of
liquid assets and a shift of LM toward point C where the final new equilibrium will
be established. At C, local investment will fall.
c. The Central Bank’s intervention:
In our story, the Central Bank proposes to take action and reduce the interest rate.
As the Central Bank can influence the supply of money, the reduction in the
interest rate will occur when there is an increase in the supply of real balances.
Let α be the reserve ratio, and the quantity of liquid assets is:
1
𝑀 = 𝑃𝐶 + 𝑅
𝛼
where PC is cash held by the public and R the total amount of reserves in
commercial banks. A reduction in the required reserve ratio (α) will lead to an
increase in the supply of liquid assets and hence, for any level of income, there
will now be an equilibrium in the liquid asset market at a lower level of interest.
This means that in addition to the change in IS and NX, there will also be a
change in LM but in the opposite direction.
54
E0 p *1
NX ( )0 LM ( M 2 , P0 )
r p0 LM ( M 0 , P0 )
E p*
NX ( 0 0 )  0
p0 LM ( M1 , P0 )
r1
C
r0 A
r2 B
E0 p *0
E0 p *1
IS (G, t , )
IS (G, t , ) p0
p0
Y
Y1 Y0 Y2
The shift downwards of LM as a result of the increase in the supply of liquid assets
will lead, together with the shift to the left of IS, to a move towards an equilibrium
at point B (the fall in demand for exports is offset by the increase in demand for
investment due to the lower interest rate). However, at B, there is a deficit in the
current account (NX<0) and with a fixed exchange rate policy this means that the
central bank will sell foreign currency in return for local currency which will lead
to a fall in the supply of liquid assets. The new equilibrium will have to be at point
C. The bank’s policy will have no long-term effect.
d. We now assume that this is an open economy with perfect capital mobility and a
flexible exchange rate regime.
The effects of the fall in exports without the intervention of the central bank will
lead to the following situation:
r LM ( M 0 , P0 )
A=C
r0  r0 * BOP
B
r1
E0 p *0 E p*
IS (G0 , t0 , )  IS (G0 , t0 , 1 1 )
p0 p0
E0 p *1
IS (G0 , t0 , )
p0
Y1 Y
Y0
The fall in demand for NX shifts IS to the left. Excess supply will lead to a fall in
output and a fall in demand for liquid assets which will shift the equilibrium from
A to B. At the lower domestic interest rate there will now be an outflow of capital
55
as the return on foreign assets is greater than that on domestic assets. The excess
demand for foreign currency (which has already been created by the fall in
exports) will lead to an increase in the nominal exchange rate E (a depreciation)
that will increase the demand for NX and shift IS back to its original position at A.
In the case where the central bank increases the supply of liquid assets, the
following picture will emerge:
r LM ( M 0 , P0 )
LM ( M1 , P0 )
A C
r0  r0 * BOP
E1 p *1
IS (G0 , t0 , )
B p0
r1
E0 p *0
IS (G0 , t0 , )
p0
E0 p *1
IS (G0 , t0 , )
p0
Y
Y1 Y0 Y2
As both IS and LM shift more or less simultaneously, the initial change would be
to move from A to B. The fall in demand for exports is offset by an increase in
demand for investment. However, the very low domestic interest rate together
with the initial fall in exports, will lead to an excess demand for foreign currency
and an increase in the nominal value of E (depreciation). This will increase the
demand for NX and lead to a new equilibrium at point C. Here, the intervention of
the bank was effective in more than offsetting the effects of the fall in demand for
exports.
Question 6
The capital city of Gloria has become a great attraction for foreigners who wish to buy
homes in it.
a. Analyse the effect of this on the economy when the exchange rate is fixed.
b. Analyse the effect of this on the economy when the exchange rate is flexible.
c. As home prices in the city increase, the government embarks on a project of public
housing. How will this affect your answers in (a) and (b)?
In this question, there is a flow of foreigners buying local assets (homes) in a country.
We assume that this is not a one off event but rather a continuous flow. It means that
56
there is an increase in the supply of foreign currency which emanates from the capital
account. Other things being equal, this means that an excess supply of foreign
currency will be formed in the market for foreign currency. In terms of choosing the
framework of analysis, this is clearly the case of an open economy with perfect capital
mobility. While it is true that the influx of capital to buy homes in Gloria will have an
effect on local house prices and, subsequently, on the general price level, we begin the
analysis assuming that this has not yet happened.
a. In the first instance, you were asked to analyse the effect of an excess supply being
formed in the foreign currency market on an economy with a fixed exchange rate
policy.
r LM ( M 0 , P0 )
LM ( M1 , P0 )
A=C
r0  r0 * BOP
B
r1
E0 p *0
IS (G0 , t0 , )
p0
Y
Y0 Y1
The gap between supply and demand for foreign currency will lead the central
bank to buy the excess supply and, in so doing, increase the supply of money to
the economy. As a result, there will now be an equilibrium in the liquid asset
market at a lower level of the interest rate. LM, therefore, will shift downwards
and the economy will be moving towards an equilibrium at point B where the
lower interest rate induces an increase in the demand for investment. However,
the lower interest rate also means that the return on foreign assets is greater than
that of domestic assets and locals will now move to buy foreign currency
denominated assets. This is on top of the increase in demand for imports which is
due to the increase in income. Altogether, the demand for foreign currency will
increase until the gap is plugged again.
57
b. We now consider the case of a flexible exchange rate.
r LM ( M 0 , P0 )
A=C
r0  r0 * BOP
B
r1
E0 p *0
IS (G0 , t0 , )
p0
E1 p *0
IS (G0 , t0 , )
p0
Y1 Y
Y0
When the exchange rate is flexible, an excess in the supply of foreign currency will
translate into a fall in the nominal exchange rate E (an appreciation). This will
lead to a fall in demand for NX which will reduce the overall demand for domestic
output and IS will shift to the left. As the interest rate drops due to the fall in
demand for liquid assets at a lower level of income, there will now be an outflow
of capital as the return on foreign assets is higher than the return on local assets.
As the demand for foreign currency increases, the nominal exchange rate will
return to its original level at point C.
c. We now consider the effects that the flow of capital into Gloria may have on
domestic prices and government policy.
To begin with, we shall ask what might be the indirect effect that the flow of
capital into Gloria will have on the country. Naturally, as there is greater demand
for accommodation, house prices in Gloria may begin to rise. This, in turn, will
have an effect on the overall price level as housing is always a component of the
price index. This will have the following effect in the case of fixed exchange rate:
58
LM ( M 0 , P1 )
r
LM ( M 0 , P0 )
LM ( M1 , P0 )
C A
r0  r0 * BOP
B
r1
E0 p *0
E0 p *0 IS (G0 , t0 , p0
)
IS (G0 , t0 , )
p1
Y
Y2 Y0 Y1
The initial effect will be the same as in the story in (a). We therefore move from A
to B. However, the increase in domestic prices will lead to an increase in demand
for imports and a fall in demand for exports as the real exchange rate falls. This
will reduce the demand for domestic products and IS shifts to the left. At the same
time, the supply of real balances falls so pushing up the equilibrium level of the
interest rate. As it is clear that IS will have to be to the left of the original one, we
can establish that the new equilibrium will have to be at a point like C. We cannot
be sure of what exactly will happen to the quantity of money M at the end of the
process but we can be sure that for an equilibrium to be established, the supply of
real balances must fall.
If we now add government policy to embark on projects of public housing, this

means an increase in public investment. IS will therefore shift to the right. If
public investment is sufficiently high, this can shift IS back to its original position
(and even beyond) and thus prevent the recessional effect which would have been
generated by foreigners wanting to buy homes in Gloria. This means that we will
end up in more or less the same situation as the one depicted in (a).
In the case of a flexible exchange rate:
59
LM ( M 0 , P1 )
r
LM ( M 0 , P0 )
C A
r0  r0 * BOP
E0 p *0
E1 p *0 IS (G0 , t0 , p0
)
IS (G0 , t0 , )
p1
Y
Y2 Y0
In this case, the fall in the nominal exchange rate E together with the increase in
domestic prices will lead to a decline in demand for net exports and a strong shift
to the left of IS. The increase in prices will also reduce the supply of real balances
and ensure that the interest rate stays the same as the international rate as
demand for liquid assets is falling with income. The economy will move from A to
C. However, here the effect of a policy of public investment will not be able to
save the day. If, without the policy, we got to point C, an increase in public
investment will cause an increase in demand and therefore shift IS to the right.
But this will lead to a higher domestic interest rate and, therefore, an inflow of
capital which will lead to a fall in the nominal exchange rate E until we return to
point C. If the flow of capital to buy homes in Gloria has an impact on local prices,
the outcome will be harmful to the economy whether or not the government
follows a programme of public investment. However, if we assume that the
provision of public housing will reduce prices then we may indeed be able to
return to point A but we cannot be sure about this.
60

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Examiners’ commentaries 2014

Examiners’ commentaries 2014

 formulate problems described in everyday language in the language of economic

What are the Examiners looking for?

However, we cannot consider a candidate with this level of knowledge alone, as an

This, of course, should not be misread as a call for mathematical competence. Of

Essay-type or discursive writing is a method of exposition of the ‘getting acquainted’

Examiners’ commentaries 2014

Comments on specific questions

Approaching the questions

Approaching the question

In this question we examine candidates’ command of consumer choice theory. In our

b. What will happen in the long run?

Approaching the question

In this question we examine the application of competitive market analysis. A market

Local Artists Commercial

b. In the long run, the following process will develop:

Local Artists Commercial

Local Artists Commercial

d. An alternative is considered here where a lump sum tax is levied on the

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Approaching the question

ii. In the case where these hours were a choice:

Such individuals who find themselves at B due to the introduction of the

a. What will be the economy’s multiplier before the change?

Approaching the question

Clearly, as 1 − 𝑡𝐻 < 1 − 𝑡𝐿 and as 𝑐 𝑅 1 < 𝑐1 , the effect of the change in α is inverse.

As income is only an argument of the consumption function, we must now write a

𝑐̅(𝑦) = 𝑐0 + 𝑐1 ∙ (1 − 𝑡𝐿 )(1 − 𝛼 − 𝛽)𝑦 + 𝑐1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛽𝑦 + 𝑐 𝑅 1 ∙ (1 − 𝑡𝐻 ) ∙ 𝛼𝑦

where the difference between M’ and M is clearly:

𝛽𝑐1 [(1 − 𝑡𝐻 ) − (1 − 𝑡𝐿 )] < 0

𝐺̅ (𝑦) = (𝛼 + 𝛽)𝑦 ∙ 𝑡𝐻 + (1 − 𝛼 − 𝛽)𝑦 ∙ 𝑡𝐿

The difference between M’ and M is:

𝛽 ∙ (𝑡𝐻 − 𝑡𝐿 ) + 𝛽 ∙ 𝑐1 ∙ (1 − 𝑡𝐻 ) − 𝛽 ∙ 𝑐1 ∙ (1 − 𝑡𝐿 ) = 𝛽[(𝑡𝐻 − 𝑡𝐿 ) + 𝑐1 ∙ ((1 − 𝑡𝐻 ) −

In Woodland, export is dominated by the timber industry. A discovery of a slow-spreading

a. Describe the initial equilibrium.

c. Will the Central Bank’s policy be effective?

Approaching the question

Before the change, at A, the following holds as NX=0:

c. The central bank’s intervention:

a. There is a fixed exchange rate.

b. There is a flexible exchange rate.

Approaching the question

Stormia (A) Hotland (B)

b. The case of a flexible exchange rate:

Stormia (A) Hotland (B)

c. There is an effect on house prices in Hotland, and the government decides to

Examiners’ commentaries 2014

Comments on specific questions

Approaching the questions

Approaching the question

In this question we examine candidates’ command of consumer choice theory. In our

Had they treated food as an inferior good:

b. What will happen in the long run?

Approaching the question

In this question we examine the application of competitive market analysis. A market

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information is full and free.

b. In the long run, the following process will develop:

Local Artists Commercial

Local Artists Commercial

d. An alternative is considered here where a lump sum tax is levied on the

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