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# CAPE Economics, June 2006, Unit 2, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, June 2006, Unit 2, Paper 2 suggested answer by Edward Bahaw

CAPE Economics, June 2006, Unit 2, Paper 2 suggested answer by Edward Bahaw

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• 1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS CAPEECONOMICS thJune 15 2006 Unit 2 Paper 2 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSJune 2006 – Unit 2 – Paper 21 a ) Exclusion of Transfer Payments from GDPGross Domestic Product (GDP) is a measure of the value of all final goods and servicesproduced in an economy over a specific period of time. Transfer payments such aspension payments which are a component of Government expenditure, are excluded inthe calculation of national income as it a payment made by government which is notassociated with any production of goods and services in the current period.1 b ) Formula for converting nominal GDP to real GDP Nominal GDP 100Real GDP = × GDP Deflator 1 1 c i a) Value of Milk in Value of Honey in Year Nominal GDP current prices current Prices 2001 100 100 200 2002 300 300 600 2003 600 600 1200 1 c i b) Value of Milk in constant Value of Honey in constant Real GDP (2001 Prices) 2001 prices 2001 Prices 100 100 200 150 200 350 200 300 500 1 c i c) Nominal GDP 100Year Nominal GDP Real GDP (2001 Prices) GDP Deflator = × Real GDP 1 200 100 = × = 1002001 200 200 200 1 600 100 = × = 1712002 600 350 350 1 1200 100 = × = 2402003 1200 500 500 1 Percentage Change 1 c ii a) 1 c ii b) 1 c ii c) Year Nominal GDP Real GDP (2001 Prices) GDP Deflator 2001 2002 200 75 71 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2003 100 43 401 d) Real GDP vs. Nominal GDP to measure well beingAs the quantity of goods and services produced increases, the value of nominal GDPwould increase. Similarly, if the prices of goods and services increase, the value ofnominal GDP would also increase, but living standards may have decreased as goods andservice become more expensive for consumers. Using nominal GDP therefore means thatit would be impossible to know exactly whether an increase is due to an increase in thequantity of goods and services, or an increase in the prices of such goods and services.To overcome the problem presented when prices increase, the GDP deflator or priceindex is used to convert nominal GDP to real GDP or GDP at constant prices. Thismeasure removes the effect of inflation on nominal GDP calculations as the prices ofgoods and services produced in different years are held constant. VALUE IN \$1 d i) GDP/GNP AT MARKET PRICE 400 DEPRECIATION 501 d ii) NNP AT MARKET PRICE 350 INDIRECT TAX 301 d iii) NNP AT FACTOR COST (NATIONAL INCOME) 320 RETAINED EARNINGS 1001 d iv) PERSONAL INCOME 220 INCOME TAX 70 (v) DISPOSABLE PERSONAL INCOME 1502 a i) Aggregate demand is the sum of all expenditures in the economy which is equal toC + I + G + X – M. This gives measure of the total demand for final goods and servicesin the economy over a particular period of time.2 a ii) The aggregate demand curve shows the amount of goods and services in the wholeeconomy that are demanded at any given average price level. This relationship is negativeas the aggregate demand curve is downward sloping.2 a iii) Aggregate supply refers to the real value of output produced by an economy. Thatis it gives the value of goods and services which can be produced within an economyfrom the use of its resources over a particular period of time.2 a iv) The aggregate supply curve shows the relationship between the average level ofprices and the level of final output produced within an economy. This relationship ispositive as the aggregate supply curve is upward sloping.2 a v) The equilibrium price level is the average price level at which the aggregatedemand and aggregate supply for the economy as a whole over a particular period of timeare equal. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS2 b i) As the government cuts taxes, the level of aggregate demand increases as shown inthe figure. Given that the economy was initially close to the full employment the result isa small increase in the equilibrium level of GDP but a significant increase in the averageprice level. P AS AD2 AD1 B P2 A P1 Y1 YF Y2 b ii) As the government increases the money supply, aggregate demand would increase.Given the existence of high unemployment and excess industrial capacity the result is asignificant expansion in the level of GDP and the average price level stays unchanged.This is shown in the figure. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS P A S AD2 AD1 B P1 A Y1 Y2 YF Y2 b ii) As the price of oil increases, the aggregate supply curve would shift to the left. Asthe figure shows this results in a decline in the level of GDP and the average price levelrises. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS P AS1 AS2 AD P2 P1 Y2 YF Y2 c) Instability of investmentsInvestments are undertaken as long as the yield or profitability is acceptable to theentrepreneur. Any factor which affects the profits to be earned from an investment cantherefore affect the investors decisions about going ahead with it or not. These factorsinclude, changes in the rate of interest, variations in the non-interest related costsassociated with investments projects such as wages, changes in government polices suchas taxation and even technological change. Since there are so many factors which affectprofitability this is why investments are likely to be unstable.In addition to profitability investors’ expectations about the future also have a veryimportant impact on their preparedness to undertake investments. This comes aboutbecause of the nature of investments which usually has a lifespan exceeding more thanone year. This makes expected yields on investments highly vulnerable to businessmenexpectations about the future, which may depend on a plethora of factors such as thedomestic political climate or even stock market conditions. If investors are generallypessimistic about the future prospects of the economy, then expected profitability wouldbe lower than usual and it is likely that under this scenario investment would be low. Incontrast, if investors are generally optimistic about the outlook of the future, theninvestments would be high.3 a i) Discretionary Fiscal Policy vs. Automatic Stabilizers EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSDiscretionary fiscal policy refers to an active decision taken by the government to changethe level of government spending and or the level of taxation to achieve amacroeconomic objective.Automatic stabilizers are mechanisms that automatically increase the net injection fromthe government sector during recessions and contract it during booms. In other words anautomatically stabilizer offsets the current economic climate without any active policydecision by the government.3 a ii) Working of Discretionary Fiscal Policy and Automatic StabilizersDuring a recession when cyclical unemployment exists the government can implementdiscretionary fiscal policy to increase aggregate expenditure by increasing governmentspending and reducing taxation. In times of inflation the government can decide to reducespending and increase taxation. This would reduce the government sector injection to thecircular flow of income and via the multiplier aggregate expenditure would contract. Thiswould be a viable solution to demand pull inflation.Unemployment benefits which grants are given by the government to the unemployed isan automatic stabilizer as it automatically increases this component of governmentexpenditure during a recession. In addition during a recession Government tax revenuetends to fall and this would also abate the recession in the economy. If there is demandpull inflationary pressure in the economy arising from excess aggregate demand, thenunemployment would be low and the government would have to spend less onunemployment benefits. In addition, tax revenue would rise and this also have adampening effect on inflation.In an economy, the MPC is 0.75. If the level of national income is currently \$900 millionand potential output is \$1100 million, what would be the required increase in governmentspending to achieve full employment assuming taxes remain unchanged.3 b i) An increase in the equilibrium level of output from \$900M to \$1100MMPC = 0.75Required increase in Y = \$200B = ∆YMultiplier = 1/(1- MPC) =1/(1-0.75) = 4Required increase in G = \$50BIf government spending increases by \$50 million, then given the multiplier of 4 nationalincome would rise by \$200M form \$900M to \$1100M.3 b ii) An increase in Government spending by \$50M EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS E Y=E AE2 E2 AE1 E1 550 500 45° O 900 1100 Y3 c) As taxes increase, consumers have less disposable income and as a resultconsumption decreases. The decrease in consumption would be determined by the MPC.For instance if taxes increase by \$200B, then consumers would face a decrease indisposable income of \$200B. If the MPC is 0.75, then consumption would decline by\$150B. As government spending increases then the total level injections in the economywould rise. For instance, if government spending increases by \$200B, then the total levelinjections in the economy would rise by this amount. Overall, the decrease in consumers’expenditure of \$150B and the increase in injections of \$200B would lead to an initial netincrease in aggregate spending of \$50B. Of course this would now be subject to themultiplier of 4 which gives an overall increase in aggregate expenditure and nationalincome of \$200B.3 d i) The balanced budget multiplier asserts that an increase in government spending andtaxation by the same magnitude results in an increase in the level of national incomewhich is equivalent to the increase in government spending. For instance if thegovernment increases its expenditure by \$10B and at the same time taxation increases bythe same amount, then national income would increase by \$10B.3 d ii) The balance budget multiplier is 1. This is because an increase in governmentexpenditure of \$200B increases aggregate expenditure and hence national income byexactly \$200B.4 a i) Two Advantages of paper money. Homogeneity - each unit of paper money will be identical to all other units. Transportability/Portability – it should be convenient to transport paper money between different destinations. It would be very awkward or inconvenient to carry out business transactions and make payments in different locations using commodity money. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS4 a ii) Two Advantages of cheques versus commodity money. Durability – cheques are more durable compared to commodity money such as potatoes which may perish loose its value over time. If this happens it would become unacceptable as a means of payment. Divisibility – a cheque can be written for a range of different values. This is necessary as different transactions require payment in different sums of money. Commodity money such as sheep or sea sheep for instance may not be as divisible in order to accommodate these different amounts.4 a iii) Two Disadvantages of commodity money Transportability/Portability – It would be very awkward or inconvenient to carry out business transactions and make payments in different locations using commodity money. Homogeneity – units of commodity money may not be identical among other units.4 b i) Acceptability and fiat or law in determining the value of moneyIn most modern economies money issued by Central Banks is neither commodity moneynor representative money but rather fiat money. Fiat money or fiat currency is moneywhich unlike commodity money has no intrinsic value and unlike representative money isnot backed by any physical commodity. Despite this, such money is still acceptable insettlement of a debt because the Government declares it as legal tender.That is fiat money fulfills the functions of money as the Government officially stipulatesthat it must be accepted in settlement of a debt. This basically means that fiat money canbe used to pay for goods and services as well as settle debts as the law of the land makesit acceptable. Any economic agent who receives fiat money from the sale of a good or aservice knows with certainty that this can be used to purchase other goods and services.Because of this acceptability and confidence in this form of money, the value ispreserved.4 c i) Transactionary motive – this refers to amount of money held for daily use tocarry out routine transactions. As an individual receives his monthly income, say at theend of January, he would spend some immediately and hold a portion of it throughout themonth of February in order to carry out daily expenditure over that period. In economicjargon, the timing of the receipt of income and daily expenditure are not perfectlysynchronized. As a result individuals must hold a proportion of their income throughoutthe month in order to fulfil daily transactions. In general, money held for thetransactionary motive tends to increase with income. It is however, not affected bychanges in the interest rate which means that the transactionary demand for money isperfectly interest inelastic. These characteristics are shown in panel A and B of the figure. Panel A: Positively related to Panel B: Not affected by the Income Interest Rate EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSM IR TB TB Y MSpeculative motive – this is any money held in excess of the transactionary andprecautionary motive. For example, if the total amount of money held by an individual is\$1,100 and his transactionary and precautionary balances are \$500 and \$200 respectively,then his speculative balance is \$400. The speculative motive for holding money, isdistinct from the other two, in that it accounts for any money held in the hope of eithermaking a speculative gain, or avoiding a possible loss as a result of an expected change inthe interest rate and hence the price of financial assets.If, for some reason, the actual rate of interest in the economy was say 5 percent butspeculators anticipated that is would rise to 8 percent then individuals would prefer tohold their wealth in the form of money since as the interest rate rises, the price offinancial assets fall. If wealth is held in the form of financial assets are then a capital losswould be incurredOn the converse side, if the actual rate of interest in the economy was say 10 percent,speculators contended that it would fall to 8 percent then individuals would hold less oftheir wealth in the form of money and thus more in the form of financial assets. This isbecause if the rate of interest falls, the price of financial assets would rise and the holdersof such assets would earn a capital gain.The Speculation Demand for Money EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 11. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS IR 10 5 SB M \$4B \$10BIn short, the above analysis simply shows that if the interest rate is expected to rise thenindividuals would hold more money in speculative balances. On the other hand if theinterest rate is expected to fall then the speculative demand for money would be low. Thisis shown in the figure which demonstrates an inverse relationship between the rate ofinterest and the speculative demand for money.4 c ii) An increase in the money supply. As the money supply increases a surplus of money is created in the money market. Inorder for the money market to clear, the rate of interest must fall to entice individuals tohold larger money balances. As the figure shows an increase in the money supply resultsin the establishment of a new equilibrium in the money market at a lower rate of interest.This represents expansionary monetary policy as the lower interest rate would lead to anincrease in the level of output and employment in an economy. IR SM1 SM2 E1 IR1 E2 IR2 LP= DM M5 a i) Demand and Supply of Shirts EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 12. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS5 a iii)5 a iv)5 b i)5 a ii) Equilibrium price = \$5 per shirt, equilibrium quantity = 1000 shirts.5 a iv) Domestic production = 800 shirts Domestic consumption = 1400 shirts5 b ii) Domestic production increases by 100 units from 800 shirts to 900.5 b iii) New level of domestic consumption is 1200 shirts.5 b iv) Imports of shirts with tariff is 300.5 b v) Tax revenue is \$300 (300 shirts @ \$1 tariff)5 c i) Net Welfare loss caused by tariff EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
• 13. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS5 c ii) Loss in Welfare from the TariffTotal Loss in Welfare = Area of Δ1 + Area of Δ2 = \$50 + \$100 = \$1505 d i) Gainers and Losers from ExportsProducers gain when free trade enables a country to become an exporter. This is becausea larger market is accessed which also means greater efficiency in the use of domesticresources as economies of scale which was previously unattainable from supplying thehome market is no possible. The increase production also creates more employment andhence more income is generated. Governments also benefit as more taxation revenue isearned from the profits generated by exporters. In terms of losers, one argument isenvironmental degradation form large scale production which can have significantlynegative impacts on society.5 d ii) Gainers and Losers from ImportsConsumers gain when a country allows trade and becomes an importer as they are able topurchases goods and services from the most efficient foreign producers. As such they paylower prices and enjoy a higher consumer surplus. The losers are the domestic producerswho are faced with a decline in market share and lower prices as foreign competitionenters the market. This results in a decline in producer surplus. The government can alsoloose as they allow free trade as tariff revenue on imports become nil.5 d iii) The gains from trade vs. the losses EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS