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# June 2010 unit 2 paper 2 answer

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June 2010 unit 2 paper 2 suggested answer by Edward Bahaw

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### June 2010 unit 2 paper 2 answer

1. 1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS CAPEECONOMICS thMay 27 2010 Unit 2 Paper 2 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
2. 2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSJune 2010 – Unit 2 – Paper 21 a i) Real Gross Domestic Product (GDP) measures the value of output produced by aneconomy using a base year or constant price level. The base year price level refers to theprice level in a particular year. This is done to compare the value of output produced indifferent years using the same set of prices. As such differences in the value of outputwould be attributable purely to differences in the quantity of goods and servicesproduced.Nominal GDP measures the value of output produced by an economy using the currentprices of goods and services. If the same quantity of goods and services are produced intwo consecutive years and the price level increases over the period, then the value ofnominal GDP would increase in the volume of output produced is the same.Nominal GDP can be converted to real GDP using the GDP deflator which is a priceindex to remove the effects of price changes in the measurement of national income. Theformula used in the conversion is given by: Nominal GDP 100Real GDP = × GDP Deflator 11 a ii) Living standards refer to the quality of life or level of net economic welfareenjoyed by citizens of a country As GDP increases, individuals would be able to affordmore goods and services and this improves their livings standards. However in additionto GDP there are many other factors which affect living standards. These include: 1. Inflation – if GDP increases but prices increase at an equal or faster rate, then individuals would not be able to afford more goods and services. 2. The distribution of income – if GDP increases but the distribution of income is uneven, then only some individuals would benefit while the rest of society would not experience an improvement in net economic wellbeing. 3. Leisure time – sometimes an increase in GDP occurs as workers in the economy work longer hours. Although this would result in an increase in income, the decrease in leisure would have a negative effect on living standards. 4. Negative Externalities – as production increases lead to a higher level of GDP, there may be an increase in pollution and environmental degradation which adversely affects the quality of life which people enjoy. 5. Accuracy – the calculation of GDP involves the assimilation of vast amounts of data. Sometimes because of the enormity of the calculation, there may be some inaccuracies which mean that the data would not properly reflect the standard of living the country achieves. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
3. 3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSC = 40 + 0.8YI = 50G = 400NX = 10 – 0.3Y1 b i) Autonomous Consumption = 401 b ii) Marginal Propensity to Consume = 0.81b iii)AE = C + I + G + X - MAE = 40 + 0.8Y + 50 + 400 + 10 – 0.3YAE = 0.5Y + 500At the equilibrium: Y = AE∴ Y = 0.5Y + 500Y – 0.5Y = 5000.5Y = 500Y = 500/0.5 = 1000The equilibrium level of national income is \$1,000.1 b iv) Multiplier 1 = MPS + MPM + MRT 1= 0.2 + 0.3 + 0 1= =2 0.51 c i) Net National Product (NNP) is Gross National Product minus a capital consumptionallowance. The capital consumption allowance covers the value of capital which wasdepleted as a result of economic activity. NNP shows the income that is left over after aprovision has been made for the replacement of used up capital.NNP = GNP – Capital Consumption EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
4. 4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS1 c ii) Personal disposable income is that part of income which is actually received byhouseholds and is available for spending or saving. It is found by subtracting income taxpayments from personal income. Income taxes refer to those which relate to households.Disposable income therefore gives the after tax income of households.Disposable Income = Personal Income – Income TaxesPersonal income is NNP adjusted for transfer payments, retained earnings and corporationtax.Personal Income= NNP + Transfer Payments– Retained Earnings – Corporation Tax2 a i) Inflationary and deflationary GapsThe inflationary and deflationary gaps exist whenever the equilibrium income level forthe economy does not correspond to the full employment level of income. At this point,the full employment level of income is the level of income where basically all productiveresources are utilized. Panel A: Inflationary Gap Panel B: Deflationary Gap EE FE FE Y=E Y=E E AE1 X F Y AE2 G E 45° 45° YF Y YE2 YF Y YE1Panel A shows the equilibrium level of income coinciding with Y E1 which exceeds thefull employment level of income YF. This occurs in a situation where people are trying tobuy more goods and services than the economy can potentially produce when allresources are fully employed. The excess demand results in higher prices or inflation.The vertical distance XY represents the inflationary gap attributable to excessive demandin the economy. If the aggregate expenditure curve is shifted downwards by this verticaldistance then this would eliminate the inflationary pressure. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
5. 5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSIn panel B the equilibrium level of income is YE2, which falls short of that required forfull employment. This is because there is insufficient demand in the economy relative topotential output. As such this implies that there are unemployed or idle resources in theeconomy. The vertical distance FG, corresponds to the deflationary gap, which representsthe amount by which the aggregate expenditure must be shifted upwards to achieve fullemployment in the economy.2 a ii) Disequilibrium UnemploymentAverage Labour Wage Supply Rate W2 WE Labour Deman d Number of Disequilibrium workers Unemployment employedIf the average wage rate is above the market equilibrium wage rate then disequilibriumunemployment is created. This is because at the higher wage rate the amount of labourwhich firms hirer would be a smaller than the amount of labour being supplied to themarket. As long as the wage rate remains above the equilibrium, the surplus labour ordisequilibrium unemployment would continue to exist in the market. Any disequilibriumunemployment that exists in the economy implies that a surplus amount of labour existsin the labour market. This surplus would induce workers to offer their labour services atlower wage rates to employers. In response, firms would be encouraged to hire morelabour as labour cost decline. Overall wages would continue to fall and firms wouldcontinue to hire more labour up to a point where all surplus labour or disequilibriumunemployment is eliminated from the market.2 b i) Investment refers to an increase in the stock of capital possessed by a nation.Capital accounts for all tools, equipment, machinery, plants, vehicles and facilities whichenable the production of goods and services in the current and future time periods. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
6. 6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS2 b ii) Factors which influence investments1. Changes in the price of output and inputs – If the price of the output which the firm sells is reduced or if its market share declines, then the firm’s revenue would fall. This would have the effect of lowering profitability and investments would decline. In addition, if costs such as wages or raw material prices increase, then this would also serve to reduce profits and discourage investments.2. Expectations – Investors’ expectations about the future have a very important impact on their preparedness to undertake investments. This comes about because of the nature of investments which usually have a lifespan exceeding more than one year. If investors are generally pessimistic about the future prospects of the economy, then investments would be lower than usual. In contrast, if investors are generally optimistic about the outlook of the future, then investments would be high.3. Government influences –There are many instances where Government policies such as tax exemption or even subsidies may encourage entrepreneurs to undertake investments. Similarly, if the marginal rate of tax were to be increased, then after tax profitability of investment would be lowered and this would tend to dissuade investments. Other government influences may include other incentives which encourage investments. In Trinidad and Tobago for instance, government initiatives in the formation of industrial estates has been a major catalyst in the growth of investments in the country.4. Technological change – As new technology is developed, investments are typically encouraged. This is because new technology is associated with improved efficiency in the utilization of factors of production in production processes which ultimately lowers the cost of production or improves product quality. Ultimately, revenue would be increased, and cost would be reduced leading to an overall increase in profitability of potential investments. Such increased profitability of investments would propel a higher level of investment demand in the economy.3 a i) Money can be defined as anything which is generally acceptable as a means ofsettling a debt obligation.3 a ii) Functions of MoneyThe functions of money account for the different roles money must perform for it to beacceptable in payment of a debt. These functions are:1. Medium of exchange – As the previous section suggests, this is the primaryfunction of money. It refers to the role of money in the exchange of goods and servicesthroughout the economy. When goods and services are provided by sellers to buyers, thebuyers in turn settle the debt obligation to the seller by making payments using money.As money is universally acceptable as a means of payment, it facilitates the exchange ofgoods and services among economic agents. In any country, the official currency issuedby the Central Bank is referred to as legal tender. This means that such money is legallyacceptable as a means of settling any debt in that nation.2. Standard of deferred payment – Many transactions in the economy involve thetransfer of goods and services among economic agents on a credit or deferred payment EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
7. 7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSbasis. This is where the goods and services are provided to buyers with paymentcontracted for a future period. Here money plays a role in that it is the standard paymentparameter used in the settlement of the future debt obligation. The standard of deferredpayment function is an extension of the medium of exchange function, where the onlydifference is that the transfer of goods and services from the seller to buyer and themonetary payments are not done simultaneously. For example, a car purchased on creditwould be accompanied by a loan agreement which specifies the amounts to be paid infuture instalments which are expressed in money terms.3. Unit of account – Money is used as a means of assigning values or prices to thevast array of goods and services throughout the economy. It is these prices which are usedto assess fairly and consistently the individual and comparative worth of items. Forexample, the value of a house could be expressed in money terms by its market valuewhich may be \$500,000. Also, if the price of a new car is \$100,000, then this means themonetary value of a home is five times the monetary value of a car.4. Store of value - Money can be used as a store of value over time for futureenjoyment. Individuals accumulate wealth by deferring current consumption. The amountof money saved as a result could be used in the future to purchase goods and serviceswhich may be desired then.3 b i) The fractional reserves banking process can be demonstrated by considering thedeposit creation process triggered from an initial or primary deposit at a commercialbank. To make a profit, the commercial bank would use the money it receives from theprimary deposit to lend to borrowers at a higher rate of interest. Typically, the CentralBank which is the Governments authority for regulating commercial banks insists thatonly a proportion of deposits can be lent out to borrowers. As such, the fraction which isnot lent must be kept as cash. This fraction is called the reserve requirement ratio, cashratio or the liquidity ratio.3b) ii) If a bank receives an initial deposit of \$100 and the cash reserve ratio is 10 percentit would lend out \$90 to a borrower. Subsequently the \$90 would be returned to the bankby another party in the form of a derivative deposit. Here the \$10 or the 10 percent notlent out is called the cash reserve or the proportion of a deposit which is kept in the formof cash at the bank. Depositor Deposits Loans Reserves Initial Deposit 1st \$100 \$90 \$10 Derivative Deposit 2nd \$90 \$81 \$9 Derivative Deposit 3rd \$81 \$73 \$8 Derivative Deposit 4th \$73 \$64 \$7 Derivative Deposit . . . Derivative Deposit . . . Derivative Deposit ∞ . . . Total Deposits \$1000 \$900 \$100 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
8. 8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSAs the \$90 derivative deposit is collected, 10 percent is kept in liquid form at thecommercial bank. This amounts to \$9 and the remaining \$81 is lent out. Eventually theremaining \$81 lend out, is re-deposited at the commercial bank of which \$73 is lent outand \$7 kept in liquid form. This process continues indefinitely, with each subsequentderivative deposit being lower than the previous. Eventually derivative deposits wouldbecome zero and total deposits are found using the formula: 1Total Deposits = Initial Deposit × Cash Reserve Ratio 1Total Deposits = 100 × = 1000 10%Conclusively the initial \$100 deposit creates additional deposits which bring the totaldeposits to \$1000.3 c i) Shortening Pay Periods for WorkersIf the pay period is shortening this means that workers would receive wages morefrequently though in smaller amounts. This means that less money would be held at anygiven time as income is received in more regular intervals. Overall the result would be afall in the demand for money. This is shown in the figure.Increase in Demand for Money IR DM1 DM2 M3 c ii) An Increase in Nominal GDPAn increase in nominal GDP can be due to either more output being produced, a highprice level or both. As a consequence individuals would have to hold more money tosupport the higher expenditure levels. This means that the demand for money wouldincrease. This is shown in the figure. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
9. 9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSIncrease in Demand for Money IR DM2 DM1 M3 c iii) An Increase in the number of ATMsAn increase in the number of ATMs would may money more readily accessible.Individuals would not need to hold as much money in their possession since theavailability of ATMs means that money can be withdrawn when needed. Sinceindividuals would hold less money this means that the demand for money woulddecrease. This is shown in the figure.Increase in Demand for Money IR DM1 DM2 M4 a) Automatic stabilizers are mechanisms that automatically increase the net injectionfrom the government sector during recessions and contract it during booms. In otherwords an automatically stabilizer offsets the current economic climate without any activepolicy decision by the government. Two examples of automatic stabilizers 1. Unemployment Benefits 2. Direct taxes EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
10. 10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS4 bi) Fiscal policy is the management of the economy through the level of governmentexpenditure and taxation. That is, the government can use this demand management toolto achieve its macroeconomic objectives by manipulating the fiscal budget.4 b ii) Three Fiscal Measures to increase employment 1. Increased government spending on projects which create direct employment. The government can increase its expenditure on projects such as infrastructure which directly creates employment opportunities. Such expenditure would also result in an increase in the productive capacity of the economy. Furthermore given the multiplier effects, aggregate expenditure throughout the economy would expand as income rises. Such increases in the demand for goods and services would also encourage entrepreneurs to produce greater output and more labour is employed. This means the increase in government spending also creates indirect employment. This type of measure would be suitable in reducing cyclical unemployment. 2. Increased government spending on education. As the government spends more on education whether in terms of facilities or financial aid, the level of human capital in the economy would rise. This means the productivity of labour would be boosted and those who were previous unemployed would be able to obtain jobs. New industries would develop and a greater proportion of the labour force would be absorbed by employment opportunities. This type of fiscal measure would be applicable to solving structural and technological unemployment. 3. Decreases taxation. Sometimes if direct taxation is too high it may be a major discouragement to economic activity. A reduction in taxation would enable workers to take home more disposable income and companies to earn greater after tax profits. Both of these factors would increase the incentives to productive activities and encourage more individuals to seek employment as well as firms to hire more workers. This can be a very effective measure to reduce cyclical unemployment as well as voluntary unemployment.4 c) Reasons why fiscal policy may not work in small open economy of the Caribbean1. Crowding Out Effect – If the government implements expansionary fiscal policy by reducing taxation, or by increasing government spending, then this will lead to a budget deficit. To finance the deficit, the government will have to borrow which puts upward pressure on the rate of interest as the government competes for limited funds with the private sector. As the rate of interest goes up, private investment and consumption are discouraged and this leads to a fall in aggregate expenditure. In other words, the high level of government spending "crowds out" private sector spending. Overall, this counteracts the impact of expansionary fiscal policy on the economy making it less effective.2. Excess Capacity – The effectiveness of fiscal policy in achieving an increase in the level of output produced in the economy also depends on whether or not the economy possesses excess capacity. If full employment already exists in the economy, then expansionary fiscal policy would be absolutely ineffective in achieving an increase in output as the only result would be inflation. If however there is spare capacity in the EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS