The real gdp

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Consider a macro economy was initially at equilibrium level of real GDP.Using an aggregate demand and aggregate supply diagram or model of the economy, graphically illustrate and discuss the immediate effects of the following events upon the economy:


  1. The Central Bank within the economy raises interest rates and tightens credit.
  2. If central Bank raises the interest rate and tightens the credit then the cost of capital for the producer's increases and the money supply will also decrease. This will then force aggregate demand curve to shift downwards. Increase in the interest rate will encourage the banks to lend money. However, due to decrease in demand the supply will fall.

  3. There is a marked drop in consumer and business confidence in consumption spending.
  4. Confidence is another key element to boost the economy. We had clearly seen this element when recession hit us recently. When recession started to hit us here in Australia then people deliberately begun to save their money reducing their expenditure level and this reduced demand for commodity in market shifting downward for the demand curve.

  5. An increase in international oil prices.
  6. According to the law of demand and supply rule, with the rise in oil price the demand for oil should fall. However, it does not apply in oil. The Demand curves will either remaining in same level or even shifting upward.

  7. An appreciation in the foreign exchange rate value of the economy's currency

When the value for the national currency increases the purchasing power parity of the currency also increases, i.e. lees money can buy more commodity. In such case now people can buy more goods and services with less money. His will also make aggregate demand curve shift upwards and will also increase the aggregate supply.


Why is it that in a simple two-sector closed economy must income equals expenditure?

In two sector closed economy we have households and firms, where households consumes the product of firm. Here households spend all income in consumption, represented by (c) and has no saving at all. By the term closed economy it's clear that there is no financial sector, government sector, overseas sector and no import and export. Here equilibrium is condition where there is no tendency for the level of income, expenditure, and output to change where,

Y=E=O i.e. Y = income, E = expenditure, and O = output.

Here the expenditure of a household becomes the income for the firm and then the firm again spends its income for the factor of production.

Hence, to maintain this relationship we need income equal to the expenditure in two-sector closed economy.


What were the key differences between Keynes theory of income determination and that of the classical economists? Why did Keynes think that the market system could break down?

Keynes's theory of the determination of equilibrium real GDP, employment, and prices focuses on the relationship between aggregate income and expenditure. Keynes used his income-expenditure model to argue that the economy's equilibrium level of output or real GDP may not correspond to the natural level of real GDP. In the income-expenditure model, the equilibrium level of real GDP is the level of real GDP that is consistent with the current level of aggregate expenditure. If the current level of aggregate expenditure is not sufficient to purchase all of the real GDP supplied, output will be cut back until the level of real GDP is equal to the level of aggregate expenditure. Hence, if the current level of aggregate expenditure is not sufficient to purchase the natural level of real GDP, then the equilibrium level of real GDP will lie somewhere below the natural level.

The classical theorists believe that prices and wages will fall, reducing producer costs and increasing the supply of real GDP until it is again equal to the natural level of real GDP.


Using the simple Keynesian model and the savings and investment diagram show the full meaning of the paradox of thrift? What would happen to equilibrium income if there is a sustained rise in private investment spending? What causes the rise in income or output to come to a stop?

Saving has the same two components autonomous saving i.e. the part that doesn't depend on income and induced saving i.e. the part that does depend on income. Let us assume that: people try to increase their saving, this leads to a decrease in autonomous consumption, this leads to a decline in equilibrium income , this leads to a decrease in induced saving. Here one important question arises that is how does the two changes balance out?

In this simple model, they cancel out exactly -- although people have tried to increase their saving, the result is a drop in equilibrium income and no change in saving. This is called The Paradox of Thrift.


Above figure clearly depicts that when saving increases from S1 to S2 then the GDP beguns to fall down as it negatively affects the investment multiplier effect.

National income can be calculated as follows:

National Income = GDP - Private consumption of fixed capital -Governmentconsumption of fixed capital Now as,

GDP = C + I + G + (X - M)

Where, I = Gross private domestic investment

Now with the increase in the Private investment spending, there will be an increase in NationalIncome. Moreover, Investment has a positive relation with national income and negative relation with interest, therefore, when investment will increase, income will go up.

Consumers will have a larger demand with a rise in disposable income, which increases with total national output. This increase is due to the positive relationship between consumption and consumers' disposable income in theconsumption function. Aggregate demand may also rise due to increases in investment (due to theaccelerator effect), while this rise is reduced if imports and tax revenues rise with income.


State the difference (Do not give a definition - you need to state the specific difference between them):


Increasing nominal pricesDecreasing nominal prices for goods and servicesfor goods and services Encourages Bank saving andDiscourages bank savings and Investmentsdecreases investment Associated with business boom.Associated with recession and and employmentUnemployment.

Expenditure multiplierMoney multiplier

Measures the rate of change inMeasure of extent to which the creation of output due to a change in autonomousin the banking system causes the growth spendingin the money supply to exceed the growth of monetary base

Balance of payments deficitbudget deficit

The conventional view is that currentThe main cause for the Budget deficit account factors are the primary cause.Is excess if expense than its income. exchange rate, the government's fiscalgovernments finance their debts by deficit, business competitivenessissuing long-termgovernment bondsor shorter term notes and bills

TradeExchange rate

Exchange of goods or services forRate of change of one currency to Economic benefitother Going concern is most for tradeExchanged rate could be either free Where buyers and sellers comeor pegged.

Together for transaction

Q.N. 6

Assuming that the money market is initially in equilibrium, trace through the effects of an expansion in the money supply on the money market, on the interest rate and also on output, employment and the price level. Under what circumstances would the central bank undertake this type of policy?

The money market is an element of thefinancial marketsfor assets involved in short-term borrowing and lending with original maturities of one year or shorter less. Trading in the money markets involvesTreasury bills,commercial paper,bankers' acceptances, certificates of deposit, federal funds, and short-livedmortgage-backed andasset-backed securities. It providesliquidityfunding for theglobal financial system. Assuming that the money market is equilibrium means there is balance in between demand and supply of above mentioned assets. The given scenario represents the expansionary monetary policy. Traditionally expansionary policy was used to fight against unemployment in recession in lowering interest rate. Low interest rate increase the potentiality of people to afford the loan, encourages investment, more job opportunities, and this will increase the income of people. When peoples income in increased their expenses will increase and this will further enhances investment multiplier effect. As said above central bank adopts this policy at the time of recession.


Why under flexible exchange rates does a nation not have to worry too much about a balance of payments deficit? What other specific advantages do flexible exchange rates give to the operation of economic policy? (2 marks)

A balance of payments deficit caused by a decrease in the demand for national exports would lead to a shortage of foreign currency as the amount of foreign currency available falls.

The fall in the value of national currency causes the price of national exports to decrease and the price of foreign imports to increase. Consequently the demand for national exports increases and the demand for foreign imports decreases. The deficit shrinks and the balance of payments returns to equilibrium.

Therefore, the governments need not worry about having to manage their balance of payments situation. If the exchange rate is allowed to fluctuate freely any disequilibrium will automatically be restored to equilibrium. The need to resort to overseas borrowing to finance balance of payments is therefore less. The attention of government can then be focused on achieving other government objectives such as inflation, unemployment, economic growth and poverty reduction.


Using the AD-AS model show how the Australian economy avoided recession last year when eight of its trading partners fell into recession due to the GFC. What are the macroeconomic dangers, facing the Federal Treasurer Mr Swan as he prepares this year's (May) federal budget?

Recession is the general contraction of the economic activities in an economy.Gross domestic production, business profit, , household income etc falls down in recession and so did happen in Australia and many other countries around the world.Recession are generally believed to be caused by a wide spread drop in spending. Basically, the Australian government made major efforts to increase the liquidity in an economy. One of its big steps was economic stimulus package. The government distributed $9 billion dollar to their people to spend which in return encourages the aggregate demand of goods and services. When the demand increases then it is quite obvious to increase in aggregate supply as well.

In talking in context to the Australian economy during recession, the government increases its spending to boost the economy. Likewise, the government reduced the housing interest loan rate and also provided first home buyer rebate. Tax offset for buying vehicles for the registered business are other activities of the Australian government to encourage people to spend their money. This will increase the liquidity in an economy.

One of the challenges for Mr. Swan in budget making process is framing the budget when one of the Australian trading partners Greece's deteriorating economic condition affecting whole Europe. Growing the economy is a main key challenge for which we have to do various other changes like reducing unemployment level, controlling inflation, interest rate, developing responsible monetary and fiscal strategies etc.


Distinguish between the concepts of comparative advantage and absolute advantage, and provide an example to illustrate these concepts.

The potentiality of a nation to produce more products than other country using the same level of resources is known as absolute advantage. Fox example, the cost of production of 10 K.G. of rice is $20 in Australia and if it costs $25 for New Zealand then Australia is supposed to have absolute advantage. Whereas the ability to produce the product by a country at lower opportunity cost than other country is known as comparative advantage. If tries to explain how trade can create value for both the countries even when one can produce one goods with fewer resources than others.

Suppose we have Australia and New Zealand. If certain level of resources these countries can produce:

Australia= 100 tonnes of clothes

New Zealand = 400 tonnes of clothes

If same level of resources is used for food production

Australia= 110 tonnes of food

New Zealand = 200 tonnes of food

Assuming that each has same constant level of opportunity cost, Australia should produce food and New Zealand should produce Clothes.


Identify whether each of the following would lead to an appreciation or depreciation of the dollar. In each case, explain why the currency either appreciates or depreciates.

Australian citizens switch from buying stock in US companies to buying stock in Australian companies: When Australian citizens switch from buying stock in US companies to buying stock in Australian companies they need US dollar and this will create more demand for US currency and thus it will appreciate the US dollar and depreciates AUD dollars.

The inflation rate in Australia decreases relative to the inflation rate in the US.

This is the case of appreciation of AUD dollars against US dollars because when inflation decreases the purchasing power of the currency increases.

The federal government takes a more restrictive view of foreign investment takeovers of Australian enterprises

In the given condition it becomes tough for foreigner to invest inside Australia and as a result the demand of Australian currency will fall down and eventually leads to the depreciation of Australian currency.

There is an expectation that the central bank in Australia will raise interest rates.

When interest rate is expected to rise then it is sure that after the increase the demand for the currency will fall down and therefore, before the changes the people will hedge the currency. So, when it is expected that the interest rate is supposed to increase then the demand for the Australian dollar will increase and this will eventually lead to the appreciation of AU dollars. (Note: here interest rate has not increase yet, it is only an expectation to increase the interest rate)