INTERMEDIATE MACROECONOMICS, SEC222

SUBMIT QUESTION 4, 10 i, 10 J, 25, 29 and 30

NOTE: QUESTIONS IN A,B,C and D should be practiced by also plotting the equilibrium income
and changes in equilibrium income in the Keynesian cross.

Assume an economy with the government sector that spends an autonomous amount of G
and levies a lump sum tax T. such that Y=C+I+G and consumers’ disposable income is Y-T

1. Suppose an economy is described by the following equations: C=50+0.8Yd, I=100, G=75 and
T=25. Where C is consumption, I is investment and Yd is disposable income. (i) Calculate the
equilibrium level of income. (ii) What is the value of the autonomous expenditure multiplier. (iii)
by how much will income change if autonomous investment increased by 50 (iv) how much will
income change if autonomous consumption increased by 10 (v) by how much will income
change if government increased spending by 50 (vi) by how much will income change if taxes
reduced by 50 (use the lump sum tax multiplier) (vii) explain the difference in the impact on
income of an increase in government spending and a reduction in taxes (viii) by how much will
income change if government spending increased to 50 and at the same time taxes increased by
the same amount (use the balanced budget multiplier)

Assume an economy with the government sector that spends an autonomous amount of G
and levies a lump sum tax T and gives transfer payments (TR). such that Y=C+I+G and
disposable income is Y-T+TR

2. Suppose C=100+0.75Yd, I=200, G=100, T=100, TR=50. Find the equilibrium level of income. (i )By
how much will income change if government increased its spending by 50 (use government
expenditure multiplier) (ii) by how much will income change if transfer payments where
increased by 50 (use the transfer payment multiplier) (iii) what is the difference between the
two multipliers and why.

Assume instead of a lump sum tax, the government levies a proportional income tax.

3. Suppose C= 50+0.8Yd, I=70, G=200, TR=100, tax rate,t= 0.2Y. (i) calculate the level of income,
(ii)calculate the amount of taxes collected (iii) what is the government budget deficit or surplus.
(ii) Calculate the autonomous expenditure multiplier and use it to calculate the change in
income if government spending increases by 10. And when autonomous investment reduces by
10. (ii) Calculate the transfer payment multiplier and use it to find the change in income if
transfer payments are reduced by 10.
4. In the Keynesian cross model, equilibrium in the economy is obtained where planned spending
equals actual spending.

(a) Explain what planned spending and actual spending are

(b) Graphically present the equilibrium condition of the economy in the Keynesian cross model.
(c) Explain how the economy adjusts to equilibrium if the economy finds itself with a level of
planned spending which is less than actual spending (3 marks)

(d) Explain why an increase in government spending leads to a greater increase in income

Section 2
5. (i)Explain and graphically represent Keynesian consumption function C=a+bY. (ii) what is
marginal propensity to consume and average propensity to consume (iii) how does MPC and
APC change as income increases? (iv) What is the consumption function? What factors it to
shift/ (v) what is a savings function? Derive the savings function from the consumption function
and show that the sum of marginal propensity to save and marginal propensity to consume is
equal to one. (vi) Why does APC differ from MPC? Explain the important features of the
Keynesian consumption function. (vii) Explain the life cycle theory of consumption and the
permanent income theory of consumption and how they differ from the Keynesian theory of
consumption.
6. According to the life cycle theory of consumption, (i)the ratio of consumption to accumulated
savings declines over time until retirement. Why is it so? What assumption about consumption
leads to this behavior? And what happens to this ratio after retirement? (ii) suppose you earn
as much as your neighbor but you are in much better health and expected to live longer than
her. Would you consume more or less than her? Why?
7. According to the life cycle theory of consumption,
(a) suppose an individual starts work at age 20. And will work until age 65. And will die at age
80. Annual labor income is k30,000. (i) what is her lifetime income, and her consumption,
and saving (ii) what is her marginal propensity to consume out of labor income?
(b) Suppose this individual above is now 40 years old. What is his wealth? What is his marginal
propensity to consume out of wealth, and out of labor income. And what is his level of
consumption?
8. According to permanent income hypothesis. Suppose permanent income is calculated as
YPt = ( 0.4Yt + 0.3Yt −1 + 0.2Yt −2 + 0.1Yt −3 ) and the consumption function is C=0.9YP
(a)If you have earned k20,000 for the past 10 years, what is your permanent income?
(b)Suppose next year you earn k30,000. What is your permanent income?
(c)What is your consumption this year and next year?
(d)What is your short run MPC and long run MPC?
(e)Suppose you continue to earn k30,000 from next year, graph the value of your permanent
income and consumption for each year.
9. (i)What is investment function (ii) distinguish between autonomous investment and induced
investment (iii) explain the actors that determine the level of investment in an economy.

Section 3
10. (a) What is the IS curve? Derive the IS curve graphically? What factors determine its slope? Why
does the IS curve slope downward? Show how the IS curve will shift due to a change in fiscal
policy.

(b) What is the LM curve? Derive the LM curve graphically. What factors determine the slope
and position of the M curve? Why does the LM curve slope upwards? Show how the LM curve
will shift due to a change in monetary policy

(c) Using the IS-LM model, analyze the impact of an increase in money supply on the
equilibrium level of income and interest rate.
(d) Using the IS-LM model, show that fiscal policy is more effective at low levels of interest rate
and income, while monetary policy is more effective at high levels of income and interest
rate.
(e) What is crowding out effect of government fiscal policy? Show how the extent of crowing
out varies in the three different ranges of the LM.
(f) Consider an economy described by the following equations: C=100+0.8Yd, I=50-25r, G=50,
T=50, Md/p=Y-25r, Ms/p=200. Calculate the IS and LM curves. Calculate the equilibrium
levels of output and interest rate. Calculate new level of income and interest rate if money
supply increased by 100. (present your solutions graphically)
(g) Consider an economy described by the following equations: C=100+0.9Yd, I=600-30r, G=300,
1
T=3Y, Md=0.4Y-50r, Ms=520. Derive the IS and LM equations and find the equilibrium
income and interest rate. What is the new level of income and interest rate if government
spending increases by 100. Calculate the government expenditure multiplier and use it to
find the full multiplier effect of a government spending increase on income, and use this
outcome to explain crowding out effect. (present your solutions graphically)
(h) Consider an economy described by the following equations: C=40+0.75Yd, I=140-10r, G=100,
T=80, Md=0.2Y-5r, Ms=85. Derive the IS and LM equations, and calculate the equilibrium
level of income and interest rate. Calculate the new level of income and interest rate if taxes
increase by 20. (present your solutions graphically)
(i) Suppose government cuts income tax. Show in the IS-LM model the impact of the tax cut
under two assumptions: 1. The government keeps the interest rate constant through an
accommodating monetary policy. 2. The money stock remains unchanged.
(j) Use the IS-LM model and investment schedule to show the effect of a removal of
investment subsidies on investment, income and interest rate.

Section 4
11. (a) Derive the aggregate demand curve. Why does it slope downward. Show the effect of an
increase in nominal stock of money on the aggregate demand curve. What are the factors that
would shift AD curve.
(b). Why does the short run aggregate supply curve slope upwards. what factors would shift it.
(c) why is the long run aggregate supply curve vertical. What factors would shift it?
 (d) Derive the short run aggregate supply curve when nominal wages are sticky. Give reasons for
the stickiness of nominal wages.

Section 5
12. Distinguish demand pull ad cost push inflation. What factors cause each of them. And how can
each of them be controlled.
13. Define inflation. Explain its effects on (a) creditors and debtors (b) persons of fixed incomes.

Section 6.
14. Explain the following types of unemployment and explain what factors are responsible for their
existence: cyclical unemployment, structural unemployment and frictional unemployment.
15. What is natural unemployment? Why is it not possible to have 0% unemployment rate even at
full employment?
16. What is full employment? Discuss with the help of a diagram the different ways of attaining full
employment.
17. (a) Unemployment is a macroeconomic problem that every economy seeks to solve. Briefly
explain 3 negative effects of unemployment on the labor market.
(b) Briefly explain how job search leads to unemployment.
(c) Give 2 examples of policies that would reduce the job search problem and therefore reduce
unemployment
(d) Briefly explain, with the help of a properly labeled diagram, how wage rigidity causes
unemployment
(e) Briefly explain the three factors that would make the real wage to be rigid.
(f) Briefly explain the four reasons why firms would choose to pay a wage higher than the
equilibrium wage (according to the efficiency wage theory).
(g) Give an example of a government policy (fiscal policy) that would reduce unemployment.
What counter effect would this have on the economy (according to the Phillips curve)?
18. . Suppose the adult population of country B is 4,000,000, the number of people employed is
2,000,000 and the number of people not employed is 1,000,000
(a). Outline the individuals that form the following categories: employed, unemployed, labor
force and not in the labor force
(b) Calculate and interpret the unemployment rate.
(c) Calculate and interpret the labor force participation rate.
19. Given that an increase in the minimum wage increases unemployment:
(a) demonstrate (graphically and explain) how an increase in minimum wage increase
unemployment
(b) which category of the labor force is mostly affected negatively by an increase in minimum
wage?
( c) what is government’s objective in passing such a law, when it would increase
unemployment?
 (d) what alternative policies would you suggest to government that would meet the same
objectives but without increasing unemployment?
20. . suppose in country T, among the employed, 20% experience job loss every month, and among
the unemployed, 12% will find jobs every month.
(a) calculate the steady state fraction of people who are unemployed
(b) what policies can be suggested that would affect the rate of job separation, and the rate of
job finding so as to reduce unemployment?
21. suppose the markup of prices over marginal cost is 5%&the wage setting equation is W=P(1-U),
where U is unemployment rate.
(a) what is the real wage, as determined by the price setting equation?
(b) what is the natural rate of unemployment?
(c) if the markup of prices over costs increases to 10%, what happens to real wage, and natural
rate of unemployment? Explain why this is so.

22. Suppose that an economy has the Phillips curve

𝜋 = 𝜋−1 - 0.5(u - 0.06).
a. What is the natural rate of unemployment?
b. Graph the short-run and long-run relationships between inflation and unemployment.
c. How much cyclical unemployment is necessary to reduce inflation by 5 percentage
points? Using Okun’s law, compute the sacrifice ratio.
d. Inflation is running at 10 percent. The Fed wants to reduce it to 5 percent. Give two
scenarios that will achieve that goal.

Section 7
23. Consider an economy described by the following equations:

Y = C + I + G + NX
Y = 5000
G = 1000
T = 1000
C = 250 + 0.75(Y − T )
I = 1000 − 50r
NX = 500 − 500
r = r* = 5

Where: r is the interest rate equal to the world interest rate r*. And:  is the exchange rate.

(a) Solve for the national savings, investment, net exports, and for the equilibrium exchange
rate.
(b) Using a clearly labeled diagram, plot the answers obtained above. Clearly showing the net
exports and S-I curves, and the equilibrium exchange rate and net exports.
 (c) Suppose that government spending raises to 1250. Solve for national saving, investment,
net exports and equilibrium exchange rate. Explain what you find.

24. Use the model of the small open economy to predict what would happen to net capital
outflow(S-I), the trade balance, the real exchange rate, and the nominal exchange rate in
response to each of the following events.
a. A fall in consumer confidence about the future induces consumers to spend less and save
more.
b. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over
domestic cars.
(c) A wave of credit-card fraud increases the frequency with which people make transactions in
cash. (3 marks)
(d) A best-seller titled “Retire Rich” convinces the public to increase the percentage of their
income devoted to saving. (3 marks)

25. The country of Zambia is a small open economy. Suddenly, a change in world fashions
makes the exports of Zambia unpopular.
a. What happens in Zambia to saving, investment, net exports, the interest rate, and the exchange
rate and exchange rate?
b. The citizens of Zambia like to travel abroad. How will this change in the exchange rate affect
them?
c. The fiscal policymakers of Zambia want to adjust taxes to maintain the exchange rate at its
previous level. What should they do? If they do this, what are the overall effects on saving,
investment, net exports, and the interest rate?

26. If the Zambian President places a 100-percent tariff on the import of Japanese luxury cars,
how would the policy affect the Zambia trade deficit? How would it affect the exchange rate?
Who would be hurt by such a policy? Who would benefit?

27. suppose over a period of five years, the total inflation over this period was 25 percent in
South Africa and 100 percent in Zambia, has it become more or less expensive to live in South
Africa compared to Zambia? Assuming that five years ago, one RAND could be exchanged for
300 KWACHA, and now one RAND can be exchanged for 500 KWACHA.

28. Suppose that some foreign countries begin to subsidize investment by instituting an
investment tax credit.
a. What happens to world investment demand as a function of the world interest rate?
b. What happens to the world interest rate, to investment in our small open economy, to our trade
balance and to our real exchange rate?
29. Suppose Zambia is a small open economy (it cannot affect the world interest rate)
with perfect capital mobility and a floating exchange rate: using the IS-LM model for a
small open economy, graphically show and briefly explain the effect on income/output,
exchange rate and net exports of the following policies:

(i) An expansionary monetary policy where the government through the central
bank increases the money supply
(ii) An expansionary fiscal policy where government increases its spending
(iii) How will the above policies affect the macroeconomic variables if the exchange
rate regime was fixed?

Section 8
30. Zambia has the following production function given by: Y = F ( K , L) = K 1/ 2 L1/ 2
(a) Depicted above is a production function with constant returns to scale. What does that
mean?
(b) Derive the per worker production function.
(c) Assume Zambia experiences no population growth or technical progress, but has
capital depreciation of 5% each year and saves 10% of output each year.
(i) Explain what the steady state level of the economy is.
(ii) Calculate the steady state level of capital per worker, steady state level of
output per worker, steady state level of consumption per worker, steady state
level of investment per worker and steady state level of depreciation per
worker.
(iii) According to the Solow model, what should nations do to have economic
growth?
(d) Explain what the golden rule level of capital is.
(e) Calculate the golden rule level of capital per worker, output per worker, depreciation
per worker and consumption per worker.
(f) Plot the results obtained in (e) above.
(g) Calculate the saving rate that would give the golden rule level.
(h) Explain what happens to the consumption level if the saving rate departs from the one
that gives the golden rule level.
(i) If the economy was to have a lower saving rate than the one that gives the golden rule
level, what kind of public policy would raise the saving rate to the golden rule level?
 31. Suppose you are a policy maker who wants to select a level of saving rate that
would maximize consumption per worker. Given that output per worker is a
square root of capital per worker, and 10% of capital depreciates every year.

(a) Construct a table with the following saving rates: 0.3, 0.4, 0.5 and 0.6. For each
saving rate, fill the table with values for capital per worker, output per worker,
depreciation per worker, consumption per worker and marginal product of capital. Do
not just present at able but show all your work clearly, or you lose marks.
(b) Which saving rate would you chose and why.

32. Consider an economy described by the following production function: Y=K 0.2L0.8
(a) What is the difference between an economy’s steady state level of capital and the golden rule
level of capital?

(b) Suppose that 10%of the capital stock wears out each year. Derive the per worker production
function, and calculate the golden rule level of capital per worker, output per worker,
consumption per worker, depreciation and investment per worker and the saving rate that gives
this golden rule level. (graph your results)