ECON 100 Tutorial 20

1. ECON 100Tutorial 20 Rob Pryce www.robpryce.co.uk/teaching

2. Question 1 With prices rising at 4.0 percent annually, and earnings rising at 3.5 percent per annually, what would be the percentage reduction in real wages over a five year period? Answer: 2.4% Real wage = Wage / Price Real wage after 1 year = 1.035/1.04 Real wage after n years = (1.035/1.04)n Real wage after 5 years = (1.035/1.04)5 =0.976 So real wages have dropped by (1-0.976) = 0.024 = 2.4%

3. Question 2a If M were to rise by 6%, Q by 4% while V is unchanged, by what percentage would P increase? MV = PQ Answer: 1.9% Start with M = V = P = Q = 1 MV =PQso (1)(1) = (1)(1) Now do the changes MV =PQso (1.06)(1) = (P)(1.04) (1.06) = (P)(1.04) P = 1.06 / 1.04 P = 1.019

4. Question 2c If M were to rise by 10%, Q by 2.5% while V is unchanged, by what percentage would P increase? MV = PQ Answer: 7.3% Start with M = V = P = Q = 1 MV =PQso (1)(1) = (1)(1) Now do the changes MV =PQso (1.1)(1) = (P)(1.025) (1.1) = (P)(1.025) P = 1.1 / 1.025 P = 1.073

5. Question 2b If the V remains constant, as M grows at a constant annual compound rate of 12.2 per cent, and Q grows at a constant annual compound rate of 10 per cent, in how many years would the price level (P) double? MV = PQ Answer: 35 years Start with M = V = P = Q = 1 Re-arrange the equation to get P on its own Now do the changes MV/Q = Pso (1.122)(1)/(1.1) = P after 1 year Pn = (1.122 / 1.1)n after n years We want to know when Pn = 2P Remember we started with P=1, so we want P=2 M V = P Q

6. Question 2b If the V remains constant, as M grows at a constant annual compound rate of 12.2 per cent, and Q grows at a constant annual compound rate of 10 per cent, in how many years would the price level (P) double? MV = PQ Answer: 35 years Pn = (1.122 / 1.1)n after n years We want to know when Pn = 2P Remember we started with P=1, so we want P=2 2 = (1.122 / 1.1)n Use logs to find n Log(2) = n log(1.122/1.1) 0.693 = n (0.0198) n = 0.693/0.0198 = 35

7. Question 2b Excel Table

8. Question 2d MV = PQ Use the structure MV ≡ PQ to explain demand pull inflation There are lots of reasons why increased demand ‘pulls’ inflation up “Rapid growth of the money supply as a consequence of increased bank and building society borrowing if interest rates are low and consumer confidence is high” (tutor2u.net)

9. Question 3 It was clear that the liberalisation of the financial system ... the increased competition between financial institutions would lead to a steady increase in the ratio of broad money to GDP. This indeed has been a consistent feature of the 1980s. There is every sign that the people are holding the increased amounts of broad money quite willingly. And so long as this is so its growth is not inflationary

10. Question 3 – The Lawson Boom Lawson boom

11. Question 4/5 These questions are just testing definitions and correct usage Don’t worry about them I’ve put Gerry’s answers in the next slides

12. Question 4 Gerry’s Answer Explain the apparent paradox: that a rise in the world price of oil has a deflationary impact upon economic activity, and causes a rise in price indices Words can have a different meaning in lay conversation than as economics jargon. For example, ‘inflation’ is generally taken to mean (in lay conversation) an increase in some price index (say, the RPI). However, if the RPI rises when commodities in widespread use have become (for whatever reason) more scarce, this would not constitute (by the jargon of economics) ‘inflation’. In economics, ‘inflation’ - or, rather, ‘price inflation’ - is the persistent tendency of prices to rise in consequence of monetary profligacy (currency debasement). The impact of monetary expansion is first to increase and then to reduce (as prices rise) demand. A rise in the world oil price is neither inflationary nor deflationary per se; though adjustment would be different within an oil-rich economy (e.g., Saudi Arabia) as compared to one with no fossil fuel reserves (e.g., Eire).

13. Question 5 Gerry’s Answer If (the definition of) inflation is more complex than a rise in price indices, how might it be defined? A definition always requires a context. Even Keynes accepts the context of the Quantity Theory of Money, ‘as soon as full employment is reached’ (TGT, p. 295)! The Quantity Theory draws from the most general of economic propositions: namely, that (unless demand increases pro rata) the more there is of something, the less valued it becomes. Thus, whenever the amount of money held in circulation exceeds the demand to hold money individuals are likely to increase their expenditure thereby (with that increased the demand for goods/services) causing prices to rise

14. Question 6 With the yield on savings at 3 percent, price inflation at 4 percent and unearned income taxed at 40 percent, calculate the real rate of return on savings net of taxation Answer: 0.9788 • So if we invest £100, we get £103 next year • So we made £3 profit, right? • But… • Prices have gone up, £103 isn’t as good as it used to be • The government want some of that profit (40%) • So really we want to calculate our real net return, taking the prices and tax into account • How?

15. Question 6 With the yield on savings at 3 percent, price inflation at 4 percent and unearned income taxed at 40 percent, calculate the real rate of return on savings net of taxation Answer: 0.9788 So if we invest £100, we get £103 next year But the government tax our £3 profit at 40% So we only get 60% of £3, which is £1.80. Our net money return is then £101.80 Prices have gone up by 4%, so our net real return is NMR / P = £101.80/1.04 = £97.88 Our net real return is 0.9788 our investment

16. Question 7 Explain the rationale for the hypothesis of the Liquidity Trap If interest rates are relatively low, bond prices are relatively high The perceived risk of a capital loss to bond holders is relatively high The low interest rate is not enough to encourage them to keep bonds So money is preferred to bonds Check out wikipediapage

17. Question 8 With the speculative demand to hold money, what is the speculation? The question here is asking what people are speculating about. The name’s Bond (prices)

18. Question 9 Liquidity preference is alternatively described as the demand to hold ____as an alternative to interest-bearing assets (bonds). As the price of bonds rises, the interest rate ____. The reason is that, (1) with a ____ coupon, the percentage yield on bonds varies ____ with their price, and (2) financial markets are competitive. Liquidity preference is therefore described as ‘interest elastic’. The less interest elastic the liquidity preference function, the ____ the LM schedule and the ____ the change in the interest rate with any change in income. This means that, as income ____ in response to a fiscal policy boost, ____ private sector investment is crowded out which implies that the multiplier effect on income ____.

19. Question 9 Liquidity preference is alternatively described as the demand to hold money as an alternative to interest-bearing assets (bonds). As the price of bonds rises, the interest rate falls. The reason is that, (1) with a fixed coupon, the percentage yield on bonds varies inversely with their price, and (2) financial markets are competitive. Liquidity preference is therefore described as ‘interest elastic’. The less interest elastic the liquidity preference function, the steeper the LM schedule and the greater the change in the interest rate with any change in income. This means that, as income rises in response to a fiscal policy boost, more private sector investment is crowded out which implies that the multiplier effect on income falls.

20. Question 9 r r IS1 IS2 IS1 IS2 Y Y Steep LM Curve Shallow LM curve If Y increases, r increases by a small bit. Less crowding out. If Y increases, r increases by a lot. Lot of crowding out

21. Question 10 Liquidity Preference determining interest rates

22. Question 10 Loanable Funds determining interest rates

23. Question 10 Problem with loanable funds Courtesy of Paul Krugman

24. Something to think about over Easter • This is the lead article for the Times on Thursday, the day after the budget. Reading it, I realised that you should able to make sense of it. • It covers: • GDP and GDP growth • Multipliers • Marginal propensity to consume • Aggregate demand • Permanent Income Hypothesis • “loose” monetary policy • You wouldn’t have known what many of these things meant at Christmas.

25. Any Questions? Email: r.pryce@lancaster.ac.uk Web: www.robpryce.co.uk/teaching OfficeHour: Wednesday, 9:45 – 10:45 Charles Carter C Floor or by appointment (email me)