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TCC Introduction to Economics 2011/12 Page 1



Suggested Answers to questions covered in our Extra lesson 2012
Section A
1(a)









The red line is the countrys PPF.
At A, the amount of X and Y:
300 3X = 200 x
100 = 2.5x
X = 40; therefore since Y= 300 3(x) and X =40 Y = 180

Initially the economy is at point B in the diagram producing 50x. So initially the binding
constraint was the labour constraint and the opportunity cost of producing x was 3Y for 1x.
The opportunity cost of producing X indicates the competitive price of X.
An increase in the stock of capital by 10% will shift the capital constraint to the position
indicated by the blue line (note that the numbers are calculated based on the fact that we
are told that the increase in the stock of capital did not affect the productivity of either
capital or labour). The new PPF is indicated by the orange line. But note that point B is still
on the PPF which therefore means that the opportunity cost of producing X or the
competitive price of X will not change but will still be 3X for 1Y since B is still on the same
labour constraint. The statement is therefore false as there will be no change in the
competitive price of X.
1(b) Apply what you have learnt from some of your tutorial questions here. You know
that increasing returns to scale applies only to the long run and because the long run total
cost curve is increasing at a decreasing rate the LRAC is falling throughout and the LRMC lies
below the LRAC. So the LRAC and MC curves are no longer U-shaped. But the short run is
not affected by returns to scale but by the law of diminishing returns and hence the SRAC
and SRMC continues to be U-shaped. There is always one output level where the LR
expansion path (from which the LRTC is derived) is equal to the SR expansion path. At this
output level the LRTC=SRTC, which therefore means that the LRAC = SRAC and at the same
Y
X
Capital
100
200
400
300
Economy A
Labour
A
40
180
B
50
New Capital constraint
220
440
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TCC Introduction to Economics 2011/12 Page 2

output level the LRMC=SRMC. But whether the LRAC=SRAC=LRMC=SRMC will depend on
whether we are on the downward sloping portion of the LRAC (i.e. facing increasing returns
to scale), at the minimum (facing constant RTS) or on the upward sloping segment of the
LRAC (decreasing RTS). Since we are looking at increasing RTS, the output level where the
SRAC is tangent to the LRAC is to the left of minimum SRAC and at this same output, the
LRMC = SRMC but at a lower level than the LRAC=SRAC.

























1(c)







We are then told that PX increased by 20%, Py fell by 20% . This therefore means that the
new Px i.e. Px1 = 1.2Pxo and the new price of Y which is Py1 = 0.8Pyo. Since the Py fell the Y-
intercept of the budget line will now be Io/0.8Pyo. Io/0.8Pyo is > Io/Pyo which therefore
AC,MC
LRAC
X
LRMC
SRAC
SRMC
LRAC=SRAC
Xo
LRMC=SRMC
LRTC.SRTC
X
LRTC
X X
X1 X1
Xo
Ray from the origin tangent to
SRTC, SRAC minimum
Output where SRTC
=LRTC
Slope of ray to the SRTC and
the LRTC are the same at this
point of tangency. Therefore
SRAC=LRAC
Slope of tangent to the SRTC
and the LRTC are the same at
this point of tangency.
Therefore SRMC=LRMC
Slope of ray to this point is steeper than the slope of the
tangent to the same point. Therefore SRAC=LRAC at a
higher level than SRMC=LRMC
A
A
SRTC
Y
X
Io/Pyo
Io/Pxo
Yo
Xo
A
Initial budget equation:
Pxo.Xo + Pyo.Yo = Io
0.5Io + 0.5Io = Io
Hence:
Pxo.Xo = 0.5Io
Therefore Xo = 0.5Io/Pxo
And
Pyo.Yo = 0.5Io
Therefore Yo = 0.5Io/Pyo

Uo
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TCC Introduction to Economics 2011/12 Page 3

means that Io/0/8Pyo will be above Io/Pyo on the Y-intercept. On the other hand Io/1.2Pxo
is < Io/Pxo which means that the x-intercept of the budget line will be to the left of Io/Pxo.
We can therefore see that the new budget line will be steeper than the original budget line
and the question we need to ask now is whether this new steeper budget line will pass
through point A i.e. can we still buy our original bundle of goods Xo and Yo now that the
price of good X has increased and the price of Y fell.
To prove this we need to ask whether we have the income to buy the X and Y at A at the
new price of X and Y. This can be represented by the following equation:
1.2Pxo.Xo +0.8Pyo.Yo = I?
0.5Io 0.5Io
1.2Pxo ______ + 0.8Pyo. ______ = !?
Pxo Pyo

1.2(0.5Io) + 0.8(0.5Io) = I?
0.6Io + 0.4Io =Io
This therefore confirms that the new budget line will pass through point A as we do have
the income to buy that very same bundle at their new prices.










Looking at the new budget line (red) that passes through A, we can see that the individual
will be better off as he will be able to move to a higher indifference curve U1 when he is
maximizing his satisfaction at point B on the new budget line.





Y
X
Io/Pyo
Io/Pxo
Yo
Xo
A
B
U1
Uo
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TCC Introduction to Economics 2011/12 Page 4

1(d)







Lets assume that X is the Giffen good. Hence to find our answer to the question we need to
change the price of X, lets assume that the price of X fell. The individual was initially at
point A and at the price of Pxo he had Xo of good X. When the price fell to Px1 it caused the
budget line to rotate out and we are now looking at the red budget line. Since Px fell, the
substitution effect saw the individual buying more X as he moved from A to C. In this case,
real income increased and if X is a Giffen good (which is an inferior good except that for a
Giffen good the negative IE will be greater than the negative SE) he will end up at a point
like B
G
where he will be buying less X now that its price declined. Plotting this information
showing the relationship between the PX and the quantity of X bought gives us a demand
curve that is positively sloped. When the demand curve is positively sloped the issue of
whether the price elasticity of demand is <1 or >1 becomes irrelevant.

As to whether the Giffen good X and Y are complements or substitutes, note that we are
going to follow strictly to the definition of a complement and substitute making use of the
concept of the cross price elasticity of demand. The cross price elasticity of demand tells us
what happened to the quantity demanded of one good when the price of another good
changes. So for example in this case we are looking at what happens to the quantity
demanded of Y when the price of X changes (in this case fell). If the two goods are
complements then the fall in the price of X will cause an increase in the quantity demanded
of Y, and therefore the cross price elasticity of demand is <0 (negative). But if the fall in the
price of X results in a decrease in the quantity demanded of Y, the cross price elasticity of
demand is then >0 (positive). In this case we saw that when X is a Giffen good and the price
of X fell, the individual bought less X but ended up buying more Y. The cross price elasticity
of demand is therefore <0 indicating that the two goods are complements.

1(e) The question as you can see is somewhat vague. We could be looking at an increase
in variable cost which includes the cost of labour which means that there will be
implications in both the short run and the long run, or we could be looking only at an
increase in fixed cost e.g. the cost of capital in which there will only be long run implications.
Prof Amos did highlight that in such cases where there is no mention as to what kind of cost
has increased we should then assume an increase in the variable cost. This question then
becomes pretty straight forward. We need to shift both the MC and AC up and recall that
we need to shift them up and to the left.

PX
Io/Px1
SE
X
A
X=NG
D
G

A
X= IG
B
G

B
G

Io/Pxo
C
Px
X
Xo Xo X1
PX1
Pxo
Complements
Gross Substitutes
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TCC Introduction to Economics 2011/12 Page 5










In the short run since MC has increased, each firm will want to produce a smaller output.
This reduces the market supply causing the market price to increase in the short run. At the
higher price of P1, competitive firms are now producing output X1 and they are making
losses equal to the shaded area. In the long run, some firms will leave the industry. The exit
of firms will reduce the market supply and increase the market price. Firms will stop leaving
once normal profits are restored which is when the market supply is at S2 and the market
price at P2. At the new market price P2, competitive firms are making normal profit once
again.

So the statement that an increase in cost will bring about a decrease in the number of firms
is true. Will it increase welfare if the price elasticity of demand is <1? Regardless of the
price elasticity of demand, market price has increased and output has declined. The area of
consumer surplus has definitely shrunk which means that there is a decline not an increase
in welfare.

1(f)
Since the variable cost is x
3
, MC is therefore 3x
2
and AVC is x
2
. The difference between this
question and a rather identical one we did earlier is that now we will not be drawing the
MC and AVC rising at a constant rate. Refer to the diagram on the next page. The key word
that we are looking at is ...firm will have to stop its operations immediately.












P
P
X
Po
Xo
A
EXo
MC
S=EMC
AC
D
A
Po
X
MC1
AC1
P1
P1
B
S1=EMC1
X1
B
EX2
P2 P2 C
S2=EMC1
X2
EX1
1
C
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TCC Introduction to Economics 2011/12 Page 6











So basically the word stop its operations immediately means that our focus is on the short-
run. It also means that we are looking at a situation where the firm is making losses in the
short run and deciding whether the firm should shutdown or still produce. From the
diagram we can see that though the firm is making losses in the short run (P < AC), the firm
will still produce as it is still making operational profits (i.e. its P > AVC) and therefore it will
be able to limit its loss to an amount less than the fixed cost (which is the green border
rectangle). Note that even if P is lower than Po this will still be our conclusion as the main
reason is because at the profit maximizing output level which is where P=MC, P will always
be greater than AVC as MC is always > AVC.

1(g)
The answers to the question on the Nash equilibrium is very similar to other questions I
have given you in the Guidelines for Microeconomics. When you have a question on the
Nash equilibrium, remember we are looking at the duopoly model that we talked about
when we covered the oligopoly market structure. All the answers for the Nash equilibrium,
requires that you include the following diagram:









$
X
AC
Po MC
AVC=x
2

AC
AVC
Xo
MC=3X
2

P
Xc: Competitive
Cournot
MR D
Xm: Monopolist
Pm
Pd
A
C
Xd
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TCC Introduction to Economics 2011/12 Page 7

Remember we have a simple model where we are looking at a linear demand curve (P= -
|X) and MC=0. All these have to be spelt out in your answer. The competitive market
produces the output Xc (where P=MC. Work out the value of the output. It should be /|).
When it produces this output the competitive market is only making normal profit. The
monopolist on the other hand, produces the output where MR=MC and it therefore
produces half the output of perfect competition (since MR is two times steeper than the
demand curve. Its output = /2|) and it is making profit (which is equal to its revenue which
is the red border rectangle). The duopolist at the Nash equilibrium, indicated by what I
marked as Cournot ( a model of non-cooperation between the two firms) is also making
profit and both firms together are producing 2/3 of the market output (so each firm
produces 1/3 of the market output, the proof is given in the lecture notes). Hence the total
output of the two firms is greater than if the market was supplied by a single monopolist.

1(h) The original budget line we are looking at is marked in blue, the hourly real wage
rate is eo and the individuals original optimum was at A, he was working Lo hours (=L(bar)-
Leo). The budget line that reflects the lump sum payment which is independent of work
and a reduction in hourly pay is indicated by the red budget line. As you can see there are
many possible answers here as we do know what is the amount of the lump sum benefit r
how much was the hourly wage reduced.
















L
_
X
A
Leo
In this first diagram we can see that under the
new scheme, the individual is as well off as he
was before (on the same indifference curve) but
he is now, at B, working less hours than he did
at A.
U1
eo
B
Leisure hours
Working hours
Le1
e1
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TCC Introduction to Economics 2011/12 Page 8





















Note that the question stated that giving working people a lump sum payment which is
independent of their work while reducing their hourly wage can only make the individual worse
off as they will work less. And what we have shown in our answer is that even if they end up
working less they can be as well off, better off or worse off. Secondly we have also shown that
they may not end up working less.

2(a) In this question, we are looking at two goods, days of holidays (X) be it at home or
abroad and all other goods (represented by Y). The initial budget line is as shown below





L
_
X
A
Leo
In this diagram, the individual will be worse off
as he will move to a lower indifference curve on
the new (red) budget line. Whether he will work
more or less hours depends on whether leisure
is a normal or inferior good. If leisure is an
inferior good, he will definitely be working less
hours than before (he will be at a point like B
IG
for example. But if leisure is a normal good he
could end up working more or less hours than at
A. If he is at BN1 (SE (A to C)<IE (C to BN1) he
will end up working more hours. But if he is at
BN2, he will end up working less hours (SE (A to
C) > IE (C to BN2).
U1
wo
C
Leisure hours
Working hours
Le = NG
B
IG

BN1
BN2
IE
SE
L
_
A
Leo
In this diagram the individual will be better off
under the new scheme as he will be able to
move to a higher indifference curve on the red
budget line. Now if leisure is a normal good the
individual will definitely end up working less
hours than before. But if it is an inferior good,
he could end up working less hours than at A if
he is at B1 or more hours if he is at B2.
U1
wo
C
Leisure hours
Working hours
X
Le=NG
B1
B2
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TCC Introduction to Economics 2011/12 Page 9















Where the gradient of the line is the relative price of the two goods i.e. PXo/Pyo and the
maximum point on the X-intercept indicates the maximum number of holiday days (this is
equal to I
N
/PXo) and the maximum point on the Y-intercept indicates the maximum of all
other goods that can be bought given the income and the price of Y (I
N
/Pyo). The individual
was initially maximizing his satisfaction at point A taking Xo number of holiday days. The
fact that the question subsequently mentioned about tax relief means that the income is
actually the income after tax (so to indicate this we will represent the individuals after
tax income as I
N
.)

The scheme that we are looking at is as follows: (i) government offers a fixed amount of tax
relief per each day of holiday at home i.e. when the individual holidays at home he will
receive a subsidy for each day he holidays at home; and (ii) there will be a tax (T) imposed if
the individual holidays more than X(bar) number of days. Note too that this tax will be
greater than the overall tax relief. So how will (i) and (ii) affect the budget line?

Lets start with (i) it is a subsidy for each day of holiday up to X(bar) so we are looking at a
per unit subsidy and this will lower the Px from Pxo to Pxo-s . This therefore means that the
more holiday days (up to X(bar)) the greater the amount of subsidy he gets. The new budget
line starts from I
N
/PYo and it will fanned further out as X increases (new budget line lies
above the original budget line up to X(bar). The gap between the new and old budget line
gets wider indicating that he gets more subsidy as the number of holiday days increase
(note that the slope of this new budget line up to x(bar) is Pxo-s/Pyo. But once we reach
X(bar) the scheme changes. For holiday more than X(bar) remember that the government










X
Y
I
N
/PXo
I
N
/PYo
A
Xo
Yo
Uo
Figure 1
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TCC Introduction to Economics 2011/12 Page 10
















charge a special lump sum tax which is greater than the overall tax relief. So how is this
shown? The lump sum tax will not change the gradient of the budget line but will cause the
budget line to shift left or inward in a parallel manner. The income the individual now at
X(bar) has will be I
N
(PXo s)X T and hence the amount of Y he can buy will be I
N
(PXo
s)X T/Pyo. The vertical gap between the two new budget lines before and after X(bar) is
the T (can you see that the vertical distance (which is T) is greater than the subsidy (which is
equal to the vertical distance between the original budget line and the new budget line with
the subsidy at X(bar).
(b) For the individual who was initially taking less than X(bar) days of holiday, the new
scheme makes him better off as he is able to move to a higher IC since the new budget line
lies everywhere above the original budget line. We can see both the SE and IE here.
















In the diagram above the SE is from A to C. The IE is from C to B1 or B2 depending on
whether holiday is a NG or an IG. But note that regardless of whether holiday is a normal
good or inferior good, the individual will end up taking more days of holidays as he moves to
a point like B1 (NG) or B2 (IG). So regardless of whether holiday is a NG or IG, the policy
X
I
N
/PXo
I
N
/PYo
A
Pxo/Pyo
X


X
+
I
N
(Pxo - s)
A/PYo
X/ Pyo


I
N
(Pxo - s)
A/PYo
X - T/ Pyo

+ I
N
(Pxo - s)
A/PYo
X - T/ PXo

X
I
N
/PXo
I
N
/PYo
A
Pxo/Pyo
X

X inferior
X Normal

X
+
I
N
(Pxo - s)
A/PYo
X - T/ Pyo

+ I
N
(Pxo - s)
A/PYo
X - T/ PXo

C
B1
B2

Figure 2
Figure 3
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TCC Introduction to Economics 2011/12 Page 11

achieved the governments objective which is to increase the days of holidaying at home.
Note that in the case where X is a normal good, it is possible for the individual to increase
the days of holiday right up to X(bar) but he will not go beyond X(bar). So again the
objective was achieved.

(c) We are now looking at the individual who takes more than X(bar) days of holidays.
For this situation we only have the IE as the original and new budget lines are parallel (which















means that there is no change in relative price, hence no SE). What our answer will be now
will depend on whether the government is able to monitor the number of days of holidays
the individual is taking. If the individual did claim the subsidy for holidays up to X(bar) it is
possible that the government may not be able to know that he is now taking more than
X(bar) number of days of holidays. So in this case the individual will not be taxed and he will
therefore be able to remain on his original budget If he cannot hide from the government
then there are two possible answers: (i) He could end up at a point like D and be better off.
In this case he will meet the governments objective of taking less holidays, take advantage
of the subsidy and holiday at home. This possibility is shown in the diagram below:















X
I
N
/PXo
I
N
/PYo
A
Pxo/Pyo
X


X
+
I
N
(Pxo - s)
A/PYo
X - T/ Pyo

+ I
N
(Pxo - s)
A/PYo
X - T/ PXo

X inferior
X Normal
X
I
N
/PXo
I
N
/PYo
A
Pxo/Pyo
X


X
+
I
N
(Pxo - s)
A/PYo
X - T/ Pyo

+ I
N
(Pxo - s)
A/PYo
X - T/ PXo

D
Uo
U1
Figure 4
Figure 5
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TCC Introduction to Economics 2011/12 Page 12

When he is at D it means that he treats holidays as an inferior goods. Even if he considers C
to be a NG the only possible position he can go to is D, be better off and take lesser number
of days of holidays. (2) The individual who still wants to take more than X(bar) days of
holidays will now face the tax, which means that he will now be worse off than before and is
he treats X as a NG he will take lesser holidays but if X is an inferior good he will in fact take
more days of holidays (this is shown in Figure 4).
(d) Actually our answer is in (b) and (C). I will just copy and paste them here. In (b) we saw
that for the individual who goes for less than X(bar) days of holidays originally: (i) the new
scheme makes him better off as he is able to move to a higher IC since the new budget line
lies everywhere above the original budget line; (ii) Regardless of whether holiday is a NG or
IG, the policy achieved the governments objective which is to increase the days of
holidaying at home. In (c) for those who originally consumed more than X(bar) days of
holidays: (i) In the case where the individual claims the subsidy and where the government
is able to monitor the number of days of holidays (i) He could end up at a point like D and be
better off. In this case he will meet the governments objective of taking less holidays, take
advantage of the subsidy and holiday at home; (ii) For the individual who wants more than
X(bar) days of holidays he will now face the tax, which means that he will now be worse off
than before and is he treats X as a NG he will take lesser holidays but if X is an inferior good
he will in fact take more days of holidays. In the case where the individual wants to take
more than X(bar) days of holidays will now face the tax, which means that he will now be
worse off than before and is he treats X as a NG he will take lesser holidays but if X is an
inferior good he will in fact take more days of holidays.
3.















Note that although in this question there is no specification about the price elasticity of
demand of the two groups of customers, it is quite obvious that the demand of the
corporate travelers will be inelastic and that of the self financing travelers will be elastic
(that is they will be more sensitive to changes in prices). Hence, we need to illustrate this in
the diagram that we draw. At the initial market price of Po, firms are making normal profits
and producing output Xo. Corporate travelers are at A
C
, spending Po.XCo on air travel . Self
Corporate
Self Financing
Firm
Market
P P
P
X
X X X
DC
Ds
MC
D
AC
AC As
S=EMC
A
Po
Po Po
Po
A
XCo Xso Xo
EXo
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TCC Introduction to Economics 2011/12 Page 13

financing travelers are at As, spending Po. Xso on air travel. Not able to tell about the
market share of each group.

(b) The new technology will lower cost (variable cost) and hence shift the MC and the AC
down to MC1 and AC1 (shift it vertically down)















With the shift of the MC curve, there will be an expansion in the output of the air travel
even at the original price, Po i.e. even in the short run. The increase in the market supply to
S1 causes the market price to fall to P1 in the short run. The air travel industry is now
making profit equal to the shaded area. Corporate travelers will be traveling more as they
move to Bc and so will the self financing travelers as they move to Bs. However, corporate
travelers will be spending less on air travel as their demand is inelastic (P > X) but the
self financing travelers will be spending more on air travel since their demand is elastic (P
<X).

Long run: As existing firms are making profit, new firms will enter the industry. The entry
increases the market price and lowers the market price further until normal profit is
restored. This is when the market supply is at S2 and the market price is at P2. Firms will be
back to producing their original output and making normal profit. Market output has
increased as there are now more firms in the industry. Both corporate and self financing
travelers will be traveling even more in the long run and the spending of the corporate
travelers will continue to fall (demand is inelastic) whereas that of the self financing
travelers will increase further (demand is elastic).









Corporate
Self Financing
Firm
Market
P P
P
X
X X X
DC
Ds
MC1
D
AC
AC As
S=EMC
A
Bc
Po Po
Po
A
XCo Xso
Xo
EXo
MC
AC1
S1
Cc
P1 P1
B
P1
EX1
X1
S2
P2 P2 P2
C
P2
Po
P1
Bs
Cs
B
C
XC1
XC2
Xs1
Xs2
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TCC Introduction to Economics 2011/12 Page 14

(c) Government gives corporate travelers a tax break on their spending on air travel:
















Please note that I am just showing one set of cost curves and this is the new set as the new
technology is already there now that the government is deciding to give the corporate
travelers a tax break. Hence we are starting from the last equilibrium price and output etc
we had in part (b). Note that the tax break is similar to giving Corporate travelers a subsidy.
Hence, their demand for air travel shifts right and this in turn increases the market demand
to D1 and the market price to P3 in the short run. Competitive firms are now making profit
equal to the shaded area when they produce output X2. Corporate travelers are traveling
more in the short run as they move to Ec but they are spending less as their demand is
inelastic. As for the self financing travelers, they are travelling less and spending less on
travelling as their demand is elastic ( |P < +X).

In the long run, new firms will enter the industry. This increases the market supply and
lowers the market price. New firms will continue to enter so long as there are profits to be
made and will stop once normal profit is restored which is when the market supply
increases to S3 and the market price falls back to P2. At P2, firms are back to producing the
output at C (and making normal profit) but since there are now more firms in the industry,
the industry output has increased. Self financing travelers will return to their initial position
at Cs but Corporate travelers will travel even more in the long run as they move to Fc but
their spending has declined even further given their inelastic demand. [For this question
note that it is difficult to comment about the distribution of sales unless we know the size of
the corporate travelers compared with the self financing travelers. Perhaps all we can say is
that as corporate travelers are travelling more then their share of the market is growing].






Corporate
Self Financing
Firm
Market
P P
P
X
X X X
DC
Ds
MC1
D
CC
Cs C
XC2
Xs2 Xo
AC1
EXo
S2
P2 P2 P2
C
P2
DC1
D1
P3 P3 P3 P3
X2
E
XC2
Ec
Xs3
Es
XC3
Fc
S3
E
E
C
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 15

17. Note that in this question, since the long run total cost is given as C(x) = cx, it
therefore means that MC = c is a constant and AC is also a constant.

(a) Initial long run equilibrium:











o - c
The market price is hence: P = o - | ( ________) = c
|
[Even if you do not compute it out you can see that P has to be c.]

(b) Effects of a decrease in |

| is the slope of the demand curve (dP/dX). Therefore a decrease in | means that the
demand curve has become flatter. This means an increase in the market output












With the market demand curve becoming flatter, what happens in the short run is that
there is an increase in the market price to P1. If you were to draw in one more diagram for
the firm, this means that initially it was making normal profit producing at the minimum of
its AC curve (note that the SR cost curves are still the usual U-shaped curves) and now in the
SR with price rising to P1, the firm will produce a bigger output than before and it will be
making economic profits. As each exiting firm is producing a bigger output, this is reflected
by an increase in market output to X1 in the short run. As a result in the long run we have
the entry of new firms, which then shifts the SR supply curve right and lower the market
D (P = o -|X)
C
Market output: where P=MC
o-|X = c
o- c
o- c = |X, therefore X = ______
|

Since the market output (X) = nx, therefore
the output of each firm is
o - c 1 o - c
nx = ______ x = __ _____
| n |
P
X
D (P = o -|X)
C
X
P
D1 (P = o - |X)
SR Supply
curve
LR Supply
curve
SR Supply curve
P1
S1
B
X
o
Xo
X1
A
D
X
P
C
MC1
AC1
A
Xo
B
P1
X1
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 16

price. Entry of new firms end when normal profits are once again restored and that is when
the market equilibrium is at D.

At the new equilibrium D:
New market output: where P=MC
o- |X = c
o- c
o- c =|X, therefore X = ______
|

No change in market price.
Since the market output (X) = nx, therefore the output of each firm is
o - c 1 o - c
nx = ______ x = ___ _______
| n |

Note that this n we are looking at now will be > than the initial n because of the entry of
new firms, so lets call the new n=n+k

(c) Initially :

Each firms output was
1 o - c
__ _____
n |

After the change, each firms output is
1 o - c
____ _____
n + k |

We can now equate the two output as when the firm is making profit in the LR each firm is
producing the same original output (which is at the minimum of the AC curve which has not
changed).
1 o - c 1 o - c
__ _____ = _____ _____
n | n + k |


n + k |
________ = ______
n |

| (n +k) = | n
n| + |k = |n
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 17

|k = |n - n|
n(| - |)
K = _________
|





5. The monopolist faces a local and international demand. The international demand has a
higher price elasticity of demand than the local demand (It does not say that the
international demand is perfectly elastic). The second information we have is that the long
run marginal cost is constant.









[Since the international demand has a higher elasticity than the local demand, it means that
the international consumers are more sensitive to price, hence for this reason I have drawn
the local demand curve starting from a higher price level than the international demand as
the local consumers are less sensitive to price changes and therefore even at a higher price
they will still buy the good].







Indicates the number of new firms that
entered the market
Po
Market demand
Both
Po
Po
DL
DI
DT
X
P
DT
MR
You should be able to work out that at the kink, the
MR of the flatter demand curve is higher than the
MR of the steeper demand curve by using the
following equation:
1
MR=P 1 - ____
|q|

1 1
For the steeper demand curve ____ > ____ of the
|q| |q|
flatter demand curve. Therefore the MR of the
steeper demand curve is smaller than the MR of the
flatter demand curve.
P
P
P Local
demand
Local International
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 18

(b) If the monopolist cannot price discriminate, whether he will sell locally only or both
locally and








Note that when the monopolist increases his output beyond A, first from A to F, for each
unit he produces MC>MR which gives rise to an area of loss (AEF which will reduce the profit
he has made up to A. However, if he increases his output even further i.e. from F to B, note
that now MR>MC, so we have an area of gain (FCB), which will add to the monopolists
profit. If the area of loss (AEF) is > area of gain (FCB) the monopolist will produce only Xo
and sell it locally at Po. But if the area of gain (FCB) > area of loss (AEF), the monopolist will
then produce the output at B i.e. X1 and sell both locally and abroad at P1.

(c) An increase in exporting license fee








An increase in exporting license fee only increases the monopolists fixed cost. This
therefore raises only the monopolists AC and it only affects that part of the AC curve from
output Xo and above (as the monopolist only exports from that portion of the demand
curve onwards (for the initial part of the demand curve the monopolist is only selling
locally). So the first part of the new AC curve is the same as the original AC curve but from
output Xo onwards there is an increase in the fixed cost because of the export license fee.
In this part of the question we are assuming that the monopolist is producing the output at
B i.e. X1. Since he is selling abroad it must therefore mean that for him to produce at B in
X
P
Po
DT
MR
abroad i.e. at A or B respectively will
depend on whether the area of loss
(AEF) which arises when the monopolist
increases his output beyond A is greater
or smaller than the area of gain (FCB).
If the monopolist produces at A where
MR=MC, he will produce output Xo and
sell it only locally at Po (note that for
every unit of x produced up to Xo,
MR>MC so each unit produced is adding
to the monopolists profit until Xo+.
MC
A
Xo
E
B
F
C
X1
P1
Po
DT
MR
To answer this part of the question, we
need to first add in the AC curve. Note
that since MC is a constant it means that
AVC is also a constant and equal to the
MC but AC (which is made up of the AVC
and AFC) is not a constant because AFC
is always falling as output increases. In
view of this, the AC curve is above the
MC curve (cos it includes the AFC) and
it is falling (because AFC is falling). The
initial AC is drawn in blue.
MC
A
Xo
E
B
F
C
X1
P1
P
Xo
ACo
AC1
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 19

the first place the area of gain (FCB) is > area of loss (AEF). Note that at this output level, the
selling price is P1 and the AC of producing X1 (look at the blue AC curve) is less than P1. So
initially the monopolist was making above normal profit for that output level. But now
whether it will still produce the output X1 will depend on how much was the increased in
the exporting license fee i.e. how high did that part of the AC curve increase. If the price can
still cover the new AC at X1, the monopolist will still produce X1 and he will still be selling
locally and abroad. If the new AC curve at X1 is higher than the price P1, the monopolist will
be making losses and therefore it is better for him to produce only Xo and sell it locally.

Section B:

6(a) This question talks about profit which therefore means that profits constitute a
share of national income. So if profit is Y, then the income that goes to the household will
be Y-Y or (1-)Y. (Caution: When profits is mentioned you need to do this first or else you
will make the mistake when it comes to writing the consumption equation. The likelihood
is that you will write it in the normal way as C= Co + C1 (1-t)Y)

C (Y) = Co + C1 (1-t)(1-)Y
I(r) = Io-I1r +Y [Dont forget to add Y]
G= Go
X(EP*/P) = Xo (EoPo*)
IM(EP*/P, Y) = Imo(EoPo*/Po) + m1Y [Why did we write it this way?]

For a closed economy:
At equilibrium: Y=E
Y = Co + C1 (1-t)(1-)Y + Io-I1r +Y + Go
Y - C1 (1-t)(1-)Y Y = Co + Io I1r + Go
Y (1 - C1 (1-t)(1-) ) = Co + Io I1r + Go

1
Y = ___________________ Co + Io I1r + Go
1 [C1 (1-t)(1-) + +

The closed economy multiplier is

1
__________________
1 [C1 (1-t)(1-) + +

In an Open Economy:

Y = Co + C1 (1-t)(1-)Y + Io-I1r +Y + Go + (Xo-Imo)(EoPo*/Po) m1Y
Y - C1 (1-t)(1-)Y Y + m1Y = Co + Io I1r + Go + (Xo Imo)(EoPo*/Po)
Y (1 - C1 (1-t)(1-) - + m1) = A(r,EoPo*/Po)
1
Y = _____________________ A (r,EoPo*/Po)
1 [C1 (1-t)(1-)+ - m1]
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 20

Since = m1 (according to the question) the multiplier for an open economy is therefore:

1
________________
1 [C1 (1-t)(1-)+

When we compare this multiplier with the multiplier for a closed economy

1
__________________ >
1 [C1 (1-t)(1-) + +

The closed economy multiplier is bigger than the open economy multiplier.

6(b) This is taken to mean that there is a fall in prices in the country (please do not
interpret it that when price of houses fall it affects ones wealth and hence it affects
consumption. Note that the consumption equation we have written is not a function of
wealth but of income). When domestic price falls it increases the supply of liquid assets and
shifts the LM down. Dont forget that when we are looking at an open economy, prices also
affect the real exchange rate. A fall in domestic prices will increase the real exchange rate. It
makes the countrys exports more attractive to others but its imports become more
expensive. Hence, its net exports increase which therefore causes the IS to shift right.














In your answer you could have shifted the IS right and the LM down and straight away move
to its new long run equilibrium at C. Alternatively, if you do not want to do this you can then
either (i) shift LM down more than the IS shifts to the right in which case we will be looking
at a fall in domestic interest rate below that of the international interest rate. This would
then result in a capital outflow from the country resulting in an excess demand for foreign
currency. Then if it is a fixed exchange rate system the central bank will sell foreign
currency. This reduces the countrys reserves and the supply of liquid assets which will then
shift the LM up. You will still end at a new equilibrium that is to the right of A. So again no
recession; or in a flexible exchange rate system the nominal exchange rate would have
increased meaning that the currency depreciates thereby increasing net exports and shift
the IS further right. Answer is still the same that the new equilibrium is to the right of A and
there is no recession; OR (ii) shift the IS right more than the LM shifts down which therefore
1
________________
1 [C1 (1-t)(1-)+


r
Y
LMo(Mo,Po)
ISo(Go,To, EoPo*/Po)
BOP
A
ro=ro*
Yo
LM1(Mo,P1)
1
2
IS1(Go,To, EoPo*/P1)
C
Y1
r
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 21

means that you will end up with domestic interest rate being higher than the international
interest rate. This would then have resulted in a capital inflow into the country and hence
there will be an excess supply of foreign currency. In a fixed exchange rate system, the
government would buy foreign currency which then increases the countrys reserves and
the supply of liquid assets. LM will then shift down again and the new equilibrium will be
still to the right of A. In a flexible exchange rate system, E will fall meaning that the domestic
currency appreciates. This will reduce NX and shift the IS left somewhat and our new
equilibrium will still be to the right of A. So no recession either.

6(c) Note the information given:
(i) In A, the rate of tax is fixed and the government adjusts its spending so that the
budget is balanced
(ii) In economy B the government adjusts the tax rate to fit its fixed level of spending.

Note too that we are looking at a balanced budget policy but the question did not ask us for
the balanced budget multiplier.

Economy A:
C(Y) = Co + C1(1-t)Y
I (r) = Io I1r
G = tY

Economy B:
C(Y) = Co + C1(1-t)Y
I (r) = Io I1r
t = G/Y

Economy A: At equilibrium Y=E
Y = Co + C1(1-t)Y + Io I1r + tY
Y - C1(1-t)Y tY = Co + Io I1r
Y (1-C1(1-t) t) = Co + Io I1r

1
Y = _____________ Co + Io I1r
1 [c1(1-t) + t]

Economy B: At equilibrium Y=E
Y = Co + C1(1-G/Y)Y + Io I1r + G
Y = Co + C1Y C1G + Io I1r + G
Y - C1Y = Co C1G + Io I1r + G
Y (1-C1) = Co C1G + Io I1r + G

1
Y = ______ Co - C1G + Io I1r + G
1 c1

The effect of on output of an equal change in the autonomous component depends on the
size of the multiplier. Comparing the multipliers in the two countries:
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TCC Introduction to Economics 2011/12 Page 22


Economy A Economy B

1 1 1
____________ > _____
1 [c1(1-t) + t] 1- C1

This therefore means that an equal increase in autonomous component in both countries
will result in a greater increase in the output of economy A than economy B. Hence the
statement is true.

6(d) In order to lower interest rate, the central bank must have adopted an expansionary
monetary policy. This therefore becomes our starting point for this question. As a start we shift the
LM down.







In the short run the economy moves to B and at B the economy is facing a current account
deficit (imports increased with the movement from A to B since Y has increased). A current
account deficit means that there is an excess demand for foreign currency. Since we have a
fixed exchange rate system, the central bank will sell foreign currency to keep the exchange
rate fixed. This reduces the countrys reserves and its money supply. The reduction in
money supply shifts the LM up and the economy moves back to its original position at A.
Hence the central bank did not succeed in reducing interest rate in the country.

6(e) Case where investment is independent of income (this is the usual way we write the
investment equation):

C(Y) = Co + C1(1-t)Y
I(r) = Io I
1
r
G = Go
At equilibrium: Y = E
Y = Co + C1 (1-t)Y + Io I
1
r +Go
Y C1(1-t)Y= Co + Io I
1
r + Go
Y (1 C1 (1-t)) = Co + Io I
1
r + Go


r
Y
ISo(Go, To, EoPo*/Po)
A
LMo(Mo,Po)
ro
Yo
B
LM1(M1,Po)
NXo=0(Eopo*/Po)
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 23

1
Y = ___________ Co + Io I
1
r + Go
1 C1(1-t)

When investment rises with income:
I = Io I
1
r +I
2
Y

At equilibrium: Y= E
Y = Co + C1(1-t)Y + Io I
1
r + I
2
Y + Go
Y C1(1-t)Y I
2
Y = Co + Io I
1
r + Go
Y (1 C1(1-t) I
2
) = Co + Io I
1
r + Go

1
Y = ______________ Co + Io I1r + Go
1 [C1(1-t) +I
2
]

Comparing the two multipliers, the multiplier where I increases as income increases is
bigger than the case where I is not affected by income. This therefore means that the IS
curve in the case where I rises with income is flatter than the case where investment is not
affected by income.
[Alternatively you can also arrive at your answer by writing the equation for the slope of the
IS curve]

6(f) When people deposit a greater part of their money in the banks this will increase the
amount of loans that banks can make, which therefore increases the money supply. Why?
The more banks lend the more new deposits will be created in the process and if you recall
deposits are part of the countrys money supply.

The formula for total loans (L) :
L = LM.K
L = (DM 1) K

What the formula tells us is that an increase in deposits (K) will cause loans to increase by a
multiple, that multiple depends on the size of the loan multiplier which is equal to DM 1
(where DM=deposit multiplier). The size of the loans multiplier therefore does not depend
on what happens to deposits but it depends on the deposit multiplier. The deposit multiplier
as we know is affect by the reserve ratio as the DM = 1/ , where = reserve ratio. The
statement is therefore false that an increase in deposits will bring about an increase in the
loan multiplier. The loan multiplier depends on the deposit multiplier which in turn is
affected by the reserve ratio ().

6(g) Poor usually have a higher marginal propensity to consume and a lower marginal
propensity to import than the rich. So when income is transferred from the rich to the poor,
the richs income falls and the poors income increases. This therefore results in an increase
in consumption and a decrease in imports. Aggregate demand therefore increases and the
IS shifts to the right. In this model which we are looking at, we will also need to shift NX=0
line to the right as IM has declined which means that NX has increased.
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 24











Since both IS and the NX=0 line are shifting right you need to apply your decision rule here
as to which curve has shifted more (remember at interest rate ro when we are on the new
IS, what must NX be for I to remain a constant). In the short run, the economy is at B and at
B there is a current account surplus and hence an excess supply of foreign currency. In a
fixed exchange rate system, the central bank will buy up the excess supply of foreign
currency. The countrys reserves and money supply therefore increases and the LM
therefore shifts down and the economy is finally at C, at a higher output level and lower
interest rate. Statement is therefore true that there will be an expansionary effect on the
economy since Y increased.

6(h) Here we are looking at the capital formation equation for an open economy:

I = S + (T-G) (X IM)

A fall in government deficit (deficit becomes smaller) [can be read as an increase in
government surplus] will have a positive effect on investment (I).
An increase in the current account surplus [can be read as a decrease in current account
deficit] in turn will cause I to fall .
Since both the fall in government deficit and the increase in current account surplus are
equivalent which therefore means that I will not change unless there is a change in savings.

7.
Key points:
1. Poor have a higher MPC i.e. C1
P
> C1
R

2. Poors share of national income is . So if the poors share of Y is Y then the share
of income of the rest or rich (R) will be Y Y or (1-)Y. Note that the poor do not
pay taxes (unless the question states that they do or when you are given tax rates
for the rich and the poor).
3. Government pursues a balanced budget policy where spending is adjusted to the
level of tax raised and we have a proportional tax system

r
Y
ISo(Go, To, EoPo*/Po)
A
LMo(Mo,Po)
ro
Yo
B
LM1(M1,Po)
NXo=0(Eopo*/Po)
NXo=0(Eopo*/Po)
.
ISo(Go, To, EoPo*/Po)
.
Y1
C
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TCC Introduction to Economics 2011/12 Page 25

The following are the equations we need to write to find the multiplier:
C
P
= C
o
P
+ C
1
P
Y *Consumption equation of the poor+
C
R
= C
o
R
+ C
1
R
(1-t)(1-)Y [Consumption equation of the rest or the rich]

Total consumption in the country:
C (Y) = C
o
+ C
1
P
Y + C
1
R
(1-t)(1-)Y
I (r) = I
o
I
1
r
G = t(1-)Y [We have a balanced budget policy and G is adjusted to the tax raised and
in this case there are no transfers]

E = C
o
+ C
1
P
Y + C
1
R
(1-t)(1-)Y + I
o
I
1
r + t(1-)Y

At equilibrium: Y = E
Y = = C
o
+ C
1
P
Y + C
1
R
(1-t)(1-)Y + I
o
I
1
r + t(1-)Y
Y - C
1
P
Y - C
1
R
(1-t)(1-)Y - t(1-)Y = C
o
+ I
o
I
1
r
Y ( 1 - C
1
P
- C
1
R
(1-t)(1-) - t(1-)) = Co + Io I1r

1
Y = _____________________________ Co + Io I1r
1 [ C
1
P
+ C
1
R
(1-t)(1-)+ t(1-)+



(b) Increase in tax rate (t)

The increase in t affects the economys multiplier

Effect on the multiplier:
1
_____________________________
1 [ C
1
P
+ C
1
R
(1-t)(1-)+ t(1-)+



If we differentiate M with respect to t:
dM
___ = - C
1
R
(1-)+(1-) = (1-C
1
R
)(1-) >0
dt

this means that an increase in t increase in M and therefore an increase in the multiplier.
Hence when there is an increase in t, we need to shift the IS right and make it flatter.





M
Economys multiplier
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TCC Introduction to Economics 2011/12 Page 26

Prices and wages are fixed












(c) Prices and wages are flexible
























(d) Now on top of the increase in t we are looking at an increase in depravation (i.e.
decrease in which means that the poors share of income has declined)

An increase in depravation again affects the economys multiplier, so when we differentiate
M with respect to :


r
Y
LMo(Mo,Po)
ISo(Go,to)
ro
Yo
A
IS1(Go,t1)
B
r1
Y1
When the IS shifts right, at the original
interest rate (ro) there is now an excess
demand for goods. This causes Y to
increase, which in turn increases the
demand for liquid assets. Interest rate
therefore increases which then gives rise
to a partial crowding out effect (i.e. fall in
investment) and the economy is finally at
its new equilibrium at B. End result, r and
Y increase.
Y
ISo(Go,to)
ro
Yo
A
IS1(Go,t1)
B
r1
Y1
ADo(Go,to)
Po
Yo
A
r
LMo(Mo,Po)
P
Y
SASo(Wo)
LM1(Mo,P1)
AD1(Go,t1)
B P1
SAS1(W1)
C
P2
C
r2
LM2(Mo,P2)
The increase in t shifts both the IS and AD to the
right. However when AD increases price also rises.
The increase in price in turn reduces the supply of
liquid assets causing the LM to shift up. In the
short run the economy moves from A to B.
Since real wage at B is lower than at A workers
will be able to negotiate for a higher money wage
at the next round of wage negotiation. When
money wage increases it shifts the SAS to SAS1.
The shift of the SAS results in a further price
increase and a further decline in the supply of
liquid assets. This causes the LM to shift up again.
When all expectations are met, the economy will
be at point C i.e. income will not change in the
long run. But price, interest rate and money wage
have all increased. When prices and wages are
flexible the increase in interest rate will result in a
complete crowding out of investment (to fund the
increase in government spending)
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TCC Introduction to Economics 2011/12 Page 27


dM
____ = C
1
P
C
1
R
+C
1
R
t - t
d

[while we know that C
1
P
> C
1
R
, you can see the answer above could be positive or negative
as C
1
R
t t is negative ]

If it is positive it means it means that the + +M +multiplier so we need to shift the IS
left and make it steeper.
If it is negative it means it means that the + |M | multiplier so we need to shift the
IS right and make it flatter.


























8. The first thing we need to do is to find out the impact of the dramatic climate
change. According to the question it turned of the countrys land arid. So the question is
what does it affectthe IS, LM or something else. Think through.

The destruction of a of a countrys land is a shock to production, a reduction in a countrys
ability to produce. Hence this is an example of one of those questions where we start off not
by shifting the IS or LM but by shifting the SAS (remember this is the short run aggregate
r
Y
LMo(Mo,Po)
ISo(Go,to, o)
ro
Yo
A
IS1(Go,t1, o)
B
r1
Y1
If the results are positive we are now
looking at C as the final equilibrium
(When prices and wages are fixed)
Interest rate and Y still increases but
by an amount smaller than without
the +. When prices and wages are
flexible we also need to adjust the IS in
the same manner. The end result is
that Y will still not change but the
increase in r, P and W will be smaller.
IS2(Go,t1, 1)
r2
Y2
C
Y
ISo(Go,to, o)
ro
Yo
A
IS1(Go,t1, o)
B
r1
Y1
IS2(Go,t1, 1)
r2
Y2
C
LMo(Mo,Po)
If the results are negative we are now
looking at C (when prices and wages are
fixed) as the final equilibrium. Interest
rate and Y still increases but by an
amount bigger than without the +.
When prices and wages are flexible we
also need to adjust the IS in the same
manner. The end result is that Y will still
not change but the increase in r, P and
W will be even bigger.

STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 28

supply curve) and changing the countrys potential output (shift the LRAS). The original
output Yo is no longer attainable.

[To understand the above we need to take a look at what is happening in the labour market]













Note that the number of workers at A and C are the same so why is there a fall in output ? It
is because each unit of labour is less productive than before as the MPL of is now lower. The
changes mentioned here will be reflected in the diagram below. The fall in potential output
at the initial real wage (hence the initial money wage and price) shifts the SAS to SAS1(Wo).

























SL
DLo
eo
DL1
e
Lo
The destruction of the land
reduces the MPL since labour has
less land to work with. The MPL
curve (which is the demand for
labour curve) therefore shifts left.
So initially we move for A to B
when the MPL declined. At B we
have an excess labour supply so
this cases money wage and hence
real wage to fall until we reach the
new equilibrium at C.
A B
C e1
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 29

(a) Closed economy flexible price and wages
























Initially the economy was at A and the potential output was Yo. With of the countrys land
becoming arid, as mentioned before this shock in output reduced the countrys ability to
produce and hence its potential output. The SAS therefore shifts left (at the same money
wage). Not forgetting that the excess supply of labour in the labour market causes money
wage to fall. The fall in money wage therefore shifts the SAS to SAS 2. Price in the economy
increases as there is an excess demand for goods. The increase in price reduces the supply
of liquid assets and in turn causes the LM to shift up. The economy therefore moves to B
and the potential output is now Y1.

At B, real wage is lower than it was at A.






r
LMo(Mo,Po)
ro
A
Y
ISo(Go, to,)
Yo
r1
B
Y1
P
SASo(Wo)
Po
A
Y
ADo(Go, to,Mo,)
Yo
LM1(Mo,P1)
Y1
P1
B
SAS1(Wo)
A
SAS2(W1)
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 30

(b) An open economy, no capital mobility and a fixed exchange rate


















From our analysis of the closed economy we saw that the destruction of of the countrys
land resulted in an increase in domestic price. The fact that the countrys good are now
relatively more expensive will now cause its NX to fall (note that real exchange rate falls).
This shifts both the IS and NX=0 line to the left. At the same time the increase in price also
reduces the supply of liquid assets which therefore shifts the LM up. If you want to you can
shift all the three lines such that we move to the new long run equilibrium at B. You can
verify whether your diagram is correctly drawn by using the capital formation equation: I= S
+T-G-(X-IM). Note that when we are at B, NX is balanced. We can assume that T-G is a
constant too. Hence since Y has declined which means that S has declined, investment will
also have to decline which therefore means that interest rate must be at a higher level.















r
Y
ro
ISo(Go,to, EoPo*/Po)
LMo(Mo,Po)
Yo
A
IS1(Go,To, EoPo*/P1)
B
NX1=0 (EoPo*/P1)
LM1(Mo,P1)
Y1
NX
B
=0 (P
A
/EoPo
B
, Y
A
)
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 31

(c) And (d) Open economy, perfect capital mobility

















Like before the increase in domestic price lowered the real exchange rate. This causes the
countrys NX to fall and therefore shifts its IS to the left. At the same time, the increase in
price reduces the supply of liquid assets which shifts the LM up. In a very simple situation,
the shift of the IS and LM brings us to point B (both for the fixed and flexible exchange rate).
Alternatively you could have also shifted the LM more than the IS, in which case point B
would have been at a higher interest rate and if we are looking at the fixed exchange rate
system the central bank will then have to buy the excess supply of foreign currency which
arose because of capital inflows into the country. This increases the countrys reserves and
the money supply which would then shift the LM down. The new equilibrium will still be
where at a lower output level as in our diagram above. If we were looking at a flexible
exchange rate system, the nominal exchange rate would have declined and this would have
reduced the countrys NX and shifted the IS left and the economy will still end up at a lower
output level. [Alternatively you could have shifted the IS more than the LM and come up
with an analysis starting from a position B where the domestic interest rate is lower than
the foreign interest rate].

9. Points to note: The major trading partner experienced a large increase in its labour
supply, so what is the implication of this on the home country.

We therefore start our analysis with the major trading partner where the change is taking
place and we will first look at the labour market in that country.







ro = ro*
ISo(Go,to, EoPo*/Po)
A
BOP
IS1(Go,t1, EoPo*/P1)
B
LMo(Mo,Po)
Y1 Yo
LM1(Mo,P1)
r
Y
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 32


















(a) An open economy without capital mobility and a fixed exchange rate regime
































W/P
L
SL
DL = MPL
(W/P)o
Lo L1
A
The increase in the supply of
labour shifts the supply curve
to the right. The implication of
this is that the main trading
partners potential output will
increase and given the excess
supply of labour in the labour
market, money wage and
hence real wage will fall in the
main trading partner. This
change will be reflected in the
main trading partners AD-AS
diagram.
SL
(W/P)1
Y*
LM*(Mo,Po)
IS*(Go,To)
ro*
Yo*
P*
Y*
SAS*(Wo)
AD*(Go,To,Mo)
Po*
A
Yo*
A
SAS1*(Wo)
SAS2*(W1)
P1* B
Y1*
Y1*
LM*(Mo,P1)
r1*
B
r*
I will leave you to explain this
diagram as it is very similar to
what we have done before. The
only difference is that money
wage fell in this case and
therefore we will have to shift
the SAS right again.

End result: main thing to note is
that the potential output of the
main trading partner has
increased and its price fell, which
will therefore make her goods
relatively cheaper compared with
that of the home country
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 33

































Our starting point will be that prices in the main trading partner fell. This will therefore (i)
increase the supply of liquid assets in the main trading partner (shift the LM* down); and (ii)
now that the main trading partners goods are cheaper it will increase her NX and therefore
shift the IS* and NX*=0 line to the right (For AD it is a movement because P* is on the axis of
the diagram).

The two important changes we need to take into consideration to find out the effect on the
home country is (i) with the fall in price in the main trading partner, the home countrys
goods are now relatively more expensive, so we expect a fall in the home countrys X and an
increase in her IM. The home countrys NX will fall and this as you know will shift its IS and
NX=0 lines to the left; (ii) Y* of the main trading partner has increased and that means that
the main trading partner will buy more imports from the home country, so this will cause
the home countrys NX to increase and shift the IS and NX=0 line of the home country to the
right, therefore offsetting somewhat the initial leftward shift of the IS and the NX. I am only
going to draw one new set of IS and NX=0 line for the home country and please note that
the positions of these new IS and NX=0 lines have incorporated both the changes I have
Y*
LM*(Mo,Po)
IS*(Go,To, Po*/EoPo)
ro*
Yo*
P*
Y*
SAS*(Wo)
AD*(Go,To, Eo, Po, Mo)
Po*
A
Yo*
A
SAS2*(W1)
P1* B
Y1*
Y1*
LM*(1Mo,P1)
r1*
B
r*
NXo*=0(Po/EoPo*, Y)
Main Trading Partner
Y
LM(Mo,Po)
IS(Go,To, EoPo*/Po,Y*)
ro
Yo
A
Y1
LM1(M1,Po)
B
r
NXo=0(EoPo*/Po, Y*)
Home country
IS*1(Go,To, P1*/EoPo)
NX1*=0(P1/EoPo*, Y)
NX1=0(EoP1*/Po, Y1*)
IS1(Go,To, EoP1*/Po,Y1*)
r1
C
r2
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 34

mentioned. *Dont forget to apply the decision rule as to which curve i.e. the IS or the NX=0
line shifts more].

In the short run, the home country will move from A to B. At B, the country is experiencing a
current account deficit which means there is an excess demand for foreign currency. The
central bank will therefore sell foreign currency. This reduces the countrys reserves and its
money supply also falls thus shifting the LM up until the new long run equilibrium at C is
attained. End result: the economys output fell.

(b) An open economy with perfect capital mobility and a fixed exchange rate regime;
(c)An open economy with perfect capital mobility and a flexible exchange rate


















Since the main trading partners goods are now relatively cheaper there will be a decline in
the home countrys NX and this therefore shifts the home countrys IS to the left. The
position of IS1 also incorporates the fact that income in the main trading partner has
increased which means that they will import more from the home country. This will
somewhat offset the initial fall in NX. In the short run, the home economy is at B and
domestic interest rate is now lower than international interest rate. This makes foreign
assets relatively more attractive hence resulting in capital outflows from the country and an
excess demand for foreign currency results. In a fixed exchange rate system, the central
bank will intervene and sell foreign currency. This action reduces the countrys reserves as
well as its money supply and causes the LM to shift up. The new long run equilibrium is at
point C. The country is worse off as output has declined. Had the exchange rate been
flexible, the excess demand for foreign currency would have resulted in a depreciation of its
currency (E, the nominal exchange rate increases). This makes the domestic countrys
exports relatively cheaper and its imports more expensive. Its NX will therefore rise and this
will then shift the IS to the right and in the long run the economy will return to its original
equilibrium position at A.




Y
ro= ro*
Yo
A
ISo(Go,to,EoPo*/Po, Y*)
LMo(Mo,Po)
C
BOP
B
Y1
LM1(M1,Po)
IS1(Go,to,EoP1*/Po, Y1*)
r1
Y2
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 35

10. Points to note:
- Drastic decline in international air travel. Implications is that we must be looking at a
country where the tourism industry plays a key role and for such a country tourists arrival in
the country is very important, it is an important source of revenue. Hence the drop in
international travel will reduce the countrys X and hence its NX.
- Question then mentioned that in some countries this was accompanied by a sharp
increase in government spending, which therefore implies that in some countries there will
be no such increase in G. So this gives us a clue that we need to look at both situations.

(a) Open economy, no capital mobility and fixed exchange rates. Compare the effects
that these developments would have on countries in which expenditures on securities
increased substantially and those in which spending on security have hardly changed.


















The fall in the countrys NX due to the decline in international travel means that we need to
shift both the IS and NX=0 lines left (use the capital formation again to determine which
must shift more we need to show a current account deficit). In the short run the economy
moved to B and it has a current account deficit (and hence an excess demand for foreign
currency). In a fixed exchange rate system, the central bank will sell foreign currency. This
reduces the countrys reserves and its money supply and shifts the LM up. The economys
new equilibrium will be at C at a lower output level and a higher interest rate.

For the country which increased its spending on security (so we now have an increase in G),
this increase in G will offset the initial fall in NX. So overall IS will shift left but by less than if
there is no increase in G (we are looking at the green IS line). Please refer to the diagram
below. I have left the IS (no change in G) in the diagram (red dotted line) for purpose of
comparison. The new long run equilibrium CG is at a higher level of interest rate compared






Y
ro
A
ISo(Go,To,EoPo*/Po)
LMo(Mo,Po)
r
B
Y1
NXo=0 (EoPo*/Po)
r1
Yo
NX.=0 (EoPo*/Po)
LM2(M1,P1)
C
r2
r2
IS.(Go,To,EoPo*/Po)
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 36




















with when the government did not increase its spending on security. So what this tells us is
that the country where the government increased its spending will be worse off in the long
run as its interest rate rose much more than the other country (where G did not increase).

(b) How would such development affect an open economy with capital mobility and a
fixed exchange rate?
(c) Would your answer to (b) remain the same had the exchange rate regime been
flexible?

Country where the government did not increase its spending:


















Like before the drop in international travel reduced the countrys exports and therefore its
NX fell and shifted the IS left. In the short run the economy moved from A to B. As domestic
Y
ro
A
ISo(Go,To,EoPo*/Po)
LMo(Mo,Po)
r
B
Y1
r1
IS.(G1,To,EoPo*/Po)
Yo
LM2(M1,P1)
C
r2
NXo=0 (EoPo*/Po)
NX.=0 (EoPo*/Po)
C
G

Y
ro= ro*
Yo
A
ISo(Go,To,EoPo*/Po)
LMo(Mo,Po)
r
C
Y1
BOP
= LM2(M1,P1)
IS1(Go,To,E1P1*/P1)
B
r1
LM1(M1,P1)
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 37

interest rate is lower than international interest rate, capital will flow out of the country as
foreign assets become more attractive. There is now therefore an excess demand for
foreign currency. In a fixed exchange rate system, the government will sell foreign currency.
This reduces the countrys reserves and money supply and shifts the LM up. The economys
new long run equilibrium is at C (a lower level of output). Had the exchange rate been
flexible, E (the nominal exchange rate) would have increased. The depreciation of its
currency increases its NX and shifts the IS curve right back to its original position at A (no
change in Y).
















The diagram above is for the country where the government increases its spending. The
same thing happens in the country where the government increased its spending. The only
difference is that the IS will not be so far left as before as there is some offset with the
increase in G (we are now looking at the green IS curve). Like before because interest rate
(at B) is now lower than the international interest rate, capital will flow out of the country
and an excess demand for foreign currency develops. In a fixed exchange rate system, the
central bank will sell foreign currency. This reduces the countrys reserves and money supply
and shifts the LM up. The new long run equilibrium is at C. Output falls by a smaller
amount here than it did in the country where the government did not increase its
spending. But had the exchange rate been flexible the depreciation of its currency will
increase its NX and shift the IS right and bring the economy back to its original equilibrium at
A (so the results are exactly the same as in the absence of an increase in government
spending).

11. Points to note:
- Looking at an open economy
- One with chronic deficit in the current account and in the governments budget (so
this country has a huge current account deficit as well as a huge budget deficit)
- To correct the situation the government wants to reduce its spending (which will
help to reduce the size of the budget deficit) and curtail imports (which will help to
reduce the size of its current account deficit). So we are looking at a cut in G (which
is a contractionary fiscal policy and which will reduce AE and therefore shift the IS
left) as well as a cut in IM which is usually reflected by a reduction in the marginal
Y
ro= ro*
Yo
A
ISo(Go,To,EoPo*/Po)
LMo(Mo,Po)
C
Y1
BOP
= LM2(M1,P1)
IS2(G1,To,EoPo*/Po)
B
r1
IS1(Go,To,EoPo*/Po)
LM1(M1,Po)
C
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 38

propensity to import (m1) and which will definitely therefore affect the multiplier
since m1 will appear in the multiplier.

(a) Why is the government concerned?

The government is concerned because as we know a budget deficit has a negative effect on
investment in the country (look at the capital formation equation). A current account deficit
we have seen has a positive effect on investment. But we must not forget that when we
have a current account deficit it means that the capital account is in surplus. The question is
how long can the capital account surplus be sustained bearing in mind that for there to be a
capital account surplus, domestic interest rate must be high. The fact that the government is
concerned means that they are aware that the capital inflow cannot be sustained.

(b) What will be the effects of the proposed policy on an economy where there is no
capital mobility and there is a fixed exchange rate policy?
To find the implications of the policy of cutting G and reducing imports we will first need to
write the different equations for our economy and work out the multiplier. Though the
question did not specifically ask for the multiplier, in this instance we will still be required to
work out the multiplier as one of the things that is being changed is m1 and m1 is definitely
in the multiplier.

C(Y) = Co + C1(1-t)Y
I(r) = Io I1r
G = Go
X(EP*/P) = Xo (EoPo*/Po)
IM(EP*/P, Y) = Imo (EoPo*/Po) + m1Y

E = Co + C1(1-t)Y + Io I1r + Go + (Xo Imo)(EoPo*/Po) m1Y

At equilibrium: Y=E
Y = Co + C1(1-t)Y + Io I1r + Go + (Xo Imo)(EoPo*/Po) m1Y
Y - C1(1-t)Y + m1Y = Co + Io I1r + (Xo Imo)(EoPo*/Po)
Y (1 - C1(1-t) + m1) = Co + Io I1r + (Xo Imo)(EoPo*/Po)

1
Y = ____________________ Co + Io I1r + Go + (Xo Imo)(EoPo*/Po)
1 [C1(1-t) - m1]



A reduction in G reduces autonomous spending and therefore shift the IS left.

A reduction in m1 will on the other hand affect the multiplier. If we differentiate M with
respect to m1, you can see that the result is negative which means that a reduction in m1
increase in M and therefore an increase in the size of the multiplier. This shifts the IS right
and makes it flatter.

M
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 39

Conclusion: While the reduction in G shifts the IS left, the reduction in m1 shifts the IS to
shift right and makes it flatter. So the question we need to first answer here is whether the
new flatter IS will be to the right or left of the original IS at the original position A in our
diagram below.

How to make our decision? Make use of the capital formation equation

I = S + (T-G) (X IM)

Note that the reduction in G will reduce the existing budget deficit and it will increase the
right hand side of the equation. The reduction in IM will reduce the current account deficit
will reduce the right hand side of the equation. But between the two the fall in G will have a
bigger effect. So overall the right hand side of the equation is still bigger. Therefore at the
original interest rate ro, for I to remain constant private savings must fall. For private savings
to fall, income (Y) must fall. From here we can conclude at the same original interest rate,
ro, the new flatter IS curve must be to the left of the original IS curve.
















Whether you draw the new IS curve cutting the original IS curve or not is not an issue here.
The main thing is that your diagram must show that at the original interest rate, ro, the new
IS curve must be to the left of the original IS curve. Now that we know how to draw the new
IS curve in relation to the original one we can then apply it to our model which is an open
economy without capital mobility and a fixed exchange rate.











Y Yo
A
ISo(Go,to,EoPo*/Po, m1)
ro
LMo(Mo,Po)
r
IS1(G1,to,EoPo*/Po, m1)
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 40



















(Please note that this is indeed a unique question in that we should not be starting at an
initial long run equilibrium like point A. If we started off at point A there would be no way
that we will be able to show the current account deficit that is mentioned in the question.
So we are actually at a point to the right of A e.g A) Since this is the model that we are
looking at, the governments policy will not just affect the IS curve but it will also affect the
NX=0 line since there is a reduction in imports. So we also need to shift the NX=0 line to the
right. The economy is at B in the short run and is having a current account surplus (and
therefore an excess supply of foreign currency). In a fixed exchange rate system, the central
bank will buy up the excess supply of foreign currency. This increases the countrys reserves
and money supply and shifts the LM down. The new long run equilibrium is at C at a higher
income level and lower interest rate.

(c) What will be the effects of the proposed policy on an economy where there is
perfect capital mobility and a fixed exchange rate regime?
(d) Would your answer to (C) change had there been a flexible exchange rate regime?
















Y Yo
A
ISo(Go,to,EoPo*/Po, m1)
ro
LMo(Mo,Po)
IS1(G1,to,EoPo*/Po, m1)
r
NXo=0(EoPo*/Po)
A
B
r1
NX.=0(EoPo*/Po)
r2
C
LM1(M1,Po)
Y2
Y1
Y
ro=ro*
Yo
A
BOP
ISo(Go,To,EoPo*/Po,m1)
LMo(Mo,Po)
r
IS1(G1,To,EoPo*/Po,m1)
B
r1
Y1
LM1(M1,Po)
C
Y2
IS2(G1,To,E1Po*/Po,m1)
=D
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 41

When the IS shifts left and becomes flatter due to the change in the governments policy,
the economy moves to B in the short run. At B, domestic interest rate is lower than foreign
interest rate and this causes a capital outflow from the country. An excess demand for
foreign currency result. In a fixed exchange rate system: the central bank will sell foreign
currency. This reduces the countrys reserves and money supply and shifts the LM up. The
new long run equilibrium is at C at a lower output or income level. In a flexible exchange
rate system, the excess demand for foreign currency causes E, the nominal exchange rate to
increase. The domestic currency depreciates and this will increase the countrys NX as its
exports are now cheaper and imports have become more expensive. The increase in its NX
shifts the IS right and the economy will return to its original position at A(=D) with no
change in income.

Extra Question
1. As a result of an increase in labour productivity, the economy experiences a sharp
increase in purchases of local firms by foreign buyers. A local think tank (AskUs)
suggested in a newspaper article that the benefits of the increase in productivity
would be eroded unless the government abandoned its flexible exchange rate policy.
The economy is an open economy with perfect capital mobility. 2007 prelim

(a) Analyse the changes in the case of flexible exchange rate;
(b) Analyse the changes in the case of a fixed exchange rate;
(c) Discuss the claim of the AskUs think tank.
Suggested Answer
Points to note: Increase in labour productivity first thought that comes to mind is that
more output will be produced which means an increase in potential output. So if we first
take a look at what happens in the labour market:


















This increase in the potential output due to the increase in labour productivity will be
reflected in the AD-AS diagram as shown below.
W/P
L
SL
DL = MPL
(W/P)o
Lo L1
A
The increase in labour
productivity shifts the DL curve
to the right. And at the same
real wage (W/P)o, output has
increased (area under the MPL
curve gives us the total
output). Ultimately, given the
excess demand for labour at
the original real wage, money
wage and hence real wage will
increase to (W/P)1
DL = MPL
(W/P)1
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TCC Introduction to Economics 2011/12 Page 42































The increase in productivity shifts the SAS right to SAS1(Wo) and the subsequent increase in
money wage will shift the SAS to SAS2(W1). Overall effect is that price falls to P1. The fall in
domestic price will increase the supply of liquid assets and therefore shift the LM down to
LM1. The new equilibrium is at B, at a higher output level Y1 and a lower price (P1) and
lower interest rate (r1).

(a) Analyse the changes in the case of flexible exchange rate;
(Model is open economic and perfect capital mobility)

The first set of diagram shows what happens in an open economy with perfect capital
mobility when labour productivity alone increases. I have removed SAS1 from this diagram
below so that we do not have too many lines to complicate the diagram. But note that this
is not the only thing that is changing in the question. We were also told that there is an
increase in purchases of local firms by foreign firms. In order not to complicate our analysis I
will first use the diagrams to illustrate what happens when labour productivity alone
increases and once thats done move on to make further changes to the diagram to show
the second change.


r
Y
LM(Mo,Po)
IS(Go,To)
ro
Yo
P
Y
SAS(Wo)
AD(Go,To,Mo)
Po
A
Yo
A
SAS1(Wo)
SAS2(W1)
P1
B
Y1
Y1
LM(1Mo,P1)
r1 B
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 43





























Let me just briefly repeat what happened so that we can go step by step to draw the
diagram. The increase in labour productivity we saw shifted the SAS to SAS2 (1
st
change) and
brought about a fall in domestic price to P1. The fall in price in turn increased the supply of
liquid assets and therefore shifted the LM down AND (since we are looking at an open
economy we must not forget that the change in domestic price will also affect the real
exchange rate) it also lowered the real exchange rate. As domestic goods are now relatively
cheaper the country will therefore enjoy an increase in NX and this now shifts the IS to the
right (2
nd
change) (only a movement along the AD as price is on the axis of the diagram). So
the economy is at B when there is an increase in labour productivity. (So all the red lines
show what happens when productivity increase).

I am going to reproduce this diagram again below so that I can now add in the effect of an
increase in purchase of local firms by foreign buyers. This change will be shown in blue. In
the exam you need to only draw one set of diagram and do all the changes but remember
that you must explain what you are doing).






r
Y
LM(Mo,Po)
IS(Go,To,EoPo*/Po)
ro
Yo
P
Y
SAS(Wo)
AD(Go,To,EoPo*/Po,Mo)
Po
A
Yo
A
SAS2(W1)
P1
B
Y1
Y1
LM1(Mo,P1)
B
BOP
1
2
2
IS1(Go,To,E1Po*/Po)
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 44






























What happens when in addition to the above, the economy experiences a sharp increase in
the purchase of local firms by foreign buyers. This tells us that there is capital inflow into the
country and therefore we now have an excess supply of foreign currency. In a flexible
exchange rate system, the excess supply of foreign currency would result in an appreciation
of the domestic currency which then reduces the countrys exports and increase her imports
i.e. its NX falls. This shifts both the IS and AD left causing price to fall (3
rd
change). The fall in
price will once again increase the supply of liquid assets and shift the LM down (4
th
change).
Note that with the shift of the IS, AD and LM (indicated by all the blue lines), the economy
has moved to C. Domestic interest rate (r1) is now lower than foreign interest rate. Capital
will flow out of this domestic country and there is now an excess demand for foreign
currency. In a flexible exchange rate system, E, the nominal exchange rate, increases
meaning that the currency depreciates. This in turn increases the countrys and shifts the IS
and AD right. The increase in AD causes price to rise and this will reduce the supply of liquid
assets and shift the LM up (conclusion IS and AD shift right and LM shift up). Taking all these
changes into account, the economy will finally be at B (=D) in both diagrams (note that I
have changed the notations for the IS, AD when the economy moves back to B(=D).




r
Y
LM(Mo,Po)
IS(Go,To,EoPo*/Po)
ro
Yo
P
Y
SAS(Wo)
AD(Go,To,Eo,Po*,Mo)
Po
A
Yo
A
SAS2(W1)
P1
B
Y1
Y1
LM1(Mo,P1)
B
BOP
1
2
3
2
IS1(Go,To,EoPo*/P1)
IS2(Go,To,E1Po*/P1)
3
3
LM2(Mo,P2)
r1
C
C
Y2
Y2
AD1(Go,To,E1,Po*,Mo)
P2
= AD2(Go,To,E2,Po*,Mo)
4
= IS3(Go,To,E2Po*/P1)
4
=D
=D
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 45

(b) Analyse the changes in the case of fixed exchange rate;
(Model is open economic and perfect capital mobility)





























If the exchange rate is fixed, like before when we are just looking at the effect of an increase
in labour productivity, all the changes are the same and shown in red. Now lets bring in the
capital inflow that arises when foreign buyers buy up local firms. Recall that it resulted in an
excess supply of foreign currency. In a fixed exchange rate system, the central bank will buy
up the excess supply of foreign currency. The countrys reserves and money supply
therefore increases causing the LM to shift down and AD to shift to the right. But remember
that when AD increases, price will rise and this will reduce the supply of liquid assets
somewhat. The position of LM2 incorporates both the increase in the supply of liquid assets
as well as the increase in price to P2. Taking these changes into account the economy is now
at C in the short run.

As domestic interest rate is now lower than international interest rate, capital will now flow
out of the country since domestic assets have become less attractive. There is now an
excess demand for foreign currency. In a fixed exchange rate system, the central bank will
sell foreign currency. This reduces the countrys reserves and money which therefore shifts
the LM up. The reduction in the supply of liquid assets causes interest rate to rise therefore
reducing investment which causes the AD to shift left. The economy will go back to B when
the LM shifts up and AD shifts left.
r
Y
LM(Mo,Po)
IS(Go,To,EoPo*/Po)
ro
Yo
P
Y
SAS(Wo)
AD(Go,To,Eo,Po*,Mo)
Po
A
Yo
A
SAS2(W1)
P1
B
Y1
Y1
LM1(Mo,P1)
B
BOP
1
2
2
IS1(Go,To,E1Po*/Po)
LM2(M1,P1)
3
AD1(Go,To,Eo,Po*,M1)
r1 C
P2
C
Y2
Y2
STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7 ONLY

TCC Introduction to Economics 2011/12 Page 46


Conclusion: Whether we are looking at the flexible or the fixed exchange rate system, note
that our conclusions are the same as we finally end up at B, at a higher output level and
lower prices. This therefore means that the local think tanks views were wrong.