The Multiplier, Growth and Money and Banking: Economics 9708 (Cambridge International AS & A Level)

Money performs several distinct functions in an economy: medium of exchange, unit of account, store of value, and standard of deferred payment.

Which of the following best illustrates money acting as a store of value?

Astera is an open economy with a government sector. Economists estimate that, out of every additional $1 of national income earned, households save $0.20 (so the marginal propensity to save, $MPS = 0.2$), pay $0.10 in tax (so the marginal rate of tax, $MRT = 0.1$), and spend $0.10 on imported goods (so the marginal propensity to import, $MPM = 0.1$).

(a) Calculate the marginal propensity to consume ($MPC$) for Astera. [2]

(b) Calculate the value of the multiplier, $k$, for Astera's economy, using $k = \dfrac{1}{MPS+MRT+MPM}$. [2]

(c) The government of Astera increases its spending by $40 million. Calculate the resulting change in Astera's equilibrium national income, $\Delta Y$. [3]

(d) Explain, using the concept of leakages (withdrawals) from the circular flow of income, why a rise in Astera's marginal propensity to import ($MPM$) would reduce the value of the multiplier calculated in (b). [3]

The table shows estimates of actual real GDP and potential real GDP for the economy of Norvale over four consecutive years.

(a) Calculate Norvale's output gap in each year, expressed as a percentage of potential real GDP. [4]

(b) State, with a reason based on your answer to (a), in which year Norvale first experienced a negative output gap, and explain what a negative output gap indicates about how fully the economy is using its resources. [3]

(c) Using the concept of the business (trade) cycle, identify which phase of the cycle Year 2 and Year 4 most likely represent, justifying your answer with reference to the output gaps you calculated. [2]

(d) Explain how one automatic stabiliser would tend to reduce the fall in Norvale's actual real GDP between Year 3 and Year 4, without any new decision being made by the government. [2]

Bank Celoria is one of the commercial banks operating in the country of Larenta, where the central bank requires all commercial banks to hold reserves equal to 8% of deposits (a reserve ratio of 0.08). A new customer deposits $5 million in cash into an account at Bank Celoria.

(a) State two functions of a commercial bank, other than accepting deposits from customers. [2]

(b) Calculate the bank (credit) multiplier for Larenta's banking system. [2]

(c) Assuming the banking system as a whole lends out the maximum amount possible at each stage, calculate the maximum eventual increase in Larenta's money supply that could result from the initial $5 million deposit. [2]

(d) Explain how the process of credit creation calculated in (c) actually takes place, referring to what commercial banks do with deposits over and above the required reserve ratio. [3]

(e) State one reason why, in reality, the increase in the money supply is likely to be smaller than the maximum calculated in (c). [2]

According to the Keynesian theory of liquidity preference, households and firms hold money rather than other assets (such as bonds) for three main motives.

(a) Explain what is meant by the transactions motive, the precautionary motive and the speculative motive for holding money. [3]

(b) Under liquidity preference theory, the demand for money is drawn against the rate of interest, while in the short run the supply of money is fixed by the central bank and banking system independently of the interest rate. Explain how the equilibrium rate of interest is determined in the money market, and what would tend to happen to the interest rate if the actual rate were currently below this equilibrium level. [3]

(c) A country's central bank increases the money supply while the demand for money is unchanged. Assess the likely effect of this on the equilibrium rate of interest, and discuss one reason why the actual fall in the interest rate might be smaller than the liquidity preference model predicts. [3]

(d) State one way in which the loanable funds theory of interest rate determination differs from the liquidity preference (Keynesian) theory used in (b). [2]

In the labour market, disequilibrium unemployment exists when the real wage rate is above the level that would clear the market, so that the quantity of labour supplied exceeds the quantity of labour demanded. Equilibrium unemployment, by contrast, can exist even when the labour market has cleared (real wage = market-clearing wage), because it takes time for some workers to move between jobs or find suitable work.

Which of the following is the best example of disequilibrium unemployment caused by a fall in aggregate demand for labour (demand-deficient / cyclical unemployment)?

Kestria is a small open economy with a government sector. Planned aggregate expenditure (AE) is made up of consumption (C), investment (I), government spending (G) and net exports (X − M), where:

$C = 60 + 0.7Y \qquad I = 150 \qquad G = 200 \qquad X = 130 \qquad M = 40 + 0.1Y$

(all values in $ million), and Y is national income ($ million).

(a) Show that planned aggregate expenditure simplifies to $AE = 500 + 0.6Y$, and use this to calculate Kestria's equilibrium level of national income (where $Y = AE$). [4]

(b) State the value of the multiplier implied by this model, and show that it is consistent with the $0.6Y$ term in your answer to (a). [2]

(c) Investment in Kestria rises by $50 million, with autonomous consumption, government spending and exports unchanged. Use the multiplier from (b) to calculate the new equilibrium level of national income. [2]

(d) State one reason why the equilibrium level of national income calculated in (a) might not represent Kestria's full-employment level of national income. [2]

Economists in Bregmoor observe that as the economy entered a downturn phase of the business cycle, actual real GDP fell increasingly below its potential level, and the unemployment rate rose sharply. Eighteen months after real GDP growth resumed in the recovery phase, unemployment remained noticeably higher than it had been before the downturn began.

(a) Explain how a downturn in the business cycle can cause disequilibrium unemployment to emerge in the labour market. [4]

(b) Explain why disequilibrium (demand-deficient) unemployment might persist in Bregmoor even after real GDP begins growing again during the recovery phase. [3]

(c) Distinguish between disequilibrium unemployment and equilibrium unemployment, and explain why some unemployment could still be recorded in Bregmoor even at the peak of a subsequent boom. [4]

Solmark's central bank analyses inflation using the quantity theory of money, $MV = PT$, where $M$ is the money supply, $V$ is the velocity of circulation, $P$ is the general price level, and $T$ is the real volume of transactions (output) in the economy. In Year 1, Solmark's money supply is $800 million and the velocity of circulation is 5 times per year.

(a) Calculate the money value of transactions, $PT$, in Solmark in Year 1. [2]

(b) In Year 2, the central bank increases the money supply by 10% to $880 million, while the velocity of circulation stays at 5. Assuming, as the (strict) quantity theory of money does, that the real volume of transactions $T$ is unchanged, calculate the new value of $PT$ and hence the percentage change in the price level $P$. [3]

(c) Explain, with reference to $MV=PT$, why the (strict) quantity theory of money predicts a direct, proportional relationship between growth of the money supply and the rate of inflation. [3]

(d) State one reason why, in reality, a 10% increase in the money supply might cause the price level to rise by less than 10%. [2]

The multiplier is often presented as a single, constant value, $k = \dfrac{1}{MPS+MRT+MPM}$, which is then applied to any change in a component of aggregate demand to predict the resulting change in equilibrium national income.

Which of the following is the most significant limitation of using a single, constant multiplier value in this way to predict the effect of a change in government spending on the real economy?