Revision for Semester Test 2 (2024)

Chapter 5

1.
a) True
Proof:
MV = PY
V = PY/M
V = 18000/9000
V=2
k = 1/V = 0.5

M(1/k) = PY
9000 (1/k) = 18000
See p. 100 in our textbook

b) True
Proof:
Theory
Wakanda: k is large, V is small, money changes hands infrequently
Ghudaza: k is small, V is big, money changes hands frequently (often)

Assume PY = 18 000; V = 2 in Wakanda, V = 10 in Ghudaza

Wakanda: k = ½ = 0.5
Ghudaza: k = 1/10 = 0.1

Wakanda: M(2) = 18 000; 2M = 18 000; M = 9 000

Ghudaza: M(10) = 18 000; 10M = 18 000; M = 1 800

c) True
See your Worksheet for a discussion of Keynes’ motives for holding money; p. 101 in
your textbook and pp. 597 – 600 of Parkin’s textbook

d) True
See your Worksheet for a discussion of Keynes’ motives for holding money.
Note: there is an inverse relationship between interest rates and bond prices. When
interest rates decrease, bond prices increase.
If interest rates are currently low (below their typical level), people will anticipate that
interest rates will rise in the future. If interest rates rise, bond prices will fall. So,
individuals expect bond prices to fall in the future.
Given this expectation of a future fall in bond prices, individuals may prefer to hold
money rather than to buy bonds. They speculate that they can buy bonds at a lower
price in the future when bond prices drop.
So, the speculative motive arises because people want to avoid predicted losses from
holding shares and bonds that are expected to fall in value!

e) False
See your Worksheet for a discussion of Keynes’ motives for holding money and pp. 597
– 600 of Parkin’s textbook

f) True
See your Worksheet for a discussion of Keynes’ motives for holding money.
 If production decreases it implies a decrease in income and therefore a decrease in the
demand for precautionary balances.

g) True
Implied in your textbook. Also see pp. 597 – 600 of Parkin’s textbook

h) True
See your worksheet’s questions
While striving for a zero-inflation rate might theoretically minimise shoe-leather costs, in
reality, it’s a challenging target to maintain due to factors like productivity growth and
supply shocks. Increases in productivity can lead to increased supply of goods and
services, which can put downward pressure on prices (deflation). To avoid deflation,
central banks may aim for a low, positive inflation rate. These are unexpected events
that suddenly change the supply of a product or commodity, affecting its price. For
example, a natural disaster might cause a spike in food prices. These unpredictable
factors make it difficult to maintain a constant zero inflation rate.

i) True
See pp. 117 – 118 of your textbook

2. Value of money = 1/P

So, P = 1/0.125
So, P = 8
MV = PY
80 000V=8 * 60 000
80 000V = 480 000
V = 480 000/80 000
V=6

3. Set Ld = Ls
2 400 – 4w = 20w
2 400 = 24w
w = 100
Substitute w = 100 into either the Ld or Ls equation.
Ls = (20 * 100) = 2 000
Y = 5*(1001/3)*(8002/3) = 2 000
Md/P = 240 + 0.45Y – 1 400i
Substitute. Md/P = (240 + 0.45(2 000) – 1 400(0.1)) = (240 + 900 - 140) = 1 000 (Real
money demand)
Nominal money demand = 1 000 * 4 = 4 000
MV = PY
4 000V = (4 * 2 000)
4 000V = 8 000
V=2

4.
𝑌𝑌 0.4𝑌𝑌
= 0.5
𝑉𝑉 𝑖𝑖
𝑖𝑖 0.5 𝑌𝑌 = 0.4𝑌𝑌𝑌𝑌
𝑖𝑖 0.5 𝑌𝑌
= 0.4𝑉𝑉
𝑌𝑌
𝑖𝑖 0.5
= 0.4𝑉𝑉
1
0.5
𝑖𝑖 = 0.4𝑉𝑉
 2.5𝑖𝑖 0.5 = 𝑉𝑉
2. 5(9)0.5 = 𝑉𝑉
7.5 = 𝑉𝑉

5. Answer: C
Actual inflation rate: (162 – 150)/150 * 100 = 8%
Expect inflation rate: 2%
Loan repayment: 1800/15000 = 12%
Ex post (actual) real interest rate: 12 – 8 = 4%
Ex ante (expected) real interest rate: 12 – 2 = 10%

6. Answer: C
Actual (ex post) Inflation rate = (142.1 – 140)/140 * 100 = 1.5%
But, expected (ex ante) inflation rate = 1%
Loan = 720 / 12 000 * 100 = 6%
Ex post real interest rate = i – actual inflation rate: 6 – 1.5 = 4.5%
Ex ante real interest rate = i – expected inflation rate: 6 – 1 = 5%

7. Production: 8 * (243)0.2 * (3 125)0.8

Production: 8 * 3 * 625
Production: 15 000

Goods market equilibrium condition: Y = C + I + G (closed economy)

15 000 = [400 + 0.8(15 000 – 3 000)] + [500 – 20r] + 5 500
15 000 = [400 + 0.8(12 000)] + [500 – 20r] + 5 500
15 000 = [400 + 9 600] + [500 – 20r] + 5 500
15 000 = 10 000 + 500 – 20r + 5 500
20r = 10 000 + 5 500 + 500 – 15 000
20r = 1 000
r = 5 (r = 5%)

w = W/P = MPL
MPL = 0.8 * 8 * (243)0.2 * (3 125)0.8-1
MPL = 6.4 * 3 * 0.2
MPL = 3.84

Aggregate price level

(M/P)d = (M/P)
0.05Y – 2 200r = 2 560/P
0.05(15 000) – 2 200(0.05) = 2 560/P
750 – 110 = 2 560 / P
640 = 2 560/P
640P = 2 560
P = 2 560/850
P=4

Nominal wage = W = w * P
Nominal wage = 3.84 * 4
Nominal wage = 15.36

Chapter 6

1. Answer: A
See Chapter 6’s worksheet
2. Answer: B
See Chapter 6’s worksheet

3. Answer: A

4.
a) To calculate the trade balance (X - Z):
Merchandise exports 967 500
Add: Net gold exports 59 500
Less: Merchandise imports 1082000
TRADE BALANCE -55 000

b) To calculate the balance on the current account:

TRADE BALANCE -55 000
Add: Service receipts 198 000
Less: Payments for services 200 300
Plus: Income receipts 97 800
Less: Income payments 199 000
Plus: Current transfers -33 000
BALANCE ON THE CURRENT ACCOUNT -191 500

c) To calculate the balance on the financial account:

Net direct investment -51 200
Net portfolio investment 122 600
Net financial derivatives 4 900
Net other investment 119 000
Reserve assets 14 000
BALANCE ON THE FINANCIAL ACCOUNT 209 300

d) To calculate the unrecorded transactions:

BALANCE ON THE CURRENT ACCOUNT -191 500
Plus: Capital transfer account 250
Plus: BALANCE ON THE FINANCIAL ACCOUNT 209 300
Plus: UNRECORDED TRANSACTIONS 18 050

(Unrecorded transactions ensure that your BoP balances!)

Balance on the current a/c + Capital transfer a/c + unrecorded transactions must give
us the save value (with the opposite sign) as the Balance on the financial a/c

5. Answer: B
Explanation: PPP holds → epsilon = 1 → currency does not change in real terms.
Aloeburg has same real interest rate but lower nominal interest rate → must have lower
inflation → currency in Aloeburg will become stronger over time = appreciate in nominal
terms.

6. Answer: C
Real GDP is given by 𝒀𝒀=(𝑲𝑲,𝑳𝑳)= (1000.5)* (9000.5) = 1*10*30 = 300
In order to find the closed-economy interest rate, we set national saving (𝑺𝑺) equal
to investment (𝑰𝑰).
C = 75 + 0.5(300 – 50)
C = 75 + 0.5(250)
C = 200
 National saving is 𝑺𝑺=𝒀𝒀−𝑪𝑪−𝑮𝑮
National saving = 300 – 200 – 60 = 40.
S=I
40 = 80 - 4r
4r = 80 – 40
4r = 40
r = 10

Investment is still given by 𝑰𝑰= 80 – 4r (but, opened up to trade so, r = 5)

I = 80 – 4(5) = 60
This implies that net exports and net capital outflows are now given by 𝑵𝑵𝑵𝑵 = 𝑺𝑺−𝑰𝑰
NX = 40 – 60.
NX = -20.
Other way of calculating the trade balance
NX = Y – C – I – G
NX = 300 – 200 – 60 – 60
NX = -20
And the equilibrium real exchange rate
NX = 20 - 20ε
-20 = 20 - 20ε
20ε = 20 + 20
20ε = 40
ε=2
∈∗ 𝑃𝑃∗ 2∗ 11
The nominal exchange rate is: 𝑒𝑒 = = = 2.2
𝑃𝑃 10

7. Answer: B
The budget deficit has decreased from -R102 to -R31
Opposite of Figure 6-9 on p. 143
So, an increase in saving increases the supply of Sokovian Rands which reduces the
real exchange rate (cause the real exchange rate to depreciate) and causes net exports
to increase.

8. Answer: D

Chapter 7

1. Answer: A
See your textbook

2. While the accepted answer is B, there is some argument for A, too. Answer: B
See your textbook

3.
∆𝑦𝑦 50 − 60 −10
= = = −10
∆𝑥𝑥 6−5 1
Y = mx + c
w = aL + b
60 = -10(5) + b
60 = -50 + b
110 = b
w = -10Ld + 110
10Ld = 110 – w
Ld = 11 – 0.1w
 ∆𝑦𝑦 50 − 60 −10
= = = 10
∆𝑥𝑥 4−5 −1

Y = mx + c
w = aL + b
60 = 10(5) + b
60 = 50 + b
10 = b

w = 10Ls + 10
-10Ls = -w + 10
Ls = 0.1w - 1

Equilibrium: Ld = Ls
11 – 0.1w = 0.1w – 1
12 = 0.2w
w = 60

Ls – Ld = surplus
0.1w – 1 – (11 – 0.1w) = 4
0.1w – 1 – 11 + 0.1w = 4
0.2w = 4 + 1 + 11
0.2w = 16
w = 80

4. Answer: D
Equilibrium in the union sector:
80 – 0.5W = 1.5W
-1.5W – 0.5W = - 80
-2W = -80
W = 40
L = 60
Equilibrium in the non-union sector:
160 – 2.5W = 1.5W
-2.5W – 1.5W = -160
-4W = -160
W = 40
L = 60

At the higher wage of R60.00 per hour,

LdU = 80 – 0.5(60) = 50 per day.
LsU = 1.5(60) = 90
Surplus = 90 – 50 = 40

If the 40 workers take non-unionised jobs, the non-union wage rate would fall. The non-
union supply curve becomes LsN = 1.5W + 40
160 – 2.5W = 1.5W + 40
-2.5W – 1.5W = 40 - 160
-4W = - 120
W = 30
L =85
 𝑛𝑛𝑛𝑛.𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑤𝑤ℎ𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 5 250
5. 1st quarter: 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = ∗ 100 = (5 250+29 750)
∗
𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓
5 2500
100 = (35 ∗ 100 = 15%
000)
2 quarter:
nd

fU = 0.06 * 5 250 = 315

SE = 0.2 * 29 750 = 5 950
𝑛𝑛𝑛𝑛.𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑤𝑤ℎ𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
2nd quarter: 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = ∗ 100 =
𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓
5 250+5 950−315 10 885
(5 250+29 750)
∗ 100 = (35 000)
∗ 100 = 31.1%
% change = (new – old)/old * 100 = 107.33%

6.

Exit #Unemployed at # of # months for

Duration rate start of month # of exiters stayers duration
1 0.6 386250 231750 154500 231750
2 0.3 154500 46350 108150 92700
3 0.3 108150 32445 75705 97335
4 0.2 75705 15141 60564 60564
5 0.25 60564 15141 45423 75705
6 1 45423 45423 0 272538

830592 Total months unemployed

75 705 + 272 538 Long-term unemployed
=348 243 months (five or more)
41.93% Long-term unemployment %
Note: if long-term unemployment was defined as spells of unemployment that last four
or more months the % would be 49.22%.

7. Before the price floor

150-4Ld = 2Ls + 30
150 – 30 = 2L + 4L
120 = 6L
L = 20
Substitute L = 20 into the demand or supply equation.
w = 70

CS = ½ * b * h
CS = ½ * (20 – 0) * (150 – 70)
CS = ½ * 20 * 80
CS = 800
After the price floor
110 = - 4Ld + 150
4Ld = 150 – 110
4Ld = 40
Ld = 10

110 =2Ls + 30
110 – 30 = 2Ls
80 =2Ls
Ls = 40

New CS
½*b*h
½ * (10 – 0) * (150-110)
½ * 10 * 40
200

Difference between old and new CS = 800 – 200 = 600

What price would the seller be willing to sell the quantity demanded of 10 units at?
Substitute Ld=10 into the supply equation
Ls = 2(10) + 30
Ls = 50
Chapters 8, 9.1 and 10.3

1. What is the per-worker production function, y = f(k)?

Y = 10K0.5L0.5
𝑌𝑌 10𝐾𝐾0.5 𝐿𝐿0.5
=
𝐿𝐿 𝐿𝐿
𝑦𝑦 = 10𝐾𝐾 0.5 𝐿𝐿0.5−1
𝑦𝑦 = 10𝐾𝐾 0.5 𝐿𝐿−0.5
10𝐾𝐾 0.5
𝑦𝑦 = � �
𝐿𝐿
𝑦𝑦 = 10𝑘𝑘 0.5
Determine the steady state values of capital per worker, k, and output per worker, y.
Steady state requires that the Δk (change in the capital intensity) = 0.
We know that δ = 0.03, n = 0.02 and that s = 0.05. We know that the
Δk = sf(k) – (δ + n)k
And since Δk = 0, then
0 = sf(k*) – (δ + n)k*
sf(k*) = (δ + n)k*
Substituting in our values for f(k), k, δ and n we have
0.05(10k*0.5) = (0.03 + 0.02)(k*)
0.5k*0.5 = 0.05k* (Divide both sides by 0.05 & get…)
10k*0.5 = k*(Divide both sides by k*1/3 & get…)
10 = k*(1 – 0.5)
10 = k*(0.5) (get rid of the ½ (i.e. 0.5) by using the inverse value)
102 = k*
100 = k*
1 1 1
𝑠𝑠𝑠𝑠 �1−𝛼𝛼�
∗
0.05 ∗ 10 �1−0.5� 0.5 �0.5�
𝑘𝑘 = � � = � � =� � = 100
(𝑛𝑛 + 𝑑𝑑 (0.02 + 0.03 (0.05
Output per worker at the steady state = 𝑦𝑦 = 𝑓𝑓(𝑘𝑘) = 𝑦𝑦 = 10𝑘𝑘 0.5 = 𝑦𝑦 = 10(100)0.5
Output per worker at the steady state =10(1000.5) = 100
 i* = sy*
i* = 0.05(100) = 5

c* = (1 – s)y*
c* = (1 – 0.05)*100
c* = 0.95 * 100
c* = 95

y* = c* + i*
100 = 95 + 5

2. Answer: D

What is the per-worker production function, y = f(k)?

Y = 2K0.5L0.5
𝑌𝑌 2𝐾𝐾 1/2 𝐿𝐿0.5
=
𝐿𝐿 𝐿𝐿
𝑦𝑦 = 2𝐾𝐾 0.5 𝐿𝐿0.5−1
𝑦𝑦 = 2𝐾𝐾 0.5 𝐿𝐿−0.5
2𝐾𝐾 0.5
𝑦𝑦 = � �
𝐿𝐿
𝑦𝑦 = 2𝑘𝑘 0.5

Determine the steady state values of capital per worker, k, and output per worker, y.
Steady state requires that the Δk (change in the capital intensity) = 0.
We know that δ = 0.1, n = 0.0 and that s = 0.2. We know that the
Δk = sf(k) – (δ + n)k
And since Δk = 0, then
0 = sf(k*) – (δ + n)k*
sf(k*) = (δ + n)k*
Substituting in our values for f(k), k, δ and n we have
0.2(2k*0.5) = (0.1 + 0)(k*)
0.4k*0.5 = 0.1k* (Divide both sides by 0.1 & get…)
4k*0.5 = k*(Divide both sides by k*1/2 & get…)
4 = k*(1 – 0.5)
4 = k*(0.5) (get rid of the ½ (i.e. 0.5) by using the inverse value)
42 = k*
16 = k*

𝑠𝑠𝑠𝑠 � 1 � 1
0.2 ∗ 2 �1−1/2�
𝑘𝑘 ∗ = ( ) 1−𝛼𝛼 = ( ) = 16
𝑛𝑛 + 𝛿𝛿 0 + 0.1

y* = 2k0.5
y* = 2(16)0.5
y* = 8
& that c* = (1 – s)y* = (1 – 0.2) * 8 = 0.8 * 8 = 6.4
i = sf(k*) = 0.2(8) = 1.6

Recall: SparrowVille’s policymakers seek to identify the steady state that maximises
consumption and have tasked you with determining this point
The saving function, denoted as s, equals 0.2. The population growth rate, labelled as
n, stands at 0, while the depreciation rate, d, is 0.1.
Per-worker production function:
1
𝑦𝑦 = 2𝑘𝑘 2
 𝑀𝑀𝑀𝑀𝑀𝑀 = 𝛿𝛿 (𝑎𝑎𝑎𝑎 𝑡𝑡ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑖𝑖𝑖𝑖 𝑛𝑛𝑛𝑛 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔ℎ)
𝑀𝑀𝑀𝑀𝑀𝑀 = 0.1
In order to proceed, we need to calculate MPK. In mathematical terms, this is the first
derivative of the production function with respect to k, i.e.,
1 1
𝑀𝑀𝑀𝑀𝑀𝑀 = ∗ 2𝑘𝑘 2−1
2
1
𝑀𝑀𝑀𝑀𝑀𝑀 = 1𝑘𝑘 2−1

𝜕𝜕𝜕𝜕 1
𝑀𝑀𝑀𝑀𝑀𝑀 = = 1/2
𝜕𝜕𝜕𝜕 𝑘𝑘
1
0.1 = 1/2
𝑘𝑘
1
0.1 ∗ 𝑘𝑘 2 = 1
0.1𝑘𝑘1/2 = 1
1 1
𝑘𝑘 2 =
0.1
1
𝑘𝑘 2 = 10

Now, square the answer (inverse of ½)

∗
𝑘𝑘𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 = 100
Remember: if k* ≠ k*gold, then social welfare is not maximised ⇒ s has to be modified!
(In this case it has to be increased!)

1 1
𝑠𝑠𝑠𝑠 �1−𝛼𝛼� 0.2 ∗ 2 �1−1�
𝑘𝑘 ∗ = � � = � � 2 = 16
𝑛𝑛 + 𝛿𝛿 0 + 0.1
𝛼𝛼𝛼𝛼 � 1 � 1
0.5 ∗ 2 �1−1/2
∗ �
𝑘𝑘𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 =( ) 1−𝛼𝛼 = ( ) = 100
𝑛𝑛 + 𝛿𝛿 0 + 0.1

3. Per-worker production function:

𝑌𝑌 𝐾𝐾 0.5 𝐿𝐿0.5
=
𝐿𝐿 𝐿𝐿
𝑦𝑦 = 𝐾𝐾 0.5 𝐿𝐿0.5−1
𝑦𝑦 = 𝐾𝐾 0.5 𝐿𝐿−0.5
𝐾𝐾 0.5
𝑦𝑦 = � �
𝐿𝐿
𝑦𝑦 = 𝑘𝑘 0.5

Determine the steady state values of capital per worker, k, and output per worker, y.
Steady state requires that the Δk (change in the capital intensity) = 0.
We know that δ = 0.05, n = 0.01 and that s = 0.4. We know that the
Δk = sf(k) – (δ + n)k
And since Δk = 0, then
0 = sf(k*) – (δ + n)k*
sf(k*) = (δ + n)k*
Substituting in our values for f(k), k, δ and n we have
0.4(1k*0.5) = (0.05 + 0.01)(k*)
0.4k*0.5 = 0.06k* (Divide both sides by 0.06 & get…)
6.67k*0.5 = k*(Divide both sides by k*1/2 & get…)
6.67 = k*(1 – 0.5)
6.67 = k*(0.5) (get rid of the ½ (i.e. 0.5) by using the inverse value)
 6.672 = k*
44.49 = k*

𝑠𝑠𝑠𝑠 � 1 � 1
0.4 ∗ 1 �1−1/2�
𝑘𝑘 ∗ = ( ) 1−𝛼𝛼 = ( ) = 44.44 (𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)
𝑛𝑛 + 𝛿𝛿 0.01 + 0.05

𝑀𝑀𝑀𝑀𝑀𝑀 = 𝛿𝛿 + 𝑛𝑛
𝑀𝑀𝑀𝑀𝑀𝑀 = 0.05 + 0.01
𝑀𝑀𝑀𝑀𝑀𝑀 = 0.06
In order to proceed, we need to calculate MPK. In mathematical terms, this is the first
derivative of the production function with respect to k, i.e.,
𝑀𝑀𝑀𝑀𝑀𝑀 = 0.5𝑘𝑘 0.5−1

𝑑𝑑𝑑𝑑 0.5
𝑀𝑀𝑀𝑀𝑀𝑀 = = 0.5
𝑑𝑑𝑑𝑑 𝑘𝑘
0.5
0.06 = 0.5
𝑘𝑘
0.06𝑘𝑘 0.5 = 0.5
0.5
𝑘𝑘 0.5 =
0.06
𝑘𝑘 0.5 = 8.33
∗
𝑘𝑘𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 = 69.44

1 1
� 1�
∗
𝛼𝛼𝛼𝛼 �1−𝛼𝛼� 0.5 ∗ 1 1−
𝑘𝑘𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 =� � = � � 2 = 69.44
𝑛𝑛 + 𝛿𝛿 0.05 + 0.01

4. For income per person to grow, saving must exceed the steady-state level. In steady
state, saving (or investment) will be offset by depreciation and population growth.
𝑠𝑠𝑠𝑠(𝑘𝑘)=(𝑛𝑛+𝛿𝛿)𝑘𝑘
𝑠𝑠45k0.5=(𝑛𝑛+𝛿𝛿)225
Substituting into this equation the information given in the question, we have:
𝑠𝑠45×2250.5=(0.02+0.10)225
𝑠𝑠45x15=27
𝑠𝑠675=27
𝑠𝑠=0.04s
The steady-state rate of saving is 4%.
Thus, saving must exceed 4% for income per person to grow.

5. We know from Chapter 3 that, with a Cobb–Douglas production function, capital’s share
of income is α = MPK(K/Y). Rearranging this and plugging in the values established
above, we have:
MPK = α/(K/Y) MPK = 0.3/2.5
MPK = 0.12.
In the Golden Rule steady state, the marginal product of capital must be MPK = n + δ
MPK = 0.04 + 0.05
MPK = 0.09.
In the Golden Rule steady state, the marginal product of capital is 9%, whereas it is 12%
in the initial steady state. Hence, this economy needs to increase k to reach the Golden
Rule steady state.

6. Answer: B

7. Answer: D
 s
To calculate the ICOR (v), use the Harrod-Domar equation, g = , which can be
v
s 35% 0.35
rewritten as v = . So, 𝑣𝑣 = = = 4.0. Thus, the ICOR was about 4.0.
g 8.75% 0.0875

8. Answer: C

Long questions

Chapter 5

1. False. In a cashless society, there would be no shoe-leather costs (i.e., the cost of
inflation from reducing real money balances, such as the inconvenience of needing to
make more frequent trips to the bank), as there would be no cash balances on which to
economise. But menu costs would remain for anticipated inflation. The costs of
unanticipated inflation would remain as well: both the risk of wealth transfers plus
confusion in price signals.

2. Lenin was certainly right. There is no subtler, no surer means of overturning the existing
basis of society than to debauch the currency. The process engages all the hidden
forces of economic law on the side of destruction and does it in a manner which not one
man in a million is able to diagnose.

3. This statement is incorrect because in the long run an increase in the quantity of money
increases only the price level. Indeed, it increases the price level by the same
percentage. So if the SARB followed the advice and increased the quantity of money
by 100% (which doubles it), then in the long run the only effect is to increase the price
level by 100%.

4. The linkages among money, prices, and interest rates are interconnected, with changes
in one variable affecting the others. The Fisher effect describes how changes in inflation
impact nominal interest rates, which, in turn, affect the demand for money. This
feedback loop creates a dynamic relationship where changes in expected inflation can
influence both nominal interest rates and the demand for money, ultimately impacting
the price level in the economy. Monetary policymakers must consider these
relationships when formulating policy, as changes in the money supply can affect
inflation expectations, interest rates, and overall economic stability. Therefore,
understanding the Fisher effect and its implications is crucial for effective monetary
policy implementation.

5. Shoeleather Costs: To minimise holding onto rapidly devaluing currency, citizens of

Econonia likely withdrew smaller amounts of cash more frequently, increasing trips to
the bank and shifted towards using barter for everyday transactions, reducing reliance
on cash.
Menu Costs: Businesses likely contended with the constant need to adjust prices to
keep up with inflation, increasing menu printing and advertising costs and the difficulty
in accurately predicting future costs, potentially leading to inaccurate pricing and lost
profits.
Increased Variability of Relative Prices: Prices would not all rise at the same pace,
causing confusion:
Consumers struggled to compare prices effectively, making informed purchasing
decisions difficult.
Businesses with slower price adjustments might face temporary disadvantages
compared to those raising prices faster.
 Unintended Changes in Tax Liabilities: The tax system likely wasn't indexed to
inflation, resulting in people being taxed on a higher nominal income that did not reflect
the decrease in purchasing power. There might therefore have been potential tax
bracket changes due to inflated income levels, even if real income hadn't grown.
Confusion and Inconvenience: The ever-changing unit of account (currency) led to
difficulty in planning and budgeting due to the uncertain value of money over time. One
might have also have experienced and increase in the time and effort spent calculating
the true value of transactions due to inflation.
Arbitrary Redistributions of Wealth: Inflation significantly impacted wealth
distribution. Debtors benefited as they repaid loans with devalued currency, reducing
the real burden of their debt. Creditors lost purchasing power as they received loan
repayments worth less than what they loaned.

Chapter 6

Recall:
1. Britain and World:

Jamaica:
 The increase in British government taxation leads to an increase in world saving and
shifts the world national savings curve to the right, as the British level of public savings
increases. This effectively decreases the world interest rate, from r1* to r2*.
Since Jamaica is a small open economy, Jamaica’s Investment and National Savings
Curves do not shift. Thus, the shock causes excess demand in Jamica’s goods market
(i.e., loanable funds market). Consequently, investment in Jamica would increase (now
I(r2)*). Compared with the initial equilibrium, in the new equilibrium, neither aggregate
consumption or total saving in Jamaica has changed.
In the market for foreign exchange, there is a decrease in the quantity of NCO (S – I).
As such, the (S – I) curve would shift to the left. This decreases the net capital outflows
and decreases Jamaica’s trade surplus. To obtain this change in the trade surplus, the
real exchange rate in the small open economy would have to rise (increasing the real
exchange rate). The appreciation of the Jamaican currency also decreases NX.

2. The government budget deficit has increased between 2022 and 2023. The shock
causes excess demand on the goods market (i.e., the loanable funds market), and a
shift of the national saving curve to the left.
 The reduction in saving lowers (S – I) as there will be a reduction in the supply of
Sokovia’s currency to be exchanged into foreign currency. This shift causes the real
exchange rate to increase (i.e., there has been an appreciation of the Sokovian
currency). Due to this appreciation in the Sokovian currency, domestic goods become
more expensive relative to foreign goods, causing exports to fall, and imports to rise.
These changes in exports and imports cause net exports to fall.

3. The government budget deficit has increased between 2022 and 2023. The shock
causes excess demand on the goods market (i.e., the loanable funds market), and a
shift of the national saving curve to the left.
 The reduction in saving lowers (S – I) as there will be a reduction in the supply of
Sokovia’s currency to be exchanged into foreign currency. This shift causes the real
exchange rate to increase (i.e., there has been an appreciation of the Sokovian
currency). Due to this appreciation in the Sokovian currency, domestic goods become
more expensive relative to foreign goods, causing exports to fall, and imports to rise.
These changes in exports and imports cause net exports to fall.

4. Governor Bernanke’s statement is consistent with the models in Chapter 6. We can

assess what a decrease in the world interest rate will have on the United States’ trade
balance by starting with the identity Y = C + I + G + NX. If we rearrange this expression,
we find that Y – C – G – I = NX, where Y – C – G is the level of savings in an economy
(what is produced minus what is consumed). Therefore, S – I = NX.
Because the global interest rate decreases (as a result of the increase in world savings),
it is now cheaper to invest and investment in the U.S. will increase. If we assume that
this is primarily non-U.S. saving, then for the United States, the saving curve doesn’t
shift but we get a movement along the investment curve as illustrated below. That is,
the decline in the world interest rate increases the difference between I and S (I gets
 bigger and we assume that S stays the same). Because net exports are defined as NX
= S – I, the increase in I pushes the U.S. further into deficit.

Chapter 7

1. The first is frictional unemployment, which results from people and employers taking
time to search for the best match. Frictional unemployment would be higher in countries
that have generous unemployment compensation.

The second explanation for the natural rate of unemployment is that wages in some
labour markets are above equilibrium. One rationale for setting wages above equilibrium
is to attract and retain productive workers. There is no obvious reason why these
efficiency wages should contribute to unemployment more in say South Africa than in
Botswana. Wages can also be above equilibrium in some markets because of minimum
wage laws. So, some unemployment in South Africa might result from higher minimum
wages. Finally, unions may negotiate higher wages for their members, causing a rise in
unemployment. South Africa may have greater union membership rates and or more
powerful unions than in Botswana.

2. True.
The classical model of the economy is derived from the ideas of the classical, or pre-
Keynesian, economists. The classical model is based on the assumptions that wages
and prices adjust to clear markets and that monetary policy does not influence real
variables.
Classical economists argue that unemployment results from wages being sticky. The
explanations for sticky wages include the relative-wage explanation and explicit
contracts. Wages may also be held above the equilibrium wage because of efficiency
wages, imperfect information, unions, or minimum wages.
Efficiency wages' are paid to increase the productivity of the workforce, for example, by
providing an incentive not to shirk. When firms have an incentive to pay efficiency
wages, firms may be unwilling to cut wages even if workers would accept jobs at a wage
lower than the prevailing one.
This means that more individuals would like to work than the number of jobs firms have
an incentive to create. In other words, at the efficiency wage, desired labour supply
exceeds labour demand. This gives rise to structural unemployment. Without the
efficiency wage or other rigidities, the real wage would fall to bring demand and supply
into line. But the efficiency wage prevents this adjustment, so the excess of desired
labour supply above labour demand is classical unemployment. (Consequently,
 unemployment does not exert downward pressure on wages, so these remain above
their market clearing level.)

To bring quantity demanded into line with quantity supplied, the real wage would need
to fall. `

3. The efficiency wage theory has three basic themes:

Moral hazard: the wage is high enough to prevent people from shirking because the
opportunity cost of losing a job is high, as is the cost of monitoring and reducing turnover
costs associated with searching for and hiring new workers.
Productivity: better-paid workers are healthier and so can work harder.
Worker quality/adverse selection: higher wages attract higher-quality workers.
First, the topic of wage floors is not explicitly discussed in the text; the text uses the
language “wage rigidity”—which is the same thing, but the efficiency wage reflects a
fixed wage floor, as denoted by w in the figure, which follows.

w* is the equilibrium wage. This creates an excess supply of labour, Ls>Ld; the
difference is structural unemployment.
Thus, while the wage benefits those who receive the higher wage, it creates
unemployment for those who do not, as Ld(w ) <Ls(w). If the living wage is above the
market-clearing wage, there could be the unintended consequence of a higher (fixed)
wage.
Note that considerable discussion about the benefits and costs of higher wages
continues. One argument is that higher wages lead to greater aggregate demand and
hence reduce the level of unemployment rather than exacerbate it.
4. The answers to this problem are somewhat complicated, because both plans provide a
new benefit and a new cost. Plan A’s new benefit is doubled benefits while its new cost
is benefits for a shorter period of time. Plan B’s new benefit is benefits for twice as long
while its new cost is that it offers half the benefit of the status quo. Moreover, the results
of the plans likely depend on the point of time in the unemployment spell under
consideration.

Overall Unemployment Rate:

As Plan A offers twice the benefit, people may find that they change jobs more frequently
if they are fairly certain of finding new employment. In the United States, most
unemployed workers find new employment within 13 weeks, so plan A may encourage
the (short-term) unemployment rate to increase. In contrast, plan B may encourage the
(short-term) unemployment rate to fall as people receive less benefit when unemployed.

Average Duration of Unemployment Spells:

At the start of an unemployment spell, Plan A may encourage longer spells as the benefit
to unemployment remains high. As the 13th week approaches, however, Plan A will
likely encourage ending an unemployment spell as benefits will expire sooner. Thus,
there will likely be longer short spells but fewer long spells under Plan A.

Plan B is exactly the opposite. At the start of an unemployment spell, plan B will likely
encourage ending the spell as the benefit to continuing is lower than the status quo. As
the 26th week approaches, however, Plan B will encourage a longer spell as benefits
(though at a lower level) will continue for another 26 weeks.

Distribution of Accepted Wages:

The distribution of accepted wages follows the distribution of unemployment spells.
Under Plan A, the accepted wage will be higher than the accepted wage under the status
quo early in the unemployment spell, but will be lower later in the unemployment spell.
Similarly, the distribution of accepted wages under Plan B will be lower than the
accepted wage under the status quo early in the unemployment spell but higher later in
the unemployment spell.

5. Unions play a significant role in shaping wage levels and employment dynamics, often
leading to wage rigidity and structural unemployment. Through collective bargaining,
unions negotiate wages and working conditions with employers, resulting in wages that
may be above the equilibrium level determined by market forces.

When unions secure wages above the equilibrium level, the quantity of labour
demanded by firms decreases, while the quantity supplied of labour rises, leading to
higher rates of unemployment and job rationing. Moreover, the threat of unionisation
can influence wages even in non-unionised firms, as employers may raise wages to
avoid unionisation efforts and maintain labour peace.

The conflict between insiders (existing employees) and outsiders (unemployed workers)
further exacerbates wage rigidity and unemployment. Insiders are those who seek to
preserve high wages, and who keep their jobs after the wage rate has been set above
the equilibrium level. Outsiders are workers who become unemployed in light of the
increase in the wage rate above the equilibrium level. Outsiders have two choices: either
get a job in a firm that is not unionised or remain unemployed and wait for a job to open
up in the union sector. As a result, the natural rate of unemployment is higher than it
would be without unions.

However, the impact of unions on wages and employment varies across countries and
industries. In some countries with centralised wage bargaining, unions may have less
 influence on wage levels and employment dynamics, as the government plays a key role
in mediating labour disputes and setting wage policies.

Overall, while unions can improve wages and working conditions for their members, they
may also contribute to wage rigidity and structural unemployment, particularly in
industries heavily influenced by collective bargaining and unionisation efforts.

Chapter 8, 9.1 and 10.3

1. The key assumptions are:

• constant returns to scale production function;
• diminishing returns to each factor of production;
• the savings and depreciation rates are exogenous;
• a closed economy;
• output is divided between consumption and investment goods; and
• total factor productivity is exogenous

2. False.
The model implies that the economy will not exhibit growth in the long-run. However, it
will experience growth in the short run because capital accumulation is a determinant
for growth. The statement would be true if it referred to long-term or sustained growth.
For that the model shows that technological progress is required.

3. False. An economy in which the saving rate is zero is an economy in which capital is
equal to zero. In this case, output is also equal to zero, and so is consumption. As
saving rate increases, values of capital per worker, output per worker, and consumption
per worker will also increase. However, if the saving rate is equal to 1, people save all
their income, and consumption is also equal to zero. Therefore, the saving rate that
maximises the steady-state level of consumption is somewhere between 0 and 1.

4. Disagree
An increase in the saving rate does not affect growth in the long run, but it does increase
growth in the short run. In addition, an increase in the saving rate leads to an increase
in the long-run level of output per worker. Finally, the average South African saving rate
has remained below 20% since the advent of democracy in 1994 (see Figure below).

Figure: Gross savings (percentage of GDP - South Africa)

Source: Author’s own formulation using data from World Bank (2023a)

We can be quite confident that this savings rate is below the golden-rule rate (the saving
rate in the Solow growth model that leads to the steady state in which consumption per
worker is maximised). It implies that an increase in the saving rate would increase
steady-state consumption per worker in the long run.
5. Dynamically stable means that if k (capital per worker) starts below the steady state, it
increases, and vice versa. The reason for this is the diminishing returns to capital in the
production function. At a low level of k, each unit of k is very useful and supports a lot
of production. This high level of production means a high level of investment (since we
assumed a constant saving rate), which causes k to increase. And vice versa for high
levels of k.

6.

An increase in the population growth rate from “n” to “n’” rotates the capital widening line
to the left from (n+d)k to (n’+d)k.
We see that this changes the slope of the line denoting break-even investment (i.e., the
capital widening line). It becomes steeper.
The production & saving functions do not change.
Since there are now more workers, sy declines, therefore k begins to decline, output per
worker declines & the economy moves to a new steady state (point C).
More workers also means that capital per worker declines from k* to k** & saving per
worker falls from sy0 to sy4 (Not necessary for our module – but can be mentioned).
Output per worker falls from y* to y**.
Thus, an increase in the population growth rate leads to lower average income in the
Solow model.
The new steady state growth rate of the entire economy has increased from “n” to “n’”
at point C due to the fact that with a higher population growth rate, Y needs to grow
faster to keep y constant.
The long term effect of a change in population growth from n to n` where n` > n, is hence
that GDP per capita falls from y* to y`*. We have thus found that the steady state level
of y changes as n changes. The growth of y in the steady state does not change,
however. Population growth hence has no growth effect (in the steady state). In the
transition from the old to the new steady state, there will be negative growth in y.
Now why is this the case?
Why does the steady state level of y become lower as the population growth increases?
To maintain the same level of capital per capita next period, the current generation
has to invest more than before (the `cake' has to be larger if everybody is to have the
same amount of cake as before). This will only be possible if the savings rate s changed,
which it by assumption does not do here. This means that the amount of capital per
 capita has to go down over time, as the amount of investment is less than what the
society needs to invest in order to keep the capital stock constant. But the key here
is that as the capital stock becomes lower and lower, the marginal return of the
capital increases (due to the assumption about decreasing marginal return to capital),
and this is what ensures that this process of capital de-accumulation will converge
and hit the new steady state.

7. The production function in per capita: is given by the equation y = f(k). The shape of the
production function has a bowed-out shape due to the assumption that production is
characterised by diminishing returns for both capital and labour. The production function
has constant returns to scale, indicating that as capital-labour ratio rises, output per
world will rise. The breakeven investment function (d)k: outlines the amount of
investment needed in an economy to maintain a particular capital-labour ratio. In this
theory the assumption is that labour and capital are the key resources of production. It
is also assumed that people save a constant proportion of their income (s). The shape
of the savings function follows the shape of the production function. Savings are
constant portion of income, so if output increases at a decreasing rate, then savings will
also increase at a decreasing rate.

The economy begins at a steady state with saving rate s1 and capital stock k*. Because
the economy is at a steady state, the amount of investment exactly offsets the amount
of depreciation. When the saving rate decreases from s1 to s2, sf(k) curve shifts
downward from s1f(k) to s2f(k). Immediately after the change, investment is lower, but
the capital stock and depreciation are unchanged. Therefore, investment is now lower
than depreciation. The capital stock gradually falls until the economy reaches the new
steady state k**, which has a lower capital stock and a lower level of output than the old
steady state.
 Lower s ⇒ lower k*.
 & since y = f(k) ,
 lower k* ⇒ lower y*.
 Lower labour productivity
 The Solow model predicts that countries with lower rates of saving & investment
will have lower levels of capital per worker & income per worker in the long run (&
thus a lower standard of living)

8. The production function in per capita: is given by the equation y = f(k). The shape of the
production function has a bowed-out shape due to the assumption that production is
characterised by diminishing returns for both capital and labour. The production function
 has constant returns to scale, indicating that as capital-labour ratio rises, output per
world will rise. The breakeven investment function (d)k: outlines the amount of
investment needed in an economy to maintain a particular capital-labour ratio. In this
theory the assumption is that labour and capital are the key resources of production. It
is also assumed that people save a constant proportion of their income (s). The shape
of the savings function follows the shape of the production function. Savings are
constant portion of income, so if output increases at a decreasing rate, then savings will
also increase at a decreasing rate.

The economy begins at a steady state with saving rate s1 and capital stock k*. Because
the economy is at a steady state, the amount of investment exactly offsets the amount
of depreciation. When the saving rate decreases from s1 to s2, sf(k) curve shifts
downward from s1f(k) to s2f(k). Immediately after the change, investment is lower, but
the capital stock and depreciation are unchanged. Therefore, investment is now lower
than depreciation. The capital stock gradually falls until the economy reaches the new
steady state k**, which has a lower capital stock and a lower level of output than the old
steady state.
 Lower s ⇒ lower k*.
 & since y = f(k) ,
 lower k* ⇒ lower y*.
 Lower labour productivity
 The Solow model predicts that countries with lower rates of saving & investment
will have lower levels of capital per worker & income per worker in the long run (&
thus a lower standard of living)