1.

Suppose that this years money supply is $600 billion, nominal GDP is $12 trillion, and real GDP is $4 trillion. a) What is the price level? What is the velocity of money? GDP Deflator (Price Level) = Nominal GDP Real GDP = $12 trillion $ 4 trillion =3 V=Velocity of money, P=Price level (GDP Deflator), Y=Quantity of output (Real GDP), M=Quantity of money V = (P Y)/M = (3 $4 trillion) / $600 billion = $ 12 trillion / $600 billion = 20 [The price level is 3 and the velocity of money is 20.] b) Suppose that velocity is constant and the economys output of goods and services rises by 10% each year. i. What will happen to nominal GDP and the price level the next year if the Reserve Bank keeps the money supply constant? MV=PY

(M V)

constant = P 10% Y 10%

M ($600 billion) V (20) = P (3 90%) Y ($4 trillion 110%) $0.6 trillion 20 = 2.7 $4.4 trillion $12 trillion = $11.88 trillion ~ $12 trillion

GDP Deflator (Price Level) = Nominal GDP Real GDP Nominal GDP = Price level Real GDP = 2.7 $600 billion = $1620 billion [Nominal GDP will be $1620 billion and the price level will decrease 10%, which is 2.7 the next year if the Reserve Bank keeps the money supply constant.] ii. What money supply should the Reserve Bank set next year if it wants to keep the price level stable? MV=PY M 10% (V) constant = (P) constant Y 10%

M ($600 billion 110%) V (20) = P (3) Y ($4 trillion 110%) $0.66 trillion 20 = 3 $4.4 trillion

$13.2 trillion = $13.2 trillion [The Reserve Bank should increase money supply 10%, which is $0.66 trillion next year if it wants to keep the price level stable.]
iii.

What money supply should the Reserve Bank set the next year if it wants inflation of 10%? MV=PY M 20% (V) constant = P 10% Y 10%

($600 billion 120%) 20 = (3 $4 trillion) 120% $0.72 trillion 20 = 14.4 trillion $14.4 trillion = $14.4 trillion [The Reserve Bank should increase money supply 20%, which is $0.72 trillion next year if it wants inflation of 10%.] 2. Because of the sub-prime mortgage and related financial crisis in the United States and European Union, US/EU consumers cut back on spendingincluding on Malaysian exports. (a) Show the impact in Malaysia of this drop in exports using the AD-AS model.

Any event that changes net exports for a given price level also shifts aggregate demand. This recession overseas bring down Malaysia GDP componentnet exports at every price level and shifts aggregate-demand curve for Malaysia economy to the left, from AD1 to AD2. In the short run, Malaysia economy moves along the initial short-run aggregate-supply curve, AS1, going from point A to point B. Hence, quantity of output drops from Y1 to Y2 and price level drops from P1 to P2. Due to the decrease in aggregate demand, firms respond to lower sales and production by reducing employment which leads to falling incomes and rising unemployment. We assume that the policymakers do nothing, so the Malaysia economy will correct itself by shifting the short-run aggregate-supply curve to the right from AS1 to AS2. The price level drop from P1 to P2; hence, the new price level is below the initial price level that people had come to expect. However, over time, in the long run, as the expected price level adjusts as expectations catch up with reality, the short-run aggregate supply curve shifts to the right from AS1 to AS2 and the Malaysia economy reaches point C where new aggregate-demand curve intercept the long-run aggregate-supply curve. This leads to a fall in the price level from P2 to P3 and quantity of output returns to its natural rate, Y1. Once expectations catch up

with reality, the firms will hire more workers with lower nominal wage and increase production as the labour cost is lower than before according to sticky-wage theory. Hence, this leads to lower incomes, increase employment and increase quantity of output. (b) Briefly enumerate the fiscal policies the government of Malaysia can use to mitigate the negative economic consequences/increased unemployment flowing from the fall in Malaysian exports. What are some of the limitations of fiscal policies? In order to reduce the negative economic consequences, the policymakers can take some actions by using fiscal policy to increase aggregate demand such as increase government spending and decrease the level of tax to shift the aggregate-demand curve to the right which could stimulate the spending decisions of firms and households. Increase government spending gives various form of income support to the people in need to stabilize the economy; decrease the level of tax raises households disposable income and firms profit level which influences their spending decisions. Hence, as total quantity of goods and service demanded at each level in Malaysia is increased, the aggregate-demand curve will shift to the right. In turn, unemployment is reduced. Firstly, poor information is one of the limitations in fiscal policy. In fact, information on the current economic conditions such as employment, output and prices are only available with a lag which causes a lot of uncertainties in getting the desired result as the information on hand is not up to date. For instance, with insufficient information, government may choose improper decision and create economic crisis. So, policymakers always have the difficulties in forecasting the economy and there is a possibility that their forecast is wrong. Secondly, time lags cause inefficiency of fiscal policy to policymakers. Time is required to make the tax and expenditure changes to stabilize the economy which causes time lags in implementing fiscal policy. Hence, the government plans to increase aggregate demand can

take a long time to filter into the economy and it may be too late. Furthermore, policymakers usually need to wait for two or more years to get the full impact on the economy. Due to the time lags, there are uncertainties in the period of waiting which means that policymakers are not certain that fiscal policy will always have the desired result. Thirdly, the effects of fiscal policy is depends on the size of multiplier and crowding out effects. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar (Mankiw 2007, p.555). While multiplier effect helps fiscal policy increase aggregate demand dramatically, there is crowding out effect that offset the aggregate demand. If the size of crowding out effect is larger than multiplier effect, the expansionary fiscal policy will cause adverse effect on aggregate demand and economy, vice versa. Due to the multiplier and crowding out effects, the impact of fiscal policy on economy is uncertain.

3. Assuming the level of investment is $16 billion which is autonomous (i.e. independent of the level of total output), refer to the table below and answer the following questions: a) Determine the equilibrium level of output and income which the private sector of this closed economy would provide. If this economy has a labour force of 70 million, will there exist an inflationary or a recessionary gap? Explain the consequences of this gap. The equilibrium level of output and income which the private sector of this closed economy would provide is where the total quantity of goods produced (GDP),

which is $340 billion in real domestic output (GDP) is precisely equal to the total quantity of goods purchased (C + I), which is $324 billion in consumption plus $16 billion in investment equal to $340 billion. If this economy has a labour force of 70 million, there will be exist a recessionary gap because at the equilibrium level, the possible levels of employment is $65 million which is less $5 millions than the labour force as it means that the economy is not in full employment. The consequences of this gap are the recessionary gap produces a contractionary or depressing impact on the economy (Jackson and Mc Iver 2004, p. 231) which will cause multiple declines in real GDP. The key consequences of this recessionary gap are less real production than that corresponding with full employment and, perhaps most important, more unemployment than that corresponding with full employment. b) What are the sizes of the MPC and the MPS? MPC (marginal propensity to consume) = Change in consumption Change in income

= $324 billion - $308 billion $340 billion - $320 billion = $16 billion $ 20 billion = 0.8 MPS (marginal propensity to save) = Change in saving

Change in income = $16 billion - $12 billion $340 billion - $320 billion = $4 billion $20 billion = 0.2 [The sizes of the MPC is 0.8 and the MPS is 0.2]

References Jackson, J. and Mc Iver, R. 2004, Macroeconomics, 7th edn, Mc-Graw Hill. Mankiw, NG 2007, Essentials of Economics, 4th edn, South-Western, Mason.