Friday, November 7, 2008

On HP3 May 2008

This is the New Zealand data we did in class and as homework. I checked out what you handed in and I can't say that I was very impressed. Remember that our trimester exam in December will be a two hour paper 3 without choice (3 out of 3) so it may be a good idea to try to practice a bit more on this rather demanding paper. So:
a(i): you are asked to define 'nominal' (interest rates - in the extract). The term is in contrast to 'real' and it implies the value of a variable without adjusting for inflation. So, the nominal interest rate is the interest rate a bank quotes for a deposit or a loan while the real interest rate would be the nominal rate minus the (expected) rate of inflation.
a(ii): you are asked to define the term 'inflationary gap'. An inflationary gap arises if the equilibrium level of real income is above the full employment level (Ye>Yfe). This implies that unemployment is (temporarily) below the natural rate. Remember that you could always draw a diagram to illustrate your definition which makes sense to do only if you are unsure about the wording you employ as 'a vague definition accompanied by an appropriate diagram' permits examiners to award 2/2 points.

b: the question asks you to explain (using a diagram) why a widening current account deficit tends to depreciate a currency. The currncy is the NZ dollar so the vertical axis should read 'price of NZ$ expressed in US$ i.e. US$/NZ$' while the horizontal should read 'NZ$s traded per period'. There is a demand for NZ$ and a supply of NZ$. Remember that, assuming away capital flows, the demand for a currency in the forex market reflects the value of its exports of goods and services while the supply of its currency its imports. Given that the data reveal that the NZ current account deficit is becoming bigger one could argue that imports increased shifting the supply of NZ$ to the right and/or that exports shrunk shifting the demand for NZ$ to the left and thus leading to the depreciation of the NZ$ (in your answer you could also define a current account deficit - when the value of imports of goods and services exceeds the value of exports of goods and services; or, when the sum of net exports of goods and services, net income form investments and net transfers of money is negative)

c: the question asks you to explain the impact of a falling growth rate on the amout of goods and services produced i.e. on real income. The key is to remember that a lower growth rate means that output continues to rise but at a decreasing rate. So, more goods and services will still be produced (real output still rises / economic activity still increases) but not as fast as initially expected. Analysts expected real GDP to increase by about 4.5% but now they expect it to still rise but by less (by only 2.8%). You are not required to employ a diagram but you could, by drawing a standard AD/AS with two AD curves drawn to the right of an original AD curve (think - we do this stuff in class).

d: Think: what am I asked to evaluate here? You are asked to evaluate the consequences for New Zealand of increasing interest rates. Remember that to move into the top marks band (level 3: 6,7,8 out of 8) you must include explicit references / quotations from the extract. Your answer must not be in a vat. You are asked to evaluate a policy move within a very specific context.

Describing what the point of employing tight monetary policy in this specific setup is and how how tight monetary policy works may be a way to start. Your answer could include the expected consequences on households and consumption expenditures as well as on businesses and investment spending. Remember that not all households and firms are the same. Remember also that changes in interest rates affect the exchange rate (explain how) and thus the external sector (explain how; use text). There are short run and long run effects. Are there effects on the distribution of income or on efficiency? The policy is undertaken presumably because of the expected benefits. But there are also costs. Describe these. Are these benefits worth the costs? Why? (think of the benefits of price stability or the costs of runaway inflation).

Make sure you organize your thoughts. Make sure you leave a blank line between different points you make. You could use a diagram but do not feel obliged to do so.

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