Aggregate Demand

Section A

1. Define the following (2 marks each):

1. Aggregate demand

Aggregate demand is the total demand for final goods and services in an economy at a given time. Together with the aggregate supply they form the market clearing equilibrium, in which the output of an economy is determined and equal to Y= C + I + G + NX.

1. The compound annual GDP growth rate

The compound annual GDP growth rate is the mean annual growth rate of GDP over a specified period of time. It is a compounded rate because with every period that passes, a set percentage of growth is going to grow the economy even more in absolute terms.

1. The Golden Rule level of Savings

The Golden Rule Level of Savings is the steady-state value of capital per worker which maximises consumption per worker. The concept enforces the idea that a higher saving rate is not always a good thing and policy makers have to choose a savings rate which maximises total welfare in the steady-state.

2. Examine the veracity of the following statements (8 marks each)

1. Deflation cannot occur with rational expectations.

Assume a simple AS-AD model in which deflation occurs because of drop in aggregate demand that drives the price down, as illustrated below. The reason for which deflation and aggregate demand then keep going down instead of finding an equilibrium is because of the expectations that prices are going to keep falling, so economic agents delay allocating resources, which in turn re-enforces the downwards spiral. In a rational context, with consumers and investors making decisions with perfect information available, the spiral would eventually stop, since the agents are aware that the contraction is temporary and they can maximise utility if they act at that point. However, simply by assuming rational expectations we also assume perfect information, which has been empirically proven to be false, as agents do not have that level of knowledge, and therefore cannot act rational. Thus, while deflation should theoretically not happen with rational expectations, those expectations do not hold when tested.

[pic 1]

1. Technological change is crucial to long run growth.

The above statement is the core assumption of the Solow model, illustrated in the diagram below. Since the level of output in a Solow economy can only be moved by a change in technological progress (A), the assumption means you cannot have long term growth, without technological change. Any other kind of shock to the production function will be temporary and therefore not lead to a permanent increase in total output. This is the only way to permanently change the steady-state of an economy and achieve an increase in output from y0 to y1, as illustrated in the diagram below.

[pic 2]

1. The Expectations Hypothesis of bond prices implies an investor is indifferent between holding an n-period bond or rolling over her investment in one-period bonds n times.

The Expectations Hypothesis states that long-term interest rates hold a forecast for short-term interest rates in the future. It is also thought to be one of the main components of the yield curve, since investors form opinions on long term bonds through this lens. However, this theory has been challenged empirically and is also based on classical assumptions such as rational expectations and perfect knowledge, which are known to not empirically accurate. Thus, while in a perfect market with no frictions, this rationale holds and makes financing and investing clearer for all parties involved, it tends to not be the case in real world. However, the principle of this hypothesis is correct to identify short term bonds as a starting point for estimating longer-term bonds. Therefore, the above example would be correct according to this theory.

Section B

5. Economic Growth:

1. Define conditional and unconditional convergence in economic development. Explain why each occurs in an appropriate version of the Solow model. (10)

Unconditional convergence states that economies with the access to the same technology and have the same population growth rate (n) and the same savings propensity (s) should converge to the same steady-state equilibrium. This phenomenon is depicted in the diagram below, which shows how an excess of capital per worker will converge to the same level as a shortage of capital per worker. Thus, this concept means that poorer countries will grow relatively fast, while rich economies will grow quite slowly. That is given in the diminishing slope of the production function and is a core consequence of the Solow model.