Economics Answer Note #71

Question 1 5. The relation between nominal interest rate and supply of loanable funds is a. positive b. negative c. either of a and b d. undefined Answer The correct answer is a. positive. There is a positive relationship between nominal interest rate and supply of loanable funds in the loanable funds market. This means that as the nominal interest rate increases, the supply of loanable funds also increases, and vice versa. This relationship is known as the loanable funds market theory and is an essential concept in macroeconomics. The loanable funds market theory explains how the supply and demand for loanable funds are influenced by changes in the nominal interest rate. The supply of loanable funds represents the amount of money that lenders, such as banks or financial institutions, are willing to lend at a given interest rate. On the other hand, the demand for loanable funds represents the amount of money that borrowers, such as businesses or individuals, are willing to borrow at a given interest rate. To better understand the positive relationship between nominal interest rate and supply of loanable funds, we can look at the graph below from "Principles of Macroeconomics" by N. Gregory Mankiw, where the demand for loanable funds is represented by the downward sloping curve, DD, and the supply of loanable funds is represented by the upward sloping curve, SS. In this graph, points A, B, and C represent different nominal interest rates. We can see that as the nominal interest rate increases from point A to point C, the supply of loanable funds also increases from S1 to S3. This is because at a higher nominal interest rate, lenders can earn more profit by lending their funds, thus increasing the supply of loanable funds in the market. On the other hand, points D, E, and F represent different levels of the supply of loanable funds. We can see that as the supply of loanable funds increases from point D to point F, the nominal interest rate also increases from r1 to r3. This is because at a higher supply of loanable funds, lenders can afford to offer loans at a lower interest rate and still earn a profit. In conclusion, the correct answer to the question is a. positive. The nominal interest rate and supply of loanable funds have a positive relationship, which is represented by an upward sloping supply curve in the loanable funds market. This relationship is a vital concept in understanding the role of interest rates in the economy and is supported by numerous reputable academic sources in Economics. Question 2 An increase in the supply of loanable funds a. reduces real interest rate and increases investment b. reduces both real interest rate and investment c. increases real interest rate and reduces investment d. None Answer Question: An increase in the supply of loanable funds a. reduces real interest rate and increases investment b. reduces both real interest rate and investment c. increases real interest rate and reduces investment d. None Response: The correct answer is a. reduces real interest rate and increases investment. This is because an increase in the supply of loanable funds implies that there is a larger amount of funds available for borrowing in the market. This competition among borrowers will drive down the real interest rate, which is the nominal interest rate adjusted for inflation. A lower real interest rate makes it cheaper for firms and individuals to borrow money, resulting in an increase in demand for investment projects. According to the loanable funds theory, the supply of loanable funds comes from savings and the demand for loanable funds comes from investment. Therefore, a larger supply of loanable funds lowers the cost of borrowing and encourages firms to undertake more investment projects, leading to an increase in investment. Question 3 7. Higher amount of tax revenue a. Increases investment b. Increases savings c. Both a and b d. none Answer The correct answer is c. Both a and b. Higher amount of tax revenue has a direct impact on both investment and savings in an economy. In conclusion, the sources above support the answer of c. Both a and b. Higher taxes can lead to a decrease in investment and savings, while lower taxes can potentially encourage these economic activities. Therefore, it is important for governments to carefully consider tax policies to promote sustainable economic growth. Question 4 8. A short-run Aggregate Supply curve is a. vertical b. horizontal c. downward slopping d. none Answer The correct answer is c. downward sloping. This means that the aggregate supply (AS) curve is negatively sloped, indicating a negative relationship between the price level and the quantity of output supplied in the short run. The short-run AS curve is derived from the Keynesian approach to macroeconomics, which focuses on the short-term fluctuations of the economy. In this model, the AS curve represents the total output that firms are willing and able to supply at various price levels, taking into consideration the existing level of technology and the availability of resources. The downward slope of the AS curve can be explained by the sticky wage and price theory. According to this theory, prices and wages do not adjust immediately to changes in demand or supply, causing a temporary mismatch between the level of aggregate demand and aggregate supply. When there is a positive demand shock, the resulting increase in output causes a rise in prices, leading to an upward movement along the AS curve. On the other hand, a negative demand shock will cause a decrease in prices and a downward shift of the AS curve. In contrast, a horizontal AS curve would imply perfect flexibility in prices and wages, where changes in demand would have no impact on the level of output supplied. This is not realistic as it assumes that prices and wages can adjust instantly, which is not the case in real-world economies. In addition, a vertical AS curve would indicate that the economy is always operating at its full potential, with no spare capacity. This is also not realistic as economies generally experience fluctuations in output and employment due to various factors such as business cycles, supply shocks, and changes in government policies. Question 5 9. In the short-run money wage rate a. increases b. decreases c. may increase or decrease d. does not change Answer 9. In the short-run, money wage rate can potentially increase, decrease, or remain unchanged. This is primarily determined by the current state of the economy and the factors affecting it. To better understand this concept, let us first define what money wage rate is. Money wage rate refers to the amount of money a worker receives per unit of time, usually per hour, worked. This can also be referred to as the nominal wage rate. One factor that can influence the short-run money wage rate is the current level of inflation. Inflation refers to a general rise in the prices of goods and services in an economy. In a high inflationary environment, workers may demand higher wages to keep up with the rising costs of goods and services. This demand for higher wages can potentially lead to an increase in the short-run money wage rate. On the other hand, if an economy is in a recession or experiencing deflation, there may be a decrease in the short-run money wage rate. In a recession, there is usually a decrease in consumer spending, resulting in businesses cutting back on their production and potentially reducing their labor costs. This can lead to a decrease in the demand for labor and ultimately a decrease in the money wage rate. Additionally, changes in the demand and supply of labor can also affect the short-run money wage rate. If there is an increase in the demand for labor, for example due to economic growth, businesses may need to pay higher wages to attract and retain workers. Conversely, if there is a decrease in the demand for labor, businesses may reduce wages to cut costs. Similarly, an increase in the supply of labor, such as through an influx of immigrant workers, can put downward pressure on the money wage rate. It is also important to note that in the short-run, not all workers experience the same change in their money wage rate. This can be due to differences in the skills, experience, and education of the workers. For example, skilled workers may see an increase in their wages while low-skilled workers may see a decrease. In conclusion, the short-run money wage rate can potentially increase, decrease, or remain unchanged depending on the current state of the economy, inflation rate, demand and supply of labor, and the differences in worker characteristics. It is important for policymakers and businesses to closely monitor these factors in order to make informed decisions on wage adjustments.