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Answers to Pause-for-Thought Questions Chapter 10 . p370 If the money supply is cut by 10 per cent, what must happen to the velocity of circulation if there is no change in GDP at current prices? If there is no change in GDP at constant prices then the fall in the money supply has been offset by an increase in the velocity at which money circulates round the economy. In other words, the amount of money in circulation is working harder. Referring to the formula MV = PY, if GDP at current prices (= PY) is constant, then a fall in M of 10% must be accompanied by a rise in V of 11.11% if MV is to remain constant. (Check this out with some figures.) p375 If a shift in the aggregate demand curve from AD to AD1 in Figure 10.4 causes a movement from point a to point d in the long run, will a shift in the aggregate demand curve from AD1 to AD cause a movement from point d back to point a in the long run? Yes, if there were disinvestment as the result of the fall in aggregate demand, and if there had been no technological progress as a result of the previous shift from AD to AD1. If, however, earlier investment had led to new more productive plant and machinery being used, then a fall in aggregate demand will lead to the older, less efficient plant and machinery being scrapped. The result will be that the eventual equilibrium will be below point a. p378 What determines how rapidly the short-run Phillips curves in Figure 10.5 shift upwards? The more that unemployment is kept below the natural rate (i.e. the more rapid the increase in aggregate demand) and the steeper the short-run Phillips curve, the more rapidly will the short-run Phillips curve shift upwards. In other words, the higher is point b in Figure 10.5, the more rapidly will inflation rise. p382 For what reasons would a new classical economist support the policy of the Bank of England publishing its inflation forecasts and the minutes of the deliberations of the Monetary Policy Committee? This will make information more perfect and hence reduce unanticipated changes in aggregate demand, thereby reducing deviations of unemployment and output from the natural level. The increased confidence will then strengthen the supply side of the economy as the greater certainty encourages more investment and hence an increase in potential and actual output. p386 Why is it important in the Keynesian analysis for there to be a steady expansion of aggregate demand? To create a climate of confidence and certainty so as to encourage investment. p392 Do you agree that ‘ever more rapid financial flows across the world that are unpredictable and uncertain’ make Keynesian discretionary fiscal (and monetary) policy less suitable? Explain. Discretionary fiscal policy can be undermined by international financial flows. For example, if government expenditure is raised in order to stimulate the economy, the resulting increase in demand for money will drive up the rate of interest. This will lead to an inflow of finance from abroad and an appreciation of the rate of exchange. This will reduce the demand for exports (an injection) and increase the demand for imports (a withdrawal). The effect will therefore be to dampen the rise in Answers to pause-for-thought questions in Essentials of Economics (3rd edition), John Sloman aggregate demand. Also, the unpredictability of international financial flows makes the effects of fiscal (and monetary policy) changes less predictable. Note that if there had been a policy of maintaining interest rates at the original level, and thus increasing money supply in line with the extra demand for money, then the above effects would not have occurred. What this means is that if fiscal policy is to be effective, it must be backed up by monetary policy. p397 If there were a gradual increase in the saving rate over time, would this lead to sustained economic growth even without technological progress? Yes, but the rate of economic growth would gradually slow down, given that the Y curve gets less and less steep. If, however, the extra saving were invested in research and development, with the result that the Y curve shifted upwards, this would allow a higher output to result from the extra saving and hence a faster rate of economic growth as saving increased over time. p403 If taxes as a proportion of national income have risen since 1979, does this mean that there can have been no positive incentive effects of the various tax measures taken by first the Conservative and then the Labour governments? It depends on the type of tax change. A rise in the average rate of tax but a reduction in the marginal rate of tax could encourage people to work more because they keep more of any rise in income. This effect could be achieved by reducing the marginal rate of income tax but removing various personal allowances (such as the married man’s allowance). Both Conservative and Labour governments adopted such policies. It also depends on how people perceive tax changes. If people are given an income tax cut, this might act as an incentive, even if VAT has gone up so as to keep the amount they can purchase the same as before. They may believe that they are better off because their take home pay has gone up in money terms, even though in real terms there is no change in their income. p406 How might a new classical economist criticise these various forms of interventionist supply-side policy? In each case, they would argue that firms are in a much better position to determine the appropriate level of investment in training, research, etc. than is the government. Government expenditure on such things, they argue, is often wasteful and not really directed to the needs of industry. It is much better, argue new classical economists, to remove impediments to firms making such investment themselves. Impediments include various government and local authority rules and regulations. 2