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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
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
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
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.