Introductory Macroeconomics, ECON10003
Semester 2, 2020
This is a group assignment. You may work in groups of up to three people although students may
choose to work and submit their assignments on their own (in which case you will need to create
‘a group’ with only one person in it). All group members must come from the same tutorial. The
assignment is due by 4pm on 16 October.
The submission process will have two steps. The first step is for group registration and the second
step is for submission of the assignment. The group registration link will be available from the
Assignment 2 Module on Canvas and students must register in a group by 9 October. If you choose
to do the assignment on your own you will still have to register as a group of one, without registering
you will not be able to submit the assignment. Finally the submission link will be available from
13 October until 4pm on the 16 October. Submit your assignment electronically using the link
accessible via the Canvas under the Assignment 2 Module. Late assignments will not be accepted;
please apply for Special Consideration if for some documented reason you cannot submit by the
due deadline.
Grading criteria: The tutors will grade the assignment according to the following criteria:
• Ability to use material discussed in lectures, tutorials, and in the textbook to answer the
assignment questions in a logical and coherent fashion (90 per cent weight).
• Overall presentation of the assignment. This includes spelling, grammar, correct construction
of diagrams, etc. (10 per cent weight).
• The maximum assignment length is 1000 words.
• Please note that the University and the teaching staff take academic integrity seriously. Please
be aware that plagiarism and collusion are unacceptable. Further details can be found in the
subject guide.
1. Covid-19 and the Macroeconomy
In Tutorial 4 we discussed what impact Covid-19 would have upon output in a simple Key-
nesian model. In this question, we extend this analysis by examining the impactof Covid-19
in the context of the AD-AS model.
a) Suppose Covid-19 reduces the exogenous component of consumption (C̄), planned invest-
ment, I P and exports X. What impact will this have upon the position of our AD and
AS curves. Explain your reasoning by using a diagram. (1 marks)
Solution: We discussed in the past how a decrease in consumption, planned investment
and exports leads to a shift down in the Planned Aggregate Expenditure curve. Cor-
responding to this shift down in the PAE curve is an inward shift in the AD Curve. A
corresponding diagram is shown in Figure 1. There is no shift in the AS curve.
This also reveals what happens in the short run in response to the Covid shock. There
is a reduction in both the level of output and in the inflation rate as the economy moves
from point A to point B.
b) Explain how the macroeconomy would adjust to the Covid-19 shock (as described above)
in the long run if there was no change in the monetary policy reaction function or fiscal
policy in response to the pandemic. Explain your reasoning using a diagram. (2 marks)
1
Output (Y)
PAE Output
PAE(0)
A
PAE(1)
Y1 Y*0
Output (Y)
inflation
AS(pi0, Y*0)
pi0 A
AD(0)
AD(1)
Y*0 Output (Y)
Figure 1: Impact of Covid-19 shock on the macroeconomy
AS(pi0, Y*0)
AS(pi1, Y*0)
AS(pi_LR, Y*0)
pi0 A
B
pi1
C
pi2
pi_LR
AD(0)
AD(1)
Y1 Y2 Y*
Figure 2: Return to equilibrium from Covid-19 shock
2
Solution: The economy is not in a long run equilibrium at point B in Figure 1. The level
of output lies below potential output. As a result, inflation is less than expectations.
Over time, inflation expectations adjust downwards and this leads to a shift down in
the AS curve. As the AS curve shifts downwards, we find that there is an increase in
output due to a reduction in interest rate as inflation falls. There is an intermediate
equilibrium at point C. The AS curve continues to shift down until we reach a new long
run equilibrium at point D where output has returned to potential output and inflation
equals the expected level at πLR - the long run level of inflation.
c) In response to the pandemic, the government has pursued a policy of increasing payments
to unemployed individuals (ie. Jobseeker). In addition, it has foreshadowed a reduction
in taxes in the October budget update. Explain what impact these policies will have
upon the macroeconomy with reference to the AD-AS model. (2 marks)
Solution: Both of these policies reduce the amount of tax that is paid by households in
the economy. In our simple linear model,
T = T̄ + τ Y
where T̄ is a component of tax that is independent of income and τ Y is a component
of tax that depends upon income. Unemployment benefits are a transfer that is paid to
individuals that are unemployed. An increase in this component is a reduction in T̄ . A
reduction in taxes could be a reduction in τ or a reduction in T̄ . The net impact upon
our economy will be similar regardless of whether it is driven by increased unemployment
benefits or lower taxes. It will lead to an increase in consumption and this will shift the
AD curve to the right. A diagram is shown in Figure 3. The shift to the right may be
greater than, less than, or equal to the initial shift to the left. In the diagram, the shifts
(left and right) are of equal distance.
3
Output (Y)
PAE Output
PAE(0)
A
PAE(1)
Y1 Y*0
Output (Y)
inflation
AS(pi0, Y*0)
pi0 A
AD(0)
AD(1)
Y*0 Output (Y)
Figure 3: Effect of Covid-19 shock and tax reductions in AD-AS model. There is an initial shift
down in the PAE and shift to the left of the AD curve due to impact of Covid-19 on consumption,
investment and exports. There is a counter-acting shift to the right of PAE and shift right of the
AD curve due to unemployment benefits and reduced taxes.
4
y/l, θy/l
y/l
(y/l)'
(y/l)*
(d + n)k/l
B
θ’(y/l)’ θ'y/l
θy/l
θ(y/l)* A
(k/l)* (k/l)'
k/l
Figure 4: Effect of an increase in the saving rate in the Solow-Swan model
2. The Solow-Swan Model
a) Consider an that is initially in a steady state equilibrium. Assume that in this equilibrium
it has a saving rate of 50 per cent and a depreciation rate of 2 per cent. Further assume
that the population is constant and that the level of output produced can be represented
by the following production function:
Y = AK α L1−α
where A = 1 and α = 0.5. Use the Solow-Swan model to determine the level of capital
per worker and output per worker in this economy. (1 mark)
Solution: Our equilibrium features θA(K/L)α = δK/L. This can be rewritten as
K/L1−α = θ/δ. Substituting in values, we find K/L = 625 and Y /L = 25.
b) Now suppose the government introduces a set of policies to increase domestic savings. As
a result, the saving rate increases to 60 per cent. What is the new steady state level of
capital per worker and output per worker. (1 mark)
Solution: We still have K/L1−α = θ/δ but a higher value of θ. Substituting in values,
we find K/L = 900 and Y /L = 30
c) Use a Solow-Swan diagram to show the qualitative effects of this increase in the saving
rate upon steady state output per worker and capital per worker. Briefly describe the
intuition behind this result. (2 marks)
Solution: See the Figure 4. An increase in the saving rate raises the saving per worker
curve. This implies at the original equilibrium of A that the saving per worker exceeds
replacement investment. This implies that over time the stock of capital per worker
will tend to increase until we reach a new steady state equilibrium at point B. At this
point, we return to a situation in which saving per worker equals replacement investment.
There is a new higher level of output per worker as capital per worker has increased.
d) Economists typically argue that welfare within society is determined by the level of
consumption rather than the level of output. How does consumption per worker change
in the above example when the saving rate increases from 50 to 60 per cent? Are higher
5
levels of GDP per capita necessarily a sign of higher consumption in the Solow-Swan
model? (1 mark)
Solution: We can evaluate consumption per worker using the following equation:
Y
(1 − θ)
L
We have calculated output per worker and saving rates are given. In the first economy
the consumption per worker is 12.5. In the second economy, with the higher saving
rates and output per worker the consumption per worker equals 12. This is an example
in which an increase in the saving rate does not increase consumption per worker even
though there is an increase in output per worker.
