Seven lessons built from your slides and Parkin, each one ending in the exact kind of question your final asks. Then the whole Spring 2026 paper, solved.
Tick a lesson off at the bottom of each unit. Your progress is saved in this browser.
Work top to bottom. Every unit follows the same rhythm: plain-English idea → formula or diagram → worked example → exam-style practice. Do not read the answer until you have written something down. Reading a solution feels like learning and is not.
For every theory question, answer in three moves, in this order: 1) draw and label the graph, 2) say which curve shifts and why, 3) state the consequences. Markers award points for all three separately.
GDP is the price tag on everything a country finished making inside its borders this year. Three rules keep you out of trouble: count it only if it is final (not an ingredient), only if it was made here (not imported), and only if it was made this year (not resold).
Every taka someone spends is a taka someone else earns. So spending and income must give the same total. That is why both approaches land on the same number, and why you can use one to check the other in an exam.
Nominal GDP rises when prices rise even if the country makes nothing extra. Real GDP strips prices out by valuing every year's output at one fixed base year price. The gap between the two is pure inflation, and the deflator measures that gap.
Note the shortcut you will need: in the base year, nominal GDP and real GDP are the same number, so the deflator is always exactly 100 in the base year. If you compute a base-year deflator that is not 100, you have made an arithmetic error.
| Item | Yr 1 qty | Yr 1 price | Yr 2 qty | Yr 2 price |
|---|---|---|---|---|
| Rice | 100 | Tk 50 | 120 | Tk 60 |
| Fish | 50 | Tk 200 | 60 | Tk 250 |
An economy produces only two goods. 2023 is the base year.
| Good | Production | Import | Export | Consumption | P 2023 | P 2024 |
|---|---|---|---|---|---|---|
| Wheat | 200 | 0 | 50 | 150 | $8 | $10 |
| Oil | 0 | 80 | 0 | 80 | $20 | $26 |
(a) Nominal GDP 2023. (b) Nominal GDP 2024. (c) GDP deflator 2024. Quantities are constant.
Why oil vanishes from GDP: it is imported, so it enters C at +1,600 and M at −1,600 and cancels exactly. Imported goods are never part of domestic production. This is the single most common mistake on this question type.
Money goes round between four sectors: households, firms, government and the rest of the world. Households supply labour, land and capital through factor markets and earn income. They spend it in goods markets as consumption (C). Firms add investment (I), government adds G, and the rest of the world adds net exports (X − M). Because every taka spent is a taka earned, GDP can be measured three ways and all three must agree: output, income, or expenditure.
| Approach | Add up | Never include |
|---|---|---|
| Expenditure | C + I + G + (X − M) | Intermediate goods · used goods · financial transactions (shares, bonds) · transfer payments (pensions, benefits) · non-market activity (home gardening, unpaid housework) · illegal or unreported work |
| Income | Wages + rent + interest + profit + mixed income + taxes on production − subsidies + depreciation | Transfer payments · capital gains · private gifts · income earned abroad · sale of used goods |
| Term | Meaning |
|---|---|
| Expansion | Real GDP increases, moving toward or beyond potential GDP |
| Recession | Real GDP falls for at least two consecutive quarters |
| Peak | Highest real GDP before a recession begins |
| Trough | Lowest real GDP before a new expansion starts |
| Potential GDP | Output when labour, capital, land and entrepreneurship are all fully employed |
Real GDP measures production, not wellbeing. Six things it misses:
A household hires a cleaner for Tk 5,000 a month. The following year the cleaner marries into the household and does the same work unpaid. What happens to GDP, and what does this reveal about GDP as a welfare measure?
GDP falls by Tk 60,000 a year, even though exactly the same work is being done and the household is no worse off. Paid cleaning is a market transaction and counts; household production is not counted because it is never bought or sold.
This exposes the household production limitation: GDP measures marketed output, not welfare. Countries where more work happens inside the home will have GDP understated relative to countries where the same work is bought in, which makes raw GDP comparisons across countries misleading.
Classify each for the expenditure approach: (i) flour bought by a bakery, (ii) a second-hand motorcycle, (iii) a government pension payment, (iv) a new house bought by a household, (v) shares in a company.
(i) Excluded — intermediate good, its value is already inside the price of the bread.
(ii) Excluded — used good, counted when first produced.
(iii) Excluded — transfer payment, no good or service is produced in exchange.
(iv) Included as Investment (I) — this is the exception to remember: new housing is I, not C.
(v) Excluded — a purely financial transaction, nothing is produced.
Split the country into boxes. Everyone 16+ who is not in jail or hospital is the working-age population. Of those, anyone working or actively hunting is in the labour force. Every rate you will ever be asked for is just one box divided by another. Get the boxes right and the maths is trivial.
Unemployment rate divides by the labour force. Participation rate divides by the working-age population. Swapping these two denominators is the most frequent lost mark in this whole course. The working-age population is always the bigger number.
| Type | What causes it | Exam giveaway phrase |
|---|---|---|
| Frictional | Normal job search; people moving between jobs | "recent graduates searching", "voluntarily quit", "between jobs" |
| Structural | Skills no longer match the jobs that exist | "automation", "technological change", "factory closed permanently" |
| Cyclical | The business cycle; a recession | "recession", "downturn", "slump in demand" |
| Natural | Frictional + Structural (cyclical is excluded) | this is what remains at full employment |
The link you must be able to state: if actual unemployment sits above the natural rate, there is cyclical unemployment, real GDP is below potential GDP, and the output gap is negative (a recessionary gap). If actual sits below natural, the gap is positive (an inflationary gap). At full employment the gap is exactly zero.
The CPI prices a fixed basket. You keep base-year quantities frozen and only let prices move. If an exam table gives you current-year quantities as well, they are a deliberate distractor.
This is asked almost every year, so learn one clean reason rather than four vague ones.
| CPI | GDP deflator | |
|---|---|---|
| Covers | Consumer goods only | All domestic production: C, I, G and exports |
| Imports | Included (consumers buy them) | Excluded (not made here) |
| Exports | Excluded | Included |
| Basket | Fixed base-year quantities | Current-year quantities |
Best single sentence to write: "The CPI includes imported goods but excludes exports and capital goods, while the GDP deflator does the reverse, so when import prices rise faster than export prices the CPI shows higher inflation than the deflator."
The four CPI biases (all push the same way, so CPI overstates true inflation): new goods bias, quality change bias, commodity substitution bias, outlet substitution bias.
Country Zeta, all figures in millions:
| Category | Number |
|---|---|
| Working-age population | 200 |
| Employed | 120 |
| Unemployed after factories automated | 8 |
| Unemployed while changing jobs voluntarily | 6 |
| Unemployed because of the current recession | 6 |
(a) Unemployment rate. (b) Participation rate. (c) Natural rate, and what it implies for the output gap. (d) If 4 million of the recession-hit workers are rehired, what is the new unemployment rate?
Watch the labour force in part (d). Hiring someone already counted as unemployed does not change the labour force, so the denominator stays at 140. It only changes if someone enters or leaves the labour force entirely.
Lost incomes and production. Benefits never fully replace lost wages, and less production means less
consumption and investment, lowering living standards now and later.
Lost human capital. Long spells out of work permanently damage a career — a manager forced into a
low-skill job may never return to the same level. The burden is not shared equally, which makes unemployment a
political problem as well as an economic one.
You must be available for work and in one of three categories:
Most costly unemployment is long-term job loss. Short spells and voluntary job changes cost far less, but the headline rate hides the difference, so the same number can mean very different things.
| Influence | Effect |
|---|---|
| Age distribution | A young population means more first-time seekers and more job switching, so frictional unemployment is higher. |
| Pace of structural change | Rapid technological change or intense global competition raises structural unemployment; stable technology keeps it low. |
| Minimum wage | Set above the market-clearing wage it creates a surplus of labour, especially among low-skilled and entry-level workers. |
| Efficiency wage | Firms pay above market rate to raise productivity and cut turnover; fewer workers are hired than at the lower wage. |
| Unemployment benefits | More generous benefits reduce the urgency to take a job, lengthening search. Europe's higher natural rates versus the US are the standard example. |
A country introduces far more generous unemployment benefits and raises the minimum wage well above the market-clearing level. Explain the effect on the natural rate of unemployment and on full employment.
Both measures raise the natural rate.
The minimum wage above equilibrium means the real wage is above the market-clearing level, so the quantity of labour demanded falls short of the quantity supplied. That surplus is unemployment, concentrated among low-skilled and entry-level workers, and it is structural.
More generous unemployment benefits reduce the incentive to find work quickly, so people search longer before accepting a job. That lengthens spells and raises frictional unemployment.
Consequence: since natural unemployment = frictional + structural, the natural rate rises on both counts. Because full employment is defined as the actual rate equalling the natural rate, full employment now occurs at a higher measured unemployment rate, and potential GDP is correspondingly lower.
Inflation turns out much higher than anyone expected. Identify who gains and who loses among (i) a worker on a three-year fixed wage contract, (ii) a bank that issued a 10-year fixed-rate mortgage, (iii) that mortgage borrower.
(i) The worker loses. Prices rise but the money wage is locked, so the
real wage falls and purchasing power is lost. The employer gains, because revenue rises while the wage bill
does not — this is inflation redistributing income.
(ii) The bank loses. Repayments are fixed in money terms, so the money it gets back buys less than
expected. The fixed interest rate does not cover the loss in real value.
(iii) The borrower gains. They repay in money worth less than the money they borrowed — inflation
redistributing wealth from lender to borrower.
The general rule: unexpected inflation moves value from lenders to borrowers, and unexpected deflation
moves it back.
All three models in this course are the same picture with different labels. Two lines cross. Something happens. One line moves. They cross somewhere new. You describe what changed. That is it. If you can do that once, you can do it for AD–AS, loanable funds and the money market without learning anything genuinely new.
Every graph has a vertical axis (up the side) and a horizontal axis (along the bottom). In economics the rule never changes:
Once you know what "the thing" is, you know both axis labels. Memorise this one table and you can label any diagram in this course correctly:
| Model | The "thing" being traded | Vertical axis = its price | Horizontal axis = its quantity |
|---|---|---|---|
| AD–AS | All goods and services | Price level | Real GDP |
| Loanable funds | Borrowed money | Real interest rate | Loanable funds |
| Money market | Money itself | Nominal interest rate | Real money (M/P) |
Why the interest rate is a "price": it is what you pay to borrow money, or what you give up by holding money instead of lending it. So it belongs on the vertical axis exactly like any other price.
A point on a graph is one pair of facts. Drop a dashed line down to find its quantity, and a dashed line across to find its price. That is all a point ever means.
You only ever need two shapes, plus one special vertical line. Learn the reason, not the picture, because the reason is what earns the marks.
| Shape | Which curves | The one-line reason |
|---|---|---|
| Downward ╲ buyers | AD, DLF, MD | When the price goes up, buyers want less. Dearer borrowing means fewer projects worth doing; a higher interest rate means holding money costs more. |
| Upward ╱ sellers | SAS, SLF | When the price goes up, sellers supply more. A higher price level with fixed wages means bigger profit per unit; a higher interest rate rewards saving. |
| Vertical │ fixed | LAS, MS | The quantity does not respond to price at all. Potential GDP depends on resources and technology; the money supply is simply whatever the central bank decides. |
Buyers slope down, sellers slope up, and anything the price cannot influence stands straight up. There are only two vertical curves in the whole course: LAS and MS.
Where the two lines cross, the amount buyers want equals the amount sellers offer, so nothing pushes the price any further. Mark it with a dot, call it E₀, and drop your two dashed lines to read off P₀ and Q₀. Every question in this course is: the crossing point moved — where to, and what does that mean?
This single confusion costs more marks in ECO 102 than anything else. If the price on the vertical axis changes, you slide along the existing curve. The curve does not move. Anything else that matters moves the whole curve sideways.
Say it correctly in the exam. The wording is marked:
| Situation | Correct phrase | Wrong phrase |
|---|---|---|
| Interest rate rose, so firms borrow less | "the quantity of loanable funds demanded fell" | |
| Firms expect higher profits, so they borrow more | "demand increased, DLF shifted right" |
Shifts are always sideways, left or right. Never up or down, and never rotate a curve. Use this test, which works for every curve in the course:
Ask yourself one question: at the same price as before, is there now more or less? If less, the line moves left. A left shift of an upward curve looks like it went "up", and that is fine, but always think of it as horizontal or you will misread the new quantity.
Once one curve has moved, find the answer mechanically. Do not guess.
When only one curve moves, the new equilibrium slides along the curve that stayed still. So if AD stays put and SAS shifts left, E₁ must sit further up the unchanged AD curve, which immediately tells you price up and quantity down. You can get the answer before you have drawn anything neatly.
Use this exact sequence for every diagram question in the exam:
| # | Do this | Worked on the oil shock |
|---|---|---|
| 1 | Draw and label both axes, then draw the curves in their starting position. Mark E₀ and drop dashed lines to P₀ and Q₀. | Price level and Real GDP. Draw AD, SAS₀ and vertical LAS crossing at E₀. |
| 2 | Decide which single curve the shock hits, and state why in one sentence. | Oil is an input cost, so it hits SAS. AD and LAS are untouched. |
| 3 | Decide the direction using the more/less test, and draw the new curve with a shift arrow. Subscript it ₁. | Costs up means less supplied at every price, so SAS shifts left to SAS₁. |
| 4 | Mark E₁, read off the new P and Q, then write the consequences in words. | P rises, real GDP falls, unemployment rises above natural rate: stagflation and a recessionary gap. |
Marks are awarded separately for each step, so even a partly wrong answer with a properly labelled diagram and a clear reason will score well. Never answer a diagram question in prose alone.
Every shock this course can throw at you, and exactly what it does. Learn this table and Section B is largely solved.
| What happens | Curve | Direction | Result |
|---|---|---|---|
| Oil / raw material / wage costs rise | SAS | ← Left | P ↑, Y ↓ (stagflation) |
| Oil costs fall, or wages fall | SAS | → Right | P ↓, Y ↑ |
| Government raises spending or cuts taxes | AD | → Right | P ↑, Y ↑ |
| Government cuts spending or raises taxes | AD | ← Left | P ↓, Y ↓ |
| More labour, capital or better technology | LAS (and SAS) | → Right | Potential GDP ↑ |
| Households' disposable income rises (tax cut) | SLF | → Right | r ↓, funds ↑, investment ↑ |
| Government budget deficit | DLF | → Right | r ↑, crowding out |
| Government budget surplus | SLF | → Right | r ↓, investment ↑ |
| Tax on interest income | SLF | ← Left | r ↑, investment ↓ |
| Firms expect higher profits | DLF | → Right | r ↑, funds ↑ |
| Central bank sells bonds (contractionary) | MS | ← Left | i ↑, investment ↓, AD ← |
| Central bank buys bonds (expansionary) | MS | → Right | i ↓, investment ↑, AD → |
| Real GDP rises | MD | → Right | i ↑ |
| Financial innovation (cards, mobile banking) | MD | ← Left | i ↓ |
| Price level rises (money market only) | MS | ← Left | M/P falls, so i ↑ |
For each shock, write down (i) which curve moves, (ii) which way, (iii) what happens to the price and quantity on that diagram. Spend two minutes, then check.
| # | Curve | Direction | Why, and the result |
|---|---|---|---|
| 1 | SAS | ← Left | Input costs rise, so less is supplied at every price level. Price level ↑, real GDP ↓, unemployment ↑. Stagflation and a recessionary gap. |
| 2 | MS | → Right | Buying bonds injects reserves, banks lend more, deposits rise, money supply grows. Nominal interest rate ↓. Investment then ↑ and AD shifts right. |
| 3 | AD | → Right | Higher transfers and government spending raise disposable income and spending. Price level ↑, real GDP ↑, unemployment ↓. Risk of an inflationary gap. |
| 4 | SLF | ← Left | Taxing interest cuts the after-tax return to saving, so households save less. Real interest rate ↑, quantity of funds ↓, investment ↓ and long-run growth slows. |
| 5 | AD | ← Left | Expected future income is an AD shifter. Households cut spending today. Price level ↓, real GDP ↓, unemployment ↑. A recessionary gap opens. |
| 6 | MD | ← Left | Financial innovation means the same transactions need less money held. With MS fixed, the nominal interest rate ↓. |
If you got 5 or 6 right, move on to Unit 3. If you got 3 or fewer, reread Steps 5 and 6 and redo the drill before continuing. Everything after this depends on it.
This is supply and demand for the whole economy at once. The quantity on the horizontal axis is real GDP. The price on the vertical axis is the price level. Everything you already know about shifting curves still works; only the labels change.
| Curve | Shape | Why |
|---|---|---|
| LAS Long-run aggregate supply | Vertical at potential GDP | Money wages fully adjust, so the real wage returns to full employment no matter what the price level is. Potential GDP depends on resources and technology, not on prices. |
| SAS Short-run aggregate supply | Upward sloping | The money wage rate is fixed in the short run. A higher price level with fixed wages means a lower real wage, so firms hire more and produce more. |
| AD Aggregate demand | Downward sloping | Wealth effect, intertemporal substitution and international substitution (below). |
| Shifts AD | Shifts SAS | Shifts LAS |
|---|---|---|
| Expected future income, inflation, profits · Fiscal policy (G, taxes, transfers) · Monetary policy (money supply, interest rate) · World economy (exchange rate, foreign income) | Money wage rate · Prices of other inputs, e.g. oil · Change in potential GDP | Quantity of labour · Quantity of capital · Technology |
An oil price rise raises firms' costs, so it moves SAS to the left. It does not touch LAS, because potential GDP depends on resources and technology, not on input prices. Writing "oil prices reduce aggregate demand" is a serious conceptual error.
Normally when output falls, prices fall too, because a slump is caused by weak demand. An oil shock is different: it hits costs, so output falls and prices rise at the same time. That combination has its own name, stagflation, and its presence is the fingerprint of a supply shock rather than a demand shock.
| Situation | Condition | Gap name | Unemployment |
|---|---|---|---|
| Above full employment | Real GDP > Potential GDP | Inflationary gap | Below natural rate |
| Full employment | Real GDP = Potential GDP | No gap | Equals natural rate |
| Below full employment | Real GDP < Potential GDP | Recessionary gap | Above natural rate |
This is the part students skip, and it is worth marks on its own.
Either way the economy returns to LAS. The adjustment is slow, which is why governments intervene.
A severe drought sharply raises food and raw-material prices across an economy that began at full employment.
(a) Use the AD–AS model to explain the effect on real GDP, the price level and
unemployment in the short run. Draw a labelled diagram. (6)
(b) Identify the output gap and explain two ways the economy could return to potential GDP. (4)
Draw exactly Fig. 2 above, relabelled: AD unchanged, SAS₀ shifting left to SAS₁, LAS vertical and unmoved, E₀ on LAS, E₁ up and to the left of it. Label P₀, P₁, Y₀, Y₁ and mark the recessionary gap on the horizontal axis.
SAS shifts left. E₀→E₁ climbs the unchanged AD curve, so the price level rises P₀→P₁ while real GDP falls Y₀→Y₁, opening a recessionary gap to the left of LAS.
The drought raises the price of raw materials, which is an input cost for firms. At every price level firms are now willing to supply less output, so short-run aggregate supply shifts left, SAS₀ → SAS₁. Aggregate demand is unchanged, because nothing has happened to wealth, expectations, fiscal or monetary policy, or the world economy. LAS is unchanged, because potential GDP depends on the quantity of labour and capital and on technology, none of which the drought has permanently altered.
Equilibrium moves from E₀ to E₁ along the unchanged AD curve. The price level rises from P₀ to P₁ and real GDP falls from Y₀ to Y₁. Since firms produce less they employ fewer workers, so unemployment rises above the natural rate. Rising prices together with falling output is stagflation.
The output gap is negative: real GDP is below potential GDP, so this is a recessionary gap. It is a problem because output and income are permanently lost, unemployment above the natural rate destroys human capital as skills decay, and household living standards fall.
Two routes back to potential:
1. Automatic wage adjustment. Unemployment above the natural rate creates a surplus of labour, which
pushes the money wage rate down. Firms' costs fall, SAS shifts back right to SAS₀, real GDP returns to
potential and the price level falls back. This works but is slow.
2. Expansionary policy. The government raises spending or cuts taxes, or the central bank increases
the money supply and lowers the interest rate. Either shifts AD right, restoring real GDP to potential
faster. The trade-off is that this raises the price level further rather than reversing the inflation.
Put the two long-run forces on one diagram and the whole model clicks.
An economy\u2019s potential GDP grows by 3% a year while aggregate demand grows by 7% a year. Using AS\u2013AD, explain the outcome. What if AD instead grew by exactly 3%?
AD growing at 7% against LAS at 3%. LAS shifts right by 3%, so capacity genuinely rises and real GDP grows. But AD shifts right by more than LAS, so the extra demand cannot be met by extra capacity alone and is absorbed by rising prices. Result: real GDP grows, and the price level rises persistently — this is demand-pull inflation. If AD keeps outpacing LAS, real GDP is pushed above potential and an inflationary gap opens, with unemployment below the natural rate.
If AD grew at exactly 3%. AD and LAS shift right by the same amount, so the intersection moves horizontally. Real GDP grows at 3% with a stable price level — growth without inflation. This is the ideal outcome and shows the point: inflation comes from the gap between demand growth and capacity growth, not from growth itself.
Bundle every bank, bond and share market in the country into one giant market for borrowing. Savers supply the funds, investors and the government demand them, and the price that clears the market is the real interest rate.
Household income splits three ways, and total spending splits four ways. Setting them equal gives the identity the whole chapter rests on:
| Curve | Slope and reason | Shifts when… |
|---|---|---|
| DLF demand | Downward. A higher real interest rate makes fewer investment projects profitable, so firms borrow less. | Expected profit changes · a government budget deficit appears or grows |
| SLF supply | Upward. A higher real interest rate rewards saving, so households supply more funds. | Disposable income · expected future income · wealth · default risk |
A change in the real interest rate moves you along a curve. Anything else shifts the curve. Examiners test this deliberately, so never write "the interest rate rose so demand fell"; write "the quantity of loanable funds demanded fell".
| Budget surplus (T > G) | Budget deficit (G > T) | |
|---|---|---|
| Effect on curve | Adds to supply: SLF shifts right | Adds to demand: DLF shifts right |
| Real interest rate | Falls | Rises |
| Private saving | Falls | Rises |
| Investment | Rises | Falls — crowding out |
The government and private firms are queuing at the same window for the same pool of savings. When the government borrows more, it bids the interest rate up, and some firms that would have invested at the old rate now walk away. Government borrowing has "crowded out" private investment.
An important detail worth a mark: investment falls by less than the size of the deficit, because the higher interest rate also persuades households to save more, which partly refills the pool.
This is the counter-argument, and questions often ask for it explicitly.
The logic: taxpayers are rational. They know a deficit today means higher taxes tomorrow. So they save more now to pay those future taxes. That extra private saving shifts SLF right by exactly the same amount that the deficit shifted DLF right.
The result: the real interest rate is unchanged, investment is unchanged, and there is no crowding out. Only the quantity of funds traded rises. Parkin treats this as an extreme case, with reality probably somewhere in between.
A government announces a large increase in the tax-free income threshold, cutting income tax for most households while leaving government spending unchanged.
(a) How does the tax cut change the loanable funds market through its effect on
household saving? Use a labelled diagram. (4)
(b) Will the budget move to deficit or surplus, how does that affect the same market, and would the
outcome differ if the Ricardo-Barro effect held? (6)
Diagram: DLF unchanged and downward sloping; SLF₀ shifting right to SLF₁; new equilibrium below and to the right of the old one; label r₀ > r₁ and Q₀ < Q₁.
Higher disposable income raises saving, so SLF shifts right. The real interest rate falls r₀→r₁, the quantity of funds rises Q₀→Q₁ and investment increases.
Shift and reason: a lower income tax raises households' disposable income. Disposable income is one of the shifters of the supply of loanable funds, so at every real interest rate households can save more and SLF shifts right.
New equilibrium: the real interest rate falls from r₀ to r₁ and the quantity of loanable funds rises from Q₀ to Q₁. Cheaper borrowing makes more projects profitable, so investment increases.
With tax revenue down and spending unchanged, T < G, so the government moves into a budget deficit (or a larger one).
Diagram: this is Fig. 3. A deficit is government borrowing, which is added to the private demand for loanable funds (PDLF) to give total demand, so DLF shifts right to DLF₁.
The deficit is added to private demand PDLF, so total demand DLF₁ sits to its right. The real interest rate rises r₀→r₁ and private investment is crowded out.
New equilibrium: the real interest rate rises from r₀ to r₁ and the quantity of funds rises. Higher borrowing costs make some private projects unprofitable, so private investment falls. This is the crowding-out effect. Investment falls by less than the deficit, because the higher rate also draws out extra private saving.
Net of both channels: supply shifted right in part (a) and demand shifts right here. The quantity of funds definitely rises; the effect on the interest rate depends on which shift is larger. In the standard Parkin treatment the deficit effect dominates, so the rate rises on balance.
If the Ricardo-Barro effect holds, the outcome changes completely. Rational taxpayers recognise that today's deficit must be paid for by higher taxes in future, so they save the entire tax cut instead of spending it. SLF shifts right by exactly the amount DLF shifted right (Fig. 4).
Ricardo-Barro: both curves shift right by the same distance, so the real interest rate is unchanged and investment is unaffected. Only the quantity traded rises, so there is no crowding out.
In an open economy the interest rate is set in the world market, not the domestic one. World demand (DLFW) is the sum of all countries' demands and world supply (SLFW) is the sum of all countries' supplies. The world equilibrium real interest rate makes global demand equal global supply.
| International borrower | International lender | |
|---|---|---|
| If isolated, domestic rate would be… | Above the world rate (e.g. 6% vs 5%) | Below the world rate (e.g. 4% vs 5%) |
| At the world rate… | Domestic demand exceeds domestic supply | Domestic supply exceeds domestic demand |
| The gap is… | Net foreign borrowing — funds flow in | Net foreign lending — funds flow out |
| Why it happens | Investment needs exceed domestic saving | Domestic saving exceeds investment |
| Who benefits | Domestic borrowers get cheaper global capital | Domestic savers earn a higher return abroad |
Country A\u2019s domestic loanable funds market alone would clear at 7%. The world equilibrium real interest rate is 5%. Explain Country A\u2019s position, assuming it is a small country.
Country A becomes an international borrower.
Why: its isolated domestic rate of 7% is above the world rate of 5%, which tells us domestic investment demand is large relative to domestic saving. Once integrated into the global market, Country A faces the world rate of 5%, not 7%.
At 5%: the lower rate makes more investment projects profitable, so the quantity of loanable funds demanded rises, while the lower return discourages saving, so the quantity supplied falls. Domestic demand therefore exceeds domestic supply, and that horizontal gap is net foreign borrowing.
Consequences: funds flow in from abroad, domestic borrowers (firms and the government) get access to cheaper global capital than they could raise at home, and investment is higher than it would have been in isolation. Because Country A is small, its borrowing does not move the world rate — it simply takes the 5% as given.
Money pays no interest, so holding it costs you the interest you gave up. That forgone interest is the "price" of money. When it is high you hold less; when it is low you hold more. The central bank fixes how much money exists, and the interest rate moves until people are content to hold exactly that amount.
Parkin plots real money = M ÷ P on the horizontal axis. This matters: a rise in the price level does not shift money demand, because people want the same real purchasing power in their wallet. Instead a higher P reduces M/P, which shifts the MS curve left. Getting this backwards is a classic error.
| Influence | Effect | Movement or shift? |
|---|---|---|
| Nominal interest rate ↑ | Quantity of real money demanded falls | Movement along MD |
| Real GDP ↑ | More transactions, so more money needed | MD shifts right |
| Financial innovation (cards, mobile banking) | Less cash needed | MD shifts left |
| Price level ↑ | Nominal money demand rises proportionally; real money demand unchanged | MD does not shift |
Examiners like this mechanism because it shows you understand why the graph works.
Remember the inverse rule: bond price up ⟹ interest rate down. Always.
Mobile financial services spread rapidly across a country, so households need far less cash for daily transactions. The central bank holds the money supply constant.
Explain the effect on the nominal interest rate using a labelled money market diagram, and describe the mechanism through the bond market.
MS is a vertical line, unchanged. MD₀ shifts left to MD₁. The new equilibrium sits lower down the same vertical MS line. Label i₀ above i₁.
MS is fixed. Financial innovation shifts MD left, so at i₀ people hold more money than they want. They buy bonds, bond prices rise and the interest rate falls i₀→i₁.
Financial innovation is one of the four influences on money holding. Mobile banking lets people carry out the same transactions holding less money, so at every interest rate the quantity of real money demanded falls: MD shifts left. The money supply is fixed by the central bank, so MS does not move.
At the original interest rate i₀ people now hold more money than they want. They get rid of the surplus by buying bonds. Greater demand for bonds raises bond prices, and since a bond pays a fixed sum, a higher price means a lower interest rate. This continues until the rate has fallen to i₁, where people are again content to hold exactly the money that exists. The nominal interest rate therefore falls.
The government has two levers. Fiscal policy is taxing and spending. Monetary policy is controlling money and interest rates. Both end up moving the same AD curve, just by different routes.
| Expansionary | Contractionary | |
|---|---|---|
| Used when | Recessionary gap, Real GDP < potential | Inflationary gap, Real GDP > potential |
| Action | Raise G, cut taxes, raise transfers | Cut G, raise taxes |
| Mechanism | Disposable income ↑ → consumption ↑ | Disposable income ↓ → consumption ↓ |
| AD | Shifts right | Shifts left |
| Result | Real GDP ↑, price level ↑, unemployment ↓ | Real GDP ↓, inflation eases |
Taxes do not only move AD; they also damage incentives, which moves LAS.
An open market operation is the central bank buying or selling government bonds. This is the main tool, and you must be able to describe the full sequence.
When the central bank sells a bond, the buyer pays with money that comes out of the banking system. Reserves fall. Because banks lend a multiple of their reserves, the fall in deposits is larger than the value of bonds sold. That multiplied contraction is why a modest operation moves the whole money supply.
This is the answer structure for any policy question. Three linked markets:
An economy is operating above potential GDP with rising inflation. The central bank decides to act.
(a) Explain how the central bank conducts open market operations under
contractionary policy, how this changes the money supply, and illustrate the effect on the nominal
interest rate. (6)
(b) Explain the likely short-run effects on investment and overall economic activity. (4)
Draw Fig. 5: MD downward sloping and unchanged, MS₀ vertical shifting left to MS₁, equilibrium moving up the MD curve from E₀ to E₁, with i₁ above i₀ and M₁ left of M₀. Horizontal axis is real money (M/P).
Selling bonds drains reserves and deposits, so MS shifts left. People sell bonds to rebuild balances, bond prices fall and the nominal interest rate rises i₀→i₁.
To tighten, the central bank sells government bonds in the open market. Commercial banks and private investors pay for those bonds with funds drawn from the banking system, so bank reserves fall. With fewer reserves banks must cut lending, and since lending creates deposits, deposits fall by a multiple of the reserves withdrawn. The quantity of money therefore decreases and MS shifts left.
At the old rate i₀ people now hold less money than they want. To rebuild their holdings they sell bonds. The extra supply of bonds pushes bond prices down, and a lower bond price for a fixed payment means a higher interest rate. Equilibrium settles at E₁, so the nominal interest rate rises from i₀ to i₁.
Investment. The higher interest rate raises the cost of borrowing. In the loanable funds market credit becomes more expensive, so projects that were marginally profitable no longer cover their financing cost and firms cut back. Investment falls. Interest-sensitive consumer spending on housing and durables falls too.
Overall activity. Lower investment and consumption mean aggregate demand shifts left. Real GDP falls back toward potential, closing the inflationary gap, and inflationary pressure eases. Employment falls and unemployment rises toward the natural rate. The intended outcome is lower inflation and stabilised prices, at the cost of slower growth in the short run.
Without taxes, the labour market clears where labour supply meets labour demand, employment is maximised and the economy produces potential GDP.
An income tax drives a tax wedge between the wage firms pay and the wage workers receive. Because workers decide how much to work based on the after-tax real wage, the incentive to work falls: labour supply contracts, employment declines, and potential GDP decreases.
A tax on capital income such as interest reduces the after-tax return to savers. Saving becomes less attractive, so households save less. In the loanable funds market SLF shifts left, the real interest rate firms face rises, and higher borrowing costs discourage investment. As investment declines, capital accumulation slows and the growth rate of real GDP falls over time.
| Effect on AD (short run) | Effect on AS (long run) | |
|---|---|---|
| Expansionary G ↑ or taxes ↓ | Disposable income and consumption rise, so AD shifts right: real GDP and employment rise | Lower taxes strengthen incentives to work, save and invest, so LAS shifts right and potential GDP rises |
| Contractionary G ↓ or taxes ↑ | Disposable income and consumption fall, so AD shifts left: inflationary pressure eases | Higher taxes weaken incentives to work, save and invest, so LAS shifts left and potential GDP falls |
Monetary policy is the central bank's control of the money supply and interest rates. Its objectives are to stabilise output, control inflation, reduce unemployment and support economic growth. Unlike fiscal policy it involves no government spending or taxation.
A government cuts income tax. Explain the effect on aggregate demand AND on aggregate supply, and state why answering with only one of them loses marks.
Effect on AD (short run). A lower income tax raises households' disposable income, so consumption rises. AD shifts right, raising real GDP and employment and putting upward pressure on the price level. If the economy was already at potential, this opens an inflationary gap.
Effect on AS (long run). The tax cut narrows the tax wedge between the wage firms pay and the wage workers receive. Because workers respond to the after-tax wage, labour supply increases, employment at full employment rises, the economy moves up its production function and potential GDP rises, so LAS shifts right. If the cut also reduces tax on capital income, saving rises, SLF shifts right, the real interest rate falls and investment rises, reinforcing the LAS shift.
Why both matter. The AD effect is temporary and inflationary; the AS effect is permanent and non-inflationary. If AD and LAS both shift right, output rises with far less price pressure than the AD shift alone would cause. Answering with AD only makes the tax cut look purely inflationary and misses the entire supply-side argument, which is the point of Chapter 30. The offsetting risk to mention is the budget deficit, which raises the real interest rate and crowds out investment.
Every question below is set out exactly as it appears on the real paper: same wording, same tables, same part-marks. Maths answers are given as answers only. Theory answers follow the fixed 4-move pattern.
The fictional economy of "Novaria" produces wheat flour, bread, tractors and coffee beans. Assuming 2024 is the base year, the table below summarises the quantities and market prices for 2024 and 2025:
| Economic Activity | 2024 Qty | 2024 Price ($) | 2025 Qty | 2025 Price ($) |
|---|---|---|---|---|
| Wheat flours used for baking bread | 1,000 | 10 | 1,200 | 12 |
| Households purchased breads for consumption | 500 | 40 | 600 | 50 |
| Local businesses invested in buying tractors | 10 | 5,000 | 12 | 5,500 |
| Domestically produced coffee Beans were exported | 200 | 15 | 220 | 20 |
a) Nominal GDP and Real GDP for 2025, using the expenditure approach. [3]
b) Percentage change in Nominal GDP between 2024 and 2025. [3]
c) Real GDP Growth Rate between 2024 and 2025. [2]
Wheat flour is excluded. It is used for baking bread, so it is an intermediate good and counting it would double-count. Bread = C, tractors = I, coffee = X.
The economy of "Zenthia" produces steel, cars, machinery and tea, and imports phones. Assuming 2023 is the base year:
| Economic Activity | 2023 Qty | 2023 Price ($) | 2024 Qty | 2024 Price ($) |
|---|---|---|---|---|
| Steel used to manufacture cars | 800 | 25 | 900 | 30 |
| Households purchased cars for consumption | 300 | 1,200 | 340 | 1,350 |
| Firms invested in buying machinery | 20 | 4,000 | 22 | 4,200 |
| Domestically produced tea was exported | 500 | 8 | 560 | 9 |
| Households purchased imported phones | 400 | 150 | 450 | 170 |
a) Nominal GDP for 2023 and 2024, expenditure approach. [4]
b) Real GDP for 2024 and the GDP Deflator for 2024. [3]
c) Percentage change in Nominal GDP and the Real GDP Growth Rate. [3]
Two traps at once. Steel is used to manufacture cars → intermediate, exclude it. Phones are imported → subtract as M.
In the country of Econopolis, households consume only four goods: Rice, Cheese, Laptops and Coffee. Assume 2022 as the base year.
| Goods Consumed | 2022 (Base Year) | 2023 | 2024 | |||
|---|---|---|---|---|---|---|
| Price ($) | Qty | Price ($) | Qty | Price ($) | Qty | |
| Rice | 10 | 150 | 12 | 135 | 15 | 130 |
| Cheese | 15 | 50 | 20 | 40 | 25 | 30 |
| Laptops | 100 | 10 | 90 | 15 | 80 | 20 |
| Coffee | 20 | 15 | 30 | 10 | 26 | 12 |
a) CPI for 2023 and 2024. [4]
b) Inflation rate for both 2023 and 2024, and interpret your results. [3]
Use 2022 quantities throughout — 150 rice, 50 cheese, 10 laptops, 15 coffee. The 2023 and 2024 quantity columns are deliberate distractors.
In Marisol, households consume only four goods. Assume 2022 as the base year.
| Goods Consumed | 2022 (Base Year) | 2023 | 2024 | |||
|---|---|---|---|---|---|---|
| Price ($) | Qty | Price ($) | Qty | Price ($) | Qty | |
| Bread | 5 | 200 | 6 | 190 | 7 | 180 |
| Fuel | 60 | 80 | 78 | 70 | 72 | 75 |
| Rent | 900 | 12 | 990 | 12 | 1,080 | 12 |
| Medicine | 25 | 40 | 30 | 45 | 38 | 50 |
a) CPI for 2023 and 2024. [4]
b) Inflation for both years, interpreted. [3]
c) One reason the CPI may overstate the true rise in the cost of living. [3]
Consider the economy of Velora:
| Category | Number (millions) |
|---|---|
| Total working-age population | 185 |
| Employed across all sectors | 124 |
| Unemployed after textile plants automated | 7 |
| School leavers searching for a first job | 9 |
| Unemployed due to the construction downturn | 6 |
a) Labour force participation rate and employment-to-population ratio. [3]
b) Unemployment rate and the natural rate of unemployment. [3]
c) Implications for Real GDP, Potential GDP and the Output Gap. [2]
d) If 4 million of the downturn-hit workers are rehired, what percentage of the remaining unemployed is
structurally unemployed? [2]
Unemployed = 7 + 9 + 6 = 22 · Labour force = 124 + 22 = 146
The government of Maryland wants to boost the economy after the pandemic crisis. They have decided to reduce the income tax on wage earners from 10% to 8%. How does a decrease in income tax affect the labor market and potential GDP? Briefly discuss and depict using appropriate diagrams.
The question says "diagrams" in the plural, so two are required: the labour market (real wage rate against quantity of labour) and the production function (real GDP against quantity of labour).
An income tax creates a tax wedge between the wage firms pay and the wage workers receive. Workers
base their supply decision on the after-tax real wage, so a tax discourages work. Cutting the rate from
10% to 8% narrows the wedge, so more people are willing to work at any given wage:
labour supply shifts right, LS₀ → LS₁.
Labour demand does not shift — productivity and the marginal product of labour are unchanged.
The production function does not shift either; we move along it.
Equilibrium moves down the unchanged labour demand curve: employment rises L₀ → L₁ while the real wage paid by firms falls slightly. The wage received by workers is higher than before, because the wedge shrank. On the production function, higher employment means the economy moves up the curve, so real GDP rises Y₀ → Y₁.
Because the extra output is produced at full employment, this is a rise in potential GDP, not a
temporary boom. In AD–AS terms, LAS shifts right.
The trade-off: lost tax revenue risks a budget deficit, which via Chapter 24 raises the real
interest rate and crowds out investment, partly offsetting the gain. Making that link between Unit 07 and
Unit 05 is what separates a strong answer from an average one.
In Country X, which is heavily dependent on oil as a production input, the ongoing geopolitical conflict has caused an oil shortage. Since oil is essential for machinery, transport, and energy-intensive production processes, workers cannot work as efficiently as before without adequate fuel and power. How does this impact the labor market model and the production function? Briefly discuss and illustrate using appropriate diagrams.
Start with the production function. Without fuel, workers cannot operate machinery or transport
efficiently, so the same quantity of labour now produces less output: the production function
shifts down, PF₀ → PF₁.
The labour market follows. Labour demand is derived from the marginal product of labour. Since each
worker now adds less output, firms will pay less and hire fewer: labour demand shifts left, LD₀ → LD₁.
Labour supply does not shift — households' willingness to work at a given real wage is unchanged.
Equilibrium moves down the unchanged labour supply curve: the real wage falls W₀ → W₁ and employment falls L₀ → L₁. On the production function the economy is hit twice: it sits on a lower curve and at lower employment, so potential GDP falls sharply.
Potential GDP falls, so LAS shifts left. This is what makes a shortage more serious than an oil
price rise: a price rise shifts only SAS and is temporary, whereas a shortage that stops workers
producing damages capacity itself.
Consequences: lower real wages cut incomes and consumption; employment and output both fall; and because
LAS has moved, the economy cannot simply wait for wages to adjust — output does not return to the old potential
until fuel supply is restored. Combined with the leftward SAS shift from higher costs, the result is
stagflation with permanently lower capacity until the shortage ends.
According to the Bureau of Statistics of Country X, the working-age population (15–64 years) has increased by 4.88% over the past ten years, reaching 65.5% (10.82 crore) of the total population. Recently, the country has experienced a strong economic recovery, leading to increased job creation and a significant fall in the unemployment rate. Discuss how this situation might affect the real GDP and potential GDP of Country X.
The population growth is a POTENTIAL GDP effect. A working-age population 4.88% larger means a bigger
labour force and a higher full-employment quantity of labour. That is one of Parkin's three causes of
higher potential GDP, so labour supply shifts right, the economy moves up the production function, and
LAS shifts right.
The fall in unemployment is a REAL GDP effect. Recovery and job creation cut cyclical unemployment,
closing a recessionary gap. That moves output toward potential, it does not raise potential.
Real GDP rises on both counts — the recovery closes the gap and capacity itself has grown. Potential GDP rises only because of the larger labour force.
The output gap narrows toward zero and unemployment approaches the natural rate. Two cautions worth a mark each: if aggregate demand grows faster than potential GDP the economy can overshoot into an inflationary gap, with unemployment below the natural rate and rising prices; and the demographic gain is only realised if the new entrants are actually absorbed into employment, otherwise the participation rate falls and the potential is wasted.
| Good | Production | Import | Export | Consumption | P 2024 | P 2025 |
|---|---|---|---|---|---|---|
| Rice | 150 | 0 | 0 | 150 | $10 | $12 |
| Milk | 100 | 0 | 0 | 100 | $20 | $25 |
| Gasoline | 0 | 60 | 0 | 60 | $15 | $18 |
| Cotton | 40 | 0 | 40 | 0 | $30 | $32 |
2024 is the base year and all quantities are constant across both years.
Check with the production approach: (150×10) + (100×20) + (0×15) + (40×30) = 1,500 + 2,000 + 0 + 1,200 = 4,700 ✓ Both approaches agree, which confirms the answer. Note gasoline contributes nothing: it is imported, so it enters C and M and cancels out.
So prices of domestically produced output rose 18.72%.
The consumer basket is the consumption column: 150 rice, 100 milk, 60 gasoline. Cotton is excluded because households consume none of it.
| Good | Basket qty | Cost at 2024 prices | Cost at 2025 prices |
|---|---|---|---|
| Rice | 150 | 150 × 10 = 1,500 | 150 × 12 = 1,800 |
| Milk | 100 | 100 × 20 = 2,000 | 100 × 25 = 2,500 |
| Gasoline | 60 | 60 × 15 = 900 | 60 × 18 = 1,080 |
| Total | $4,400 | $5,380 |
The CPI in the base year is always exactly 100. If you get anything else, you have used the wrong basket or the wrong prices.
The reason: the two measures cover different goods. Gasoline is imported, so it is in the CPI basket (households buy it) but is excluded from GDP. Its price rose 20%. Cotton is exported, so it is in GDP but not in the consumer basket, and its price rose only 6.7%. Because the CPI carries the fast-rising imported good and the deflator carries the slow-rising exported good instead, CPI inflation exceeds deflator inflation.
Alternative accepted answer: the CPI uses a fixed base-year basket while the deflator uses current quantities, so the CPI suffers substitution bias and tends to overstate inflation.
| Category | Millions | Classification |
|---|---|---|
| Total working-age population | 160 | — |
| Employed in AI robotics, smart agriculture, virtual design | 108 | Employed |
| Unemployed due to automation in retail | 5 | Structural |
| Recent graduates searching for first job | 5 | Frictional |
| Unemployed due to recession in manufacturing | 4 | Cyclical |
Note the denominator is 122, not 160. Dividing by the working-age population here is the single most common error on this question.
Implications, which is where the marks are:
Only the frictional group changed. Structural and cyclical numbers are untouched, so do not recalculate them.
All three are answerable from this guide. If you are short on time, Q2 and Q3 are the safest: they are single-diagram questions with clean, well-rehearsed chains. Q1 is the hardest because part (b) has two opposing shifts plus the Ricardo-Barro extension.
The Finance Minister raises the tax-free income threshold for male taxpayers from Tk 2.5 lakh to Tk 3 lakh, and for female taxpayers and those over 65 from Tk 3 lakh to Tk 3.5 lakh.
(a) A reduction in tax raises after-tax income and savings. How will it change
the loanable funds market? Illustrate with a labelled diagram. (4)
(b) Deficit or surplus? How does the budget condition affect the loanable funds market? Would the outcome
change under Ricardo-Barro? (6)
Real interest rate on the vertical axis, loanable funds on the horizontal. DLF downward sloping and unchanged. SLF₀ shifts right to SLF₁. New equilibrium E₁ lies below and to the right of E₀. Mark r₀ above r₁, and Q₀ left of Q₁.
Higher disposable income raises saving, so SLF shifts right. The real interest rate falls r₀→r₁, the quantity of funds rises Q₀→Q₁ and investment increases.
Raising the tax-free threshold lowers income tax paid, which raises households' disposable income. Disposable income is one of the listed shifters of the supply of loanable funds: with more income available, households save more at every real interest rate. Therefore the supply of loanable funds increases and SLF shifts right. The demand curve does not move, because neither expected profit nor the government's borrowing has changed through this channel.
At the old rate r₀ there is now a surplus of loanable funds. Lenders compete and the real interest rate falls to r₁. As it falls, more investment projects become profitable, so the quantity of funds demanded rises along DLF until the market clears at Q₁. The results are a lower real interest rate, a greater quantity of loanable funds and higher investment, which supports capital accumulation and long-run growth.
Tax revenue T falls while government spending G is unchanged, so T < G. The government moves into a budget deficit (or an existing deficit widens). This is the expected outcome the question is pointing at with "serious economic implications".
Diagram: DLF₀ shifts right to DLF₁. Show the private demand curve PDLF underneath, with the horizontal distance between PDLF and DLF₁ labelled as the budget deficit. New equilibrium E₁ is above and to the right of E₀.
The deficit is added to private demand PDLF, so total demand DLF₁ sits to its right. The real interest rate rises r₀→r₁ and private investment is crowded out.
Why: the government must borrow to cover the deficit. In Parkin's framework the government's borrowing is added to the private demand for loanable funds, so total demand DLF = PDLF + deficit shifts right.
Consequences: the real interest rate rises. Higher borrowing costs make some private projects unprofitable, so private investment falls. This is the crowding-out effect: government borrowing displaces private investment. Investment falls by less than the full deficit, because the higher real interest rate also induces households to save more, partly offsetting it. Lower investment means slower capital accumulation and weaker long-run growth.
Note that (a) and (b) push the interest rate in opposite directions: higher saving shifts SLF right (rate down) while the deficit shifts DLF right (rate up). The quantity of loanable funds unambiguously rises. The net effect on the rate depends on which shift is larger; in the standard treatment the deficit effect dominates, so the rate rises overall.
The outcome changes completely. Ricardo-Barro assumes taxpayers are rational and forward-looking: they understand that a deficit today must be repaid by higher taxes tomorrow, so they save the whole tax cut to meet that future liability. Private saving therefore rises by exactly the amount of the deficit, and SLF shifts right by the same distance that DLF shifted right. On the diagram both curves move right together.
Ricardo-Barro: both curves shift right by the same distance, so the real interest rate is unchanged and investment is unaffected. Only the quantity traded rises, so there is no crowding out.
Conflict disrupts global oil supply. Crude prices rise drastically, raising production costs for almost all businesses.
(a) Using the appropriate model, explain how the rise in oil prices affects
real GDP, the price level and unemployment in the short run. Illustrate. (6)
(b) Identify the type of output gap, explain why it is a problem, and discuss how the economy could
return to potential GDP. (4)
Use the AD–AS model. Price level on the vertical axis, real GDP on the horizontal. Draw LAS vertical at potential GDP, SAS₀ upward sloping and AD downward sloping, all intersecting at E₀ on LAS (start at full employment). Then shift SAS₀ left to SAS₁. The new equilibrium E₁ lies up and to the left along the unchanged AD curve. Label P₀ < P₁ and Y₁ < Y₀, and mark the gap between Y₁ and potential GDP. This is exactly Fig. 2 in Unit 3 above.
SAS shifts left. E₀→E₁ climbs the unchanged AD curve, so the price level rises P₀→P₁ while real GDP falls Y₀→Y₁, opening a recessionary gap to the left of LAS.
Oil is an input into production and transport for almost every firm in the economy.
A sharp rise in the crude price raises firms' costs of production at every price level, so firms are
willing to supply less real GDP at each price. Short-run aggregate supply decreases: SAS₀ → SAS₁.
AD does not shift, because nothing has changed in wealth, expectations, fiscal policy, monetary policy
or the world economy through this channel.
LAS does not shift, because potential GDP is determined by the quantity of labour and capital and by
technology. The oil shock is a temporary change in an input price, not a change in productive capacity.
Equilibrium moves from E₀ to E₁: the price level rises from P₀ to P₁ and real GDP falls from Y₀ to Y₁. Because firms are producing less output they need fewer workers, so employment falls and unemployment rises above the natural rate. Rising prices combined with falling output is stagflation, which is the distinctive signature of a negative supply shock, and it is exactly what the United States experienced in the oil crises of the 1970s and early 1980s.
Real GDP Y₁ is now below potential GDP, so the output gap is
negative: this is a recessionary gap.
It is a problem because: output and income that could have been produced are permanently lost;
unemployment above the natural rate means lost incomes for households and reduced consumption and
investment; and prolonged unemployment causes lost human capital as workers' skills decay, so the
damage outlives the shock itself. Meanwhile households face a higher cost of living, so real wages fall.
Route 1 — automatic adjustment through the money wage rate.
With unemployment above the natural rate there is an excess supply of labour, which puts downward
pressure on the money wage rate. As wages fall, firms' costs fall, so SAS shifts back to the right
toward SAS₀. Real GDP rises back to potential GDP and the price level falls back. The same happens
naturally if oil prices themselves subside. This route works but is slow, because money wages are
sticky downward.
Route 2 — expansionary policy. The government can raise spending or cut taxes, or the central bank can
increase the money supply and lower the interest rate. Either shifts AD to the right, restoring real
GDP to potential more quickly. The trade-off is that this closes the gap by raising the price level
further rather than reversing the inflation, so policymakers face a genuine dilemma: fight the
recession or fight the inflation, but not both at once.
Facing persistent inflationary pressure, the central bank of a rapidly growing economy adopts contractionary monetary policy, conducting open-market operations to reduce excess liquidity.
(a) Explain how the central bank carries out open-market operations under
contractionary policy, how these actions affect the supply of money, and illustrate the impact on the
nominal interest rate. (6)
(b) Explain the likely short-run effects on investment and overall economic activity. (4)
Draw the money market: nominal interest rate on the vertical axis, real money (M/P) on the horizontal. MD slopes downward. MS is vertical because the central bank fixes the quantity. Shift MS₀ left to MS₁. Equilibrium moves up along MD from E₀ to E₁, with i₁ above i₀ and M₁ to the left of M₀. This is Fig. 5 in Unit 5 above.
Selling bonds drains reserves and deposits, so MS shifts left. People sell bonds to rebuild balances, bond prices fall and the nominal interest rate rises i₀→i₁.
An open market operation is the central bank's buying or selling of government
securities. Under contractionary policy the central bank sells government bonds in the open
market to commercial banks and private investors.
Buyers pay for those bonds with funds drawn out of the banking system, so banks' reserves fall.
Because banks lend a multiple of their reserves, the fall in reserves forces them to reduce lending,
and since bank lending creates deposits, deposits fall by a multiple of the reserves withdrawn.
Deposits are the largest component of the money supply, so the quantity of money decreases and the
MS curve shifts left.
At the original rate i₀ people now hold less money than they wish to hold. To rebuild their money balances they sell bonds. This increased supply of bonds drives bond prices down, and because a bond pays a fixed sum, a lower bond price means a higher interest rate. The process continues until the rate has risen to i₁, where the quantity of real money demanded once again equals the reduced quantity supplied. The nominal interest rate rises from i₀ to i₁.
The higher nominal interest rate raises the real cost of borrowing. In the loanable funds market credit becomes more expensive, so projects that were only marginally profitable no longer cover their financing costs and firms abandon them. Investment falls. Interest-sensitive household spending falls too, particularly on housing, cars and other durables bought on credit, and banks also tighten lending standards so fewer borrowers qualify.
Lower investment and lower consumption together mean aggregate demand
shifts left. In the AD–AS diagram real GDP falls back toward potential GDP, closing the
inflationary gap the economy started with, and the price level rises more slowly, so
inflationary pressure eases. Employment falls and unemployment rises toward the natural rate.
Overall outcome: lower inflation and more stable prices, achieved at the cost of slower growth and
higher unemployment in the short run. This is the standard trade-off of contractionary monetary policy,
and stating it explicitly is usually worth a mark.
| Unit | Fast learner | Steady / from zero |
|---|---|---|
| 1 · Measuring GDP (Ch 21) | 1.5 h | 3 h |
| 2 · Jobs and Inflation (Ch 22) | 1.5 h | 3 h |
| ◈ · Graph Bootcamp (foundation) | 1 h | 2 h |
| 3 · AD–AS (Ch 27) | 2.5 h | 5 h |
| 4 · Loanable Funds (Ch 24) | 2 h | 4 h |
| 5 · Money Market (Ch 25) | 1.5 h | 3 h |
| 6 · Fiscal & Monetary Policy (Ch 30, 31) | 2 h | 4 h |
| ★ Full exam under timed conditions | 2 h | 3 h |
| Total | 14 hours | 27 hours |
Add roughly 3 hours of spaced revision in the final two days: redraw all six diagrams from a blank page, and redo Section A without looking.