ABF507 Mock Exam 1 - 8 Core Topics

📋 Exam Information

Item	Details
Total Points	100
Time Allowed	120 minutes
Questions	8 Questions
Format	Calculation + Essay

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Question 1: GDP Measurement & Calculation (12 points)

Data for Country Alpha (2025):

Component	Value ($ billions)
Consumption (C)	750
Investment (I)	200
Government (G)	280
Exports (X)	120
Imports (M)	150
Depreciation	60
Net Factor Income from Abroad	30

Q1.1 (4 points)

Calculate GDP using the expenditure approach.

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Formula: GDP = C + I + G + (X - M)

$GDP = 750 + 200 + 280 + (120 - 150)$ $= 750 + 200 + 280 - 30 = 1200$

Answer: GDP = $1,200 billion

Q1.2 (4 points)

Calculate GNP and NDP.

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GNP: $GNP = GDP + NFIA = 1200 + 30 = 1230$

NDP: $NDP = GDP - Depreciation = 1200 - 60 = 1140$

• GNP = $1,230 billion
• NDP = $1,140 billion

Q1.3 (4 points)

If Nominal GDP (2026) = $1,350B and Real GDP (2026) = $1,250B, calculate the GDP Deflator and inflation rate.

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GDP Deflator: $Deflator = \frac{Nominal}{Real} \times 100 = \frac{1350}{1250} \times 100 = 108$

Inflation Rate (base year = 100): $Inflation = \frac{108 - 100}{100} \times 100% = 8%$

• GDP Deflator = 108
• Inflation Rate = 8%

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Question 2: Elasticity Calculation - Midpoint Method (14 points)

Part A (8 points)

A clothing store observes:

• Before: Price = $80, Quantity = 500 units
• After: Price = $100, Quantity = 400 units

Calculate PED using the midpoint method and classify the elasticity.

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$PED = \frac{(Q_2 - Q_1) / [(Q_1 + Q_2)/2]}{(P_2 - P_1) / [(P_1 + P_2)/2]}$

Step 1: Averages

• $Q_{avg} = (500 + 400) / 2 = 450$
• $P_{avg} = (80 + 100) / 2 = 90$

Step 2: % Changes $%\Delta Q = \frac{400 - 500}{450} = \frac{-100}{450} = -22.22%$ $%\Delta P = \frac{100 - 80}{90} = \frac{20}{90} = 22.22%$

Step 3: PED $PED = \frac{-22.22%}{22.22%} = -1.0$

PED = -1.0 (Unit Elastic)

At unit elasticity, revenue stays constant when price changes.

Part B (6 points)

Calculate total revenue at both price points and verify the elasticity classification.

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Revenue Calculation:

• Before: TR = $80 × 500 = $40,000
• After: TR = $100 × 400 = $40,000

Revenue is UNCHANGED ($40,000 both times)

This confirms Unit Elastic (|PED| = 1): price change has no effect on total revenue.

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Question 3: Digital Finance & Money Supply (12 points)

Scenario:

Digital banks in Country Doughland offer high-yield e-savings products. Traditional banks are facing deposit outflows, and central bank data shows an unexplained jump in M2.

Q3.1 (6 points)

Analyze how digital-finance innovation affects the measurement and control of money supply.

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Effects on MEASUREMENT:

Point 1: Blurred M1/M2 Boundaries

• Digital wallets allow instant transfers between savings and transactions
• Traditional M2 definitions may not capture new instruments
• Money appears in multiple categories simultaneously

Point 2: Velocity Increases

• Digital payments are instantaneous
• Same money circulates faster
• Official statistics may underestimate activity

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Effects on CONTROL:

Point 1: Reserve Requirements Less Effective

• Digital banks operate with lower costs and may hold fewer reserves
• Money flows quickly to non-bank platforms
• Central bank's reserve ratio tool has diminished impact

Point 2: Interest Rate Transmission Weakened

• Digital platforms may set rates independent of policy rate
• Consumers quickly switch to highest-yield options
• Traditional banks lose pricing control

Q3.2 (6 points)

Suggest THREE approaches for how the central bank should adapt reserve requirements.

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Approach 1: Extend Reserves to Digital Platforms

• Apply reserve requirements to e-money issuers and digital wallets
• Creates level playing field with traditional banks
• Maintains monetary policy effectiveness

Approach 2: Dynamic/Tiered Reserve Requirements

• Adjust ratios based on deposit velocity and risk
• Higher reserves for highly liquid digital accounts
• Use real-time data for calibration

Approach 3: Central Bank Digital Currency (CBDC)

• Issue digital currency directly from central bank
• Provides alternative to private digital platforms
• Enables programmable monetary policy
• Gives central bank direct control over digital money

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Question 4: Ageing Population & Investment (12 points)

Scenario:

Country Bronland has an aging population and shrinking labor force. Households increase precautionary savings, but firms reduce investment due to lower demand expectations.

Q4.1 (6 points)

Discuss TWO points on how an ageing population may hinder investment.

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Point 1: Reduced Consumer Demand → Lower Investment

• Elderly consume less (no need for houses, cars)
• Shrinking working-age population = fewer consumers
• Businesses see declining future demand
• Rational response: reduce investment in capacity
• Example: Japan's "lost decades"

Point 2: Labor Shortage → Lower Return on Capital

• Investment requires workers to operate capital
• Fewer workers → lower marginal productivity of capital
• Each new machine generates less output
• Firms invest less because return on investment decreases

Q4.2 (6 points)

Discuss TWO points on how fiscal policy might FAIL to stimulate investment under these conditions.

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Point 1: Crowding Out Effect

• Government borrows to fund stimulus
• Increased demand for funds → higher interest rates
• Higher rates discourage private investment
• Net effect: Government spending replaces private investment

Point 2: Ricardian Equivalence

• Households expect future taxes to pay for current spending
• Rational response: save more now (especially elderly)
• Increased savings offset stimulus spending
• Investment unchanged because demand unchanged

Point 3: Structural vs Cyclical Mismatch

• Fiscal stimulus works for cyclical downturns
• Ageing is a STRUCTURAL problem
• Temporary stimulus cannot fix permanent demographic shift

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Question 5: M2 Contraction & Deflation (10 points)

Scenario:

After a major bank failure, households withdrew deposits, reducing M2 by 15%. Investment plunged, and the currency strengthened unexpectedly.

Question: Explain why M2 contraction may cause deflationary pressure.

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Step 1: M2 Falls → Less Money in Circulation

• Bank failure triggers panic withdrawals
• Money multiplier works in reverse
• Credit creation collapses
• Total money supply shrinks

Step 2: Less Money → Lower Aggregate Demand

• Households and firms have less liquidity
• Consumption (C) falls as people hoard cash
• Investment (I) falls as credit dries up
• AD shifts LEFT

Step 3: Lower AD → Downward Price Pressure

• Same supply but less demand → prices fall
• Firms cut prices to attract customers
• Wage pressures turn negative
• DEFLATION begins

Step 4: Deflationary Spiral

• If people expect prices to fall, they delay purchases
• Delay reduces demand further
• Self-fulfilling spiral
• Real interest rates rise (nominal can't go below zero)

Why Currency Strengthens:

• Less money → each unit worth more
• Deflation increases purchasing power
• Attracts international investors
• Capital inflows strengthen currency

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Question 6: Monetary Easing & Capital Outflows (12 points)

Scenario:

Country Araland's central bank unexpectedly reduces policy rate from 3.0% to 1.5%. Household savings fall, investment surges, and inflation expectations rise.

Q6.1 (6 points)

Discuss TWO ways monetary easing may crowd out OR crowd in private investment in the long term.

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CROWDING IN (Investment INCREASES):

Effect 1: Lower Borrowing Costs

• Interest rate halved (3% → 1.5%)
• Cost of capital decreases
• More projects become profitable (NPV positive)
• Investment increases

Effect 2: Improved Confidence

• Central bank signals commitment to growth
• Animal spirits revive
• Positive sentiment leads to investment
• Multiplier effects spread

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CROWDING OUT (Long-run DECREASE):

Effect 1: Asset Price Inflation

• Low rates push money into speculation
• Stock/property prices inflate
• Capital flows to speculation, not productive investment
• Creates bubbles

Effect 2: Inflation Uncertainty

• Aggressive easing raises inflation expectations
• Uncertainty about future real returns
• Businesses hesitate on long-term investment

Q6.2 (6 points)

Evaluate TWO ways capital outflows may occur.

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Mechanism 1: Interest Rate Differential

• Domestic rate falls to 1.5%
• Foreign rates higher (e.g., US at 4%)
• Carry trade reverses: money moves abroad
• Capital outflows weaken currency

Mechanism 2: Loss of Confidence

• Unexpected rate cut signals desperation
• Investors question central bank credibility
• Fear of inflation or currency collapse
• Capital flight to safe havens (USD, CHF)

Consequences:

• Currency depreciation
• Import prices rise
• Foreign reserves depleted
• Potential financial instability

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Question 7: Regression Analysis & Interpretation (14 points)

Regression Model (ASEAN Economies):

$$CO_2 = 1.8 + 0.6 \times GDPcapita_{(2.00)} + 0.4 \times Gini_{(2.01)} - 0.3 \times GreenInvest_{(3.21)}$$

Figures in brackets are t-statistics. Critical value = 2.0

Q7.1 (6 points)

Interpret the coefficient for GreenInvestment. Is it statistically significant?

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Coefficient Interpretation:

• β = -0.3 means: for each 1-unit increase in green investment, CO₂ emissions DECREASE by 0.3 units
• Negative sign indicates inverse relationship
• Green investment is environmentally beneficial

Statistical Significance:

• t-statistic = 3.21
• |t| = 3.21 > 2.0 (critical value)
• YES, statistically significant at 5% level
• We can confidently say green investment reduces emissions

Q7.2 (8 points)

Debate TWO points each on how inequality (Gini) and green investment affect environmental outcomes, referring to regression results.

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INEQUALITY (Gini):

Point 1: Higher Inequality → Higher Emissions

• Coefficient = +0.4, significant (t = 2.01)
• Wealthy elites consume disproportionately more
• Multiple homes, private jets, luxury goods
• Political power may block environmental regulations

Point 2: Counter-argument

• Correlation ≠ causation
• Rapidly growing economies have both high Gini AND high emissions
• Omitted variable: industrialization stage affects both

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GREEN INVESTMENT:

Point 1: Reduces Emissions (Strong Evidence)

• Coefficient = -0.3, highly significant (t = 3.21)
• Investment in renewable energy, clean tech
• Replaces fossil fuel infrastructure
• Policy implication: subsidize green investment

Point 2: Limitations

• Diminishing returns over time
• Benefits may have time lag
• Needs sustained political will

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Question 8: Fiscal vs Monetary Policy Comparison (14 points)

Q8.1 (8 points)

Compare and contrast monetary policy and fiscal policy in terms of: a) Authority and tools b) Speed and precision c) Limitations

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Aspect	Monetary Policy	Fiscal Policy
Authority	Central Bank (independent)	Government (political)
Tools	Interest rates, OMO, reserve requirements	Government spending, taxation
Speed	Fast (weeks)	Slow (months for legislation)
Precision	Less precise (indirect effects)	More targeted (specific sectors)
Political	Independent	Highly political

Limitations:

Monetary Policy:

• Liquidity trap (rates can't go below zero)
• Time lags (6-18 months for full effect)
• Banks may not pass rate cuts to customers

Fiscal Policy:

• Legislative delays
• Crowding out private investment
• Increases national debt

Q8.2 (6 points)

During a recession with high unemployment and low inflation, which policy mix would you recommend? Explain.

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Recommendation: Combined Expansionary Approach

Monetary Policy:

• Cut interest rates aggressively
• Quantitative easing if needed
• Fast implementation helps quickly

Fiscal Policy:

• Increase government spending on infrastructure
• Temporary tax cuts to boost consumption
• Targeted support for unemployed

Why Both:

• Monetary alone may be insufficient (liquidity trap risk)
• Fiscal provides direct demand stimulus
• Creates jobs directly (infrastructure)
• Synergy: low rates make government borrowing cheaper

Transmission: $\text{Low rates} + G\uparrow + T\downarrow \rightarrow C\uparrow + I\uparrow \rightarrow AD\uparrow \rightarrow \text{Output & Jobs}$

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🏁 Summary

Q	Topic	Points
1	GDP Calculation	12
2	Elasticity (Midpoint)	14
3	Digital Finance & M2	12
4	Ageing & Investment	12
5	M2 & Deflation	10
6	Monetary Easing & Capital Outflows	12
7	Regression Analysis	14
8	Fiscal vs Monetary Policy	14
Total		100

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Good luck! Show all working for partial credit.