ABF507 Mock Exam 2 - 8 Core Topics (Alternative Scenarios)

📋 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 Beta (2025):

Component	Value (€ billions)
Consumption (C)	620
Investment (I)	180
Government (G)	240
Exports (X)	200
Imports (M)	160
Depreciation	45
Net Factor Income from Abroad	-15

Q1.1 (4 points)

Calculate GDP using the expenditure approach.

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

$GDP = 620 + 180 + 240 + (200 - 160)$ $= 620 + 180 + 240 + 40 = 1080$

Answer: GDP = €1,080 billion

Q1.2 (4 points)

Calculate GNP and NNP (Net National Product).

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GNP: $GNP = GDP + NFIA = 1080 + (-15) = 1065$

NNP: $NNP = GNP - Depreciation = 1065 - 45 = 1020$

• GNP = €1,065 billion
• NNP = €1,020 billion

Note: NFIA is NEGATIVE (-15), meaning more income flows OUT than IN. This is typical for countries with many foreign-owned businesses.

Q1.3 (4 points)

Country Beta's GDP deflator rose from 105 to 112 year-on-year. Calculate the inflation rate.

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$Inflation = \frac{Deflator_{new} - Deflator_{old}}{Deflator_{old}} \times 100%$

$= \frac{112 - 105}{105} \times 100% = 6.67%$

Inflation Rate = 6.67%

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Question 2: Elasticity - Multiple Types with Midpoint Method (14 points)

Part A: Cross Elasticity (7 points)

When the price of coffee rises from $4 to $5, the quantity demanded of tea increases from 200 to 280 cups per week.

Calculate XED (Cross Elasticity of Demand) using the midpoint method. Are these goods substitutes or complements?

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$XED = \frac{%\Delta Q_{tea}}{%\Delta P_{coffee}} = \frac{(Q_2 - Q_1)/Q_{avg}}{(P_2 - P_1)/P_{avg}}$

Step 1: Averages

• $Q_{avg} = (200 + 280) / 2 = 240$
• $P_{avg} = (4 + 5) / 2 = 4.5$

Step 2: % Changes $%\Delta Q_{tea} = \frac{280 - 200}{240} = \frac{80}{240} = 33.33%$ $%\Delta P_{coffee} = \frac{5 - 4}{4.5} = \frac{1}{4.5} = 22.22%$

Step 3: XED $XED = \frac{33.33%}{22.22%} = +1.5$

XED = +1.5 (Positive = SUBSTITUTES)

When coffee price rises, tea demand increases. This confirms tea and coffee are substitutes (XED > 0).

Part B: Income Elasticity (7 points)

When average income rises from $40,000 to $50,000, demand for organic food increases from 100 to 150 units, while demand for instant noodles falls from 80 to 60 units.

Calculate YED for each good and classify them.

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Income Averages:

• $Y_{avg} = (40000 + 50000) / 2 = 45000$
• $%\Delta Y = \frac{10000}{45000} = 22.22%$

Organic Food:

• $Q_{avg} = (100 + 150) / 2 = 125$
• $%\Delta Q = \frac{50}{125} = 40%$
• $YED = \frac{40%}{22.22%} = +1.8$

Instant Noodles:

• $Q_{avg} = (80 + 60) / 2 = 70$
• $%\Delta Q = \frac{-20}{70} = -28.57%$
• $YED = \frac{-28.57%}{22.22%} = -1.29$

Good	YED	Classification
Organic Food	+1.8	Luxury good (YED > 1)
Instant Noodles	-1.29	Inferior good (YED < 0)

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Question 3: Fintech Innovation & Banking (12 points)

Scenario:

Country Techland experiences explosive growth in peer-to-peer (P2P) lending platforms and cryptocurrency wallets. Traditional bank deposits are shrinking rapidly.

Q3.1 (6 points)

Analyze how fintech innovations challenge traditional banking and monetary policy.

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Challenge 1: Disintermediation

• P2P platforms bypass banks entirely
• Savers connect directly with borrowers
• Banks lose traditional deposit → loan model
• Credit creation outside banking system

Challenge 2: Regulatory Gaps

• Fintech operates in regulatory gray zones
• Not subject to same capital requirements
• Consumer protection may be inadequate
• Systemic risks may build up undetected

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Monetary Policy Challenges:

Challenge 1: Interest Rate Transmission Weakened

• P2P rates determined by market, not policy rate
• Central bank rate changes ignored by platforms
• Less influence over credit conditions

Challenge 2: Money Supply Measurement

• Cryptocurrency not in M2 definition
• P2P deposits may be miscounted
• Velocity of digital money unknown

Q3.2 (6 points)

Recommend THREE regulatory responses to preserve financial stability.

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Response 1: Prudential Regulation for Fintech

• License P2P lenders as financial institutions
• Apply capital and liquidity requirements
• Regular audits and stress tests
• Protects consumers and system

Response 2: Sandbox Approach

• Controlled testing environment for innovation
• Monitor risks before full deployment
• Balance innovation with safety
• Learn before regulating

Response 3: Interoperability Requirements

• Require fintech to integrate with central bank systems
• Enable monitoring of money flows
• Preserve policy transmission channels
• Example: Real-time payment systems

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Question 4: Demographic Transition & Economic Growth (12 points)

Scenario:

Country Silverland has seen its dependency ratio (dependents/working-age) rise from 0.4 to 0.7 over 20 years. Pension costs have doubled, and productivity growth has stalled.

Q4.1 (6 points)

Explain TWO economic consequences of rising dependency ratio.

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Consequence 1: Fiscal Pressure

• More retirees claim pensions and healthcare
• Fewer workers pay taxes
• Tax base shrinks while spending rises
• Budget deficits and national debt increase
• May require benefit cuts or tax increases

Consequence 2: Slower GDP Growth

• GDP growth = Labor growth + Productivity growth
• Shrinking workforce = negative labor contribution
• Need higher productivity just to maintain output
• Per-capita growth may decline

$\text{GDP Growth} \approx \underbrace{n}{\text{Labor↓}} + \underbrace{g}{\text{Productivity}}$

Q4.2 (6 points)

Propose TWO policy responses to mitigate negative effects.

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Policy 1: Raise Retirement Age

• Increases effective labor supply
• Reduces pension payouts duration
• Utilizes experienced workers
• Challenge: resistance from workers

Policy 2: Pro-Natalist Policies

• Child subsidies, parental leave
• Childcare support
• Long-term fix (20+ years to affect workforce)
• Has worked in France, Scandinavian countries

Policy 3: Immigration

• Import working-age labor
• Immediate impact on dependency ratio
• Brings skills and entrepreneurship
• Political challenges in some countries

Policy 4: Automation Investment

• Replace workers with robots/AI
• Boost productivity to offset labor decline
• Maintain output with fewer workers

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Question 5: Credit Crunch & Deflation (10 points)

Scenario:

After a sovereign debt crisis, Country Rustland's banks tightened lending standards dramatically. Bank credit to private sector fell 20% year-on-year. Property prices dropped 15%.

Question: Analyze the transmission mechanism from credit crunch to deflation.

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Stage 1: Credit Supply Shock

• Banks fear defaults → raise lending standards
• Fewer loans approved
• Interest spreads widen
• Money multiplier falls

Stage 2: Aggregate Demand Collapse

• Households can't borrow for consumption
• Firms can't finance investment
• Property buyers disappear (prices fall 15%)
• C↓ + I↓ → AD shifts LEFT

Stage 3: Deflationary Pressure $AD↓ \rightarrow P↓$

• Firms cut prices to move inventory
• Wage growth turns negative
• General price level falls

Stage 4: Debt Deflation Spiral (Fisher Effect)

• Real value of debt rises as prices fall
• Borrowers struggle to repay
• More defaults → more bank losses
• Banks tighten further
• Self-reinforcing downward spiral

Stage 5: Expectations Anchor

• If deflation expected, consumers delay purchases
• "Why buy today if cheaper tomorrow?"
• Further reduces demand
• Hard to escape once entrenched

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Question 6: Exchange Rate & Interest Rate Policy (12 points)

Scenario:

Country Floatland allows its currency to float freely. Its central bank cuts rates from 4% to 2% to stimulate a stagnant economy. Within weeks, the currency depreciates 10%.

Q6.1 (6 points)

Explain TWO channels through which rate cuts lead to currency depreciation.

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Channel 1: Interest Rate Parity

• Lower rates reduce returns on domestic assets
• International investors seek higher yields elsewhere
• Sell domestic currency to buy foreign assets
• Increased supply of domestic currency → depreciation

$i_{domestic}↓ < i_{foreign} \Rightarrow \text{Capital Outflow} \Rightarrow \text{Currency↓}$

Channel 2: Inflation Expectations

• Rate cut signals easier monetary policy
• Markets expect higher future inflation
• Currency's purchasing power expected to fall
• Speculators sell currency in advance

Q6.2 (6 points)

Discuss TWO potential benefits and TWO risks of allowing this depreciation.

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BENEFITS:

Benefit 1: Export Competitiveness

• Domestic goods cheaper for foreigners
• Exporters gain market share
• Tourism increases
• Improves trade balance (J-curve effect)

Benefit 2: Import Substitution

• Imports become expensive
• Consumers switch to domestic alternatives
• Supports local industries

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RISKS:

Risk 1: Imported Inflation

• Oil, commodities priced in USD
• Import prices rise 10%+
• Cost-push inflation
• May force central bank to reverse cuts

Risk 2: Foreign Debt Burden

• If government/firms borrowed in USD
• Debt becomes 10% more expensive in local currency
• Could trigger defaults
• Financial instability

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Question 7: Regression Analysis - Economic Growth (14 points)

Model (Panel of Emerging Markets):

$$Growth = 2.1 - 0.4 \times Inflation_{(2.85)} + 0.8 \times TradeOpen_{(3.10)} + 0.5 \times Education_{(1.45)}$$

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

Q7.1 (6 points)

Identify which variables are statistically significant and interpret the TradeOpenness coefficient.

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Statistical Significance (|t| > 2.0):

| Variable | t-stat | |t| | Significant? | |----------|--------|-----|--------------| | Inflation | 2.85 | 2.85 | ✅ YES | | TradeOpenness | 3.10 | 3.10 | ✅ YES | | Education | 1.45 | 1.45 | ❌ NO |

TradeOpenness Interpretation:

• Coefficient = +0.8
• For each 1-unit increase in trade openness, economic growth increases by 0.8 percentage points
• Highly significant (t = 3.10)
• Confirms benefits of international trade

Q7.2 (8 points)

Discuss why Education might not be significant despite theory suggesting it should matter. Propose TWO explanations.

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Explanation 1: Time Lag

• Education's benefits take decades to materialize
• Child educated today → productive worker in 20 years
• Cross-sectional data may miss this lag
• Panel data might show effect over longer horizon

Explanation 2: Measurement Issues

• "Education" may be poorly measured
• Years of schooling ≠ quality of education
• School enrollment ≠ actual learning
• Better measure might show significance

Explanation 3: Multicollinearity

• Education may correlate with TradeOpenness
• Open economies invest more in education
• Effect captured by trade variable
• Check correlation matrix

Explanation 4: Threshold Effects

• Education only matters after certain level
• Linear model misses non-linear relationship
• Could try quadratic term: Education²

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Question 8: Monetary vs Fiscal Policy - Stagflation (14 points)

Scenario:

Country Stuckland faces stagflation: inflation at 8% and unemployment at 9%. The economy is simultaneously experiencing high prices and high unemployment.

Q8.1 (8 points)

Explain why stagflation is particularly challenging for policymakers. Discuss the trade-offs.

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The Stagflation Dilemma:

Traditional Policy Responses:

• High inflation → Tight monetary policy (raise rates)
• High unemployment → Loose fiscal/monetary policy (lower rates, increase spending)

The Problem:

• These responses are CONTRADICTORY
• Can't tighten AND loosen simultaneously

Trade-off 1: Fight Inflation

• Raise interest rates
• Reduces AD → lowers inflation
• BUT: Also reduces output and employment
• Makes unemployment WORSE

Trade-off 2: Fight Unemployment

• Cut rates, increase spending
• Boosts AD → creates jobs
• BUT: With supply constraints, prices rise
• Makes inflation WORSE

Root Cause Matters:

• Demand-pull inflation: can fix with tightening
• Cost-push (stagflation): Supply-side problem
• AD policy alone cannot solve

Q8.2 (6 points)

Recommend a policy mix to address stagflation. Explain your reasoning.

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Recommended Approach: Supply-Side Focus + Gradual Tightening

Monetary Policy:

• Gradual, measured rate increases
• Anchor inflation expectations without crushing economy
• Communicate clearly to maintain credibility

Fiscal Policy:

• Resist temptation for demand stimulus
• Focus on supply-side measures:
  • Reduce regulatory burdens
  • Cut taxes on production (not consumption)
  • Invest in infrastructure (long-term supply boost)

Supply-Side Reforms:

• Energy policy: increase domestic production
• Labor market flexibility
• Trade agreements: reduce input costs
• Technology investment: boost productivity

Example: Volcker Approach (1980s USA)

• High rates to kill inflation expectations
• Short-term pain (recession)
• Long-term gain (stable prices enabled growth)

Key Insight: $\text{Stagflation} = \text{Supply Shock} \rightarrow \text{Need Supply-Side Solution}$

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🏁 Summary

Q	Topic	Points
1	GDP & National Income	12
2	Elasticity (XED, YED)	14
3	Fintech & Banking	12
4	Demographic Transition	12
5	Credit Crunch & Deflation	10
6	Exchange Rate & Interest Rate	12
7	Regression Analysis	14
8	Stagflation Policy	14
Total		100

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Good luck! Show all working for partial credit.