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Test C – Question 1
In 2000, there was a significant decrease in the number of tourists arriving in Israel, and following this, a wave of layoffs began in the tourism industry.
- Assume that in the initial state the economy is in unemployment .
Show and explain, using a revenue curve, the change that will occur in the composition of production in the economy due to the wave of layoffs in the tourism industry. - Show a complete diagram of the balance of payments.
Model the changes that will occur in the scheme due to the decrease in the number of tourists arriving in Israel. - Assume that in the initial state the economy is in equilibrium with unemployment .
Show and explain, using the Keynesian model, the effect of the decline in the number of tourists on the size of the GDP and the size of the deflationary gap.
answer:
Section A:
The yield curve shows us the range of products and services that a country can produce. This curve is also called the “production possibilities frontier” – a concept that indicates that the country cannot produce more than the range of products/services that lie on the yield curve.
- On the revenue curve (e.g. point D) – a situation in which the country uses virtually all factors of production and cannot produce more of a particular product without giving up the production of other products.
- Inside the payoff curve (e.g. point B) – a situation in which the country does not use all the factors of production in the country, and it can increase production in the economy, if it uses all the factors of production. In this situation, there is unemployment of some of the factors of production.
Section A of the question states that the economy is in a starting position of unemployment.
For the sake of simplicity, we will draw the return curve so that the horizontal axis represents tourism services (in fact, this is a product called “tourism services” and includes: hotel accommodation, visits to tourist sites, and everything that tourists find money for). The vertical axis represents the rest of the products and services produced in the economy. Since in the initial state the economy is unemployed – the economy is inside the return curve, that is: the economy is at point A (for example) where `X_0` tourism services and `Y_0` other products and services are produced.
After the wave of layoffs in the tourism industry, fewer tourism services will be provided and unemployment will increase even more. Assuming that there are layoffs only in the tourism industry – the economy will move to point B. At this point, fewer “tourism services” (only `X_1` ) are now produced compared to the initial situation, but the same amount of other goods and services as in the initial situation.
Section B:
The balance of payments is a report that presents a consolidated picture of the inflow and outflow of foreign currency (= foreign exchange) into and out of Israel during a certain period (usually a year).
When foreign currency enters the country – the amount is marked with a “+”.
When foreign currency leaves the country, the amount is marked with a “-“.
The balance of payments – as its name suggests, includes the items in it that are supposed to balance each other, namely:
Current account + capital account and financial account + net reserve assets + statistical differences = 0.
- The export of tourism services is small, and therefore the foreign exchange flows entering the country due to the export of services will decrease. Let’s assume, for example, that the decrease is from 10.9 to 8.9 (a decrease of 2). As a result, the current account decreases and falls from: -1.4 to: -3.4 (a decrease of 2).
- The country’s foreign exchange reserves are small (since fewer tourists are coming and therefore less foreign currency is coming into the country). As a result, net reserve assets will increase from: +2.9 to: +4.9 (an increase of 2).
Explanation: Due to the decrease in exports of services, there was a decrease in the current account (in the example in the table, this is a decrease of $2 billion). In order to balance this decrease and “reset” the balance sheet, a source of foreign exchange is needed, which is the state’s reserve assets. In fact, we will treat the reserve assets as an additional source of foreign exchange receipts and therefore indicate that they increased by NIS 2 billion.
Note: In the opposite situation, where, for example, there was an increase in the export of tourism services and therefore an increase in the current account – the reserve assets constitute a use, and therefore in the balance sheet we would indicate that they decreased.
Section C:
The output in the initial state is `Y_0` , which is actually “aggregate demand”, that is, the sum of all demand in the economy (private consumption + public consumption + investments + exports – imports).
In the initial situation, the economy is in equilibrium with unemployment – that is, not all factors of production in the economy are utilized, and therefore `Y_0` is less than the maximum possible output `(Y_F)` , which is the output in a situation where all factors of production in the economy are utilized and there is no unemployment.
The deflationary gap is a situation in which, in a state of equilibrium, actual output is less than maximum output, and therefore in the initial state there is in fact a “deflationary gap in the economy.”
Explanation: `E_0` is the aggregate demand curve of the economy that crosses the 45° auxiliary line at a national income level `Y_0` , which is less than `Y_F` , and therefore `Y_0` is an equilibrium point in the initial situation and not `Y_F` . The reason for this is clear: with a gross domestic product `Y_F` (= national income) the output `CO` is produced, but with this income the quantity `BO` is only wanted to be bought.
In Figure 3, this is expressed in the existence of the gap `Bc` . This gap is called the “deflationary gap”. It represents the difference between what is produced and what is wanted to be bought in a state of full employment. This gap is expressed in reality in the “excess” of goods and services produced relative to demand, and it causes a decrease in prices and a reduction in national income, up to the equilibrium point which is `Y_0` (before the decrease in tourism).
Following the decrease in the number of tourists, exports will decrease (as we saw in the previous section, tourists from abroad who come to Israel are actually included in “exports of tourism services”). Due to the decrease in exports, aggregate demand `(E)` will also decrease, as there is:
`E = C+G+I+XM`
( `C` = private consumption, `G` = public consumption, `I` = investment, `X` = exports, `M` = imports)
From the equation we see that if `X` is small – `E` is also small.
Due to the decrease in the number of tourists and the decrease in exports and aggregate demand, output will be even smaller (to `Y_1` ) and the deflationary gap in the economy will increase to `CD` .