Sample micro and macro questions to help summer vacation candidates to prepare for their interviews.
What is a public good?
Public goods are goods that have the characteristics of being non-rival and non-excludable. For example, a park is a public good because people do not need to compete to use it. One person using it does not prevent another from using it.
Because you cannot prevent people from using a public good, you cannot charge them for using it either. This means that there is no incentive for a private company to provide a public good because they cannot make any profit from doing so.
This then is a market failure and the government must step in to provide the public good.
Why does the government provide street lighting?
Street lighting is a form of public good. It is non-rival. However, it may be excludable. For example, a motorist could be forced to pay a toll for the lights to come on.
But the cost of setting up a toll on each street may be too expensive. As such, a private company is unlikely to want to undertake such an endeavour. Furthermore, the social benefits from providing streetlights – such as reduced accidents, etc could not be reflected in the cost that a company could charge.
In this case it would make more sense for the government to provide street lighting, as there are economies of scale in providing the entire neighbourhood with lighting. There are also cross-subsidisation costs (ie providing street lights reduces crime and therefore reduces policing costs).
Why does the government provide insurance against unemployment?
The need for insurance arises because there is an uncertainty about the future. In this case, there is an uncertainty that one will be employed forever in the future. The market failure, thus, is lack of information.
Whilst the private sector can provide insurance, it is unlikely to provide unemployment insurance. There are three reasons for this: adverse selection, moral hazard and probabilities.
Adverse selection suggests that an individual who knows that they are likely to be unemployed in the future will take out the insurance. Unfortunately, an insurance company has no real way of knowing whether an individual is likely to quit his job or has a bad employment history without undertaking expensive investigation. Therefore, in order to provide insurance the company would need to charge high premiums – which consequently disincentivises good workers from taking out insurance.
Moral hazard suggests that an individual who takes out the insurance now has incentive to take more risks and possibly lose their jobs. This is because the marginal cost of being unemployed is decreased because the insured individual knows they will get an insurance payout whilst unemployed.
Finally an insurance company is usually able to diversify its risk probabilities such that if one individual has to claim on their insurance another one does not (ie in case of a fire – it is unlikely that two houses in different neighbourhoods would go up in flames in the same period). However, it is likely that when an economy is badly affected that an entire industry goes bust and everyone loses their jobs. In such an event, it is unlikely that an insurance company would be able to make the payouts and so would go bust.
The government, however, can address all of the above issues discussed. It can monitor an individual’s employment history and assess whether unnecessary risks were taken. It can create criteria for eligibility of unemployment insurance payouts as well as ensure individuals look for work. And finally, it can take income from tax receipts, etc to pay for unemployment benefits when necessary and similarly recoup these incomes when the economy picks up.
What is fiscal and monetary policy?
Fiscal policy is the use of government spending and tax collection to influence the economy. Whereas, monetary policy attempts to influence the economy via interest rates and the supply of money.
Which components of aggregate demand might a fall in interest rates affect in the short run?
Aggregate demand is total demand for goods and services in an economy. It is often expressed as consumption, plus investment, plus government spending, plus exports, minus imports. A cut in interest rates has the potential to affect many of these components.
Cutting interest rates would affect consumption. Households would have less incentive to save and more incentive to borrow, and hence increase spending. This is because they would receive less interest on their savings and have to pay less interest on loans, such as a mortgage, encouraging borrowing.
Similarly, cutting interest rates may affect investment. Lower interest rates would make more potential business projects profitable, suggesting firms will increase investment.
Both exports and imports may also be affected. If UK interest rates fall while other countries interest rates remained unchanged, investors may move their money out of the UK and into other economies. This outflow of ‘hot money’ could cause sterling to weaken making UK exports cheaper and imports more expensive. This will lead to greater demand for UK exports and less demand for imports. The overall affect this will have on aggregate demand would depend on the price elasticity of exports and imports.
Why do many economists worry about deflation?
Deflation is a fall in the general price level of goods and services.
The main reason economists worry about deflation is that it can depress economic activity. When consumers and firms expect prices to fall it reduces the incentive for them to spend. As savers will receive a higher real rate of return on their savings and a consumer who forgoes buying a good today may be able to purchase the same good for less in the future.
Consumers and firms would also have less incentive to borrow money which could be used to fund consumption or investment. As anyone taking out a loan will know they will have to repay the loan in pounds that are worth more than the pounds they originally borrowed. Deflation is often mentioned as a factor that has contributed to Japan’s stagnant economic performance since the early 1990s.
Another problem from deflation is it can lead to higher unemployment due to the rigidity of wages. In a deflationary economy wages as well as prices should fall. But wages tend to be ‘sticky downwards’, as it’s difficult to cut workers nominal pay. This might mean that an economy is not able to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept a decline in wages.
Aside from cutting interest rates how else did the Bank of England try to stimulate the economy during the recession?
The Bank of England’s (BoE) conventional tool to stimulate the economy and hence boost inflation is the base rate. But it is not possible to reduce nominal interest rates below zero. As the BoE had reduced the base rate to just 0.5% and there was still a risk of very low inflation or even deflation it had to find an alternative tool to affect the economy.
The BoE instead decide to inject money directly into the economy by what is sometimes called ‘quantitative easing’. This worked by the BoE purchasing government and private sector bonds. There are a variety of ways through which this could affect the economy. For example, as the sellers of bonds would have more money available they could increase their spending. The economy could still be boosted if rather than spending this extra money they invested it by purchasing other assets instead, such as shares. A greater demand for shares will push up share prices. This would make shareowners feel better off and so they might go out and spend more.
The extent that quantitative easing has helped to boost the economy is controversial. It is difficult to assess its effectiveness, as we do not known what the counterfactual would have been in such an unusual economic period.