BUSINESS ECONOMICS Part II: Macroeconomics

Transcription

1 Dr. Kenneth Matziorinis BUSINESS ECONOMICS Part II: Macroeconomics SOLUTIONS TO END-OF-CHAPTER PROBLEMS 6.1 i) U = (L - N) = 17,189,000-15,957,000 = 1,232,000 persons ii) (U / L) x 100 = 1,232,000 / 17,189,000 x 100 = 7.2 iii) (N / L) x 100 = 15,957,000 / 17,189,000 x 100 = 92.8 iv) or = 92.8 iv) N t - N t-1 / N t-1 x 100 = 15,957,000-15,643,000 / 15,643,000 x 100 = 2.0 growth in employment (people with jobs) from 2003 to 2004 v) Labour force is the total number of persons of working age (i.e. 15 years and over) who are able and willing to work. vi) PR = (L / CP) x 100 = 17,189,000 / 25,390,000 x 100 = 67.7 The participation rate shows the proportion of persons who are of working age and able to work who are interested or willing to work. vii) The "full-employment" unemployment rate in Canada is presently considered to be about 6. viii) Three types of unemployment: Frictional Unemployment: Here people are unemployed because they voluntarily decided to quit their job so that they can get a better job, move to another part of the country, go back to school, give birth to a child etc. It reflects personal factors which have nothing to say about the state of labour markets or the economy. Structural Unemployment: Here people lose their job against their will. The reason has to do with the fact that their job skill is no longer current or in demand by employers because the skill has been super ceded by machines or the market is no longer interested in the product that skill is used to make. Structural unemployment is concentrated in specific job skill areas and industries so it tends to be localized. Cyclical Unemployment: Here people lose their job because the state of the overall economy is bad. When total demand for goods and services falls, employers cut down on production which results in lay-offs for a portion of the workforce. Cyclical unemployment is easy to detect since it affects the vast majority of industries and spreads across all regions of the economy.

2 6.2 You divide the unemployment rate by the seasonality factor: i.e. UR / SF = S.A.U.R.: Seasonally Seasonality Seasonally Month Unadjusted Factor Adjusted Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec UNADJUSTED AND SEASONALLY-ADJUSTED UNEMPLOYMENT RATE IN CANADA, BY MONTH 15 Percent () UR Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Unadjusted Seasonally Adjusted

3 6.3 You are given the following annual inflation data for Canada for the period: Year Rate of Inflation CPI a) See table above: Eg.: 100 x = 104.8; x = 112.9; x = Eg.: 100 / = 97.2; 97.2 / = 94.1 b) The CPI is a measure of cumulative inflation over time in goods and services bought at the retail level by households only, i.e. consumer goods and services only. The IPI is a measure of cumulative inflation over time in the price of all goods and services sold in the economy, i.e. consumer, producer, government and export prices, and is the broadest or economy-wide measure of inflation available, for this reason it is used as the GDP price deflator in the calculation of real GDP. c) The federal government in conjunction with the Bank of Canada have set a target for annual inflation at 2, within a band of 1-3 over time. d) Headline inflation is the all-items number reported every month by Statistics Canada that makes the headlines in newspapers. The core inflation strips out volatile components of the index such as food and energy prices that can swing up and down from month to month so we have a more clearer or stable view of underlying inflation in the country.

4 6.4 i) AE = C + I + G + X - M = Aggregate expenditure or aggregate demand for domestically produced goods and services. AE = $ 1,209,391 million in 2003 ii) GDP = AE + )V = $ 1,216,191 million in 2003 This is the formula used in the expenditure approach to measure GDP or national income. iii) GDP > AE, because during the year 2003 the total production (output) of goods in Canada exceeded the demand for them. Producers had unsold goods which they added to their existing stock of inventories. As a result, there was a net accumulation of inventories equal to $6.8 billion. When this happens it is a bad sign about the direction of the economy because it implies that firms will have to reduce output in the near future in order to bring their inventories closer in line with demand and this results in employment cutbacks and a slow-down in the economy. iv) During the year inventories rose by $ 6,800.0 million (+)V). This happened because the demand for goods fell short of the production of goods (i.e. sales failed to match production). v) ( X / GDP ) x 100 = 461,266 / 1,216,191 x 100 = 37.9 In 2003 Canada exported 37.9 of its total production of goods and services. It shows that Canada's economy depends a lot on the rest of the world for jobs and its income. vi) ( I / GDP) x 100 = 238,073 / 1,216,191 x 100 = 19.6 This rate is called the rate of gross fixed capital formation (GFCF) and shows what portion of our annual output of goods and services is devoted toward the future. The more we spend on new machinery and equipment and the construction of factory, commercial and engineering structures such as roads, bridges, pipelines, sewers etc. the better off we will be in the future. It is an important indicator of a country's underlying economic health and long-term economic prospects. 6.5 i) NDI = Wages and salaries + Corporation profits + government business enterprise profits + interest and miscellaneous investment income + net farm incomes + unincorporated business income and rent + inventory valuation adjustment. NDI represents the dollar value of factor services (resources) such as labour, capital, land and entrepreneurial services supplied by households to firms annually. NDI = (617, , , ,223 +1, , ,075) = $ 911,165 million in 2003

5 ii) GDP = NDI + CCA + IT ; this is the factor income approach to the measurement of national income; GDP = 911, , ,424 = $ 1,216,191 million in 2003 iii) In 2003 Canada's income shares were as follows: Employment Income: Wages & Salaries / NDI = 617,753 / 911,165 x 100 = 67.8 Corporate Profits: Corporate Profits / NDI = 147,592 / 911,165 x 100 = 16.2 Investment Income: Investment income / NDI = 50,223 / 911,165 x 100 = 5.5 iv) Capital consumption allowance (CCA) is a sum of money firms deduct from their revenues in order to determine their profit. It is a cost of doing business and represents the amount by which fixed capital goods such as buildings, machinery and equipment are used up or consumed annually in the process of producing goods and services for sale. CCA is known as depreciation in economics. Generally accepted accounting principles (GAAP) require that the cost of a durable fixed asset such as a machine or a building be amortized over a period of time instead of being charged as an operating expense in the year of acquisition. The idea behind this is simple. If the asset has a useful life of say 10 years, its cost should be spread over 10 years as well to reflect the fact that it is gradually being used up in production. 6.6 i) GNP = GDP + investment income received from non-residents - investment income paid to non-residents. GNP = 1,216, ,000-57,991 = $ 1,188,200 million in 2003 ii) GNP and GDP defer in the way they define Canadian income. GDP defines as Canadian income all income generated inside Canada's geographical borders, even though part of that income ends up in the pockets of non-residents who supplied the resources that made it possible to generate that income. GNP, on the other hand, defines as income all income that ends up in the pockets of Canadian residents, irrespective of where in the world this income was generated. Thus to find GNP we add to GDP income that Canadians received from production activity outside their borders but subtract the income from Canadian production activity that was paid to investors who reside outside our borders. Since Canada is a net-debtor nation, which means that we owe foreigners more than they owe us, we pay them much more than they pay us with the result that the income that accrues to Canadian residents is less than the income that is generated inside our borders. iii) NNP = GNP - CCA = 1,188, ,602 = $ 1,024,598 million in 2003 iv) Net Investment income paid to non-residents ($27,991 million) / GDP x 100 (57,991-30,000) / 1,216,191 x 100 = 2.3 of GDP

6 6.7 i) PI = NDI - Corporate income taxes - Retained Earnings + Transfer Payments + Miscal. Adjustments. It represents the total income Canadian households received from all sources but before personal income taxes. PI = 911,165-40,963-66, , ,058 = $ 930,093 million in 2003 ii) PDI = PI - Personal income taxes (incl. social security contributions). It is the sum of money -after taxes- that Canadians have available to spend or to save, as they see fit. PDI = 930, ,914 = $ 729,179 million in 2003 iii) PDI / Population = 729,179,000,000 / 31,600,000 = $ 23,075 per person iv) GDP / Population = 1,216,191,000,000 / 31,600,000 = $ 38,487 per person; this is a broad measure of a country's standard of living. v) S / PDI x 100 = 41,388 / 729,179 x 100 = 5.7 In 2003 Canadian households saved 5.7 of their after-tax income and they spent (consumed) the rest. vi) C / PDI x 100 = 687,791 / 729,179 x 100 = 94.3 Remember that PDI = C + S, and the consumption and saving rates add up to i) Real GDP = GDP / IPI x 100 = 1,318.6 / x 100 = $ 1,137.7 billion in Q ii) GDP is the market value of all final goods and services produced by the market sector of the economy during the year. Nominal GDP is based on each year's current market prices whereas Real GDP is based on some base year's constant prices. Nominal GDP is not comparable over time because it incorporates the effect of inflation. Real GDP has the inflation effect removed and represents the level of output in the economy. Hence, Real GDP is a more meaningful measure of production. iii) Per capita GDP in nominal terms: GDP / Population = 1,318,600,000,000 / 32,040,000 = valued at 2004 prices $ 41,155 per person Per capita GDP in real terms: Real GDP / Population = 1,137,700,000,000 / 32,040,000 = $ 35,509 per person valued in constant 1997 dollars ( i.e. based on 1997 prices).

7 iv) UR = U / L x 100 = (L - N) / L x 100 = 1,217,000 / 17,280,000 x 100 = 7.0 v) PR = L / CP x 100 = 17,280,000 / 25,600,000 x 100 = 67.5 vi) Assuming that the economy's "full-employment" unemployment rate is at 6, potential GDP is the output that would be produced if 94 or.94 of the labour force were employed. To get a rough estimate of the potential GDP we can use the simple rule of three: Actual GDP = Potential GDP Actual NR "Full employment" NR thus, 1,318.6 /.93 = Potential GDP /.94 Potential GDP = $ 1,332.8 billion in 2004 Output or GDP Gap = Potential GDP - Actual GDP = 1, ,318.6 = $ 14.2 billion vii) - Canada's expected growth rate for 2004/2005: 3.0 $1,137.7 x 1.03 = $ 1, billion in Q4, Canada's expected inflation rate for 2004/2005: x = in Q4, Canada's expected nominal GDP in Q4, 2005: Expected Real GDP x Expected Implicit Price Index / 100 = 1, x / 100 = $ 1,392.1 billion viii) Output per worker: RGDP / N = 1,137,700,000,000 / 16,063,000 = $ 70,827 per employed person. Output per employee is a general measure of labour productivity. It is one of the three measures of a country s long-term economic prospects.

8 6.9 i) A turning point is when real GDP stops growing and starts falling, or stops falling and begins growing ii) The peak is an upper turning point, the maximum point of the business cycle iii) The trough is the lower turning point or the minimum point of the business cycle iv) Expansion is when real GDP is rising from quarter to quarter or year to year v) Recovery is the early part of economic expansion following a trough and until the previous peak has been surpassed vi) Boom is the latter part of an expansion, close or at the peak of the economic cycle vii) Recession is two consecutive (back-to-back) quarters of decline in real GDP. When output has been falling for six months the economy is said to be in recession. viii) Depression is a deep and prolonged drop in real GDP. Typically output can fall by more than 5 and keep falling or not rising for a period of 5-10 years

9 6.10 Nominal Implicit Real Rate of Rate of Year GDP Price GDP Inflation Growth Index Real GDP: GDP / IPI x 100 Growth Rate: RGDP t - RGDP t-1 / RGDP t-1 x 100 Inflation Rate: IPI t - IPI t-1 / IPI t-l x 100

10 OUTPUT (REAL GDP) GROWTH IN CANADA: Real GDP (Constant 1992 Dollars) Real GDP RATE OF INFLATION IN CANADA AS MEASURED BY IMPLICIT PRICE INDEX: Annual Percent () Rate of Change in I.P.I Rate of Inflation

11 RATE OF GROWTH (IN REAL GDP) IN CANADA: Annual Percent () Rate of Growth in Real GDP GROWTH IN CANADA'S LIVING STANDARD, Per Capita Real GDP in 1992 Dollars (000s of $) Per Capita Real GDP

12 6.11 a) The three most important indicators of short-term economic performance are: The seasonally-adjusted rate of unemployment The annual rate of inflation (using the CPI or the IPI) The annual rate of economic growth (using Real GDP or GNP) b) The three most important indicators of long-term economic performance are: The rate of productivity growth The rate of gross fixed capital formation (business & public investment) The rate of national saving in the economy c) Total Production Real GDP National Income GDP or GNP Economic power GDP or GNP Standard of living Per Capita GDP or GNP Cost of living CPI or IPI Loss of Purchasing power Rate of Inflation Size of Manpower Labour Force Job Creation Unemployment Rate Productivity RGDP / Person Employed (N) Willingness to work Participation Rate Tax burden Personal + Indirect Taxes / PI Willingness to save Pers. Saving / PDI Willingness to spend Pers. Consumption C/PDI Consumer spending power Personal Disposable Income (PDI) Cost of borrowing Interest Rate 6.12 Macroeconomic Indicator Ideal a) Unemployment Rate < 6.0 b) Inflation Rate < 2.0 c) Growth Rate > 3.5 d) Productivity Growth Rate > 2.0 e) National Saving Rate > 20.0 f) Investment (GFCF) Rate > 20.0 g) Living Standard $24,888 $28,771 h) PDI per capita $17,324 $19,301

13 As it can be seen from the above results, Canada s three short-term indicators of economic performance have improved during this period, the unemployment rate is down, the growth rate is up and the inflation rate remains low. The three long-term indicators of economic performance show even stronger improvement, the savings and investment rates are up considerably to healthy levels while the productivity growth rate is showing improvement. Obviously we still have some work to do but overall this is a big turn-around compared to a) b) Since 1962, the cost of living in Canada has risen more than 6 times or d) $100 / X 100 = $ $100 in 1962 will buy you today less than $16.5 worth of products. The buying power of money has shrank to less than one sixth of its value in e)

14 CANADA S COST OF LIVING AS MEASURED BY THE CONSUMER PRICE INDEX (CPI): = CPI ( 1962 = ) CPI

15 7.1 You are provided with the following fictitious national income and consumption data: Y=GDP C S MPC MPS APC APS a) Calculate S, MPC, MPS, APC and APS S = Y - C Eg.: -20 = MPC = )C = = 15 = 0.75 )Y MPS = )S = (-20) = +5 = 0.25 )Y also MPS = MPC = = 0.25 APC = C = 260 = 1.08 Y 240 APS = S = -20 = Y 240 also APS = APC = = b) Explain the difference between MPC and APC. MPC is the relative change in consumption expenditure ()C) to a given change in income

16 ()Y) and expresses how fast we spend the money we earn. It is called the marginal propensity to consume and it measures the rate of spending in relation to the rate of earning. In the above example, it says that the average consumer tends to spend seventy five cents out of every dollar they earn. By measuring how fast we spend the money we earn, MPC serves as a measure of our willingness to spend (consume) and captures consumer psychology. It is the most important behavioural variable in macroeconomic theory. When consumer sentiment shifts from a mood of optimism to a mood of pessimism, the amount we spend out of every dollar we earn diminishes and the MPC declines. APC is the cumulative average of total consumption expenditure to total income (C/Y) and it is called the average propensity to consume. It includes autonomous consumption (") which is how much we have to spend to survive, even when we do not earn any income. Since it is the average of two totals, it does not capture changes in consumer psychology and therefore it lacks the behavioural significance that the MPC has. Observe that APC tends to fall as our income rises from a value greater than one (APC > 1) to a value of less than one (APC < 1). In other words, at low levels of income, we cannot help but consume more than we earn because our survival needs come first. But as our income rises to a higher level, we consume more, and even though we consume more we spend less than we earn and we can afford to save as well. At the break/even level of income, we spend as much as we earn, so at that point we neither go to debt any more, nor do we save either, i.e. (APC = 1) c) On graph paper, plot (C) against (Y) (i.e., C on Y-axis; Y on X-axis). Then draw the 45 degree line (hint: plot Y against Y). See attached diagram d) What is the break/even level of income? What is the meaning of this concept? The break/even level of income (Y b/e ) = $320 billion. It is where Y = C or S = 0 e) What is the slope of the consumption function? What is it equal to? The slope of the consumption function is )C / )Y = 0.75 and is equal to the MPC f) On separate graph paper, plot (S) against (Y) (i.e., S on Y-axis (vertical) and Y on X-axis (horizontal). See attached diagram g) What is the break/even level of income? Should it be the same as (d) above? The break/even level of income is (Y b/e ) = $320 billion. It is where S = 0 or Y = C h) What is the slope of the Saving Function? What is it equal to? The slope of the saving function is )S / )Y = 0.25 and is equal to the MPS or 1 - MPC

17 Income and Consumption Expenditure and the Break/Even Point 440 Income (Y) vs. Consumption (C) Income (Y) Consumption (C) Saving vs Dis-saving Saving (S)

18 7.2 You are given the following national income and expenditure data for the Canadian economy, in billions of dollars ($). Change in GDP=Y=AS C I G X M AE=AD Inventory a) Calculate AE for each level of income (Y) and determine the equilibrium level of income (Ye) and changes in inventories. See above table. Ye = $380 billion, where AS = AE or where )V = 0 b) On graph paper, plot the AE and AS curves; point out the equilibrium point (AE and AS on vertical axis, Y on horizontal axis; AE, AS and Y are in billions of dollars). See attached diagram c) Calculate the MPC, MPS, MPM and MPCD. MPC = )C = = 15 = 0.75 )Y

19 MPS = 1 - MPC = = 0.25 MPM = )M = = 5 = 0.25 )Y MPCD = MPC - MPM = = 0.50 What it means is that consumers tend to spend 75 of the income they earn while they spend 25 of the income they earn on imported goods and services. In other words, only 50 of the income they earn gets spent on domestically produced goods and services. 460 AS vs. AE and Equilibrium Income AS AE

20 d) Calculate the Multiplier (k) of the economy. k = 1 = 1 = 1 = 2x 1 - MPCD What this means is that every dollar injected into the economy in the form of an expenditure triggers two dollars of additional economic activity in the form of additional output and income. e) Assuming that the full-employment (Yf) level of income occurs at Yf=$420 billion, how large is the output (GDP) gap? How large is the expenditure gap? What type of expenditure gap do we have? Recessionary or Inflationary? Illustrate on graph b) above. The output gap or GDP gap = Yf - Ye = $420 - $380 = $40 billion This means that the economy is producing $40 billion below its maximum production capacity or potential output or full-employment level of GDP. When the economy is producing below its potential it is characterized with high unemployment and is what happens when the economy undergoes a recession. It is called a recessionary or deflationary gap. The economy is not producing up to capacity because there is not enough aggregate demand (AE) to propel the economy to a higher level of production. Hence we have a recessionary gap. The size of the recessionary gap = GDP gap = $40 = $20 billion k 2 What this means is that if aggregate demand (AE) where to rise by $20 billion, the multiplier effect would trigger a $40 billion rise in output and income, i.e. )AE x k = )Y or $20 x 2 = $40 billion See the next diagram for a graphical illustration: If the AE curve where to shift upwards by $20 billion to AE, the equilibrium level of income Ye will increase to the full-employment level of income Yf, and equilibrium at full employment will be achieved, i.e. Ye = Yf

21 AS AE AE' 7.3 You are given the following equation for the consumption function: C = Y a) What is the level of autonomous consumption expenditure? What does this mean? Autonomous consumption, " = 100 It means that even if income (Y) where to fall to xero, households will still spend $100 billion a year, the minimum they need to spend on consumption to survive. b) What is the marginal propensity to spend (MPC)? What does MPC mean? Discuss. MPC = 0.8, It means that out of every dollar of income households will spend 80 cents. It shows that consumers spend $80 out of every $100 they earn and this indicates their willingness to spend out of income. c) Write the equation for the Saving Function. What is the marginal propensity to save (MPS)? What does MPS mean? How are MPC and MPS related? S = Y - C

22 S = Y - ( Y) S = Y Y S = ( Y Y ) S = Y The MPS = 0.2 (the slope of the function). It means that out of every $100 earned, households will tend to save $20, or 20 of their earned income. Remember that: MPC + MPS = 1.00 or MPS = 1 - MPC = = 0.2 d) Create a Table which shows the different levels of consumption (C) which correspond to the different levels of income (Y) from 0 to 1000 in 100 increments. Then, on graph paper plot C against Y (Y should be on horizontal axis). Income (Y) Consumption ( C ) Saving Income Consumption

23 e) Create another Table which shows the different levels of consumption (C) which correspond to different rates of spending (MPC) from 0 to 1.00 in 0.10 increments. For your purposes assume that the level of income remains constant at Y = 500. Then, on a separate graph plot C against MPC. Income (Y) MPC Consumption ( C ) Consumption

24 7.4 a) MPC = 0.6, from C = Y MPM = 0.2, from M = Y MPC D = MPC - MPM = = 0.4 k = 1 / 1 - MPC D = 1 / 1 - (MPC - MPM) = 1 / = 1 / 0.6 = 1.67 b) To find Ye solve for AS = AE. Since AS = Y, then solve for Y = AE Y = AE = C + I + G + X - M = Y ( Y ) = Y Y = Y Y Y = Y = 300 Y = 300/0.6 = 500 Therefore, Ye = $500 Billion c) Y = AE = C + I + G + X - M = Y ( Y ) = Y Y = Y Y Y = Y = 310 Y = 310/0.6 = Therefore, Ye = $516.7 Billion. The Multiplier is not affected since neither MPC nor MPM changed. d) Y = AE = C + I + G + X - M = Y ( Y ) = Y Y = Y Y Y = Y = 320 Y = 320/0.6 = Therefore, Ye = $533.3 Billion. The Multiplier is not affected since neither MPC nor MPM changed.

25 e) Y = AE = C + I + G + X - M = Y ( Y ) = Y Y = Y Y Y = Y = 300 Y = 300/0.5 = 600 Therefore, Ye = $600 Billion In this case the multiplier (k) does change since the MPC has increased to 0.7 from 0.6 k = 1 / 1 - MPC D = 1 / 1 - ( ) = 1 / = 1 / 0.5 = You are given the following equations: C = Yd Consumption Function Yd = Y - ( T + Sb ) Relationship between PDI and GDP (or Y) T = Y Tax Function Sb = 0.20 Y Business Saving Function I = 115 Investment Function G = 140 Government Expenditure Function X = 145 Export Function M = Y Import Function a) Since C and Sp is expressed as a function of Yd (i.e. PDI) we need to convert these functions out of gross income (Y). Thus, Yd = Y - ( Y Y ) = Y Y = Yd = Y Sp = Yd - C = Yd Yd = Yd (Note that MPC out of Yd = 0.87 while MPSp out of Yd = 0.13) Now, substitute Y for Yd: Sp = ( Y ) = Y = Sp = Y b) MPM = )M / ) Y = 0.25 which is the coefficient or slope of the import function MPT = )T / ) Y = 0.20 which is the coefficient or slope of the tax function

26 MPS = MPSp + MPSb = = c) The income multiplier (k) is: k = 1 / MPW = 1 / (MPS + MPT + MPM) = 1 / = k = 1 / = 1.37 x d) To calculate Ye we also need to convert the C-function as a function of Y: C = Yd = ( Y ) = Y C = Y To find the equilibrium level of income (Ye) we need to solve for AS = AE Since AS is also equal to Y, we solve for: Y = AE Y = C + I + G + X - M Y = Y Y Y = Y Y Y = Y = Y = / = Thus, Ye = $551.2 billion e) J = I + G + X = = $ 400 billion L = S + T + M = Y Y Y Y = Y = (551.2) = $ 400 billion f) C = (551.2) = $299.0 billion Sp = (551.2) = $21.7 billion Sb = 0.20 (551.2) = $110.2 billion St = (551.2) = $131.9 billion T = (551.2) = $120.2 billion I / Y = 115 / X 100 = 20.8 X / Y = 145 / X 100 = 26.3 S + T = = $252.1 billion I + G = = $255.0 billion

27

28 g)

29 7.8 a) Yd = Y Y Y Yd = Y b) C = ( Y) C = Y c) Sp = ( Y) Sp = Y d) G = BG - TP = = $130 bil. e) MPSp = 0.05 (from the personal saving function Sp) MPSb = 0.15 (from the business saving function) MPM = 0.30 (from the import function) MPT = 0.35 (from the tax function) MPW = 0.85 k = 1 / MPW = f) AS = AE Y = C + I + G + X - M Y = Y Y Y = Y 0.85Y = 510 Ye= $ 600 billion g) C = (600) = $390 bil. I = $120 G = $130 X = $160 M = (600) = $200 T = 0.35(600) = $210 bil BG = = $230 bil h) Budgetary balance: T - BG = = $-20 bil i) International trade balance: X - M = = $-40 bil j) Savings/Investment balance: S - I = = $-20 bil where S = Sp + Sb =0.15Y Y = Y k) (S - I) + (T - BG) + (M - X) = 0 or (S - I) + (T - BG) = (X - M) Thus, ( -20 ) + ( -20 ) = ( -40 )

30 8.1 a) Since we have an output gap (GDP gap) of $40 billion, it implies that the economy is not producing at full-capacity (Yf), therefore, it is experiencing a recessionary gap (deflationary gap) of $20 billion. Therefore, the government should pursue an expansionary fiscal policy, i.e. increase the level of government spending ()G) and decrease the level of taxes through a cut in income tax rates ()MPT) or both. b) Since the expenditure gap i.e. the amount of deficient spending power in the economy, is equal to $20 billion, the government should raise spending by $20 billion, i.e. )G = $20 Thus, + )G x k = +)Y Or, $20 x 2 = $40 billion c) The government should lower income taxes by a lump sum of $40 billion -)T + )Yd + x (MPCD) )CD + )AE x k + )Y -$40 + $ $20 + $20 x 2 + $40 billion d) Initially, the government will have to borrow $20 billion (assuming it chooses the option of raising government spending), thus the initial budget deficit will be $20 billion Once the rise in government expenditures raises the country s total income by $40 billion, the government stands to benefit as well by seeing its tax revenue rise by the change in income times the marginal income tax rate (MPT) which is assumed to be 0.20 or 20. The government will see its tax revenue (T) rise by $8 billion Thus, + )Y x MPT = + )T + $40 x 0.20 = + $8 billion Thus the final impact on its budget deficit will not be $20 billion but $12 billion + )G = $20 Less + )T = $ 8 )G - )T = $12 billion e) Initially, the government s debt-to-gdp ratio stands at $150 / $380 = 39.5 After the expansionary policy action, the government s debt-to-gdp ratio will fall to 38.6 because even though the public debt rises by $12 billion to $162 billion, the country s national income or GDP rises as well by $40 billion.

31 Increase in government debt: $150 + $12 = $162, thus $162 / $420 = a) To find Ye solve for AS = AE. Since AS = Y, then solve for Y = AE Y = AE = C + I + G + X - M = Y ( Y ) = Y Y = Y Y Y = Y = 285 Y = 285/0.6 = 475 Therefore, Ye = $475 Billion b) If Yf = $500 Billion, then GDP Gap or Output Gap is: Yf - Ye = $500 - $475 = $25 Billion The Expenditure Gap is: GDP Gap / Multiplier The Multiplier (k) is: 1 / 1 - MPC D = 1 / 1 - ( ) = 1 / = 1 / 0.6 = Therefore, the GDP Gap is $25 / 1.67 = $15 Billion Since Ye < Yf, we have a Recessionary (Deflationary) Gap c) The type of fiscal policy recommended here is Expansionary fiscal policy, i.e. an increase in government spending (+)G) or a decrease in tax collections (-)T) or a combination of both. d) )G x k = )Y )G x = $25 Therefore, )G = $15 Billion 8.3 a) marketable bonds are issued in large denominations for terms ranging from 1 year to 30 years, and pay a fixed rate of interest over the duration of the bond until they mature. Treasury bills are issues in smaller denominations for terms ranging from 3 months (91 days) to 365 days. They do not carry a coupon rate of interest but rather are sold at a discount over their face value, but when they mature they pay the full face value. Canada savings bonds are not really bonds, rather they are government securities that issued to the retail investing public. They can be redeemed (cashed in) at any time, and the holder receives the accrued interest until the day they cash them in. They are similar to a bank term deposit certificate.

32 b) The relationship between interest rates and bond prices is inversely proportional, meaning that whenever interest rates rise, the price of bonds falls and whenever interest rates fall, the price of bonds rises. This happens because they carry a fixed rate of interest over the life of the bond. 8.4 a) An Expansionary fiscal policy is a deliberate government budgetary action designed to give a boost to the economy, namely an increase in government spending (+)G) or a decrease in tax collections (+)T) or a combination of both. b) A Contractionary fiscal policy is deliberate government budgetary action designed to slow down the growth in aggregate demand in the economy and by extension reduce the rate of inflation by taking pressure off limited production capacity, namely through a decrease in government spending (-)G) or an increase in tax collections (+)T) or a combination of both. c) Automatic or Built-in Stabilizers are various government programs or institutional features that have the result of automatically raising government spending and automatically lowering tax collections when the economy slows down; and automatically lowering government spending and raising tax collections when the economy picks up. The best example of an automatic stabilizer is the Employment Insurance System. When the economy slows down, falls into recession and workers lose their jobs, they stop paying premiums into the employment insurance fund, i.e. like a tax cut (-)T) but they draw out of the plan employment insurance payments, like an increase in government spending (+)G). Other examples include a) social assistance (welfare payments to the poor when employment insurance payments run out); b) the progressive nature of the income tax system, i.e. as personal income rises, we are pushed to a higher tax bracket and as personal income falls we are pushed to a lower tax bracket, thus the marginal propensity to pay tax (MPT) falls when the economy slows down and rises when the economy picks u; and c) agricultural support programs whereby during years of low agricultural output farmers income is subsidized by the government to ease the negative impact on their financial condition. d) An annually-balanced budget is a budget that the government is supposed to balance, i.e. T = G in each calendar or fiscal year, i.e. over a twelve month period. A cyclically-balanced budget is a budget that the government is supposed to balance over the span of the business cycle, i.e. over a seven (7) year period. The advantage of the cyclicallybalanced budget is that the government s hands are not tied, instead the government has the leeway to run budget deficits during recession years with the budget returning automatically to balance or surplus during expansion years. This way, the government has the room to exercise its fiscal policy obligations toward the economy. 8.5 a) The public debt is the total debt accumulated by the government sector. It is the total amount borrowed over the years and outstanding at a given point of time. An other way of defining it is as the sum of all deficits minus surpluses over the years. In Canada, the public debt is the debt of the federal government, but since provincial governments also have the power to borrow, public debt should also include the total debt accumulated by all provincial

33 governments. When we add the debts of the two levels of government we have total government debt. An even broader measure of debt should also include the debts of municipal governments. b) A budget surplus is when government revenues for the year exceed government expenditures leaving a surplus of funds. A budget deficit is when government expenditures for the year exceed government revenues, leaving a deficit that needs to be financed by borrowing money. A balanced budget is when the level of government revenues for the year is equal to the level of government expenditures. c) The budget deficit is the difference between what the government spends during a year and what it collects in revenues (is a flow variable). The public debt on the other hand is the total debt accumulated over time and outstanding at a point in time (is a stock variable). d) The budget deficit is the excess of what the government spends minus what it collects during a single year (T - G). The trade deficit, is the excess of what a country imports from the rest of the world minus what it exports to the rest of the world during a given year (X - M). A more complete measure of the trade balance is known as the current account balance. e) Public debt is the debt of the government or public sector. Private debt is the debt of the private sector of the economy, meaning the combined debt of households and businesses. f) Public debt is the total debt of the government sector of the economy (federal, provincial and local or municipal levels of government). External debt is the debt of the country owed to non-residents, i.e. to counterparties in the rest of the world. The external debt includes both debts of the public as well as private sectors of the economy. 8.7 a) The three options a government has to finance a budget deficit are: i) borrow from the general public, i.e. borrow from its own citizens, directly from individuals as with Canada Savings Bonds or indirectly through institutions such as banks, life insurance companies, pensions funds and investment funds. ii) borrow from foreigners (non-residents), i.e. borrow savings from other countries. iii) borrow from the central bank. Since central banks are part of the government, borrowing from a central bank implies the creation of money, i.e. like printing money b) The federal government issues securities which are IOUs. There are three types of securities issued by the federal government: i) bonds (securities with terms ranging from 1 year to 5, 10, 20 and 30 years). Bonds are redeemable only at maturity, i.e. the end of the term; are transferable, i.e. can be sold in the secondary market and pay a fixed interest rate for the term of the bond called the coupon rate.

34 ii) treasury-bills (securities with terms less than 1 year, like 1 month, 3 months, 6 months, 9 months and up to 364 days). Like bonds, t-bills are redeemable only at maturity, but are transferable before maturity. Unlike bonds they do not carry a coupon rate, rather they are discount instruments, meaning they are purchased at a discount to their face value, the difference being the gain. In Canada, they are issued every two weeks on a Wednesday. iii) Canada Savings Bonds. CSBs are not really bonds but investment certificates, since they are redeemable, i.e. cashable at any time prior to maturity without risk of losing the interest earned to that day. c) The potentially most inflationary means of financing a budget deficit is borrowing from the central bank since it involves the creation of money. The least inflationary method is borrowing from the general public, i.e. internal borrowing from your own citizens. 8.8 a) ( ) / x (365 / 91) x 100 = 7.46 b) ( ) / x (365 / 182) x 100 = 1.79 c) ( X ) / X x (365 / 91) x 100 = 5.27 ( X) / X x 365 / 91 = X / 91 X = X = X X = The Bid Price (X) = d) ( X ) / X x (365 / 224 ) x 100 = 5.61 The Bid Price (X) =

35 8.9 B C D E F G Gross Federal Public GDP IPI Total Interest Governmt Year Debt current $ 1997=10 0 Populati on Cost Revenues B/C*100 F/G*100 F/C*100 F/B*100 B/D*100 B/D*100/E a) ( i ) ( ii ) ( iii ) ( iv ) ( v ) ( v i ) Interest Interest Real Cost to Interest to Cost to Real Debt Debt-to- Revenue GDP Public Debt per GDP Debt Year Ratio Ratio Ratio Ratio 1997 $ Capita

36 b) Discussion: i) The debt-to-gdp ratio decreased between 1952 and 1977, increased between 1977 and 1997 and has been falling since. In 1997, it reached 69.0 of GDP. ii) When you divide the annual interest cost of servicing the public debt by total federal government revenue, you will find that while in the 1950s and 1960s interest charges absorbed less than 10 of federal revenue, by the 1980s and 1990s, interest payments account for a third of federal government revenue. This indicates that the federal government had less money to allocate toward all other functions of government. A financial squeeze. Since then the situation has improved considerably iii) Has the same significance as ii) above, but instead relates interest charges to GDP. Interest charges account for nearly 5 of GDP in 1997 compared to less than 1 in the 1950s and 1960s. iv) The interest charges to public debt shows the effective average rate of interest being paid by the federal government to service its debt. The average rate of interest paid on federal debt has more than doubled during this period from less than 4.0 in the 1950s to about 8.0 in the 1980s and early 1990s. v) By dividing the gross public debt by the implicit price deflator, we get a picture of the real (inflation adjusted) level of public debt. Debt per capita increased slowly between 1952 and 1972, but has doubled since then. This dramatic rise in the debt level is not sustainable in the future. Sooner or later any government is forced to stop borrowing, starts raising taxes and cuts spending. This is what happened during the 1990s. Since 1997 the federal government has achieved budget surpluses which have brought down the debt/gdp ratio to under 50 in vi) On a per capita basis, the federal government debt has also being rising. Conclusion: The growth in the federal government's debt has not been fictional, nor is it only due to inflation. The public debt has risen in real terms, has risen relative to the population and relative to our production. Obviously by the 1990s, Canada reached its limits in terms of the ability of the federal government to carry any more debt. Since 1997, the situation has improved considerably and continues to get better now Since potential GDP, Yf = $575 billion and the actual or Ye = $551.2 billion, a) GDP gap = Yf - Ye = $23.8 billion, since Ye < Yf, it is a recessionary (deflationary) gap The size of the expenditure gap = GDP Gap / k = $23.8 / 1.37 = $17.37 billion

37 b) It is recommended that the government pursue expansionary fiscal and expansionary monetary policies, i.e. +)G, - )T, + )Sm, - )r c) If the government chooses to eliminate the gap by raising expenditures, it should increase them by the amount of the expenditure gap, i.e. by $17.37 billion, i.e. +)G x k = +)Y Following this fiscal policy action the government budget deficit will rise from $ bil. to $ billion. T - G = (575.0) - ( ) = = $-32.4 billion. The budget deficit will increase by $12.6 billion d) If the government chooses to eliminate the gap by cutting taxes, it should cut income tax rates by: - )I ==> + )Yd ===> MPC ===> + )C D ===> + )AE ===> k ===> + ) Y To find )T, solve for Yf = AE: Yf = C + I + G + X - M 575 = J(575) (575) J= (575) J= J= 0.552, where is the new coefficient of the consumption function C = Yd Yd = Y = Y Y y C = Y where = 0.87 (0.60) Then, if = 0.87 J, then J = Yd = Y = Y Y Y T = Y, thus the new MPT will be = Therefore, the tax rate must be lowered from 20 to 16.6 Following this fiscal policy action the budget deficit will rise to $ billion, i.e. T - G = (575) = $-34.5 billion The budget deficit will rise by $14.7 billion, assuming no other variables such as MPC, MPM and MPSb have changed. e) Clearly raising government spending results in a lower deficit than cutting taxes.

38 Problem # 9-1 Interest Rate (r)() Money Demand (Dm) Money Supply (Sm) The money multiplier (Mk) is: 1 1 Mk = = = 1 MPL ,b) Assuming that the Bank of Canada purchases $2 billion of treasury bills from chartered banks it buys the securities from them and pays them with cash, thereby increasing their liquid reserves. Then the banks take this cash and they loan it out to clients. Because the money multiplier is x5, the total supply of money in the economy will increase by $2 bil X 5 = $ 10 billion. With the money supply higher by 10 billion, short-term interest rates will fall from 12 to 10. This is what is known as an expansionary monetary policy. Hence, the money Supply will increase by $2 billion H 5 = $10 billion and interest rates fall to ,c) Assuming that the Bank of Canada sells $2 billion of treasury bills to chartered banks, it sells the securities to them and gets paid in cash from them, thereby reducing the cash reserves of chartered banks by $2 billion. Because the money multiplier is x5, the total supply of money in the economy is reduced by $2 bil x 5 = $10. With the money supply lower by $10 billion, short-term interest rates will rise from 12 to 14. This is what is known as a contractionary monetary policy. Hence, the money Supply will decrease by $2 billion H 5 = $10 billion and interest rates rise to ,d) Assuming that as a consequence of the GDP increase the demand for money rises by $10 billion then, with the money supply remaining constant at $60 billion, the equilibrium interest rate is pushed up from 12 to 14. With more demand but the same supply of money in the economy, money because more scarce, and the price of money increases.

39 9-1,e) To mitigate the rise in interest rates, the Bank of Canada can expand the supply of money by $10 billion by buying $2 billion in treasury bills from the chartered banks as in 5.1 b above. As a result interest rates remain constant at 12. This is what is known as an accommodating monetary policy a) The main measures of money supply are: M1: demand (chequing or non-interest paying deposits) with chartered banks M2: demand, saving and term deposits (all deposits) with chartered banks M2+ all deposits with banks and non-bank deposit taking financial institutions (NBFIs) b) M1 consists of demand deposits only, whereas M2 consists of all deposits c) M2 consists of all deposits with chartered banks only whereas M2+ consists of all deposits with banks and non-bank financial intermediaries (NBFIs) like trust companies, caisse populaires. d) M2 and M a) The net interest spread is the difference between the average interest charged on loans and the average interest paid on deposits b) The short-term interest rate is the interest rate charged or paid on deposits and loans with short-term maturities, strictly speaking involving terms of 1 year or less, but broadly speaking of terms ranging up to 5 years. Short-term interest rates are known as money market rates. c) The long-term interest rate is the interest rate charged or paid on long-term loans such as government and corporate bonds. These loans are better known as securities and the interest rate is called the yield. It involves debt securities with terms ranging from 5 years all the way out to 30 years. Bonds with a 10-year term are the most representative of long-term bonds. d) The difference between long-term rates and short-term rates reflects the premium a lender charges the borrower for assuming the risk of fixing the rate for a long period of time, during which it is hard to predict what will happen to interest rates in financial markets. It is known as the long vs short interest rate differential and reflects the steepness of the yield curve. Since the lender takes on this risk it is normal that he be compensated for the extra risk by charging a higher rate. This is why normally, long-term interest rates are higher than short-term interest rates. e) The real rate of interest is the interest rate charged or received on a deposit or a