University of Toronto October 28, 2011 ECO 209Y MACROECONOMIC THEORY AND POLICY. Term Test #1 L0101 L0301 L0401 M 2-4 W 2-4 R 2-4

Transcription

1 Department of Economics Prof. Gustavo Indart University of Toronto October 28, 2011 ECO 209Y MACROECONOMIC THEORY AND POLICY SOLUTIONS Term Test #1 LAST NAME FIRST NAME STUDENT NUMBER Circle your section of the course: L0101 L0301 L0401 M 2-4 W 2-4 R 2-4 INSTRUCTIONS: 1. The total time for this test is 1 hour and 40 minutes. 2. Aids allowed: a simple, non-programmable calculator. 3. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /36 Part III 1. /10 Part II /24 2. /10 TOTAL /80 Page 1 of 10

2 PART I (36 marks) Instructions: Enter your answer to each question in the table below. Table cells left blank will receive a zero mark for that question. Each question is worth 3 marks for a maximum of 36 possible marks. No deductions will be made for incorrect answers D B C C A B E C E D B D 1. Acme Publishers Ltd. produced 10,000 economics textbooks last year, which it sold at $120 a piece. In order to produce these 10,000 textbooks, Acme hired 12 workers at a cost of $350,000 to operate 5 printers valued at $25,000 a piece. In addition, Acme spent $450,000 in the paper and ink, the only two materials needed to produce these textbooks. Finally, ACME had to pay $75,000 in taxes on the $150,000 profit it made from this venture. Acme s contribution to GDP is A) $500,000. B) $700,000. C) $575,000. D) $750,000. E) none of the above. 2. Suppose that the federal government runs a budget surplus of $20 billion. It collects $100 billion in taxes, and it has the following expenditures: $20 billion in Social Security benefits, $10 billion in interest on the national debt, $10 billion in rent, and $40 billion in wages. The government contribution to GDP is A) $80 billion. B) $50 billion. C) $70 billion. D) $40 billion E) none of the above Use this space for rough work. Page 2 of 10

3 3. In a closed economy, which one of the following statements about national savings is false? A) National savings is the sum of private saving minus government budget deficit. B) National savings reflects the output that remains after the demand of consumers and the government has been satisfied. C) National savings is the total amount of banks savings deposits. D) National savings equals investment at the equilibrium interest rate. E) Both A) and C) are false. 4. Which of the following transactions is viewed as investment when calculating GDP? A) The Bank of Montreal buys $10,000 of federal government bonds. B) Daniel, a construction worker, builds himself a garage. C) Your family buys a newly constructed home. D) The Art Gallery of Ontario buys a Picasso for $10 million. E) Both B) and C). 5. Suppose that an economy produces only apples, bananas, and oranges, and that prices (in dollars) and quantities (in millions of pounds) are as shown in the following table: Year 2009 Year 2010 Good Quantity Price Quantity Price Apples 20 $6 15 $5 Bananas 10 $8 15 $10 Oranges 5 $10 8 $12 If 2009 is the base period, what is the approximate value of the GDP deflator for 2010? A) B) C) D) E) None of the above. Use this space for rough work. Page 3 of 10

4 6. Consider an open economy in equilibrium where private savings equals private investment and the government has a positive budget surplus. Given the above, which of the following is true? [Note: The notation is as used in class.] A) C + I + G > Y. B) C + I + G < Y. C) NX < 0. D) X = Q. E) None of the above is true. 7. Consider the AE model of an open economy developed in class. Suppose that an economy is initially in equilibrium and autonomous exports increase. All else equal, which of the following will be false in the new equilibrium? A) Government budget deficit will decrease. B) Imports will increase. C) Private investment will not change. D) Consumption will increase. E) Private savings will decrease. 8. If autonomous taxes decreased by $100 million, which one of the following would be true in the new equilibrium? A) The government budget deficit would increase by $100 million. B) The government budget deficit would increase by more than $100 million. C) The government budget deficit would increase by less than $100 million. D) The government budget deficit would decrease by $100 million. E) The government budget deficit would decrease by less than $100 million. Use this space for rough work. Page 4 of 10

5 9. If investment were extremely sensitive to changes in the interest rate, which one of the following would be true? A) The expenditure multiplier would be relative large. B) The AE curve corresponding to each interest rate would be relatively flat. C) A given change in the interest rate would cause a relatively large shift outward of the IS curve. D) The slope of the IS curve would be relatively steep. E) None of the above would be true. 10. Which of the following would cause the IS curve to shift inwards? A) An increase in autonomous investment. B) An increase in the rate of interest. C) A decrease in the rate of interest. D) An increase in autonomous private savings. E) Both B) and D). 11. If the economy were experiencing an expansion, all else equal, which of the following would be true? A) Government transfer payments would be rising. B) The cyclical budget deficit would be decreasing. C) The structural budget surplus would be increasing. D) Consumption would be rising and private savings would be falling. E) Both C) and D) would be true. 12. Suppose that the MPC YD = MPC Y and that government purchases and autonomous taxes both rose by $100 million, then equilibrium income would A) remain unchanged. B) increase but by less than $100 million. C) increase by more than $100 million. D) increase by $100 million. E) fall by less than $100 million. Use this space for rough work. Page 5 of 10

6 PART II (24 marks) Consider the following model of the economy: C = YD 10i I = i Y G = 260 TR = 100 TA = Y Y fe = 3500 a) What is the equation for the IS curve in this model? (4 marks) First, we must find the equation for the AE curve: AE = C + I + G = [ (Y TA + TR) 10i ] + [ i Y ] = i Y [ Y Y ] = i Y (0.9Y + 50) = i + 0.8Y Second, we must find the equilibrium in the goods market by equating Y and AE: Y = i + 0.8Y 25i = Y i = Y b) If the rate of interest is 5 percent (i.e., i = 5), what is the equation for the corresponding AE curve? (1 mark) What is the level of equilibrium income when i = 5? (1 mark) What is the size of the aggregate expenditure multiplier? (2 marks) 1) We have found above the equation for the AE curve as a function of i and making the replacement we find: AE = = i + 0.8Y = Y = Y 2) To find equilibrium income we must equate Y and AE: Y = AE Y = Y 0.2Y = 600 Y* = ) Finally, the expression for the expenditure multiplier is: α AE = 1 / (1 slope of AE curve) = 1 / ( 1 0.8) = 1 / 0.2 = 5 Page 6 of 10

7 c) What is the level of private saving (S) when the economy is in equilibrium at i = 5? What is the level of government saving (or budget surplus, BS) when the economy is in this equilibrium? What is the level of national saving (S N ) when the economy is in this equilibrium? What is the level of private investment in this equilibrium (6 marks) 1) Since S = YD C, let s find the values of YD and C: YD = Y TA + TR = Y Y = Y = (3000) = 2750 C = YD 10i = (2750) 10 (5) = = 2475 Therefore, S = YD C = = 275 2) BS = TA (G + TR) = (3000) ( ) = 10 3) S N = S + BS = = 265 4) I = i Y = (5) (3000) = = 265 d) Given the situation of the economy and the budgetary situation of the government you have described above, what do you think the government should do to improve that situation? (3 marks) The economy is in a deep recession since Y = 3000 and Y fe = In addition, the government is running only a small deficit since BS = 10, which represents about 0.33 percent of GDP. Moreover, this deficit is not only small but cyclical in nature since at the level of full employment income ($3500) the government would be running a surplus. Indeed, BS fe = TA G TR = (3500) = = 40. Therefore, it seems clear that expansionary fiscal policy should be implemented in order to get Y closer to full employment even at the cost of increasing the government deficit in the short run. Page 7 of 10

8 e) By how much could government purchases (G) increase without moving the government into a situation of a structural deficit? What would be the level of equilibrium income if the government were to increase G by this amount? (2 marks) 1) A structural deficit means that at the level current level of expenditure the government would also be running a deficit at the level of full employment income. We have shown above that this is not the case the government would be running a surplus of $40 at Y = $3500. Therefore, the government could increase its purchases by $40 and still have a balanced budget at Y fe. 2) An increase in G equal to $40 would cause equilibrium income to increase by: Y = α AE G = 5 ($40) = $200. Therefore, the new level of income would be Y = $3200. f) All else equal, what change in government purchases (G) would be necessary for the economy to reach the level of full-employment income? (1 mark) Given this increase in G, what would be the level of government saving (or budget surplus) at the level of fullemployment income? (1 mark) In your view, should the government implement such an increase in G? (3 marks) 1) Since Y fe = $3500, equilibrium income must increase by $500. Given that α AE = 5, G must be $100. 2) Given G = $100 and Y fe = $3500, BS fe = (3500) = = 60. 3) Should the government increase G by $100? It could be argued that the government should increase G enough to stop the decline in Y and, at the same time, trigger a sufficient increase in Y to restore some degree of confidence on the part of the private sector. The crucial point here is to regain the confidence of households in order for them to start spending once again. In turn, once consumers start spending, at some point the business sector will also start investing once again. Will a $100 increase in G be enough? Or will it be too much? A $100 increase in G will cause the government to increase its deficit in the short run to more than 3% of the current level of GDP. This is a relatively large deficit but the economy is in a deep recession and this increase in G might not be even enough to jump start the economy and restore the confidence of the private sector. In any case, in these circumstances it s better to err on the plus side rather than on the minus side. If the increase in G is excessive there is always time to reduce it at a faster pace as the level of economic activity starts moving closer to full employment and inflationary pressure builds up. That s why most of the increase in G should be on infrastructure investment since, in addition to increasing economic efficiency, once the projects are completed G can go back to its initial level. Page 8 of 10

9 PART III (20 marks) Instructions: Answer true, false, or uncertain to the following statements. Marks will be given entirely for your explanation. Each question is worth 10 marks. 1. Expansionary fiscal policy is less effective with respect to income when investment is an increasing function of income. (Show your answer algebraically and explain the economics.) This statement is false. Let s consider a closed economy initially in equilibrium, and let s assume first that investment does not depend on Y (i.e., only C is assumed to depend on the level of Y). What is the impact of this increase in G on equilibrium Y? An increase in G increases autonomous AE by the same amount and through the multiplying process causes equilibrium income to increase further by the increase in G times the expenditure multiplier Y = α AE G. Let s look at this multiplying process. The increase in G increases autonomous AE and creates a situation of disequilibrium in the economy where AE > Y. Firms start selling more than they are actually producing and thus they experience an involuntary decrease in inventories. It is this involuntary decrease in inventories that gives the signal to the firms that production must be adjusted upwards, and thus output and income increase. As Y increases, a fraction c of any additional dollar of Y is re-spent by consumers in the purchase of goods and services i.e., the marginal propensity to spend is equal to the MPC Y and thus AE increases further and so does Y. This is the multiplying effect of an increase in autonomous expenditure and, in this case, the expenditure multiplier is α AE = 1 / [(1 c (1 t)]. Let s consider now the case of a closed economy initially in equilibrium, but assuming that consumption and investment both depend on the level of Y. What is the impact of this increase in G on equilibrium Y? As before, the increase in G increases autonomous AE by the same amount and through the multiplying process causes equilibrium income to increase further by the increase in G times the expenditure multiplier Y = α AE G. This multiplying process is also basically the same as before, except for one important point. As Y increases to eliminate the excess demand in the economy, a fraction c of any additional dollar of Y is re-spent by consumers in the purchase of goods and services but now also another fraction f (i.e., the marginal propensity to invest) of any additional dollar of Y is re-spent by firms in the purchase of final goods (i.e., on investment) i.e., the marginal propensity to spend is now equal to the MPC Y plus the marginal propensity to invest and thus AE increases further and so does Y. In this case, then, the multiplying effect of an increase in autonomous expenditure is greater since the expenditure multiplier is α AE = 1 / [1 c (1 t) f], where 1 / [1 c (1 t) f] > 1 / [1 c (1 t)]. Therefore, the statement is false: An increase in G is more effective in increasing Y when investment is also an increasing function of income. Page 9 of 10

10 2. Assuming that the tax rate (t) is positive, an increase of $100 million in government purchases accompanied by an increase of $100 million in autonomous taxes will leave both the government budget surplus and the level of equilibrium income unchanged. (Show your answer algebraically and explain the economics.) This statement is false. Let s examine first the respective impacts on equilibrium Y of an increase of $100 in G and of an increase of $100 million in T. On the one hand, an increase of $100 in G directly increases autonomous AE by $100 and through the multiplying process causes equilibrium income to increase further by $100 times the expenditure multiplier Y = α AE G = α AE (100). On the other hand, an increase of $100 in autonomous taxes decreases autonomous AE only indirectly and by a lesser amount. Indeed, the $100 increase in autonomous taxes directly decreases YD by $100 at all levels of Y, but not all of this decrease in YD translates into a decrease in C. At all levels of Y, consumers will reduce expenditure only by a fraction c of the decrease in disposable income and thus autonomous expenditure will change (decrease) by AE = ( c) T = ( c)(100). Therefore, equilibrium income will decrease by Y = α AE ( c) T = α AE ( c) (100). The overall change in Y will thus be Y = α AE G + α AE ( c) T and since G = T = 100, Y = α AE (1 c) G = α AE (1 c)(100) > 0. Therefore, contrary to the statement, Y will increase as a result of this policy combination. Let s examine now the impact on the government BS. On the one hand, the $100 increase in both Y and T leaves the BS initially unchanged. Indeed, the $100 increase in G will increase overall government expenditures by this amount and reduce the BS by $100, while the $100 increase in autonomous taxes will increase government revenues by this amount and increase the BS by $100. On the other hand, since equilibrium Y will increase by α AE (1 c)(100), then government revenues will further increase by t Y. Therefore, contrary to the statement, at the end of the process of adjustment the government BS will increase by t Y. Therefore, the statement is false a $100 increase in G accompanied by a $100 increase in autonomous taxes will increase both Y and the BS. Page 10 of 10