SOLUTION ECO 209Y - L5101 MACROECONOMIC THEORY. Term Test #1 LAST NAME FIRST NAME STUDENT NUMBER. University of Toronto June 22, 2004 INSTRUCTIONS:

Transcription

1 Department of Economics Prof. Gustavo Indart University of Toronto June 22, 2004 SOLUTION ECO 209Y - L5101 MACROECONOMIC THEORY Term Test #1 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 1 hour and 45 minutes. 2. This exam consists of three parts. 3. This question booklet has 11 (eleven) pages. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /50 Part II /20 Part III 1. /10 2. /10 3. /10 TOTAL /100 Page 1 of 11

2 PART I (50 marks) Instructions: Circle the most appropriate answer. Each question is worth 2.5 (two and one-half) marks. No deductions will be made for incorrect answers. 1. The production approach, the expenditure approach, and the income approach will all give the same measure of GDP assuming a) investment income from abroad is not included b) there is neither depreciation nor indirect taxes c) government transfers payments are nil d) there is no undistributed corporate profits e) there is no payment of interest on the national debt 2. The pop-corn industry produced $1 billion worth of pop-corn in 2003, using $500 million worth of corn as the only intermediate product. The pop-corn industry also paid $300 million in wages and salaries, $50 million in rent, and $50 million in taxes. The contribution of the pop-corn industry to the country=s GDP in 2003 was a) $1.4 billion b) $1 billion c) $0.9 billion d) $0.5 billion e) none of the above 3. Which one of the following expenses is not considered as investment when measuring GDP? a) a new coffee-maker bought by a Starbuck=s franchise b) the construction of a garage in John=s backyard by a private constructor c) Kim=s purchase of one thousand shares of IBM d) a new limousine bought for the use of the chairman of Magna Corporation e) the construction of a new house for the use of the Premier of Ontario 4. Consider the following facts about the economy: C = 1000; S = 100; G = 300; TA = 350; TR = 50; NX = 50; and the government s debt is nil. The value of GDP is a) 1300 b) 1350 c) 1400 d) 1450 e) not sufficient information to determine 5. Consider a closed economy with fixed prices and a balanced government budget at the initial equilibrium situation. A reduction in government purchases will cause a) the level of consumption to fall, business inventories to rise, and a government surplus b) business inventories to rise and a government deficit, but no change in the level of consumption c) business inventories and the level of consumption to fall, but no change in the government budget balance d) both the level of consumption and business inventories to fall, and a government deficit e) none of the above Page 2 of 11

3 6. Consider the following facts about the economy: GDP = 1000; G = 250; C = 500; NX 100; and the budget deficit is 40. The value of disposable income is a) 750 b) 790 c) 850 d) 960 e) none of the above 7. Consider a closed economy with fixed prices. If the MPC YD = 0.8 and there is a $0.375 tax levied on each dollar of income, a $40 increase in government purchases will cause the budget surplus to a) decrease by $10 b) decrease by $20 c) decrease by $30 d) decrease by $35 e) decrease by $40 8. Consider a fixed-price model of the economy. If the economy is initially in equilibrium, inventory investment will be positive when a) there is a decrease in autonomous expenditure b) saving exceeds the desired level of investment c) the actual level of investment exceeds the desired level of investment d) firms expect an increase in the volume of sales e) all of the above 9. Let MPC YD be the marginal propensity to consume out of disposable income, MPC Y be the marginal propensity to consume out of income, and MPS YD be the marginal propensity to save out of disposable income. If taxes are positive but not a function of income, then a) MPC YD > MPC Y b) MPC YD < MPC Y c) MPC YD = MPC Y d) MPC YD + MPS YD = MPC Y e) MPC YD + MPS YD < MPC Y 10. Consider the fixed-price, aggregate expenditure model of the economy. Which one of the following will not be true when the marginal tax rate increases? a) the aggregate expenditure curve becomes flatter b) equilibrium output falls c) disposable income decreases d) consumption decreases e) savings increase 11. Consider the IS-LM framework in a fixed-price model of the economy. Any point above the IS curve depicts a situation of a) excess demand in the goods market and excess supply in the money market b) excess supply in the goods market c) excess demand in the goods market d) excess supply in both the goods and money markets e) excess supply in the goods market but equilibrium in the money market Page 3 of 11

4 12. Consider the IS-LM framework in a fixed-price model of the economy. Any point below the LM curve depicts a situation of a) excess demand in the goods market and excess supply in the money market b) excess supply in the money market c) excess demand in the money market d) excess demand in both the goods and money markets e) excess supply in the money market but equilibrium in the goods market 13. Consider the IS-LM framework in a fixed-price model of the economy. An increase in the rate of interest will cause a) the IS curve to shift up to the right b) the IS curve to shift down to the left c) the LM curve to shift up to the left d) the LM curve to shift down to the right e) none of the above 14. Consider a model of an open economy with fixed prices, fixed exchange rates, and perfect capital mobility. Given an increase in the level of US income, which one of the following statements is true with respect to its impact on the Canadian economy? a) exports will increase, the money supply will decrease, and the rate of interest will rise b) exports will increase and the value of the Canadian dollar will appreciate c) exports will increase and the money supply will decrease d) exports will increase and the money supply will increase e) exports will increase, the value of the Canadian dollar will appreciate, and the money supply will increase 15. Initially, the German mark is worth 25 cents. Suppose the Canadian dollar is devalued by 50% and then by an additional 20%. The new exchange rate is a) 10 cents b) 17.5 cents c) 62.5 cents d) 0.83 cents e) none of the above 16. A devaluation of the domestic currency shifts the a) the IS curve to the left b) the LM curve to the left c) the IS curve to the right d) the LM curve to the right e) both the IS and the LM curves to the right 17. Consider a model of an open economy with fixed prices, fixed exchange rates, and imperfect capital mobility. If the Bank of Canada pursues expansionary monetary policy, a) equilibrium interest will fall, equilibrium income will rise, and foreign currency reserves will decrease b) equilibrium interest will remain unchanged, equilibrium income will rise, and foreign currency reserves will decrease c) both equilibrium rate of interest and equilibrium income will remain unchanged and foreign currency reserves will decrease d) equilibrium interest will fall, equilibrium income will increase, and foreign currency reserves will increase e) both equilibrium interest and equilibrium income will remain unchanged and foreign currency reserves will increase Page 4 of 11

5 18. Consider a model of an open economy with fixed prices, fixed exchange rates, and perfect capital mobility. If the federal government pursues expansionary fiscal policy, a) equilibrium interest will fall, equilibrium income will rise, and foreign currency reserves will decrease b) equilibrium interest will remain unchanged, equilibrium income will rise, and foreign currency reserves will increase c) both equilibrium rate of interest and equilibrium income will remain unchanged and foreign currency reserves will decrease d) equilibrium interest will fall, equilibrium income will increase, and foreign currency reserves will increase e) equilibrium interest will remain unchanged, equilibrium income will rise, and foreign currency reserves will decrease 19. Consider a model of an open economy with fixed prices, fixed exchange rates, and perfect capital mobility. Suppose that initial equilibrium income is below full employment and that there is external balance. An increase in autonomous exports will cause a) foreign reserves to decrease, the balance in the current account to improve, and the balance in the capital account to deteriorate b) foreign reserves to increase, but the balance in both the current and the capital account to remain unchanged c) foreign reserves to increase, the balance in the current account to improve, and the balance in the capital account to deteriorate d) foreign reserves to increase, the balance in the current account to deteriorate, and the balance in the capital account to improve f) foreign reserves to decrease, but the balance in both the current and the capital account to remain unchanged 20. Consider a model of an open economy with fixed prices, fixed exchange rates, and imperfect capital mobility, and that the BP curve is flatter than the LM curve. Suppose that initial equilibrium income is below full employment and that there is external balance. An increase in autonomous investment will cause a) foreign reserves to decrease, the balance in the current account to improve, and the balance in the capital account to deteriorate b) foreign reserves to increase, but the balance in both the current and the capital account to remain unchanged c) foreign reserves to increase, the balance in the current account to improve, and the balance in the capital account to deteriorate d) foreign reserves to increase, the balance in the current account to deteriorate, and the balance in the capital account to improve e) foreign reserves to decrease, but the balance in both the current and the capital account to remain unchanged Solutions to Multiple Choice Questions b d c c a b a e c e b c e d c c c b d d Page 5 of 11

6 PART II (20 marks) Instructions: Answer the following question in the space provided. Consider the following hypothetical closed economy: C = YD I = i + 0.1Y G = 200 TA = 200 TR = 0 L = 0.5Y - 75i M = 1000 P = 2 a) Derive the equilibrium values of income (Y) and the rate of interest (i). [Note that the level of income is in billions and the rate of interest in percent.] (4 marks) To find equilibrium Y and equilibrium i we must first derive the expressions for the IS and the LM curves. IS Curve We must find the expression for the AE curve and equate it to Y: AE = C + I + G = YD i + 0.1Y = Y 0.5(200) 40i + 0.1Y = i + 0.6Y YD = Y TA = Y 200 Y = AE Y = i + 0.6Y 0.4Y = i Y = 1200/0.4 (40/0.4)i IS: Y = i or i = Y LM Curve L = M/P 0.5Y 75i = 1000/2 0.5Y = i Y = 500/0.5 + (75/0.5)i LM: Y = i or i = -20/3 + (1/150)Y To find Y* and i* we must equate IS and LM: IS = LM i = i 250i = 2000 i* = 8 And plugging i* = 8 into either the IS or LM curve we obtain: Y* = (8) = 2200 Page 6 of 11

7 b) Calculate the equilibrium levels of consumption, savings, and investment. (3 marks) C* = YD* and YD* = Y* = = 2000 C* = (2000) = = 1400 S* = YD* - C* = = 600 I* = i* + 0.1Y* = (8) + 0.1(2200) = = 600 Note that I = S since the government has a balanced budget (TA = G = 200). c) Suppose that the government increases its expenditure on goods and services by $50 billion. What is the new equilibrium level of income? (2 marks) What is the new equilibrium rate of interest? (2 marks) If G = 50, then AE = i + 0.6Y and the expression for the IS curve will be: Y = i + 0.6Y 0.4Y = i Y = i Equating IS and LM: i = i 250i = 2125 i* = 8.5 And plugging this value for i* in the IS curve: Y* = (8.5) = = 2275 Page 7 of 11

8 d) Go back to the initial equilibrium situation of point a) above. Suppose now that the Bank of Canada increases the money supply just enough to reduce the equilibrium rate of interest to 5%. By how much will the Bank of Canada increase the nominal money supply? (2 marks) What is the new equilibrium level of income? (2 marks) What is the new equilibrium level of investment? (1 marks) The nominal money supply has to increase sufficiently so the new LM curve will intersect the IS curve at the level of the rate of interest equal to 5%. We must first find what the new equilibrium income will be. To do this, we go to the equation for the IS curve and see what the value of Y will be when i =5: i 8 5 LM LM IS Y(000 ) Y = (5) = = The equation for the LM curve is: M /P = L M /2 = 0.5Y 75i M /2 = 0.5(2500) 75(5) = = 875 M = 1750 M = 750 I = i + 0.1Y = (5) + 0.1(2500) = 750 e) What are the values of the fiscal policy multiplier ($ FP ) and the monetary policy multiplier ($ MP )? (4 marks) Fiscal Policy Multiplier $ FP = Y / G = 75 / 50 = 1.5 or $ FP = 1 / (1 c f + bk/h) = 1 / [ (0.5)/75] = 1 / (2/3) = 1.5 Monetary Policy Multiplier $ MP = Y / (M /P ) = 300 / (750/2) = 300 / 375 = 0.8 or $ MP = 1 / [(h/b) (1 c f) + k] = 1 / [(75/40) ( ) 0.5] = 1 / (5/4) = 0.8 Page 8 of 11

9 PART III (30 marks) Instructions: Answer true, false, or uncertain to the following statements. Be sure to justify your answers (no justification, no marks!). Answer all questions in the space provided on question sheet (if space is not sufficient, continue on the back of the previous page). Each question is worth 10 (ten) marks. 1. Consider the aggregate expenditure (AE) model where investment is equal to autonomous investment. An increase in government transfer payments accompanied by an equal increase in lump-sum taxes will cause equilibrium income to increase while leaving the government budget surplus unchanged. False An increase of equal size in both government transfer payments ( TR ) and lump-sum taxes ( T ) will leave disposable income (YD) unchanged at each level of Y. Therefore, consumption expenditure (C) will not be affected and neither will be aggregate expenditure (AE). If AE is not affected, then equilibrium income (Y) will not change. Consider a closed economy where AE = C + I + G. In the model we developed in class, the equation for the AE curve was given by AE = AE + c (1 t)y, where AE = C c T + c TR + I + G. Given T = TR, the change in overall autonomous aggregate expenditure will be: AE = c T + c TR = c ( TR T ) = 0. The government budget surplus will also remain unchanged: BS = TA G TR If TA = TR, then BS = TA TR = 0. Therefore, the statement is false: an increase of equal size in both TR and T will leave both the budget surplus and equilibrium income unchanged. Page 9 of 11

10 2. Suppose that government expenditure is given by the expression G = G + d (Y fe Y), where d > 0, Y fe is full employment output, Y is actual output, and thus Y fe Y represents the output gap. If G depends on the output gap, then the IS curve will be steeper and monetary policy more effective than when G is exogenously determined. False If G = G + d (Y fe Y), then AE = AE b i + [c (1 t) d] Y where AE = C c T + c TR + I + G + d Y fe. In this case, therefore, the AE curve is flatter since c (1 t) d < c (1 t). If the AE becomes flatter, then the IS curve will become steeper. Indeed, let s equate Y and AE to find the expression for the IS curve: Y = AE b i + [c (1 t) d] Y [1 c (1 t) + d] Y = AE b i i = AE / b {[1 c (1 t) + d] / b} Y And the slope of the IS curve is steeper since 1 c (1 t) + d > 1 c (1 t). This part of the statement is true, but not the last part since monetary policy is less, and not more, effective when the IS curve is steeper. We can show this in two ways: graphically and algebraically. i LM IS 1 LM In the graph on the left we can observe that a shift to the right of the LM curve will cause equilibrium income to increase by more when the IS curve is flatter. We can also show that the $ MP is smaller when G depends on the output gap and the IS curve is steeper. Indeed, in this case $ MP is: $ MP = 1 / {(h / b) [1 c (1 t) + d] + k} IS 2 and 1 / {(h / b) [1 c (1 t)] + k} > 1 / {(h / b) [1 c (1 t) +d] + k}. Y 0 Y 2 Y 1 Y The economic explanation is as follows. Since G decreases as Y increases, any increase in the real money supply will have a smaller multiplying effect on equilibrium income. Page 10 of 11

11 3. Suppose that there exists external balance at the initial equilibrium level of income. Under a fixed exchange rate system and no capital mobility, a relative increase in the US price level will cause Canadian GDP to rise. (Show your answer graphically and explain the economics.) True Ceteris paribus, an increase in the US price level relative to the Canadian price level will increase the real exchange rate (RER = e P f / P) for US dollars. A higher RER means that Canadian goods are now relatively cheaper than US goods, that is, Canadian goods are now more internationally competitive vis-à-vis US goods. Therefore, Canadian exports to the US will increase and Canadian imports from the US will decrease, resulting in an increase in net exports (NX). An increase in NX means that aggregate expenditure (AE) rises, creating a situation of i disequilibrium in the goods market (AE > Y). LM Graphically, this means a shift of the IS curve to the right to IS. Higher NX implies the LM appearance of a surplus in the foreign exchange market, prompting the Bank of Canada to buy foreign currency and to increase, therefore, the real money supply. A IS higher stock of money means a shift to the right of the LM curve. Since AE > Y now, firms IS will start to sell more goods than they are producing and inventories will start to fall. Firms will realize that this is a rather Y 1 Y 2 Y permanent situation and will start speeding up production. Therefore, Y will start to increase. As Y increases, the demand for real balances also increases and the rate of interest rises. Since the money market remains always in equilibrium, the adjustment path is along the LM curve. Note that as i increases, investment decreases (shown by a movement up along the IS curve). Note that there is some partial crowding out since investment falls (because of the higher interest rate) while net exports increases. Also note that X increases while Q could either increase or decrease, although the increase in X would be greater than any increase in Q (and thus NX rises). In addition, the surplus in the external sector implies that the Bank of Canada foreign reserves will increase. Page 11 of 11