SOLUTION ECO 202Y - L5101 MACROECONOMIC THEORY. Term Test #1 LAST NAME FIRST NAME STUDENT NUMBER. University of Toronto June 18, 2002 INSTRUCTIONS:

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1 Department of Economics Prof. Gustavo Indart University of Toronto June 18, 2002 SOLUTION ECO 202Y - L5101 MACROECONOMIC THEORY Term Test #1 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 1 hour and 50 minutes. 2. This exam consists of three parts. 3. This question booklet has 10 (ten) pages. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /45 Part II /15 Part III 1. /10 2. /10 3. /10 4. /10 TOTAL /100 Page 1 of 10

2 PART I (45 marks) Instructions: Circle the most appropriate answer. Each question is worth 3 (three) marks. No deductions will be made for incorrect answers. 1. Acme Steel Co. produces 1,000 tons of steel. Steel sells for $30 per ton. Acme pays wages of $10,000. Acme buys $15,000 worth of coal, which is needed to produce the steel. Acme pays $2,000 in taxes. Acme s contribution to GDP is (a) $15,000 (b) $20,000 (c) $30,100 (d) $45, Suppose that the government collects $3 million in taxes, pays $2 million in Social Security benefits, pays $0.5 million in interest on the national debt, and pays workers $1 million in wages. The government contribution to GDP is (a) $0 (b) $1 million (c) $3 million (d) $3.5 million 3. Suppose that an economy produces only food and clothing, and that price and quantity data are given in the table below. Year 1 nominal GDP is Year 1 Year 2 Good Quantity Price Quantity Price Food 20 $6 25 $10 Clothing 10 $8 20 $7 (a) $200 (b) $270 (c) $310 (d) $ Consider the economy described in question 2 above and suppose that Year 1 is the base year. Year 2 real GDP is (a) $200 (b) $270 (c) $310 (d) $ The marginal propensity to consume out of income (MPC Y ) (a) shows the fraction of income which is used for consumption (b) added to the marginal propensity to save (mps) always equals zero (c) is the relationship between a change in consumer purchases and the change in income which allowed consumption to change (d) declines as income declines, eventually becoming zero as income reaches zero Page 2 of 10

3 6. Assume a model with no government and no foreign sector. If the savings function is defined as S = (0.1)Y and autonomous investment increases by 200, by how much will consumption increase? (a) 180 (b) 200 (c) 1,800 (d) 2, The reason that an increase in autonomous spending leads to an even greater increase in equilibrium income is that (a) as firms increase output to meet demand, income increases, and this induces more consumption spending (b) the multiplier increases with an increase in autonomous spending (c) people save less as their income increases (d) there is unwanted inventory accumulation, leading firms to lower prices thereby encouraging increased consumer spending 8. The fluctuations in the level of income that result from changes in investment spending (a) tend to be larger with a larger MPC YD (b) depend only on the magnitude of the changes in investment spending but not on the size of the MPC YD (c) tend to be larger with a larger MPS YD (d) tend to be larger if the income tax rate (t) is larger 9. Assume an economy with no foreign sector, a marginal propensity to save (MPS YD ) equalt to 1/10, and a marginal income tax rate (t) equal to1/3. If autonomous saving decreases by 300, which of the following is true? (a) total consumption will increase by 300 (b) national income will increase by 500 (c) disposable income will increase by 750 (d) the budget deficit will decrease by Generally speaking, the effect on income resulting from a change in investment spending is greater if (a) the marginal propensity to consume is smaller (b) the marginal propensity to save is larger (c) the average propensity to consume is smaller (a) the marginal propensity to save is smaller 11. We can expect the IS-curve to become flatter as (a) the marginal propensity to consume decreases (b) money demand becomes more interest sensitive (c) investment becomes more sensitive to interest rate changes (a) the income tax rate increases Page 3 of 10

4 12. A decrease in the interest sensitivity of money demand will (a) increase the size of the monetary policy multiplier (b) decrease the size of the monetary policy multiplier (c) make fiscal policy more effective (d) make the LM-curve flatter 13. Fiscal policy is much more effective in increasing national income if (a) investment is not very responsive to interest rate changes (b) money demand is not very responsive to interest rate changes (c) the income tax rate is very high (d) investment is very responsive to interest rate changes 14. Net exports will increase if (a) there is an increase in domestic income (b) there is a decrease in the real exchange rate (c) there is an increase in domestic inflation (d) many of our trade partners experience inflation 15. If the price level of Canadian goods is 200, the price level of foreign goods is 125, and the dollar price of foreign currency is 1.20, what is the real exchange rate? (a) 1.92 (b) 1.60 (c) 1.04 (d) 0.75 Page 4 of 10

5 PART II (15 marks) Instructions: Answer the following question in the space provided on this question booklet (if space is not sufficient, continue on the back of the previous page). Consider the following model under fixed exchange rates: AE = C + I + G + NX L = (1/3)Y - 10i C = YD M = 700 I = i P = 2 G = 120 TA = 0.25Y NX = -20 YD = Y - TA (6) (a) Derive the equilibrium values of income (Y) and the rate of interest (i). We must derive the equations for the IS and LM curves. To derive the equation for the IS curve we must first derive the equation for the AE curve: AE = C + I + G + NX = ( YD) + (300-20i) = (Y 0.25Y) 20i = i + 0.6Y To find the equation for the IS curve we must equate Y = AE: Y = i + 0.6Y 0.4Y = i 20i = Y i = Y To find the equation for the LM curve we must equate M/P = L: 350 = (1/3)Y - 10i 10i = (1/3)Y i = (1/30)Y To find equilibrium Y we must equate IS = LM: Y = (1/30)Y 40 = (1/50)Y + (1/30)Y 40 = (8/150)Y Y* = 750 And to find equilibrium i we substitute in the IS curve: i* = Y* = (750) = = 10 (2) (b) Derive the equilibrium values of consumption (C) and real balances (L). C* = YD* = (0.75Y*) = Y* = (750) = 550 L* = (1/3)Y* - 10i* = (1/3)(750) 10(10) = = 350 Page 5 of 10

6 (4) (c) How much of investment (I) will be crowded out if the government increases its purchases by )G = 160 and nominal money supply (M) remains unchanged. If )G = 160, then the vertical intercept of the IS curve increases by )G/b = 160/20 = 8, and the equation for the new IS curve becomes i = Y. The new equilibrium income is: IS = LM Y = (1/30)Y 48 = (8/150)Y Y* = 900. And the new equilibrium rate of interest is: i* = (900) = = 15. Therefore the crowding out is )I = -20)i = -20(5) = (4) (d) By how much will the equilibrium level of income (Y) and the interest rate (i) change, if the nominal supply of money is increased to M = 1,100 and government expenditure remains at the original level of 120. The equation for the new LM curve becomes: 550 = (1/3)Y i 10i = (1/3)Y i = (1/30)Y. And the new equilibrium income is: Y = (1/30)Y 60 = (8/150)Y Y* = 1,125. And the new equilibrium rate of interest is: i* = (1,125) = = 2.5. Therefore, )Y = 1, = 375 and )i = = Page 6 of 10

7 PART III (40 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 model for a closed economy as developed in class, where taxes are independent of income (i.e., t = 0). A policy of greater transfer payments and an unchanged budget surplus will have an expansionary effect on the economy. False. A policy of greater transfer payments and an unchanged budget surplus means that taxes must increase by the same amount as transfer payments have. Indeed, BS = TA (G + TR) ö )BS = )TA - )(G + TR) = )TA - )G - )TR = 0 Assuming )G = 0, then )TA = )TR; and since TA = T, )T = )TR. Fiscal policy will have an expansionary effect on the economy when it causes aggregate expenditure (AE) to increase. In the aggregate expenditure model developed in class, autonomous aggregate expenditure was equal to: AE = C - ct + ctr + G + I. In our case, the change in aggregate expenditure is equal to: )AE = -c)t + c)tr = 0 since )T = )TR. Therefore the statement is false: A policy of lower taxes and unchanged budget surplus will have no effect on the economy. Page 7 of 10

8 2. Consider the closed economy, simple expenditure model developed in class where taxes are proportional to income. An increase in government purchases will always pay for itself since it raises national income and hence the government s tax revenues. False. Let s see how this policy changes the budget surplus, BS = TA (G + TR): )BS = )TA - )(G + TR) = )TA - )G if we assume )TR = 0. Assuming TA = ty, then )TA = t)y. Let s see how the increase in G changes Y. The simple expenditure multiplier in this model is: " AE = 1 / [1 - c(1 t)]. Therefore, )Y = " AE )G = {1 / [1 - c(1 t)]} )G. Therefore, the change in the budget surplus is: )BS = )TA - )G = t)y - )G = t{1 / [1 - c(1 t)]})g - )G = {[t 1 + c(1 t)] / [1 - c(1 t)]} )G = {[t 1 + c - ct)] / [1 - c(1 t)]} )G = - {[(1 c)(1 - t)] / [1 - c(1 t)]} )G < 0. The statement is thus false since the budget surplus decreases as government expenditure increases. Page 8 of 10

9 3. An increase in the interest sensitivity of the demand for real balances (h) will reduce the effectiveness of fiscal policy. (Show your answer graphically and explain the economics.) False. Since the fiscal policy multiplier is given by: $ FP = 1 / [1 c(1 t) + bk/h], an increase in h will make $ FP larger, and thus fiscal policy more effective. We can see this also graphically. Consider two LM curves with different interest sensitivities (where h > h) initially intersecting the IS curve at the same point. Since the slope of the LM curve is k/h, a larger h implies a flatter LM curve. The diagram shows that expansionary fiscal policy --as reflected by the shift of the IS curve up to the right to IS -- has a greater impact on Y when the LM is flatter (because the rate of interest increases less and thus there is less crowding out). i LM(h) LM(h ) IS IS Y 0 Y 1 Y 1 Y Page 9 of 10

10 4. Under a fixed exchange rate system and perfect capital mobility, an increase in foreign interest rates will cause the level of domestic output to rise. (Show your answer graphically and explain the economics.) False. Under perfect capital mobility, the BP curve is horizontal at the level of the foreign rate of interest. An increase in the foreign rate of interest thus causes the BP curve to shift up to BP. Suppose that initially the economy is in equilibrium at point E. As the BP curve shifts up, the initial point of equilibrium is now below the BP curve thus representing a situation of excess demand in the foreign exchange market (deficit). Indeed, as the foreign rate of interest increases above the domestic rate a massive output of capital will follow thus increasing the demand for foreign exchange. In order to keep the value of foreign exchange at the fixed rate the Bank of Canada must sell foreign currency to satisfy this excess demand. As the Bank of Canada sells foreign exchange the money supply decreases and the LM curve shifts up to the left to LM. This reduction in money supply leads to a higher domestic rate of interest and thus to a smaller level of investment (and aggregate expenditure). The result, therefore, is a recession and a fall in the level of domestic output. The statement, therefore, is false. i LM LM i 2 * E 2 BP i 1 * E 1 BP IS Y 2 Y 1 Y Page 10 of 10