Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 1 of 10

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1 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 1 of If Canada was a closed economy, the reduction in government expenditures would reduce aggregate demand and thus shift the aggregate demand curve to the left. Canada, however, is a small open economy with perfect capital mobility. As a result, we must consider the choice of exchange rate policy. If the Bank of Canada has chosen to allow the exchange rate to be flexible, fiscal policy has no lasting influence on the position of the aggregate demand curve. If the Bank of Canada has chosen to fix the exchange rate, fiscal policy has a large and lasting influence on the position of the aggregate demand curve. In this case, the reduction in government expenditures causes the aggregate demand curve to shift to the left. 2. If Canada was a closed economy, the pessimism of consumers would reduce aggregate demand and reduce output in the short run. Canada, however, is a small open economy with perfect capital mobility. As a result, we must consider the choice of exchange rate policy. If the Bank of Canada has chosen to allow the exchange rate to be flexible, the change in consumption has no lasting influence on the position of the aggregate demand curve. If the Bank of Canada has chosen to fix the exchange rate, changes in consumption have a large and lasting influence on the position of the aggregate demand curve. In this case, the increase in consumer pessimism causes the aggregate demand curve to shift to the left. 3. A balanced budget law would remove automatic stabilizers. Suppose the economy goes into recession. Automatic stabilizers such as the income tax and social welfare programs ensure that spending does not fall too much. But they also give rise to a government deficit. Under a balanced budget law, the government would have to increase taxes or cut spending, which would make the recession worse. 4. There is no short-run difference. Both policies operate by changing aggregate demand, and so both kinds of policies have the same implications for output and prices. 5. By less than $2 billion because the crowding-out effect, which reduces the shift in aggregate demand, more than offsets the multiplier effect, which amplifies the shift. 6 A decrease in taxes with a fixed exchange rate, because fiscal policy has no crowding-out effect on investment or net exports. 7. (a) Multiplier = 1/(1-0.75) = 4. $10/4 = $2.5 billion. (b) (c) (d) (e) Multiplier = 1/( ) = 2 $10/2 = $5 billion. More, because as the government spends more, firms spend less on plant and equipment so aggregate demand won t increase by as much as the multiplier suggests. More of a problem. Government spending raises interest rates. The more sensitive investment is to the interest rate, the more it is reduced or crowded out by government spending. More likely to allow the economy to adjust on its own because if the economy adjusts on its own before the impact of the fiscal policy is felt, the fiscal policy will be destabilizing. 8. (a) They decreased the money supply (or lowered its growth rate). (b) Because monetary policy acts on the economy with a lag. If the Bank of Canada waits until inflation has arrived, the effect of its policy will arrive too late. Thus, the Bank of Canada responds to its forecast of inflation.

2 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 2 of (a) Closed Economy An expansion in the money supply reduces the interest rate, as shown in the figure below. Open Economy In an open economy with a flexible exchange rate, Canadian and foreign savers find Canadian assets less attractive than foreign assets because of the lower Canadian interest rates. As a result, they buy foreign assets and sell Canadian assets causing the real exchange rate to fall. This will increase net exports and, therefore, increase the demand for money until interest rates return to world interest rates. This is shown in the figure below.

3 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 3 of 10 In a small open economy with fixed exchange rates, the reduction in interest rates causes the dollar to depreciate. However, the central bank will purchase Canadian currency in the foreign exchange market in order to prevent this depreciation. As a result, the money supply will also decrease until interest rates return to world levels. This is illustrated in the figure below. (b) Closed Economy When an increase in credit card availability reduces the cash people hold, money demand decreases from MD 1 to MD 2, as shown in the figure below. As a result, the interest rate drops. Open Economy In an open economy with a flexible exchange rate, Canadian and foreign savers find Canadian assets less attractive than foreign assets because of the fall in Canadian interest rates. As a result, they buy foreign assets and sell Canadian assets causing the real exchange rate to fall. This will increase net exports and, therefore, increase the demand for money until interest rates return to world interest rates. This is shown in the figure below.

4 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 4 of 10 In a small open economy with fixed exchange rates, the reduction in interest rates causes the dollar to depreciate. However, the central bank will purchase Canadian currency in the foreign exchange market in order to prevent this depreciation. As a result, the money supply will also decrease until interest rates return to world levels. This is illustrated in the figure below.

5 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 5 of 10 (c) Closed Economy When households decide to hold more money to use for holiday shopping, the money demand curve shifts tot he right from MD 1 to MD 2, as shown in the figure below. The result is a rise in the interest rate. Open Economy In an open economy with a flexible exchange rate, the rise in interest rates attracts foreign savings, so the real exchange rate will rise. This will reduce net exports and, therefore, reduce the demand for money until interest rates return to world interest rates. This is shown in the figure below.

6 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 6 of 10 In a small open economy with fixed exchange rates, the rise in interest rates will tend to cause the dollar to appreciate. However, the central bank will purchase foreign currency in order to prevent this appreciation. As a result, the money supply will also increase until interest rates return to world levels. This is illustrated in the figure below. (d) Closed Economy When a wave of optimism boosts business investment, money demand increases from MD 1 to MD 2 in the figure below. The increase in money demand increases the interest rate.

7 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 7 of 10 Open Economy With a flexible exchange rate policy, the increase in interest rates will cause the real exchange rate to rise. Because of the rise in the exchange rate, there will be a reduction in next exports which will offset the rise in investment. This reduction in net exports will offset the increased demand for money created by the new investment. With perfect capital mobility, the demand for money will move back until interest rates return to the initial interest rate. This is illustrated in the figure below. With a fixed exchange rate policy, the Bank of Canada will cause the supply of money to expand as it purchases foreign currency. It must purchase this foreign currency in order to maintain the value of the Canadian dollar. This will cause the supply of money to expand until interest rates are restored to the initial interest rate. This is illustrated in the figure below.

8 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 8 of 10 (e) Closed Economy When an increase in oil prices shifts the short-run aggregate-supply curve upward, the increased price level increases money demand. The money demand curve shifts to the right from MD 1 to MD 2, as shown in the figure below. The result is a rise in the interest rate. Open Economy In an open economy with a flexible exchange rate, the rise in interest rates attracts foreign savings, so the real exchange rate will rise. This will reduce net exports and, therefore, reduce the demand for money until interest rates return to the world interest rate. This is shown in the figure below.

9 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 9 of 10 In a small open economy with fixed exchange rates, the rise in interest rates will tend to cause the dollar to appreciate. However, the central bank will purchase foreign currency in order to prevent this appreciation. As a result, the money supply will also increase until interest rates return to world levels. This is illustrated in the figure below. 10. (a) When more ATMs are available in a closed economy, so that people s money demand is reduced, the money demand curve shifts tot he left from MD 1 to MD 2, as shown in the figure below. If the Bank of Canada does not change the money supply, which is at MS 1, the interest rate will decline from r 1 to r 2. The decline in the interest rate shifts the aggregate-demand curve to the right, as consumption and investment increase. (b) If the Bank of Canada wants to stabilize aggregate demand, it should reduce the money supply to MS 2, so the interest rate will remain at r 1 and aggregate demand won t change.

10 Solutions for BUSI 101: Review and Discussion Questions Lesson 10 Page 10 of (a) Tax revenue declines when the economy goes into a recession because taxes are closely related to economic activity. In a recession, people s incomes and wages fall, as do firms profits, and the volume of sales so taxes collected on all these things decline. (b) (c) Government spending rises when the economy goes into a recession because more people get Employment Insurance benefits, welfare benefits, and other forms of income support. If the government were to operate under a strict balance-budget rule, it would have to raise tax rates or cut government spending in a recession. Both would reduce aggregate demand, making the recession more severe.