SOLUTIONS ECO 202Y MACROECONOMIC THEORY. Midterm Test #3. University of Toronto March 19, 2003 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS:

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1 Department of Economics Prof. Gustavo Indart University of Toronto March 19, 2003 SOLUTIONS ECO 202Y MACROECONOMIC THEORY Midterm Test #3 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 50 minutes. 2. This exam consists of two parts. 3. This question booklet has 7 (seven) pages. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /20 Part II 1. /10 2. /10 3. /10 4. /10 TOTAL /60

2 2 PART I (20 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. In an open economy with no capital mobility, the aggregate demand curve will shift a. rightward as a result of cutting government spending b. leftward as a result of higher foreign prices c. leftward as a result of higher nominal balances d. rightward as a result of higher nominal exchange rate 2. Given the production function Y = AF(K,N) and assuming constant returns to scale, the contribution of growth in capital to growth in total output can be estimated by a. adding the growth rate of capital to the term A b. multiplying the growth rate of capital by capital's share in production c. subtracting the growth rate of labor from the rate of technological advancement d. multiplying the capital-labor ratio by the level of output 3. The life-cycle theory of consumption implies that a. countries with different age distributions have different MPCs b. the MPC out of wealth is close to 1 c. the MPC out of permanent income does not change with age d. individuals' savings rates are fairly stable over their lifetimes 4. If you are age 20, have no accumulated wealth, and have an expected average annual income of $24,000, how much should you consume each year if you want to retire at age 65 and expect to live until age 80? You desire to leave no estate and to consume an equal amount in each of the next 60 years. a. $24,000 b. $22,000 c. $20,000 d. $18, According to the neoclassical theory of business fixed investment, which of the following is true? a. investment spending is governed by the discrepancy between the desired and actual interest rates b. the desired capital stock decreases with a decrease in the rental cost of capital c. monetary and fiscal policy affect investment with long lags d. the desired capital stock decreases with an increase in the expected level of output

3 3 6. Which of the following will decrease the rental cost of capital? a. an increase in the expected rate of inflation b. an increase in the rate of depreciation c. an increase in the real interest rate d. a decrease in the expected rate of inflation 7. The precautionary demand for money will increase with a. less uncertainty about future events b. higher interest rates c. lower value placed by people and institutions on risk avoidance d. harsher consequences for being unable to pay bills 8. If interest rates are currently very high and you expect them to go down soon, you will most likely a. sell your bonds now, while their yield is high and they are more marketable b. want to hold more money now to undertake more transactions since you expect economic activity to increase c. hold on to your bonds for now but expect to sell some of them later once interest rates have declined d. hold on to your money for now, wait until interest rates have dropped, and then buy some more bonds

4 4 PART II (40 marks) Instructions: Answer true, false, or uncertain to the following statements in the space provided (if the space is not sufficient, continue on the back of the previous page). Be sure to justify your answers (no justification, no marks!). Each question is worth 10 (ten) marks. 1. The permanent-income theory of consumption helps to explain the empirical observation of decreasing average propensity to consume in the short-run and of constant average propensity to consume in the long-run. TRUE According to the permanent-income theory of consumption, people gear their consumption behaviour to their permanent or long-term consumption opportunities and not to the level of their current disposable income (YD). In other words, they gear their consumption behaviour to their expected long-run average disposable income or permanent income (C = cyp). Individuals, therefore, attempt to have a rather constant level of consumption over time based on their current wealth and their expected lifetime income. But how do individuals estimate their expected long-run average disposable income or permanent income? When disposable income is constant every year, then C permanent income is equal to current disposable income (YP = YD). But when current disposable income changes with respect to last year s level, then permanent income is not equal to the new current level C LR of disposable income because the individual doesn t know whether this change in income is permanent or not. Transitory changes in income are assumed to have only a marginal effect on the level of C SR consumption (only to the extent that they affect the individual s lifetime income). Only permanent changes in income fully affect the individual s estimate of her permanent income. Since the individual doesn t whether a change in current income is permanent or not, she will have the form her expectations of how YD -1 YD 0 YD much might be permanent and how much might be only transitory. Let s say that the individual believes that a fraction 2, where 2 < 1, of the change in her current disposable income is permanent. Therefore, she estimates her permanent income to be: YP = YD (YD YD -1 ) = 2YD + (1-2)YD -1. Therefore, the long-run consumption function is thus C = cyp, where the long-run MPC is equal to c. In turn, the short-run consumption function is: C = cyp = c[2yd + (1-2)YD -1 ] = c(1-2)yd -1 + c2yd, where the short-run MPC is equal to c2 < c. Therefore, the vertical intercept of the long-run consumption function is zero and thus the long-run APC is constant and equal to the long-run MPC (equal to c). The vertical intercept of the short-run consumption function is c(1-2)yd -1 > 0, and thus the short-run APC is a decreasing function of YD. The statement is thus true.

5 5 2. An increase in inventory investment always indicates an upcoming economic recession. FALSE An increase in inventory could be the result of an upcoming recession but also of an expected expansion of the economy. In the first case the increase in inventory would be unanticipated or unplanned, and in the second it would be anticipated or planned. When the economy starts moving into a recession, the first thing that firms observe is a decline in the level of sales. However, firms don t whether this decline in sales is permanent or not and thus initially they don t make any adjustment to the level of production. Since production continues at the same level as before while sales decline, the result is an unanticipated increase in inventories. When the economy is picking up and the expectation of the firm is that sales will grow in the near future, the firm will try to build inventories to be able to meet the future demand from their customers. In this case, therefore, the firm will increase production in order to build up inventories to meet future sales. Here the increase in inventories is anticipated or planned. Therefore, the statement is false. An increase in inventories could indicate either an upcoming recession or an upcoming economic boom. In one case the increase in inventories will be unanticipated or unplanned, and in the other the increase in inventories will be anticipated or planned.

6 6 3. Bonds pay interest and money does not. Therefore, if investors could be sure that they would not make capital losses on bonds, they would always hold their wealth in the form of bonds and never hold any of their wealth in the form of money. TRUE Suppose there are only two forms of assets: money and bonds. Money holdings pay no interest while bonds do. Therefore, the opportunity cost of holding money is the forgone interest. Why do individuals hold their wealth in the form of money (and receive no interest) when they could hold it in the form of bonds and receive a pay off (interest). The reason is that assets with higher expected pay offs always involve greater risks in the sense that these pay offs are more volatile (and could be positive or negative). A risk-averse (rational) individual would try to minimize the risk of her investments and thus would prefer to diversify her investments, that is, would prefer to hold a portfolio investment instead of putting all her wealth into just one form of asset. The reason why individuals hold some wealth in the form of a non interest-paying asset (money) is because money is the safest asset. Even considering the possibility of inflation (and thus of a loss of value of money), the risk of holding bonds is even greater because it involves the risk of the volatility of the real return (positive or negative) in addition to the risk of inflation. Now, if investors could be sure that they would not make capital losses on bonds that is, that the price of bonds could not fall (or, which is the same, the interest rate could not rise) then they would know with certainty that they will obtain at least a nominal (positive) return equal to the promised return on the face value of the bond. This certain nominal return is of course greater than the return on money holding (zero), and thus individuals would hold all their assets in the form of bonds and none in the form of money.

7 7 4. According to James Tobin and William Baumol (the Square-Root Formula), an increase in the price level will have no effect on either the nominal or the real demand for money. FALSE The expression for the Square-Root Formula developed by Tobin and Baumol is as follows: M = %tc.y N / 2i where M is nominal demand for money, tc is the cost of transferring funds from the savings to the chequing account (or to cash), Y N is the level of nominal income, and i is the rate of interest (opportunity cost of holding money). Since Y N = P.Y, an increase in P will increase Y N in the same proportion. For instance, if the level of P doubles then the level of Y N will double as well. If P the price level doubles, then (on average) the prices of all goods and services in the economy double. In particular, the level of tc the price of one (banking) service doubles. Therefore, a doubling of the price level causes the value of the expression inside the square root to quadruple (i.e., to be multiplied by 4). If we take the square root of 4 (equal to 2), then we have that the corresponding change in M will be 2 times the original value of the expression inside the square root, that is, a doubling of the price level causes a doubling of the nominal demand for money. In other words, changes in P cause a proportional change in the nominal demand for money. Now, if both P and M change in the same proportion, then M/P the real demand for money does not change. Therefore, changes in P leave the real demand for money unchanged. The statement is therefore false.