Economics 1012A Introduction to Macroeconomics Spring 2004 Dr. R. E. Mueller Second Midterm Examination March 19, 2004

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1 Economics 1012A Introduction to Macroeconomics Spring 2004 Dr. R. E. Mueller Second Midterm Examination March 19, 2004 Follow the instructions for each of the two parts of this examination. This examination is worth 100 points total and will count as 20 percent of your final course grade. Note: The use of calculators in prohibited. PART I: MULTIPLE CHOICE Answer all of the following questions by selecting the most appropriate answer on the bubble sheet. Each question is worth 2 points (40 points total). 1. The development of money as a medium of exchange has facilitated the expansion of trade because a. holding money increases people's wealth. b. holding money increases people's income. c. no other mediums of exchange are available. d. money eliminates the "double coincidence of wants" problem. 2. Assume that there is no foreign trade or income tax. If government spending is increased by $500 and taxes are reduced by $500, equilibrium output will change by a. -$500. b. $0. c. $500. d. an amount that cannot be determined from this information. 3. The economy can be in equilibrium if, and only if, a. planned investment is zero. b. planned investment equals actual investment. c. planned investment is greater than actual investment. d. actual investment is zero. 4. Which of the following represents an action by the Bank of Canada that is designed to decrease the money supply? a. an increase in federal tax rates b. selling government securities in the open market c. a decrease in the Bank rate d. a transfer of government funds from the Bank of Canada to private banks 5. Which of the following statements is CORRECT? a. When the interest rate rises, it becomes more expensive to borrow, and fewer investment projects are likely to be undertaken. b. When the interest rate rises, it becomes more expensive to borrow, and Version 3 1

2 more investment projects are likely to be undertaken. c. When the interest rate rises, it becomes less costly to borrow, and more investment projects are likely to be undertaken. d. When the interest rate rises, it becomes less costly to borrow, and fewer investment projects are likely to be undertaken. Version 3 2

3 6. Which of the following statements is TRUE? a. As the government increases spending by $1, planned aggregate expenditure increases initially by less than $1. b. When taxes are cut, the initial increase in planned aggregate expenditure is equal to the change in taxes. c. The final effect on the equilibrium level of income is smaller for a tax increase of $1 billion than it is for a government spending decrease of $1 billion. d. The balanced-budget multiplier is used whenever the increase in government spending is the same size as the decrease in taxes. 7. Which of the following is an example of fiat money? a. cigarettes b. a gram of gold c. a one-hundred dollar bill d. a government bond 8. Which of the following pairs of events will definitely lead to a decrease in the equilibrium interest rate? a. the purchase of government securities by the Bank of Canada and a decrease in the level of aggregate output b. an increase in the Bank rate and an increase in the price level c. a decrease in the Bank rate and an increase in the level of aggregate output d. the sale of government securities by the Bank of Canada and a decrease in the price level 9. The interest rate that banks are charged when they borrow reserves from other banks is the a. commercial paper rate. b. AAA corporate bond rate. c. overnight rate. d. prime rate. 10. The presence of automatic stabilizers means that the federal deficit is than it otherwise would be in a recession and than it otherwise would be in an expansion. a. smaller; smaller b. smaller; larger c. larger; smaller d. larger; larger 11. During the spring of 1991, economists began to observe that lower interest rates were not having much of an effect on investment spending plans. A possible explanation for this is that a. firms were expecting their sales to increase in the near future. b. the cost of capital was falling relative to the cost of labour. c. investment demand is very sensitive to changes in the interest rate. d. capital utilization rates were very low. Version 3 3

4 12. If autonomous consumption increases, the size of the multiplier would a. increase. b. decrease. c. remain constant. d. either increase or decrease depending on the size of the change in autonomous consumption. Version 3 4

5 13. Which of the following sequences best describes the crowding-out effect? a. Gç Yç rç Iè and net export è. b. Gç Yç MD ç r ç I è and net export è. c. Gç Yç MS ç r ç I ç and net export ç. d. Gç rè and I ç and net export ç. 14. Under fixed exchange rates a. Canada's money supply will be approximately equal to the United States' money supply. b. Canada's income tax rates will be largely determined by United States income tax rates. c. The value of $1 Canadian will equal the value of $1 U.S. d. Canada's interest rates will be largely determined by United States interest rates. 15. Gresham's Law refers to the tendency a. for good money to drive out bad. b. for bad money to drive out good. c. for counterfeit money to drive out fiat money. d. for fiat money to drive out counterfeit money. 16. The Tiny Tots Toy Company manufactures only sleds. In 1993 Tiny Tots manufactured sleds, but sold only 9000 sleds. In 1993 Tiny Tots' change in inventory was a sleds. b sleds. c sleds. d sleds. 17. Canada's recovery from the Great Depression was triggered by: a. high investment in residential construction in Ontario and Alberta. b. the development of nickel mines in northern Ontario. c. increases in government purchases related to World War II. d. improvements in government benefits to the unemployed. 18. A decrease in lump-sum taxes will a. make the consumption function flatter. b. make the consumption function steeper. c. have no effect on the slope of the consumption function. d. make the consumption function nonlinear. 19. If the government wants to reduce unemployment, government spending should be and/or taxes should be. a. increased; increased b. increased; decreased c. decreased; increased d. decreased; decreased 20. Which of the following actions is an example of expansionary fiscal policy? a. a decrease in welfare payments Version 3 5

6 b. a purchase of government securities in the open market c. a decrease in the Bank rate d. a decrease in the corporate profits tax rates Version 3 6

7 Part II: SHORT ANSWER Answer any three of the following four questions in the space provided. Be sure to show your work. Each question is worth 20 points (60 points total). 1. Suppose a closed Canadian economy can be summarised with the following system of equations: (1) C = a + by d (2) Y d = Y - T (3) T = T a (4) I = I a (5) G = G a Assume a = 180, T a = 100, I a = 200, G a = 200, b = a. Determine the equilibrium level of aggregate output or income (Y). b. Suppose government economists calculate the full employment (i.e., target) level of aggregate output (Y FE ) to be (i) By how much would G a have to be increased OR decreased, assuming T a is held constant? (ii) By how much would T a have to be increased OR decreased, assuming G a is held constant? Version 3 7

8 (iii) By how much would G a and T a have to change if the government wanted to maintain a balanced budget? c. Suppose that the government decided make taxes (T) also a function of Y, such that T = ty, where t =.25. Solve for the new equilibrium level of Y. d. What happens to the government s budget? Is it now a deficit or surplus? Calculate this figure. Version 3 8

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10 2. The Bank of Canada recently announced that both the overnight rate and the bank rate declined by 25 basis points (i.e., 0.25 percentage points). This quickly translated into a decrease in the interest rates that the chartered banks charge. Show and explain what type of effect this should have on output as a result of changes in both investment and in net exports. Version 3 10

11 3. Show and explain why fixed exchange rates do not allow a country such as Canada to pursue an independent monetary policy that will benefit the domestic economy. Version 3 11

12 4. Using the appropriate figures, show and explain how the crowding out effect could completely mitigate the effects of expansionary fiscal policy. Your discussion should include both the effects on investment and on net exports. Version 3 12

13 ANSWER KEY ECON 1012A MIDTERM #2 SPRING 2004 PART 1: MULTIPLE CHOICE 1. d 2. d 3. b 4. b 5. a 6. c 7. c 8. a 9. c 10. c 11. d 12. c 13. b 14. d 15. b 16. b 17. c 18. c 19. b 20. d PART II: SHORT ANSWER 1. a. Y = AE Y = a + b(y T) + I + G Y = (Y 100) Y 0.8Y = Y = 500 Y = 2500 b. (i) Since the multiplier in this case is 1/(1 MPC) = 5, government expenditures would have to decrease by 80 in order to decrease Y by 400. (ii) The tax multiplier is MPC/(1 MPC) = -0.8/0.2 = -4. Therefore, taxes must increase by 100 to decrease Y by 400. (iii) The balanced budget multiplier equals the government expenditure multiplier plus the taxation multiplier. This equals 1. Therefore both taxes and government expenditures would have to change by the same amount to maintain a balanced budget. In this case, taxes would have to increase by 400. c. Now we have Version 3 13

14 Y = AE Y = a + b(y ty) + I + G Y = (Y.25Y) Y = 0.6Y Y = 580 Y = 1450 d. Since G = 200 and T = 0.25Y = 0.25(1450) = 362.5, the government has a surplus of This interest rate decrease would result in an increase in investment in both housing and fixed capital investment (assuming these are somewhat sensitive to the interest rate) which will lead to an increase in output. It will also lead to a depreciation of the Canadian dollar as investors move their financial capital outside of Canada to obtain a higher rate of return. This will depreciate the Canadian dollar which will result in an increase in exports and an decrease in imports. In other words, net exports will increase which will lead to a further increase in Y. This is shown as an unambiguous increase in AE which leads to and increase in output (Y). This, of course, is shown as a shift upwards of the AE function which results in a higher Y. 3. When exchange rates are fixed an increase in the money supply, for example, will result in an interest rate that is lower than the prevailing international rates (say those in the U.S.). This will result in an exodus of financial capital which will chase the higher rate of return outside of Canada. As a result, there will be downward pressure on the Canadian dollar as demand for other currencies increases. Since Canada is committed to a policy of fixed exchange rates, there must be an decrease in the money supply that will increase the value of the Canadian dollar internationally but raise the domestic interest rate. This renders Canadian monetary policy ineffective. 4. Expansionary fiscal policy (i.e., an increase in G or a decrease in T) results in the AE curve shifting upwards which results in an increase in Y. Ceteris paribus, this results in an increase in money demand which (assuming no increase in the money supply) results in an increase in the interest rate. This decreases I (assuming it is sensitive to an increase in r) and also a decrease in net exports since the domestic interest rate increases which causes the Canadian dollar to appreciate vis-à-vis other currencies. This results in a decrease in exports and an increase in imports. All of these lead to an unambiguous decrease in output (Y). Version 3 14