UNIVERSITY OF TORONTO Faculty of Arts and Science APRIL/MAY EXAMINATIONS 2006 ECO 209Y1 Y. Duration: 2 hours

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1 UNIVERSITY OF TORONTO Faculty of Arts and Science APRIL/MAY EXAMINATIONS 2006 ECO 209Y1 Y Duration: 2 hours Examination Aids allowed: Non-programmable calculator only There are five parts to the exam PART A (30 marks) Pages All students must do the multiple choice questions in this section. The answers must be recorded on the scantron form provided with the exam. PART B (70 Marks) Page 5 - Only students in Professor Carr s section L0101 should do the questions in this section. PART C (70 Marks) Page 6 - Only students in Professor Indart s sections L0201, L0401 and L5101 should do the questions in this section. PART D (70 Marks) Page Only students in Professor Ghaeli s section L0301 should do the questions in this section. PART E (70 Marks) Page Only students in Professor Anjomshoa s section L5201 should do the questions in this section. Page 1 of 10

2 PART A Common Section (30 marks) This section of the exam is to be done by all students. INSTRUCTIONS: Multiple choice questions are to be answered using a black pencil or a black or blue ball-point pen on the separate SCANTRON sheet being supplied. Be sure to fill in your name and student number on the SCANTRON sheet! Write the name of your instructor on the SCANTRON sheet (in the area where it says DO NOT WRITE IN THIS SPACE ). Each question is worth 3 marks. No deductions will be made for incorrect answers. Write your answers to the multiple choice questions ALSO on the first page of the first examination booklet used for short answer questions. You may use this question booklet for rough work, and then transfer your answers to each multiple choice question onto the separate SCANTRON sheet. Your answers must be on the SCANTRON sheet. In case of a disagreement, the answer to be marked is the one on the SCANTRON sheet. 1. Assume a model with fixed prices, and unemployment resources where a restrictive monetary policy is combined with an expansionary fiscal policy. Which is more likely to occur? a) unemployment and interest rates will both go down b) unemployment will go down but interest rates will stay the same c) investment and consumption will both increase d) interest rates and consumption will both decrease e) interest rates will increase 2. If money supply is M = 1,200, bank deposits are D = 840 and high-powered money is B = 480, then a) the currency-deposit ratio is 30% and the money-multiplier is 4 b) the currency-deposit ratio is 40% and the money-multiplier is 4 c) the currency-deposit ratio is 30% and the money-multiplier is 2.5 d) the currency-deposit ratio is 40% and the money-multiplier is 2.5 e) none of the above 3. If the current level of output in the economy is $10 billion a year, the current year's capital stock in the economy is $25 billion, the savings rate is 20 percent and the rate of depreciation of capital stock is 3 percent, next year's capital stock will be and the growth rate of the capital stock will be. a) $26.25 billion; 5% b) $27.00 billion; 8% c) $26.25 billion; 105% d) $27.75 billion; 11% e) none of the above Page 2 of 10

3 4. The permanent-income theory of consumption predicts that most of an increase in transitory income will be a) spent on luxury consumption goods b) spent on basic consumption goods c) paid in taxes d) saved e) used to buy imports 5. In the Classical model, with flexible prices and full employment, an increase in government purchases a) will result in an increase in potential output b) will result in an increase in the nominal interest rate c) will result in an increase in consumption spending d) will result in an increase in net exports e) both b) and c) are correct 6. Which of the following is a liability that appears on the balance sheet of the Bank of Canada? a) deposits of the chartered banks b) foreign exchange reserves c) Government of Canada bonds d) loans to chartered banks e) none of the above 7. All of the following are components of balance sheet of a chartered bank except a) loans made to households and firms b) deposits of the Government of Canada c) currency held by households and firms d) loans from the Bank of Canada e) Government of Canada bonds 8. The national debt a) is the annual difference between government spending and tax collections b) the total amount that households and businesses owe to those from whom they have borrowed c) the total amount the current generation owes to preceding generations d) the total amount that the government still owes to those from whom it has borrowed e) none of the above Page 3 of 10

4 9. Mr. Smith is a Canadian citizen i) he buys 100 shares of a Canadian company in the Toronto Stock Exchange (TSX) ii) his company expands its production by installing a new production line iii) he purchases an imported Mexican rug for his home iv) he provides 200 hours of consultation services to other companies through his company Which of the above would increase this year s Canada GDP? a) i, ii, iv b) ii, iv c) ii, iii, iv d) i, ii e) i, ii, iii 10. In the short-run, with fixed prices and unemployment, the effect of a tax increase on real GDP will be neutralized if a) the Bank of Canada loosens monetary policy, which shifts the LM curve down to the right and lowers interest rates b) the Bank of Canada tightens monetary policy, which shifts the IS curve to the left and raises interest rates c) the Bank of Canada tightens monetary policy, which shifts the LM curve up to the left and raises interest rates d) the Bank of Canada loosens monetary policy, which shifts the IS curve to the right and raises interest rates e) the Bank of Canada loosens monetary policy, which shifts the LM curve down to the right and raises interest rates Page 4 of 10

5 PART B Professor Carr (70 marks) Students enrolled in Section LO101 (Professor Carr s section) must do the questions in this section. Answer the following questions TRUE, FALSE or UNCERTAIN. Give a brief explanation of your answer. Marks will be given primarily for the explanation. 1. The introduction of indexation in wage contracts (linking wage increases to increases in the price level) will result in an increase in the rate of inflation since whenever inflation occurs wages will automatically increase and this will result in an increase in inflation. 2. Inflation is not a serious economic problem since its primary effect is to redistribute income and this effect can be eliminated through indexation. 3. Assuming flexible prices and full employment, a perfectly expected increase in the rate of growth of the U.S. money supply will have a greater effect on Canadian GDP and interest rates under a system of flexible versus fixed exchange rates. 4. The Bank of Canada buying gold from the chartered banks, the switching of the Government of Canada account from the Bank of Canada to the chartered banks and a run on the banks will all contribute to an increase in the money supply. 5. Given the existence of capital mobility between Canada and the U.S., market rates of interest in Canada must always be equal to market rates of interest in the United States. 6. The permenant income hypothesis implies that a perfectly anticipated increase in disposable income will have no affect on consumption. 7. The Canadian economy is currently doing well due to strong energy and commodity prices. To prevent the Canadian economy from overheating, the Bank of Canada should adopt a contractionary monetary policy. Such a policy will prolong the economic boom that Canada is experiencing. Page 5 of 10

6 PART C Professor Indart (70 marks) To be answered by students from Professor Indart s Section (L0201, L0401 and L5101) Instructions: Answer TRUE, FALSE, or UNCERTAIN to the following statements. Be sure to justify your answers (no justification, no marks!). Use diagrams whenever appropriate and explain the economics. Each question is worth 10 (ten) marks. 1. According to the standard fixed-price IS-LM model, monetary policy cannot change real output as long as investment is independent of interest rates. 2. If prices are fixed, a decrease in foreign interest rates will cause domestic output to fall under perfect capital mobility and flexible exchange rates. 3. The Ontario economy is slowing down as a result of the appreciation of the Canadian dollar, while the Alberta economy is producing at full capacity as a result of the oil boom. Therefore, the Bank of Canada should increase the overnight rate of interest in order to both reduce the pressure on the price level coming from Alberta and to put a break to the appreciation of the Canadian dollar. 4. A decrease in the price level, which is seen by firms but is not seen and is not expected by the workers, will result in a lower real wage and fewer workers hired. 5. Suppose a neurosurgeon and a professional gambler have the same log-run marginal propensity to consume; in this case, the Life-Cycle/Permanent Income Theory of Consumption will predict that their short-run marginal propensities to consume will also be equal. 6. Expansionary fiscal policy will increase the income velocity of money. 7. An increase in government spending financed by borrowing from the public will increase the supply of money. Page 6 of 10

7 PART D Professor Ghaeli (70 marks) Only students from Professor Ghaeli s section L0301 should do the questions in this part of the exam. Instructions: This section contains ten (10) short-answer questions. Please answer all questions. Marks for each question indicated in brackets. 1. When exchange rates are flexible and capital is perfectly mobile, the monetary policy is completely ineffective. Discuss, using appropriate graph. (8 marks) 2. If we were in a liquidity trap, then fiscal expansion is unlikely to result in crowding out. Discuss, using appropriate graph. (6 marks) 3. The higher the marginal propensity to import, the lower the size of the multiplier. Discuss. (6 marks) 4. Assume the following model of the expenditure sector: Y = C + I + G + NX C = (4/5)YD YD = Y - TA + TR TA = (1/6)Y TR o = 180 I o = 160 G o = 100 NX o = - 40 If the government wants to increase the equilibrium level of income (Y) to the fullemployment level Y * = 2,700, by how much should government purchases (G) be changed? (10 marks) 5. Assume the money sector can be described by these equations: M/P = 400 and m d = (1/4)Y - 10i. In the expenditure sector only investment spending (I) is affected by the interest rate (i), and the equation of the IS-curve is: Y = 2,000-40i. If the size of the expenditure multiplier is a = 2, show the effect of an increase in government purchases by?g = 200 on income and the interest rate. (10 marks) 6. If the central bank keeps the supply of money constant, then the money supply curve is vertical, which implies a vertical LM-curve. True or False? Discuss. (6 marks) Page 7 of 10

8 7. In the Mundell-Fleming model, an exogenous decrease in the level of foreign interest rate does not have any impact on the domestic economy under a fixed exchange rate. True or False? Discuss. (6 marks) 8. There is a limit to how much additional tax revenue the government can create through inflation. Discuss, using appropriate graph. (6 marks) 9. If government spending is increased, money demand will increase. Discuss, using IS-LM model. (6 marks) 10. The Bank of Canada would face a dilemma when the government runs continuous large budget deficits. Discuss. (6 marks) Page 8 of 10

9 PART E Professor Anjomshoa (70 marks) Only students from Professor Anjomshoa s section L5201 should do the questions in this part of the exam. 1. [5 points] Using well-marked IS/LM, AS/AD, and UIP curves, show an open economy with flexible exchange rate regime in its medium rum equilibrium, where money supply is increasing 5% per year every year. [Draw for two years, and assume P = P e = 1 and E = 1 for the first year.] 2. [5 points] Using well-marked IS/LM, AS/AD, and UIP curves for an open economy with credible pegged exchange rate regime, starting from a medium run equilibrium, show the impact of a devaluation policy, in short and medium rum equilibrium. 3. [15 points total] Consider a consumer who likes to have the same consumption levels in both periods of a 2-period horizon. She has $28 in period 1, $39 in period 2, and interest rate is 20%. a) Suppose there are only borrowing/lending possibilities. Draw her budget line, and find her optimal consumption levels in periods 1, and 2, and also the optimal level of lending/borrowing. (10 points) The table below shows the marginal product of capital, i.e. the extra units of output that we can get by an additional unit of capital (investment). I = K 0 1 st 2 nd 3 rd 4 th 5 th 6 th Y b) If there are both, borrowing/lending and investment, possibilities available. Find her optimal consumption levels in periods 1, and 2, and also the optimal levels of lending/borrowing, and investment. (5 points) 4. [10 points] If the Phillips Curve is given by π t = π t e + 16% 2u t. The unemployment rate is initially equal to natural rate of unemployment, and inflation rate is π t = 10%. Suppose half the people really believe that the authorities can implement a disinflation policy, and reduce the inflation to 2%, while half the people are not sure that the authorities can stick to the policy. How long should the authorities keep the unemployment rate 2% above the natural level to reduce inflation to 2%? Page 9 of 10

10 5. [5 points] What is seignorage, and how it is related to the Laffer curve? If real money supply is $100B, what should government do to collect $5B seignorage? 6. [5 points] If the yield to maturity on 1-year, 2-year, and 3-year bonds are 5%, 5.25%, and 5.5%, respectively, find the current interest rate, and the expected interest rates for next year, and the year after next year. 7. [5 points] In permanent income theory of consumption, if the consumption function is C t = 0.8 Y t P, where the permanent income is defined as: Y t P = 0.05Y t Y t Y t Y t Determine the MPC out of permanent and transitory incomes. 8. [10 points total] Suppose interest rate is 6% a year. Answer following questions. a) What is the price of a 30 year annuity, which pays $800 a year, starting 4 years from now? (4 points) b) A project needs $30,000 initial investment, this year. Then it will pay back $1,000 next year, which will be growing 2% a year, every year forever. Is this project profitable? (6 points) 9. [10 points] Consider an economy with production function: Y = K + K 0.7 N 0.3, in long run using Solow growth model, where growth rate of labor force is 2%, depreciation rate is 13%, and saving rate is 20%. Show if this economy has a steady state equilibrium. Does this model show convergence among countries? Page 10 of 10