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1 Department of Economics University of Toronto at Mississauga ECO202Y5Y Macroeconomic Theory and Policy July 2003 Test Two Dr. Gu Date: Tuesday, July 8, 2003 Time allowed: Two hours Aids allowed: Calculator Notes: This test consists of 12 multiple-choice questions in part I and 5 long questions in part II. Each multiple-choice question is worth 3 marks, and each of the long questions worth 13 marks except that the last one worth 12 marks. There is no partial mark for any multiple-choice question. For a long question, you may be given partial marks on the basis of the relative number of correct points that you will have made. It is important to hand in a complete test without missing page. Any missing page will be counted as zero mark. Any answer written with pencil is not valid (except figures) This test is worth 25% of your final course grade Print last name: Solution Given name: Student number: Section number Do not write on the space below, for markers only Questions Allocated marks Points Questions Allocated marks Total 100 Points 1

2 Part I 1. Suppose you hold a consol which promises to pay you $50 each year, forever, starting next year. If the nominal interest rate is 5% and not expected to change, the PV of this consol is: a. $110 b. $900 c. $1000 d. will increase as the nominal interest rate increases Answer: c 2. An increase in expected inflation will result in: a. a lower r and higher i b. a lower r and lower i c. a higher r and higher i d. a higher r and lower i Answer: a 3. Which of the following events would tend to cause the greatest reduction in current consumption? a. A one time tax increase of $1000 b. A temporary decline in current income of $1000 c. A permanent decrease in your annual salary of $1000 d. Both a and b Answer: c 4. Suppose firms expected future profits and future real interest rates to remain constant at their current levels. Given this information, we know that investment will decrease if: a. The real interest rate falls b. The rate of depreciation falls c. Current profit falls d. The user cost of capital decreases Answer: c 5. The arbitrage relation between one-year and two-year bonds indicates that: a. $P 1t = $P 2t b. i 1t = i 2t c. the expected return from holding a one-year bond is equal to the expected return from holding a two-year bond. d. the yield to maturity on a one-year bond is equal to the yield to maturity on a two-year bond Answer: c 2

3 6. Assume that the one-year interest rate is on the vertical axis in the IS-LM model and that the yield curve is initially upward sloping. If financial markets now expect an increase in taxes in one-year, we would expect that: a. The yield curve will become steeper b. i 2t will decrease c. i 2t will increase d. none of the above Answer: b (i 2t is the long rate) 7. A reduction in the real exchange rate indicates that: a. Foreign goods are now relatively more expensive compared to domestic goods b. Domestic goods are now relatively more expensive compared to foreign goods c. A real depreciation of the domestic currency has occurred d. A real appreciation of the domestic currency has occurred e. Both b and d Answer: e 8. Suppose i = 10%, i * = 8% and our dollar is expected to appreciate by 3% during the next year. Given this information, we know that: a. individuals will prefer to hold domestic bonds b. individuals will prefer to hold foreign bonds c. the expected return from holding a foreign bond (measured in dollars) will be 5% d. the expected return from holding a foreign bond (measured in dollars) will be 11% e. both a and c f. both b and d Answer: e 9. Suppose a government wishes to increase Y and leave NX unchanged. The government, therefore, should: a. increase G b. reduce T c. increase G and increase ε d. increase ε Answer: c 10. The goods market is in equilibrium when: a. NX=0 b. Y equals the demand for domestic goods c. Y equals domestic demand for goods d. Domestic demand equals demand for domestic goods Answer: b 3

4 11. A reduction in G under flexible exchange rates will cause: a. An increase in NX b. An increase in E c. A reduction in Y d. All of the above Answer: d 12. Suppose there is a simultaneous reduction in G and increase in M under flexible exchange rates. Given this information, we know with certainty that: a. E increases b. E decreases c. Y increases d. Y decreases Answer: a Part II Important: Show the necessary steps that lead to your answer in each part of the following questions. High marks will be given on the basis of your neat, complete explanation. 13. Suppose the goods market in an open economy is characterized by: C= Y D I= i+0.2Y G=200=T i=10% X= Y * +100ε Q=0.1Y-50ε ε=2 (foreign income)y * =1000 a. Find Y * and NX *, and check if Y * =Z * b. Suppose G is increased by 200. What is the equilibrium change in Y and in NX? Use this numerical example to explain the possible consequence of fiscal expansion (twin deficits) c. Suppose Y * is increased by 200. What is the equilibrium change in Y and in NX? Use this numerical example to explain the effects of a foreign expansion on the domestic economy and compare outcomes in parts b and c d. Graphically illustrate the effects of the fiscal policy change in part b on output, budget deficits and the trade balance (using the IS-LM graph, along with the IP and NX curves) Solution: (a) Y= i Y * =2800, NX * =40. Z * =C * +I * +G+NX * = =2800=Y * (b) G=200 Y= i Y * =3200, NX * =-40. We see that Y * =2800 rises to Y * =3200. However, G-T=0 rises to G-T= =200 a fiscal deficit. Also, NX * =40 drops to NX * =-40 a trade deficit. That is, the economy will experience the twin deficits due to the fiscal expansion. (c) Y * =200 Y= i Y * =2840, NX * =52. We see that Y * >Y * and NX * > NX *. This, along with the result in (b), shows that a foreign spending expansion is preferred to our own spending spree since the former leads to an improvement in our trade balance while 4

5 increasing our GDP. However, the domestic expansion in an attempt to boost GDP would produce a twin-deficit situation which is undesirable. (d) Under the Marshall-Lerner condition, i IS LM IP E 0 Y NX NX 14. Discuss the properties of the LM curve with its defining equation a. Use graphs to derive the LM curve from the money demand/supply curves b. Show by graph why a rise in M/P causes the LM curve to shift down c. In parts a and b you should plot nominal interest rate i on the vertical axis. Then, expected inflation will not affect the LM relation. Explain why in brief. d. If the real interest rate r is measured in the vertical axis, show by graph why a rise in π e shifts the LM curve down Solution: The defining equation of the LM curve is the equil condition in financial markets: M/P=Y*L(i) 5

6 (a) Suppose that Y rises to Y. Then, M D =Y*L(i) shifts up to (M D ) =Y *L(i) (M/P) S LM (M D ) M D Y Y (b) For any given Y o, increase M to M LM M D M/P M /P Y o (c) The opportunity cost of holding money is determined only by the nominal interest rate i and not affected by the expected inflation rate π e. For any given i, changes in π e will alter the real rate of return, r, on bond holding and the purchasing power of money M, but not change the total opportunity cost of holding money. E.g., suppose i=10%. Case 1 where π e =0, i=r=10%, the opportunity cost of holding M (due to giving up holding bonds) is 10%; Case 2 where π e =4%, r=6%, the opportunity cost of holding M consists of: (i) r=6% because of giving up interestbearing bonds and (ii) π e =4% inflation tax on M holding (M is losing its purchasing power) 6

7 (d) It is r rather than i that is measured on the vertical axis. The equil condition for financial markets is M/P=Y*L(r+π e ). Let M D =Y*L(r+π e ). π e L for any given r o M D shifts leftward. For any given Y o and with M/P fixed, π e r in order for L to remain unchanged LM shifts down r M D r LM r o M/P Y o 15. Suppose P and P * are both increasing. Now suppose that our dollar experiences a 5% nominal depreciation. a. Which country is experiencing the higher rate of inflation if the domestic currency experiences a real appreciation? Briefly explain. b. Which country is experiencing the higher rate of inflation if the domestic currency experiences a real depreciation? c. Compare the changes in P and P * if the real exchange rate does not change. Solution: E increases by 5% and P and P * are both increasing. Use ε = EP * /P a. If the real exchange rate appreciates ( falls ) while the nominal exchange rate depreciates ( increases ), this implies that P must be increasing at a rate at least 5% above the rate of increase in P *. The more than 5% higher rate of inflation in the domestic economy more than offsets the nominal depreciation. b. Not clear. There are two cases. Case 1: Foreign country is experiencing the higher rate of inflation. This would cause the real depreciation to be even greater. Case 2: Inflation in the domestic economy is greater than in the foreign country; however, the differential must be less than 5% to have a real depreciation or prevent a real appreciation. c. The nominal depreciation of 5% would cause, all else fixed, a 5% real depreciation; however, both P and P * are increasing AND the real exchange rate does not change. What is happening? The rate of inflation in the domestic economy must be exactly 5% higher than in the foreign country to offset the increase in P * AND the nominal depreciation. 7

8 16. Use the graph provided below to answer the following questions. Assume that the economy is initially operating at point A. Now suppose there is an unexpected reduction in spending which causes the leftward shift in the IS curve. a. Explain what effect this unexpected reduction in spending will have on stock prices P S if the economy moves to point B b. Explain what type of a policy response by the Bank of Canada financial markets expect if the economy is to move to point C c. Explain what type of a policy response by the Bank of Canada financial markets expect if the economy is to move to point D d. Suppose the economy does move to point C (from point A). What effect will this event have on stock prices? Explain. e. Suppose the economy does move to point D (from point A). What effect will this event have on stock prices? Explain. i LM C A B IS D IS Y Solution: Use the stock pricing formula discussed in class: i P S ; Y P S (a) The unexpected reduction in spending will cause the interest rate to fall and output to fall. The lower future interest rate would increase stock prices while the lower future output would reduce stock prices. So, we do not know which effect will dominate so that the net effect is ambiguous. (b) The Bank of Canada acts to keep the interest rate fixed at its original level. To do so, the Bank would have to pursue contractionary monetary policy; reduce the money supply to shift the LM curve up so it intersects the new IS curve at point C (c) The Bank of Canada acts to keep Y fixed at its original level. To do so, the Bank would have to pursue expansionary monetary policy; increase the money supply to shift the LM curve down so it intersects the new IS curve at point D (d) Stock prices will fall. The lower output will cause individuals to revise down their expectations of future profits. There is no change in the interest rate here to offset this. 8

9 (e) Stock prices will rise. The lower interest rate will increase the present value of future profits. There is no output effect to offset this. 17. For this question, assume the Marshall-Lerner condition does NOT hold. Further assume that there is a trade deficit at the initial level of output. Now suppose that a real depreciation occurs. a. Discuss and explain what effect this depreciation will have on the NX line, the ZZ line and domestic output. Using graphs, illustrate the effects of this depreciation. Clearly illustrate in the graph, the new equilibrium. b. Based on your analysis in part a, what type of exchange rate policy should be pursued in the short-run ( when the Marshall-Lerner condition does not hold) to increase economic activity? Explain. Solution: (a) See the graph. The economy moves from point A to B. Since the Marshall-Lerner condition does not hold, a depreciation will cause NX to fall, the NX line to shift down and the ZZ line to shift down (the size of the shifts in ZZ and NX will be the same). Such a policy will cause Y to fall to Y. (b) An appreciation can be pursued since it would cause an increase in Y. Even if the quantities of X and Q would fall, the price effect would dominate, causing a rise in NX and hence a rise in ZZ and Y. 9

10 Graph for part a Z 45 0 line ZZ A ZZ B Y Y Y NX 0 Y TB Y B A NX NX 10