UNIVERSITY OF TORONTO Faculty of Arts and Science APRIL/MAY EXAMINATIONS 2012 ECO 209Y1 Y. Duration: 2 hours

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1 UNIVERSITY OF TORONTO Faculty of Arts and Science APRIL/MAY EXAMINATIONS 2012 ECO 209Y1 Y Duration: 2 hours Examination Aids allowed: Non-programmable calculator only There are four parts to the exam: PART A (30 marks) Pages 2-4 All students in ALL sections of the course 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 Indart s sections L0101, L0301, and L0401 should do the questions in this section. PART C (70 Marks) Page 6 Only students in Professor Carr s section L0201 should do the questions in this section. PART D (70 Marks) Pages 7-8 Only students in Professor Ghaeli s section L5101 should do the questions in this section. Page 1 of 8

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 ballpoint 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 and onto the first page of the first examination booklet used for short answer questions. 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. Consider the fixed-price (Keynesian) model of the economy. Those economists who believe that fiscal policy is more effective in increasing output than monetary policy argue that the a) responsiveness of investment to the interest rate is small. b) responsiveness of investment to the interest rate is large. c) IS curve is nearly horizontal. d) LM curve is nearly vertical. e) responsiveness of money demand to interest rate is large. 2. John buys a one-year government bond for $400. He receives principal and interest totalling $436 one year later. During the year the CPI rose from 150 to 162, but he had thought the CPI would be at 159 by the end of the year. John had expected the real interest rate to be, but it actually turned out to be. a) 8%, 1%. b) 6%, 3%. c) 3%, 1%. d) 1%, 3%. e) 3%, 2%. Page 2 of 8

3 3. The government can lower inflation with a low sacrifice ratio (i.e. with a small loss in output or a small increase in unemployment) if the a) money supply is reduced slowly. b) public has adaptive expectations. c) money supply is reduced rapidly. d) public believes that policymakers are committed to reducing inflation. e) public has no faith in policymakers commitment to reduce inflation. 4. Consider the fixed-price (Keynesian) model of the economy. If the government increased taxes to reduce the budget deficit, but the Bank of Canada held the money supply constant, then the two policies together would generally lead to income and a interest rate. a) lower; lower. b) lower; higher. c) no change in; lower. d) no change in; higher. e) higher; lower. 5. All else equal, if people decide to hold more currency, a) the money multiplier will remain unchanged but money supply will fall. b) the monetary base and the money supply will both decrease. c) the money multiplier will increase and the money supply will expand. d) the money multiplier will decrease but the money supply will not change. e) the money multiplier will decrease but the monetary base will not change. 6. Suppose you find a $100 bill that was lost for several years under your grandmother s mattress and you deposit this money in a commercial bank. If the target reserve ratio is 20 percent, all excess reserves are always lent out, and there is no cash drain on the banking system, which one of the following statements is correct? a) The money supply will not change since the public s deposits will increase by the same amount as their currency holdings will fall. b) The money supply will increase by $400. c) The money supply will increase by $500. d) The money supply will increase by $100. e) None of the above is correct. Page 3 of 8

4 7. Suppose a commercial bank has a target reserve ratio of 1 percent, but has an actual reserve ratio of 0.8 percent. This bank will likely a) contract its portfolio of loans. b) allow fewer cash withdrawals by the bank s customers. c) expand its portfolio of loans. d) maintain its new, higher reserve ratio because it is more profitable. e) buy government securities from the Bank of Canada. 8. Consider an economy without depreciation of the capital stock, without government transfer payments, and where personal income tax is the only source of government revenues. If GDP is $980 billion, consumption is $650 billion, private savings is $120 billion, government purchases is $180 billion, and net exports is -$30 billion, which one of the following is true in this economy? a) Disposable income is $860. b) Investment is $120. c) The budget deficit is $30. d) Personal income tax is 210. e) None of the above. 9. Assume that the public s desired currency-deposit ratio is 0.35, the banks target reserve ratio is 0.10, and total money supply is $3,600 billion. What is the amount of high-powered money (i.e., the monetary base) if there are no excess reserves in the banking system? a) $975 billion. b) $1,200 billion. c) $1,275 billion. d) $1,350 billion. e) None of the above is correct. 10. If the Bank of Canada responds to a negative supply shock by implementing expansionary monetary policy, then a) inflation will accelerate even more. b) the inflation rate and the rate of unemployment will further increase. c) firms will further increase their product prices and cut their production. d) cost of production will be reduced and the AS curve will shift back to the right. e) inflation will slowdown but unemployment will increase even more. Page 4 of 8

5 PART B Professor Indart (70 marks) Professor Indart Only students enrolled in Sections L0101, L0301, and L0401 (Professor Indart s sections) must answer the questions in this part of the exam. Instructions: Answer all 6 questions. All questions are of equal value. 1. Answer true, false, or uncertain to the following statement: In the short run, a devaluation of the domestic currency will cause the level of income to increase, the rate of interest to rise, the balance in the current account to improve, and the balance in the capital account to deteriorate. (Show your answer with the help of a diagram and explain the economics. Marks will be given entirely for your explanation. Consider the fixed-price model of an open economy with imperfect capital mobility.) 2. Answer true, false, or uncertain to the following statement: In the short run, a decrease in foreign interest rates will cause domestic output to fall, the rate of interest to rise, the balance in the current account to improve, and the balance in the capital account to deteriorate. (Show your answer with the help of a diagram and explain the economics. Marks will be given entirely for your explanation. Consider the fixed-price model of an open economy with flexible exchange rates and imperfect capital mobility.) 3. Consider a flexible-price model of an open economy with fixed exchange rates and no capital mobility. Assume this economy is currently at full employment and with a large trade surplus. The government of this country is resisting international pressure to revalue its currency and has decided instead to let the market move the economy to a simultaneous situation of internal and external balance. With the help of a diagram and using the AD-AS- NX model developed in class, explain the process of adjustment as determined by the market mechanism. 4. Describe the main characteristics that differentiate a balance-sheet-recession from a more typical recession. Comment on the relative effectiveness of expansionary monetary and fiscal policy during balance-sheet-recessions. 5. In a 2007 television interview, Mark Carney the Governor of the Bank of Canada suggested that the current target of 2% rate of inflation might be too high. What would be the short-run and long-run impact of reducing the target rate of inflation to 1%? Using the dynamic AS model developed in class, show your answer with the help of graphs and explain the economics. 6. Adjusted for inflation, the international price of oil increased from an average of $34/barrel in 2003 to an average of $95/barrel in What would have been the likely (positive and negative) effects of this price increase on the economy of a small oil-exporting country? Would these effects be different if this country had a fixed instead of a flexible exchange rate system? What could have done the government of this country to reduce some of the negative impacts? (In your answer, assume that in this country oil was produced by private firms.) Page 5 of 8

6 PART C Professor Carr (70 marks) Professor Carr Only students enrolled in Sections L0201 (Professor Carr s section) must answer the questions in this part of the exam. There are two sections in this part of the exam. Section I (50 marks) Instructions: Answer the following five questions TRUE, FALSE or UNCERTAIN. Give a brief explanation of your answer. Marks will be given entirely for your explanation. Each question is worth 10 marks. 1. If a country has a policy to intervene in foreign exchange markets to keep the price of its currency low, this policy is inflationary. 2. A decrease in the level of competition in the Canadian economy will inevitably result in an increase in the inflation rate in Canada. 3. One of the positive effects of inflation is that it results in a lower value of the Canadian dollar on foreign exchange markets and this lower external value of the Canadian dollar will result in an increase in Canadian exports to the rest of the world. 4. Discretionary monetary policy should be used to stabilize the economy and moderate the amplitude of the business cycle. 5. In a world with no deposit insurance, bank failures will ultimately result in a higher rate of inflation. Section II (20 marks) Instructions: Answer the following question. Under conditions of flexible prices and full employment analyse the effects of the following changes on real output, the real interest rate, the real wage rate, the real quantity of money and the level of real consumption and investment expenditures. (a) An increase in the rate of growth of the US money supply when Canada is on a system of fixed exchange rates. (b) The same change as in (a) except assume Canada is on a system of freely floating exchange rates. [Note: In (a) and (b) you are expected to analyse the effects of a change in the growth rate of US money supply on the Canadian economy.] (c) Workers being paid once a month instead of once a week. Page 6 of 8

7 Professor Ghaeli PART D Professor Ghaeli (70 marks) Only students from Professor Ghaeli s section L5101 must answer the questions in this part of the exam. Instructions: Answer all seven (7) questions below. 1. Country A has a capital-labor ratio that is initially twice as big as that of country B, but neither is yet in a steady state. Both countries have the same production function. Country A has a 10% saving rate, 10% population growth rate, and 5% depreciation rate, while country B has a 20% saving rate, 10% population growth rate, and 20% depreciation rate. a) Calculate the steady-state capital- labor ratio for each country. Does the initial capitallabor ratio affect your results? (6 points) b) Calculate output per worker and consumption per worker for each country. Which country has the highest output per worker? The highest consumption per worker? (6 points) c) Define convergence and discuss whether all the fundamental characteristics of different countries need to be identical for convergence to take place? (3 points) 2. Answer the following questions with the help of well-marked graphs: a) What happens to the fundamental value of a country's exchange rate when it raises its money supply in a fixed-exchange-rate system? Does this make the currency overvalued or undervalued if originally the official rate equaled the fundamental value? (2 points) b) What happens to the fundamental value of a country's exchange rate when the foreign country raises its money supply? Does this make the currency overvalued or undervalued if originally the official rate equaled the fundamental value? (2 points) c) So, if a country wants to maintain its official rate equal to its fundamental value, what must it do when the foreign country raises its money supply? What happens to inflation? (1 point) 3. Starting on a Phillips curve with expected inflation equal to 5% and unemployment at its natural rate, show what happens to unemployment if the Central Bank tries to reduce inflation, but has no credibility. As time passes and people realize that the inflation rate is now lower, what happens to the short-run Phillips curve? (5 points) Page 7 of 8

8 Professor Ghaeli 4. A country s central bank has a monetary base of $1 million which is used to buy $1 million worth of government bonds, with the government channeling this money into the economy immediately. In this country the currency deposit ratio is 25% and the reserve ratio is 25%. a) Starting with the initial creation of the monetary base, show the consolidated balance sheet of commercial banks after the first and second rounds of loans and redeposit, using T-accounts. (10 points) b) Show the balance sheets of the central bank, consolidated commercial banks and the public at the end of the process of multiple credit expansion and deposits, using T- accounts. What is the value of the multiplier? (5 points) 5. Answer true, false, or uncertain to the following statement: A sale of gold by the chartered banks to the Bank of Canada, a transfer of the Government of Canada account from the Bank of Canada to the chartered banks, a sale of bonds by the general public to the chartered banks and an increase in the Bank Rate will all result in a decrease in the money supply. Marks will be given entirely for your explanation. (5 points) 6. A country s GDP and debt last year was $4000 billion and $2000 billion, respectively. This year, the government revenue is $800 billion and the government expenditure is $1000 billion. Suppose this year s GDP is$ 4040 and the interest rate payable on existing government debt is 10 percent. a) Calculate the debt-gdp ratios for last year and this year. (6 points) b) How much did the debt-gdp ratio change and why? (4 points) c) If the government wanted to hold the debt-gdp ratio constant, what would have been the size of primary and total deficits? (10 points) 7. There is a limit to how much additional tax revenue the government can create through inflation. Discuss in the context of seigniorage. True, false or uncertain? Discuss, using an appropriate well-marked graph. (5 points) Page 8 of 8