University of Toronto June 8, 2012 ECO 209Y L0101 MACROECONOMIC THEORY. Term Test #1

Transcription

1 Department of Economics Prof. Gustavo Indart University of Toronto June 8, 2012 SOLUTIONS ECO 209Y L0101 MACROECONOMIC THEORY Term Test #1 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 1 hour and 50 minutes. 2. Aids allowed: a simple calculator. 3. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /40 Part II 1. /10 2. /10 3. /10 4. /10 TOTAL /80 Page 1 of 10

2 PART I (40 marks) Instructions: Enter your answer to each question in the table below. Only the answer recorded in the table will be marked. Table cells left blank will receive a zero mark for that question. Each question is worth 2.5 marks. No deductions will be made for incorrect answers C D C C D A C A C E A C D D D C Use the following information to answer questions 1 and 2. Suppose that an economy produces only apples, bananas, and oranges, and that price (in dollars) and quantity (in pounds) data are given in the table below. Year 2000 Year 2010 Good Quantity Price Quantity Price Apples 3,000 $2 4,000 $3 Bananas 6,000 $3 6,500 $2 Oranges 8,000 $4 9,000 $5 1. The percentage increase in nominal GDP between 2000 and 2010 is A) 15 percent. B) 20 percent. C) 25 percent. D) 30 percent. 2. Considering the year 2000 as the base year, the percentage increase in real GDP between 2000 and 2010 is approximately A) 7 percent. B) 9 percent. C) 11 percent. D) 13 percent. E) 15 percent. Use this space for rough work. Page 2 of 10

3 3. 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%. 4. 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 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 250. E) None of the above. 5. The pop-corn industry produced $1 billion worth of pop-corn in 2011, using $500 million worth of corn as the only intermediate product. The pop-corn industry also paid $300 million in wages and salaries, $50 million in rent, and $50 million in taxes. The contribution of the pop-corn industry to the country s GDP in 2011 was A) $1,400 million. B) $1,000 million. C) $900 million. D) $500 million. Use this space for rough work. Page 3 of 10

4 6. Nominal GDP in 2000 was $1,015.5 billion, and in 2008 it was $2,732.0 billion. The GDP deflator is 42.0 for 2000 and 85.7 for 2008, where 2010 is the base year. Calculate the percent change in real GDP in the period from 2000 to Rounding off to the nearest percentage point, what was the percent change in real GDP in the period from 2000 to 2008? A) 32%. B) 104%. C) 132%. D) 169%. E) None of the above is correct. 7. The reason that an increase in autonomous spending leads to an even greater increase in equilibrium income is that A) the multiplier increases with an increase in autonomous spending. B) people save less as their income increases. C) as firms increase output to meet demand, income increases, and this induces more consumption spending. D) there is unwanted inventory accumulation, leading firms to lower prices thereby encouraging increased consumer spending. E) the demand for money increases. 8. Acme Steel Co. produces 1,000 tons of steel. Steel sells for $30 per ton. Acme pays wages of $10,000. Acme buys $15,000 worth of coal, iron and other inputs needed to produce the steel. Acme pays $2,000 in taxes. Acme s contribution to GDP is A) $15,000. B) $20,000. C) $25,000. D) $45,000. Use this space for rough work. Page 4 of 10

5 9. Suppose that the government has a balanced budget. It collects $30 billion in taxes, pays $10 billion in Social Security benefits, pays $2 billion in interest on the national debt, and pays government workers $18 billion in wages. The government contribution to GDP is A) $0 billion. B) $12 billion. C) $18 billion. D) $30 billion. E) undetermined with the information provided. 10. Consider the fixed-price, aggregate expenditure model of the economy. Which one of the following will not be true when the marginal tax rate increases? A) The aggregate expenditure curve becomes flatter. B) Equilibrium output falls. C) Disposable income decreases. D) Consumption decreases. E) Savings increase. 11. Consider a closed economy with fixed prices and a balanced government budget at the initial equilibrium situation. A drop in government purchases will cause A) the level of consumption to fall, business inventories to rise, and a government surplus. B) business inventories to rise and a government deficit, but no change in the level of consumption. C) business inventories and the level of consumption to fall, but no change in the government budget balance. D) both the level of consumption and business inventories to fall, and a government deficit. 12. Consider a model of a closed economy where investment is independent of the level of income, the MPC YD is 0.8, and the tax rate (t) is A $50 billion increase in government purchases will lead to a change in the budget surplus of A) $50 billion. B) -$50 billion. C) -$ D) -$37.5. E) +$37.5. Use this space for rough work. Page 5 of 10

6 13. Assume a dealership in Toronto bought 40 Toyotas from Japan at a cost of $15,000 per car in July of 2011, and by December 31, 2011 have sold 20 of these Toyotas at a price of $20,000 each. The remaining Toyotas were sold in January 2012 at a price of $18,000 each. The effect of these transactions on GDP in the year 2011 is A) $400,000. B) $300,000. C) $200,000. D) $100, Consider the aggregate expenditure model of an open economy where national income is $520, disposable income is $440, consumption is $410, net exports is negative at $11, and the budget deficit is $15. What is the level of investment? A) $106. B) $54. C) $30. D) $ The ultimate objective of the austerians as Paul Krugman calls those obsessed with austerity programs is A) to eliminate government deficits. B) to reduce wasteful expenditures by the government. C) to improve efficiency in the economy. D) to minimize the size of the government. 16. Canada has been running a current account deficit since 2009 and it is expected to continue doing so for the foreseeable future. According to most analysts including Mark Carney, the governor of the Bank of Canada the main reason for this deficit is A) that productivity improvement by Canadian firms lags behind that of U.S. firms. B) that wages of Canadian workers are too high compared to those of their American counterparts. C) the increase in the value of the Canadian dollar. D) that the U.S. economy has remained weak, thus reducing American demand for Canadian goods and services. E) that the Canadian economy has recovered very rapidly, thus boosting Canadian demand for imported goods. Use this space for rough work. Page 6 of 10

7 PART II (40 marks) Instructions: Answer the following questions in the space provided. Each question is worth 10 marks. 1. Consider the following data for a hypothetical economy to answer the questions below. Consumption expenditure 594,089 Investment spending 194,177 Government purchases 219,816 Wages and salaries 385,492 Net income from abroad 74,689 Net exports 55,397 Capital consumption allowance 135,781 Indirect taxes 127,745 Government transfer payments 98,523 Income taxes 187,455 a) What is the value of GDP? GDP = C + I + G + NX = 594, , , ,397 = 1,063,479 b) What is the value of GNP? GNP = GDP + Net income from abroad = 594, ,689 = 1,138,168 c) What is the value of net domestic income (NDI)? NDI = GDP - Capital consumption allowance - Indirect taxes = 1,063, , ,745 = 799,953 d) What is the value of the government budget surplus (BS)? BS = Indirect taxes + Income taxes Gov t purchases Gov t transfer payments = 127, , ,816 98,523 = 3,139 Page 7 of 10

8 2. Answer true or false to the following statement (marks will be given entirely for your explanation): In the simple aggregate expenditure model for a closed economy, an increase in government purchases would have a greater impact on the level of economic activity if private investment were an increasing function of the level of income. True The larger the aggregate expenditure multiplier, the greater will be the impact of an increase in government purchases on equilibrium income. Therefore, let s examine how the size of the expenditure multiplier changes when we consider investment to be an increasing function of income. Recall that the expenditure multiplier is α AE = 1 / (1 slope of the AE curve), where the slope of the AE curve is the marginal propensity to spend. Also recall that the marginal propensity to spend represents the fraction of any additional dollar of income that is spent, and thus it is the relative size of the marginal propensity to spend that determines the multiplying effect that any initial change in autonomous aggregate expenditure has on equilibrium income. In the case of a closed economy, the marginal propensity to spend is equal to the MPC Y = c(1 t), i.e., in our closed economy model only consumption is assumed to depend on income and thus the marginal propensity to spend indicates the fraction of any additional dollar of income that is spent on consumption. In this case, therefore, the expression for the multiplier is α AE = 1 / [1 c(1 t)]. Now, suppose that investment also depends on income so I = I + fy. The constant f < 1 represents the fraction of any additional dollar of income that is spent on investment, i.e., it s the marginal propensity to invest. The marginal propensity to spend now becomes equal to the MPC Y plus the marginal propensity to invest, i.e., a larger fraction of any additional dollar of income is now re-spend purchasing goods and services a fraction is spent by consumers and another fraction is spent by businesses. Therefore, the slope of the AE curve now becomes equal to c(1 t) + f and the multiplier becomes equal to α AE = 1 / {1 [c(1 t) + f]}. Since c(1 t) + f > c(1 t), then the multiplier is larger when f > 0 and the statement is true. Page 8 of 10

9 3. Critically evaluate the following statement: Most economists believe that greater consumer and business confidence is needed to restore Canada s economic activity to pre-recession levels. In this regard, Canada s Finance Minister stated that the biggest contribution his government can make to improve economic confidence is to reduce its own spending and debt. If our economy is in a recession, i.e., if equilibrium income/output is below full-employment output, this is not because we don t have the capability to produce a larger output but rather due to a weak aggregate demand (i.e., a weak AE). Therefore, what is needed is an increase in autonomous AE in order to move the economy to a situation of excess demand (i.e., to a situation where AE > Y) for firms to get the signal that production should be increased. If we assume, for simplicity, a closed economy, then what we need is any of C, I or G to increase in order to trigger the virtues multiplying process that will eventually restore equilibrium at the level of full-employment income. But which of the different component of AE will initiate this multiplying process? Let s examine C first. Consumers confidence is usually very low during a recession and thus it will be very unlikely that they will initiate the process of economic expansion by increasing their expenditure on goods and services. Indeed, consumers might be quite worry about the possibility of losing their jobs and thus will not be in the mood to increase their expenditure. Most likely their reaction will be to do right the opposite, i.e., to reduce expenditure and increase saving (or pay off debt, which is the same) in case their pessimistic expectations become true and they are laid off. What about I? Will corporations start investing and thus creating new jobs and increasing income? As a matter of fact, as it was reported in the economic news, corporations are currently sitting on pile of money but they are not spending. And why would they? There is excess capacity in the economy which means firms can produce more with the existing capital stock but they are not. Why would they increase further the existing excess capacity? Corporations will start spending (i.e., investing) when the demand for their products start to increase, i.e., when consumer expenditure starts to increase and the excess capacity is reduced and the conditions for expansion of the productive capacity of firms are in place once again. So the above statement is right in that greater consumer and business confidence is needed to restore economic activity to pre-crisis levels, with the caveat that business confidence depends on consumer confidence being restored first. But how will this confidence be restored? The Minister of Finance thinks that a reduction in government deficit (and the debt) would do the trick. In the first place, this rationale implies that the deficit and the debt are actually responsible for the recession while the causation seems to go in the opposite direction: the government is running a fiscal deficit because of the recession. In the second place, what will be the impact of the government reducing its deficit by decreasing G (or even by increasing taxes, which they won t)? A decrease in G will cause the economy to move into a deeper recession, further reducing the confidence of both consumers and the business sector. Consumers and business sector confidence must be restored to move the economy to fullemployment equilibrium, but this confidence will start to be restored when there are some clear signs of employment and income starting to increase and for this autonomous AE must increase and not decrease! Therefore, what the government should do is to increase G rather than decreasing it. An increase in G will contribute, first, to prevent the level of economic activity from dropping even lower and, second, to start restoring confidence in the economy and creating the conditions for further expansion. As emphasized in class, increases in G will not move the economy to full employment. The economy will move to full-employment as a result of both C and I recovering their previous levels and beyond. But the latter requires consumer and business confidence to be restored, and this will not happen by itself. It needs something to trigger this change, and this something is the initial increase in Y resulting from expansionary fiscal policy. Page 9 of 10

10 4. Answer true or false to the following statement: A decrease of $10 billion in autonomous taxes will have a greater expansionary impact on equilibrium income and a smaller impact on the government budget surplus than an increase of $10 billion in government expenditure on goods and services. (Show your answer algebraically and explain the economics. Consider the AE model of a closed economy.) This statement is false. Let s examine first the respective impacts on equilibrium Y of these two policy options. On the one hand, an increase of $10 billion in G directly increases autonomous AE by $10 billion and through the multiplying process causes equilibrium income to increase further by $10 billion times the expenditure multiplier, i.e., Y = α AE G = α AE ($10 billion). On the other hand, a decrease of $10 billion in autonomous taxes increases autonomous AE only indirectly and by a lesser amount. Indeed, the $10 billion decrease in autonomous taxes directly increases YD by $10 billion at all levels of Y, but not all of this increase in YD translates into an increase in C. Consumers will spend only a fraction c of every additional dollar of disposable income and thus autonomous expenditure will increase only by c YD = c ($10 billion), which is less than $10 billion. Therefore, equilibrium income will increase by Y = α AE * c ($10 billion) which is less than Y = α AE ($10 billion). Let s examine now the respective impacts on the government BS of these two policy options. On the one hand, both policies will initially reduce the BS by $10 billion. Indeed, the $10 billion increase in G will increase overall government expenditures by this amount and reduce the BS by $10 billion, while the $10 billion decrease in autonomous taxes will reduce government revenues by this amount and reduce the BS by $10 billion as well. On the other hand, since these two policies have different impacts on equilibrium Y and government revenues (taxes) depend on the level Y, the increase in G will cause a greater increase in government revenues than the decrease in autonomous taxes. Therefore, the $10 billion decrease in autonomous taxes will end up causing a greater decrease in the government BS than the $10 billion increase in G will. Therefore, the statement is false a $10 billion increase in G will have a greater impact on equilibrium Y and a smaller impact on the government budget surplus than a $10 billion decrease in autonomous taxes. Page 10 of 10