University of Toronto June 14, 2007 ECO 209Y - L5101 MACROECONOMIC THEORY. Term Test #1 DO NOT WRITE IN THIS SPACE. Part I /24.

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1 Department of Economics Prof. Gustavo Indart University of Toronto June 14, 2007 SOLUTION ECO 209Y - L5101 MACROECONOMIC THEORY Term Test #1 LAST NAME FIRST NAME INSTRUCTIONS: STUDENT NUMBER 1. The total time for this test is 1 hour and 50 minutes. 2. This exam consists of three parts. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /24 Part II /16 Part III 1. /10 2. /10 3. /10 4. /10 TOTAL /80 Page 1 of 9

2 PART I (24 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 3 (three) marks. No deductions will be made for incorrect answers A C E D A C D A E 1. When measuring GDP through the expenditure approach, which one of the following statements about investment is correct: A) Net investment may be negative. B) Net investment includes the total of all machinery and equipment produced during the year. C) Gross investment must equal net investment. D) Gross investment plus depreciation equals net investment. E) Net investment is one of the components of total expenditure on goods and services. 2. Which of the following is not included in measures of the government expenditure component of aggregate expenditure in the national accounts? A) Salaries of civil servants whose responsibilities include the collection of the Goods and Service Tax (GST). B) The city of Edmonton s purchase of forms from a Regina printing company. C) Canada pension payments to eligible residents of Sherbrooke, Quebec. D) The government of Newfoundland pays a New York engineering consulting company. E) All of above are included. 3. Assume a dealership in Toronto bought 40 brand new cars from the Ford Motor Company in Oakville, Ontario, at a cost of $15,000 per car in July of 2006, and by December 31, 2006 has sold 20 of these cars at a price of $20,000 each. The remaining cars were sold in January 2007 at a price of $18,000 each. The effect of these transactions on GDP in the year 2006 is A) 760,000. B) 600,000. C) 400,000. D) 160,000. E) 100, The marginal propensity to consume out of income A) shows the fraction of national income which is used for consumption. B) added to the marginal propensity to save out of disposable income always equals zero. C) added to the marginal propensity to save out of disposable income always equals one. D) is the relationship between a change in consumer purchases and the change in income which allowed consumption to change. E) declines as income declines, eventually becoming zero as income reaches zero. Page 2 of 9

3 5. Suppose that the following data describes the consumption basket of a representative consumer. Food Clothing Units Prices If 2005 is the base year, the value of the GDP Deflator in 2006 was approximately A) 161. B) 165. C) 61. D) 21. E) None of the above. 6. Which of the following statement is correct with respect to Gross National Product (GNP)? A) GNP measures the value of production that is located in Canada. B) GNP measures the value of income that is earned from production in Canada. C) GNP measures the income accruing to Canadian residents. D) GNP excludes Canadian government purchases. E) GNP includes the value of illegal activities in Canada. 7. Which of the following is included in the measures of the investment component of aggregate expenditure in the national accounts? A) A Winnipeg family buys gold bars from a bank. B) A business firm buys Nortel stock. C) General Motors (Canada) increases its holdings of bank deposits. D) A construction company builds 20 new homes in Burnaby, British Columbia. E) None of the above. 8. In a fixed-price IS-LM model, if we assume that money demand is totally interest insensitive, then A) fiscal policy is ineffective. B) the liquidity preference curve is horizontal. C) the IS curve is vertical. D) interest rates cannot be lowered by fiscal or monetary policy. E) monetary policy cannot change income. Bonus question (and additional 3 marks): 9. We can expect the IS-curve to become flatter as A) the supply of money decreases. B) the marginal propensity to consume decreases. C) money demand becomes more interest sensitive. D) investment becomes less sensitive to interest rate changes. E) None of the above. Page 3 of 9

4 PART II (16 marks) Instructions: Answer the following question in the space provided on this question booklet (if space is not sufficient, continue on the back of the previous page). Assume the money sector of a simple economy is described as follows: M = 800, P = 2 and L = 0.25 Y 10 i. In the expenditure sector only investment spending (I) is affected by the rate of interest (i), and the equation for the IS curve is: Y = i. [Note: i is measured as a percentage, e.g., a 10 percent interest rate implies i = 10.] a) Derive the equilibrium values of income (Y) and the rate of interest (i). (4 marks) Equilibrium Y and i are determined by the intersection of the IS and LM curves. The equation for the LM curve is derived from the condition of equilibrium in the money market: LM-curve: L = M/P 0.25 Y 10 i = 400 Y = i Therefore, the equilibrium rate of interest is: IS = LM i = i 80 i = 400 i* = 5 And substituting in the equation for the IS curve we find that the equilibrium level of income is: Y* = i* = (5) = = 1800 b) If the size of the simple expenditure multiplier is α AE = 2, show the effect of an increase in government purchases by G = 200 on income and the rate of interest. (4 marks) Since the equation for the IS curve is Y = α AE (ĀĒ bi), an increase in G causes the IS curve to shift parallel to the right by α AE G, and given the above values this parallel shift is equal to α AE G = 2 (200) = 400. Therefore, the equation for the new IS curve is: Y = i. The new equilibrium income and rate of interest are determined by the intersection of the new IS curve and the Lm curve: IS = LM i = i 80 i = 800 i* = 10 And the new equilibrium income is: Y* = i* = (10) = Therefore, i = +5 and Y = Page 4 of 9

5 c) Can you determine how much of investment is crowded out as a result of this increase in government spending? [Hint: it would be easier to answer this question if you find first the value for the interest sensitivity of investment (b).] (4 marks) Recall that the equation for investment spending is given by I = Ī bi and that the equation for the IS curve is given by Y = α AE (ĀĒ b i) = i. Therefore, α AE b = 40 and b = 20. As the rate of interest (i) changes, investment spending (I) changes by I = -b i = -20 (5) = Therefore an increase in government expenditure G = 200 crowds out investment spending by I = However, the change in aggregate expenditure is still positive, and thus equilibrium income increases. AE = G + I = = 100, d) If the money demand equation were to change to L = 0.25 Y, how would your answer in (a) and (b) change? (4 marks) If the demand for real balances changes to L = 0.25 Y, then it would be independent of the rate of interest (vertical). The LM curve in this case is also vertical: LM L = M/P 0.25 Y = 400 Y = 1600 Equilibrium income will then be determined only by the LM curve (i.e., the money market) and fiscal policy will be completely ineffective. Therefore, equilibrium income will remain unchanged at Y* = 1600 after the increase in government expenditure. The equilibrium rate of interest will be as follows before and after the increase in government expenditure: Before the increase in government expenditure, the equation for the IS curve could be written as i = Y, and therefore i* = Y* = (1600) = 10. After the increase in government expenditure, the equation for the IS curve could be written as i = Y, and therefore i* = Y* = (1600) = 20. Therefore, with the demand for real balances independent of the rate of interest, the increase in government expenditure would cause equilibrium income and rate of interests to change as follows: i = +10 and Y = 0. This means that AE = G + I = 0 and thus G = - I. Indeed, I = -b i = -20(10) = Page 5 of 9

6 PART III (40 marks) Instructions: Answer true, false, or uncertain to the following statements. Be sure to justify your answers (no justification, no marks!). Answer all questions in the space provided on question sheet (if space is not sufficient, continue on the back of the previous page). Each question is worth 10 (ten) marks. 1. A decrease in the income sensitivity of the demand for real balances (k) will have a contractionary effect on the level of equilibrium income. (Show your answer graphically and explain the economics.) False A decrease in the income sensitivity of demand means that at each level of income the demand for money will fall. Therefore, as the demand for money falls, the rate of interest decreases. This can be observed in the diagram on the right the liquidity preference curve shifts down to L (Y 1 ) and the rate of interest falls to i 1. The money market now is in equilibrium at the rate of interest i 1 when income is Y 1, which means that the LM curve has shifted to LM (see diagram). The drop in the rate of interest causes desired investment to increase, and thus the AE curve shifts up to AE 1. A situation of excess demand develops in the goods market and thus Y starts to increase. As Y increases, the liquidity preference curve starts shifting up and the rate of interest starts to rise. Since the money market is assumed to be always in equilibrium, the adjustment path is a movement up along the LM curve. At the level of income Y 2 the goods market is again in equilibrium and the new equilibrium rate of interest is i 2. This can also be observed in the bottom diagram the AE curve starts shifting down as i increases until a new equilibrium is achieved in the goods market at Y 1 and i 1. Therefore, the statement is false. A decrease in the income sensitivity of the demand for real balances has an expansionary effect on the economy because it causes the rate of interest to fall. i M/P i 1 i 2 L(Y 1 ) i 1 L (Y 2 ) L (Y 1 ) M/P LM i i 1 i 2 i 1 AE LM Y 1 Y 2 Y 1 Y AE 1 AE 2 AE 1 Y 1 Y 2 Y 1 Y Page 6 of 9

7 2. In an open economy operating below potential output, a $1 billion increase in the government budget deficit will necessarily cause a $1 billion decrease in private investment. False In an open economy, private savings (S) are used for the financing of private investment (I), the government budget deficit (G + TR TA), and net exports (NX): S = I + (G + TR TA) + NX. Therefore, an increase of $1 billion in the budget deficit would cause a $1 billion decrease in investment if and only if S and NX were to remain unchanged. However, ceteris paribus, S will increase and NX will decrease and thus I might decrease but by less than $1 billion. Let me explain. The economy is operating below full-employment, and thus the increase in the budget deficit (as a result of either an increase in G or a decrease in TA) will have an expansionary impact on equilibrium income. As Y increases, imports also increase and NX falls. At the same time, as Y increases S also increases. Therefore, the statement is false since an increase in the government budget deficit will not cause a decrease in private investment of the same absolute size. Page 7 of 9

8 3. Consider the aggregate expenditure model for a closed economy as developed in class, where taxes are independent of income (i.e., t = 0). A policy of lower taxes and unchanged budget surplus will have an expansionary effect on the economy. False A policy of lower taxes and unchanged budget surplus means that government expenditure must decrease by the same amount as taxes have. Indeed, BS = TA (G + TR) BS = TA (G + TR) = TA G TR = 0 Assuming TR = 0, then TA = G; and since TA = T, T = G. Fiscal policy will have an expansionary effect on the economy when it causes aggregate expenditure (AE) to increase. In the aggregate expenditure model developed in class, autonomous aggregate expenditure was equal to: AE = C c T + c TR + G + I. Therefore, in this case the change in autonomous aggregate expenditure is equal to: AE = c T + G = (1 c) G And AE < 0 since (1 c) > 0 and G < 0, and therefore the statement is false: A policy of lower taxes and unchanged budget surplus will have a contractionary effect on the economy. Page 8 of 9

9 4. A decrease in autonomous exports will reduce equilibrium income but leave all other components of aggregate expenditure unchanged. (Show your answer graphically and explain the economics. Consider the IS-LM model developed in class.) False A decrease in autonomous exports will have a contractionary effect on the economy. AE will decrease by the change in autonomous exports and thus the AE curve will shift down to AE 1 and the IS curve will also shift down to IS (see diagram). Note that the horizontal shift of the IS curve is equal to the change in autonomous exports time the simple expenditure multiplier. As a result, a situation of excess demand arises in the goods market since now Y > AE at Y 1. Firms will start experiencing unexpected increases in inventories and will eventually cut down production, thus decreasing Y towards the new lower equilibrium level Y 2. As Y decreases, the demand for real balances also decreases and the rate of interest starts to fall. The adjustment path, therefore, is represented by a movement down along the LM curve. This process continues until the new equilibrium is achieved at Y 2, at which point the demand for real balances is given by L(Y 2 ) and the equilibrium rate of interest is i 2. Note that as the rate of interest falls, AE increases because desired investment increases, and thus the AE curve starts shifting up until a new equilibrium is reached at the level of aggregate expenditure AE 2 in the goods market. Since the rate of interest is now lower than before, investment is higher than in the previous equilibrium. Similarly, since Y is now also lower than before, C and Q are lower than in the previous equilibrium. Therefore, the statement is false: as autonomous exports falls, investment increases while consumption and imports fall. The only component of AE that remains unchanged is government expenditure. i i 1 M/P i 2 L(Y 1 ) i i 1 i 2 AE L(Y 2 ) LM M/P IS IS Y 1 Y 2 Y 1 Y AE 1 AE 2 AE 1 Y 1 Y 2 Y 1 Y Page 9 of 9