University of Toronto July 27, 2006 ECO 209Y - L5101 MACROECONOMIC THEORY. Term Test #2 DO NOT WRITE IN THIS SPACE. Part I /30.

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1 Department of Economics Prof. Gustavo Indart University of Toronto July 27, 2006 SOLUTION ECO 209Y - L5101 MACROECONOMIC THEORY Term Test #2 LAST NAME FIRST NAME INSTRUCTIONS: STUDENT NUMBER 1. The total time for this test is 1 hour and 50 minutes. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /30 Part II /20 Part III 1. /10 2. /10 3. /10 4. /10 5. /10 TOTAL /100 Page 1 of 11

2 PART I (30 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 C C B C A B A E C D 1. Consider a model of an open economy with fixed prices, flexible exchange rates, and positively sloped BP curve (but flatter than the LM curve). An increase in the money supply will cause A) output, the interest rate, and the exchange rate to increase B) output, the interest rate, and the exchange rate to decrease C) output and the exchange rate to increase, and the interest rate to decrease D) output to decrease, and the exchange rate and the interest rate to increase E) output and the exchange rate to decrease, and the interest rate to increase 2. In an IS-LM-BP model with flexible exchange rates and perfect capital mobility, contractionary fiscal policy will A) cause an appreciation of the domestic currency B) shift first the LM-curve and then the IS-curve to the left C) not change the overall level of output, but its composition D) cause a decrease in net exports E) lower the level of output but leave the interest rate unchanged 3. Suppose that the BP curve is flatter than the LM curve and that the government wishes to reduce interest rates without reducing the value of the Canadian dollar. The government should A) increase its spending and cut the money supply B) lower its spending and cut the money supply C) raise its spending and raise the money supply D) lower its spending and raise the money supply E) cut the money supply and leave spending unchanged 4. Under a system of imperfect capital mobility and flexible exchange rates, which of the following would be the most likely outcomes following the implementation of expansionary fiscal policy? A) lower inflation, lower interest rates, outflow of capital, currency depreciation B) higher inflation, higher interest rates, inflow of capital, currency depreciation C) higher inflation, higher interest rates, inflow of capital, currency appreciation D) lower inflation, lower interest rates, outflow of capital, currency appreciation E) higher inflation, lower interest rates, outflow of capital, currency depreciation Page 2 of 11

3 5. The concept of the diminishing marginal product of labour suggests that A) the slope of the production function increases as the input of labour decreases B) the slope of the production function decreases as the input of capital increases C) the slope of the production function increases as the input of labour increases D) the slope of the production function equals zero for all inputs of labour E) none of the above are true 6. A profit-maximizing firm will hire more labour if A) the real wage exceeds the marginal product of labour B) the marginal product of labour exceeds the real wage C) the real wage equals the marginal product of labour D) the nominal wage equals the value of the marginal product of labour E) the nominal wage exceeds the value of the marginal product of labour 7. In the long-run Classical model, the parameter ε, which measures the speed with which wages adjust to changes in the level of employment, A) equals infinity, and the AS curve is vertical B) equals zero, and the AS curve is horizontal C) is positive but less than infinity, and the AS curve is vertical D) equals infinity, and the AS curve is horizontal E) equals zero, and the AS curve is vertical 8. The Classical model of the economy includes each of the following assumptions except A) wages and prices are fully flexible B) firms do not suffer from money illusion C) the labour market is always in equilibrium with full employment D) shocks to aggregate demand change the composition but not the level of GDP E) the supply of labour is a function of the nominal wage rate 9. Consider an open economy with flexible prices, imperfect capital mobility, and flexible exchange rates. Which of the following would be the most likely outcomes following the implementation of expansionary fiscal policy? A) lower inflation, lower interest rates, outflow of capital, currency depreciation B) higher inflation, higher interest rates, inflow of capital, currency depreciation C) higher inflation, higher interest rates, inflow of capital, currency appreciation D) lower inflation, lower interest rates, outflow of capital, currency appreciation E) higher inflation, lower interest rates, outflow of capital, currency depreciation 10. The expectations-augmented Phillips curve predicts that if inflation is higher than expected, then A) the Phillips curve will shift up B) the Phillips curve will shift down C) unemployment will be above the natural rate D) unemployment will be below the natural rate E) unemployment will be at the natural rate regardless of the inflation rate Page 3 of 11

4 PART II (20 marks) Instructions: Answer the following questions in the space provided on this question booklet (if space is not sufficient, continue on the back of the previous page). Consider the following model of the economy: Aggregate Demand: P = 150 / Y Labour Demand: W = 10P / N ½ Labour Supply: W = 3N ½ / 5 Production Function: Y = 20N ½ where P is the price level, Y is real output, W is nominal wage, and N is the level of employment. a) What is understood by money illusion? (3 marks) Is there any money illusion in this model? Explain. (3 marks) Money illusion refers to the tendency of people to think in nominal rather than in real terms. People might believe that they are better off when the price of their product increases, without considering how the prices of all other products might have changed at the same time. For example, a worker suffers from money illusion when he believes that a 10 percent increase in his nominal wages (i.e., the price of his product, labour) makes him better off even if the price level in the economy has also increased by 10 percent or more. Money illusion, therefore, refers to the inability to see changes (or lack thereof) in real prices or real income. In this model there is money illusion on the part of workers, but not on the part of firms. The expression for the supply of labour shows that changes in the price level do not affect the decisions of the workers as to how much labour they would supply; that is, changes in P, which would reduce real wages, leave the position of the supply curve unchanged. However, the expression for the demand for labour shows that changes in P affect the decisions of the firms as to how much labour they would demand; that is, at each level of W firms would demand a greater quantity of labour when P increases (i.e., because the real wage decreases). Page 4 of 11

5 b) Find an expression of the equilibrium level of employment as a function of the price level. (3 marks) Equilibrium level of employment is determined by the intersection of the demand for labour and the supply of labour: N D = N S 10 P 3 N ½ = N ½ 5 50 P = 3 N N = 50 P / 3 c) Derive the expression for the Aggregate Supply (AS) curve. (4 marks) To derive the expression for the AS curve we must plug the above expression for equilibrium level of employment into the production function: Y = 20 N ½ Y = 20 (50 P / 3) ½ or Y / 20 = (50 P / 3) ½ Y 2 / 400 = 50 P / 3 P = 3 Y 2 / 20,000 Page 5 of 11

6 d) Find the equilibrium level of output and the equilibrium price level. (4 marks) Equilibrium level of output and equilibrium price level are determined by the intersection of the AD and the AS curves: AD = AS 150 / Y = 3 Y 2 / 20,000 3Y 3 = 3,000,000 Y 3 = 1,000,000 Y* = 100 We plug Y* = 100 into either the AD or AS curve and we find P*: P* = 150 / Y* P* = 150 / 100 = 1.5 e) Find the equilibrium level of employment, the equilibrium nominal wage rate, and the equilibrium real wage rate. (3 marks) 1) Given P* = 1.5 and N* = 50 P* / 3, then N* = 50 (1.5) /3 = 25. 2) Given N* = 25, we plug this value into the N S curve and we obtain W*: W* = 3 (N*) ½ / 5 = 3 (25) ½ / 5 = 3. Alternatively, we could have plugged the values of P* and N* into the N D curve and obtain the same result. W* = 10 P* / (N*) ½ = 10 (1.5) / (25) ½ = 3 Page 6 of 11

7 PART III (50 marks) Instructions: Answer true, false, or uncertain to the following statements. Answer all questions in the space provided on question sheet (if space is not sufficient, continue on the back of the previous page). Marks will be given entirely for your explanation. Each question is worth 10 (ten) marks. 1. Consider an economy with fixed prices, flexible exchange rates, and perfect capital mobility. Expansionary fiscal policy will cause the capital account to deteriorate and the current account to improve. (Show your answer with the help of graphs and explain the economics.) False An increase in government expenditure, for instance, will create a situation of excess demand in the goods market. Therefore, output will start to increase and so will the demand for money. The rate of interest will start to rise above the level of the international rate and a massive inflow of capital will ensue under perfect capital mobility. The inflow of capital will appreciate the Canadian dollar and NX will decrease. The decrease in NX will cause the IS curve to start shifting back. This process will continue as long as the domestic rate of interest lies above the level of the international rate. In the new equilibrium, therefore, the IS curve will shift all the way back and the equilibrium level of output will be as before. The level of AE is as before, but its composition has changed: government expenditure has increased and net exports have decreased by the same amount. Therefore, the statement is false: the current account has deteriorated and the capital account has improved. i LM i 1 BP IS IS Y 1 Y Page 7 of 11

8 2. Consider an economy with fixed prices, flexible exchange rates, and perfect capital mobility. An increase in foreign interest rates will cause domestic output to fall, the current account to improve, and the capital account to deteriorate. (Show your answer with the help of a diagram and explain the economics.) False If the foreign interest rate increases, there will be a massive outflow of capital under perfect capital mobility. This will cause a depreciation of the Canadian currency. The price of domestic goods will become relatively less expensive than foreign ones, and thus exports will increase and imports will decrease (i.e., net exports will increase). An increase in net exports implies an increase in aggregate expenditure and thus a situation of excess demand develops and output/income starts to increase. As output increases, the demand for money also increases and the domestic rate of interest rises. This process continues until the domestic rate of interest is once again equal to the international rate of interest. Graphically, the adjustment is as follows. If there is perfect capital mobility, then the BP curve is horizontal at the level of the international rate of interest. The increase in the international rate of interest implies a shift up of the BP curve. In turn, the increase in net exports as a result of the depreciation of the Canadian dollar causes the IS-curve to shift up to the right. Output starts to increase together with the rate of interest and thus the adjustment is along the LM curve (the money market is always in equilibrium). Equilibrium is restored when Y increases to the level where the new IS curve intersects the LM curve (and the new BP curve), and thus the rate of interest becomes equal to the international rate again. i LM i 2 BP i 1 BP IS IS Y 1 Y 2 Y Page 8 of 11

9 3. Suppose a closed economy is operating at full capacity. An increase in the expected rate of inflation will cause both the equilibrium level of output and the rate of inflation to increase and the real wage to fall in the short-run. (Show your answer with the help of a diagram and explain the economics.) False Consider an economy described by a dynamic-as curve given by the expression π = π e + λ(y Y*). Initially the economy is in long-run equilibrium, and thus the expected rate of inflation is equal to the actual rate of inflation, i.e., π 0 = π e 0. An expected increase in π to π e 1 will cause the AS curve to shift up to AS. Indeed, the AS curve will shift up because workers will negotiate higher wages to reflect the increase in the expected rate of inflation, and firms will transfer this higher cost of production to consumers in the form of higher prices. Since the equilibrium level of output and the corresponding equilibrium level of employment fell, we know that the real wage rate increased. This is the case indeed since the expected rate of inflation was greater than the actual rate of inflation, and thus the actual increase in nominal wages was greater than the actual increase in prices. π AS 1 π e 1 AS 0 π 1 π 0 = π e 0 AD Y 1 Y* Y Page 9 of 11

10 4. A decrease in the price level, which is seen by firms but is not seen and is not expected by workers, will result in a lower real wage and fewer workers being hired. (Show your answer with the help of a diagram and explain the economics.) False If workers suffer from money illusion, then a decrease in the price level (P) e.g., as a result of a decrease in autonomous aggregate demand will not affect the quantity of labour they wish to supply at each level of the nominal wage rate (W). Firms, however, will decrease the quantity of labour they wish to hire at each level of the nominal wage rate since the real wage rate (W/P) increases when the price level falls. In other words, the nominal supply of labour is not affected by the change in P while the nominal demand for labour decreases. Therefore, W will fall and so will the equilibrium level of employment (N). Since N falls, i.e., firms hire a smaller quantity of labour now, we know with certainty that the real wage rate has increased. Therefore, the statement is false: a decrease in the price level will result in a higher real wage and fewer workers being hired. This result can be observed in the following diagram. The decrease in AD creates a situation of excess supply at the initial equilibrium price P 1. The price level will start to fall and a process of adjustment will ensue both on the supply and the demand side of the economy. I will focus on the supply side to address this question. The gradual decrease in P causes the demand for labour curve to gradually shift down to the left, creating a situation of excess supply in the labour market. The nominal wage rate will thus gradually decrease until equilibrium is achieved at a lower W and lower N. Lower levels of employment translates into lower levels of output as determined by the economy s production function. The adjustment on the supply side is thus a movement down along the AS curve. W S N P AS W 1 P 1 W 2 D N P 2 AD D N AD N 2 N 1 N Y 2 Y 1 Y Page 10 of 11

11 5. 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. On the one hand, therefore, the Bank of Canada should implement contractionary monetary policy 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. On the other hand, fiscal policy should not be used since this would further exacerbate the problem. False If the Bank of Canada implements contractionary monetary policy, i.e., it will induce a reduction in the money stock, the rate of interest will rise. The increase in the rate of interest will contribute to reduce the pressure on the price level coming from Alberta since AD will decrease. However, the increase in the rate of interest will also increase the inflow of capital into Canada and further appreciate the Canadian currency. The appreciation of the domestic currency will, in turn, exacerbate the situation in Ontario. This is the problem of using only one instrument to try to achieve two different targets. And it is the problem of the overwhelming priority the Bank of Canada places on price stability at the cost of income (and employment) stability. It appears, therefore, that the use of fiscal policy might be better suited to address the present situation. For instance, an increase in taxes in Alberta (i.e., an excise tax on the production or export of oil) will reduce AD in Alberta without affecting the rest of the country. Of course, the imposition of a tax on Alberta s oil might not be politically feasible even if economically desirable. Page 11 of 11