SOLUTION ECO 209Y MACROECONOMIC THEORY. Midterm Test #1. University of Toronto October 21, 2005 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS:

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1 Department of Economics Prof. Gustavo Indart University of Toronto October 21, 2005 SOLUTION ECO 209Y MACROECONOMIC THEORY Midterm Test #1 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 50 minutes. 2. This exam consists of two parts. 3. This question booklet has 5 (five) pages. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /15 Part II 1. /10 2. /10 3. /10 TOTAL /45 /100 Page 1 of 5

2 PART I Instructions: (15 marks) Circle the most appropriate answer. Each question is worth 3 (three) marks. No deductions will be made for incorrect answers. 1. Use the following information to answer questions 3 to 5. 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 1990 Year 2000 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 Considering the year 1990 as the base year, the percentage increase in real GDP between 1990 and 2000 is a) 9.4 percent b) 11.4 percent c) 13.4 percent d) 15.4 percent 2. Consider the following information of a hypothetical economy: National Income = 5,200; Budget Deficit = 150; Disposable Income = 4,400; Net Exports = 110; and Consumption = 4,100. The value of Investment is a) $250 b) $260 c) $270 d) $ Assume an aggregate expenditure model with no government and no foreign sector. If the savings function is defined as S = Y and autonomous investment increases by 100, by how much will consumption increase? a) 100 b) 200 c) 900 d) 1, Assume an economy with no foreign sector, a marginal propensity to save (MPS YD ) equal to 1/10, and a marginal income tax rate (t) equal to1/3. If autonomous saving decreases by 300, which of the following is true? a) total consumption will increase by 300 b) national income will increase by 500 c) disposable income will increase by 500 d) the budget deficit will decrease by 200 e) investment will increase by Generally speaking, the effect on income resulting from a change in investment spending is greater if a) the marginal propensity to consume is smaller b) the marginal propensity to save is larger c) the average propensity to consume is smaller d) the marginal propensity to save is smaller e) autonomous consumption is large Page 2 of 5

3 PART II (30 marks) Instructions: Answer all questions in the space provided (if space is not sufficient, continue on the back of the previous page). Each question is worth 10 (ten) marks. 1. Using the following data for a hypothetical economy, calculate gross domestic product (GDP), net domestic income (NDI), and government budget surplus (BS): Consumption 600 Government expenditure on goods and services 250 Wages and salaries 450 Net exports 50 Capital consumption allowance (depreciation) 130 Indirect taxes 140 Government transfer payments 100 Corporate and personal income taxes 200 Gross investment 200 a) GDP = C + I + G + NX = = 1100 b) NDI = GDP Depreciation Indirect Taxes = = 830 c) BS = TA G TR Where TA = Indirect taxes + Corporate and personal income taxes = = 340. Then, BS = = 10 Page 3 of 5

4 2. Answer true or false to the following statement (marks will be given 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 the investment function were an increasing function of the level of income. True The larger the aggregate expenditure multiplier is, 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 will be spent. 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 depends on income and thus the marginal propensity to spend indicates the fraction of any additional dollar that will be spent on consumption. Therefore, in this case the expression for the multiplier is α AE = 1 / [1 c(1 t)]. Now, suppose that investment 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., the slope of the AE curve now is equal to c(1 t) + f. Therefore, the multiplier now 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 4 of 5

5 3. Answer true or false to the following statement (marks will be given for your explanation): In a closed economy, the balance budget multiplier is always equal to one. False The balance budget multiplier indicates the relative impact that a change in government purchases will have on equilibrium income when the increase in G is accompanied by a similar increase in taxes so that the budget surplus will not be affected. Well, this policy of greater G and greater taxes while BS = 0 will have an impact on equilibrium income if autonomous expenditure changes. For simplicity, suppose that TA = T and thus BS = G T = 0 since G = T. Let s see how these changes in G and T affect autonomous expenditure. Recall that AE = C ct + ctr + I + G, and thus if G = T then AE = c T + G = (1 c) G. Since AE = (1 c) G > 0, then equilibrium income will increase as follows: Y = α AE (1 c) G = (1 c) / [1 c(1 t)] G. The balance budget multiplier is then α BB = (1 c) / [1 c(1 t)], and α BB < 1 if t > 0 and the statement is false. Page 5 of 5