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1 Department of Economics University of Toronto at Mississauga ECO202Y5Y Macroeconomic Theory and Policy Summer Session: June 2003 Test One Instructor: Xinhua Gu Date: Tuesday, June 10, 2003 Time allowed: Two hours Aids allowed: Calculator Notes: This test consists of 10 multiple-choice questions in part I and 8 long questions in part II. Each multiple-choice question is worth 2 marks and each long question worth 10 marks. There is no partial mark for any multiple-choice question. You will be given partial marks for a long question on the basis of the relative number of correct points that you will have made. It is important to hand in a complete test without missing page. Any missing page will be counted as zero mark. Any answer written in pencil is not valid (except figures) This test is worth 25% of your course grade Print last name: Solution Given name: Student number: Section number: Do not write on the space below, for markers only Questions Allocated marks Points Questions Allocated marks Total 100 Points 1

2 Part One 1. Prices for which of the following are included in the GDP deflator, but not included in the consumer price index? (a) intermediate goods and services (b) firms purchases of new plants and machinery (c) imports (d) consumption goods and services Answer: (b) 2. Okun s law illustrates the relationship between: (a) the unemployment rate and the labor force participation rate (b) changes in the unemployment rate and GDP growth (c) the inflation rate and the unemployment rate (d) the rate of change in the GDP deflator and the consumer price index Answer: (b) 3. The consumption function is: C = Y D. The saving function would be: (a) S= Y D (b) S=0.75Y D (c) S= Y D (d) S= Y D Answer: (d) 4. An increase in the marginal propensity to consume will tend to cause: (a) a rise in the multiplier and a given change in government expenditures to have a smaller effect on equilibrium output (b) a rise in the multiplier and a given change in government expenditures to have a greater effect on equilibrium output (c) a fall in the multiplier and a given change in government expenditures to have a smaller effect on equilibrium output (d) a fall in the multiplier and a given change in government expenditures to have a greater effect on equilibrium output Answer: (b) 5. A reduction in $Wealth will cause: (a) a fall in money demand (b) a rise in money demand (c) a rise in bond demand (d) a fall in bond demand Answer: (d) 2

3 6. Which of the following will occur when the interest rate increases? (a) the price of bonds will fall (b) the money demand curve shifts to the left (c) the money demand shifts to the right (d) the money supply curve shifts to the right Answer: (a) 7. A rise in money demand caused by factors other than a change in income (or the interest rate) will cause: (a) the IS curve to shift to the right (b) the IS curve to shift to the left (c) the LM curve to shift down (d) the LM curve to shift up Answer: (d) 8. A Bank of Canada purchase of bonds will cause: (a) the LM curve to shift up (b) the LM curve to shift down (c) a lower interest rate, a rise in investment and a rightward shift in the IS curve (d) a higher interest rate, a fall in investment and a leftward shift in the IS curve Answer: (b) 9. A monetary expansion combined with a fiscal expansion will cause: (a) a rise in Y with ambiguous effects on i (b) a fall in Y with ambiguous effects on i (c) a rise in i with ambiguous effects on Y (d) a fall in i with ambiguous effects on Y Answer: (a) 10. A monetary contraction combined with a fiscal expansion will cause: (a) a rise in Y with ambiguous effects on i (b) a fall in Y with ambiguous effects on i (c) a rise in i with ambiguous effects on Y (d) a fall in i with ambiguous effects on Y Answer: (c) 3

4 Part Two 11. The following information comes from CANSIM (August 1998, the Canadian Data): Year Nominal GDP ($million) GDP deflator (1992=1.0) Real GDP (in 1992 $) , , , , , , , Answer the following questions: (a) What is the nominal GDP in 1994? What was the GDP deflator in 1993? (b) Using the GDP deflator (where 1992=1.0), calculate real GDP for the remaining years. (c) Based on your calculations in part (b), compare the levels of real GDP with the levels of nominal GDP for each year. What does this comparison suggest about prices (in that year relative to 1992)? (d) Explain why economists focus on real rather than nominal GDP when analyzing the level of economic activity. (a) $Y in 1994= ($744,220)=$ The GDP deflator in 1993 = $724,920/$716,123 = (b) To obtain the following values, simply divide nominal GDP by the GDP deflator: $698,544, $760,351.1, $769,750.4, $798, (c) Since the starting year in this problem coincides with the base year and since prices have been continually rising since that year, nominal GDP figures should be greater than real GDP figures. (d) Nominal GDP can change because of changes in the price level as well as changes in physical output. If economists are concerned about economic growth, they should focus on real GDP that abstracts from inflation 12. Suppose an economy consists of just three firms, and information on their production is in the following: Steel company Potato company Car company Sales revenue $600 $400 $2000 Expenses Wages Others $440 $260 $1200 $600 (Steel purchase) Profits $160 $140 $200 (a) Calculate GDP using the final goods approach (b) Calculate the value added for each firm, and GDP using the value added approach (c) Calculate labor income, capital income, and GDP using the incomes approach (d) Do these approaches yield any different levels of GDP? If yes, explain why. You must show your calculation in detail to get good marks. 4

5 (a) The value of final goods (potato and car) =$400+$2000=$2400=GDP (b) The value added =$600 for steel, $400 for potato, and $( )=$1400 for car. So, the sum of the three numbers=gdp=$2400 (c) Total wages=$( )=$1900, Total profits=$( )=$500, the sum of both numbers=gdp=$2400 (d) All three approaches to GDP yield the same level of GDP since all these approaches get rid of intermediate goods and services in their calculation. 13. Suppose that an economy is represented by the following set of functions: Z=C+I+G C= Y D T=400 I=200 Y D =Y-T G=1000 (a) Given the above functions, calculate the equilibrium level of output and illustrate it in a graph. (b) Suppose consumer confidence increases causing a rise in autonomous consumption c 0 from 300 to 400. What is the new equilibrium level of output? How much does income change as a result of this event? What is the multiplier for this economy? (c) Graphically illustrate the effects of this change in autonomous consumption on the demand line (ZZ) and Y. Clearly indicate in the graph the initial and final equilibrium levels of output. (d) Briefly explain why this increase in output is greater than the initial increase in autonomous consumption. (a) Y= (Y-400)= Y. This yields Y=1300/0.5= ZZ 1400 ZZ (b) Plug in the numbers and you get: Y= Y; Y=2800. Output rises by 200. The multiplier is 2 (every $ change in C causes a $2 change in Y). (c) See the graph. (d) As demand rises by 100, firms respond by increasing production. The higher production also represents higher income. As income rises, consumption rises again, causing firms to increase Y yet again. This is the multiplier process at work. 5

6 14. Suppose there are two different economies, both represented by the standard model presented in the lectures. Further assume that the equilibrium level of output is the same in both coutries. For simplicity, we can illustrate the equilibrium for both economies in the same graph. The demand line for economy A (B) is represented by ZZ A (ZZ B ). This situation is depicted in the following graph. (a) Briefly discuss the different characteristics of demand lines for these two economies. (b) Suppose policy makers in both countries decide to increase government spending by the same amount (e.g., G will rise by $100 billion). Briefly explain what will happen to the level of autonomous expenditures in each economy. (c) Under circumstances in (b), graphically illustrate what will happen to the demand lines as a result of this identical increase in G (d) Will the effects of this $100 billion increase in government spending on equilibrium output be the same in the two economies? Explain. (a) Autonomous expenditures are greater in B, while the MPC is greater in A (b) The level of autonomous expenditures in both countries will increase by the same amount (100). Z ZZ A ZZ B Y Y 0 Y B Y A (c) Both curves will shift up by the same amount. (d) Output will increase more in A than in B, even if G rises by the same amount. Why? The multiplier is greater in A than in B. 6

7 15. Assume that the financial market is in equilibrium initially. Use a figure to answer the following question: (a) How much money do individuals hold at the initial interest rate (i * ) Show this in the graph. (b) Suppose there is a fall in $Y. What effect will this have on money demand and on the interest rate? Show this graphically. (c) At the initial equilibrium interest rate, what has happened to money demand? What must happen to the interest rate to restore equilibrium? (d) As i changes, what happens to money demand? How much money do individuals hold at this new interest rate? Compare your answer here with that to (a). (a) As shown in the figure, individuals hold M. M S i * i * M d M d M (b) The reduction in $Y will cause a fall in money demand to M d. i * falls to i * (c) At i *, money demand is lower so money supply exceeds money demand after $Y falls. The interest rate must fall to induce individuals to hold more money (d) As the interest rate falls, money demand rises. At i *, individuals now hold M again. This is the same quantity that was held in (a). 16. Use data: R=50, CU=250, D=500 to answer the following questions: (a) Suppose the Bank of Canada wishes to increase the money supply by $100 million. What type of open market operation should it pursue? What should the dollar amount of the Bank s purchase or sale of bonds be in order for M to increase by $100 million? (b) What effect will this Bank action have on the price of bonds? Explain (c) Suppose that the Bank wants to reduce the money supply by $40 million. What type of open market operation should it pursue? What should the dollar amount of the Bank s purchase or sale of bonds be in order for M to fall by $40 million? (d) What effect will this Bank s action have on the price of bonds? Explain. 7

8 (a) θ=50/500=0.1, c=250/500=0.5, λ m =(1+c)/(θ+c)=1.5/0.6=2.5. It should buy $40 worth of bonds (100/2.5) (b) The rise in bond demand will increase the price of bonds since the Bank buys bonds so as to increase money supply, which reduces the interest rate. This in turn pushes up the bond price. (c) It should sell $16 worth of bonds (-40/2.5=-16) (d) The rise in bond supply will cause bond price to fall since the Bank sells bonds so as to decrease money supply, which increases the interest rate. This in turn pushes down the bond price. 17. Suppose the financial market is in equilibrium initially (with i 0 and Y 0 ), use graphs to answer the following questions. (a) Assume that the real money supply falls to M /P. Illustrate what happens to the real money supply curve as a result of this drop in M/P. At the initial interest rate, what type of situation exists? Briefly explain. (b) What must happen to the interest rate as a result of this drop in the real money supply? Briefly explain. Label this new equilibrium (c) What effect does this drop in the real money supply have on the position of the LM curve? (d) Using LM graphs, explain the excess supply/demand situation (for point (Y 0,i 0 )) in the financial market at the initial interest rate after the drop in M/P (a) The real money supply curve shifts to the left. At the initial interest rate, money demand exceeds money supply LM A A LM i 0 A B A M d M /P M/P Y 0 (b) The interest rate must increase to decrease money demand, thereby resulting in a new equilibrium at point A. 8

9 (c) The LM curve must shift up to reflect the higher interest rate required to maintain equilibrium in the financial market. (d) There is an excess demand for money since at the same interest rate i 0, point A is related to Y o which is greater than output (at point B) needed to restore equilibrium in the financial market after the drop in M/P. 18. Suppose that the economy initially is in equilibrium and that government spending increases. Use a graph to answer the following questions. (a) What effect will this rise in G have on the IS curve? (b) Suppose the Bank of Canada wants to maintain the interest rate at the initial level. What type of policy must the Bank pursue (i.e., contractionary or expansionary) to achieve this goal? (c) What effect will this Bank action have on the LM curve? Illustrate the effects of the higher G and the Bank s response on the IS and LM curves. Label the new equilibrium in the graph (d) What happens to consumption, saving and investment as a result of this policy mix? Briefly explain. (a) The IS curve shifts to the right (b) To keep the interest rate at the initial level, the Bank must increase the money supply as money demand increases. (c) This will shift the LM curve down. The final equilibrium is at point A (d) C and S rise since Y rises. I also rises since Y rises (there is no offsetting effect of higher interest rate here) IS LM IS LM i * A A 9

Print last name: Solution Given name: Student number: Section number:

Print last name: Solution Given name: Student number: Section number: Department of Economics University of Toronto at Mississauga ECO202Y5Y Macroeconomic Theory and Policy October 2002 Test One Instructor: Xinhua Gu Date: Friday, October 11, 2002 Time allowed: Two hours