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1 Department of Economics University of Toronto at Mississauga ECO202Y5Y Macroeconomic Theory and Policy December 2002 Test Two Instructor: X. Gu Date: Friday, December 6, 2002 Time allowed: Two hours Aids allowed: Calculator Notes: This test consists of 12 multiple-choice questions in part I and 5 long questions in part II. Each multiple-choice question is worth 3 marks, the first long question worth 12 marks, and each of the other long questions worth 13 marks, with each part allocated 3 marks. There is no partial mark for any multiple-choice question. For a long question, you may be given partial marks 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 with pencil is not valid (except figures) This test is worth 15% of your course grade Print last name: Given name: Student number: Section number Do not write on the space below, for markers only Questions Allocated marks Points Questions Allocated marks (Bonus) Total 105 Points 1

2 Part I 1. A monetary expansion combined with a fiscal contraction will cause: a. a rise in Y with ambiguous effects on the interest rate b. a reduction in Y with ambiguous effects on the interest rate c. a rise in the interest rate with ambiguous effects on Y d. a reduction in the interest rate with ambiguous effects on Y 2. Suppose that the real interest rate does not change while the nominal interest rate falls during a given period. This would suggest that: a. the expected inflation rate increased b. the change in the expected inflation rate is more than the change in the interest rate c. the change in the expected inflation rate is equal to the change in the interest rate d. the change in the expected inflation rate is less than the change in the interest rate 3. Which of the following explains why an individual s consumption is (in addition to total wealth) an increasing function of current income? a. the individual might prefer to defer consumption to later periods b. the individual might act in a simpler, less forward-looking manner c. banks are not likely to lend the amount the individual wishes to borrow to smooth C d. all of the above 4. Suppose that the yield curve is initially upward sloping, and that the current one-year interest rate increases by 2% while the expected future one-year interest rate does not change. This event will tend to cause i 2t to: a. rise by less than 2% b. rise by 2% c. fall by less than 2% d. fall by 2% 5. A reduction in the current real interest rate is now likely to have a relatively smaller effect on current output because: a. a change in current income, given unchanged expectations of future income, is unlikely to have much of an effect on spending b. the LM relation depends on the nominal interest rate c. the reduction in the current real interest rate, given unchanged expectations of future real interest rates, does not have much of an effect on spending d. policy is more effective in influencing Y under expectations 2

3 6. Suppose the Bank of Canada reduces M in the current period, and that individuals now expect the future real interest rate to be higher and future income to be lower. Then, we would expect: a. the LM to shift up and the IS to shift left in the current period b. the LM to shift down and the IS to shift left in the current period c. the LM to shift up and the IS to shift right in the current period d. the LM to shift down and the IS to shift right in the current period 7. Suppose that a budget is passed which calls for a rise in current and future government spending and that the Bank of Canada is not expected to respond to these fiscal policy changes. This increase in current and future G will: a. cause a rise in current income b. cause a rise in the current real interest rate c. have an ambiguous effect on current income d. both a and b 8. Suppose i=10%, and i * =8% and our dollar is expected to depreciate by 3% during the next year. Then, a. individuals will prefer to hold Canadian bonds b. individuals will prefer to hold foreign bonds c. the expected return from holding a foreign bond (measured in C$) will be 5% d. the expected return from holding a foreign bond (measured in C$) will be 11% e. both b and d 9. Suppose a government wishes to reduce Y and increase NX. Which of the following policies would most likely achieve this? a. increase ε b. reduce G c. increase G and increase ε d. reduce ε 10. Assume the interest parity holds. A fall in the domestic interest rate will cause: a. $ to be expected to appreciate over next year b. $ to be expected to depreciate over next year c. a reduction in E d. a reduction in the foreign interest rate 3

4 11. A monetary expansion under flexible exchange rates will cause: a. a fall in domestic interest rate, fall in E, and rise in Y b. a rise in E, and a rise in Y c. ambiguous effects on I since the domestic interest rate falls and Y rises d. a fall in the foreign interest rate and fall in E 12. With fixed exchange rates and imperfect capital mobility, a central bank s attempt to increase output will result in the following situation for a sufficiently long time: a. a rise in foreign exchange reserves b. a fall in foreign exchange reserves and a lower rate of domestic interest than the foreign rate c. a fall in bond holdings, and a rise in the domestic interest rate above i * d. the fixed exchange rate is still maintained e. b and d f. c and d Part II 13. Solve the following IS-LM model: C= Y D I= i+0.1Y G=200 T=200 (M/P) D =0.5Y-7500i M/P=500 a. Find the set of equations for the IS and LM curves b. Solve this set for the equilibrium output Y and interest rate i c. Calculate the equilibrium spending of consumption and investment, and check if Z * =Y * d. Find the interest rate and income in new equilibrium assuming that G is increased by 500 4

5 Continued from (13) 5

6 14. Suppose the goods market in an open economy is characterized by: C= Y D I= i+0.2Y G=200=T X= Y * +100ε Q=0.1Y-50ε ε=2 Y * =1000 a. Assuming that i=10%, find Y * and NX *, and check if Y * =Z * b. Suppose G is increased by 200. What is the equilibrium change in Y and in NX? Use this numerical example to explain the possible consequence of fiscal expansion (twin deficits) c. Suppose Y * is increased by 200. What is the equilibrium change in Y and in NX? Use this numerical example to explain the effects of a foreign expansion on the domestic economy d. Based on b and c, explain why a more open economy is more interested in international coordination for a spending expansion but more likely to cheat by waiting without action 6

7 Continued from (14) 7

8 15. Use the IS-LM graphs, along with the IP and NX curves (but not the BP curve), to analyze the effects of policy changes on output, budget deficits and the trade balance for an open economy under flexible exchange rates (without BP, you may ignore the ineffectiveness of fiscal policy under flexible exchange rates and perfect capital mobility) a. A fiscal expansion b. A fiscal contraction c. A monetary expansion d. The government takes measures to improve the terms of trade ε 8

9 continued from (15) 9

10 16. Suppose domestic investment depends on foreign income in addition to domestic income and interest rates. Suppose foreign income rises and affects our domestic investment positively. Answer with graphs the following questions: a. Is the increase in the demand for domestic goods greater than the rise in net exports? b. Is the increase in the domestic demand for goods the same as the rise in net exports? c. What is the effect on the domestic economy (Y and NX) of rises in foreign income? d. What difference does this setting make compared to the usual setting that I is not affected by Y * 10

11 17. Discuss the properties of the LM curve with its defining equation a. Use graphs to derive the LM curve from the money demand/supply curves b. Show by graph why a rise in M/P causes the LM curve to shift down c. In a and b you should plot nominal interest rate i on the vertical axis. Then, expected inflation will nor affect the LM relation. Explain why in brief. d. If the real interest rate r is measured in the vertical axis, show by graph why a rise in π e shifts the LM curve down 11

12 Continued from (17) 12

13 18. (Bonus Question) Suppose international capital is perfectly mobile, a. use graphs to show why a fiscal policy change under flexible exchange rates is ineffective b. use graphs to show why a monetary policy change under fixed exchange rates is ineffective c. there will be changes in the composition of the domestic demand for goods between NX and domestic goods, or in the central bank s foreign exchange reserves. Explain in brief d. How will the slope of the BP curve be changed if capital becomes less perfectly mobile? What is the implication of this change to the magnitude of monetary accommodation for a given fiscal policy change under fixed exchange rates? 13

14 Continued from (18) 14