ECO 209Y MACROECONOMIC THEORY AND POLICY

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1 Department of Economics Prof. Gustavo Indart University of Toronto March 14, 2007 ECO 209Y MACROECONOMIC THEORY AND POLICY SOLUTION Term Test #3 LAST NAME FIRST NAME STUDENT NUMBER Circle the section of the course in which you are registered: L0101 L0301 L0401 M 2-4 W 2-4 R 2-4 INSTRUCTIONS: 1. The total time for this test is 1 hour and 50 minutes. 2. This question booklet has 10 pages. 3. Answer all questions in the space provided on question sheet; if space is not sufficient, continue on the back of the previous page. 4. Aids allowed: a simple, non-programmable calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I 1. /10 Part II /17 2. /10 Part III /18 3. /10 4. /10 TOTAL /75 Page 1 of 10

2 PART I (40 marks) Instructions: Answer all questions. Each question is worth 10 marks. 1. With nearly 80 per cent of Canadian exports dependent on the U.S. economy and 90 per cent here in Ontario it is hard to imagine that this country could escape a recession in the U.S., reads a recent editorial in The Toronto Star. Comment on this statement using the model developed in class that allows for gradual adjustments to the economy once a disturbance has taken place. Show your answer with help of the corresponding AD-AS diagram and explain the economics. In you answer you must address both the short-run and long-run economic impacts of this disturbance assuming that the economy is initially at full-employment. As the U.S. economy moves into a recession, then American aggregate expenditure might be falling including their expenditure on imports from Canada. Therefore, Canadian NX would fall and Canada s AD curve would shift down to AD in period 1 i.e., at each price level the quantity demanded on goods and services would be lower. In the short-run, therefore, the Canadian economy would also move into a recession and output would fall to Y 1 and the price level would fall to P 1 in period 1. The adjustment on the supply side of the economy is as follows: 1) as P falls, the demand for labour also falls; 2) the supply of labour remains unchanged since workers do not observe the fall in P in period 1; 3) the level of employment drops as a result of the decrease in labour demand; and 4) the level of output also falls to Y 1 as N falls. Note that both W and P fall, but P falls faster than W and thus W/P rises (and thus firms demand a smaller quantity of labour). As P falls in period 1, workers and firms negotiate lower wages at all levels of N in period 2 workers do not see the change in prices in the current period but become aware of these price changes in the following period. Therefore, unit labour costs fall and the AS curve shifts down to AS 2 given the assumption that firms set prices as a constant mark-up over unit labour costs. With no further changes in AD (i.e., assuming that the initial fall in NX is permanent), the equilibrium in period 2 is at a higher level of output (Y 2 ) and a lower price level (P 2 ). This process is repeated period after period until a new long-run equilibrium is achieved where the AS curve eventually shifts down to AS 0 and full employment is restored and the price level is P 0. Note that the adjustment to the new long-run equilibrium is done through deflation, i.e., the level of NX is recovered though a decrease in the price level (and a subsequent increase in the real exchange rate). Therefore, the statement is correct in the sense that the Canadian economy will move into a recession. However, all other things remaining equal, the invisible hand of the market will move the economy back to full employment. The cost of passive economic policy, however, is that the economy might remain in recession for a long period of time. P AS 0 AS 2 P 0 = P -1 AS 0 P 1 P 2 P 0 AD AD Y 1 Y 2 Y* Y Page 2 of 10

3 2. Determine whether the following statement is true, false, or uncertain: If nominal wages were more flexible, expansionary policies would be more effective in reducing the rate of unemployment. Marks will be given entirely for your explanation. FALSE Consider the general model where wages are fully flexible and the neo-keynesian model where wages are sticky both downward and upward. The supply of labour curve corresponding to the general model has a positive slope (N S 1) while the one corresponding to the neo-keynesian model is horizontal (N S 2) at the initial level of the wage rate (W 0 ). As derived in class, the corresponding shortrun AS curve for the general model (AS 1 ) is flatter than the one for the neo-keynesian model (AS 2 ). Suppose that expansionary fiscal or monetary policy increases aggregate demand and the AD curve shifts out to AD. A situation of excess demand will arise and the price level will start to increase. In the neo-keynesian model, short-run equilibrium will be achieved at output Y 2 and price P 2. The adjustment on the supply side of the economy is as follows: 1) the increase in P causes the demand for labour to increase since the real wage decreases at each level of W (i.e., the demand for labour curve shifts to N D ); 2) workers do not see the increase in P and continue supplying any quantity demanded of labour at W 0 ; 3) thus, employment increases to N 2 and, given the production function, output increases to Y 2. Note that firms are hiring more labour because the real wage has decreased to W 0 /P 2. Note that in the general model (i.e., fully flexible wages), an increase in price to P 2 and an increase in the demand for labour to N D would cause employment to increase to N 1 and output to Y 1 because the real wage rate would be higher than in the neo-keynesian model (W 1 /P 2 > W 0 /P 2 ). But this would not be a short-run equilibrium in this model short-run equilibrium would be achieved at output Y 1 and higher price P 1. Therefore, the demand for labour curve would shift further out to D N and money wages would increase further to W 1, employment would be N 1 and output Y 1. Note that firms end up hiring less labour than in the neo-keynesian model, and thus W 1 /P 1 > W 0 /P 2. Therefore, the statement is wrong. Expansionary policy is more effective with respect to output when the nominal wage rate is less flexible. W P N S 1 AS 1 W 1 W 1 P 1 P 2 AS 2 W 0 N S 2 P 0 AD N D N D N D AD N 0 N 1 N 1 N 2 N Y 0 Y 1 Y 1 Y 2 Y Page 3 of 10

4 3. Why did the increase in oil prices in the 1970s lead to stagflation? In answering this question, use the model developed in class that allows for gradual adjustments to the economy once a disturbance has taken place. Show your answer with help of the corresponding AD-AS diagram and explain the economics. In your answer you must address both the short-run and long-run economic impacts of this disturbance assuming that the economy is initially at full-employment. The increase in oil prices increases the cost of production of almost every good and service produced in the economy. Therefore, firms will demand a higher price for their product to cover this increase in cost. In our model we assume that firms set their prices as a constant mark-up over their unit labour cost, where the mark-up is sufficient to cover all non-labour costs of production other plus the normal profit of the firm. Since the price of a non-labour cost has increased, unit labour costs do not change but the constant mark-up increases in the short-run. Therefore, the AS curve shifts up to AS 1 and the economy moves into a situation of stagflation output dropping to Y 1 and inflation increasing to π 1. Note that the actual rate of inflation in the new short-run equilibrium (π 1 ) is smaller than the contribution made by the increase in the price of oil to inflation (π 1 ). This is so because the economy has moved into recession output falling below potential output and the rate of unemployment rising above the natural rate. In the next period, two adjustments take place: on the one hand, wages are adjusted upwards to reflect the new expectations about inflation (π 1 ); and on the other hand, as unit labour costs increase the constant mark-up decreases to its original level since the impact of the increase in oil prices on non-labour costs is a one-time event. In period 2, therefore, the AS curve shifts down to AS 2 and equilibrium output increases to Y 2 (not shown in the diagram) and the rate of inflation falls to π 2 (not shown in the diagram). This process continues period after period until a new long-run equilibrium is achieved, where the level of output and the rate of inflation are equal to their original equilibrium values before the increase in the price of oil. Therefore, in the long run average prices and money wages will end up increasing in the same proportion as the price of oil did. π AS 1 AS 2 π 1 AS 0 π 1 π 0 = π -1 AD Y 1 Y* Y Page 4 of 10

5 4. Determine whether the following statement is true, false, or uncertain: Current single-digit inflation in all developed countries and most major emerging market countries is the result of strong macroeconomic policy-coordination among the governments of all these countries. Marks will be given entirely for your explanation. FALSE Indeed, all developed countries and most emerging market countries have been experiencing low rates of inflation for the last 10 years or more. This is quite unusual not in the sense that they are experiencing low rates of inflation since many of them have experienced it in the past as well, but because now they are all experiencing it at the same time. Is this generalized low rate of inflation the result of strong macroeconomic policy-coordination? No, the evidence appears to suggest otherwise. The reason that the rate of inflation is so low worldwide is that, in all these countries, wages have not been increasing as fast as in the past and this could be seen as the result of the integration into the world economy of countries such as China and those in the former Soviet block. These countries had and still have, particularly China, a large labour surplus, and this labour surplus is exerting downward pressure on wages worldwide. How is this so? On the one hand, developed countries workers employed in the import-competing sector are facing the dilemma of accepting smaller wage increases and even absolute decreases or having their sources of employment moving to lower-wage developing countries and losing their jobs altogether. On the other hand, the prices of many consumer goods (and of intermediate products) are now cheaper than in the past since they are imported from low-wage countries thus increasing real wages and reducing any upward pressure on nominal wages. This phenomenon, however, will not last forever. At some point labour markets in China and elsewhere will get tight i.e., the surplus of labour will disappear and wages will start increasing, thus exerting upward pressure on prices once again. Page 5 of 10

6 PART II (17 marks) Consider the following model of a closed economy: Goods Market C = YD YD = Y TA TA = Y I = i Y G = 8 Money Market L = Y 10 i M = 120 Labour Market Demand: W / P = 12 / N ½ Supply: W / P = 0.75 N ½ Production Function Y = 24 N ½ a) Derive an expression for the IS curve. (2 marks) Y = AE = C + I + G Y = (Y Y) i Y + 8 Y = Y 10 i Then the IS curve is given by: i = Y Page 6 of 10

7 b) Derive an expression for the LM curve. (2 marks) M / P = Y 10 i 120 / P = Y 10 i Then the LM curve is given by: i = Y 12 / P c) Derive an expression for the AD (aggregate demand) curve. (2 marks) To get the AD curve, we need to make sure that there is equilibrium in goods and money markets simultaneously, remembering that this equilibrium depends on the price level Y = Y 12 / P Then the AD curve is given by: P = 120 / Y d) Given the expressions for labour demand and supply curves, do workers and/or firms suffer from money illusion? Explain. (2 marks) In this model, neither workers nor firms suffer from money illusion because both labour supply and demand depend on prices the decisions of both workers and firms as to how much labour to supply or demand are based on the value of the real wage rate. In other words, this exercise refers to the classical model. Page 7 of 10

8 e) Calculate the equilibrium levels of employment (N), output (Y), prices (P), nominal wages (W) and interest rate (i). (5 marks) In the short-run, labour market equilibrium determines employment and thus output. That is ½ ½ 0.75 N = 12 / N So the equilibrium in the labour market implies that N = 16. Plugging this value for N in the production function, we obtain Y = 96, which essentially is the classical (vertical) AS curve. Finding the intersection of AS and AD curves we find the prices are P = 120 / 96 = Using either labour demand or supply the nominal wages are equal to $3.75. Finally, the interest rate can be obtained from the IS (or LM) curve by plugging in Y = 96 (or Y = 96 and P = 3.75): IS i = Y = (96) = = LM i = Y 12 / P = (96) 12 / 1.25 = = f) Given this model, suppose that there is an increase in government spending. Briefly explain, in words, how the endogenous variables in question e) would change. (4 marks) The increase in G causes AD to increase and thus the AD curve shifts to the right. A situation of excess demand arises in the economy at the price level starts to rise. As P increases, an adjustment takes place on both the supply and the demand sides of the economy. On the supply side, as P increases the real wage rate decreases at each level of W and thus the demand for labour increases (i.e., the labour demand curve shifts to the right) and the supply of labour decreases (i.e., the labour supply curve shifts to the left). As a result, W increases but W/P and N do not change and thus Y doesn t change either. On the demand side, as P increases the real supply of money decreases causing the LM curve to shift to the left and the rate of interest to increase. The increase in the rate of interest causes investment to fall. In the new equilibrium AE will be the same as before but G will be higher and I lower complete crowding out effect. Therefore, only the nominal variables would change, i.e., N and Y would remain unchanged but W, P and i would increase. Page 8 of 10

9 PART III (18 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 marks. No deductions will be made for incorrect answers D C A C B A 1. (From news posting of January 17) Past American recessions have sent the price of oil and other resources down; but that may no longer be so, says The Economist. Why does The Economist believe that the price of oil might not fall during the coming U.S. recession? A) Because, as President Bush asserts, Americans have become addicted to oil. B) Because the supply of oil continues to decrease. C) Because of the war in Iraq. D) Because the demand for oil continues to increase in emerging markets. E) Because the production of alternative fuels is not sufficient. 2. (From news posting of March 6) Economists argue about whether or not emerging economies will follow America into recession. The most optimistic claim that the rest of the world might not follow the fate of the U.S. because A) economies have become less intertwined through trade and finance. B) because exports to the U.S. will continue with little change during the recession. C) domestic consumption and investment continues to increase in emerging markets. D) government of emerging market will become more protectionist. E) governments of emerging markets have become more fiscally responsible and will prevent the emergence of budget deficits. 3. If the Bank of Canada responds to a negative supply shock by implementing expansionary monetary policy, then A) inflation will accelerate even more. B) the inflation rate and the rate of unemployment will further increase. C) firms will further increase their product prices and cut their production. D) cost of production will be reduced and the AS curve will shift back to the right. E) inflation will slowdown but unemployment will increase even more. 4. When actual inflation is greater than expected inflation A) unemployment rises, according to Phillips-curve analysis. B) cyclical unemployment rises, according to Phillips-curve analysis. C) there are transfers from lenders to borrowers. D) both nominal and real wages increase. E) nominal wages do not change in the current period. Page 9 of 10

10 5. Assuming everything else equal, which of the following statements describes the long-run impact of an increase in the expected rate of inflation? A) The rate of inflation will increase, real wages will rise, and real output will increase. B) The rate of inflation, real wages, and real output will all remain unchanged. C) The rate of inflation will increase, while real wages and real output will remain unchanged. D) The rate of inflation and output will remain unchanged, but real wages will fall. E) The rate of inflation and real wages will increase, but real output will remain unchanged. 6. 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 Page 10 of 10