Department of Economcs Prof. Gustavo Indart Unversty of Toronto November 9, 2006 SOLUTION ECO 209Y MACROECONOMIC THEORY Term Test #1 C LAST NAME FIRST NAME STUDENT NUMBER Crcle your secton of the course: L0101 L0201 L0401 L5101 MW 10-11 MW 1-2 MW 2-3 W 6-8 INSTRUCTIONS: 1. The total tme for ths test s 1 hour and 50 mnutes. 2. Ths exam conssts of three parts. 3. Ths queston booklet has 10 (ten) pages. 4. Ads allowed: a smple calculator. 5. Use pen nstead of pencl. DO NOT WRITE IN TH SPACE Part I /30 3. /10 Part II /15 4. /10 Part III 1. /10 2. /10 TOTAL /85 Page 1 of 10
PART I (30 marks) Instructons: Multple choce questons are to be answered usng a black pencl or a black or blue ball-pont pen on the separate SCANTRON sheet beng suppled. Be sure to fll n your name and student number on the SCANTRON sheet. Wrte your course secton number (e.g., L0101, etc.) on the SCANTRON sheet (n the area where t says DO NOT WRITE IN TH SPACE ). Each queston s worth 3 marks. No deductons wll be made for ncorrect answers. Wrte your answers also n the table below; but only answers recorded on the SCANTRON sheet wll be graded. Questons whose answers are not entered on the SCANTRON sheet wll get a zero mark. 1 2 3 4 5 6 7 8 9 10 E C B D A B A E A C 1. Suppose that the war n Afghanstan causes consumer confdence to drop. If the government wants to neutralze the mpact of the drop n consumer confdence on both GDP and the nterest rate, the followng polces are correct: A) Increase G and M. B) Increase G, decrease M. C) Decrease G, Increase M. D) Decrease G, decrease M. E) Increase G, leave M unchanged. 2. The ncome earned by a French student durng her studes n Canada s ncluded: A) In Canada s GDP and n France s GDP. B) In Canada s GNP and n France s GNP. C) In Canada s GDP and n France s GNP. D) In Canada s GDP but not n France s GDP or GNP. E) In France s GNP but not n Canada s GDP or GNP. 3. Suppose that Justn buys a newly-bult house, for whch he pays $150,000. Knowng that the rent for a smlar house s $20,000 per year and that Justn prevously lved wth hs parents, what s the mpact of ths transacton on full-year GDP? A) Consumpton rses by $150,000 and nvestment s unchanged. B) Consumpton rses by $20,000 and nvestment rses by $150,000. C) Consumpton s unchanged and nvestment rses by $150,000. D) Consumpton rses by $20,000 and nvestment s unchanged. E) GDP s unchanged. 4. Canadan real per capta dsposable ncome ncreased by about 16 percent between 1981 and 2005. Over ths perod, the share of per capta consumpton expendture n per capta dsposable ncome ncreased from about 75 percent n 2001 to more than 95 percent n 2005. Whch of the followng statements may explan ths ncrease n consumpton expendture as a share of dsposable ncome? A) The ncrease n real per capta dsposable ncome over the perod reduced the need for savng for future consumpton. B) Households had negatve expectatons about the future state of the economy and decded to spend more whle they could. C) A sgnfcant decrease n asset values convnced households that savng for the future was too rsky. D) Real rates of nterest reached hstorcally low levels n the 1990s, thus dscouragng savng and fosterng hgher consumpton expendture. E) The average propensty to consume tends to ncrease as dsposable ncome ncreases. Page 2 of 10
5. The savng and nvestment functons of a hypothetcal closed economy wth no government sector are S = 100 + 0.2 Y and I = 50, respectvely. When Y = 1 000, the nvoluntary change n nventory s A) +50. B) +100 C) +250. D) 50. E) 250. 6. In 2005, Speedy Motors purchased $5 mllon worth of steel and car parts n order to produce 1,000 cars. Speedy Motors sold n 2005 all these 1,000 cars to Global Car Dealer for $15,000 each. Global Car Dealer sold 800 of these cars to the publc n 2005, at a retal prce of $20,000 each. What was the contrbuton of Speedy Motors and Global Car Dealer to GDP n 2005? A) $5 mllon. B) $14 mllon. C) $15 mllon. D) $20 mllon. E) None of the above. 7. Suppose that taxes ncrease and money supply ncreases n such a way that output s constant n equlbrum. These polcy changes wll produce A) An ncrease n nvestment and a decrease n prvate consumpton. B) An ncrease n nvestment and a decrease n government spendng. C) An ncrease n nvestment and an ncrease n prvate savng. D) A decrease n nvestment and an ncrease n publc savng (.e., n the government budget surplus). E) Cannot say snce there s not enough nformaton. 8. An ncrease n the money supply and a drop n consumer confdence wll lead to A) A decrease n output wth an ambguous effect on the nterest rate. B) An ncrease n output and a decrease n the nterest rate. C) A decrease n output and an ncrease n the nterest rate. D) An ambguous effect on output and an ncrease n the nterest rate. E) An ambguous effect on output and a decrease n the nterest rate. 9. Whch of the followng polcy optons would smultaneously ncrease nterest rates and decrease output? A) The Bank of Canada sells bonds through open market operatons. B) The federal government ncreases ts defence purchases. C) The Bank of Canada expands the money supply. D) The federal government ncreases the tax rate. E) None of the above. 10. Suppose that nvestment (I) s not responsve to the nterest rate (that s, I does not depend on the nterest rate at all). Then A) The curve s a vertcal lne and monetary polcy s very effectve n rasng output. B) The curve s a horzontal lne and monetary polcy s very effectve n rasng output. C) The curve s a vertcal lne and monetary polcy does not affect output n the - model. D) The curve s a horzontal lne and monetary polcy does not affect output n the - model. E) The curve stll has a negatve slope, but monetary polcy monetary polcy does not affect output n the - model. Page 3 of 10
PART II (15 marks) Assume that a closed economy s descrbed by the followng equatons: C = 540 + 0.5Y D I = 250 + 0.1Y 8 TA = 300 TR = 0 G = 200 P = 2 M = 7 000 L = 2Y 100 [Note: Although you don t need to draw the and curves to answer the followng questons, you mght fnd t helpful dong t.] (a) Solve for equlbrum real output (n bllons of dollars) and equlbrum nterest rate (n percent). (5 marks) To derve the equaton for the curve we must fnd frst the equaton for the AE curve and fnd the equlbrum n the goods market. The equaton for the AE curve s: AE = C + I + G = 540 + 0.5 Y D + 250 + 0.1 Y 8 + 200 = 540 + 0.5 (Y 300) + 250 + 0.1 Y 8 + 200 = 540 150 + 250 + 200 + 0.5 Y + 0.1 Y 8 = 840 + 0.6 Y 8 In equlbrum: Y = AE Y = 840 + 0.6 Y 8 0.4 Y = 840 8 8 = 840 0.4 Y = 105 0.05 Y To derve the equaton for the curve we must fnd the equlbrum n the money market: M/P = L 7 000 / 2 = 2 Y 100 3 500 = 2 Y 100 100 = 3 500 + 2 Y = 35 + 0.02 Y We equate the and curves to fnd equlbrum real output: 105 0.05 Y = 35 + 0.02 Y 0.07 Y = 140 Y* = 2 000 We plug ths value for Y* n ether the expresson for the or curve n order to fnd equlbrum rate of nterest: * = 35 + 0.02 Y* = 35 + 0.02 (2 000) = 35 + 40 = 5 5 2000 Y Page 4 of 10
(b) Suppose that autonomous nvestment ncreases by $56 bllon. Calculate the new equlbrum real output (n bllons of dollars) and the new equlbrum nterest rate (n percent). (5 marks) You can fnd the expresson for the new curve through the same process as n part (a), but you don t need to. You should know that the upward shft of the curve s equal to I / b = 56/8 = 7. Therefore, the expresson for the new curve s: = 112 0.05 Y We equate the new curve and the curves to fnd the new equlbrum real output: 112 0.05 Y = 35 + 0.02 Y 0.07 Y = 147 Y* = 2 100 We plug ths value for Y* n ether the expresson for the new curve or curve n order to fnd the new equlbrum rate of nterest: * = 35 + 0.02 Y* = 35 + 0.02 (2 100) = 35 + 42 = 7 7 5 2000 2100 Y Page 5 of 10
(c) How would the Bank of Canada react to ths autonomous ncrease n nvestment n order to keep Y constant at the level of part (a)? Calculate the requred change n the money supply. (5 marks) The Bank of Canada must reduce the money supply n order to ncrease the rate of nterest enough to reduce nvestment (.e., the component of the nvestment functon that depends on the rate of nterest) by the same amount as the ntal ncrease n autonomous nvestment. That s, b = 8 and 8 = 56 = 7 * = 12 Therefore, the curve must shft up by 7 and thus the expresson for the new curve becomes: * = 28 + 0.02 Y* And the vertcal ntercept of the curve s (M/P)/h = (M/2)/100 and (M/2)/100 = 28 M = 28 (200) = 5 600 M = 1 400 (.e., a decrease from 7 000 to 5 600) Alternatvely, we can also fnd the requred change n M n the followng way. The decrease n the money supply should be enough to shft the curve to the left and ntersect the new curve at Y = 2 000. Ths can be seen n the followng dagram. 12 7 5 2000 2100 Y To fnd the value of the rate of nterest at the pont where ntersects we must plug Y = 2 000 n the expresson for the curve: * = 112 0.05 Y* = 112 0.05 (2 000) = 112 100 = 12 To fnd the expresson for the curve we must equate the real money supply and the real money demand: M/P = 2 Y 100 We know the values for P, Y and, and thus the only unknown s M (the nomnal supply of money): M / 2 = 2 (2 000) 100 (12) M / 2 = 4 000 1 200 = 2 800 M = 5 600 Therefore, the Bank of Canada must reduce the nomnal supply of money from 7 000 to 5 600.e., a reducton of 1 400 n order to offset the expansonary effect of the ncrease n autonomous nvestment. Page 6 of 10
PART III (40 marks) Instructons: Answer all questons n the space provded on queston sheet (f space s not suffcent, contnue on the back of the prevous page). Each queston s worth 10 (ten) marks. 1. Explan wth the help of approprate dagrams whether the followng statement s true, false, or uncertan: A mx of a fscal contracton (e.g., an ncrease n taxes) and a monetary expanson ncreases nvestment unambguously. True Let s look frst at the mpact of contractonary fscal polcy on nvestment. Assumng that desred nvestment expendture depends on the rate of nterest () but not on the level of ncome (Y), contractonary fscal polcy wll result n an ncrease n nvestment. Suppose that the economy s ntally n equlbrum at (Y 1, 1 ) and that government expendture (G) decreases. Ths causes overall aggregate expendture (AE) to fall, resultng n a stuaton of excess supply n the goods market at Y 1 and output wll start to fall to restore equlbrum n the goods market. As Y starts to fall, the demand for real balances also falls and the rate of nterest decreases. In turn, as the rate of nterest decreases, desred nvestment expendture ncreases. Dagrams 1 and 2 show ths adjustment. Frst, before any change n the rate of nterest, the decrease n G causes the AE curve to shft down to AE 2 and the curve to shft to. Then, as the rate of nterest gradually decrease and desred nvestment ncreases, the AE curve gradually shfts up untl a new equlbrum n the goods market s acheved at (Y 2, 2 ). The adjustment n the - dagram s down along the curve snce the money market s always n equlbrum. Let s look now at the mpact of expansonary monetary polcy on nvestment. Suppose that the Bank of Canada ncreases the money supply, thus creatng a stuaton of excess supply n the money market. As a result, the rate of nterest falls and desred nvestment expendture ncreases. Startng from the ntal stuaton of equlbrum at (Y 1, 1 ), Dagrams 2 and 3 show ths adjustment. As the money supply ncreases as shown n Dagram 3, the curve shfts to as shown n Dagram 2. The rate of nterest falls and desred nvestment ncreases, the level of output/ncome starts to ncrease. Ths ncrease n desred nvestment s not shown n Dagram 1. Note that as Y ncreases, the rate of nterest also ncreases because the demand for money rses. The adjustment path s up along the curve and a new equlbrum s reached at (Y 3, 3 ), where the rate of nterest s lower than 1 and thus nvestment s greater than at the ntal equlbrum. Therefore, the statement s true: a mx of contractonary fscal polcy and expansonary monetary fscal polcy unambguously cause nvestment to ncrease snce these polces renforce each other on ther mpact on the rate of nterest. AE 1 2 3 1 AE 1 AE 3 AE 2 Y 1 Y 2 Y 1 Y Y 1 Y 2 Y 1 Y 3 Y M/P (M/P) 1 3 1 L(Y 3 ) L(Y 1 ) M/P Page 7 of 10
2. Assume a closed economy s n equlbrum at (Y*, *). Suggest a polcy mx.e., a combnaton of fscal and monetary polcy to decrease the budget defct whle keepng Y constant. Show the effect of your proposed polcy mx n an - dagram, and explan. What happens to each component of aggregate output,.e., to C, I, and G? The government must mplement contractonary fscal polcy.e., a decrease n G or an ncrease n TA to reduce the budget defct. But contractonary fscal polcy wll cause the level of natonal ncome to fall. Therefore, the government should combne contractonary fscal polcy wth expansonary monetary polcy n order to keep Y unchanged. Ths polcy mx s shown n the followng dagram. 1 The economy s ntally n equlbrum at (Y 1, 1 ). Suppose now that the government decreases ts expendture on goods and servces (G) to reduce the budget defct. The decrease n G wll cause AE to fall and thus the curve wll shft down to. Ths creates a stuaton of excess demand n the goods market.e., AE < Y and output wll start to fall towards the new equlbrum at Y 2. 2 1 Y 2 Y 1 Y To prevent output from fallng, the government through the Bank of Canada should combne the decrease n G wth an ncrease n the money supply. That s, the objectve would be to keep the level of AE unchanged whle allowng ts composton to change. Indeed, the decrease n M/P wll cause the rate of nterest to fall and the nvestment component of AE to ncrease. The mpact of the ncrease n M/P s shown n the dagram by the shft of the curve to. Ths polcy mx thus allows the level of equlbrum ncome to reman at Y 1 whle the level of equlbrum rate of nterest falls to 1. Snce the level of ncome and taxes don t change, the level of C doesn t change ether. Therefore, only G decreases and I ncreases and both by exactly the same absolute amount so the overall level of AE doesn t change. Page 8 of 10
3. The Canadan economy s currently operatng at full employment but snce the U.S. s Canada s largest tradng partner many economsts expect that the present slowdown n the U.S. economy mght soon cause the Canadan economy to move nto a recesson. What polcy should the Mnster of Fnance mplement n order to keep both natonal ncome (Y) and the rate of nterest () at the present levels? Show the effect of your proposed polcy n an - dagram, and explan. What happens to each component of aggregate output,.e., to C, I, G, and NX? The slowdown n the U.S. economy wll cause ther mports from Canada to decrease,.e., Canadan exports to the U.S. wll fall. Ths represents a reducton n AE and thus the Canadan economy wll move nto a recesson. To prevent Y from fallng, the government should mplement ether expansonary fscal polcy or expansonary monetary polcy or a combnaton of both. However, snce the ntenton s to keep both Y and unchanged at the ntal equlbrum levels, then only expansonary fscal polcy must be mplemented. Ths s shown n the followng dagram. 1 The economy s ntally n equlbrum at (Y 1, 1 ). The decrease n autonomous exports causes AE to fall and thus the curve shfts down to. Ths creates a stuaton of excess demand n the goods market.e., AE < Y and output starts to fall towards the new equlbrum at Y 2. Note that as Y decreases, the demand for money also decreases and thus the rate of nterest starts to fall as well. 2 1 Y 2 Y 1 Y To prevent output and the rate of nterest from fallng, the government should mplement expansonary fscal polcy e.g., ncrease G or decrease TA. Let s suppose that the government ncreases G and thus the curve shfts back to. The ncrease n G must be equal to the decrease n X to keep overall AE unchanged, and thus the curve on the same ntal poston. As shown n the dagram, expansonary fscal polcy allows the level of equlbrum ncome to reman at Y 1 and the level of equlbrum rate of nterest at 1. Snce the level of ncome and taxes don t change, the level of C doesn t change ether. Smlarly, snce the rate of nterest doesn t change, the level of I doesn t change ether. Therefore, only G ncreases and NX decreases and both by exactly the same absolute amount so the overall level of AE doesn t change. Note that Q doesn t change ether snce Y doesn t change, and thus the change n NX s the result of only the decrease n X. Page 9 of 10
4. Suppose that General Motors announces that t wll lay off 2,000 workers when t shuts down one of ts plants n Oshawa at the end of the year. Further suppose that you are the general manager of a furnture factory supplyng the Oshawa market. What wll be the mpact of General Motors decson to shut down one of ts plants on your frm? What actons wll you take as the general manager of ths furnture factory? Assumng that most lad off workers lve n Oshawa, the decson of General Motors wll reduce the dsposable ncome of Oshawa s resdents. Therefore, one would expect the consumpton expendture of Oshawa s resdents to start fallng even before workers are actually lad off at the end of the year. If consumpton expendture were to fall, expendture on durable goods would be the component of consumpton most affected and furnture s a durable good. Therefore, I would expect furnture sales to sgnfcantly decrease n the next few months. What should I do as general manager of ths furnture factory? If, as I expect, sales wll start to fall, then nventores wll start to buld up unless I take some correctve acton. Therefore, to avod ths nvoluntary ncrease n nventores, I wll adjust producton downwards to reduce the present level of nventores and avod ts expected buld up. I wll thus start, for nstance, reducng the number of workng hours and layng off some non-essental personnel (e.g., on a rotatng bass to spread out ts socal mpact). Smlarly, I wll reduce my monthly orders of ntermedate goods requred for the producton of furnture (e.g., wood). An addtonal beneft of takng correctng actons before sales actually go down s that t wll requre a less extreme adjustment to producton snce t prevents the buldng up of nventores. Page 10 of 10