Department of Economics Prof. Gustavo Indart University of Toronto July 21, 2010 SOLUTIONS ECO 209Y L0101 MACROECONOMIC THEORY Term Test #2 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 1 hour and 50 minutes. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /21 Part II 1. /10 2. /10 3. /10 4. /10 Part III /19 TOTAL /75 Page 1 of 10
PART I (21 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. 1 2 3 4 5 6 7 C A D B A E C 1. Suppose that average income per capita in Argentina is 48,000 pesos per year and that the nominal exchange rate for Argentine pesos is 0.30. Further suppose that a given consumption basket of goods and services costs $3,500 in the Canada and 8,750 pesos in Argentina. Using the PPP exchange rate, income per capita in Argentina is: A) $14,400. B) $18,400. C) $19,200. D) $26,250. E) none of the above. 2. If capital mobility is imperfect and import demand is completely insensitive to changes in the level of domestic output, which one of the following statements is correct? A) The BP curve is horizontal. B) The BP curve is vertical. C) The BP curve is downward sloping. D) The BP curve is upward sloping if the international rate of interest is greater than the domestic rate of interest. E) The BP curve is not determinable. 3. In an IS-LM-BP model with flexible exchange rates and perfect capital mobility, contractionary fiscal policy will A) cause a depreciation of the exchange rate. B) shift first the IS curve to the left and then the LM curve to the left. C) cause a decrease in investment. D) cause an increase in net exports. E) lower the level of output but leave the interest rate unchanged. 4. Suppose that the BP curve has a positive slope but is flatter than the LM curve and that the government wishes to reduce interest rates without causing a depreciation of the Canadian dollar. The government should A) increase its spending and cut the money supply. B) lower its spending and cut the money supply. C) raise its spending and raise the money supply. D) lower its spending and raise the money supply. E) cut the money supply and leave spending unchanged. Page 2 of 10
5. Consider a small open economy with fixed prices, fixed exchange rates, and no capital mobility. Assume that BP = 0 in the initial equilibrium. If the government imposes an import quota, in the new equilibrium A) net exports will remain unchanged, but the money supply and income will both be higher. B) net exports, the money supply, and income will all remain unchanged. C) net exports, the money supply, and income will all be lower. D) net exports, the money supply, and income will all be higher. E) net exports will remain unchanged, the money supply will be lower, and income will be higher. 6. Consider an economic model with fixed prices, flexible exchange rates, and imperfect capital mobility. If the international rate of interest exceeds the domestic rate of interest, then A) net exports are negative and net capital flows are positive. B) net exports and net capital flows are both positive. C) net exports and net capital flows are both negative. D) net capital flows are positive. E) net exports are positive and net capital flows are negative. 7. In a flexible exchange rate system with perfect capital mobility, which one of the following statements is correct? A) Expansionary monetary policy will appreciate the domestic currency. B) Fiscal expansion is very effective in stimulating aggregate expenditure. C) Fiscal expansion causes an appreciation of the domestic currency. D) An increase in exogenous exports will increase net exports. E) None of the above is correct. Page 3 of 10
PART II (40 marks) Instructions: Answer all questions in the space provided. Each question is worth 10 marks. 1. Assuming imperfect capital mobility and fixed exchange rates, explain the impact of expansionary fiscal policy. In your answer, clearly indicate the effect on income, rate of interest, current account and capital account. (Show your answer with the help of an IS-LM- BP diagram and explain the economics. Assume the BP curve is flatter than the LM curve.) Suppose that initially the goods market, the money market, and the external sector are all in equilibrium. This equilibrium is shown graphically in the diagram below by the intersection of the IS, LM and BP curves at point A. This equilibrium is now disturbed by the government implementing expansionary fiscal policy, e.g., by an increase in government expenditure on goods and services. This is shown in the diagram below by a rightward shift of the IS curve to IS. The economy is still at point A and thus the money market and the external sector continue to be in equilibrium but point A now lies below the new IS curve, thus implying an excess demand in the goods market (i.e., AE > Y). This excess demand in the goods market will be eliminated by an increase in Y. Indeed, firms start selling more than what they are actually producing and thus an involuntary decrease in inventories ensues. This involuntary decrease in inventories gives the signal to firms that they must adjust production upwards. As output (and thus income) starts to increase, the demand for money also starts to rise and so the rate of interest starts to increase. The increase in the rate of interest causes an improvement in the capital account and thus a surplus arises in the exchange market creating a downward pressure on the exchange rate. Since the central bank wants to keep the exchange rate unchanged at the set level, the central bank will have to eliminate the excess supply of foreign currency. As the central bank buys foreign currency to eliminate the excess supply, the domestic money supply increases thus shifting the LM curve to the right. Note that the money market remains always in equilibrium since, as Y increases and the demand for money rises, the rate of interest adjusts immediately to equate demand and supply. Also note that equilibrium in the external sector is immediately restored by the intervention of the central bank. Therefore, the economy is always at a point where the LM and BP curves intersect i.e., the adjustment path is along the BP curve, the LM curve continuously shifting to the right as the central bank intervenes in the exchange market to eliminate any surplus. And as Y increases, the excess demand in the goods market is reduced. Also note that the increase in the rate of interest reduces AE, and thus also contributes to the reduction of the excess demand in the goods market. This process continues until the excess demand in the goods market is eliminated, i.e., until the LM, BP and IS curves all intersect at one point again (at point B in the diagram). Therefore, both equilibrium income and equilibrium rate of interest increase as a result of the increase in G. The increase in the rate of interest causes investment to decrease while the increase in Y causes imports to rise and NX to fall. Therefore, at the end of the process of adjustment the balance in the current account deteriorates and the balance in the capital account improves (because of the increase in the rate of interest). i LM LM BP i 2 B i 1 A IS IS Y 1 Y 2 Y Page 4 of 10
2. Assuming imperfect capital mobility and flexible exchange rates, explain the impact of expansionary monetary policy. In your answer, clearly indicate the effect on income, rate of interest, current account and capital account. (Show your answer with the help of an IS-LM- BP diagram and explain the economics. Assume the BP curve is flatter than the LM curve.). Suppose that initially the goods market, the money market, and the external sector are all in equilibrium. This equilibrium is shown graphically in the diagram below by the intersection of the IS, LM and BP curves at point A. This equilibrium is now disturbed by the central bank implementing expansionary monetary policy, i.e.., by increasing the nominal supply of money through an open market operation. This is shown in the diagram below by a rightward shift of the LM curve to LM. Since equilibrium in the money market is rapidly restored by a change in the rate of interest, the rate of interest drops to i 1. The decrease in the rate of interest causes the balance of the capital account to deteriorate i.e., a surplus to decrease or a deficit to increase. The gradual deterioration of the capital account (with no change in the current account) causes the domestic currency to gradually depreciate (i.e., the exchange rate to appreciate). The gradual appreciation of the exchange rate makes domestic goods more competitive in the international market and (desired) NX increases. Graphically, the increase in desired NX translates into a rightward shift of the IS curve, which creates a situation of excess demand in the goods market. An increase in desired investment as a result of the fall in the rate of interest also contributes to the emergence of this excess demand in the goods market. This excess demand in the goods market will eventually be eliminated by an increase in Y. Note that, as the exchange rate gradually appreciates and NX increases, the balance in the current account improves at each level of Y. This improvement in the current account means that, at each level of Y, the overall balance of payment will now be in equilibrium at lower rates of interest than before, i.e., that the BP starts shifting downwards. Note as well that the downward pressure on the value of the exchange rate diminishes as the balance in current account improves. As output (and thus income) starts to increase to eliminate the excess demand in the goods market, the demand for money also starts to rise and so the rate of interest starts to increase. In turn, the increase in the rate of interest slows down the deterioration in the balance in the capital and in the process of appreciation of the exchange rate. This process continues until the excess demand in the goods market is eliminated, i.e., until the LM, BP and IS curves all intersect at one point again (at point C in the diagram). Since the money market is always in equilibrium by assumption, note that the adjustment path is depicted by an upward movement along the LM curve. At the end of the process, therefore, equilibrium income increases and equilibrium rate of interest decreases as a result of the increase in the money supply. The decrease in the rate of interest causes investment to increase while the depreciation of the domestic currency causes NX to rise. Therefore, at the end of the process of adjustment the balance in the current account improves (because of the appreciation of the exchange rate) while the balance in the capital account deteriorates (because of the decrease in the rate of interest). i LM BP LM BP i 1 i 2 A C i 1 B IS IS Y 1 Y 2 Y Page 5 of 10
3. Assuming perfect capital mobility and flexible exchange rates, explain the impact on the Canadian economy of a decrease in interest rates in the U.S. In your answer, clearly indicate the effect on income, rate of interest, current account and capital account. (Show your answer with the help of an IS-LM-BP diagram and explain the economics.) Suppose that initially the goods market, the money market, and the external sector are all in equilibrium. This equilibrium is shown graphically in the diagram below by the intersection of the IS, LM and BP curves at point A. Since there is perfect capital mobility, the domestic rate of interest must be equal to the international rate (i.e., to the rate of interest in the U.S.) for the external sector to be in equilibrium. At any other level of the domestic rate of interest, the external sector would be in disequilibrium either capital flowing into the country if i > i* or capital flowing out of the country if i < i*. For that reason the BP curve is horizontal at the level of the international rate of interest. A decrease in the U.S. rate of interest causes the BP curve to shift down to this new level of i*. But the domestic rate of interest does not change immediately because the rate of interest in the U.S. had decreased. Therefore, while the goods market and the money market continue in equilibrium at point A, there is now a disequilibrium in the external sector capital flowing into the country. The increasing inflow of capital increases the supply of foreign currency in the exchange market and the exchange rate depreciate (i.e., the domestic currency appreciates). The depreciation of the exchange rate makes domestic goods relatively more expensive in the international market and thus (desired) NX starts to decrease. Graphically this is expressed by downward shift of the IS curve. As a result, an excess supply (i.e., Y > AE) arises in the goods market. This excess supply in the goods market will eventually be eliminated by a decrease in Y (once firms experienced an involuntary increase in inventories. The decrease in Y causes the demand for real balances to fall, and thus the domestic rate of interest starts to decrease. This decrease in the rate of interest eases both the inflow of capital and the depreciation of the exchange rate. This process continues as long as the domestic rate of interest remains above the new rate of interest in the U.S. The process of adjustment is completed when the excess supply in the goods market is eliminated, i.e., when the LM, BP and IS curves all intersect at one point again (at point B in the diagram). Since the money market is always in equilibrium by assumption, note that the adjustment path is depicted by a downward movement along the LM curve. At the end of the process, therefore, both equilibrium income and equilibrium rate of interest decrease. The decrease in the rate of interest causes investment to increase while the depreciation of the exchange rate causes NX to fall. Therefore, at the end of the process of adjustment the balance in the current account deteriorates (because of the depreciation of the exchange rate) while the balance in the capital account improves (due to the interest rate differential during the adjustment period). i LM i 1 * A BP i 2 * B BP IS IS Y 2 Y 1 Y Page 6 of 10
4. Assuming fixed exchange rates and no capital mobility, explain the impact of a devaluation of the domestic currency. In your answer, clearly indicate the effect on income, rate of interest, and current account. (Show your answer with the help of IS-LM-BP and X-Q diagrams and explain the economics.) i i 2 i 3 i 1 X Q BP Y 1 A B Y 2 BP IS Y 3 LM C LM IS Q Q Y X X Suppose that initially the goods market, the money market, and the external sector are all in equilibrium. This equilibrium is shown graphically in the diagram on the left by the intersection of the IS, LM and BP curves at point A. Note that since there is no capital mobility, the BP cure is vertical. A devaluation of the domestic currency makes domestic goods more competitive in the international market and thus exports increase and imports decrease. Graphically this is expressed by a shift upward of the X curve and downward of the Q curve, and by a shift outward of the IS curve to IS (because of the increase in NX). Since the BP curve indicates the level of Y at which NX = 0, the BP curve shifts to BP since BP = 0 now at Y 3. Therefore, while there is equilibrium in the money market at Y 1, there is now an excess demand in the goods market (i.e., AE > Y) and a surplus in the external sector (i.e., X > Q). Let s examine how equilibrium is restored in the goods market and in the external sector. Although the adjustment takes in both markets simultaneously, for analytical purposes it is convenient to examine the process of adjustment in two steps: first the elimination of the excess demand in the goods market, and then the elimination of the surplus in the external sector. The excess demand in the goods market must be eliminated by an increase in Y. Indeed, firms will start selling more than what they are actually producing and thus an involuntary decrease in inventories will ensue. This involuntary Y 1 Y 2 Y 3 Y decrease in inventories will give the signal to firms that they must adjust production upwards. As output (and thus income) starts to increase, the demand for money also starts to rise and so the rate of interest starts to increase. The adjustment path is along the LM curve since the money market remains always in equilibrium. The excess demand in the goods market is eliminated at point B in the diagram, where Y = Y 2 and i = i 2. Note that, as Y increases, imports also increase and thus the surplus in the external sector falls. At Y 2, however, although smaller the surplus in the external sector still remains. A surplus means that there exists an excess supply of foreign currency in the exchange market, thus putting upward pressure on the exchange rate. Given that the central bank wants to keep the exchange rate fixed at the new set level, the central bank will have to buy foreign currency in the exchange market. As the central bank buys foreign currency, the domestic money supply increases. Graphically, this is represented by a shift downwards of the LM curve. The increase in the supply of money will have a further expansionary effect in the economy income increasing as a result of the impact of the reduction of the rate of interest on investment. As Y increases, imports also increase thus eliminating the surplus in the external sector. At the end of the process of adjustment, equilibrium income would be higher than before while the rate of interest could be higher or lower depending on the relative (and opposite) impacts of the devaluation and the monetary expansion (in the diagram it is assumed that the rate of interest increases). Finally, while NX = 0 in equilibrium, X and Q are both greater than before X increasing due to the devaluation and Q increasing due the increase in Y and despite the devaluation. Page 7 of 10
PART III (19 marks) Consider an open economy with fixed prices, flexible exchange rates, and imperfect capital mobility. This economy is characterized by the following behavioural equations: C = 60 + 0.8YD P f = 2 I = 200 20i + 0.1Y P = 1 G = 300 TA = 0.25Y L = 0.2Y 10i TR = 50 M/P = 200 X = 250 + 100 ep f /P CF = 25 (i i*) Q = 400 50 ep f /P + 0.1Y i* = 9 a) What is the equation for the IS curve in this model? (3 marks) C = 60 + 0.8YD = 60 + 0.8 (Y TA + TR) = 60 + 0.8 (Y 0.25Y + 50) = 60 + 0.6Y + 40 = 100 + 0.6Y NX = X Q = 250 + 200e 400 + 100e 0.1Y = 150 + 300e 0.1Y AE = C + I + G + NX = 100 + 0.6Y + 200 20i + 0.1Y + 300 150 + 300e 0.1Y = 450 + 300e + 0.6Y 20i Y = AE Y = 450 + 300e + 0.6Y 20i 450 + 300e 0.4Y 20i = 0 i = 22.5 + 15e 0.02Y b) What is the equation for the LM curve in this model? (3 marks) L = M/P 0.2Y 10i = 200 10i = 200 + 0.2Y i = 20 + 0.02Y Page 8 of 10
c) What is the equation for the BP curve in this model? (3 marks) NX + CF = 0 150 + 300e 0.1Y + 25(i 9) = 0 150 + 300e 0.1Y + 25i 225 = 0 375 + 300e 0.1Y + 25i = 0 25i = 375 300e + 0.1Y i = 15 12e + 0.004Y d) What are the values of Y, i and e at which the goods market, the money market, and the external sector are simultaneously in equilibrium? (3 marks) IS: i = 22.5 + 15e 0.02Y (1) LM: i = 20 + 0.02Y (2) BP: i = 15 12e + 0.004Y (3) (1) (2) 42.5 + 15e 0.04Y = 0 (4) (1) (3) 7.5 + 27e 0.024Y = 0 (5) 15 (5) 27 (4) 112.5 + 405e 0.36Y 1147.5 405e + 1.08Y = 0.72Y 1035 = 0 Y = 1035/0.72 Y = 1437.5 (2) i = 20 + 0.02Y = 20 + 0.02 (1437.5) = 20 + 28.75 = 8.75 i = 8.75 (3) i = 15 12e + 0.004Y 8.75 = 15 12e + 0.004 (1437.5) 12e = 15 + 5.75 8.75 = 12 e = 1 e) What are the balances in the current account and the capital account in this equilibrium? (2 marks) NX = 150 + 300e 0.1Y = 150 + 300 0.1 (1437.5) = 150 143.75 = 6.25 CF = 25 (i i*) = 25 (8.75 9) = 6.25 Page 9 of 10
f) Suppose now that the nominal supply of money increases to 250. What are the new equilibrium values of Y, i and e? (3 marks) IS: i = 22.5 + 15e 0.02Y (1) LM: i = 25 + 0.02Y (2) BP: i = 15 12e + 0.004Y (3) (1) (2) 47.5 + 15e 0.04Y = 0 (4) (1) (3) 7.5 + 27e 0.024Y = 0 (5) 15 (5) 27 (4) 112.5 + 405e 0.36Y 1282.5 405e + 1.08Y = 0.72Y 1170 = 0 Y = 1170/0.72 Y = 1625 (2) i = 25 + 0.02Y = 25 + 0.02 (1625) = 25 + 32.5 = 7.5 i = 7.5 (3) i = 15 12e + 0.004Y 7.5 = 15 12e + 0.004 (1625) 12e = 15 + 6.5 7.5 = 14 e = 7/6 = 1.167 g) What are the balances in the current account and the capital account in this new equilibrium? (2 mark) NX = 150 + 300e 0.1Y = 150 + 300 (7/6) 0.1 (1625) = 200 162.5 = 37.5 CF = 25 (i i*) = 25 (7.5 9) = 37.5 Page 10 of 10