Department of Economics Prof. Gustavo Indart University of Toronto January 25, 2007 SOLUTION ECO 209Y MACROECONOMIC THEORY Term Test #2 LAST NAME FIRST NAME STUDENT NUMBER Circle your section of the course: L0101 L0201 L0401 L5101 MW 10-11 MW 1-2 MW 2-3 W 6-8 INSTRUCTIONS: 1. The total time for this test is 1 hour and 50 minutes. 2. This exam consists of three parts. 3. This question booklet has 10 (ten) pages. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /21 4. /10 Part II 1. /10 Part III /20 2. /10 3. /10 TOTAL /81 Page 1 of 10
PART I (24 marks) Instructions: Multiple choice questions are to be answered using a black pencil or a black or blue ballpoint pen on the separate SCANTRON sheet being supplied. Be sure to fill in your name and student number on the SCANTRON sheet. Write your course section number (e.g., L0101, etc.) on the SCANTRON sheet (in the area where it says DO NOT WRITE IN THIS SPACE ). Each question is worth 3 marks. No deductions will be made for incorrect answers. Write your answers also in the table below; but only answers recorded on the SCANTRON sheet will be graded. Questions whose answers are not entered on the SCANTRON sheet will get a zero mark. 1 2 3 4 5 6 7 8 B B C E B C A B 1. Suppose that income per capita in Mexico is 45,000 pesos and that the nominal exchange rate for Mexican pesos is 0.10. Further suppose that a given consumption basket of goods and services costs $2,250 in Canada and 15,000 pesos in Mexico. Using the PPP exchange rate, income per capita in Mexico is: A) $4,500. B) $6,750. C) $7,500. D) $9,250. E) none of the above. 2. Suppose that capital mobility is NOT perfect and that import demand is completely insensitive to changes in the level of domestic output. Then, the BP curve will be A) downward sloping. B) horizontal. C) vertical. D) upward sloping if the international rate of interest is greater than the domestic rate of interest. E) downward sloping if the domestic rate of interest is greater than the international rate of interest. 3. In an IS-LM-BP model with flexible exchange rates and perfect capital mobility, contractionary fiscal policy will A) cause an appreciation of the domestic currency. B) shift first the IS curve to the left and then the LM curve to the left. C) not change the overall level of output, but its composition. D) cause a decrease in net exports. E) lower the level of output but leave the interest rate unchanged. Page 2 of 10
4. 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. 5. In a flexible exchange rate system, a decrease in autonomous imports will cause the value of the domestic currency to A) fall. B) rise. C) rise if the BP curve is flatter than the LM curve but to fall otherwise. D) fall if the IS curve slopes up or the LM slopes down. E) fall and exports to decrease, thus leaving net exports unchanged. 6. Which of the following will cause the AD-curve to shift up to the right? A) An increase in the real money supply due to a decrease in the price level. B) A decrease in the real money supply due to a decrease in the nominal money supply. C) A decrease in the income sensitivity of the demand for real balances. D) A decrease in government transfer payments E) An increase in autonomous imports 7. The concept of diminishing marginal product of labour suggests that the slope of the production function A) increases as the quantity of labour decreases. B) decreases as the quantity of capital increases. C) increases as the quantity of labour increases. D) equals zero for all quantities of labour. E) is negative. 8. A profit-maximizing firm will hire more labour if A) the real wage exceeds the marginal product of labour. B) the marginal product of labour exceeds the real wage. C) the real wage equals the marginal product of labour. D) the nominal wage equals the value of the marginal product of labour. E) the nominal wage exceeds the value of the marginal product of labour. Page 3 of 10
PART II (40 marks) Instructions: Answer all questions in the space provided on question sheet (if space is not sufficient, continue on the back of the previous page). Each question is worth 10 (ten) marks. 1. The U.S. is experiencing significant macroeconomic imbalances: the federal government is running a record budget deficit while the current account deficit is at an all time high. The data also show that the U.S. trade deficit with China accounts for a significant portion of this current account deficit, while China s purchases of U.S. treasury bills account for a significant portion of the capital account surplus the U.S. is also experiencing. Some economists and policy advisers suggest that, in order to eliminate the current account deficit, the U.S. government should continue pressuring China to revalue its domestic currency. What impact would a significant revaluation of the Chinese currency have on the U.S. economy? In your answer you should clearly explain the expected effect on GDP, the interest rate, the current account, and the capital account of the U.S. A revaluation of the Chinese currency will make Chinese goods relatively more expensive and thus the U.S. trade account deficit with China will be reduced. This, however, will not guarantee a significant reduction in the overall U.S. current account deficit since other countries (e.g., Indonesia, Malaysia, etc.) will most likely start exporting to the U.S. what the U.S. was until now importing from China. Therefore, most likely the U.S. current account deficit will remain at most it will be marginally reduced. What about the U.S. capital account? If China will no longer have a large trade account surplus with the U.S., it will not be able to continue accumulating reserves and buying U.S. treasury bills with it. Since there is no guarantee that the countries that will take the place of China as supplier of goods to the U.S. will invest their surplus in U.S. treasury bills, the demand for U.S. treasury bills will most likely decrease and thus the price of treasury bills will drop and the U.S. rate of interest will rise. This means that the U.S. surplus in the capital account will most likely decrease. What about U.S. domestic income? Since the U.S. government budget deficit will now have to be financed with domestic savings, as indicated above a significant increase in the rate of interest is the most likely outcome. Therefore, AD will fall and the U.S. economy will move into recession. This shows that a revaluation of the Chinese currency cannot be seen as a solution for the U.S. deficit in the current account. The fiscal deficit of the government should be seen as ultimately responsible for the deficit in the current account, and this deficit must be addressed gradually in order to prevent the U.S. economy falling into a deep recession. Page 4 of 10
2. Explain with the help of appropriate diagrams whether the following statement is true, false, or uncertain: An increase in autonomous investment will cause equilibrium output to increase, the equilibrium rate of interest to rise, the balance of the current account to deteriorate, and the balance of the capital account to improve. [Note: Consider an open economy with fixed prices, fixed exchange rates, and perfect capital mobility.] FALSE An increase in autonomous investment will cause AE to increase and an excess demand will arise in the goods market. Output will start to increase to eliminate the excess demand and the demand for money will also start to increase. Therefore, the domestic rate of interest will rise above the international rate and, given our assumption of perfect capital mobility, a massive inflow of capital will ensue. This massive inflow of capital will create a surplus in the foreign exchange market, and thus the Bank of Canada will have to buy foreign currency to prevent a decrease in the value of the exchange rate. As a result of the Bank of Canada s purchases of foreign currency, the money supply will increase and the pressure on the domestic rate of interest to rise will subdue. This process will continue as long as the pressure on the domestic rate of interest to rise above the international rate remains, that is, as long as the excess demand in the goods market remains and Y continues to increase. A new equilibrium will be reached when the domestic rate of interest is equal to the international rate of interest once again as shown in the diagram below. The increase in autonomous investment causes AE to increase and the IS curve to shift to IS. As Y increases and the demand for money also increases, the rate of interest rises and a surplus in the foreign exchange market arises. Then Bank of Canada buys foreign currency and the money supply increases, causing the LM curve to start shifting to the right. This process will continue until the LM curve reaches the position of the LM curve. Here we have once again the goods market, the money market, and the external sector all in equilibrium at the same time. Therefore, the statement is false: Output will increase but the rate of interest will remain unchanged, while the balance in the current account will deteriorate (because of the increase in Y) and the balance in the capital account will improve. i LM LM i* BP IS IS Y 1 Y 2 Y Page 5 of 10
3. Explain with the help of appropriate diagrams whether the following statement is true, false, or uncertain: An increase in money supply will cause the rate of interest to rise, output to increase, and the balances in both the capital account and the current account to deteriorate. [Note: Consider an open economy where capital is perfectly mobile, the price level is fixed, and the exchange rate is flexible.] False An increase in the money supply will reduce the rate of interest. Under the assumption of perfect capital mobility, the decrease in the domestic rate of interest will cause a massive outflow of capital. In turn, given the assumption of flexible exchange rates, the massive outflow of capital will cause the Canadian dollar to depreciate. The depreciation of the Canadian dollar will increase the international competitiveness of Canadian goods and services, and thus exports will increase and imports will decrease, i.e., net exports will increase. The increase in net exports a component of desired aggregate expenditure will cause autonomous AE to increase. This creates a situation of excess demand in the goods market and output will start to increase, and so will the rate of interest since the demand for money will start to rise. The adjustment is thus along the LM curve since the money is assumed to be always in equilibrium. This is shown graphically in the diagram below. The increase in the real supply of money causes the LM curve to shift down to the right, and the rate of interest drops to i 2 since the money market is assumed to be always in equilibrium. This creates a situation of disequilibrium both in the external sector (deficit) and in the goods market (excess demand). Under the assumption of flexible exchange rates system, the exchange rate will appreciate and NX will increase, causing the IS curve to shift up to the right. This process will continue as long as the domestic rate of interest is below the international rate of interest, i.e., the IS curve will keep shifting to the right until it reaches the position of IS. Here we have once again not only equilibrium in the money market, but also in the goods markets and in the external sector. Therefore, the statement is false. Equilibrium output increases but the rate of interest doesn t change, while the balance in current account improves (due to the depreciation of the Canadian dollar) and the balance in capital account deteriorates. i LM LM i* BP i 2 IS IS Y 1 Y 2 Y Page 6 of 10
4. Explain with the help of appropriate diagrams whether the following statement is true, false, or uncertain: Since a general increase in prices raises firms profits, firms will decide to produce larger outputs. Therefore, firms will hire more labour and nominal wages, real wages, and the level of employment will all rise. [Note: Consider the Classical model of the economy.] False In the Classical model of the economy, neither firms nor workers suffer from money illusion and thus both the supply of labour and the demand for labour depend on the real wage rate (W/P). Therefore, firms will hire more labour if and only if the real wage rate decreases, and workers will offer more labour if and only if the real wage rate increases. AS P increases, therefore, an excess demand for labour will emerge in the labour market and the nominal wage rate will increase until demand and supply are once again equal. For this to happen, the real wage rate must be equal to its initial equilibrium level once again, i.e., the nominal wage rate must increase in the same proportion as the price level has. This is shown graphically in the diagram below. The increase in P reduces the real wage rate at each level of W i.e., W/P decreases and thus the demand for labour shift to the right while the supply of labour shifts to the left. The nominal wage rate increases to W 2 to restore the real wage rate to restore equilibrium in the labour market. Here we have that the level of employment doesn t change, while W increases in the same proportion as P has. Since equilibrium N doesn t change, neither does equilibrium Y. The statement is therefore false: firms are unable to hire more labour, and thus output doesn t change, while the nominal wage rate increases but the real wage does not. W N S (P 2 ) W 2 N S (P 1 ) W 1 N D (P 1 ) N D (P 2 ) N 1 N Page 7 of 10
PART III (20 marks) Instructions: Answer all questions in the space provided on question sheet (if space is not sufficient, continue on the back of the previous page). Consider an open economy with fixed prices, fixed exchange rates, and imperfect capital mobility. This economy is characterized by the following behavioural equations: C = 60 + 0.8 YD P f = 2 I = 200 20 i + 0.1 Y P = 1 G = 300 e = 0.5 TA = 0.25 Y L = 0.2 Y 10 i TR = 50 M/P = 200 X = 250 + 100 P f e/p CF = 50 + 10 i Q = 400 50 P f e/p + 0.1 Y a) What is the equation for the IS curve in this model? (3 marks) First, we must obtain the expression for the aggregate expenditure function: AE = C + I + G + NX = (60 + 0.8 YD) + (200 20 i + 0.1 Y) + 300 + 350 350 0.1 Y = 560 + 0.8 YD 20 i where YD = Y 0.25 Y + 50 = 50 + 0.75 Y = 560 + 0.8 (50 + 0.75 Y) 20 i = 600 + 0.6 Y 20 i. In equilibrium, Y = AE: Y = 600 + 0.6 Y 20 i 20 i = 600 0.4 Y. And solving for i we obtain the equation for the IS curve: i = 30 0.02 Y. b) What is the equation for the LM curve in this model? (3 marks) The LM curve is found from the money market equilibrium: L = M/P 0.2 Y 10 i = 200 10 i = 0.2 Y 200 And solving for i we obtain the equation for the LM curve: i = 0.02 Y 20. Page 8 of 10
c) What are the values of Y and i at which the goods market and the money market are simultaneously in equilibrium? (3 marks) To find the values of Y and i for which the goods market and money market are simultaneously in equilibrium we must equate the IS and LM curves: 30 0.02 Y = 0.02 Y 20 0.04 Y = 50 Y* = 1250 and i* = 0.02 (1250) 20 = 5 d) What is the equation for the BP curve in this model? (3 marks) BP = NX + CF = 350 350 0.1 Y + 50 + 10 i = 0.1 Y 50 + 10 i The equation for the BP is found by making BP = 0: 0.1 Y 50 + 10 i = 0 10 i = 50 + 0.1 Y i = 5 + 0.01 Y e) Is the external sector in equilibrium at the level of Y obtained in part (c) above? If not, what is the size of the deficit or surplus? What are the balances in the current account and the capital account at these values of Y and i? (4 marks) We have determined in (c) above that BP = 0.1 Y 50 + 10 i, and thus: BP = 0.1 (1250) 50 + 10 (5) = 125 And the balances in NX and CF are: NX = X Q = 350 350 0.1 Y = 0.1 (1250) = 125 CF = 50 + 10 (5) = 0 Page 9 of 10
f) If there were an overall deficit or surplus in the balance of payments, what would the central bank of this country do to keep the value of the exchange rate unchanged? How would the action of the central bank affect the values of Y and i you obtained in part (c) above? [Note: You do not need to provide a quantitative answer, i.e., you do not need to indicate any specific new value for Y and i as a result of the action undertaken by the central bank.] (4 marks) Since the balance of payments shows a deficit of 125, the central bank will have to sell foreign currency to eliminate this deficit if it wants to prevent the exchange rate from rising and keep e fixed at e = 0.5. As the central bank sells foreign currency to eliminate the deficit in the exchange market, the domestic money supply decreases and the LM curve shifts up to the left. Therefore, Y decreases and i increases, and the balance in both the current account and the capital account improve. This process will continue until all three markets are simultaneously in equilibrium, i.e., until the IS, the LM, and the BP curves all intersect at the same point. Note: The next question is a bonus question. Therefore, I would suggest answering it only after you have answered all other questions. Do NOT run out of time by trying to answer this question before you have completed the exam! g) What are the values of Y and i at which the goods market, the money market, and the balance of payments will all be simultaneously in equilibrium? (4 marks) Bonus question: The LM curve keeps shifting up until the IS, the LM, and the BP curves all intersect at the same point. This point of intersection will represent the equilibrium for the economy as a whole, i.e., the goods market, the money market, and the balance of payments will all be simultaneously in equilibrium at this point. Therefore, this point of equilibrium is determined by the intersection of the IS and the BP curves: IS = BP 30 0.02 Y = 5 + 0.01 Y 0.03 Y = 25 Y* = 2500/3 833.3 and i* = 30 0.02 (2500/3) = 90/3 50/3 = 40/3 13.3 Page 10 of 10