ECO 209Y MACROECONOMIC THEORY AND POLICY Term Test #2 December 13, 2017 U of T E-MAIL: @MAIL.UTORONTO.CA SURNAME (LAST NAME): GIVEN NAME (FIRST NAME): UTORID (e.g., LIHAO118): INSTRUCTIONS: The total time for this test is 2 hours. Manage your time properly! The only aid allowed is a non-programmable calculator. Write your name and identifying information above but keep this test paper and the Supplement closed until the start of the test is announced. There are three parts to the test: Part I consists of 14 multiple-choice questions (35 points); Part II is one numerical problem (10 points); and Part III includes 4 short-answer questions (40 points). The total point-value of the test is 85 points. This test includes 8 pages plus the Supplement. The Supplement contains the multiplechoice questions but you must record your answers to each multiple-choice question in the table provided on the next page. Anything written on the Supplement will not be graded. We will only collect the test papers, not the Supplement. In Parts II and III, write your answers clearly and concisely in the space provided immediately after each questions. Your entire answer must fit in the designated space. No extra space/pages are possible. You cannot use blank space for other questions nor can you write answers on the Supplement. Write in PENCIL and use an ERASER as needed. This way you can make sure to fit your final answer in the appropriate space. Please write legibly. If I can t read your handwriting, I can t award you any marks!
PART I (35 points) Instructions: Enter your answer to each of the 14 multiple-choice questions (see the Supplement) in the table below. Each correct answer is worth 2.5 points. Note that a deduction of 0.5 point will be made for each incorrect answer. Table cells left blank will receive zero points (i.e., no deduction). Do NOT guess your answers! Manage your time properly! 1 2 3 4 5 6 7 8 9 10 11 12 13 14 B C E B C D C E B A D D B D
PART II (10 points) Consider an open economy with exogenous money supply and flexible exchange rates. This economy is characterized by the following behavioural equations: C = 100 + 0.75 YD I = 100 20 i X = 200 + 50 e Q = 300 50 e + 0.1 Y G = 300 CF = 10 (i 5) TA = 0.2 Y L = 0.5 Y 20 i TR = 0 M/P = 400 a) What is the equation for the IS curve? (2 points) Given that YD = Y TA = Y 0.2 Y = 0.8 Y, then C = 100 + 0.75 YD = 100 + 0.75 (0.8 Y) = 100 + 0.6 Y; and given that NX = X Q = (200 + 50 e) (300 50 e + 0.1 Y) = 100 + 100 e 0.1 Y, then AE = C + I + G + NX = (100 + 0.6 Y) + (100 20 i) + (300) + ( 100 + 100 e 0.1 Y) = 400 20 i + 100 e + 0.5 Y. To find the expression for the IS curve we equate Y and AE: Y = 400 20 i + 100 e + 0.5 Y so 20 i = 400 + 100 e 0.5 Y and i = 20 + 5 e 0.025 Y
b) What are the equations for the LM and BP curves? (2 points) To find the equation for the LM curve we equate M/P and L: 400 = 0.5 Y 20 i 20 i = 400 + 0.5 Y i = 20 + 0.025 Y To find the expression for the BP curve we add NX and CF and equal it to 0: NX + CF = 0 [ 100 + 100 e 0.1 Y] + [10 (i 5)] = 0 100 + 100 e 0.1 Y + 10 i 50 = 0 150 + 100 e 0.1 Y + 10 i = 0 10 i = 150 100 e + 0.1 Y i = 15 10 e + 0.01 Y c) What are the equilibrium values of Y, i and e? (6 points) We have a system of three equations with three unknown: IS: i = 20 + 5 e 0.025 Y (1) LM: i = 20 + 0.025 Y (2) BP: i = 15 10 e + 0.01 Y (3) (1) (2) 0 = 20 + 5 e 0.025 Y + 20 0.025 Y 0 = 40 + 5 e 0.05 Y (4) (1) (3) 0 = 20 + 5 e 0.025 Y 15 + 10 e 0.01 Y 0 = 5 + 15 e 0.035 Y (5) 3*(4) (5) 0 = 120 + 15 e 0.15 Y 5 15 e + 0.035 Y 0 = 115 0.115 Y And solving for Y: Y = 115 / 0.115 = 1000 Plugging Y = 1000 into the equation for the LM curve we get: i = 20 + 0.025 (1000) = 20 + 25 = 5 And plugging Y = 1000 and i = 5 into the equation for the BP curve we get: 5 = 15 10 e + 0.01 (1000) 10 e = 5 + 15 + 10 = 20 e = 2
PART III (40 points) Instructions: Answer the following four questions in the space provided. Each question is worth 10 points. 1. Critically comment on the following statement: Fiscal austerity has emerged from the debate on the euro crisis as the main strategy to restore growth and employment. According to this view, decreasing fiscal deficits reduces interest rates and injects confidence in the private sector, freeing the basic instincts to invest and consume. Fiscal austerity refers to the decision of the government to reduce the fiscal deficit through a combination of spending cuts and tax increases (but mostly through spending cuts). The reason for doing so is based on the belief that government deficits (and the accumulated debt) reduce private sector s confidence and thus are indirectly responsible for the weak aggregate demand and the recessionary gap. But can fiscal austerity restore growth and employment? Will deficit reduction cause the rate of interest to fall? Will it help to restore the private sector s confidence in the economy? Are lower rates of interest and greater confidence what the doctor ordered to restore growth and employment? Rate of interest First of all, increases in government spending and larger fiscal deficits do not translate into higher rates of interest in recessionary periods. Here the government is not competing with the private sector for finite financial resources but rather borrowing and spending when the private sector is neither borrowing nor spending. The empirical evidence since the start of the Great Recession contradicts the proclaimed correlation between deficit and interest rates: It shows that record government deficits can co-exist with historically low rates of interest. Second, this same evidence suggests that low rates of interest, while helpful, are certainly not sufficient to restore growth and employment. Private sector confidence Private sector confidence is indeed needed for aggregate demand to increase and the recessionary gap to be erased. But private sector s confidence cannot be restored through a decrease in the government deficit. On the contrary: a decrease in G will cause the economy to move into a deeper recession, thus further reducing the confidence of the private sector. Consumers and business sector confidence must be restored to move the economy to full-employment equilibrium, but this confidence will start to be restored when there are clear signs of employment and income increasing and for this to happen autonomous AE must increase and not decrease! Therefore, what the government should do is to increase G rather than decreasing it. An increase in G will contribute, first, to prevent the level of economic activity from dropping even lower and, second, to start restoring confidence in the economy and creating the conditions for further expansion. As emphasized in class, increases in G will not move the economy to full employment. The economy will move to full-employment as a result of both C and I recovering their previous levels and beyond. But the latter requires consumer and business confidence to be restored, and this will not happen by itself. It will not be the outcome of what Krugman calls the confidence fairy. It needs something to trigger this change, and this something is the initial increase in Y resulting from expansionary fiscal policy.
2. Critically evaluate the following statement: If the U.S. drops out of NAFTA and imposes tariffs on Canadian goods, Canada s equilibrium income will fall, its equilibrium interest rate will rise, its capital account will improve, and its current account will deteriorate. (Show your answer with the help of a diagram and explain the economics. Consider the fixed-price level model of an open economy with fixed exchange rates and imperfect capital mobility.) i i1 LM B LM LM BP i2 C BP i1 A IS IS Y2 Y1 Y The economy is initially in equilibrium at point A (see diagram). The imposition of tariffs on Canadian goods decreases NX, and thus the IS shifts to IS. The decrease in NX deteriorates the balance in the current account (i.e., now BP < 0 at point A), and thus BP = 0 now at a higher rate of interest i.e., the BP curve shifts up to BP. The decrease in NX creates an excess supply in the goods market (AE < Y). In addition, the decrease in exports deteriorates the balance of the current account and creates an excess demand for foreign currency in the exchange market. Under a fixed exchange rate system, the central bank sells foreign currency to eliminate the excess demand in the exchange market and the money supply decreases. The LM curve thus shifts up to LM. The decrease in the money supply increases the rate of interest to i1, which causes the balance in the capital account to improve thus offsetting the previous deterioration in the current account. The economy is now at point B there is equilibrium in the money market and the external sector, but an excess supply in the goods market. Since at Y1 there is an excess supply in the goods market, firms experience involuntary increases in inventories and adjust production downwards. As Y decreases, the demand for money also falls and the domestic rate of interest decreases thus worsening the balance in the capital account and making BP < 0. The central bank sells foreign currency to eliminate the excess demand in the exchange market and the money supply decreases and the LM curve shifts up to the left. This process continues as long as an excess supply remains in the goods market, i.e., until the economy gets to point C. At the end of the process, the continuous decrease in M/P causes the LM curve to shift to LM and equilibrium income to decrease to Y2 (and the rate of interest to rise to i2). Note that the money market is always in equilibrium (by assumption) and that the intervention of the central bank in the exchange market contributes to maintaining equilibrium in the external sector at all times as well. Therefore, during the process of adjustment, the economy is always at a point of intersection between the (shifting) LM curve and the (static) BP curve. Therefore, the adjustment path is represented by a movement down along the BP curve. The statement is therefore true: the level of income decreases (to Y 2), the rate of interest increases (to i 2), the balance in the current account deteriorates (due to the decrease in exports), and the balance in the capital account improves (due to the increase in i).
3. Critically evaluate the following statement: If, due to greater uncertainty, Canadian investors choose to invest more in the U.S., then Canada s output will fall, its rate of interest will decrease, the balance in its capital account will improve, and the balance in its current account will deteriorate. (Show your answer with the help of a diagram and explain the economics. Consider the model of an open economy with a fixed-price level, flexible exchange rates, and imperfect capital mobility.) LM BP BP i1 i2 B BP i1 A IS IS Y1 Y2 Y The economy is initially in equilibrium at point A (see diagram). Canadian investors greater preference to invest in the U.S. implies a deterioration in the capital account and thus at point A there would be now a deficit in the external sector (i.e., BP < 0). Therefore, assuming for the time being no change in the exchange rate, the domestic rate of interest should be i 1 for the external sector to be in equilibrium (i.e., the BP curve would shift up to BP ). However, since the economy is at point A and there is a deficit in the balance of payments, the Canadian dollar will depreciate and the balance in the current account will improve (i.e., NX will increase) by the same absolute amount as the deterioration in the capital account. The depreciation of the Canadian dollar will cause both the BP and IS curves to shift. Indeed, the BP curve will shift back to BP and thus the external sector will now be again in equilibrium at point A while the IS curve will shift up to IS. At point A there is now equilibrium in both the money market and the external sector, but an excess supply in the goods market due to the increase in NX. Therefore, Y will increase as firms inventories fall and they adjust production upwards. The demand for money increases as Y rises, and thus the rate of interest also rises. Since the money market is always in equilibrium by assumption, the adjustment process is represented by a movement up along the LM curve. As the rate of interest rises, the balance in the capital account improves. This contributes to the appreciation of the Canadian dollar (thus recovering some of the lost ground) and now NX starts to fall. Therefore, both the BP curve and IS curve shift. The BP shifts gradually upwards as the Canadian dollar gradually appreciates, and thus the economy is always at a point of intersection between the static LM curve and the shifting BP curve i.e., the money market remains always in equilibrium (due to changes in i) and so does the external sector (due to changes in e) while the excess demand in the goods market is reduced as Y increases. The IS curve also gradually shifts down as NX gradually decreases (as e falls) and thus the excess demand in the goods market is reduced by both an increase in Y and a decrease in AE. This process continues until the excess demand in the goods market is eliminated and thus the money market, the external sector, and the goods market are all simultaneously in equilibrium (point B in the diagram). The statement is thus incorrect: while the balance in the capital account will improve and the balance in the current account will deteriorate, the level of output and the rate of interest will both rise. IS
4. Consider a small open economy with a fixed-price level, flexible exchange rate, and imperfect capital mobility. Suppose that an increase in government spending resulted in a large budget deficit. What difference would it make if this government deficit were financed either entirely by domestic investors or entirely by foreign investors? (In you answer you must compare and explain the likely shortrun impact that these two alternative ways of financing a government deficit would have on the rate of interest, level of output, current account balance, and capital account balance.) The impact of this fiscal deficit on the economy will differ greatly depending on whether it s financed with domestic saving or with foreign savings. Let s examine the likely outcomes in both cases. Deficit financed with domestic savings Suppose the deficit is financed entirely by domestic investors, i.e., with domestic savings. This means that the government will be competing with the private sector for a finite amount of financial resources (domestic savings), thus causing an increase in the domestic rate of interest. Indeed, the domestic rate of interest (i.e., the yield of the bonds) will increase since the new issue of government bonds will require a higher coupon to persuade domestic investors to purchase them in the needed quantity. This increase in the rate of interest will have a contractionary impact on aggregate demand, thus reducing to some extent the expected expansionary impact of the fiscal deficit in other words, the crowding out effect will be rather significant in this case. Since we are assuming that the fiscal deficit is financed entirely with domestic savings, then there will be no significant change in the balance of the capital account and thus there will be no significant pressure on the domestic currency to appreciate or depreciate. Therefore, neither the balance in the capital account nor the balance in the current account will be affected to any significant extent (though the current account will somehow deteriorate because of higher imports due to the increase in Y, and the capital account will somehow improve due to higher i). In short, the likely impact of this alternative of deficit financing will be an increase in the rate of interest (and thus a partial crowding out effect), an increase in the level of output, and no significant change in the balances of the capital and current accounts. Deficit financed with foreign savings Suppose instead that the deficit is financed entirely by foreign investor, i.e., with foreign savings. The demand for government bonds will now be stronger since it includes foreign buyers, thus increasing the price of bonds above what it would have been under the alternative analyzed in the previous paragraph. Therefore, the domestic rate of interest will be lower than in the case above, i.e., the new issue of government bonds will not require as high a coupon to attract investors to purchase them in the necessary quantities. The lower increase in the rate of interest will reduce any crowding out effect compared to the previous case. However, the inflow of capital will improve the balance of the capital account and will cause the domestic currency to appreciate. The appreciation of the currency will, in turn, contribute to the deterioration of the current account, i.e., NX will decrease. Therefore, there will be a crowding out effect but of a different sort: instead of a significant decrease in I (and/or C) due to higher i, the increase in G will cause NX to fall due to the decrease in e. In short, the likely impact of this alternative of deficit financing will be a smaller increase in the rate of interest, an increase in the level of output, an improvement in the balance of the capital account, and a deterioration in the balance of the current account.
ECO 209Y MACROECONOMIC THEORY AND POLICY Term Test #2 December 13, 2017 INSTRUCTIONS: Read these instructions but keep this Supplement closed until the start of the test is announced. This Supplement contains the test s multiple-choice questions but you must record your answers to each of the 14 multiple-choice questions in the table provided on page 2 of the test paper. Anything written on this Supplement will not be graded. We will only collect the test papers, not the Supplement. Each correct answer is worth 2.5 marks. Note that a deduction of 0.5 mark will be made for each incorrect answer. Table cells left blank will receive a zero mark (i.e., no deduction). Do NOT guess your answers! The only aid allowed is a non-programmable calculator. Page 9 of 12
1. Consider the fixed-price-level model of a closed economy. The short-run impact of an increase in autonomous investment will be to A) lower the interest rate and increase savings. B) raise the interest rate and increase savings. C) lower the interest rate and decrease savings. D) raise the interest rate and decrease savings. E) raise the interest rate but leave savings unchanged. 2. Consider an open economy with a fixed price level, fixed exchange rates and perfect capital mobility. Which of following events will NOT cause the position of the LM curve to change in the new equilibrium? A) An increase in foreign income. B) A rise in the foreign rate of interest. C) The Central Bank sells bonds. D) A revaluation of the exchange rate. E) The government cuts its spending. 3. Consider an open economy with a fixed price level, flexible exchange rates and perfect capital mobility. If government purchases decrease, which one of the following best describes the impact on the equilibrium values of output, interest rate, and exchange rate? A) Output, interest rates, and the exchange rate will all decrease. B) Output and interest rates will decrease, but the exchange rate will rise. C) The exchange rate and the level of output will fall, but the interest rate will remain unchanged. D) Output will rise and the exchange rate will fall while the interest rate will remain unchanged. E) The exchange rate will rise, but the level of output and the interest rate will both remain unchanged. 4. Consider an open economy with a fixed price level, flexible exchange rates and imperfect capital mobility. If the money supply decreases, which one of the following best describes the impact on the equilibrium values of output, interest rate, and exchange rate? A) Output, the interest rate and the exchange rate will all fall. B) Output and the exchange rate will both fall, while the interest rate will rise. C) Output will fall, while the interest rate and the exchange rate will both rise. D) Output, the interest rate and the exchange rate will all rise. E) Output will rise while the exchange rate and the interest rate will both fall. 5. China has been accused by Western countries of setting the value for its domestic currency too low in the past. All else equal, which one of the following statements might describe the impact of an undervalued domestic currency on the Chinese economy? A) The prices of imported goods would be artificially low for Chinese consumers. B) Inflationary pressure would be reduced in the Chinese economy. C) The Chinese money supply would tend to increase. D) China will experience greater capital inflows. E) None of the above is correct. Page 10 of 12
6. Suppose the domestic interest rate is 15%, the foreign interest rate is 11%, and the exchange rate is expected to appreciate by 3%. All else equal, what is the investors expected rate of return differential? A) 7% in favour of the home country. B) 4% in favour of the foreign country. C) 1% in favour of the foreign country. D) 1% in favour of the home country. E) Need more information to answer this question. 7. Consider an open economy with a fixed price level, fixed exchange rates, and imperfect capital mobility. If the central bank revalued the exchange rate (i.e., devalued the domestic currency), which one of the following would be true in the new equilibrium? A) Both the IS and BP curves would shift up, while the LM curve would shift down. B) Both the IS and BP curves would shift down, while the LM curve would shift up. C) The IS curve would shift up, while the LM and BP curves would shift down. D) The IS, LM and BP curves would all shift up. E) None of the above is true. 8. Consider an open economy with a fixed price level, fixed exchange rates, and perfect capital mobility. Which one of following events will cause a positively-sloped LM curve to shift down in the new equilibrium? A) A decrease in foreign income. B) A rise in the foreign rate of interest. C) The Central Bank buys government bonds in the open market. D) A devaluation of the exchange rate. E) An increase in government spending. 9. 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) $19,200. C) $35,250. D) $120,000. E) none of the above. 10. 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. E) Not enough information to determine the shape of the BP curve. Page 11 of 12
11. In an IS-LM-BP model with flexible exchange rates and perfect capital mobility, contractionary fiscal policy will cause: A) a depreciation of the exchange rate. B) the IS curve to shift down and then the LM curve to shift up. C) a decrease in investment. D) an increase in net exports. E) output to fall while leaving the interest rate unchanged. 12. Consider a small open economy with a fixed price level, fixed exchange rates, and no capital mobility. If the government imposes an import quota, which one of the following describes its impact in the new equilibrium? A) Net exports, the money supply, and income will all remain unchanged. B) Net exports, the money supply, and income will all decrease. C) Net exports, the money supply, and income will all increase. D) Net exports will remain unchanged, but the money supply and income will both increase. E) Net exports will remain unchanged, the money supply will decrease, and income will increase. 13. Third-quarter data recently released by Statistics Canada shows a significant increase in Canada s current account deficit as a result of a fall in net exports. At the same time, the data shows an increase in the capital account surplus due to greater foreign investment in Canadian securities. Which one of the following statements best explains these outcomes? A) A current account deficit needs to be financed with foreign savings which explains the surplus in the capital account. B) A greater inflow of capital causes the currency to appreciate which explains the decrease in net exports. C) The Bank of Canada s increase in the overnight rate of interest caused exports to fall which explains the increase in the current account deficit. D) The increase in the rate of interest caused the domestic production of goods and services to contract, thus fueling imports which explains the decrease in net exports. E) The rapid expansion of Canadian income caused imports to rise which explains the increase in the current account deficit. 14. The U.S. senate recently approved a cut in the corporate tax rate from 35 to 20 percent. Which one of the following statements best describes the likely impact of such a tax cut? A) It will encourage businesses to hire more workers and offer higher wage. B) It will increase corporate after-tax profits and thus investment will rise. C) It will increase aggregate demand and thus investment will rise. D) It will increase shareholders income and management compensation but will not stimulate investment. E) Both A) and B) are correct. Page 12 of 12