Department of Economics Prof. Gustavo Indart University of Toronto July 27, 2012 SOLUTIONS ECO 209Y L0101 MACROECONOMIC THEORY Term Test #3 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 1 hour and 50 minutes. 2. Aids allowed: a simple calculator. 3. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /40 Part II 1. /10 2. /10 3. /10 4. /10 TOTAL /80 Page 1 of 9
PART I (40 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 2.5 marks. No deductions will be made for incorrect answers. 1 2 3 4 5 6 7 8 C A C C B C A E 9 10 11 12 13 14 15 16 B E C A A A C C 1. In a fixed-price model of an open economy with perfect capital mobility and flexible exchange rates, a tax cut will A) increase net exports due to a domestic currency depreciation. B) increase consumption and net exports but decrease investment. C) crowd out net exports due to a domestic currency appreciation. D) partially crowd out investment due to the interest rate increase. E) cause none of the above. 2. Consider a fixed-price model of an open economy with perfect capital mobility and flexible exchange rates, and assume that in the initial equilibrium the domestic and foreign rates of interest are equal. Now if the foreign interest rate increases by 2 percentage points and the domestic currency is expected to depreciate by 3%, then in the new equilibrium the domestic interest rate will approximately A) increase by 5 percentage points. B) increase by 2 percentage points. C) increase by 1 percentage point. D) decrease by 1 percentage point. E) increase by 3 percentage points. 3. Suppose that imports are completely insensitive to changes in the level of domestic output. Then, a decrease in the degree of capital mobility will A) increase the slope of the BP curve. B) reduce the slope of the BP curve. C) cause the BP curve to shift down if the domestic rate of interest is lower than the international rate. D) cause the BP curve to shift down if the domestic rate of interest is higher than the international rate. E) have no effect on the BP curve. Page 2 of 9
4. Consider an open economy with imperfect capital mobility and a flexible exchange rate system. If the BP curve is flatter than the LM curve, a decrease in lump-sum taxes will cause A) output to fall, the rate of interest to rise, and the exchange rate to decline. B) output, the rate of interest, and the exchange rate all to rise. C) output and the rate of interest to rise and the exchange rate to fall. D) output and the rate of interest to fall and the exchange rate to rise. E) the exchange rate to rise with no change in output and the rate of interest. 5. Consider an open economy with fixed exchange rates and perfect capital mobility. Suppose the economy is initially in a situation of internal and external balance and the government now implements expansionary fiscal policy. Which one of the following statements better describes the changes once the new equilibrium is achieved? A) The exchange rate will appreciate. B) The balance in the current account will deteriorate. C) The money supply will decrease. D) The balance of the capital account will deteriorate. E) Both output and the interest rate will increase. 6. 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. 7. Consider a small open economy with fixed exchange rates and no capital mobility. Suppose that BP = 0 in the initial equilibrium. The government now eliminates an effective import quota which it had introduced a few years ago. Which one of the following statements better describes the changes once the new equilibrium is achieved? A) Net exports will remain unchanged, but the money supply and income will both be lower. 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 higher, and income will be lower. 8. Consider an open economy with perfect capital mobility and flexible exchange rates. The economy is initially in equilibrium. Which one of the following incidents will lead to an improvement in the balance of the capital account? A) A decrease in foreign income. B) A decrease in consumer s confidence. C) An expansionary fiscal policy. D) A contractionary monetary policy. E) Both C) and D). Page 3 of 9
9. Assume that the public s currency-deposit ratio is 0.35, the banks desired reserve-deposit ratio is 0.10, and total money supply is $3,600 billion. What is the amount of high-powered money (i.e., the monetary base) if there are no excess reserves in the banking system? A) $975 billion. B) $1,200 billion. C) $1,275 billion. D) $1,350 billion. E) None of the above is correct. 10. All else equal, if people decide to hold more currency, A) the money multiplier will remain unchanged but money supply will fall. B) the monetary base and the money supply will both decrease. C) the money multiplier will increase and the money supply will expand. D) the money multiplier will decrease but the money supply will not change. E) the money multiplier will decrease but the monetary base will not change. 11. Suppose you find a $100 bill that was lost for several years under your grandmother s mattress and you deposit this money in a commercial bank. If the target reserve ratio is 20 percent, all excess reserves are always lent out, and there is no cash drain on the banking system, which one of the following statements is correct? A) The money supply will not change since the public s deposits will increase by the same amount as their currency holdings will fall. B) The money supply will increase by $400. C) The money supply will increase by $500. D) The money supply will increase by $100. E) None of the above is correct. 12. Suppose a commercial bank has a target reserve ratio of 1 percent, but has an actual reserve ratio of 0.8 percent. This bank will likely A) contract its portfolio of loans. B) allow fewer cash withdrawals by the bank s customers. C) expand its portfolio of loans. D) maintain its new, higher reserve ratio because it is more profitable. E) buy government securities from the Bank of Canada. 13. Vault cash held by commercial banks is equal to $3 million, commercial banks deposits at the Central Bank are $7 million, the monetary base is $15 million, and deposits at the commercial banks are $25 million. The money multiplier is equal to A) 2.0. B) 2.5. C) 3.0. D) 3.5. E) none of the above. Page 4 of 9
14. Suppose that households and firms always keep 20 percent of their money holdings in the form currency and that the money multiplier is 3. If the government borrows $100 million from the Bank of Canada to finance a new expenditure, the demand deposits of the public will A) increase by $240. B) decrease by $240. C) remain unchanged. D) increase by $80. E) increase by more than $80 but by less than $240. 15. 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. 16. In an open economy, the AD-curve will be flatter A) the larger the monetary policy multiplier and the smaller the fiscal policy multiplier. B) the smaller the monetary policy multiplier and the larger the fiscal policy multiplier. C) the larger both the monetary policy multiplier and the fiscal policy multiplier. D) the smaller both the monetary policy multiplier and the fiscal policy multiplier. E) the smaller the fiscal policy multiplier. Page 5 of 9
PART II (40 marks) Instructions: Answer all questions in the space provided. Each question is worth 10 marks. 1. Answer true, false, or uncertain to the following statement: In the absence of active government policy, a decrease in foreign interest rates will cause domestic output to fall, the rate of interest to rise, the balance in the current account to improve, and the balance in the capital account to deteriorate. (Show your answer with the help of a diagram and explain the economics. Marks will be given entirely for your explanation. Consider the fixed-price model of an open economy with flexible exchange rates and imperfect capital mobility.) i i 1 A BP BP i 3 C BP i 2 B IS IS IS Y 2 Y 1 Y FALSE As shown in the diagram above, the economy is initially in equilibrium at point A. Since point A is also a point on the BP curve, initially there is also external balance in the economy. The drop in i* leaves the balance in the current account unchanged but causes the balance in the capital account to improve. Therefore, at point A there is now a surplus in the external sector. Note that for the external sector to remain in equilibrium (i.e., BP = 0), the domestic interest rate must decrease by the same amount as the international rate did (so the interest rate differential would remain constant and the balance in the capital account unchanged). Therefore, all else equal, the drop in the international rate of interest will cause the BP curve to shift down to BP as shown in the diagram. But the economy is at point A and thus there is now a surplus in the external sector due to the improvement in the capital account. In other words, there is now an excess supply of foreign currency in the exchange market and thus the exchange rate depreciates (i.e., the domestic currency appreciates). The appreciation of the domestic currency causes NX to fall. The appreciation of the domestic currency will cause the balance of the current account to deteriorate by the same absolute amount as the improvement in the capital account and thus the external sector will remain in equilibrium at Y 1 (i.e., BP = 0 at Y 1 ). Graphically, the appreciation of the domestic currency causes the IS curve to shift down to IS and the BP curve to shift up back to BP. At point A, there is now equilibrium in the money market (i.e., point A is on the LM curve) and equilibrium in the external sector (i.e., point A is on the BP curve), but a situation of excess supply in the goods market (i.e., point A is above the IS curve). Therefore, Y will fall. As output starts to fall (as a result to the firms involuntary increase in inventories), the demand for money decreases and the rate of interest falls to keep the money market in equilibrium. The decrease in the rate of interest also deteriorates the balance in the capital account (i.e., an excess demand for foreign currency arises in the exchange market) and thus the domestic currency depreciates. The depreciation of the domestic currency increases NX and improves the balance in the current account to maintain equilibrium in the overall balance of payments (i.e., BP = 0). Graphically, the depreciation of the domestic currency causes the IS curve to shift up and the BP curve to shift down and this process will continue as long as Y is falling, i.e., until the excess supply in the goods market is eliminated. Therefore, graphically the adjustment path can be depicted as a movement down along the LM curve the economy always being at a point of intersection between the moving BP curve and the static LM curve (i.e., the money market and the external sector always in equilibrium). Once the BP curve shifts all the way to BP and the IS curve all the way to IS, not only the money market and the external sector continue in equilibrium but now the excess supply in the goods market is also eliminated and thus a new equilibrium for the economy as a whole is reached. This is shown at point C in the diagram above. The statement is thus false: income decreases, the rate of interest falls, the balance in the current account deteriorates (due to the appreciation of the domestic currency), and the balance in the capital account improves. Page 6 of 9
2. Answer true, false, or uncertain to the following statement: A devaluation of the domestic currency will cause the level of income to increase, the rate of interest to rise, the balance in the current account to improve, and the balance in the capital account to deteriorate. (Show your answer with the help of a diagram and explain the economics. Marks will be given entirely for your explanation. Consider the fixed-price model of an open economy with imperfect capital mobility and assume that, initially, BP = 0.) TRUE Suppose that the economy is initially in equilibrium at point A (see diagram below). The devaluation of the domestic currency increases the degree of competitiveness of domestic goods in the international market, and thus NX increases. The increase in NX causes AE to increase and the IS curve shifts to the right to IS. A situation of excess demand (i.e., AE > Y) appears in the goods market. At the initial equilibrium, the devaluation of the currency causes the balance in the current account to improve while leaving the balance in the capital account unchanged. Therefore, at point A there is now a surplus in the external sector (i.e., BP > 0 and thus the supply of foreign currency is greater than its demand). For the external sector to be in equilibrium at Y 1, the rate of interest must be lower (i.e., the balance in the capital account must deteriorate by the same amount as the balance in the current account improved). Therefore, BP would be zero at Y 1 when the rate of interest is i 2 this means that the BP curve has shifted down and goes through point B. The economy is still at point A (on the LM curve). However, since there is a surplus in the external sector and the central bank wants to keep the exchange rate at the new fixed level, the central bank will buy foreign currency. As a result, the domestic supply of money will increase and the LM curve will shift to the right to LM. Now the economy is at point B both the money market and the external sector are in equilibrium but there is an excess demand in the goods market. Note that the fall in the interest rate to i 2 causes the balance in the capital account to deteriorate by the same absolute amount as the previous improvement in the current account due to the devaluation. Now Y starts to increase to eliminate the excess demand in the goods market and the domestic rate of interest starts to rise (because of the increase in demand for real balances). The increase in the rate of interest improves the balance in the capital account and creates a surplus in the external sector, which the central bank eliminates by buying foreign currency. Therefore, the money supply increases and the LM curve shifts further to the right. This process continues as long as there is an excess demand in the goods market, i.e., until the LM curves shifts all the way to LM. Note that the money market is always in equilibrium (by assumption) and that the intervention of the central bank in the exchange market helps 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 of the (shifting) LM curve and the (static) BP curve, i.e., the adjustment path is graphically represented by a movement up along the BP curve. The statement is therefore true: the level of income rises, the rate of interest falls, the balance in the current account improves, and the balance in the capital account deteriorates. i i 1 A LM LM BP LM i 3 C BP i 2 B IS IS Y 1 Y 2 Y Page 7 of 9
3. Answer true, false, or uncertain to the following statement: An increase in autonomous exports will cause income to increase, the balance in the current account to improve, and the balance in the capital account to deteriorate. (Show your answer with the help of a diagram and explain the economics. Marks will be given entirely for your explanation. Consider the fixed-price model of an open economy with flexible exchange rates and perfect capital mobility.) FALSE The goods market, the money market, and the external sector are initially in equilibrium at Y 1 and i* (point A in the diagram). An increase in autonomous exports increases NX at each level of Y, and thus the IS shifts up to IS. The increase in NX improves the balance in the current account, i.e., BP > 0 at point A. The improvement in the balance of the current account creates an excess supply of foreign currency in the exchange market and, given the assumption of a flexible exchange rate system, the exchange rate depreciates. At point A, BP = 0 once again. Since the depreciation of the exchange rate decreases NX, the IS curve shifts down to IS. Since at Y 1 there is now an excess demand in the goods market, firms will experience involuntary decreases in inventories. Firms, therefore, will adjust production upwards. As output (Y) starts to increase, the demand for money also starts to increase and the domestic rate of interest starts to rise above i* thus improving the balance in the capital account and making BP > 0. The improvement in the balance of the capital account creates an excess supply of foreign currency in the exchange market and the exchange rate depreciates further. The depreciation of the exchange rate decreases NX further and the IS curve continues shifting down to the left. This process continues as long as an excess demand remains in the goods market, i.e., until the economy moves back to point A. At the end of the process, therefore, the equilibrium income is once again Y 1 and the rate of interest is once again equal to i*. Therefore, at the end of the process NX is the same as before, i.e., the balance in the current account has not changed. Of course, imports are greater than before due to the depreciation of the exchange rate. But exports have increased by the same absolute amount as imports and thus NX have not changed. Note that exports first increased because of the increase in autonomous exports, and then decreased as the exchange rate depreciated, but the net effect is an increase. Since the balance in the current account did not change, then we can conclude that the balance in the capital account did not change either. The statement is therefore false: the level of income, the balance in the current account, and the balance in the capital account will all remain unchanged in the new equilibrium. i LM i* A BP IS IS IS Y 1 Y Page 8 of 9
4. This year the U.S. government deficit is expected to reach $1.3 trillion, similar to the levels reached every year since 2009. What difference would it make whether this government deficit is financed by domestic investors or foreign investors? In you answer you must compare and explain the likely short-run impact of these two alternative ways of financing the government deficit on the level of output, the current account balance, and the capital account balance of the U.S. This massive fiscal deficit will have a significantly different impact on the U.S. economy depending on whether it s financed with domestic saving or with foreign savings. Let s examine the likely outcomes in both cases. Financed with domestic savings Suppose the deficit were to be financed entirely (or mostly) with domestic savings. This means that the government would be competing with the private sector for a finite amount of financial resources (domestic savings), thus causing a significant increase in the domestic rate of interest. Indeed, the domestic rate of interest (i.e., the yield of the bonds) would increase dramatically since the new issue of government bonds would require a very high coupon to entice domestic investors to buy them in the necessary quantity. This increase in the rate of interest would have a contractionary impact on aggregate demand, thus reducing to a large extent the expected expansionary impact of the fiscal deficit in other words, the crowding out effect would be significant in this case and thus Y would most likely not increase enough to lift the economy out of the recession. Since we are assuming that the fiscal deficit would be financed mostly with domestic savings, then the inflow of capital would be rather small and thus the U.S. dollar would appreciate only slightly. The small appreciation of the U.S. dollar would cause a small deterioration of the balance of current account (partly offset by the decrease in imports as a result of the fall in Y). In short, the likely impact of this alternative of deficit financing would be the continuation of the recession, a slight improvement in the capital account, and a slight deterioration in the current account. Financed with foreign savings Suppose instead that the deficit were to be financed entirely (or mostly) with foreign savings. The demand for government bonds would now be stronger since it would include foreign buyers, thus increasing the price of bonds above what it would have been under the alternative analyzed in the previous paragraph. This would cause the domestic rate of interest to be significantly lower than otherwise, i.e., the new issue of government bonds would not require a high coupon to attract investors to purchase them in the necessary quantity. The lower rate of interest would reduce any possible crowding out effect, and it might even contribute to further increase AD if the rate of interest were to be even lower than before as a result of excess liquidity (a likely outcome). Therefore, the financing of the fiscal deficit with foreign savings would allow Y to increase further and hopefully (and probably) enough to lift the economy out of the recession. Since the fiscal deficit would be financed mostly with foreign savings, then the inflow of capital would be rather large and this improvement in the capital account would contribute to strengthening the value of the U.S. dollar. The strengthening of the dollar would, in turn, contribute to the deterioration of the current account. In short, the likely impact of this alternative of deficit financing would be an important increase in the level of economic activity, a significant improvement of the capital account, and a significant deterioration of the current account. Page 9 of 9