ECO 209Y MACROECONOMIC THEORY AND POLICY

Department of Economics Prof. Gustavo Indart University of Toronto December 4, 2013 ECO 209Y MACROECONOMIC THEORY AND POLICY Term Test #2 LAST NAME FIRST NAME STUDENT NUMBER Indicate your section of the course: Monday, 2-4 L0101 Wednesday, 2-4 L0301 Tuesday, 2-4 L0201 Thursday, 2-4 L0401 INSTRUCTIONS: 1. The total time for this test is 1 hour and 45 minutes. 2. Aids allowed: a simple, non-programmable calculator. 3. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /30 Part III 1. /10 Part II /15 2. /10 3. /10 TOTAL /75 Page 1 of 12

PART I (30 marks) Instructions: Enter your answer to each question in the table below. Table cells left blank will receive a zero mark for that question. Each correct answer is worth 3 marks. Note that a deduction of 1 mark will be made for each incorrect answer. 1 2 3 4 5 6 7 8 9 10 E B C D D B C C C D 1. Consider the fixed-price model of a closed economy. Fiscal policy is more effective in increasing output when A) money demand is not very responsive to interest rate changes. B) the income tax rate is very high. C) the marginal propensity to import is high. D) the marginal propensity to save is high. E) investment is not very responsive to interest rate changes. 2. Consider the fixed-price model of a closed economy. Expansionary monetary policy is more effective in increasing output when the A) income sensitivity of money demand is large. B) interest rate sensitivity of investment is large. C) IS curve is very steep. D) LM curve is very flat. E) interest rate sensitivity of money demand is large. Use this space for rough work. Page 2 of 12

3. Consider the fixed-price model of a closed economy. Regarding its impact on equilibrium income, an increase in the marginal propensity to save will make A) fiscal policy less effective while leaving the effectiveness of monetary policy unchanged. B) fiscal policy less effective and monetary policy more effective. C) fiscal and monetary policy less effective. D) fiscal and monetary policy more effective. E) fiscal policy more effective and monetary policy less effective. 4. Consider the fixed-price model of a closed economy. When the economy is in a typical liquidity trap, expansionary monetary policy is ineffective with respect to income because A) investment is insensitive to changes in the rate of interest. B) the public already holds all the money they want. C) the real demand for money is insensitive to changes in the rate of interest. D) the public is willing to hold any amount of money being offered at the current rate of interest. E) none of the above. 5. Consider the fixed-price model of an open economy. Assume the objective of Bank of Canada policy is to keep the value of the Canadian dollar approximately fixed in terms of the U.S. dollar. This will A) increase fluctuations in domestic monetary growth. B) increase the rate of interest in Canada. C) decrease the rate of interest in Canada. D) reduce the effectiveness of monetary policy. E) cause none of above. Use this space for rough work. Page 3 of 12

6. Consider the fixed-price model of an open economy with fixed exchange rates and imperfect capital mobility. A decrease in the marginal propensity to import will cause A) equilibrium income to increase, the equilibrium rate of interest to rise, the balance in the current account to improve, and the balance in the capital account to deteriorate. B) equilibrium income to increase, the equilibrium rate of interest to fall, the balance in the current account to improve, and the balance in the capital account to deteriorate. C) equilibrium income to fall, the equilibrium rate of interest to rise, the balance in the current account to deteriorate, and the balance in the capital account to improve. D) equilibrium income to fall, the equilibrium rate of interest to fall, the balance in the current account to improve, and the balance in the capital account to deteriorate. E) none of the above. 7. Suppose that the nominal exchange rate between the U.S. dollar ($) and the Canadian dollar (CAD$) is e = 0.95 and that income per capita in Canada is CAD$38,500 while in the U.S. is $35,000. Further suppose that a constant consumption basket costs CAD$2,200 in Canada and $2,000 in the U.S. Using the purchasing power parity exchange rate (e PPP), income per capita in Canada is approximately A) $40,526. B) $42,350. C) $35,000. D) $36,575. E) none of above. Use this space for rough work. Page 4 of 12

8. Consider the fixed-price model of an open economy with 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, the money supply, and income will all be lower. B) net exports, the money supply, and income will all be higher. C) net exports will remain unchanged, but the money supply and income will both be higher. D) net exports, the money supply, and income will all remain unchanged. E) net exports will remain unchanged, the money supply will be lower, and income will be higher. 9. China is being accused by Western countries of setting the value for its domestic currency too low. All else equal, which one of the following statements might describe the impact on the Chinese economy of an undervalued Chinese currency? A) The prices of imported goods would be artificially low for Chinese consumers. B) It would reduce inflationary pressure in the economy. C) The Chinese money supply would tend to increase. D) The balance in China s capital account would improve. E) None of the above is correct. 10. Consider the fixed-price model of 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 contractionary 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 increase. D) The balance of the capital account will deteriorate. E) Both output and the interest rate will decrease. Use this space for rough work. Page 5 of 12

PART II (15 marks) Consider an open economy with fixed price level, fixed exchange rates, and imperfect capital mobility. This economy is characterized by the following equations: C = 140 + 0.8YD X = 250 + 200e I = 200 20i + 0.1Y Q = 400 100e + 0.1Y G = 300 L = 0.2Y 10i TA = 0.25Y M/P = 200 TR = 50 CF = 10 (i 7) a) As a function of i, Y and e, what are the equations for the IS, LM and BP curves? (3 marks) AE = C + I + G + NX = (140 + 0.8YD) + (200 20i + 0.1Y) + 300 + (250 + 200e) (400 100e + 0.1Y) = 490 + 300e + 0.8YD 20i where YD = Y 0.25Y + 50 = 50 + 0.75Y = 490 + 300e + 0.8(50 + 0.75 Y) 20i = 530 + 300e + 0.6Y 20i In equilibrium, Y = AE: Y = 530 + 300e + 0.6Y 20i 20i = 530 + 300e 0.4Y. And solving for i we obtain the equation for the IS curve: i = 26.5 + 15e 0.02Y. The LM curve is found from the money market equilibrium: L = M/P 0.2Y 10i = 200 10i = 200 + 0.2Y And solving for i we obtain the equation for the LM curve: i = 20 + 0.02Y. Since there is imperfect capital mobility, the equation for the BP curve is BP = NX + CF = 0, where NX = X Q = (250 + 200e) (400 100e + 0.1Y) = 150 + 300e 0.1Y and CF = 10(i 7). Therefore, BP = 150 + 300e 0.1Y + 10(i 7) = 220 + 300e 0.1Y + 10i. And if BP = 0, then the equation for the BP curve is: i = 22 30e + 0.01Y. Page 6 of 12

b) If the exchange rate is fixed at e = 0.9, what are the equilibrium values of i and Y? (2 marks) What are the balances in the current account and the capital account in this equilibrium? (1 mark) If e = 0.9, the equations for the IS and BP curves are: IS: i = 26.5 + 15(0.9) 0.02Y = 40 0.02Y BP: i = 22 30(0.9) + 0.01Y = 5 + 0.01Y. Graphically, the equilibrium combination of i and Y is found at the point of intersection of the IS, LM and BP curves. Equating just two of them will be sufficient to determine this equilibrium. Let s, for instance, equate the IS and the LM curves to find Y*: 40 0.02Y = 20 + 0.02Y 0.04Y = 60 Y* = 60/0.04 = 1500. And plugging this value for Y* in any of the curves we find the equilibrium i. Let s, for instance, plug this value for Y* on the IS curve: i* = 40 0.02(1500) = 10. The balance in the current is thus: NX = 150 + 300e 0.1Y = 150 + 300 (0.9) 0.1 (1500) = 150 + 270 150 = 30. And the balance in the capital account is thus: CF = 10 (i 7) = 10 (10 7) = 30. Note: Although not needed, you might find it helpful using a diagram when answering questions c), d) and e) below. c) Suppose now that, through an open market operation, the central bank increases the real supply of money to M/P = 250. At what rate of interest will the money market be now in equilibrium? (2 marks) Since the equation for the LM curve is i = (MM /PP )/h + (k/h)y, the value of the vertical intercept becomes now 250/10 = 25. And thus the equation for the new LM curve (i.e., curve LM ) is now: i = 25 + 0.02Y. 26.5 i LM LM BP And at Y = 1500, the rate of interest will now be: i = 25 + 0.02(1500) = 25 + 30 = 5. 10 5 IS -5 1500 Y -20-25 Page 7 of 12

d) At the rate of interest determined in part c), what will be the situation in the goods market and the external sector? Briefly explain. (1 mark) How will equilibrium in the goods market and the external be restored? Briefly explain. (1 mark) What will be the values of i and Y once equilibrium is restored in the economy? (1 mark) The decrease in the rate of interest will cause desired investment to increase and thus an excess demand will arise in the goods market (i.e., AE > Y). At the same time, the decrease in the rate of interest will cause the balance in the capital account to deteriorate and thus now BP < 0 at Y = 1500. A deficit in the exchange market will thus arise, putting pressure on the exchange rate to appreciate. Since the central bank wants to keep the exchange rate fixed at e = 0.9, it will sell foreign currency from its reserves and the money supply will decrease and the rate of interest will rise. Therefore, graphically, the LM curve will start shifting back to the left and this process will continue until it shifts all the way back to its initial position. The increase in i decreases desired investment, thus reducing the excess demand in the goods market. Therefore, Y will remain unchanged at Y* = 1500 and the rate of interest will be once again equal to i* = 10. e) Let s go back to the equilibrium of part b) above. Suppose that the central bank revalues the exchange rate to e = 1.1. What are the new equilibrium values of Y and i in this economy? (2 marks) What is the new level of M/P? (2 marks) The revaluation of e causes NX to increase and thus, at the initial level of Y, there is now an excess demand in the goods market and a surplus in the balance of payments. Graphically, the revaluation of e causes both the IS and the BP curves to shift to the right. The surplus in the exchange market prompts the central bank to buy foreign currency and the money supply increases, and thus the LM curve also shifts to the right until both the goods market and the external sector are both back in equilibrium. The new equilibrium, therefore, is graphically determined at the point of intersection of the new IS and BP curves. Let s find the equations for the new IS and BP curves. i 10 7 4 LM LM LM BP IS 1500 1800 Y From part a) above, we have that the equation for the IS curve is now: i = 26.5 + 15e 0.02Y = 26.5 + 15(1.1) 0.02Y = 26.5 + 16.5 0.02Y = 43 0.02Y. And the equation for the BP curve is now: i = 22 30e + 0.01Y = 22 30(1.1) + 0.01Y = 22 33 + 0.01Y = 11 + 0.01Y. Therefore, Y* is: IS = BP 43 0.02Y = 11 + 0.01Y 0.03Y = 54 Y* = 54/0.03 = 1800. And plugging this value for Y* into either the IS or BP curve we get the value for i*: i* = 43 0.02Y* = 43 0.02(1800) = 43 36 = 7. From part a) above we can also find that the equation for the LM curve is: i = (MM /PP )/10 + 0.02Y. And at i* = 7 and Y* = 1800, MM /PP is: 7 = (MM /PP )/10 + 0.02(1800) (MM /PP )/10 = 36 7 MM /PP = 29(10) = 290. Page 8 of 12 BP IS

PART III (30 marks) Instructions: Answer the following three questions in the space provided. Each question is worth 10 marks. 1. Critically evaluate the following statement: In a closed economy, a decrease in the income sensitivity of the demand for real balances will cause equilibrium income to fall and the equilibrium rate of interest to rise. (Show your answer with the help of a diagram and explain the economics. Assume that there is initially a recessionary gap in the economy.) A decrease in the income sensitivity of the demand for real balances means that at each level of income the demand for money will be smaller i.e., the liquidity preference curve corresponding to each level of income will shift down. Therefore, an excess supply will arise in the money market at each level of income, and thus the corresponding equilibrium interest rate will be lower which implies that the LM curve will shift down to the right (though the vertical intercept will not change). Equilibrium in the economy will thus be achieved at a lower rate of interest and higher level of income. This can be observed in the following diagram. i i1 M/P A i LM LM i2 i1 B C L(Y1) L (Y2) i2 i1 i1 B A C L (Y1) IS M/P Y1 Y2 Y Recall that the expression for the demand for real balances is L = ky hi or i = ky/h (1/h) L. Therefore, the statement indicates that k decreases and thus the liquidity preference curve corresponding to each level of income shifts down by (Y/h) k and, at the level of income Y 1, the money market is now in equilibrium at the rate of interest i 1. This means that the LM curve shifts to LM, that is, at the level of income Y 1 the money market is now in equilibrium at i 1 and thus the LM curve now goes through point B = (Y 1, i 1 ). The economy is now at point B, below the IS curve, depicting a situation of excess demand in the goods market (i.e., the interest rate is too low for the goods market to be in equilibrium). Firms start selling more than they are actually producing and their inventories start to decrease in an involuntary way which gives firms the signal to adjust production upwards. As production increases, output/income increases while the money market remains in equilibrium at all times; that is, output increases and the demand for money also increases and the rate of interest now rises this is a movement up along the LM curve. On the demand side, the increase in interest rate also decreases desired investment and this is a movement up along the IS curve. Eventually, the excess demand in the goods market is eliminated at the point where the LM curve intersect the IS curve at the level of income Y 2 and rate of interest i 2. Note that the rate of interest increases because as income rises the demand for real balances increases. A new equilibrium is achieved in the money market when the level of income increases to Y 2 and thus the liquidity preference curve rises to L (Y 2), and the equilibrium rate of interest increases to i 2. Page 9 of 12

2. Critically evaluate the following statement: A devaluation of the domestic currency will cause the level of income to increase, the rate of interest to fall, 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. Consider an open economy characterized by a fixed-price level, fixed exchange rates and imperfect capital mobility. Assume that there is a recessionary gap at the initial equilibrium.) Suppose that the economy is initially in equilibrium at point A (see diagram below). The devaluation of the domestic currency increases the international competitiveness of domestic goods, 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) emerges 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 i2 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: as equilibrium moves from point A to point C, the level of income rises to Y 2, the rate of interest falls to i 3, the balance in the current account improves (due to the devaluation), and the balance in the capital account deteriorates (due to the fall in i). LM BP i i1 A LM LM i3 C BP i2 B IS IS Y1 Y2 Y Page 10 of 12

3. Critically evaluate the following statement: In Europe and elsewhere, the implementation of government austerity measures are presently justified because: 1) you should not live beyond your means; 2) governments cannot spend money they do not have; and 3) the national debt represents an unfair burden on future generations. These three propositions are usually put forward as a justification for government austerity. However, as Robert Skidelsky points out in a recent op-ed posted on Project Syndicate (November 20, 2013), these three propositions represent three recycled economic fallacies. a) You should not live beyond your means. This seems a sensible advice on a personal basis, but it ignores the effect that such a behaviour, if generalized, will have on total demand and the economy. If all households curb their expenditures, total consumption will fall and, all else equal, the economy will go into recession. This proposition represents a fallacy of composition, i.e., the false belief that the whole is the sum of its parts and thus what is good for one individual will be good for all individuals together. This refers to what Keynes identified as the paradox of thrift. Similarly, if the government tries to cut its deficit through a decrease in government purchases, it will result in less total spending and a fall in national income. Therefore, on the one hand, both government expenditure and government revenues will fall and thus the deficit will barely shrink. And on the other hand, if all countries pursue austerity simultaneously, lower government purchases will lead to a decrease in both domestic and foreign demand, thus leaving all much worse off. b) Government cannot spend money they do not have. This fallacy treats governments as if they faced the same budget constraints as households or companies. But governments are different they can always get the money they need by issuing bonds. And increasingly indebted governments do not have to pay ever-higher interest rates: They can hold down the cost of government debt by borrowing from the central bank (i.e., quantitative easing). As Skidelsky points out, with the economy still in recession (i.e., Y* < Y fe) and with near-zero interest rates, most Western governments cannot afford not to borrow. Of course, this argument does not hold for a government without its own central bank e.g., the eurozone member states. But, in any case, fiscally responsible governments should know when to spend (i.e., get into debt) and when not to, and this is the time to spend and run deficits. And, as a recent article in The Economist reminds us, this is consistent with the views of Keynes who in 1937 wrote: The boom, not the slump, is the right time for austerity at the Treasury. c) The national debt represents an unfair burden on future generations. This fallacy is repeated so often that, as Skidelsky points out, it has entered the collective unconscious. The argument is that if the current generation spends more than it earns, the next generation will be forced to earn more than it spends to pay for it. But, on the one hand, this ignores the fact that holders of the very same debt will be among the supposedly burdened future generations. In other words, the debt is owed to ourselves and it will be paid to ourselves. Therefore, those who will have their disposable incomes reduced to pay off the debt will be worse off, while those who will have their disposable incomes increased as a result of the debt cancellation will be better off. This may be bad for the distribution of wealth and income, because it will enrich the creditor at the expense of the debtor, but there will be no net burden on future generations. On the other hand, government indebtedness to finance government investment (e.g., in infrastructure, education, health, etc.) contributes to increase the wellbeing of current AND future generations. These investment expenditures represent a net benefit to both current and future generations. Page 11 of 12

Use this space for rough work. Page 12 of 12