Download Section A --- CHOOSE THE BEST ANSWER: (40 marks)

2002-2003 macroeconomics(paper II) mock exam
S703mockP2.DOC
Section A --- CHOOSE THE BEST ANSWER: (40 marks)
1.
A.
B.
C.
D.
An expansionary fiscal policy will be less effective if
the country has a low marginal propensity to import.
interest rates are rigid due to institutional and legal restrictions.
there is considerable unemployment.
households respond to a temporary rise in disposable income by reducing their marginal propensity to
consume.
D
2. Consider the following information about a hypothetical economy:
I = 10 - 100 r
I = investment
S = 0.15Y
r = interest rate
Md = 100 + 0.4Y - 500 r
S = saving
Ms = 100
Y = income
Md = demand for money
Ms = money supply
What can be said about the economy when Y = 100 , r = 8% ?
A. There is an excess supply in the money market.
B. There is an excess supply in the product market.
C. There is an excess demand in the money market.
D. There is an excess demand in the product market.
B
3. Which of the following will contract the money supply in Hong Kong ?
1) a decline in public confidence in the banks
2) the Hong Kong Bank takes over all other banks
3) a balance of payments deficit under the linked exchange rate system
A. 1) and 2) only
B. 1) and 3) only
C. 2) and 3) only
D. All 1) , 2) and 3)
B
4. Refer to the diagram below :
S = Saving
I = Investment
G = Government Expenditure
Y = National Income
Which of the following statements is INCORRECT ?
A.
B.
C.
D.
The expenditure multiplier will decrease.
The IS curve will shift to the right.
The average propensity to save will increase.
There will be a rise in realized injection.
A
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5.
In the above diagram, PQ is the amount of ______ and RS is the amount of ______.
A. dissaving ; inventories piled up in the current year.
B. dissaving ; saving
C. past inventories sold ; saving
D. past inventories sold ; inventories piled up in the current year
C
6. The steeper the IS curve is,
1) the more effective the fiscal policy will be.
2) the less effective the fiscal policy will be.
3) the more effective the monetary policy will be.
4) the less effective the monetary policy will be.
A. 1) and 3) only
B. 1) and 4) only
C. 2) and 3) only
D. 2) and 4) only
B
7. If an economy is characterized by a higher marginal propensity to import, then its expenditure
multiplier would be _____, and an expansionary fiscal policy would be ____, other things being equal.
A. smaller ; more effective
B. smaller ; less effective
C. larger ; more effective
D. larger ; less effective
B
8. Other things being equal, which of the following will cause the velocity of the circulation of money to
rise ?
A. an increase in the supply of money.
B. a decrease in the rate of interest.
C. a fall in the general price level.
D. a switch from a monthly to a weekly payroll.
D
9. Which of the following are examples of built-in stabilizers ?
1) the recurrent expenditure on education
2) the unemployment allowance
3) the allowance for the aged
4) the progressive tax system
A. 1) and 2) only
B. 1) and 3) only
C. 2) and 4) only
D. 3) and 4) only
C
10. The existence of a deflationary gap indicates that
1) the equilibrium income is below the full employment income.
2) a surplus budget should be used to eliminate the gap.
3) the economy has insufficient aggregate demand to achieve full employment.
4) the real income is smaller than the nominal income.
A. 1) and 3) only
B. 1) and 4) only
C. 2) and 3) only
D. 2) and 4) only
2
A
11. For a vertical IS curve and an upward sloping LM curve, an increase in the autonomous consumption
expenditure and a simultaneous decrease in the money supply will lead to ____ in the interest rate
and
_____ in national income.
A. an increase ; no change
B. a decrease ; no change
C. an increase ; an increase
D. no change ; no change
C
12. Given that the velocity of the circulation of money and the real output remain unchanged, an increase
in the money supply will
A. decrease the nominal rate of interest.
B. decrease the inflation rate.
C. increase the real rate of interest.
D. increase the price level.
D
13. According to the equation of exchange, if the money supply is fixed at a time when both the nominal
and the real income are increasing, we can conclude that
A. full employment is achieved.
B. the unemployment rate is rising.
C. the velocity of the circulation of money is falling.
D. the velocity of the circulation of money is rising.
D
14. Consider a closed economy with expenditure given by :
C = 1000
C : consumption
I = 400
I : investment
G = 200
G : government expenditure
Ta = 100
Ta : Tax
Tr = 50
Tr : Transfer Payment
The gross national product (G.N.P.) of the economy is
A. 1450
B. 1500
C. 1550
D. 1600
D
Study the following balance sheet of a banking system and answer the following successive two (items 15
& 16) questions :
Assets ($)
Reserves
4000
Loans
3000
Investments 1000
Liabilities ($)
_____
Demand deposits 8000
15. Suppose the banking system has $ 2000 excess reserves. When the central bank buys $ 2000 worth
of government bonds from the non-bank public, the excess reserves of the banking system would
increase by
A. $ 0
B. $ 1000
C. $ 1500
D. $ 2000
C
16. If the banks engage in credit creation after the purchase of government bonds by the central bank,
which of the following statements will be TRUE ?
1) The maximum amount of demand deposits will be $24 000 .
2) The loans will increase.
3) The excess reserves will decrease.
A. 1) and 2) only
B. 1) and 3) only
C. 2) and 3) only
D. All 1) , 2) and 3)
D
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17. The Quantity Theory of Money is
A. always true because total expenditure are always equal to total output.
B. valid because the price level is rigid in the short run.
C. valid because it is an identity.
D. None of the above.
D
18. Assume the presence of a natural rate of unemployment.
A. This indicates there is a loss in economic efficiency.
B. There will be a downward pressure on nominal wages.
C. This indicates the presence of search activities in the labour market.
D. This indicates there is insufficient aggregate demand.
C
19. A labour retraining programme can help to reduce
A. search unemployment.
B. frictional unemployment.
C. structural unemployment.
D. cyclical unemployment.
C
20. Which of the following will lead to a decrease in the rate of unemployment ?
A. a decrease in the money supply.
B. an increase in unemployment benefit.
C. an unexpected increase in the inflation rate.
D. an increase in the income tax rate.
C
21. If the assets and liabilities of four persons are listed as follows, who will gain most from an unanticipated
inflation?
Mr. A
Mr. B
Mr. C
Mr. D
Monetary Assets
$100
$100
$100
$100
Monetary Liabilities
100
50
150
200
Real Assets
200
250
250
220
Real Liabilities
400
300
200
100
A. Mr. A
B. Mr. B
C. Mr. C
D. Mr. D
D
22. A country's terms of trade will worsen when
A. the volume of imports increases faster than the volume of exports.
B. the value of total imports has risen relative to the value of total exports.
C. the ratio of export price to import price rises.
D. trading partners revalue their currencies.
D
23. The Purchasing Power Parity Theory implies that
A. domestic inflation will be reflected in exchange rate movements.
B. short term movements in exchange rates will not be affected by expectations.
C. the existence of transaction costs tends to hinder exchange rate movements.
D. the exchange value of a currency goes in the same direction as its domestic interest rates.
A
24. The major difference between a quota and a tariff on imports lies in their effects on
A. wealth redistribution.
B. domestic production.
C. domestic consumption.
D. the price level.
A
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25. A 10% appreciation in the value of a country's currency causes the volume of its imports to change by
10% and the volume of its exports to change by 15%. The overall effect of these changes on this
country will be :
A. its balance of payments will be 5% worse than before.
B. its marginal propensity to import will fall.
C. its terms of trade will be worse.
D. its balance of trade will be worse.
D
26. Refer to the following diagram about a country :
AB = pre-trade consumption possibility curve
AC = post-trade consumption possibility curve
Which of the following statements about the country are correct ?
1) Trade allows consumption to go beyond its production possibility curve.
2) It has a comparative advantage over its trading partner in the production of X.
3) The cost to its trading partner of producing 1 Y is higher than 1.5 X.
A. 1) and 2) only
B. 1) and 3) only
C. 2) and 3) only
D. All 1), 2) and 3)
B
27. Which of the following are claimed to be advantages of a flexible exchange rate system when
compared with a fixed exchange rate system ?
1) The influence of market forces prevents speculative pressures against a country's currency.
2) A government can pursue an independent monetary policy unaffected by the balance of payments
problem.
3) Floating exchange rates are not influenced by non-trade factors such as interest rates.
4) Automatic adjustments in exchange rates correct a balance of payments disequilibrium.
A. 1) and 2) only
C. 2) and 4) only
C
B. 1) and 3) only
D. 3) and 4) only
28. The following are the items in the balance of payments account of a country.
Items
$ billion
Imports
500
Exports
300
Interest receipt
30
Overseas investment by domestic companies
65
Foreign investment in the country
30
Fall in reserves
50
The amount that the country has to borrow to balance the account is
A. $ 85 billion
B. $ 155 billion
C. $ 185 billion
D. $ 255 billion
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B
29.
In the above diagram, AA and BB are the production-possibility frontiers of Countries A and B,
respectively.
A. Country A will not trade with Country B.
B. Country A will export Good X to Country B.
C. Country B has a comparative advantage in the production of Good X.
D. Country B has an absolute advantage over Country A in the production of Good Y.
C
30. Which of the following CANNOT reduce a balance of payments deficit?
A. the imposition of import quotas
B. wages rise faster than productivity
C. an increase in domestic interest rates relative to those abroad
D. increased productivity in import-substituting industries
B
Section B : (40 marks)
B1. “When investment exceeds saving, national income will rise.”
“Actual investment always equals to actual saving. ”
How can both statements be true ? Explain.
(8 marks)
Suggested Approach to B1
The first sentence refers to the planned saving may not equal to planned investment. When they are
equal, the economy is expected to be in equilibrium.
(2 marks)
It is due to the difference between ex-ante and ex-post variables. When ex-ante investment exceeds
planned saving, there will be an unintended inventory dis-investment which is a signal to producers
to step up their production so that income will rise. Firms will adjust its production level
correspondingly and national income changes to reach at equilibrium
(3 marks)
However, in ex-post sense, actual saving must always equal to actual investment as observed.
Increase in inventory counted as unplanned inventory investment ; and the reverse holds.
Both statements can be correct as the terms investment & saving used in the two statements have
different specific meanings.
(3 marks)
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(4 marks)
B2. (a) Explain why the LM curve is upward sloping.
(b) Explain how the LM curve be affected by an increase in the money supply in the presence of a
liquidity trap.
(4 marks)
Suggested Approach to B2:
(a) An increase in national income, Y (holding Ms and r unchanged), this leads to an increase in
transaction demand for money, Mt. Then rate of interest will be raised as an excess demand for
money (Md>Ms) created. In order to restore the money market equilibrium, asset demand of
money, Ma, falls as interest rate is up.
Thus, there is a positive relationship between the r and Y. The two variables move in the same
direction in maintaining money market equilibrium.
(4)
(b) In the presence of a liquidity trap, LM curve is horizontal. Any increase in Ms will be absorbed
by the public without reducing the interest rate. Any effort to increase in the Ms has no effect on the
LM curve. (4)
B3. Consider the following economic model :
C = 30 + 0.9 Y
C = consumption expenditure
I = 10
Y = income
G = 10
I = investment expenditure
X = 70
X = exports
M = 10 + 0.1 Y
M = imports
(a) Find the equilibrium level of income and the corresponding trade balance.
(4 marks)
(b) Supposing exports increase by one unit, explain the impact of this on income and trade balance.
(4 marks)
Suggested Approach to B3:
(a) At equilibrium, Y = E = C+I+G+X-M =30+09Y+10+10+70-10-0.1Y,
2Y=110, Y=550
Trade Balance = X- M =70 – (10+0.1*550) = 70 – 65 = 5 ;
(4 marks)
(b) Multiplier is 1/(1 – c + m) = 1/(1 – 0.9 + 0.1) = 1/0.2 = 5
Therefore, a unit increase in export will increase income by 5 units. So, the new equilibrium
income will 550+5=555. The new trade balance will be (70 +1) – (10 + 0.1*555) = 5.5
Therefore, trade balance will be increased by 0.5
(4 marks)
B4. (a) Explain how the sale of government bonds by the central bank to the public affects the money
supply.
(4 marks)
(b) Use the equation of exchange to explain how prices can increase even if the money supply is
reduced.
(4 marks)
Suggested Approach to B4:
(a) When the central bank sells govt bonds to the public, buyers have to pay the govt either in the
form of cash or cheques. The amount of deposits in banks reduces immediately by the amount
of the govt bonds sold. Assume that banks hold no excess reserves, they have to recall back the
loans. Their lending as well as credit creation ability will be reduced. Sales of govt bonds will
reduce the money supply. (4 marks)
(b) Equation of exchange is an identity : MV = PY, where M is nominal money supply, V is velocity
of money circulation, P is the level of price and Y is real output. We can use it to predict
inflation if assumption is made.
The equation of exchange is an identity which states the total volume of transactions (MV) in an
economy equals nominal income (PY). Since it is an identity, any change on one side of the
equation must be accompanied by the same % change on the other side in the same direction.
When the M decreases by 10%, the P will fall by the same % if V and Y are constant. However,
there is no such assumption has been made the equation of exchange. Therefore if we assume V
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to be constant, 10% fall in M implies a rise in the price level if Y drops by more than 10%. We
can also assume constant Y, then 10% fall in M can lead to a rise in P if V rises by more than
10%. (4 marks)
B5. 'The classical Quantity Theory of Money is a theory of full employment.' Do you agree ?
Explain your answer.
(8 marks)
Suggested Approach to B5:
I agree.
According to the classical Quantity Theory of Money, MV=PY, where M is nominal money supply,
V is velocity of money circulation, P is the level of price and Y is real output. In the short run, V is
assumed to be constant as subject to the non-adjustment of the institutional arrangement. (3 marks)
Suppose in the first period, M remains unchanged, and so do to the P and Y. During the next period,
suppose M rises by, say 6% unexpectedly, and P only rises by 5%. The figures for unemployment
actually roughly reflect the real Y level. A 1% fall in unemployment indicates roughly a 1% rise in
real output, so that the equation of exchange is balanced according to the Quantity Theory of
Money.
Alternatively, it can be illustrated by the short run Phillips Curve.
(3 marks)
However, in the long run, as the people will be no longer fooled by the sudden change in the
quantity of money supply (if they do correctly anticipate the change in money supply), the long run
Phillips Curve will be vertical with the x-intercept as the natural unemployment rate. (2 marks)
Section C: (40 marks)
C6. Consider the following balance sheet of a banking system.
Reserves
Loans
Assets ($)
Liabilities($)
1000 Deposits
5000
4000
(a) Suppose the public does not hold any cash and deposits all cash into the banking system and the banks
are fully loaned up. What is the required reserve ratio of the banks ? What is the money supply? (3 marks)
(b) Now suppose the public needs to hold some cash and hence draws cash from the banks.
( i ) Explain whether the money supply would increase or decrease if the required reserve ratio
remained unchanged.
(3 marks)
( ii ) Suppose the public holds $1 cash for every $10 deposit and the government revises the required
reserve ratio to 0.1. Find the new money supply.
(4 marks)
Suggested Approach to C6:
(a) Money supply equals to the total deposits in the banking system, which is 5000; and the
Required Reserve Ratio (RRR) = 1000/5000 = 0.2
(3 marks)
(b) (i) The Money supply will fall because when customers withdraw deposits from banks, reserves
and deposits would drop by the same amount. As a result, reserves fall short of the required ones.
To meet the minimum reserve requirement, banks have to call back loans. This process goes on as a
reverse credit contraction (or creation in the opposite direction) . Since the banking multiplier is 5,
the maximum amount of decrease in deposits and hence the money supply will decrease by 5.
(3 marks)
(ii) When 10% of total deposit is held in the form of cash, reserves will drop by 500. However, the
RRR also drops from 0.2 to 0.1, no banks will face problems in meeting the minimum reserve
requirement. Therefore, banks do not have to call back loans and there is no effect on total deposit.
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Money supply = deposits in the banking system + cash held by the public = 5000+500=$5500.
(4 marks)
C7. An economic turmoil was experienced by the Asian countries in the past few years. Most of the
Asian currencies, except Renminbi (Rmb, the currency of People‘s Republic of China) and Hong
Kong dollar, had been depreciated or devaluated against US dollar in the period.
(a) What is the difference between “depreciation” and “devaluation” of a country‘s currency. (2 marks)
(b) Explain why and how a “depreciation” or “devaluation” will reduce a country‘s trade deficit.
Under what condition will this measure be effective ?
(5 marks)
(c) State the economic consequence if China were to declare devaluation of Rmb whilst Hong Kong
dollar remains its strength against US dollar under the linked exchange rate system of 7.8 pegged
to 1 US dollar.
(7 marks)
Suggested Approach to C7:
(a) Depreciation refers to the lowering in exchange value with other currencies in the exchange
market under floating exchange rate system.
Devaluation ---declared by the government under fixed exchange rate system.
(2
marks)
(b) By devaluation or through depreciation, the external value of a currency falls in foreign
exchange market. The export prices become more competitive in foreign countries and the import
prices of other countries' products become higher. Hence the external balance will be improved.
The effectiveness depends upon the exchange rate elasticity of demand of exports abroad (e) and
the exchange rate elasticity of demand for imports (e*). If e + e* > 1 ==>effective ;
If e + e* = 1 ==>unchanged ;
If e + e* < 1 ==> external deficit worsen .
(5 marks)
(c) The export volume of Chinese products to US and other foreign markets will be increased.
Those investors from H.K. in China, e.g. in the Pearl River Delta regions, will be benefit and the
volume of re-exports will be increased too. Thus H.K.‘s income in turn will be favoured .
However, the import goods will become more expensive and the terms of trade worsen.
The relative strength of change in export value and import value actually depends on the elasticities
of demand of export goods and import goods. The trade balance is favourable if both demands are
price elastic and reverse if both demands are price inelastic.
(4 mks)
However, the immediate impact is our tourist revenue will be hurt as visitors will find it more
expensive to travel H.K. than other Asian countries. It is also less attractive to foreign investors to
put their money here. Capital inflow decreases and capital outflow prevails. Thus H.K.‘s B.O.P.
will be unfavourable. Then, interest rate will be high under the pegged rate of 7.8 and economic
recession is possibly resulted. (3 mks)
(total 7 marks in (c))
C8. A small open economy has experienced a short-term favourable balance of payments as a result of an
increase in aggregate demand in real sector. Suppose a floating exchange rate system is adopted.
Use the IS-LM model to
(a) show how the external balance of payments surplus arises, and
(4 marks)
(b) show the likely effect on the economy.
(4 marks)
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Suggested Approach to C8:
(a)
I'
r
r1
M
I
ro
L
S
Yo
Y1
s' (Export, C, I, G
=>r
==>capital inflow
Y
At original position of Yo and ro, both internal and external equilibria are attained.
Then suppose real sector booms (either one or both of X-M, C, I, G increased), IS shifts to the
right position as I'S'. . Net export induces current balance more favourable.
Income rises to Y1 and interest rate up to r1. Since r1 is higher than r0, then, influx of capital is
likely to occur in the short run.
Hence, a short-term surplus of B.O.P. is experienced.
(4 marks)
(b) Since a floating rate of exchange is adopted, appreciation is likely to occur in the foreign
exchange market as a result of in (a), as higher import demanded with higher income Y and influx
of capital bidding up exchange value of local currency with others.
Then after appreciation, net exports and consumption decrease and it brings down the r and Y.
Capital inflow will become less. The original equilibria will be eventually restored. (4 marks)
C9.
(a) What is meant by 'crowding out' effect?
(3 marks)
(b) Explain how the degree of 'crowding out' depends on
(i) the interest elasticity of the demand for money; and
(ii) the interest elasticity of investment.
(5 marks)
Suggested Approach to C9:
(a) 'Crowding out' effect means when the govt practices an expansionary fiscal policy , the
increased spending will push up the level of interest rate, given a fixed Ms. Higher rate of
interest will dampen investment, deterring income to rise by its full multiplier. To the most
extreme, all investment will be crowded out and the income will stay unchanged as it implies
public expenditure is totally substituted for private investment. Thus, fiscal policy is rendered
totally ineffective.
(3 marks)
(b) (i) The degree of 'crowding out' depends on the interest elasticity of the demand for money.
If money demand is interest elastic, i.e. the elasticity is large its absolute value, the LM curve
will be flat. Then, even a negligible increase in interest rate is capable of releasing a large fund
of idle money. Crowding out effect is insignificant. To the extreme, Md is perfectly elastic. And,
vice versa.
(ii) The degree of 'crowding out' depends on the interest elasticity of investment.
If the interest elasticity of investment is very large ( interest elastic), the IS curve will be flat.
Even a very small rise in the interest rate will crowd out substantial amount of investment. To
the extreme, investment is perfectly elastic, the IS curve will be horizontal. There will be 100%
crowding out effect. On the contrary, if the investment is interest-inelastic, the IS will be steep
and the crowding out is insignificant.
(Correct diagrams are entertained)
(5 marks)
End of Paper
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