Download Test 1 - Department of Economics

Department of Economics
University of Toronto
SOLUTIONS
Prof. Gustavo Indart
June 8, 2012
ECO 209Y – L0101
MACROECONOMIC THEORY
Term Test #1
LAST NAME
FIRST NAME
STUDENT NUMBER
INSTRUCTIONS:
1.
2.
3.
The total time for this test is 1 hour and 50 minutes.
Aids allowed: a simple calculator.
Use pen instead of pencil.
DO NOT WRITE IN THIS SPACE
Part I
Part II
TOTAL
/40
1.
/10
2.
/10
3.
/10
4.
/10
/80
Page 1 of 10
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
9
10
11
12
13
14
15
16
C
D
C
C
D
A
C
A
C
E
A
C
D
D
D
C
Use the following information to answer questions 1 and 2. Suppose that an economy produces
only apples, bananas, and oranges, and that price (in dollars) and quantity (in pounds) data are
given in the table below.
Good
Apples
Bananas
Oranges
Year 2000
Quantity
3,000
6,000
8,000
Price
$2
$3
$4
Year 2010
Quantity
4,000
6,500
9,000
Price
$3
$2
$5
1. The percentage increase in nominal GDP between 2000 and 2010 is
A) 15 percent.
B) 20 percent.
C) 25 percent.
D) 30 percent.
E) none of the above.
2. Considering the year 2000 as the base year, the percentage increase in real GDP between
2000 and 2010 is approximately
A) 7 percent.
B) 9 percent.
C) 11 percent.
D) 13 percent.
E) 15 percent.
Use this space for rough work.
Page 2 of 10
3. John buys a one-year government bond for $400. He receives principal and interest totalling
$436 one year later. During the year the CPI rose from 150 to 162, but he had thought the
CPI would be at 159 by the end of the year. John had expected the real interest rate to be
____________, but it actually turned out to be __________.
A) 8%, 1%.
B) 6%, 3%.
C) 3%, 1%.
D) 1%, 3%.
E) 3%, 2%.
4. Consider an economy without depreciation of the capital stock, without government transfer
payments, and where personal income tax is the only source of government revenues. If
GDP is $980 billion, consumption is $650 billion, private savings is $120 billion, government
purchases is $180 billion, and net exports is -$30 billion, which of the following is true in this
economy?
A) Disposable income is $860.
B) Investment is $120.
C) The budget deficit is -$30.
D) Personal income tax is 250.
E) None of the above.
5. The pop-corn industry produced $1 billion worth of pop-corn in 2011, using $500 million
worth of corn as the only intermediate product. The pop-corn industry also paid $300 million
in wages and salaries, $50 million in rent, and $50 million in taxes. The contribution of the
pop-corn industry to the country’s GDP in 2011 was
A) $1,400 million.
B) $1,000 million.
C) $900 million.
D) $500 million.
E) none of the above.
Use this space for rough work.
Page 3 of 10
6. Nominal GDP in 2000 was $1,015.5 billion, and in 2008 it was $2,732.0 billion. The GDP
deflator is 42.0 for 2000 and 85.7 for 2008, where 2010 is the base year. Calculate the
percent change in real GDP in the period from 2000 to 2008. Rounding off to the nearest
percentage point, what was the percent change in real GDP in the period from 2000 to
2008?
A) 32%.
B) 104%.
C) 132%.
D) 169%.
E) None of the above is correct.
7. The reason that an increase in autonomous spending leads to an even greater increase in
equilibrium income is that
A) the multiplier increases with an increase in autonomous spending.
B) people save less as their income increases.
C) as firms increase output to meet demand, income increases, and this induces more
consumption spending.
D) there is unwanted inventory accumulation, leading firms to lower prices thereby
encouraging increased consumer spending.
E) the demand for money increases.
8. Acme Steel Co. produces 1,000 tons of steel. Steel sells for $30 per ton. Acme pays wages
of $10,000. Acme buys $15,000 worth of coal, iron and other inputs needed to produce the
steel. Acme pays $2,000 in taxes. Acme’s contribution to GDP is
A) $15,000.
B) $20,000.
C) $25,000.
D) $45,000.
E) none of the above.
Use this space for rough work.
Page 4 of 10
9. Suppose that the government has a balanced budget. It collects $30 billion in taxes, pays
$10 billion in Social Security benefits, pays $2 billion in interest on the national debt, and
pays government workers $18 billion in wages. The government contribution to GDP is
A) $0 billion.
B) $12 billion.
C) $18 billion.
D) $30 billion.
E) undetermined with the information provided.
10. Consider the fixed-price, aggregate expenditure model of the economy. Which one of the
following will not be true when the marginal tax rate increases?
A) The aggregate expenditure curve becomes flatter.
B) Equilibrium output falls.
C) Disposable income decreases.
D) Consumption decreases.
E) Savings increase.
11. Consider a closed economy with fixed prices and a balanced government budget at the
initial equilibrium situation. A drop in government purchases will cause
A) the level of consumption to fall, business inventories to rise, and a government
surplus.
B) business inventories to rise and a government deficit, but no change in the level of
consumption.
C) business inventories and the level of consumption to fall, but no change in the
government budget balance.
D) both the level of consumption and business inventories to fall, and a government
deficit.
E) none of the above.
12. Consider a model of a closed economy where investment is independent of the level of
income, the MPCYD is 0.8, and the tax rate (t) is 0.25. A $50 billion increase in government
purchases will lead to a change in the budget surplus of
A) $50 billion.
B) -$50 billion.
C) -$18.75.
D) -$37.5.
E) +$37.5.
Use this space for rough work.
Page 5 of 10
13. Assume a dealership in Toronto bought 40 Toyotas from Japan at a cost of $15,000 per car
in July of 2011, and by December 31, 2011 have sold 20 of these Toyotas at a price of
$20,000 each. The remaining Toyotas were sold in January 2012 at a price of $18,000
each. The effect of these transactions on GDP in the year 2011 is
A) $400,000.
B) $300,000.
C) $200,000.
D) $100,000.
E) none of the above.
14. Consider the aggregate expenditure model of an open economy where national income is
$520, disposable income is $440, consumption is $410, net exports is negative at –$11, and
the budget deficit is $15. What is the level of investment?
A) $106.
B) $54.
C) $30.
D) $26.
E) none of the above.
15. The ultimate objective of the “austerians” — as Paul Krugman calls those obsessed with
austerity programs — is
A) to eliminate government deficits.
B) to reduce wasteful expenditures by the government.
C) to improve efficiency in the economy.
D) to minimize the size of the government.
E) none of the above.
16. Canada has been running a current account deficit since 2009 and it is expected to continue
doing so for the foreseeable future. According to most analysts — including Mark Carney,
the governor of the Bank of Canada — the main reason for this deficit is
A) that productivity improvement by Canadian firms lags behind that of U.S. firms.
B) that wages of Canadian workers are too high compared to those of their American
counterparts.
C) the increase in the value of the Canadian dollar.
D) that the U.S. economy has remained weak, thus reducing American demand for
Canadian goods and services.
E) that the Canadian economy has recovered very rapidly, thus boosting Canadian
demand for imported goods.
Use this space for rough work.
Page 6 of 10
PART II
(40 marks)
Instructions: Answer the following questions in the space provided. Each question is worth 10
marks.
1. Consider the following data for a hypothetical economy to answer the questions below.
Consumption expenditure
Investment spending
Government purchases
Wages and salaries
Net income from abroad
594,089
194,177
219,816
385,492
74,689
Net exports
Capital consumption allowance
Indirect taxes
Government transfer payments
Income taxes
55,397
135,781
127,745
98,523
187,455
a) What is the value of GDP?
GDP = C + I + G + NX = 594,089 + 194,177 + 219,816 + 55,397 = 1,063,479
b) What is the value of GNP?
GNP = GDP + Net income from abroad = 594,089 + 74,689 = 1,138,168
c) What is the value of net domestic income (NDI)?
NDI = GDP - Capital consumption allowance - Indirect taxes
= 1,063,479 – 135,781 – 127,745
= 799,953
d) What is the value of the government budget surplus (BS)?
BS = Indirect taxes + Income taxes – Gov’t purchases – Gov’t transfer payments
= 127,745 + 187,455 – 219,816 – 98,523
= – 3,139
Page 7 of 10
2. Answer true or false to the following statement (marks will be given entirely for your
explanation): “In the simple aggregate expenditure model for a closed economy, an increase
in government purchases would have a greater impact on the level of economic activity if
private investment were an increasing function of the level of income.”
True
The larger the aggregate expenditure multiplier, the greater will be the impact of an increase in
government purchases on equilibrium income. Therefore, let’s examine how the size of the
expenditure multiplier changes when we consider investment to be an increasing function of
income.
Recall that the expenditure multiplier is αAE = 1 / (1 – slope of the AE curve), where the slope of
the AE curve is the marginal propensity to spend. Also recall that the marginal propensity to
spend represents the fraction of any additional dollar of income that is spent, and thus it is the
relative size of the marginal propensity to spend that determines the multiplying effect that any
initial change in autonomous aggregate expenditure has on equilibrium income.
In the case of a closed economy, the marginal propensity to spend is equal to the MPCY = c(1 –
t), i.e., in our closed economy model only consumption is assumed to depend on income and
thus the marginal propensity to spend indicates the fraction of any additional dollar of income
that is spent on consumption. In this case, therefore, the expression for the multiplier is
αAE = 1 / [1 – c(1 – t)].
Now, suppose that investment also depends on income so I = I + fY. The constant f < 1
represents the fraction of any additional dollar of income that is spent on investment, i.e., it’s the
marginal propensity to invest. The marginal propensity to spend now becomes equal to the
MPCY plus the marginal propensity to invest, i.e., a larger fraction of any additional dollar of
income is now re-spend purchasing goods and services — a fraction is spent by consumers and
another fraction is spent by businesses. Therefore, the slope of the AE curve now becomes
equal to c(1 – t) + f and the multiplier becomes equal to
αAE = 1 / {1 – [c(1 – t) + f]}.
Since c(1 – t) + f > c(1 – t), then the multiplier is larger when f > 0 and the statement is true.
Page 8 of 10
3. Critically evaluate the following statement: “Most economists believe that greater consumer
and business confidence is needed to restore Canada’s economic activity to pre-recession
levels. In this regard, Canada’s Finance Minister stated that the biggest contribution his
government can make to improve economic confidence is to reduce its own spending and
debt.”
If our economy is in a recession, i.e., if equilibrium income/output is below full-employment output,
this is not because we don’t have the capability to produce a larger output but rather due to a weak
aggregate demand (i.e., a weak AE). Therefore, what is needed is an increase in autonomous AE in
order to move the economy to a situation of excess demand (i.e., to a situation where AE > Y) for
firms to get the signal that production should be increased. If we assume, for simplicity, a closed
economy, then what we need is any of C, I or G to increase in order to trigger the virtues multiplying
process that will eventually restore equilibrium at the level of full-employment income. But which of
the different component of AE will initiate this multiplying process?
Let’s examine C first. Consumers’ confidence is usually very low during a recession and thus it will
be very unlikely that they will initiate the process of economic expansion by increasing their
expenditure on goods and services. Indeed, consumers might be quite worry about the possibility of
losing their jobs and thus will not be in the mood to increase their expenditure. Most likely their
reaction will be to do right the opposite, i.e., to reduce expenditure and increase saving (or pay off
debt, which is the same) in case their pessimistic expectations become true and they are laid off.
What about I? Will corporations start investing and thus creating new jobs and increasing income?
As a matter of fact, as it was reported in the economic news, corporations are currently sitting on pile
of money but they are not spending. And why would they? There is excess capacity in the economy
which means firms can produce more with the existing capital stock but they are not. Why would
they increase further the existing “excess” capacity? Corporations will start spending (i.e., investing)
when the demand for their products start to increase, i.e., when consumer expenditure starts to
increase and the excess capacity is reduced and the conditions for expansion of the productive
capacity of firms are in place once again.
So the above statement is right in that greater consumer and business confidence is needed to
restore economic activity to pre-crisis levels, with the caveat that business confidence depends on
consumer confidence being restored first. But how will this confidence be restored? The Minister of
Finance thinks that a reduction in government deficit (and the debt) would do the trick. In the first
place, this rationale implies that the deficit and the debt are actually responsible for the recession
while the causation seems to go in the opposite direction: the government is running a fiscal deficit
because of the recession. In the second place, what will be the impact of the government reducing
its deficit by decreasing G (or even by increasing taxes, which they won’t)? A decrease in G will
cause the economy to move into a deeper recession, further reducing the confidence of both
consumers and the business sector.
Consumers and business sector confidence must be restored to move the economy to fullemployment equilibrium, but this confidence will start to be restored when there are some clear signs
of employment and income starting to increase — and for this 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 needs something to trigger this change, and this
something is the initial increase in Y resulting from expansionary fiscal policy.
Page 9 of 10
4. Answer true or false to the following statement: “A decrease of $10 billion in autonomous
taxes will have a greater expansionary impact on equilibrium income and a smaller impact
on the government budget surplus than an increase of $10 billion in government expenditure
on goods and services.” (Show your answer algebraically and explain the economics.
Consider the AE model of a closed economy.)
This statement is false.
Let’s examine first the respective impacts on equilibrium Y of these two policy options.
On the one hand, an increase of $10 billion in G directly increases autonomous AE by $10
billion and through the multiplying process causes equilibrium income to increase further by $10
billion times the expenditure multiplier, i.e., ∆Y = αAE∆G = αAE ($10 billion).
On the other hand, a decrease of $10 billion in autonomous taxes increases autonomous AE
only indirectly and by a lesser amount. Indeed, the $10 billion decrease in autonomous taxes
directly increases YD by $10 billion at all levels of Y, but not all of this increase in YD translates
into an increase in C. Consumers will spend only a fraction “c” of every additional dollar of
disposable income and thus autonomous expenditure will increase only by c∆YD = c ($10
billion), which is less than $10 billion. Therefore, equilibrium income will increase by ∆Y = αAE *
c ($10 billion) which is less than ∆Y = αAE ($10 billion).
Let’s examine now the respective impacts on the government BS of these two policy options.
On the one hand, both policies will initially reduce the BS by $10 billion. Indeed, the $10 billion
increase in G will increase overall government expenditures by this amount and reduce the BS
by $10 billion, while the $10 billion decrease in autonomous taxes will reduce government
revenues by this amount and reduce the BS by $10 billion as well. On the other hand, since
these two policies have different impacts on equilibrium Y and government revenues (taxes)
depend on the level Y, the increase in G will cause a greater increase in government revenues
than the decrease in autonomous taxes. Therefore, the $10 billion decrease in autonomous
taxes will end up causing a greater decrease in the government BS than the $10 billion increase
in G will.
Therefore, the statement is false — a $10 billion increase in G will have a greater impact on
equilibrium Y and a smaller impact on the government budget surplus than a $10 billion
decrease in autonomous taxes.
Page 10 of 10