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Department of Economics
University of Toronto
Prof. Gustavo Indart
November 9, 2006
ECO 209Y
MACROECONOMIC THEORY
SOLUTION
C
Term Test #1
LAST NAME
FIRST NAME
STUDENT NUMBER
Circle your section of the course:
L0101
MW – 10-11
L0201
MW – 1-2
L0401
MW – 2-3
L5101
W – 6-8
INSTRUCTIONS:
1.
2.
3.
4.
5.
The total time for this test is 1 hour and 50 minutes.
This exam consists of three parts.
This question booklet has 10 (ten) pages.
Aids allowed: a simple calculator.
Use pen instead of pencil.
DO NOT WRITE IN THIS SPACE
Part I
/30
3.
/10
Part II
/15
4.
/10
Part III 1.
/10
2.
/10
TOTAL
/85
Page 1 of 10
PART I
(30 marks)
Instructions:
• Multiple choice questions are to be answered using a black pencil or a black or blue ball-point pen
on the separate SCANTRON sheet being supplied.
• Be sure to fill in your name and student number on the SCANTRON sheet. Write your course
section number (e.g., L0101, etc.) on the SCANTRON sheet (in the area where it says “DO NOT
WRITE IN THIS SPACE”).
• Each question is worth 3 marks. No deductions will be made for incorrect answers.
• Write your answers also in the table below; but only answers recorded on the SCANTRON sheet will
be graded. Questions whose answers are not entered on the SCANTRON sheet will get a zero
mark.
1
2
3
4
5
6
7
8
9
10
E
C
B
D
A
B
A
E
A
C
1. Suppose that the war in Afghanistan causes consumer confidence to drop. If the government wants
to neutralize the impact of the drop in consumer confidence on both GDP and the interest rate, the
following policies are correct:
A) Increase G and M.
B) Increase G, decrease M.
C) Decrease G, Increase M.
D) Decrease G, decrease M.
E) Increase G, leave M unchanged.
2. The income earned by a French student during her studies in Canada is included:
A) In Canada’s GDP and in France’s GDP.
B) In Canada’s GNP and in France’s GNP.
C) In Canada’s GDP and in France’s GNP.
D) In Canada’s GDP but not in France’s GDP or GNP.
E) In France’s GNP but not in Canada’s GDP or GNP.
3. Suppose that Justin buys a newly-built house, for which he pays $150,000. Knowing that the rent for
a similar house is $20,000 per year and that Justin previously lived with his parents, what is the
impact of this transaction on full-year GDP?
A) Consumption rises by $150,000 and investment is unchanged.
B) Consumption rises by $20,000 and investment rises by $150,000.
C) Consumption is unchanged and investment rises by $150,000.
D) Consumption rises by $20,000 and investment is unchanged.
E) GDP is unchanged.
4. Canadian real per capita disposable income increased by about 16 percent between 1981 and 2005.
Over this period, the share of per capita consumption expenditure in per capita disposable income
increased from about 75 percent in 2001 to more than 95 percent in 2005. Which of the following
statements may explain this increase in consumption expenditure as a share of disposable income?
A) The increase in real per capita disposable income over the period reduced the need for
saving for future consumption.
B) Households had negative expectations about the future state of the economy and decided to
spend more while they could.
C) A significant decrease in asset values convinced households that saving for the future was
too risky.
D) Real rates of interest reached historically low levels in the 1990s, thus discouraging saving
and fostering higher consumption expenditure.
E) The average propensity to consume tends to increase as disposable income increases.
Page 2 of 10
5. The saving and investment functions of a hypothetical closed economy with no government sector
are S = – 100 + 0.2 Y and I = 50, respectively. When Y = 1 000, the involuntary change in inventory is
A) +50.
B) +100
C) +250.
D) –50.
E) –250.
6. In 2005, Speedy Motors purchased $5 million worth of steel and car parts in order to produce 1,000
cars. Speedy Motors sold in 2005 all these 1,000 cars to Global Car Dealer for $15,000 each. Global
Car Dealer sold 800 of these cars to the public in 2005, at a retail price of $20,000 each. What was
the contribution of Speedy Motors and Global Car Dealer to GDP in 2005?
A) $5 million.
B) $14 million.
C) $15 million.
D) $20 million.
E) None of the above.
7. Suppose that taxes increase and money supply increases in such a way that output is constant in
equilibrium. These policy changes will produce
A) An increase in investment and a decrease in private consumption.
B) An increase in investment and a decrease in government spending.
C) An increase in investment and an increase in private saving.
D) A decrease in investment and an increase in public saving (i.e., in the government budget
surplus).
E) Cannot say since there is not enough information.
8. An increase in the money supply and a drop in consumer confidence will lead to
A) A decrease in output with an ambiguous effect on the interest rate.
B) An increase in output and a decrease in the interest rate.
C) A decrease in output and an increase in the interest rate.
D) An ambiguous effect on output and an increase in the interest rate.
E) An ambiguous effect on output and a decrease in the interest rate.
9. Which of the following policy options would simultaneously increase interest rates and decrease
output?
A) The Bank of Canada sells bonds through open market operations.
B) The federal government increases its defence purchases.
C) The Bank of Canada expands the money supply.
D) The federal government increases the tax rate.
E) None of the above.
10. Suppose that investment (I) is not responsive to the interest rate (that is, I does not depend on the
interest rate at all). Then
A) The IS curve is a vertical line and monetary policy is very effective in raising output.
B) The IS curve is a horizontal line and monetary policy is very effective in raising output.
C) The IS curve is a vertical line and monetary policy does not affect output in the IS-LM model.
D) The IS curve is a horizontal line and monetary policy does not affect output in the IS-LM
model.
E) The IS curve still has a negative slope, but monetary policy monetary policy does not affect
output in the IS-LM model.
Page 3 of 10
PART II
(15 marks)
Assume that a closed economy is described by the following equations:
C = 540 + 0.5YD
I = 250 + 0.1Y – 8i
TA = 300
TR = 0
G = 200
P=2
M = 7 000
L = 2Y – 100i
[Note: Although you don’t need to draw the IS and LM curves to answer the following questions,
you might find it helpful doing it.]
(a)
Solve for equilibrium real output (in billions of dollars) and equilibrium interest rate (in percent). (5
marks)
To derive the equation for the IS curve we must find first the equation for the AE curve and find the
equilibrium in the goods market.
The equation for the AE curve is:
AE = C + I + G
= 540 + 0.5 YD + 250 + 0.1 Y – 8 i + 200
= 540 + 0.5 (Y – 300) + 250 + 0.1 Y – 8 i + 200
= 540 – 150 + 250 + 200 + 0.5 Y + 0.1 Y – 8 i
= 840 + 0.6 Y – 8 i
In equilibrium: Y = AE
Y = 840 + 0.6 Y – 8 i Æ 0.4 Y = 840 – 8 i Æ 8 i = 840 – 0.4 Y Æ i = 105 – 0.05 Y
To derive the equation for the LM curve we must find the equilibrium in the money market:
M/P = L Æ 7 000 / 2 = 2 Y – 100 i Æ 3 500 = 2 Y – 100 i Æ 100 i = – 3 500 + 2 Y Æ i = – 35 + 0.02 Y
We equate the IS and LM curves to find equilibrium real output:
105 – 0.05 Y = – 35 + 0.02 Y Æ 0.07 Y = 140 Æ Y* = 2 000
We plug this value for Y* in either the expression for the IS or LM curve in order to find equilibrium rate of
interest:
i* = – 35 + 0.02 Y* = – 35 + 0.02 (2 000) = – 35 + 40 = 5
i
LM
5
IS
2000
Y
Page 4 of 10
(b)
Suppose that autonomous investment increases by $56 billion. Calculate the new equilibrium real
output (in billions of dollars) and the new equilibrium interest rate (in percent). (5 marks)
You can find the expression for the new IS curve through the same process as in part (a), but you don’t need
to. You should know that the upward shift of the IS curve is equal to ∆I / b = 56/8 = 7. Therefore, the
expression for the new IS curve is:
i = 112 – 0.05 Y
We equate the new IS curve and the LM curves to find the new equilibrium real output:
112 – 0.05 Y = – 35 + 0.02 Y Æ 0.07 Y = 147 Æ Y* = 2 100
We plug this value for Y* in either the expression for the new IS curve or LM curve in order to find the new
equilibrium rate of interest:
i* = – 35 + 0.02 Y* = – 35 + 0.02 (2 100) = – 35 + 42 = 7
i
LM
7
5
IS’
IS
2000 2100
Y
Page 5 of 10
(c)
How would the Bank of Canada react to this autonomous increase in investment in order to keep Y
constant at the level of part (a)? Calculate the required change in the money supply. (5 marks)
The Bank of Canada must reduce the money supply in order to increase the rate of interest enough to
reduce investment (i.e., the component of the investment function that depends on the rate of interest) by the
same amount as the initial increase in autonomous investment. That is,
−b∆i = −8 ∆i and −8 ∆i = −56 Æ ∆i = 7 Æ i* = 12
Therefore, the LM curve must shift up by 7 and thus the expression for the new LM curve becomes:
i* = – 28 + 0.02 Y*
And the vertical intercept of the LM curve is −(M/P)/h = −(M/2)/100 and
−(M/2)/100 = −28 Æ M = 28 (200) = 5 600 Æ ∆M = −1 400 (i.e., a decrease from 7 000 to 5 600)
Alternatively, we can also find the required change in M in the following way. The decrease in the money
supply should be enough to shift the LM curve to the left and intersect the new IS curve at Y = 2 000. This
can be seen in the following diagram.
LM’
i
LM
12
7
5
IS’
IS
2000 2100
Y
To find the value of the rate of interest at the point where LM’ intersects IS’ we must plug Y = 2 000 in the
expression for the IS’ curve:
i* = 112 – 0.05 Y* = 112 – 0.05 (2 000) = 112 – 100 = 12
To find the expression for the LM’ curve we must equate the real money supply and the real money demand:
M/P = 2 Y – 100 i
We know the values for P, Y and i, and thus the only unknown is M (the nominal supply of money):
M / 2 = 2 (2 000) – 100 (12) Æ M / 2 = 4 000 – 1 200 = 2 800 Æ M = 5 600
Therefore, the Bank of Canada must reduce the nominal supply of money from 7 000 to 5 600 − i.e., a
reduction of 1 400 − in order to offset the expansionary effect of the increase in autonomous investment.
Page 6 of 10
PART III
(40 marks)
Instructions: Answer all questions in the space provided on question sheet (if space is not sufficient,
continue on the back of the previous page). Each question is worth 10 (ten) marks.
1. Explain with the help of appropriate diagrams whether the following statement is true, false, or uncertain:
“A mix of a fiscal contraction (e.g., an increase in taxes) and a monetary expansion increases investment
unambiguously.”
True
Let’s look first at the impact of contractionary fiscal policy
on investment. Assuming that desired investment
expenditure depends on the rate of interest (i) but not on
the level of income (Y), contractionary fiscal policy will
result in an increase in investment.
Suppose that the economy is initially in equilibrium at (Y1,
i1) and that government expenditure (G) decreases. This
causes overall aggregate expenditure (AE) to fall, resulting
in a situation of excess supply in the goods market at Y1
and output will start to fall to restore equilibrium in the
goods market.
As Y starts to fall, the demand for real balances also falls
and the rate of interest decreases. In turn, as the rate of
interest decreases, desired investment expenditure
increases.
Diagrams 1 and 2 show this adjustment. First, before any
change in the rate of interest, the decrease in G causes the
AE curve to shift down to AE2 and the IS curve to shift to
IS’. Then, as the rate of interest gradually decrease and
desired investment increases, the AE curve gradually shifts
up until a new equilibrium in the goods market is achieved
at (Y2, i2). The adjustment in the IS-LM diagram is down
along the LM curve since the money market is always in
equilibrium.
Let’s look now at the impact of expansionary monetary
policy on investment. Suppose that the Bank of Canada
increases the money supply, thus creating a situation of
excess supply in the money market. As a result, the rate of
interest falls and desired investment expenditure increases.
Starting from the initial situation of equilibrium at (Y1, i1),
Diagrams 2 and 3 show this adjustment. As the money
supply increases as shown in Diagram 3, the LM curve
shifts to LM’ as shown in Diagram 2. The rate of interest
falls and desired investment increases, the level of
output/income starts to increase. This increase in desired
investment is not shown in Diagram 1. Note that as Y
increases, the rate of interest also increases because the
demand for money rises. The adjustment path is up along
the LM’ curve and a new equilibrium is reached at (Y3, i3),
where the rate of interest is lower than i1 – and thus
investment is greater than at the initial equilibrium.
Therefore, the statement is true: a mix of contractionary
fiscal policy and expansionary monetary fiscal policy
unambiguously cause investment to increase since these
policies reinforce each other on their impact on the rate of
interest.
AE
AE1
AE3
AE2
Y1‘
Y2
Y1
Y
i
LM
i1
LM’
i2
i3
i1’
IS
IS’
Y1‘
i
M/P
Y2
Y1
Y3
Y
(M/P)’
i1
i3
i1’
L(Y3)
L(Y1)
M/P
Page 7 of 10
2. Assume a closed economy is in equilibrium at (Y*, i*). Suggest a policy mix – i.e., a combination of fiscal
and monetary policy – to decrease the budget deficit while keeping Y constant. Show the effect of your
proposed policy mix in an IS-LM diagram, and explain. What happens to each component of aggregate
output, i.e., to C, I, and G?
The government must implement contractionary fiscal policy – i.e., a decrease in G or an increase in TA – to
reduce the budget deficit. But contractionary fiscal policy will cause the level of national income to fall.
Therefore, the government should combine contractionary fiscal policy with expansionary monetary policy in
order to keep Y unchanged. This policy mix is shown in the following diagram.
i
LM
LM’
i1
i2
i1’
IS
IS’
Y2
Y1
Y
The economy is initially in equilibrium at (Y1, i1). Suppose
now that the government decreases its expenditure on
goods and services (G) to reduce the budget deficit. The
decrease in G will cause AE to fall and thus the IS curve will
shift down to IS’. This creates a situation of excess demand
in the goods market – i.e., AE < Y – and output will start to
fall towards the new equilibrium at Y2.
To prevent output from falling, the government – through the
Bank of Canada – should combine the decrease in G with an
increase in the money supply. That is, the objective would
be to keep the level of AE unchanged while allowing its
composition to change. Indeed, the decrease in M/P will
cause the rate of interest to fall and the investment
component of AE to increase. The impact of the increase in
M/P is shown in the diagram by the shift of the LM curve to
LM’.
This policy mix thus allows the level of equilibrium income to remain at Y1 while the level of equilibrium rate
of interest falls to i1’. Since the level of income and taxes don’t change, the level of C doesn’t change either.
Therefore, only G decreases and I increases – and both by exactly the same absolute amount so the overall
level of AE doesn’t change.
Page 8 of 10
3. The Canadian economy is currently operating at full employment but – since the U.S. is Canada’s largest
trading partner – many economists expect that the present slowdown in the U.S. economy might soon
cause the Canadian economy to move into a recession. What policy should the Minister of Finance
implement in order to keep both national income (Y) and the rate of interest (i) at the present levels?
Show the effect of your proposed policy in an IS-LM diagram, and explain. What happens to each
component of aggregate output, i.e., to C, I, G, and NX?
The slowdown in the U.S. economy will cause their imports from Canada to decrease, i.e., Canadian exports
to the U.S. will fall. This represents a reduction in AE and thus the Canadian economy will move into a
recession. To prevent Y from falling, the government should implement either expansionary fiscal policy or
expansionary monetary policy or a combination of both. However, since the intention is to keep both Y and i
unchanged at the initial equilibrium levels, then only expansionary fiscal policy must be implemented. This is
shown in the following diagram.
i
The economy is initially in equilibrium at (Y1, i1). The
decrease in autonomous exports causes AE to fall and thus
the IS curve shifts down to IS’. This creates a situation of
excess demand in the goods market – i.e., AE < Y – and
output starts to fall towards the new equilibrium at Y2. Note
that as Y decreases, the demand for money also decreases
and thus the rate of interest starts to fall as well.
LM
i1
i2
i1’
IS
IS’
Y2
Y1
Y
To prevent output and the rate of interest from falling, the
government should implement expansionary fiscal policy –
e.g., increase G or decrease TA. Let’s suppose that the
government increases G and thus the IS’ curve shifts back
to IS. The increase in G must be equal to the decrease in X
to keep overall AE unchanged, and thus the IS curve on the
same initial position.
As shown in the diagram, expansionary fiscal policy allows
the level of equilibrium income to remain at Y1 and the level
of equilibrium rate of interest at i1. Since the level of income and taxes don’t change, the level of C doesn’t
change either. Similarly, since the rate of interest doesn’t change, the level of I doesn’t change either.
Therefore, only G increases and NX decreases – and both by exactly the same absolute amount so the
overall level of AE doesn’t change. Note that Q doesn’t change either since Y doesn’t change, and thus the
change in NX is the result of only the decrease in X.
Page 9 of 10
4. Suppose that General Motors announces that it will lay off 2,000 workers when it shuts down one of its
plants in Oshawa at the end of the year. Further suppose that you are the general manager of a furniture
factory supplying the Oshawa market. What will be the impact of General Motors decision to shut down
one of its plants on your firm? What actions will you take as the general manager of this furniture
factory?
Assuming that most laid off workers live in Oshawa, the decision of General Motors will reduce the
disposable income of Oshawa’s residents. Therefore, one would expect the consumption expenditure of
Oshawa’s residents to start falling even before workers are actually laid off at the end of the year. If
consumption expenditure were to fall, expenditure on durable goods would be the component of
consumption most affected – and furniture is a durable good. Therefore, I would expect furniture sales to
significantly decrease in the next few months.
What should I do as general manager of this furniture factory? If, as I expect, sales will start to fall, then
inventories will start to build up unless I take some corrective action. Therefore, to avoid this involuntary
increase in inventories, I will adjust production downwards to reduce the present level of inventories and
avoid its expected build up. I will thus start, for instance, reducing the number of working hours and laying off
some non-essential personnel (e.g., on a rotating basis to spread out its social impact). Similarly, I will
reduce my monthly orders of intermediate goods required for the production of furniture (e.g., wood). An
additional benefit of taking correcting actions before sales actually go down is that it will require a less
extreme adjustment to production since it prevents the building up of inventories.
Page 10 of 10