Download SOLUTIONS - Department of Economics

Department of Economics
University of Toronto
Prof. Gustavo Indart
December 7, 2011
ECO 209Y
MACROECONOMIC THEORY AND POLICY
Term Test #2
SOLUTIONS
LAST NAME
FIRST NAME
STUDENT NUMBER
Circle your section of the course:
L0101
L0301
L0401
M – 2-4
W – 2-4
R – 2-4
INSTRUCTIONS:
1.
2.
3.
The total time for this test is 1 hour and 50 minutes.
Aids allowed: a simple, non-programmable calculator.
Use pen instead of pencil.
DO NOT WRITE IN THIS SPACE
Part I
/36
Part II
/14
TOTAL
Part III
1.
/10
2.
/10
3.
/10
/80
Page 1 of 10
PART I
(36 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 question is worth 3 marks for a maximum of 36 possible marks. No deductions will be
made for incorrect answers.
1
2
3
4
5
6
7
8
9
10
11
12
D
C
C
D
E
D
D
B
E
A
D
E
1. Due to a reduction in consumer confidence, a hypothetical economy went into recession
about six months ago. As a result, both output and the real interest rate decreased. The
economy has now recovered and equilibrium output and equilibrium interest rate have both
returned to their pre-recession levels. Which of the following is most likely to have
happened?
A) The central bank decreased the money supply.
B) The central bank increased the money supply.
C) The government did not intervene in the economy.
D) The government increased its purchases of goods.
E) The government increased taxes.
2. In a fixed-price model of a closed economy, a $1 increase in government expenditure will
have the largest impact on the rate of interest when it is financed by
A) raising taxes to the rich.
B) raising taxes to the middle class.
C) borrowing from the public.
D) borrowing from the central bank.
E) cutting other expenditure programs.
Use this space for rough work.
Page 2 of 10
3. Consider the fixed-price model of a closed economy. If the demand for real balances
increases at each level of the market rate of interest, which one of the following statements
is correct?
A) The IS curve shifts up to the right and income increases.
B) The IS curve shifts down to the left and the LM curve shifts down to the right.
C) The LM curve shifts up to the left and income decreases.
D) The LM curve shifts up to the left and the IS curve shifts down to the left.
E) The LM curve shifts down to the right and income increases.
4. A policy of a balanced budget over the business cycle would
A) require increasing government expenditures when revenues are rising.
B) require increasing taxes when revenues are falling.
C) call for substantial government infrastructure investments in periods of economic
boom.
D) allow for the implementation of countercyclical policies without affecting the level of
the national debt.
E) allow for the implementation of countercyclical policies without affecting the debt-toGDP ratio.
5. Consider the IS-LM framework in a fixed-price model of the economy. An increase in the
rate of interest will cause
A) the IS curve to shift up to the right.
B) the IS curve to shift down to the left.
C) the LM curve to shift up to the left.
D) the LM curve to shift down to the right.
E) none of the above.
6. Consider the IS-LM framework in a fixed-price model of the economy. If investment
spending is very sensitive to the interest rate, which one of the following statements is
correct?
A) The LM curve will be relatively steep and the IS curve relatively flat.
B) The LM curve will be relatively steep.
C) Both the IS and the LM curve will be relatively flat.
D) The IS curve should be relatively flat.
E) None of the above is correct.
Use this space for rough work.
Page 3 of 10
7. Suppose money and bonds are the only two assets in the economy. Assuming all else
equal, if bond holders attempt to sell bonds in order to increase their money holdings, at the
end of the process of adjustment
A) the money held by individuals and businesses will increase by the same amount as
their bond holdings will decrease.
B) the money held by individuals and businesses will decrease by the same amount as
their bond holdings will increase.
C) individuals and business will reduce their bond holdings but will keep their money
holdings unchanged.
D) individuals and businesses will keep both their total money holdings and their total
bond holdings unchanged.
E) individuals and business will reduce both their bond holdings and their money
holdings by the same amount.
8. Consider a fixed-price, IS-LM model of the economy. If there is a simultaneous tax cut and
open market sale of bonds, which one of the following statements describes the most likely
outcome?
A) Both output and the interest rate will increase.
B) The interest rate will increase but output could increase or decrease.
C) Output will increase but the rate of interest could increase or decrease.
D) The interest rate will increase while output will decrease.
E) None of the above.
9. Although GDP figures for the third quarter of 2011 show that China’s economy grew by an
impressive 9.1 percent from a year earlier, growth was nonetheless lower than the 9.5
percent recorded in the second quarter. Which of the following statements correctly
describe the reaction of Chinese authorities to the apparent slowdown of the economy?
A) China’s central bank is pursuing less restrictive monetary policy by loosening lending
requirements.
B) Chinese policy makers believe that inflation at about 6.1 percent is still a problem
and are thus reluctant to ease monetary policy.
C) Concerned about the European debt crisis, Chinese policy makers are reducing
government expenditure and the fiscal deficit.
D) China’s central bank is now focusing on maintaining growth, rather than on tackling
inflation.
E) Both a) and d) are correct.
Use this space for rough work.
Page 4 of 10
10. In the Keynesian model of the economy, which one of the following statements better
describes the difference between using monetary and fiscal policy to eliminate a recession?
A) An expansionary monetary policy will leave the economy with a lower real interest
rate than an expansionary fiscal policy.
B) Monetary policy will eliminate a recession quicker than fiscal policy will.
C) An expansionary fiscal policy will leave the economy with a lower real interest rate
than an expansionary monetary policy.
D) Fiscal policy will eliminate a recession quicker than monetary policy will.
E) None of the above.
11. Suppose that average income per capita in Uruguay is 240,000 pesos per year and that the
nominal exchange rate for Uruguayan pesos is 0.05. Further suppose that a given
consumption basket of goods and services costs $4,500 in the Canada and 75,000 pesos in
Uruguay. Using the PPP exchange rate, income per capita in Uruguay is:
A) $9,600.
B) $12,000
C) $13,200
D) $14,400.
E) $15,600.
12. Chinese production of export-oriented goods has become more expensive over the last
couple of years. In 2011 alone, minimum wages in most Chinese coastal provinces rose by
more than 21% while the renminbi (i.e., the Chinese currency) continued to appreciate.
Given this relative loss of competitiveness, which of the following statements correctly
describes the changes observed in the Chinese economy over the last couple of years?
A) Chinese firms are moving their labour-intensive operations to other Asian and African
countries.
B) The Chinese government is heavily investing in the infrastructure of inland provinces
to lure the labour-intensive operations of successful coastal firms.
C) Parts of China’s manufacturing sector are now moving up the value-added chain by
producing more capital-intensive and more skill-intensive goods.
D) The Chinese government is making important investment efforts to rapidly deepen
China’s skills and technology base throughout the economy.
E) All of the above are correct.
Use this space for rough work.
Page 5 of 10
PART II
(14 marks)
Consider the following model of the economy:
L = 0.1Y – 10i
M=
P=1
C = 325 + 0.8YD – 10i
I = 100 – 15i + 0.08Y
G=
TR = 100
TA = 50 + 0.1Y
NX = 100 – 0.05Y
a) What is the equation for the AE curve? What is the equation for the IS curve? [Note that
these equations will be expressed as a function of .] (2 marks)
First, we must find the equation for the AE curve:
AE = C + I + G
= [ 325 + 0.8 (Y – TA + TR) – 10i ] + [ 100 – 15i + 0.08Y ] +
= 525 +
– 25i + 0.03Y + 0.8 [ Y – 50 – 0.1Y + 100 ]
= 525 +
– 25i + 0.03Y + 0.8 (0.9Y + 50)
= 565 +
– 25i + 0.75Y
+ 100 – 0.05Y
Second, we derive the equation for the IS curve by equating Y and AE:
Y = 565 +
– 25i + 0.75Y Æ 25i = 565 +
– 0.25Y Æ i = 22.6 + 0.04
– 0.01Y
b) What is the equation for the LM curve? [Note that this equation will be expressed as a
function of .] (2 marks)
We derive the equation for the LM curve by equating L and M/P:
0.1Y – 10i =
10i = –
+ 0.1Y Æ i = –0.1
+ 0.01Y
c) What are the values of the expenditure multiplier (αAE), the fiscal policy multiplier (βFP), and
the monetary policy multiplier (βMP)? (3 marks)
1) Since the marginal propensity to spend (i.e., the slope of the AE curve) is 0.75, the
simple expenditure multiplier is: αAE = 1 / (1 – 0.75) = 1 / 0.25 = 4.
2) Given the expression for equilibrium income of part c) above, the fiscal policy multiplier
is: βFP = DY / DG = 2.
3) Given the expression for equilibrium income of part c) above, the monetary policy
multiplier is: βMP = DY / DM = 5.
Page 6 of 10
d) If equilibrium income (Y*) is 2800 and the equilibrium rate of interest (i*) is 5 (where 5 means
5 percent), what are the corresponding values of G and M? (3 marks)
To find the corresponding level of G we must plug the values of Y* and i* in the equation for
the IS curve:
i* = 22.6 + 0.04G – 0.01Y*
0.04G = i* – 22.6 + 0.01Y*
G = 25i* – 565 + 0.25Y* = 125 – 565 + 700 = 260.
To find the corresponding level of M we must plug the values of Y* and i* in the equation for
the LM curve:
i* = –0.1M + 0.01Y*
0.1M = 0.01Y* – i*
M = 0.1Y* – 10i* = 280 – 50 = 230.
e) Suppose that at the present level of equilibrium income there is a recessionary gap of 200. If
the government wants to eliminate this recessionary gap while maintaining the rate of
interest at 5, what combination of an increase in G and an increase in M is required? (4
marks)
To find the required increase in G we must go to the expression for the IS curve and plug
the values for i* = 5 and Yfe = 3000:
i* = 22.6 + 0.04G – 0.01Y*
0.04G = i* – 22.6 + 0.01Y*
G = 25i* – 565 + 0.25Y* = 125 – 565 + 750 = 310.
Therefore, G must increase by 50.
Alternatively, we could have obtained this result by using the simple expenditure multiplier:
DY = αAE DG Æ DG = DY / αAE = 200 / 4 = 50.
To find the required increase in M we must go to the expression for the LM curve and plug
the values for i* = 5 and Yfe = 3000:
i* = –0.1M + 0.01Y*
0.1M = 0.01Y* – i*
M = 0.1Y* – 10i* = 300 – 50 = 250.
Therefore, M must increase by 20.
Page 7 of 10
PART III
(30 marks)
Instructions: Answer all questions in the space provided. Each question is worth 10 marks.
1. Critically evaluate the following statement: “The undervaluation of the renminbi (the Chinese
currency) is the underlying cause of the large deficit in the U.S. trade account.”
The evidence suggests that the undervaluation of the renminbi is not the main cause of the
large deficit in the U.S. overall trade account. If it were, then a sufficient revaluation of the
renminbi would be enough to eliminate this deficit. But, what would be the most likely impact
of a significant revaluation of the renminbi?
No doubt that a revaluation of the Chinese currency would make Chinese goods relatively
more expensive and thus the U.S. trade account deficit with China would certainly be
reduced. This, however, would not guarantee a significant and immediate reduction in the
“overall” U.S. trade account deficit. On the one hand, current trade deficits with other
countries — including countries with floating currency regimes such as Germany and Japan
— would continue. On the other hand, countries like India, Indonesia, Malaysia, etc. would
most likely start exporting to the U.S. what the U.S. was until now importing from China.
Therefore, most likely the U.S. overall trade account deficit would remain as is or, at most, it
would be only marginally reduced in the short run.
It appears, therefore, that a revaluation of the Chinese currency cannot be seen as a
solution for the U.S. overall trade account deficit, which suggests the conclusion that the
apparent undervaluation of the renminbi is not the main cause of this deficit. It could be
argued that the main cause of the U.S. overall trade account deficit is the huge fiscal deficit
of the U.S. government together with the willingness of foreign investors (including the Bank
of China, of course) to finance it. It is the external financing of the fiscal deficit — i.e., the
surplus in the U.S. capital account — that appreciates the U.S. dollar to levels that make
American goods and services less competitive in the international market with the resulting
increase in the deficit of the current account. Therefore, the current account deficit will most
likely continue as long as there is a fiscal deficit in need of external financing. Therefore, the
fiscal deficit is the main problem that needs to be addressed. But, of course, the problem of
the U.S. fiscal deficit must be addressed in a way that it would allow for its gradual reduction
to prevent the U.S. economy (and the world economy) falling into an even deeper recession.
Page 8 of 10
2. Critically evaluate the following statement: “Expansionary monetary policy is very effective in
reducing a recessionary gap when the interest sensitivity of the demand for real balances is
very small.” (Show your answer with the help of appropriate diagrams and explain the
economics.)
This statement seems correct.
We must keep in mind that, given the interest sensitivity of investment (and consumption),
the greater the drop in the rate of interest the greater the expansionary impact on the
economy. Therefore, given the interest sensitivity of investment (and consumption), the
effectiveness of expansionary monetary policy will be determined by how much it can cause
the rate of interest to fall. If the interest sensitivity of demand — the “h” in our equation for
the demand for real balances — is relatively small, then a given change in the money supply
will have a relatively great impact on the rate of interest (or, equivalently, a large change in
the rate of interest will have a relatively small impact on the quantity demanded of money).
Graphically, this means that both the liquidity preference curve and the LM curve are
relatively steep. In the diagram below we have sketched two liquidity preference curves
corresponding to the initial equilibrium income Y1 — liquidity preference curve L1 assumes a
relatively small interest sensitivity of the demand for real balances, while liquidity preference
curve L2 assumes a relatively large h. In turn, the curves LM1 and LM2 are the LM curves
corresponding to a relatively small and a relatively large h, respectively.
i
M/P
LM1
i
(M/P)’
LM1’
LM2
LM2’
i1
i2’
i1
i2’
L2
i2
i2
L1
IS
M/P
Y1
Y2
Y
On the one hand, as the money supply increases to (M/P)’, the impact on the rate of interest
will be rather small when the interest sensitivity of the real demand for money is relatively
large — the rate of interest will fall only to i2’. In this case, therefore, the impact that it will
have on the real sector of the economy will be rather negligible. Indeed, equilibrium income
will marginally increase to the level where the curve LM2’ intersects the IS curve (not shown
in the diagram).
On the other hand, the same increase in the money supply will have a relatively large impact
on the rate of interest when h is relatively small — the rate of interest will fall to i2. In this
case, therefore, the impact that it will have on the real sector of the economy will be quite
significant. Indeed, equilibrium income will increase to Y2, i.e., to the level where the curve
LM2 intersects the IS curve.
Page 9 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 thinks 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 in the goods
market (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 expenditures.
Most likely their reaction will be to do right the opposite, i.e., to reduce expenditures and increase
savings (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 current “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 to happen 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 10 of 10