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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