Download Test 3 - Department of Economics

Department of Economics
University of Toronto
SOLUTIONS
Prof. Gustavo Indart
July 27, 2012
ECO 209Y – L0101
MACROECONOMIC THEORY
Term Test #3
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 9
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
C
A
C
C
B
C
A
E
9
10
11
12
13
14
15
16
B
E
C
A
A
A
C
C
1. In a fixed-price model of an open economy with perfect capital mobility and flexible
exchange rates, a tax cut will
A) increase net exports due to a domestic currency depreciation.
B) increase consumption and net exports but decrease investment.
C) crowd out net exports due to a domestic currency appreciation.
D) partially crowd out investment due to the interest rate increase.
E) cause none of the above.
2. Consider a fixed-price model of an open economy with perfect capital mobility and flexible
exchange rates, and assume that in the initial equilibrium the domestic and foreign rates of
interest are equal. Now if the foreign interest rate increases by 2 percentage points and the
domestic currency is expected to depreciate by 3%, then in the new equilibrium the
domestic interest rate will approximately
A) increase by 5 percentage points.
B) increase by 2 percentage points.
C) increase by 1 percentage point.
D) decrease by 1 percentage point.
E) increase by 3 percentage points.
3. Suppose that imports are completely insensitive to changes in the level of domestic output.
Then, a decrease in the degree of capital mobility will
A) increase the slope of the BP curve.
B) reduce the slope of the BP curve.
C) cause the BP curve to shift down if the domestic rate of interest is lower than the
international rate.
D) cause the BP curve to shift down if the domestic rate of interest is higher than the
international rate.
E) have no effect on the BP curve.
Page 2 of 9
4. Consider an open economy with imperfect capital mobility and a flexible exchange rate
system. If the BP curve is flatter than the LM curve, a decrease in lump-sum taxes will cause
A) output to fall, the rate of interest to rise, and the exchange rate to decline.
B) output, the rate of interest, and the exchange rate all to rise.
C) output and the rate of interest to rise and the exchange rate to fall.
D) output and the rate of interest to fall and the exchange rate to rise.
E) the exchange rate to rise with no change in output and the rate of interest.
5. Consider an open economy with fixed exchange rates and perfect capital mobility. Suppose
the economy is initially in a situation of internal and external balance and the government
now implements expansionary fiscal policy. Which one of the following statements better
describes the changes once the new equilibrium is achieved?
A) The exchange rate will appreciate.
B) The balance in the current account will deteriorate.
C) The money supply will decrease.
D) The balance of the capital account will deteriorate.
E) Both output and the interest rate will increase.
6. In a flexible exchange rate system with perfect capital mobility, which one of the following
statements is correct?
A) Expansionary monetary policy will appreciate the domestic currency.
B) Fiscal expansion is very effective in stimulating aggregate expenditure.
C) Fiscal expansion causes an appreciation of the domestic currency.
D) An increase in exogenous exports will increase net exports.
E) None of the above is correct.
7. Consider a small open economy with fixed exchange rates and no capital mobility. Suppose
that BP = 0 in the initial equilibrium. The government now eliminates an effective import
quota which it had introduced a few years ago. Which one of the following statements better
describes the changes once the new equilibrium is achieved?
A) Net exports will remain unchanged, but the money supply and income will both be
lower.
B) Net exports, the money supply, and income will all remain unchanged.
C) Net exports, the money supply, and income will all be lower.
D) Net exports, the money supply, and income will all be higher.
E) Net exports will remain unchanged, the money supply will be higher, and income will
be lower.
8. Consider an open economy with perfect capital mobility and flexible exchange rates. The
economy is initially in equilibrium. Which one of the following incidents will lead to an
improvement in the balance of the capital account?
A) A decrease in foreign income.
B) A decrease in consumer’s confidence.
C) An expansionary fiscal policy.
D) A contractionary monetary policy.
E) Both C) and D).
Page 3 of 9
9. Assume that the public’s currency-deposit ratio is 0.35, the banks’ desired reserve-deposit
ratio is 0.10, and total money supply is $3,600 billion. What is the amount of high-powered
money (i.e., the monetary base) if there are no excess reserves in the banking system?
A) $975 billion.
B) $1,200 billion.
C) $1,275 billion.
D) $1,350 billion.
E) None of the above is correct.
10. All else equal, if people decide to hold more currency,
A) the money multiplier will remain unchanged but money supply will fall.
B) the monetary base and the money supply will both decrease.
C) the money multiplier will increase and the money supply will expand.
D) the money multiplier will decrease but the money supply will not change.
E) the money multiplier will decrease but the monetary base will not change.
11. Suppose you find a $100 bill that was lost for several years under your grandmother’s
mattress and you deposit this money in a commercial bank. If the target reserve ratio is 20
percent, all excess reserves are always lent out, and there is no cash drain on the banking
system, which one of the following statements is correct?
A) The money supply will not change since the public’s deposits will increase by the
same amount as their currency holdings will fall.
B) The money supply will increase by $400.
C) The money supply will increase by $500.
D) The money supply will increase by $100.
E) None of the above is correct.
12. Suppose a commercial bank has a target reserve ratio of 1 percent, but has an actual
reserve ratio of 0.8 percent. This bank will likely
A) contract its portfolio of loans.
B) allow fewer cash withdrawals by the bank’s customers.
C) expand its portfolio of loans.
D) maintain its new, higher reserve ratio because it is more profitable.
E) buy government securities from the Bank of Canada.
13. Vault cash held by commercial banks is equal to $3 million, commercial banks’ deposits at
the Central Bank are $7 million, the monetary base is $15 million, and deposits at the
commercial banks are $25 million. The money multiplier is equal to
A) 2.0.
B) 2.5.
C) 3.0.
D) 3.5.
E) none of the above.
Page 4 of 9
14. Suppose that households and firms always keep 20 percent of their money holdings in the
form currency and that the money multiplier is 3. If the government borrows $100 million
from the Bank of Canada to finance a new expenditure, the demand deposits of the public
will
A) increase by $240.
B) decrease by $240.
C) remain unchanged.
D) increase by $80.
E) increase by more than $80 but by less than $240.
15. Which of the following will cause the AD-curve to shift up to the right?
A) An increase in the real money supply due to a decrease in the price level.
B) A decrease in the real money supply due to a decrease in the nominal money
supply.
C) A decrease in the income sensitivity of the demand for real balances.
D) A decrease in government transfer payments.
E) An increase in autonomous imports.
16. In an open economy, the AD-curve will be flatter
A) the larger the monetary policy multiplier and the smaller the fiscal policy multiplier.
B) the smaller the monetary policy multiplier and the larger the fiscal policy multiplier.
C) the larger both the monetary policy multiplier and the fiscal policy multiplier.
D) the smaller both the monetary policy multiplier and the fiscal policy multiplier.
E) the smaller the fiscal policy multiplier.
Page 5 of 9
PART II
(40 marks)
Instructions: Answer all questions in the space provided. Each question is worth 10 marks.
1. Answer true, false, or uncertain to the following statement: “In the absence of active
government policy, a decrease in foreign interest rates will cause domestic output to fall, the
rate of interest to rise, the balance in the current account to improve, and the balance in the
capital account to deteriorate.” (Show your answer with the help of a diagram and explain
the economics. Marks will be given entirely for your explanation. Consider the fixed-price
model of an open economy with flexible exchange rates and imperfect capital mobility.)
BP
i
A
i1
i3
BP”
BP’
C
i2
B
IS”
IS’
Y2
Y1
IS
Y
FALSE
As shown in the diagram above, the economy is initially in equilibrium at point A. Since point A is also a point on the
BP curve, initially there is also external balance in the economy. The drop in i* leaves the balance in the current
account unchanged but causes the balance in the capital account to improve. Therefore, at point A there is now a
surplus in the external sector. Note that for the external sector to remain in equilibrium (i.e., BP = 0), the domestic
interest rate must decrease by the same amount as the international rate did (so the interest rate differential would
remain constant and the balance in the capital account unchanged). Therefore, all else equal, the drop in the
international rate of interest will cause the BP curve to shift down to BP’ as shown in the diagram.
But the economy is at point A and thus there is now a surplus in the external sector due to the improvement in the
capital account. In other words, there is now an excess supply of foreign currency in the exchange market and thus
the exchange rate depreciates (i.e., the domestic currency appreciates). The appreciation of the domestic currency
causes NX to fall. The appreciation of the domestic currency will cause the balance of the current account to
deteriorate by the same absolute amount as the improvement in the capital account and thus the external sector will
remain in equilibrium at Y1 (i.e., BP = 0 at Y1). Graphically, the appreciation of the domestic currency causes the IS
curve to shift down to IS’ and the BP’ curve to shift up back to BP. At point A, there is now equilibrium in the money
market (i.e., point A is on the LM curve) and equilibrium in the external sector (i.e., point A is on the BP curve), but a
situation of excess supply in the goods market (i.e., point A is above the IS’ curve). Therefore, Y will fall.
As output starts to fall (as a result to the firms’ involuntary increase in inventories), the demand for money decreases
and the rate of interest falls to keep the money market in equilibrium. The decrease in the rate of interest also
deteriorates the balance in the capital account (i.e., an excess demand for foreign currency arises in the exchange
market) and thus the domestic currency depreciates. The depreciation of the domestic currency increases NX and
improves the balance in the current account to maintain equilibrium in the overall balance of payments (i.e., BP = 0).
Graphically, the depreciation of the domestic currency causes the IS curve to shift up and the BP curve to shift down
and this process will continue as long as Y is falling, i.e., until the excess supply in the goods market is eliminated.
Therefore, graphically the adjustment path can be depicted as a movement down along the LM curve—the economy
always being at a point of intersection between the moving BP curve and the static LM curve (i.e., the money market
and the external sector always in equilibrium). Once the BP curve shifts all the way to BP” and the IS’ curve all the
way to IS”, not only the money market and the external sector continue in equilibrium but now the excess supply in
the goods market is also eliminated and thus a new equilibrium for the economy as a whole is reached. This is shown
at point C in the diagram above.
The statement is thus false: income decreases, the rate of interest falls, the balance in the current account
deteriorates (due to the appreciation of the domestic currency), and the balance in the capital account improves.
Page 6 of 9
2. Answer true, false, or uncertain to the following statement: “A devaluation of the domestic
currency will cause the level of income to increase, the rate of interest to rise, the balance in
the current account to improve, and the balance in the capital account to deteriorate.” (Show
your answer with the help of a diagram and explain the economics. Marks will be given
entirely for your explanation. Consider the fixed-price model of an open economy with
imperfect capital mobility and assume that, initially, BP = 0.)
TRUE
Suppose that the economy is initially in equilibrium at point A (see diagram below). The devaluation of the
domestic currency increases the degree of competitiveness of domestic goods in the international market,
and thus NX increases. The increase in NX causes AE to increase and the IS curve shifts to the right to
IS’. A situation of excess demand (i.e., AE > Y) appears in the goods market.
At the initial equilibrium, the devaluation of the currency causes the balance in the current account to
improve while leaving the balance in the capital account unchanged. Therefore, at point A there is now a
surplus in the external sector (i.e., BP > 0 and thus the supply of foreign currency is greater than its
demand). For the external sector to be in equilibrium at Y1, the rate of interest must be lower (i.e., the
balance in the capital account must deteriorate by the same amount as the balance in the current account
improved). Therefore, BP would be zero at Y1 when the rate of interest is i2 — this means that the BP
curve has shifted down and goes through point B.
The economy is still at point A (on the LM curve). However, since there is a surplus in the external sector
and the central bank wants to keep the exchange rate at the new fixed level, the central bank will buy
foreign currency. As a result, the domestic supply of money will increase and the LM curve will shift to the
right to LM’. Now the economy is at point B — both the money market and the external sector are in
equilibrium but there is an excess demand in the goods market. Note that the fall in the interest rate to i2
causes the balance in the capital account to deteriorate by the same absolute amount as the previous
improvement in the current account due to the devaluation.
Now Y starts to increase to eliminate the excess demand in the goods market and the domestic rate of
interest starts to rise (because of the increase in demand for real balances). The increase in the rate of
interest improves the balance in the capital account and creates a surplus in the external sector, which
the central bank eliminates by buying foreign currency. Therefore, the money supply increases and the
LM’ curve shifts further to the right. This process continues as long as there is an excess demand in the
goods market, i.e., until the LM’ curves shifts all the way to LM’’. Note that the money market is always in
equilibrium (by assumption) and that the intervention of the central bank in the exchange market helps
maintaining equilibrium in the external sector at all times as well. Therefore, during the process of
adjustment, the economy is always at a point of intersection of the (shifting) LM curve and the (static) BP’
curve, i.e., the adjustment path is graphically represented by a movement up along the BP’ curve.
The statement is therefore true: the level of income rises, the rate of interest falls, the balance in the
current account improves, and the balance in the capital account deteriorates.
LM
i
i1
A
LM’
C
i3
i2
BP
LM”
BP’
B
IS
Y1
Y2
IS’
Y
Page 7 of 9
3. Answer true, false, or uncertain to the following statement: “An increase in autonomous
exports will cause income to increase, the balance in the current account to improve, and
the balance in the capital account to deteriorate.” (Show your answer with the help of a
diagram and explain the economics. Marks will be given entirely for your explanation.
Consider the fixed-price model of an open economy with flexible exchange rates and perfect
capital mobility.)
FALSE
The goods market, the money market, and the external sector are initially in equilibrium at Y1 and i* (point
A in the diagram). An increase in autonomous exports increases NX at each level of Y, and thus the IS
shifts up to IS’. The increase in NX improves the balance in the current account, i.e., BP > 0 at point A.
The improvement in the balance of the current account creates an excess supply of foreign currency in
the exchange market and, given the assumption of a flexible exchange rate system, the exchange rate
depreciates. At point A, BP = 0 once again. Since the depreciation of the exchange rate decreases NX,
the IS curve shifts down to IS”.
Since at Y1 there is now an excess demand in the goods market, firms will experience involuntary
decreases in inventories. Firms, therefore, will adjust production upwards. As output (Y) starts to
increase, the demand for money also starts to increase and the domestic rate of interest starts to rise
above i* — thus improving the balance in the capital account and making BP > 0. The improvement in the
balance of the capital account creates an excess supply of foreign currency in the exchange market and
the exchange rate depreciates further. The depreciation of the exchange rate decreases NX further and
the IS curve continues shifting down to the left.
This process continues as long as an excess demand remains in the goods market, i.e., until the
economy moves back to point A. At the end of the process, therefore, the equilibrium income is once
again Y1 and the rate of interest is once again equal to i*.
Therefore, at the end of the process NX is the same as before, i.e., the balance in the current account
has not changed. Of course, imports are greater than before due to the depreciation of the exchange rate.
But exports have increased by the same absolute amount as imports and thus NX have not changed.
Note that exports first increased because of the increase in autonomous exports, and then decreased as
the exchange rate depreciated, but the net effect is an increase.
Since the balance in the current account did not change, then we can conclude that the balance in the
capital account did not change either.
The statement is therefore false: the level of income, the balance in the current account, and the balance
in the capital account will all remain unchanged in the new equilibrium.
i
LM
A
i*
BP
IS
Y1
IS”
IS’
Y
Page 8 of 9
4. This year the U.S. government deficit is expected to reach $1.3 trillion, similar to the levels
reached every year since 2009. What difference would it make whether this government
deficit is financed by domestic investors or foreign investors? In you answer you must
compare and explain the likely short-run impact of these two alternative ways of financing
the government deficit on the level of output, the current account balance, and the capital
account balance of the U.S.
This massive fiscal deficit will have a significantly different impact on the U.S. economy
depending on whether it’s financed with domestic saving or with foreign savings. Let’s examine
the likely outcomes in both cases.
Financed with domestic savings – Suppose the deficit were to be financed entirely (or mostly)
with domestic savings. This means that the government would be competing with the private
sector for a finite amount of financial resources (domestic savings), thus causing a significant
increase in the domestic rate of interest. Indeed, the domestic rate of interest (i.e., the yield of
the bonds) would increase dramatically since the new issue of government bonds would require
a very high coupon to entice domestic investors to buy them in the necessary quantity. This
increase in the rate of interest would have a contractionary impact on aggregate demand, thus
reducing to a large extent the expected expansionary impact of the fiscal deficit — in other
words, the crowding out effect would be significant in this case and thus Y would most likely not
increase enough to lift the economy out of the recession. Since we are assuming that the fiscal
deficit would be financed mostly with domestic savings, then the inflow of capital would be
rather small and thus the U.S. dollar would appreciate only slightly. The small appreciation of the U.S.
dollar would cause a small deterioration of the balance of current account (partly offset by the decrease in
imports as a result of the fall in Y).
In short, the likely impact of this alternative of deficit financing would be the continuation of the
recession, a slight improvement in the capital account, and a slight deterioration in the current
account.
Financed with foreign savings – Suppose instead that the deficit were to be financed entirely
(or mostly) with foreign savings. The demand for government bonds would now be stronger
since it would include foreign buyers, thus increasing the price of bonds above what it would
have been under the alternative analyzed in the previous paragraph. This would cause the
domestic rate of interest to be significantly lower than otherwise, i.e., the new issue of
government bonds would not require a high coupon to attract investors to purchase them in the
necessary quantity. The lower rate of interest would reduce any possible crowding out effect,
and it might even contribute to further increase AD if the rate of interest were to be even lower
than before as a result of excess liquidity (a likely outcome). Therefore, the financing of the fiscal
deficit with foreign savings would allow Y to increase further and hopefully (and probably)
enough to lift the economy out of the recession. Since the fiscal deficit would be financed mostly
with foreign savings, then the inflow of capital would be rather large — and this improvement in
the capital account would contribute to strengthening the value of the U.S. dollar. The
strengthening of the dollar would, in turn, contribute to the deterioration of the current account.
In short, the likely impact of this alternative of deficit financing would be an important increase in
the level of economic activity, a significant improvement of the capital account, and a significant
deterioration of the current account.
Page 9 of 9