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Queen’s University
Department of Economics
Econ 223
Midterm Examination
Winter 2002
Name ______________________ Student Number _____________________
Marina Adshade
February 11, 2002
Please read all the questions carefully. Record your responses in the answer
booklet provided. Answers without any explanations will receive zero marks.
You are encouraged to draw diagrams to support your answers. The exam has
two parts.
Part I consists of true, false, uncertain question. Marks will be awarded based on
the logical arguments given to support your answer. Do any five of the seven
questions. Each question is worth 8 marks for a total of 50 marks.
Part II consists of one long question. The question is worth 40 marks, with the
grades for each part give.
The exam is 80 minutes long. Be certain to allocate you time according to the
marks for each question. Upon completion of your exam hand in your answer
booklet and this exam.
Good Luck!
Part I
Answer any 5 of the following 7 questions. Please explain whether they are
true, false or uncertain. Each question is worth 8 marks for a total of 50. One
mark will be allocated for correctly stating whether the statement is true, false or
uncertain. The remainder of the marks will be given based on the explanation.
Explanations in all questions will require a the use of diagrams.
1. Reducing the tax on capital output is an effective means to increase
output and decrease interest rates in the short run.
2. A one time increase in the supply of workers to the labour force will
ultimately lead to higher inflation.
3. Expectations that a country will finance it’s debt through seignorage will
decrease real interest rates in the short run and increase nominal interest
rates in the long run.
4. A one time increase in lump sum taxes will decrease aggregate demand in
the short run and decrease prices in the long run.
5. An increase in government spending will increase net exports and
decrease exchange rates in the short run.
6. High interest elasticity of demand leads to more inflationary pressure
following a monetary expansion then a low interest elasticity of money
demand.
7. The problem of fiscal policy crowding out investment is only relevant in the
short run.
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Solutions:
Part I
The following are very brief solutions to the midterm. In order to get full marks
all diagrams must be included (diagrams are indicated in the brackets) and
labeled. Additionally, all movements in the market must be fully explained. For
example if price levels change then there must be a thorough explanation that
changes in the level of output has caused firms to change their pricing in the
long run. The same holds for interest rates (i.e. borrowers increase the price
they are willing to pay for savers dollars until the interest rate reaches a
position where saving = investment).
For example:
Government expenditure increases:
Consumption decreases shifting the savings curve to the left. Interest rates
are now higher at every level of investment as borrowers complete for savers
dollars. Higher interest rates in the goods market, for a fixed level of output,
means that the IS curve shifts up and to the right. Aggregate output is now
above full employment level and firms begin to increase prices in response to
higher (aggregate demand). Higher price levels in the asset market increase
interest rates at every level of output, the LM curve shifts up until the general
equilibrium is restored, higher interest rates and higher price level.
Is better than:
The IS curve shifts up and to the left. The LM curve shifts up and to the right.
Interest rates are higher and output is the same.
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1. False: Decreased tax on capital output (or the MPK) decreases the UC at
every level of capital. Investment in the goods market shifts up and IS
curve shifts up. Higher output and higher interest rates in the short-run.
Deflation and higher interest rates in the long run. ( Market for capital,
Goods market and IS-LM)
2. False: Labour supply increases increase full-employment employement
and the wage. Full-employment output increases and the FE curve shifts
to the right. Price levels adjust and the LM curve shifts down. Long-run
deflation and increased output. (Labour Market and IS-LM)
3. True. Expectations that the money supply will increase decreases the
demand for money, the LM curve shifts to the right (note – not an increase
in money supply). Short run interest rates decrease. Price levels adjust to
bring the interest back to its long run equilibrium level but the increase in
the price level, i.e. inflation increases nominal interest rates by that
amount. (Asset Market and IS-LM)
4. Uncertain. If Richardian equivalence holds no change. If not the AD curve
shifts down and to the left. In the short-run, when prices are fixed
aggregate output decreases. In the long-run prices decrease and the
SRAS curve shifts down to the new equilibrium. (AD-AS)
5. False/uncertain. In the open economy the IS curve shifts up and to the
right. Output increases, increasing NX and decreasing the exchange rate.
Interest rates increase increasing the exchange rate which decreases NX
as domestic goods become more expensive. In the short run if the interest
rate effect dominates (which we assumed in class) then NX decrease.
(Goods market in an open economy and IS-LM)
6. True. A high interest rate elasticity (where interest rate elasticity is
negative) means that the money demand curve is more steeply sloped.
Any changes in the level of money supply will have greater changes in the
interest rate, i.e. a larger shift in the LM curve. The larger the shift in the
LM curve from a monetary expansion the higher prices will need to
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increase to bring the market back into equilibrium. (Asset Market and ISLM)
7. False. Crowding out is both a short-run and long-run concept. (Goods
market and IS-LM, possible goods market in an open economy).
Part II
Answer all parts of the following question. Illustrate your answers with
graphs, when appropriate, and label graphs with the values you obtain
from your calculations. The question is worth 40 marks, with the
distribution of grades given.
Consider an open economy described as follows:
Cd = 200 + 0.5Y – 400 r
Id = 300 – 400 r
NX = 100 – 0.1 Y – 800 r
Md = P (0.5 Y – 10r)
M = 874
a) Write the condition that determines the goods market equilibrium in this
open economy. Derive the IS curve as a function of government
spending (G). What are the levels of equilibrium interest rates (r) and net
exports (NX) when G = 20 and Y = 875?
[5]
The condition that determines in the goods market equilibrium is Sd – Id = NX.
Y = C + I + G + NX
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Y = (200 + 0.5Y – 400r) + (300 – 400r) + G + (100 – 0.1Y –800r)
1600r = (600 + G) – 0.6Y (IS)
r = 0.059
NX = - 34.7
b) Write the condition that determines the asset market equilibrium in this
economy. Derive the LM curve as a function of the price level. What is the
price level (P) when this economy is in long-run equilibrium?
[5]
The condition that defines the asset equilibrium is Md / P = M / P
P (0.5 Y – 10r) = 874 (LM)
P= 2
The government decides to undertake a monetary expansion. If the
money supply is now M = 899 what is condition that determines the
short-run equilibrium? At this equilibrium what is the real interest rate
(r), output (Y) and net exports (NX)?
[5]
The condition that defines the short run equilibrium is IS=LM
P (0.5 Y – 10r) = 899 (LM)
1600r = (600 + G) – 0.6Y (IS)
P = 2 (prices fixed in the short-run)
The easiest way to do this is to multiply the LM equation by 80 and subtract:
1600r = 80Y – 71920 (LM)
1600r = -0.6Y + 620 (IS)
0 = 80.6 Y – 72540
Y = 900
Substituting for Y in the IS equation:
1600r = -0.6(900) + 620
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r = 0.05
NX = 100 – 0.1 Y – 800 r
NX = 100 – 0.1 (900) – 800 (0.05) = - 30
c) In the long-run what is the level of real interest rates (r), output (Y), net
exports (NX) and the price level (P)? What does this say about Money
Neutrality in the open economy? What has happened to the levels of both
nominal and real exchange rates?
[10]
In the long run prices adjust but we return to the full employment output Y =
875. Everything returns to the position in a) except the price level which is
given by the new LM curve with Y = 875 and r = 0.06
P (0.5 Y – 10r) = 899
P (0.5 (875) – 10 (0.06)) = 899
P = 2.06
So money is neutral in the open economy (all real variable are unaffected by
the monetary policy in the long run).
Real exchange rates remain unchanged in the long run (buy adjust in the
short run). If domestic price levels increase (which they have) and we
assume that foreign price levels are unchanged then nominal exchange rates
must have decreased where:
Δe / e = Δenom / enom + ΔP/ P - ΔPfor / Pfor
d) If this country had strong trade ties with another country what might be the
effect of this monetary expansion on the economy of it’s trading partner?
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Use diagrams to explain your answer. (hint: It might be useful to draw both
countries goods market diagrams (in an open economy) when answering
this question)
[15]
This is from my class notes (except in class I did a monetary contraction, not
expansion). There should be diagrams for IS-LM and the goods market
equilibrium (showing changes in the NX curve) for a compete answer.
Monetary Expansion:
** Letting the country with the monetary expansion be the ‘foreign’ economy.
1. The foreign LM curve shifts down and to the right.
2. Foreign imports increase as output increases, the foreign currency
depreciates (due to the drop in the relative real interest rate) and the
domestic currency appreciates.
3. The domestic IS curve shifts down as NX decrease (domestic goods are
relatively more expensive).
4. Foreign price levels increase so there is real domestic appreciation.
5. In the long run the adjustment in the exchange rate returns the IS curve to
it’s original position
There is more than one way to do this question. The long run outcome will be the
same with both economies returning to their initial equilibrium. There are several
assumptions being made in the short run however concerning the effect of Y and
r on NX and the speed at which the domestic economy adjusts.
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