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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. 2 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. 3 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 4 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 5 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 6 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? 7 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. 8