Download solutions - Department of Economics

Department of Economics
University of Toronto
Prof. Gustavo Indart
December 5, 2008
SOLUTIONS
ECO 209Y
MACROECONOMIC THEORY AND POLICY
Term Test # 2
LAST NAME
FIRST NAME
STUDENT NUMBER
Circle your section of the course:
L5101
M – 6-8
L0301
W – 2-4
L0401
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
/16
TOTAL
Part III
1.
/12
2.
/12
3.
/12
4.
/12
/100
Page 1 of 11
PART I
(36 marks)
Instructions:
• Multiple choice questions are to be answered using a black pencil or a black or
blue ball-point pen on the separate SCANTRON sheet being supplied.
• Be sure to fill in your name and student number on the SCANTRON sheet!
• Each question is worth 3 marks. No deductions will be made for incorrect
answers.
• Write your answers to the multiple choice questions ALSO in the table below.
You may use this question booklet for rough work, and then transfer your answers
to each multiple choice question onto the separate SCANTRON sheet. Your
answers must be on the SCANTRON sheet. In case of a disagreement, the answer
to be marked is the one on the SCANTRON sheet.
1
2
3
4
5
6
7
8
9
10
11
12
E
D
B
B
C
C
B
D
B
C
A
E
1. Suppose that income per capita in Mexico is 45,000 pesos and that the nominal
exchange rate for Mexican pesos is 0.10. Further suppose that a given consumption
basket of goods and services costs $2,250 in Canada and 15,000 pesos in Mexico.
Using the PPP exchange rate, income per capita in Mexico is
A) $4,500.
B) $6,000.
C) $7,500.
D) $9,250.
E) None of the above.
2. When the economy is in a liquidity trap, expansionary monetary policy is ineffective
with respect to income because
A) investment is insensitive to changes in the rate of interest.
B) the public already holds all the money they want.
C) the real demand for money is insensitive to changes in the rate of interest.
D) the public is willing to hold any amount of money being offered at the current
rate of interest.
E) none of the above.
3. Consider a fixed price model of a closed economy. A reduction in savings at each
level of disposable income will
A) shift the IS curve to the left.
B) shift the IS curve to the right.
C) shift the LM curve down.
D) shift the LM curve up.
E) leave both the IS and the LM curves unchanged.
Page 2 of 11
4. The BP curve will be flatter
A) the larger is the marginal propensity to import.
B) the larger is the interest responsiveness of capital flows.
C) the larger is the money supply.
D) the larger the marginal propensity to consume.
E) the smaller the interest sensitivity of investment.
5. Consider a fixed price model of a closed economy, and suppose that consumption
demand declines as the interest rate increases. The slope of the IS curve will
A) be steeper the more sensitive consumption demand is to changes in the
interest rate.
B) be flatter if the interest sensitivity of consumption is greater than the interest
sensitivity of investment.
C) be steeper the less sensitive consumption demand is to changes in the
interest rate.
D) not depend on the sensitivity of consumption demand to changes in the
interest rate.
E) depend on the sensitivity of consumption to changes in the interest rate, but it
is not possible to answer the question from the information provided.
6. Consider a fixed price model of a closed economy, and suppose that the money
supply is positively related to the interest rate. Then all else equal,
A) the IS curve will be steeper than it is when the money supply is fixed.
B) the IS curve will be flatter than it is when the money supply is fixed.
C) the LM curve will be flatter than it is when the money supply is fixed.
D) the LM curve will be steeper than it is when the money supply is fixed.
E) neither the slope of the IS curve nor the slope of the LM curve will be
affected.
7. Consider the fixed-price model of an open economy with perfect capital mobility and
a fixed exchange rate. Which of the following best expresses how policy could affect
aggregate output in the short-run?
A) Monetary policy and fiscal policy are both ineffective.
B) Monetary policy is ineffective and fiscal policy is effective.
C) Monetary and fiscal policy must be coordinated.
D) Monetary policy is effective and fiscal policy is ineffective.
E) Monetary policy and fiscal policy are both effective.
8. In a model with perfect capital mobility and fixed exchange rates a cut in lump-sum
taxes will
A) be totally crowded out due to a decrease in investment.
B) crowd out net exports due to an exchange rate appreciation.
C) increase net exports due to a depreciation of the exchange rate.
D) increase consumption and decrease net exports but leave investment
unchanged.
E) None of the above.
Page 3 of 11
9. (From economic news – October 27) From a low of US$0.63 in 2003, the
Canadian dollar appreciated to a record level of US$1.10 in September of 2007 – a
75 percent appreciation! This increase in the value of the Canadian dollar was a
reflection of
A) a change in our ability to efficiently produce high-value goods and services.
B) speculative financial pressures to profit from a commodities bubble.
C) the solid fundamentals of the Canadian economy.
D) expansionary monetary policy by the Bank of Canada.
E) none of the above.
10. (From economic news – November 8) When a country is slipping into a recession,
as Canada is now, prudent governments stimulate the economy and create jobs. But
what’s the best way of doing that?
A) Reducing the rate of interest to stimulate consumption and investment
expenditure.
B) Decreasing income taxes on the wealthy in order to stimulate investment.
C) Increasing government expenditure on infrastructure.
D) Increasing the salaries of government employees to stimulate their
consumption expenditure.
E) Increasing expenditure on new social programs in order to reduce the rate of
unemployment.
11. (From economic news – November 3) After 12 years of running healthy budget
surpluses, the federal government is expected to run a deficit of $3.4 to $14.0 billion
this fiscal year. This deterioration of the government budget surplus is mainly due to
A) the decrease in direct and indirect taxes over the last few years.
B) the current slowdown of the Canadian economy.
C) the increase in wages and salaries of government employees.
D) the tight monetary policy implemented by the Bank of Canada.
E) the appreciation of the Canadian dollar.
12. (From economic news – November 28) In its recent economic update of
November 27, the Minister of Finance proposed to balance the federal government
budget by
A) cutting program spending.
B) selling government assets.
C) reducing the total wage bill of the public sector.
D) cutting back transfer payments to the poorer provinces.
E) implementing all of the above.
Page 4 of 11
PART II
(16 marks)
Consider an open economy with fixed prices, fixed exchange rates, and imperfect
capital mobility. This economy is characterized by the following equations:
C = 60 + 0.8 YD
I = 200 – 20 i + 0.1 Y
G = 300
TA = 0.25 Y
TR = 50
X = 250 + 100 ePf/P
Q = 400 – 50 ePf/P + 0.1 Y
Pf = 2
P=1
L = 0.2 Y – 10 i
M = 200
e = 0.9
CF = 10 (i – 6)
a) What is the equation for the IS curve in this model? (2 marks)
First, we must obtain the expression for the aggregate expenditure function:
AE = C + I + G + NX
= (60 + 0.8 YD) + (200 – 20 i + 0.1 Y) + 300 + (250 + 100 ePf/P) – (400 – 50 ePf/P + 0.1
Y)
= 410 + 150 ePf/P + 0.8 YD – 20 i
where YD = Y – 0.25 Y + 50 = 50 + 0.75 Y
= 410 + 150 ePf/P + 0.8 (50 + 0.75 Y) – 20 i
= 450 + 150 ePf/P + 0.6 Y – 20 i
where ePf/P = 0.9 (2/1) = 1.8
= 720 + 0.6 Y – 20 i.
In equilibrium, Y = AE:
Y = 720 + 0.6 Y – 20 i Æ 20 i = 720 – 0.4 Y.
And solving for i we obtain the equation for the IS curve:
i = 36 – 0.02 Y.
b) What is the equation for the LM curve in this model? (2 marks)
The LM curve is found from the money market equilibrium:
L = M/P Æ 0.2 Y – 10 i = 200 Æ 10 i = 0.2 Y – 200
And solving for i we obtain the equation for the LM curve:
i = 0.02 Y – 20.
Page 5 of 11
c) What is the equation for the BP curve in this model? (2 marks)
Since there is imperfect capital mobility, the equation for the BP curve is BP = NX + CF = 0,
where
NX = X – Q = (250 + 100 ePf/P) – (400 – 50 ePf/P + 0.1 Y)
= – 150 + 150 (1.8) – 0.1 Y
= 120 – 0.1 Y
and CF = 10 (i – 6).
Therefore, BP = 120 – 0.1 Y + 10 i – 60 = 60 – 0.1 Y + 10 i = 0 and thus the expression for
the BP curve is i = – 6 + 0.01 Y
d) What are the equilibrium values of Y and i in this economy? (2 marks)
Since the exchange rate is fixed, monetary policy is completely ineffective and thus the LM
curve becomes redundant in the determination of equilibrium income and the equilibrium
rate of interest. Therefore, to find the equilibrium value of Y we must equate the IS and the
BP curves:
36 – 0.02 Y = – 6 + 0.01 Y Æ 0.03 Y = 42 Æ Y = 42/0.03 = 1400
And plugging this value for Y* into either the expression for the IS or the BP curve we find i*:
IS: i = 36 – 0.02 Y = 36 – 0.02 (1400) = 36 – 28 = 8
e) What are the balances in the current and capital accounts in the above equilibrium? (2
marks)
NX = X – Q
= (250 + 100 ePf/P) – (400 – 50 ePf/P + 0.1 Y)
= – 150 + 150 ePf/P – 0.1 Y
= – 150 + 150 (1.8) – 0.1 Y
= 120 – 0.1 (1400)
= 120 – 140
= – 20
CF = 10 (i – 6) = 10 (8 – 6) = 20.
Page 6 of 11
f) Suppose that the international rate of interest increases to i* = 9. What are the new
equilibrium values of Y and i in this economy? (4 marks) What is the new level of M? (2
marks)
[Note: A graphical analysis of this situation will give you a hint as to how to answer
the question.]
Graphical analysis: The increase in the
international rate of interest deteriorates
the balance in the capital account while
leaving the balance in the current
account unchanged. Therefore, now BP
< 0 at point A. This implies that at each
level of Y the domestic rate of interest
must be higher than before in order for
BP to be equal to 0 (i.e., the BP curve
shifts up to BP’). Since the economy is
still at point A, the goods market and the
money market are still in equilibrium but
there is a deficit in the external sector
(i.e., the demand for foreign currency is
greater than its supply). To keep the
exchange rate unchanged, the central
bank sells foreign currency and thus the
domestic money supply decreases.
Therefore, at each level of Y the money
market will be in equilibrium at a higher
rate of interest (i.e., the LM curve shifts
up to the left). This process continues
until the LM curve shifts all the way to
LM’ and the external sector is in
equilibrium once again (at point B).
i
LM’
BP’
B
LM
10
BP
A
8
IS
//
1300
1400
Y
Mathematical analysis:
The equation for the BP curve changes because the equation for CF changes. Indeed, the
equation for NX remains as before NX = 120 – 0.1 Y but the equation for CF is now CF = 10
(i – 9).
Therefore, BP = 120 – 0.1 Y + 10 i – 90 = 30 – 0.1 Y + 10 i = 0 and thus the expression for
the BP curve is i = – 3 + 0.01 Y.
To find the new equilibrium value of Y we must equate the IS and the BP curves:
36 – 0.02 Y = – 3 + 0.01 Y Æ 0.03 Y = 39 Æ Y = 39/0.03 = 1300.
And plugging this value for Y* into either the expression for the IS or the BP curve we find i*:
IS: i = 36 – 0.02 Y = 36 – 0.02 (1300) = 36 – 26 = 10.
Let’s find the new level of M:
L = M/P Æ 0.2 Y – 10 i = M Æ M = 0.2 (1300) – 10 (10) = 260 – 100 = 160.
Page 7 of 11
PART III (48 marks)
Instructions: Answer all questions in the space provided. Each question is worth 12
marks.
1. Comment on the following recent statement by Prime Minister Harper: “There are
occasions in which deficits are not necessarily bad, but in fact, they are essential.” In
your comment, clearly identify the specific “occasion” Harper was referring to and
critically analyze the likely effectiveness of the different policy options available to
the government to address that situation. (To simplify the analysis, consider the
fixed-price model of a closed economy.)
Harper was referring here to the economic crisis Canada and the rest of the world are facing at the
present time. He was also suggesting that a balanced budget was not only difficult to achieve but also ill
advised given the present circumstances. The statement also appears a bit misleading since he seems to
be favouring a deficit resulting from expansionary fiscal policy. The government’s economic update that
followed a few days later showed that Harper was not much in support of running any type of deficit even
under the difficult present economic circumstances.
What policy options are available to the government to address this economic crisis?
One possibility is the implementation of expansionary monetary policy, the policy alternative most
favoured by conservative economists. In some countries (e.g., Japan, Switzerland, the U.S.), this might
not be possible since they are already facing a liquidity trap (i.e., the rate of interest is very low and there
is not much room for further decreases). Canada, however, is not in this situation – the rate of interest
can go lower.
The Bank of Canada, however, cannot directly increase the money supply nor directly decrease the rate
of interest paid by the public. The Bank of Canada can only attempt to increase the liquidity of the
commercial banks in order to induce them to reduce interest rates and increase loans to the public. The
Bank of Canada has attempted this with little success. First, it has reduced the bank rate (i.e., the rate
commercial banks paid to the Bank of Canada when they borrow money from the Bank). When the
system works normally, a reduction in the bank rate is rapidly transferred to the public through a reduction
in commercial rates. Not this time – the Bank lowered the bank rate twice but commercial rates decreased
only marginally. Instead, banks have borrowed more in order to increase their reserves to protect
themselves from some of their assets (loans to the public) going bad but not to increase loans to the
public. Second, the Bank of Canada (and the government) can buy assets (loans) from the commercial
banks in order to increase their liquidity in the hope that they will increase the loans to the public. The
government has purchased $75 billion in mortgage loans but this did not translate in greater credit to the
public and lower interest rates. Right the opposite – some interest rates (e.g., on credit card) went up. So
expansionary monetary policy is not working – banks have tried to increase their reserves instead of
increasing credit to the public.
Moreover, even if banks were to reduce the commercial rates and offer more loans to the public,
consumers and businesses are not in a spending mood. They are trying to balance their accounts and
paying off debts to reduce their liabilities, and thus any reduction in interest rates will have a rather small
impact in the demand for loans.
Therefore, the only government option appears to be expansionary fiscal policy – either a reduction in
taxes or an increase in expenditure. A reduction in taxes has already been implemented with little impact
– disposable income increased but expenditure did not, only savings went up.
Increasing government expenditure appears to be the only possible alternative. But what type of
expenditure? It must be a type that will not contribute to generate a structural deficit, i.e., a one-time
expenditure such as expenditure on infrastructure. This will contribute to increase employment in the
short run but also to increase our long run productive capacity.
Page 8 of 11
2. Assuming imperfect capital mobility and fixed exchange rates, explain the impact
that the imposition of tariffs on the imports of cars would have on the Canadian
economy. In your answer, clearly indicate the impact on equilibrium income,
equilibrium rate of interest, and the balances in the current and capital accounts
under the assumption of no retaliatory measures by the rest of the world. (Show your
answer with help of an IS-LM-BP diagram and explain the economics.)
The imposition of a tariff on Canadian car imports will result in an increase in NX, and thus the IS curve
will shift up to the right (see diagram). This creates a situation of excess demand in the goods market and
Y will have to increase to restore equilibrium.
In addition, the imposition of the tariff improves the balance in the current account while leaving the
balance in the capital account unchanged. Therefore, now BP > 0 at point A. 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 has improved). Therefore, BP
would be 0 at Y1 when the rate of interest is i2 — this means that the BP curve has shifted down and will
go through point B (see diagram).
Since at point A there is a surplus in the external sector (i.e., the supply for foreign currency is greater
than its demand), the Bank of Canada buys foreign currency to keep the exchange rate unchanged and
thus the domestic money supply increases. Therefore, the LM curve shifts down to the right to LM’ (see
diagram). The domestic rate of interest falls to i2 and the balance in the capital account deteriorates by
the same absolute amount as the balance in the current account improved. Therefore, at point B now
both the money market and the external sector are in equilibrium but there is an excess demand in the
goods market.
As Y starts to increase to eliminate the excess demand, the rate of interest also starts to rise as the
demand for real balances increases. In turn, the increase in the rate of interest improves the balance in
the capital account and a surplus arises in the external sector. The Bank of Canada buys foreign currency
to keep the exchange rate unchanged and thus the domestic money supply increases further. Therefore,
the LM curve starts shifting to the right and this process continues until it shifts all the way to LM’’ (see
diagram). As the Bank of Canada buys foreign currency to keep the exchange rate unchanged, then both
the money market and the external sector are kept in equilibrium (i.e., the adjustment path is a movement
up along the BP’ curve). The new equilibrium is at point C where the excess demand in the goods market
is eliminated.
Therefore, the results of the imposition of the tariff on car imports are as follows. First, the level of
equilibrium Y definitely increases. Second, the rate of interest will decrease (as a result of the increase in
the money supply). Third, the balance in the current account will improve as a result of the tariff, which
means that the tariff effect will be greater than the income effect on imports. Of course, the composition of
Q will change and the import of cars will be lower than before despite this income effect. And finally, the
balance in the capital account will deteriorate as a result of the decrease in the rate of interest. These
results are shown in the diagram below.
i
LM
LM’’
LM’
BP
i1
A
BP’
C
i3
i2
B
IS’
IS
Y1
Y2
Y
Page 9 of 11
3. Assuming imperfect capital mobility and fixed exchange rates, explain the impact of
an open market sale (of government bonds) by the Bank of Canada. In your answer,
clearly indicate the effect on equilibrium income, equilibrium rate of interest, and the
balances in the current and capital accounts. (Show your answer with help of an ISLM-BP diagram and explain the economics.)
An open market sale decreases the money supply and thus the domestic rate of interest increases.
Graphically, the decrease in the money supply is represented by a shift of the LM curve to the left, i.e., at
each level of Y the money market will now be in equilibrium at a higher rate of interest (see diagram
below).
At the initial level of income (Y1), the money market is now in equilibrium at a higher interest rate (i2).
Therefore, while the money market continues in equilibrium, the goods market and the external sector are
now in disequilibrium. As a result of the increase in the rate of interest, there is now an excess supply in
the goods market because of the decrease in desired investment, and an excess supply in the exchange
market due to the improvement in the capital account. Since any adjustment in the goods market takes
time to be realized but the adjustment in the external sector is very quick, let’s examine the latter first.
To keep the exchange rate unchanged, the Bank of Canada buys foreign currency to eliminate the
excess supply and thus the domestic money supply increases. Therefore, the LM curve starts shifting
back to the right and the domestic rate of interest falls. This process continues as long as BP > 0, i.e.,
until the LM’ curve shifts all the way back to LM and the external sector is in equilibrium once again. At
this point, the initial improvement in the balance of the current account is completely offset.
The adjustment in the goods market is as follows. As the rate of interest starts to fall back towards its
initial level, desired investment also increases. Once the rate of interest is back to its initial level, the level
of desired investment is also as before and the excess supply in the goods market is eliminated. Note that
the adjustment in the goods market takes place only on the demand side of the economy—desired
investment first increases and then decreases back to its initial level without any change in the level of
output taking place.
Therefore, the results of the open market sale by the Bank of Canada are as follows. First, the level of
equilibrium Y and the rate of interest remain as before, which indicates that monetary policy is completely
ineffective with respect to income in this model. Second, since the exchange rate and the level of income
do not change, the balance in the current account also remains as before. Finally, since the overall
balance of payments is again equal to zero and the balance in the current account has not changed, then
the balance in the capital account is also the same as before. Note, however, that the balance in the
capital account deteriorated during the period of adjustment—this deterioration being equal to the loss of
foreign reserves by the Bank of Canada.
LM’
i
LM
i2
BP
i1
A
IS
Y1
Y
Page 10 of 11
4. Assuming imperfect capital mobility and fixed exchange rates, explain the impact of
a devaluation of the domestic currency by the central bank. In your answer, clearly
indicate the effect on equilibrium income, equilibrium rate of interest, and the
balances in the current and capital accounts. (Show your answer with help of an ISLM-BP diagram and explain the economics.)
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’ (see
diagram). A situation of excess demand (i.e., AE > Y) arises 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., 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 has improved). Therefore, BP would be 0 at Y1 when
the rate of interest is i2 — this means that the BP curve has shifted down and will go 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 buys foreign currency.
As a result, the domestic supply of money increases and the LM curve shifts to the right to LM’ (see diagram).
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 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.
Y starts to increase to eliminate the excess demand in the goods market, and thus the domestic rate of interest
starts to rise as well (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 and thus the money supply increases and the LM’ curve shifts to the
right. This process continues as long as there is a surplus in the external sector, 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 contributes to maintain equilibrium in the external
sector at all times as well. The economy, therefore, is always at a point of intersection of the (shifting) LM curve
and the (static) BP’ curve. Therefore, the adjustment path is graphically represented by a movement up along
the BP’ curve.
Therefore, the results of the currency devaluation are as follows. First, the level of equilibrium Y increases while
the rate of interest decreases. Second, since the domestic currency was devalued, the balance in the current
account improves. And third, since the balance in the current account improves, the balance in the capital
account necessarily deteriorates (which means that the domestic rate of interest is lower than before).
LM
i
i1
BP
A
LM’’
BP’
C
i3
i2
LM’
B
IS
Y1
Y2
IS’
Y
Page 11 of 11