Department of Economics University of Toronto

Prof. Gustavo Indart June 19, 2003

SOLUTION

ECO 202Y L0101 MACROECONOMIC THEORY Term Test #1

LAST NAME FIRST NAME STUDENT NUMBER

INSTRUCTIONS: 1. 2. 3. 4. 5. The total time for this test is 1 hour and 50 minutes. This exam consists of three parts. This question booklet has 12 (twelve) pages. Aids allowed: a simple calculator. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE

Part I Part II Part III 1. 2. 3.

/50 /20 /10 /10 /10

TOTAL

/100

Page 1 of 5

PART I
Instructions:

(50 marks) Circle the most appropriate answer. Each question is worth 2.5 (two and one-half) marks. No deductions will be made for incorrect answers.

1. Suppose that savings are $986.9 billion, investment is $796.5 billion, and the current account balance is -$55.1 billion. What is the government budget surplus? a) -$245.5 billion b) -$135.3 billion c) $135.3 billion d) $245.5 billion 2. Jims Nursery produces and sells $1,300 worth of flowers. Jim uses $200 in seeds and fertilizer, pays his workers $700 in wages, pays $100 in taxes, and pays $200 in interest on a loan. Jims contribution to GDP is a) $900 b) $1,000 c) $1,100 d) $1,800 3. Assume a Canadian dealer bought 100 TVs from Korea for $250 each in 1996. He subsequently sold 80 of them in 1996 for $450 each, and the rest in 1997 for $400 each. By how much was the Canadian GDP affected in 1996? a) $45,000 b) $36,000 c) $19,000 d) $16,000 4. Suppose that an economy produces only food and clothing, and that price and quantity data are given in the table below. Using Year 2 as the base year, what is the percent change in real output from Year 1 to Year 2? Round off to the nearest percentage point. Year 1 Good Food Clothing a. b. c. d. 8% 10% 12% 15% Quantity 4000 5000 Price $4 $3 Quantity 4500 5200 Year 2 Price $6 $2

5. Nominal GDP in 1970 was $1,015.5 billion, and in 1980 it was $2,732.0 billion. The GDP deflator is 42.0 for 1970 and 85.7 for 1980, where 1982 is the base year. Calculate the percent change in real GDP in the decade from 1970 to 1980. Round off to the nearest percentage point. a) 32% b) 104% c) 132% d) 169% 6. The aggregate expenditure (AE) curve will be steeper a) the larger is the interest sensitivity of investment demand b) the smaller is the interest sensitivity of money demand c) the larger is the tax rate d) the smaller is the marginal propensity to import

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7. The IS curve will be steeper a) the smaller is he interest sensitivity of investment demand b) the larger is the tax rate c) the smaller is the marginal propensity to consume d) all of the above 8. A reduction in the demand for real balances at each level of the market rate of interest shifts a) the IS curve up to the right b) the IS curve down to the left c) the LM curve up to the left d) the LM curve down to the right 9. The real demand for money curve is steeper hen a) the larger is the interest sensitivity of investment demand b) the smaller is the interest sensitivity of money demand c) the larger is interest sensitivity of consumption demand d) none of the above 10. The shift in the IS curve that occurs when government expenditure increases is larger a) the smaller is the marginal propensity to consume b) the larger is the tax rate c) the smaller is the marginal propensity to import d) the smaller is the increase in government expenditure 11. The shift in the LM curve that occurs when the money supply increases is larger a) the larger is the interest sensitivity of investment demand b) the larger is the income sensitivity of money demand c) the smaller is the interest sensitivity of money demand d) all of the above 12. Suppose that consumption demand declines as the interest rate increases. The IS curve will be steeper a) the more sensitive consumption demand is to changes in the interest rate b) the less sensitive consumption demand is to changes in the interest rate c) the IS curve will not depend on the sensitivity of consumption demand to changes in the interest rate d) the IS curve will 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. 13. In the full IS-LM model, an increase in government expenditure accompanied by an increase in the tax rate that is chosen in such a way that the size of the government budget deficit stays the same will cause output to increase by a) more than the increase in government expenditure b) exactly by the amount of the increase in government expenditure c) less than the increase in government expenditure d) depends on the various elasticities.

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14. The LM curve is steeper a) the more sensitive is investment demand to changes in the interest rate b) the more sensitive is money demand to changes in the interest rate c) the larger is the sensitivity of money demand to changes in the level of income d) all of the above. 15. Suppose that the money supply varies directly with 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 16. Suppose that the government collects $3 million in taxes, pays $2 million in Social Security benefits, pays $0.5 million in interest on the national debt, and pays workers $1 million in wages. The government contribution to GDP is a) $0 b) $1 million c) $3 million d) $3.5 million 17. Assume a model with no government and no foreign sector. If the savings function is defined as S = - 300 + (0.1)Y and autonomous investment increases by 200, by how much will consumption increase? a) 180 b) 200 c) 1,800 d) 2,000 18. If the price level of Canadian goods is 200, the price level of foreign goods is 125, and the dollar price of foreign currency is 2.40, what is the real exchange rate? a) 3.50 b) 3.00 c) 2.50 d) 1.50 19. If Canada acquired net foreign assets of $50 billion in one year, this would be the equivalent of a) net imports of $50 billion b) net foreign borrowing of $50 billion c) a capital account deficit of $50 billion d) a current account deficit of $50 billion 20. If a country has a balance of payment deficit, then a) Its capital outflows exceed its capital inflows b) It cannot compete in international markets c) It is reducing its reserves of foreign currency d) It has a current account deficit

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PART II
Instructions:

(20 marks) Answer the following question in the space provided.

Consider the following hypothetical economy: AE = C + I + G + NX C = 300 + 0.8YD I = 300 - 20i G = 200 (6) (a) X = 60 Q = 120 + 0.2Y TA = 100 + 0.25Y TR = 50 L = 0.4Y - 10i M = 700 P=2

Derive the equilibrium values of income (Y) and the rate of interest (i). [Note that the level of income is in billions and the rate of interest in percent.]

Equilibrium is determined by the intersection of the IS and LM curves. To find the expression for the IS curve we must first find the expression for the AE curve. AE = C + I + G + NX = 300 + 0.8(Y 100 0.25Y + 50) + 300 20i + 200 + 60 120 0.2Y = 700 20i + 0.4Y Equilibrium in the goods market implies that Y = AE, Y = 700 20i + 0.4Y 20i = 700 0.6Y and thus the expression for the IS curve is: i = 35 0.03Y. To find the expression for the LM curve we must equate L and M/P, 0.4Y - 10i = 350 10i = -350 + 0.4Y and thus the expression for the LM curve is: i = -35 + 0.04Y. Equating the IS and LM curve to find equilibrium Y, 35 0.03Y = -35 + 0.04Y 0.07Y = 70 Y* = 1000. To find equilibrium i we plug the value of Y* in either the expression for the IS or the LM curve, IS: LM: i* = 35 0.03(1000) = 35 30 = 5 i* = -35 + 0.04 (1000) = -35 + 40 = 5

(4)

(b)

What are the values of the fiscal policy multiplier ($FP) and the monetary policy multiplier ($MP)? 1 1 = = 1 0.8(1 0.25) + 0.2 + 20(0.4)/10 1 = = [1 0.8(1 0.25) + 0.2](10/20) + 0.4 0.7 1.4 1 = 10/7 1 = 5/7

$FP =

1 c(1 t) + m + bk/h 1

$MP =

[1 c(1 t) + m] (h/b) + k

If you cannot remember the expressions for $FP and/or $MP, using the solution to part (c) below you can find the value for $FP. Indeed, DY = $FP DG, where DY = 50 and DG = 70 $FP = DY / DG = 50 / 70 = 5/7. Now, using the solution to part (d) below you can find the value of $MP. Indeed, DY = $MP D(M/P), where DY = 66 and D(M/P) = 46 $MP = DY / D(M/P) = 66 / 46 = 10/7.

(5)

(c)

Suppose that the government increases its expenditure on goods and services by $70 billion. What is the new equilibrium level of income? What is the new equilibrium rate of interest?

One way to answer this question is by finding first the change in Y as a result of the increase in G, that is, )Y = $FP )G = (5/7) 70 = 50 Therefore, the new equilibrium level of income is: Y* = 1050. To find the equilibrium rate of interest, we plug this value for Y* in the expression for the LM curve [note that we cannot plug this value in the expression for the IS curve since this curve has changed after the increase in G]: i* = -35 + 0.04 (1050) = -35 + 42 = 7.

We can also answer this question by finding first the expression for the new IS curve, where the vertical intercept is AE/b = 770 / 20 = 38.5. Therefore, the expression for the new IS curve is: i = 38.5 0.03Y. Equating the IS and LM curve we find the new equilibrium income: 38.5 0.03Y = -35 + 0.04Y 0.07Y = 72.5 Y* = 72.5 / 0.07 = 1050. Plugging this value for Y* into the expression for the IS curve or the LM curve we find the new equilibrium rate of interest.

(5)

(d)

Go back to the initial equilibrium situation of point a) above. Suppose now that at the same time that the government increases its expenditure on goods and services by $70 billion, the Bank of Canada also increases the money supply to prevent any change in the equilibrium rate of interest. By how much will the Bank of Canada increase the money supply?

Lets find first the new equilibrium level of income when DG = 70 and i* = 5. To find the value of this new Y* we must plug i* = 5 into the expression for the new IS curve: i* = 38.5 0.03Y* 5 = 38.5 0.03Y* 0.03Y* = 38.5 5 Y* = 33.5 / 0.03 = 1116. [Note that the increase in M/P causes equilibrium income to increase by an additional $66 billion.] The money market is in equilibrium when M/P = L. That is, M/P = 0.4Y 10i and plugging the values for P = 2, Y = 1116 and i = 5 we get: M = 2[0.4(1116) 10(5)] = 2 (446 - 50) = 2(396) = 793 Therefore, the increase in the money supply must be )M = 793 - 700 = 93.

PART III

(30 marks)

Instructions: Answer true, false, or uncertain to the following statements. Be sure to justify your answers (no justification, no marks!). Answer all questions in the space provided on question sheet (if space is not sufficient, continue on the back of the previous page). Each question is worth 10 (ten) marks. 1. According to the standard fixed price IS-LM model, monetary policy cannot change real output as long as investment is independent of interest rates. (Show your answer graphically and explain the economics.) True. Monetary policy affects equilibrium output through the change in investment caused by the change in the rate of interest. An increase in the money supply, for instance, will decrease the rate of interest and, if investment is sensitive to changes in the rate of interest, the level of investment will increase and Y will also increase. Now, if investment is independent of the rate of interest (i.e., the IS curve is vertical), then a decrease in the rate of interest will have no effect on investment and thus on output. i i I (M/P) i0 i1 L(Y0) (M/P) i0 i1

M/P

2. If an economy finds itself in the Classical case - i.e., in the extreme situation opposite to the liquidity trap - the government should use expansionary monetary policy - and not expansionary fiscal policy - to increase equilibrium income. (Show your answer graphically and explain the economics.) True. The Classical Case represents the opposite situation encountered in the Liquidity Trap case. Here the demand for money is completely unresponsive to changes in the rate of interest (it depends only on the level of output), that is, the L curve is vertical. Therefore, the LM curve is also vertical and monetary policy has the maximum effect on output. Lets see why a vertical demand for money curve determines a vertical LM curve. Recall that L = kY - hi. If the demand for money is completely unresponsive to the rate of interest, then L is, in this case, equal to kY only (i.e., h = 0). Equilibrium in the money market is determined by the intersection of demand and supply, i.e., where M/P = ky. We can also write this equation in the following way: Y = (M/P) / k. Now, if the nominal money supply is fixed at M1 and the price level is fixed at P, then the level of output will be Y1 = (M1/P) / k. Thus the supply of money determines the level of output and the combination of the level of output Y1 with any level of the rate of interest represents an equilibrium in the money market, that is, the LM curve is vertical. An increase in the nominal money supply to M2 will increase the level of equilibrium output to Y2, and the combination of Y2 with any level of the rate of interest will represent a new equilibrium in the money market - that is, it will cause the vertical LM curve to shift to the right. At the same time, fiscal policy is completely ineffective in this case. Indeed, and increase in government expenditure, for instance, will cause the rate of interest to increase in a way as to reduce investment by the same absolute amount as G has increased. Therefore, there is complete crowding out effect in this case. i (M/P) = L (M/P) = L i LM LM

i1

i2

IS

M1/P

M2/P

M/P

Y1

Y2

3. An increase in the income sensitivity of the demand for real balances (k) will reduce the effectiveness of fiscal policy. (Show your answer graphically and explain the economics.) True. Since the fiscal policy multiplier is given by: $FP = 1 / [1 c(1 t) + bk/h], an increase in k will make $FP smaller, and thus fiscal policy less effective. We can see this also graphically. Since the slope of the LM curve is k/h, an increase in k to k makes the LM curve steeper. The diagram shows that expansionary fiscal policy as reflected by the shift of the IS curve up to the right to IS has a smaller impact on Y when the LM is steeper (because the rate of interest increases more and thus there is greater crowding out). The economic explanation is as follows. Greater sensitivity of the demand for real balances means that a given change in income will cause a greater increase in the demand for money, and thus a greater increase in the rate of interest. In turn, a higher rate of interest translates into a lower investment level and, therefore, into a greater crowding out effect. i LM(k)

LM(k)

IS IS Y0 Y1 Y0 Y1 Y