ECONOMICS290finalexam_winter2010

Examination April 2010

IT WOULD BE GREATLY APPRECIATED IF EXAM WAS WRITTEN IN PENThe opposite page can be used for rough work. Proctors including Professor Johnson cannot answer questions related to the content of the test since 5% of the class is writing in Accessible Learning and cannot have the same access to the course instructor.

If you feel that a question is unclear in any way state both what you believe the question means and then present your answer. Grades will be allocated for both your interpretation of the question and your answer.

The examination is worth a total of 74 points allocated as:

ONE 8 TWO 6 THREE 16 FOUR 6 FIVE 8 SIX 4 SEVEN 4 EIGHT 10 NINE 12

Question One (8 points)

This graph appears in Chapter 25

-1

0

1

2

3

4

5

94 96 98 00 02 04 06 08

Total CPI

CoreCPI

infla

tion

(per

cent

cha

nge

in p

rices

from

12

mon

ths

prev

ious

)

(A) (2 points)

Provide a definition of inflation accessible to a non-economist

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Examination April 2010(B) (2 points)

Between 2002 and 2003, inflation reached a value of 5 using the total CPI and only 3 using core inflation. Explain why these values for inflation can be so different in the same year?

(C) (2 points)

If inflation was 5% in 2003, and your wage was $22.00 an hour in 2002, what is the wage that would keep your real wage constant between 2002 and 2003?

(D) (2 points)

If the tax brackets for income tax in 2002 and 2003 were as below, explain how would you expect an inflation rate of 5% observed between 2002 and 2003 to change the average income tax rate?

Income Bracket Tax rate 2002 Tax Rate 20030 dollars to 19,999 dollar 10% 10%Above 20,000 dollars 25% 25%

2

Examination April 2010Question Two (6 points)

The goods market equilibrium in the IS-LM model focuses on the relationship between i, the interest rate and Y the level of real output :

The equations in a closed economy are:

C = c0 + c1 ( Y – T ) the endogenous level of consumption

T the level of taxes net of transfers

I = b0 + b1 Y - b2 i I the endogenous level of investment i the rate of interest

G the exogenous level of real government spending

(A) (2 points)

Use the equations above to make an argument that there is a negative relationship between the rate of interest and the equilibrium level of output in the market for goods. You can solve the equations for the IS curve and show it has a negative slope or you may make a verbal argument based on the equations.

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(B) (2 points)

The government spending multiplier in the IS-LM model does depend on the parameter denoted b2 in the investment equation. This can be demonstrated with the simulation.

The Initial Solution to the ModelThe equilibrium interest rate (%) is 5 The equilibrium level of consumption is 400The equilibrium level of real income is 1000.00 The equilibrium level of investment is 350

Government spending is increased by 10 units.

The New Solution to the ModelThe equilibrium interest rate (%) is 5.33333333 The equilibrium level of consumption is 403.333333The equilibrium level of real income is 1013.33333 The equilibrium level of investment is 350

The government spending multiplier per unit increase in government spending is:

(C) (2 points)

I changed the value of the parameter b2 The Initial Solution to the ModelThe equilibrium interest rate (%) is 3.75015242 The equilibrium level of consumption is 400.001524The equilibrium level of real income is 1000.00 The equilibrium level of investment is 358.749848

Government spending is increased by 10 units.

The New Solution to the ModelThe equilibrium interest rate (%) is 4.07273306 The equilibrium level of consumption is 403.227331The equilibrium level of real income is 1012.90932 The equilibrium level of investment is 358.427267

Did I increase, decrease or leave unchanged the value of b2. Explain your reasoning and make reference to the data above.

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Examination April 2010Question Three (16 points)

A set of equations that represent an open economy in the short run are:

C = c0 + c1 ( Y – T ) C consumption Y real output

Q = q1 Y Q imports

X = x1 Y* X exports Y* is foreign income

I I investment is exogenous

T T is taxes net of transfers

G Real government spending on goods and services

(A) (2 points)

Solve for the equilibrium level of income in this economy

(B) (2 points)

The multiplier with respect to a one unit change in T, the level of taxes is

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Examination April 2010(C) (2 points)

In this economy it is possible to calculate a balanced budget multiplier, that is, the increase in income if there is a one unit increase in G and, at the same time, a one unit increase in T.

Calculate the balanced budget multiplier

(D) (2 points)

How does the trade balance change in this economy if the level of foreign income rises by 1 unit?

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(E) (6 points) The open economy equations are repeated:


Q = q1 Y Q imports

X = x1 Y* X exports Y* is foreign income

I I investment is exogenous T T is taxes net of transfers


There are similar equations for a closed economy


I I investment is exogenous T is taxes net of transfers


The diagram below contains 3 lines that show equilibrium for this closed economy and for this open economy. Each line needs a label AND a slope. Place these on the diagram

(F) (2 points)

Will the government spending multiplier be larger or smaller in the closed economy than in the open economy? Why?

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Examination April 2010Question Four (6 points)

(A) (2 points)

Using the balance sheets below, indicate how in the simplest possible world, the central bank acts to increase the money supply by 100 units. In this simplest possible world, the only component of the money supply is currency.

Central Bank Balance Sheet (billions of dollars)

Assets Liabilities

Government Bonds 500 Currency 500

Household Balance Sheet (billions of dollars)

Assets Liabilities

Government Bonds 1000 Mortgages issued by households 2000

Houses 3000

Currency 500

(B) (2 points)

Explain how, in this simplest possible financial world, the increase in the money supply by 100 units would decrease interest rates on bonds.

(C) (2 points)

There are times where a central bank could increase the money supply by 100 units and the interest rate does not change. Why?

8


Question Five (points)

(A) (2 points)

SCENARIO THREE

A one year change in domestic monetary policy that leaves future expected nominal exchange rate fixed

Year

Domestic Interest

Rate

Foreign Interest

Rate

Year t Exchange

Rate*

Year t+1 Expected

Exchange Rate in Year t

1998 2.00 2.00 1.4000 1.40001999 2.00 2.00 1.4000 1.40002000 2.00 2.00 1.4000 1.40002001 3.00 2.00 1.40002002 2.00 2.00 1.4000 1.40002003 2.00 2.00 1.4000 1.4000

* Exchange rates are measured in units of domestic currency per unit of foreign currency

Calculate, assuming interest rate parity, an exact value to 4 decimal points for the Year t Exchange Rate

(B ) (2 points)

The Federal Budget includes the average private sector forecasts for a number of variables. We saw these forecasts on the second term test. Here we use the data from those forecasts.

In 2012, the average private sector forecast for the Treasury bill rate (an interest rate) in Canada is 3.8%. The exchange rate forecast is 97.7 US cents per Canadian dollar in 2012 and 99.3 US cents per Canadian dollar in 2013. NOTICE THE EXCHANGE RATE UNITS

What is the average private forecast of US interest rates in 2012 if interest rate parity holds? (you can use the approximation or the exact method). There is room for rough work on opposite page

9

Examination April 2010 The headline below refers to a slide in the value of the Euro against the U.S. dollar. The Euro is the currency unit of the European Union. It trades against the U.S. dollar in the same way the Canadian dollar trades against the U.S. dollar.

Euro’s recent slide welcomed as boost to exports by business

European companies are happy with a weaker euro as it will help them boost exports this year, Europe’s business federation said Monday Waterloo Region Record: February 16, 2010

Here are data for 2006 and 2008. The data are from the Economic Report of the President, 2010.

(C) (2 points)

What percent real depreciation (or appreciation) was experienced by the Euro area with respect to trade with the United States between 2006 and 2008? Specify whether it is a depreciation or appreciation. You may be exact or use the approximation.

Euro per US dollar (average)

Consumer Price Index in United States

Consumer Price Index in Germany

2006 1.2563 201.6 156.22008 1.4726 215.3 163.9

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Here are some data for the Current Account of the United States in 2008

Billions of dollarsItem 2008Exports 1276Imports 2117

Investment income received 764.6Investment income paid 646.4

(D) (2 points)

Does this data indicate whether the United States is a debtor to the rest of the world or a creditor to the rest of the world in 2008?

You will not need all this space

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Examination April 2010Question Six (4 points)

An initial equilibrium in an open economy is characterized byFiscal Policy Monetary Policy

Government Spending

Net Taxes

Money Supply

Foreign Interest

Rate

G T M i*205 205 100 5

The initial equilibrium level of income is 1000.00

A final equilibrium is characterized by:

Fiscal Policy Monetary Policy

Government Spending

Net Taxes

Money Supply

Foreign Interest

Rate

G T M i*215 205 100 5

The final equilibrium level of income is 1006.70

(A) (2 points)

Show the changes in the diagram below that correspond to this change in the level of government spending. The expected exchange rate does not change.

(B) (2 points)

Would the government spending multiplier be larger than 0.67 if the Bank of Canada had fixed the value of the exchange rate at 1.0 domestic currency units per unit of foreign currency? Use the diagram.

Formula for equilibrium interest rate5.0000 %

Formula for equilibrium exchange rate1.000

Formula for equilibrium interest rate6.00 %

Formula for equilibrium exchange rate0.99

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Examination April 2010Question Seven (4 points)

Great emphasis is placed on increasing the level of productivity, for example:

Crane: Canadians can't afford to lose productivity race Toronto Star March 31, 2010…Without productivity improvement we will condemn ourselves to a standard of living which is in decline relative to the rest of the world – this decade – and absolute decline next decade,"

The aggregate supply side of the model is usually presented in two diagrams:

(A) (2 points)

Show clearly which curves would shift with an increase in the level of productivity.

(B) (2 points)

Explain how and why an increase in the level of productivity would change the level of employment in the medium run

13


Question Eight (10 points)

The initial equilibrium in Period t

Nominal Money Supply

Real Government

Spending

Real Net

Taxes

Full Employment

OutputReal

OutputPrice Level

Expected Price Level

M G T Yn Y P Pe 90 200 200 1000 1000 100 100

Your choices for period t+1 through the rest of time

Time Period Relative to t M G T Yn Y P Pe Pt-1

t+1 ?? 200 200 1000 1006.34 115.85 100.00 100.00t+2 ?? 200 200 1000 1000.31 116.63 115.85 115.85t+3 ?? 200 200 1000 1000.02 116.66 116.63 116.63t+4 ?? 200 200 1000 1000.00 116.67 116.66 116.66t+5 ?? 200 200 1000 1000.00 116.67 116.67 116.67t+6 ?? 200 200 1000 1000.00 116.67 116.67 116.67t+7 ?? 200 200 1000 1000.00 116.67 116.67 116.67t+8 ?? 200 200 1000 1000.00 116.67 116.67 116.67t+9 ?? 200 200 1000 1000.00 116.67 116.67 116.67

t+10 ?? 200 200 1000 1000.00 116.67 116.67 116.67

The final equilibrium after "many" periods

M G T Yn Y P Pe Many periods after t+1 ?? 200 200 1000 1000.00 116.67 116.67

(A) (4 points)

Add AS and AD curves for period t+1. Then show clearly the AD and AS curves that represent many periods after t+1.

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Examination April 2010(B) (2 points)

Between the initial equilibrium and the final equilibrium in this model (many periods after t+1) ,

Is the unemployment rate higher, lower or the same? Explain your reasoning.

(C) (2 points)

Between the initial equilibrium and the final equilibrium in this model (many periods after t+1) ,

Is the rate of interest higher, lower or the same? Explain your reasoning.

(D) (2 points)

Calculate the value of the money supply represented by ??

15


Question Nine (14 points)

The AS-AD model can be used to address some of the policy issues as Canada and other countries emerge from the 2009-10 recession

(A) (2 points)

In the diagram above, place the aggregate demand curve on the diagram to illustrate a recession in 2009.

What caused the aggregate demand curve to shift in Canada?

(B) (3 points)

In Canada, there was, as of the federal budget in 2009, a fiscal policy response, and throughout 2009, a monetary policy response by the Bank of Canada. Complete these sentences:

The Bank of Canada chose to:

The federal government chose to:

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Examination April 2010(C) (3 points)

Even with the policy responses above, there was still a recession in 2009. Please give an estimate within one percentage point of the unemployment rate in 2008, the unemployment rate in 2009 and explain how your estimates illustrate a recession

Unemployment rate in 2008 ________________

Unemployment rate in 2009 __________________

Explanation of how the values you chose sensibly illustrate a recession in 2009

(D) (2 points)

The formula below describes the evolution of the government’s debt-to-GDP ratio:

This is a formula where it is assumed you will be able to identify the meaning of the symbols. Bt

is the amount of government debt outstanding in real terms at the end of period t

The meaning and name of this component of the formula is

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Examination April 2010The formula (repeated) below describes the evolution of the government’s debt-to-GDP ratio: This is a formula where it is assumed you will be able to identify the meaning of the symbols. Bt

is the amount of government debt outstanding in real terms at the end of period t

(E) (2 points)

Use the components of this equation to identify one key difference between the fiscal plans outlined by the federal government budget in January 2010 and the Ontario government budget in April 2010.

(F) (2 points)

Use the equation repeated above and the data to identify one reason why Greece is in deeper fiscal trouble than Britain and one reason why Britain is in deeper fiscal trouble than Greece.

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ECONOMICS290finalexam_winter2010