Department of Economics Prof.

Gustavo Indart
University of Toronto July 15, 2002

ECO 208Y - L5101

SOLUTION
MACROECONOMIC THEORY

Term Test #2

LAST NAME

FIRST NAME

STUDENT NUMBER

INSTRUCTIONS:

1. The total time for this test is 1 hour and 50 minutes.

2. This exam consists of two parts.
3. This question booklet has 9 (nine) pages.
4. Aids allowed: a simple calculator.
5. Use pen instead of pencil.

DO NOT WRITE IN THIS SPACE

Part I /45

Part II 1. /11

2. /11

3. /11

4. /11

5. /11

TOTAL /100

Page 1 of 9
PART I (45 marks)

Instructions: Circle the most appropriate answer. Each question is worth 3 (three) marks. No
deductions will be made for incorrect answers.

1. Net exports will increase if

(a) there is an increase in domestic income
(b) there is a decrease in the real exchange rate
(c) there is an increase in domestic inflation
(d) many of our trade partners experience inflation

2. When exchange rates are fixed and capital is perfectly mobile then monetary policy
(a) is very effective
(b) is completely ineffective
(c) can be conducted independently of exchange rate considerations
(d) always has to be accommodated by fiscal policy

3. Compared to a closed economy in an open economy fiscal policy is

(a) more effective because the marginal propensity to import is positive
(b) equally effective because domestic fiscal policy has no effect on the trade
balance
(c) less effective because part of the increase in domestic income is spent on
foreign goods
(d) less effective because expansionary fiscal policy always has to be supplemented
by restrictive monetary policy

4. Which of the following is NOT true?

(a) a rise in foreign income ceteris paribus improves a country's trade balance and
thus leads to an increase in aggregate demand
(b) a rise in domestic interest rates improves a country's trade balance since it
decreases imports
(c) an exchange rate depreciation by a home country worsens its trade balance and
thus decreases aggregate demand
(d) a decrease in exports leads to lower interest rates and a currency depreciation

5. Consider an open economy with imperfect capital mobility, if exchange rates are flexible and
central banks do not intervene in foreign exchange markets then
(a) balance of payments deficits of debtor nations will tend to worsen
(b) capital flows will not occur since all interest rates are the same
(c) each nation's balance of payments will be zero
(d) each nation's trade account balance and capital account balance will always be
equal

6. In a model with perfect capital mobility and flexible exchange rates a tax cut will
(a) be totally crowded out due to a decrease in investment
(b) crowd out net exports due to an exchange rate depreciation
(c) increase net exports due to a depreciation of the exchange rate
(d) increase consumption and net exports but decrease investment
Page 2 of 9
7. In an IS-LM model with flexible exchange rates and perfect capital mobility restrictive fiscal
policy will
(a) cause an appreciation of the domestic currency
(b) shift first the LM-curve and then the IS-curve to the left
(c) not change the overall level of output but its composition
(d) lower the level of output but leave the interest rate unchanged

8. In an IS-LM model with fixed exchange rates and perfect capital mobility a restriction in
money supply will
(a) shift the LM-curve first to the left and then back to the right as the central
bank is forced to buy foreign currency
(b) shift the LM-curve first to the right and then back to the left as the central bank is
forced to sell foreign currency reserves
(c) shift the LM-curve and then the IS-curve to the left because of a drop in net
exports
(d) shift the LM-curve and then the IS-curve to the right because of an increase in
imports

9. In an IS-LM model with fixed exchange rates and perfect capital mobility a cut in
government spending will
(a) shift the IS-curve down to the left without affecting the LM-curve
(b) shift the IS-curve down to the left but then back up to the right because of the
resulting increase in net exports
(c) shift the IS-curve down to the left and then the LM-curve up to the left as
the Bank of Canada is forced to decrease the money supply
(d) shift the IS-curve down to the left and then the LM-curve down to the right as the
Bank of Canada is forced to expand the money supply

10. The introduction of exchange rate expectations requires us to modify our condition for
balance of payments equilibrium by
(a) dropping the assumption of perfect capital mobility
(b) maintaining the assumption of perfect capital mobility and dropping the
condition of equality between the domestic and international interest rates
(c) dropping both assumptions of perfect capital mobility and the condition of
equality between the domestic and international interest rates
(d) dropping the assumption of perfect capital mobility and adding in the condition of
equality between the domestic and international interest rates

11. Assume that a country experiences a severe decline in exports due to a lack of technical
innovation in its domestic industries. What kind of policy should this country employ to get
back to a situation of internal and external balance?
(a) an increase in government spending
(b) an increase in tariffs on import goods
(c) a restrictive monetary/expansionary fiscal policy combination
(d) expansionary fiscal policy combined with an increase in tariffs on import
goods

Page 3 of 9
12. A profit-maximizing firm will hire labour until
(a) the real wage exceeds the marginal product of labour
(b) the marginal product of labour exceeds the real wage
(c) the real wage equals the marginal product of labour
(d) the nominal wage equals the marginal product of labour

13. Which of the following is NOT reflected in a shift of the AD-curve?

(a) a change in real money balances due to a change in the price level
(b) a change in real money balances due to a change in nominal money supply
(c) a change in government transfer payments
(d) a change in autonomous investment

14. In the very short-run Keynesian model, the parameter ,, which measures the speed with
which wages adjust, equals
(a) infinity, and the Aggregate Supply curve is vertical
(b) zero, and the Aggregate Supply curve is horizontal
(c) infinity, and the Aggregate Supply curve is horizontal
(d) between zero and infinity, and the Aggregate Supply curve has a positive slope

15. The original Phillips Curve expresses the relationship between

(a) the rate of unemployment and the rate of change in the price level
(b) the rate of change in the price level and the rate of change in the nominal wage
(c) the rate of unemployment and the rate of change in the nominal wage
(d) the rate of unemployment and the rate of change in the real wage

Page 4 of 9
PART II (55 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 11 (eleven) marks.

1. Consider the IS-LM-BP model, where the BP curve is flatter than the LM curve. A decrease
in foreign interest rates will cause domestic output to fall under imperfect capital mobility and
flexible exchange rates. (Show your answer graphically and explain the economics.)

True.

If interest rates fall abroad (causing the BP curve to shift down by )i*/a to BP’), there will be a net inflow
of capital in Canada –thus improving the balance in the capital account-- since the domestic rate of
interest has not changed yet. This will cause an appreciation of the Canadian dollar (i.e., a depreciation of
the exchange rate). The price of domestic goods will become relatively more expensive on world markets,
resulting in a decrease in net exports (i.e., lower exports and higher imports) --thus worsening the
balance in current account. A decrease in net exports, in turn, implies a decrease in aggregate
expenditure and the IS curve starts shifting down to the left. A new equilibrium will be reached when the
IS curve shifts all the way to IS’ (see diagram) where the overall balance of payment is once again equal
to zero (i.e., the improvement in the capital account is equal in absolute value to the worsening in the
current account) and the net inflow of capital and the appreciation of the Canadian dollar stop. Therefore,
the domestic output falls as a result of the fall in foreign rates of interest.

LM

BP

BP’
-BP/a

-BP’/a
IS

IS’

Y1 Y0 Y

Page 5 of 9
2. Consider the IS-LM-BP model. Under a fixed exchange rate system and imperfect capital
mobility, expansionary monetary policy will permanently decrease the domestic rate of
interest and increase the equilibrium level of output in the economy. (Show your answer
graphically and explain the economics.)

False.

An increase in the nominal supply of money will cause the LM curve to shift down to the right to LM’
causing the domestic rate of interest initially to fall. The reduction in the domestic rate of interest –
everything else equal— will result in a net outflow of capital, thus creating an increase in the demand for
foreign exchange in the exchange market (i.e., an excess demand for foreign currency). To keep the
exchange rate fixed at the existing level, the Bank of Canada will have to sell foreign currency to eliminate
this excess demand. As the Bank of Canada sells foreign currency it decreases the money supply in the
process, thus causing the LM’ curve to start shifting back up to the left. As long as we have a deficit in the
external sector –equilibrium is below the BP curve—the outflow of capital will persist, the Bank of Canada
will keep reducing its reserves in foreign currency, and the money supply will keep decreasing. The new
equilibrium will be reached when the LM’ curve moves all the way back to its initial position, thus leaving
the equilibrium rate of interest and the level of output unchanged.

LM
LM’

BP

i0

IS

Y0 Y

Page 6 of 9
3. Expansionary fiscal policy does not affect the level of real output or real money balances in
the classical AS-curve case. (Show your answer graphically using both the AD-AS and IS-
LM frameworks, and explain the economics.)

False.

Expansionary fiscal policy (e.g., an increase in government expenditure) will shift the IS curve up to the
right to IS’, and the AD curve up to the right to AD’, causing excessive demand for goods and services at
the existing price level. This forces the price level up, reducing the real supply of money and causing the
LM(P0) curve to shift up to the left to LM(P1). Interest rates increase, which result in a lower level of
investment spending. In other words, the increase in the price level and the interest rate continues until
aggregate expenditure is reduced to the original full-employment level, i.e., until the increase in
government completely crowds out investment.

AS
P
i LM(P1)

i1
LM(P0) P1

i0 IS’ P0

IS AD’

AD

Y* Y0 Y Y* Y0 Y

Page 7 of 9
4. Consider the AD-AS model where the expression for the AS curve is given by:
P = P-1 + 8(Y – Y*).
Assuming that the economy is originally at the level of full employment, a permanent
decrease in AD will result in a permanent decrease in equilibrium output unless the
government implements countercyclical fiscal or monetary policy. (Note: Show your answer
graphically and explain the economics.)

False.

The permanent decrease in AD causes a fall in equilibrium income and an increase in unemployment in
the short-run. Graphically, the AD curve shifts down to the left to AD’ and output falls below full
employment and the price level decreases.

If the government uses countercyclical (i.e., expansionary) fiscal or monetary policy, then AD increases
thus offsetting the initial permanent decrease. Therefore, government intervention could avoid the
reduction in output and the increase in unemployment in the short-run. Graphically, government
expansionary fiscal or monetary policy will cause the AD’ curve to shift back to the right to AD leaving
output and the price level unchanged.

But even without government intervention, the decrease in output will not be permanent. In the long-run,
equilibrium output will be restored at the full employment level though at a lower price level. The reason
for this is that the decrease in the price level will cause the SAS curve to shift down to the right since
labour cost will be lower. This can be observed in the diagram below. As the price level falls, the SAS
curve shifts down in the following period and this will continue as long as the level of equilibrium output is
below the level of full employment output. The new long-run equilibrium is restored when equilibrium
output is once again equal to full employment output, and thus the price level is equal to last period price
level.

P
LAS
SAS0

SAS2
P0
SAS0’

P1
P2

P0’
AD

AD’

Y1 Y2 Y* Y

Page 8 of 9
5. Consider the AD-AS model where the expression for the dynamic AS curve is given by:
B = B-1 + 8(Y – Y*).
Assuming that the economy is originally at the level of full employment, expansionary
monetary policy will cause an increase the rate of inflation but no change in the level of
output. (Show your answer graphically and explain the economics.)

False.

An increase in the nominal supply of money will cause the AD curve to shift up to the right to AD’
increasing the level of output to Y1 and the rate of inflation to B1 in the short-run (period 1). Therefore,
expansionary monetary policy is effective in the short-run in the sense that it causes equilibrium
income to increase (though at a cost of higher inflation). Since the model assumes adaptive
expectations, the increase in the rate of inflation in period 1 will increase the expected rate of
inflation in period 2 to increase to B1, thus causing the AS0 to shift up to the left to AS2. In period
2, therefore, the equilibrium level of output falls to Y2 while the rate of inflation increase further to
B2. The same process is repeated in period 3 and subsequent periods, thus showing that the
effect of expansionary monetary policy on income starts to fade in the medium-run. In the long-
run, the AS curve shifts all the way up to AS0‘ where it intersect the AD’ curve at the level of full-
employment. The statement, therefore, is true only in the long-run.

AS0’
AS3

B0’ AS2

B2 AS0
B1

B0
AD’

AD

Y* Y2 Y1 Y

Page 9 of 9