Concordia University

Department of Economics
ECON 203 INTRODUCTION TO MACROECONOMICS
Summer 2011
COMMON FINAL EXAMINATION VERSION 1 AND ANSWERS

FAMILY NAME: ___________________________ GIVEN NAME(S):_____________________________

STUDENT NUMBER: __________________________________________________
Please read all instructions carefully.
1.

This is a three-hour exam (180 minutes). The questions are worth 150 marks altogether. It is a good
strategy to spend one minute per mark for your answers (150 minutes) and spend the remaining time
(30 minutes) to review your answers.

2.

The exam consists of four parts:

(i) Part I: 25 multiple-choice questions (25 marks);
(ii) Part II: Choose 5 out of 7 true-false questions (25 marks);
(iii) Part III: Choose 4 out of 5 long questions (60 marks), and
(iv) Part IV: One current events question (40 marks).

3.

Write your name, student ID and answers for the multiple-choice questions on the computer scan-sheet
with a PENCIL. Please also write the VERSION of the exam on the computer scan-sheet. For Parts II
to IV, write all your answers on this exam. Do not use additional booklets.

4.

You are allowed to use a non-programmable calculator and a dictionary. You may use either pen or pencil
to provide your answers for Parts II to IV.

5.

You are not allowed to tear any pages out of this exam.

Grades:
Part I:

__________

Part II:

__________

Part III:

__________

Part IV:

__________

Total:

Part I: Multiple Choice Questions. Write all answers on the computer sheet with a PENCIL (Total=25 marks).
1.

Which of the following statements is FALSE?

a) If double counting is not prevented, the GDP measurement will be too high.
b) GDP includes all market values of goods and services produced during a given time period.
c) Since GDP includes only the value of currently produced goods, second-hand transactions are not included in GDP.
d) The official GDP value is very likely an over-estimation of the actual value of goods and services produced in an economy.
e) GNP can be higher or lower than GDP.

2.

If nominal GDP grows by 10% and the GDP deflator decreases from 125 to 120, then real GDP:
a) Falls by approximately 5%.
b) Falls by approximately 14%.
c) Rises by approximately 6%.
d) Rises by approximately 12%.
e) None of the answers is correct.

3. The wealth, interest rate and foreign trade effects all help explain:
a) Why the aggregate supply curve is upward sloping.
b) Shifts in the aggregate supply curve.
c) Why the aggregate demand curve is downward sloping.
d) Shifts in the aggregate demand curve.
e) Both C and D are correct.
4.

The speed at which an economy adjusts to eliminate an income gap depends on:
a) The flexibility of the prices of goods and services in the economy.
b) The strength of labour unions.
c) The size of the potential GDP.
d) Only A and B are correct.
e) All of the answers are correct.

5.

In Pluto, 200,000 people are in the labour force and the unemployment rate is 5%. As Pluto moves out of a recession and the
prospect of finding jobs increases, 10,000 previously discouraged workers become "encouraged" to search for jobs. The
unemployment rate becomes
a) 6.42%.
b) 9.52%.
c) 10%.
d) 12.5%.
e) None of the answers is correct.

6.

If the reserve ratio of all commercial banks is 0.15 and the currency deposit ratio of the public is 0.25, then an open market
purchase of bonds by the central bank of $100 million will result in
a) $250 million decrease in money supply.
b) $250 million increase in money supply.
c) $312.5 million decrease in money supply.
d) $312.5 million increase in money supply.
e) None of the answers is correct.

7.

For a given change in autonomous expenditure, economies with lower income tax rate t will:
a) Experience no business cycle fluctuations in real GDP and employment.
b) Experience smaller business cycle fluctuations in real GDP and employment.
c) Experience larger business cycle fluctuations in real GDP and employment.
d) Experience larger business cycle fluctuations in real GDP but not in employment.
e) Experience larger business cycle fluctuations in real GDP and employment only if the government runs a balanced budget.

8.

The BOC wants the inflation rate to lie in between:

a) 0% and 3%.
b) 1% and 2%.
c) 1% and 3%.
d) 4% and 6%.
e) 5% and 8%.
2

9.

The New Democratic Party (NDP) wants the Conservative government to spend more money on all social services. If the NDP
wants the spending to have maximum effect on economic growth, which of the following consumption equations would it prefer
to see?
a) C=120+0.4(Y-T)
b) C=80+0.8(Y-T)
c) C=150+0.75(Y-T)
d) C=110+0.9(Y-T)
e) C=250+0.6(Y-T)

10. If an economy is heading towards a recession and if the authorities want to minimize the drop in real GDP, they should:
a) Decrease taxes and decrease money supply.
b) Decrease taxes and increase money supply.
c) Increase government expenditure and decrease money supply.
d) Decrease government expenditure and increase money supply.
e) Run a balanced budget and keep money supply constant.
11. If the Bank of Canada buys bonds in an open market, the present value of the bond will ____ and the interest rate will ___.
a) Increase, increase
b) Increase, decrease
c) Decrease, increase
d) Decrease, decrease
e) Decrease, not be affected.
12. If potential output equals 5,500 and short-run equilibrium output equals 4,500, there is a(n) ______ gap and the Bank of
Canada, according to Taylor rule, will _____ interest rates in order to close the gap.
a) Recessionary; raise.
b) Recessionary; lower.
c) Recessionary; not change.
d) Inflationary; raise.
e) Inflationary; lower.
13. Under a fixed exchange rate system, if the current account has a net negative value of $300 and the capital account has a net
positive value of $250, there will be ________ in official reserves of ________.
a) A decrease; $50.
b) A decrease; $550.
c) An increase; $50.
d) An increase; $550.
e) An increase; $250.
14. Suppose it costs C$0.95 to buy U.S.$1. If the Bank of Canada does NOT want the C$ to strengthen further, then ___
a) It should raise income taxes.
b) It should sell bonds in the open market.
c) It should cut interest rates.
d) It should do B and C only.
e) It should do all of the above.
15. Which of the following statements is (are) CORRECT?
a) If Y<AE, inventory will rise to bring Y=AE again.
b) If income falls and savings also fall, then the MPS is negative.
c) A positive capital account means that the economy is a net borrower in the international financial market.
d) The higher the price level, the higher the potential GDP.
e) All of the answers are correct.
16. The United Kingdom has recently introduced austerity plans into its economy in an effort to reign in its public debts by cutting
government expenditure on education, health care and the hiring of public servants. Which of the following observation(s) will
lessen the negative impact of these spending cuts on the United Kingdoms GDP?
a) Their marginal propensity to import is very low.
b) Their income tax system is a lump sum or constant tax system.
c) Their crowding-in or crowding-out effect is very strong.
d) Their marginal propensity to consume is very low.
e) Both C and D are correct.
3

17. In contrast to the United Kingdom, the U.S. government has opted for an injection of fiscal spending into its economy. If the
U.S. MPC is 0.8, the net income tax rate is 0.2, the marginal propensity to import is 0.04, and the government increases
spending by $60 billion, then we would expect the U.S. GDP to increase by:
a) $29.41 billion.
b) $50 billion.
c) $71.42 billion.
d) $150 billion.
e) None of the answers is correct.
18. The direction of discretionary fiscal policy cannot be examined by the simple look at the changes in the actual budget deficits or
surpluses. This is because:
a) Those changes may reflect the changes in the general price level.
b) Those changes may reflect changes in the tax revenues as a result of change in actual GDP.
c) Those changes may reflect the changes in the tax revenues as a result of change in exports.
d) Those changes may reflect changes in the tax revenues as a result of change in potential GDP.
e) All of the answers are correct.
19. Assume that the tax rate t is 0.2, Yp is 1,000 and G is 180. Which of the following statements is (are) INCORRECT?
a) The structural budget balance is 20.
b) With negative GDP gap of 20%, the budget balance is -20.
c) With positive GDP gap, the structural budget balance will be smaller than 20.
d) There will be zero budget balance when Y is 900.
e) Both A and B are incorrect.
20. Which of the following choices is (are) INCORRECT?
a) If CA is 5, KA is +3, then this central bank has sold some of its foreign exchange reserves.
b) If CA is +5, KA is -3, then this central bank has accumulated more foreign exchange reserves.
c) If CA is +5 and KA is -3, then this countrys currency will appreciate under a flexible exchange rate regime.
d) If CA>0, then this country is a borrower.
e) All of the answers are incorrect.
21. If the purchasing power parity holds, then the real exchange rate is equal to ____. If the U.S. inflation rate is 4% and Canadas
inflation rate is 5%, then the nominal exchange rate of the Canadian dollar (C$), from Canadas perspective, will ___.
a) Any number; decrease by approximately 9%, which is a C$ appreciation.
b) Any number; increase by approximately 9%, which is a C$ depreciation.
c) Two; decrease by approximately 1%, which is a C$ appreciation.
d) One; decrease by approximately 1%, which is a C$ appreciation.
e) One; increase by approximately 1%, which is a C$ depreciation.
22. Under ______ exchange rates, a fiscal contraction that pushes interest rates ____ will crowd _____ net exports through ______.
a) Flexible; down; in; a depreciation of the domestic currency
b) Flexible; down; in; an appreciation of the domestic currency
c) Flexible; up; out; a depreciation of the domestic currency
d) Flexible; up; out; an appreciation of the domestic currency
e) Fixed; up; in; an appreciation of the domestic currency
23. Suppose consumption (C) is $30,000 when income is $32,000, and the marginal propensity to save (MPS) is 0.25. An increase
in income causes C to rise to $36,000. What is the new income?
a) $24,500
b) $35,000
c) $40,000
d) $42,500
e) None of the answers is correct.
24. Continued long run economic growth is most likely to be fostered by:
a) Expansionary fiscal policy.
b) Elimination of short run output gaps.
c) Decreasing taxes on consumer goods.
d) Technical improvement embodied in physical or human capital.
e) All of the answers are correct.
4

25. The increase in oil and commodity prices in the last few years has caused a strong appreciation in the Canadian dollar by
lowering the exchange rate from $1.57 (Canadian) to $0.95 (Canadian) for U.S.$1. If we assume that the price levels of goods
and services across these two countries to be constant over the last few years, then the real exchange rate (from Canadas
perspective) must have _____ and Canadas net export (NX) must have _______.
a) Decreased; increased
b) Decreased; decreased
c) Increased; decreased
d) Increased; increased
e) Stayed constant; decreased

Part II: True/False Questions. Answer FIVE of the following seven questions in the allotted space. If more than
five questions were answered, only the first five will be marked. State whether each statement is true or false and
explain. Use graphs to support your answers when applicable. No marks will be awarded to simply stating true
or false without explanation (Total=25 marks).
1.

Suppose investment confidence in Canada drops because of pessimistic economic outlook. If Canadas marginal
propensity to import is very high, the drop in Canadas GDP will be quite small.
Ans: True If Y , C, but so will our imports the larger is MPZ, the larger is our drop in imports,
therefore the smaller will be our job loss due to imports Y will not fall by as much. In other words, if MPZ
is large, the multiplier is small, so the drop in investment spending will lead to a smaller detrimental effect on
Y.

2.

The simultaneous occurrence of an increase in the price of oil and a decrease in consumer confidence could lead to a
decrease in output while leaving prices unchanged. (Hint: Draw a graph to support your answer.)
Ans: True An increase in the price of oil will increase the cost of production, which implies a leftward shift
of the AS curve (contractionary AS shock). This entails an increase in prices and a reduction in output. A
decrease in consumer confidence implies a leftward shift of the AD curve (contractionary AD shock). This
entails opposing effects on prices and a decrease in output. The combination of the two shifts will result in a
definitive decrease in output but an ambiguous result on prices, depending on the relative strength of each of
the two shifts.

3.

Under a fixed exchange rate regime, if CA= -$40 billion and KA= $25 billion, this implies that this countrys central
bank is accumulating $65 billion in foreign exchange reserves. This accumulation of reserves is required; otherwise,
this countrys currency will face the pressure to appreciate.
Ans: False BP=0 = CA+KA+ORT, so ORT= $15 billion. The net outflow of $$ into this country from the
CA side is $40, but the net inflow of $$ from the KA side is $25. The central bank has to supply the remaining
$15 in order to keep e constant, which means it is selling or depleting $15 billion in reserves. Otherwise, there
will be an excess demand for foreign $, and this countrys currency will depreciate.

4.

Under a flexible exchange rate regime, expansionary fiscal policies will not create crowding out effects.
Ans: False G, Y, Md, i, this currency appreciates, so crowding out private sector expenditures, such
as I and NX.

5.

The concept of diminishing marginal product dictates that as more people continuously enter the labour force, with
the capital stock held constant, the GDP per capita will also rise continuously.
Ans: False As L rises and K kept constant, the additional L becomes less and less productive due to overcrowding, mismanagement, etc. As a result, the rise in output will begin to slow down, even though output
may still be rising. The total Y or GDP per L will fall continuously.

6.

If the central bank of a country (such as the U.S.) injects additional money into the economy, the effects of such an
expansionary monetary policy differ depending on whether we are examining the economy in the short run or in the
long run. (Hint: Use a graph to support your answer.)
Ans: True In the short run, AD shifts out, Y and P will rise. Monetary policy can indeed raise Y at the
expense of having a higher price level. In the long run, however, as P has risen, so would input costs such as
5

wages. When wages rise, AS shifts left as the firms cut back on employment. Eventually, Y=0 and P>0 in
the long run.
Western Canada (such as Alberta) exports fuel while Central/Eastern Canada (such as Ontario and Quebec) exports
manufactured goods. Given that fuel prices have been rising recently and the fact that about 80% of our
manufactured goods are exported to the U.S., we can conclude that the Western Canadian economy is indirectly
benefiting the Central/Eastern Canadian economy.
Ans: False the rise in the value of fuel means foreigners need to buy more Canadian dollars to pay for our
fuel exports. This drives the value of the Canadian dollar up. The appreciation of the C$ stemming from the
western provinces will lead to a loss in competitiveness in Ontarios exports.

7.

Part III: Answer FOUR of the following five questions. Round your answers to TWO decimal places,
if applicable. If more than four questions were answered, only the first four will be marked (Total=60 marks).
Question 1: Okuns Law (15 marks)
The table below gives information for the potential output Yp and real output Y values for a fictitious country.
Year
2005
2006
2007
2008

Potential Yp
($ million)
810
814.05
820.16
855.01

Growth in
Yp (%)
----0.5
0.75
4.25

Real Y
($ million)
810
848.48
810.29
781.93

Growth in
Y (%)
----4.75
-4.5
-3.5

Unemployment
Rate (%)
4.88
2.75
5.38
9.26

Output Gap
(%)
0
4.23
-1.2
-8.55

Output Gap
Type (- or +)
---+
-

(i)

Fill in the above table using Okuns law and other relevant equations. Also identify whether the output gaps are
recessionary (-) or inflationary (+) for each year. Use the space below for your calculations, if needed (9 marks).

(ii)

Suppose the economy is currently under an inflationary gap due to consumer optimism. State the equations for
budget balance (BB) and structural budget balance (SBB). Explain whether BB will be smaller or larger (in
absolute term) than SBB under this economic boom, prior to any policy interventions. For simplicity, suppose
BB=SBB=0 before this economic boom (2 marks).
Ans: BB = tY-G, SBB = tYp-G, since Y>Yp, then BB>SBB=0.

(iii)

Suppose this economy operates under a flexible exchange rate system. Discuss the effectiveness of fiscal and
monetary policies if we want to narrow this output gap. As an economist, which of these two types of policies
would you recommend? Explain (4 marks).
Ans: We want Y G and t Y Md i I and NX Y; Ms i I+NX Y;
choose monetary policy.

Question 2: Economic Growth and Growth Accounting (15 marks)

Suppose a fictitious economy has the following average annual rates of growth between 1996 and 2005:
- Potential GDP (Yp)
5.14%
- Labour force (L or N) 3%
- Capital stock (K)
1.2%
The share of labour income in national income is 2/3 and the share of capital income is 1/3. Use growth accounting to
find the contributions to the annual growth in Yp that came from:
(i) The growth in the labour force (2 marks).
Ans: The growth accounting equation is: Y = A + 2/3L + 1/3K
L = Labour force, and as 2/3 of L is contributed to the GDP (Y), that means:
Contribution from growth in labour force = 2/3 3% = 2%
(ii) The growth in the capital stock (2 marks).

Ans: The growth accounting equation is: Y = A + 2/3L + 1/3K

K = Capital stock, and as 1/3 of K is contributed to the GDP (Y), that means:
Contribution from growth in capital stock = 1/3 1.2% = 0.4%
(iii) The Solow residual (2 marks).
Ans: The Solow residual measured by A is founded by rearranging the growth accounting equation as
follows: A = Y - 2/3L - 1/3K
Y is given in the question (Potential GDP = 5.14%), we found 2/3L in part (i) to be =2%, and 1/3K in part (ii)
to be = 0.4%, therefore:
A = Y - 2/3L - 1/3K = 5.14% - 2% - 0.4% = 2.74%
(iv) Consider the three sources of growth from parts (i), (ii) and (iii) above: Which type is the best, that is, the most
desirable and most sustainable? Explain why this source of growth is the best while the other two sources are less
desirable or sustainable (5 marks).
Ans: (iii) because it does not require extra hard work from labour and extra capital accumulation through
higher past savings/lower consumption. Better production methods (technological improvement) can allow us
to produce more while working for the same number of hours and using the same equipment if we have more
efficient or smarter at what we do.
(v) Consider countries such as China and India: These countries have experienced rapid labour force growth in the past
few decades. If the rate of capital stock accumulation were zero (i.e., capital stock constant) in these countries,
discuss the economic concept that can be used to predict future per-capita Yp growth in these two countries (2
marks).
Ans: Diminishing marginal product, since K is constant and only L is growing as L continues to and no
additional K, workers become less and less productive, and hence per-capita Yp will rise by smaller and
smaller values.
(vi) Consider countries such as China and India: Suppose together with labour force growth, these countries have also
been accumulating more capital stock over time. However, the rates of capital accumulation were lower than the
rates of labour force growth. Discuss the economic concept that can be used to predict future per-capita Yp growth
in these two countries (2 marks).
Ans: Constant returns to scale (CRS), since both L and K are but K at a lower rate than L , this means
we do not have constant returns to scale as a result, Yp per capita will still grow, but at smaller and smaller
values.

Question 3: The AE Model (15 marks)

In this question we analyze the Canadian economy. The simplified economy is specified as follows:
A. Goods market, all values are in billions of C$:
B. Money market, all Md values are in billions of C$:
- Consumption expenditure: C = 100 + 0.8(Y-T)
- Interest rate: i = 0.025 or 2.5%.
- Investment expenditure: I = 1,000 4,800i
- Money demand: Md =1,400 19,000i.
- Government expenditure: G = 540
- Lump-sum constant taxes: T = 540
- Exports=60
- Imports=40
(i)

Find the equilibrium Y and money supply (2 marks).

Ans: AE=C+I+G+NX=100+0.8 (Y-540)+1,000-4,800*0.025+20=1,180+0.8Y
At equilibrium, planned expenditure becomes actual expenditure on domestically produced goods and
services, so AE=Y and the equation above becomes Y=1,180+0.8Y. From here, Y (1-0.8)=1,180 therefore, Y
=1,180/0.2=5,540.
The money supply equals the money demand at equilibrium, therefore the money supply is 1,40019,000*0.025=925.

(ii)

The Conference Board of Canada has recently announced that consumer confidence in Canada dropped in the
month of June 2011 due to concerns over the E.U. and the U.S. debt problems. Let the drop in consumer
confidence to be equal to 10 points, so now C=90 + 0.8(Y-T).
(a) Find the value of the goods market multiplier (1 mark).
Ans: 1/(1 - 0.8) = 5
(b)

Find the new Y, by either using the long calculation method or by using the multiplier (2 marks).
Ans: Y = 5 * -10 = -50
New Y = 5540 - 50 = 5,490

(c)

Explain intuitively and numerically how the fall in consumer confidence would affect the economy through
the multiplier. Use three rounds of effects to demonstrate the multiplier effects. Let the first round be related
to car purchases, the second round related to clothing, and the third round related to food (6 marks).
Ans: Round 1 Consumer Confidence= -10, so Y = -10.
Round 2 Y= -10, but C= -8 only on Canadian made the net drop in Y of Canada is only 8.
Round 3 Y= -8, so C = -6.4 only on Canadian food the net drop in Y of Canada is only 6.4.

(iii) Suppose the Bank of Canada (BOC) tries to reverse this effect on the economy. Find the new i and the money
supply required in order to push the Y level back to the original Y level that you have found in (i) (4 marks).
Ans: Want I=10, so need new 890=1,000-4,800i, so new i=0.0229 (or 2.29%) and Ms=964.9.

Question 4: Exchange Rates, Central Bank Interventions and PPP (15 marks)
Suppose that in 1990, the price levels in the United States and Argentina were 100. By 2002, the price level in the United
States has increased to 190, while the price level in Argentina has risen to 570. Suppose the nominal exchange rate
between two countries in 1990 was $1USD = 1.6 AR Pesos.
(i)

Find the inflation rate of the United States and the inflation rate of Argentina, respectively (2 marks).
Ans: The inflation rate of the US is (190-100)/100 = 90%
The inflation rate of Argentina is (570-100)/100 = 470%
The US experienced lower inflation as their prices increased by 90%, while prices in Argentina increased by
470%.

(ii)

Find the real exchange rate in 1990, from the perspective of Argentina (1 mark).
Ans: The real exchange rate in 1990 = er*PUSD/PAR=1.6*100/100= 1.6

(iii)

Suppose Argentina had a fixed exchange rate system against the US dollar. The initial nominal exchange rate in
1990 was fixed. Find the 2002 real exchange rate for Argentina. Has Argentina experienced a real exchange rate
appreciation or depreciation by 2002? Explain (2 marks).
Ans: The real exchange rate in 2002 is er*PUSD/PAR=1.6*190/570= 0.53.
Since PUSD/PAR=190/570 <1, Argentinas real exchange rate with the US has appreciated (the Argentinean
peso experienced a real increase in its value).

(iv)

Explain why you would expect Argentina's net exports to rise or fall as a result of (iii) (2 marks).
Ans: Argentinas net exports would fall. Intuitively, a real appreciation in the value of the peso makes
Argentinean goods more expensive for foreign buyers and imports less expensive for domestic consumers,
thus decreasing the value of exports and increasing the value of imports, leading to a decrease in NX.

(v)

Explain why the Argentinean peso was overvalued or undervalued, and by how much (2 marks).
Ans: The Argentinian peso is overvalued, because it should have taken 4.8 AR (1.6*570/190= 4.8) to buy one
USD, not 1.6 AR.

(vi)

From 1990 to 2002, the central bank of Argentina must have taken what actions in order to maintain the fixed
exchange rate? Explain, and also explain how such actions have affected Argentinas US$ reserves (3 marks).
Ans: Maintaining a fixed exchange rate requires central bank intervention in the foreign exchange market.
In this case, the central bank of Argentina will intervene by selling foreign currency ($US) to fix the
exchange rate. Central banks official exchange reserves (of foreign currency holdings) will fall.

(vii) In reality, Argentina abandoned its fixed exchange rate in 2002 and the Argentinean peso was allowed to fluctuate.
According to the Purchasing Power Parity, what must be the new nominal exchange rate (from the perspective of
Argentina) once the peso has been allowed to fluctuate? (3 marks)
Ans: When Purchasing Power Parity holds, the real exchange rate is 1. Therefore, the nominal exchange
rate is equal to the relative price, er=570/190=3.

Question 5: Taylor Rule (15 marks)

The Taylor rule states that a central bank can monitor inflation and GDP by following the equation given by
i = i0 + ( - *) + (Y - Yp). In reality, the Bank of Canada does seem to follow this rule, and set a targeted inflation rate *.
For this question, suppose * = 2%. Suppose the current inflation = *, Y = Yp and i0 = 10%.
(i)

Find the value of i (1 mark).

Ans: i = i0 + ( - *) + (Y - Yp)= 10%

(ii)

Now suppose a drop in investment confidence leads to Y - Yp = -3%. Let us put aside inflation rates for now.
According to Taylor rule, what interest rate should the Bank of Canada now set? (1 mark)
Ans: i = i0 + ( - *) + (Y Yp)= 10% + (-3%) = 7% .

(iii)

Suppose = * - 0.5i. Find the new (1 mark).

Ans: The new is = * 0.5i = * 0.5(i i0 ) = 2% 0.5(7% 10%) = 3.5%

(iv)

Suppose the Bank knew that the new would be higher. In order to balance between inflation and GDP targets, it
has to set a new interest rate weighing both of these effects. Now find the new i that the Bank should set knowing
that = * - 0.5i. [Hint: Solve the new i as an unknown and do not use the value found in part (ii).] (2 marks)
Ans: i = i0 + ( - *) + (Y Yp) = i0 + (* 0.5i *) + (Y Yp) i = 8%.

(v)

Find the corresponding inflation rate (2 marks).

Ans: The new is = * 0.5i = * (i i0 ) = 2% 0.5(8% 10%) = 3%

(vi)

Compare your answers from parts (i) and (iv): Discuss how the change in the interest rate will affect this countrys
capital account and current account if it currently operates under a flexible exchange rate system. For simplicity,
ignore the Interest Rate Parity condition, i.e., people do not form expectations on future exchange rates (3 marks).
Ans: The drop in interest rate from 10% to 8% will induce capital outflow from Canada to other countries.
Canada will see a drop in our capital account value and become a bigger lender to other countries. As our
interest drops, our C$ depreciates, and our NX will rise. Our current account will also rise. In the end, the
KA=CA because ORT=0 under a flexible exchange rate. The BP=0.

(vii) Compare your answers from parts (i) and (iv). Write down the Interest Rate Parity equation and use it to explain
whether we would expect an appreciation or a depreciation in the Canadian dollar in the future (3 marks).
Ans: The central bank has dropped the interest rate from 10% (point (i) result) to 8% (point (iv) result).
According to the Interest Rate Parity equation, ic = iforeign + expected %e, and assuming iforeign has not
changed, expected %e has to be negative. We expect an appreciation in the C$ in the future.
(viii) Are your predictions on the value of the Canadian dollar consistent between parts (vi) and (vii)? Explain (2 marks).
Ans: We predict an immediate depreciation in the C$ but a future appreciation in the C$. It is true that if
right now ic drops, people rush out of Canadian assets into assets in other countries. However, since foreign
assets pay a higher rate of return, the future money supply in the foreign countries would also be rising
relative to that in Canada. The relative worth of the Canadian dollar will be rising in the future. The
immediate response is to get out of Canadian assets into foreign assets, but if people have forward-looking
behaviour, they also care about whether the higher payoff rate offered by foreign assets paid in F$ really
makes a difference.

10

Part IV: Answer the following question. ANSWER ALL PARTS (Total = 40 marks).
In 2008, the inflated housing markets and reckless over-lending by commercial banks in the U.S. and Europe created a
liquidity crisis or credit crunch for the banking industry. In this multiple-part question, we want to explore what has
been happening in Canada since then. Assume that GDP=Y=Yp in 2008, immediately before this banking crisis. Also
assume that BB=SBB=0 prior to the banking crisis.
(i)
Article 1: Why should I care about the credit crunch?
A
Garry Marr And Jonathan Chevreau, Financial Post, Tuesday, Jan 15, 2008

Forget tomorrow, Canadians are already getting hit in the pocketbook by the debt-market crisis, and it could get a lot worse. David Dodge, former governor of
the Bank of Canada, said this week the average Canadian could ultimately be "pulled down" as banks scramble to come up with a deal to save the debt market
and prevent the loss of $300-billion worth of outstanding loans. And that's just the tip of the iceberg.
"I would compare what's going on now with the onset of the Depression period in the late 1920s and early 1930s," says Steven Hochberg, chief market analyst
with Atlanta-based Elliott Wave International. "The potential is for it to be a lot worse simply because of the amount of credit outstanding." The total creditmarket debt as a percentage of gross domestic product is more than double what it was during the Great Depression, he says.

rticle 1: Discuss how the monetary base (H), reserve ratio (rr) and currency ratio (cr) are likely to be affected by
the panic that erupted because of the banking crisis (3 marks). Use the Y=AE graph to illustrate and explain how
the money market panic will transmit into the goods market (3 marks).
Ans: H = currency held by the public+reserves of banks, which is controlled by the BOC not likely to
have changed since the BOC does not change H at the onset of the crisis (if students answer BOC H in
response to crisis, OK, which it subsequently did). Banks are more concerned about keeping enough
reserves to operate given that some loans are going into default, more likely rr. Public more concerned
about banks, less confidence, more likely to hold more wealth in cash, so cr (if students mention deposit
insurance and so cr may not be increasing much, OK). In the 45-degree graph, AE shifts down due to
investment/consumer pessimism or panic OR drop in Ms leading to higher interest rates and lower
investment expenditure Y drops.

AE shifts downward, Y falls.

Article 2: Bank of Canada raises interest rate to 0.5 per cent

CTV.ca News Staff, Tue. Jun. 1 2010 9:07 PM ET
The days of record low interest rates in Canada appear to be coming to an end, as the Bank of Canada announced Tuesday its first interest rate increase in three
years. The central bank hiked its overnight lending rate from 0.25 per cent to 0.5 per cent, an increase that was quickly matched by major banks.
Prime lending rates, which banks extend to their best customers, quickly followed the Bank of Canada increase. The TD Bank was the first to announce a
quarter-point hike in its prime-lending rate to 2.5 per cent, effective Wednesday. The Royal has followed suit and all the other major banks are expected to
announce the same increase to their primes.

(ii)

Article 2: Since 2008, the Bank of Canada (BOC) has been cutting its target overnight interest rate (OIR) that
eventually reached its lowest feasible rate of 0.25% for the first time in Canadian history. However, since June
2010, the BOC has begun raising the target OIR. Discuss what changes in the short run Y and the inflation rates
must have prompted the action of the BOC (2 marks). Also explain why commercial banks followed the BOCs
action by raising their prime rates (4 marks).
Ans: BOC must have seen increasing Y and inflation rates, signs that the economy is rebounding. To control
inflation and knowing that the stronger Y can withstand a higher interest rate, the target OIR has been
raised from 0.25% to 1% in the time period. Since the target OIR is bounded by the bank rate and deposit
rate, a rise in the target OIR also implies the bank rate has risen. This means the cost of borrowing from the
BOC has increased. As a result, the cost of operating banks has increased, and so the banks turn around to
charge their customers (us) more. The best customers would have to pay a higher prime rate, and so would
customers with less than perfect credit record.
11

Article 3: Central bank holds key interest rate at 1 per cent

CTV News.ca Staff, Date: Tue. Jul. 19 2011 5:02 PM ET
The Bank of Canada declined to raise its key overnight interest rate Tuesday. The overnight target rate has remained steady at one per cent since it was last raised
in September 2010.
BNN's Michael Kane said the bank didn't give any signs to the financial world Tuesday that the rate would be changing any time soon. "The majority of people
who are talking to us on Bay Street are saying it's going to be 2012," Kane told CTV News Channel on Tuesday morning, just after the central bank announced its
rate decision.

(iii)

Article 3: By September 2010, the BOC has stopped raising its target OIR. Its decision to hold the target OIR
steady is also related to the international bond market. Discuss how the expansionary monetary policies in the
period 2008 to June 2010 have affected the bond market (3 marks). How should the BOC change its target OIR if
it wants to stabilize the bond market? Explain (3 marks).
Ans: The increase in money supply and fall in interest rates imply that the present value or price of bonds
must have increased. As the price of bonds rise, the value of bonds has become increasingly inflated. This is
because when panic and uncertainty set in during the crisis, financial agents seek out safer financial
instruments, such as bonds, to park their money in. The BOC should raise interest rates slowly in order to
slowly correct the bond market bubble or over-valuation.

Article 4: Obama: No deal on debt, deficit without compromise

The Associated Press, Date: Mon. Jul. 11 2011 9:13 PM ET
WASHINGTON President Barack Obama declared Monday he would reject any stopgap extension of the nation's borrowing limit, adding fresh urgency for
Republicans and fellow Democrats to resolve intense tax and spending disputes and head off economic calamity.
A potential deal -- a package of spending cuts and tax increases that could total $2 trillion or more over a decade -- is considered necessary for the U.S. to avoid
defaulting on its $14.3 trillion debt.

(iv)

Article 4: It appears that the U.S. government is leaning towards cutting government spending and raising taxes in
order to prevent a debt default (inability to pay maturing principals and interests). If the U.S. eventually passes a
bill that would cut massive spending, use a demand-and-supply diagram for exchange rates to explain how this
would immediately affect the value of the Canadian dollar through changes in interest rates in the U.S. (4 marks).
Also discuss how this would affect our GDP (2 marks).
Ans: If the U.S. G and T, then GDP of the U.S. will fall as GDP falls, money demand in the U.S. falls,
interest rates in the U.S. will fall ius lower than ic increase in demand for Canadian financial assets
increase in demand for C$, so C$ will appreciate our NX will fall due to lower export demand from the
U.S. and also due to C$ appreciation our GDP will fall. (If students answer risks in U.S. assets , so
traders flock to Canadian assets, so C$ appreciates, OK).

Demand for C$ increases, supply of US$ increases, e falls, C$ appreciates.

(v)

Article 4: What should the BOC do to its target OIR if the U.S. bill passes? Explain (2 marks). Also explain
whether it should use SRA or SPRA to keep the new target OIR from rising (2 marks).
Ans: BOC can also cut our target OIR to minimize the appreciation in the C$ to keep the target OIR
from rising, the BOC has to engage in SPRA, special purchase and resale agreements, to inject liquidity into
the overnight market and keep the cost of borrowing low.

12

Article 5: NDP platform pledges 'immediate action'

www.cbc.ca, Posted: Apr 10, 2011 11:06 AM ET
The platform included a number of previously announced commitments, including help for family caregivers, a defence policy that prioritizes ships for Canada's
navy instead of fighter jets, and a crime prevention and community safety program that would cost roughly $255 million. It also includes plans to create more
affordable housing, reduce poverty and improve access to childcare and post-secondary education.
The NDP also pledged to expand care for seniors, including increasing funding for forgivable loans to help keep seniors in their homes, helping families retrofit
their homes to create secondary suites for senior family members and addressing the shortage of long-term care beds. It has also pledged a $2.2-billion
compensation package for Quebec for implementing the HST.

(vi)

Articles 4+5: Our federal opposition party, the NDP, has promised increases in social spending. Suppose their
platform will be realized. Explain how this would affect Canadas budget balance (BB) and structural budget
balance (SBB), assuming that the average income tax rate remains constant (a rise in tax rates for the rich and a
drop in tax rates for the poor). Also discuss whether BB and SBB will change by the same or different amounts (2
marks). What should the BOC do to the target OIR if the U.S. bill (article 4) passes and our own government
spending increases? Explain and demonstrate graphically by using the AD/AS/LAS diagram (4 marks).
Ans: BB = tY-G and SBB = tYp-G, with higher G, both BB and SBB will rise in absolute value (bigger
deficit) the deficit under BB will be smaller than the deficit under SBB because the rise in G will raise Y
in short run but not Yp, so BB changes by a smaller amount compared to SBB from part (v), the BOC
should cut the target OIR if it wants to maintain a strong Y in Canada however, now that G in the
Canada would rise, which may fuel inflation while stimulating Y, the BOC may not want to raise the target
OIR after all. It may want to wait and see whether the effects from the drop in U.S. Y is offset by the rise in
our own G more likely to keep target OIR constant.

AD decreases due to US recession, our NX falls; AD increases due to NDP increase in

social spending; AD may not be affected in the end.

13

Article 6: Canadas Largest Companies Accelerated Spending Last Quarter

Bloomberg, By Ilan Kolet and Theophilos Argitis, February 25, 2011, 11:31 AM EST
Canadas largest companies, led by oil and gas producers, accelerated their capital spending at the end of last year, suggesting investment by the nations energy
businesses is helping to drive the nations expansion.
The Bank of Canadas quarterly business outlook survey released last month found that 44 percent of companies said they expect to increase machinery and
equipment investment over the next 12 months. That compares with 46 percent in the third quarter, which was the highest recording since the recession.

(vii) Article 6: Suppose a countrys standard of living is defined by its per-capita GDP. Explain why capital
accumulation is required to maintain a constant standard of living and the economic concept that can be used to
explain this result (3 marks).
Ans: With population and labour force growing, capital accumulation is needed to maintain the standard of
living in an economy. If employment and capital stock grow at equal rates, total GDP grows at the same rate
and per-capita GDP remains unchanged. This means that production involves constant returns to scale.
(viii) Article 6: Use the AD/AS/LAS diagram to demonstrate how we adjust from the short run Y to the new long run
equilibrium level. If the BOC wants to maintain the same price level (or keep the inflation rate constant at 2%),
should it adopt expansionary or contractionary monetary policies? Explain and demonstrate graphically (3 marks).
Ans: Short run AS shifts right, together with LAS shifting right both will drive down the price level and
the inflation rate may fall below our targeted 2% BOC has to cut interest rates to stimulate AD and push
the price level higher or keep inflation rates at 2%.

The End.

14