Department of Economics Prof.

Gustavo Indart
University of Toronto June 17, 2002

ECO 208Y - L5101

SOLUTION MACROECONOMIC THEORY

Term Test #1

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 three parts.
3. This question booklet has 10 (ten) pages.
4. Aids allowed: a simple calculator.
5. Use pen instead of pencil.

DO NOT WRITE IN THIS SPACE

Part I /45

Part II /15

Part III 1. /10

2. /10

3. /10

4. /10

TOTAL /100

Page 1 of 10
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. Jim’s 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. Jim’s contribution to GDP is
(a) $900
(b) $1,000
(c) $1,100
(d) $1,800

2. Suppose that an economy produces only bread and computers, and that price and
quantity data are given in the table below. If Year 1 is the base year, the GDP (price)
deflator for Year 2 is approximately

Year 1 Year 2
Good Quantity Price Quantity Price
Bread 30 $10 40 $15
Computers 10 $50 30 $60

(a) $100.0
(b) $126.3
(c) $131.3
(d) $181.0

3. Suppose that GDP is equal to 1000, private saving is equal to 250, net export is equal to
-100, and the government budget deficit is equal to 50. Private investment must equal
(a) $150
(b) $200
(c) $250
(d) $300

4. In a simple expenditure model with no government and no foreign sector, if saving is

defined as S = - 200 + 0.1Y and investment is I = 200, what is the equilibrium level of
consumption?
(a) 3,800
(b) 3,600
(c) 1,000
(d) 2,000

5. In a simple expenditure model with no government and no foreign sector, a decline in

investment of $10 will lead to a $50 decline in income if
(a) the MPSYD is 0.2
(b) the MPCYD is 0.5
(c) the ratio of total consumption to total income is 0.8
(d) changes in consumption divided by changes in income equal 0.2
Page 2 of 10
6. Assume a simple expenditure model with no foreign sector, an income tax rate (t) equal
to zero, and a consumption function defined as C = 400 + (0.75)YD. When government
transfer payments are decreased by 200, then income will
(a) decrease by 600
(b) decrease by 800
(c) increase by 800
(d) increase by 600

7. Assume the consumption function is defined as C = 800 + (0.75)YD and the marginal
income tax rate is t = 0.5. If autonomous investment decreases by 50, then the budget
deficit would
(a) remain unaffected
(b) increase by 10
(c) increase by 100
(d) increase by 40

8. Assume an economy with no foreign sector, a marginal propensity to save of MPSYD =

1/10, and a marginal income tax rate of t = 1/3. What change in government purchases
would lead to an increase in national income of 500?
(a) 50
(b) 100
(c) 200
(d) 300

9. Assume that the savings function is of the form S = - 100 + 0.2YD and the income tax
rate is t = 0.25. What would be the effect on equilibrium income of a decrease in
autonomous consumption of 50?
(a) a decrease in income of 400
(b) a decrease in income of 250
(c) a decrease in income of 200
(d) a decrease in income of 125

10. Assume a model with a marginal propensity to save of MPSYD = 0.2 and an income tax
rate of t = 0.25. What could cause the level of equilibrium income to decrease by 1000?
(a) a decrease in autonomous net exports of 400
(b) a decrease in government transfer payments of 500
(c) a decrease in government purchases of 250
(d) an increase in autonomous investment of 500

11. We can expect the IS-curve to get steeper, as

(a) money demand becomes less sensitive to changes in the interest rate
(b) the marginal propensity to save increases
(c) investment becomes more sensitive to changes in the interest rate
(d) the income tax rate decreases

Page 3 of 10
12. The LM-curve becomes steeper if
(a) money demand becomes less interest sensitive
(b) money demand becomes more interest sensitive
(c) investment becomes more interest sensitive
(d) money demand becomes less sensitive to income changes

13. An increase in the interest sensitivity of money demand will

(a) increase the size of the monetary policy multiplier
(b) decrease the size of the monetary policy multiplier
(c) make fiscal policy less effective
(d) make the LM-curve steeper

14. 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

15. 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 1.20, what is the real exchange rate?
(a) 1.92
(b) 1.60
(c) 1.04
(d) 0.75

Page 4 of 10
PART II (15 marks)

Instructions: Answer the following question in the space provided on this question booklet (if
space is not sufficient, continue on the back of the previous page).

Assume the money sector of a simple economy is described as follows: M = 800, P = 2 and
L = 0.25Y – 10i. In the expenditure sector only investment spending (I) is affected by the rate of
interest (i), and the equation for the IS curve is: Y = 2,000 – 40i. [Note: i is measured as a
percentage, e.g., a 10 percent interest rate implies i = 10.]

(4) (a) Derive the equilibrium values of income (Y) and the rate of interest (i).

Equilibrium Y and i are determined by the intersection of the IS and LM curves.

The equation for the LM curve is derived from the condition of equilibrium in the
money market:

LM-curve: L = M/P ö 0.25Y – 10i = 400 ö Y = 1,600 + 40i

Therefore, the equilibrium rate of interest is:

IS = LM ö 2,000 – 40i = 1,600 + 40i ö 80i = 400 i* = 5

And substituting in the equation for the IS curve we find that the equilibrium level
of income is:

Y* = 2,000 – 40i* = 2,000 – 40(5) = 2,000 – 200 = 1,800

(3) (b) If the size of the simple expenditure multiplier is "AE = 2, show the effect of an
increase in government purchases by )G = 200 on income and the rate of
interest.

Since the equation for the IS curve is Y = "AE (ĀĒ – bi), an increase in G causes the
IS curve to shift parallel to the right by "AE)G, and given the above values this
parallel shift is equal to "AE)G = 2(200) = 400. Therefore, the equation for the new
IS’ curve is: Y = 2,400 – 40i.

The new equilibrium income and rate of interest are determined by the
intersection of the new IS’ curve and the Lm curve:

IS’ = LM ö 2,400 – 40i = 1,600 + 40i ö 80i = 800 ö I* = 10

And the new equilibrium income is: Y* = 2,400 – 40i* = 2,400 – 40(10) = 2,000.

Therefore, )i = +5 and )Y = +200.

Page 5 of 10
(4) (c) Can you determine how much of investment is crowded out as a result of this
increase in government spending? [Hint: it would be easier to answer this
question if you find first the value for the interest sensitivity of investment (b).]

Recall that the equation for investment spending is given by I = Ī – bi and that the
equation for the IS’ curve is given by Y = "AE (ĀĒ – bi) = 2,400 – 40i. Therefore,
"AE.b = 40 and b = 20.

As the rate of interest (i) changes, investment spending (I) changes by )I = -b)i = -
20(5) = -100.

Therefore an increase in government expenditure )G = 200 crowds out investment

spending by )I = -100. However, the change in aggregate expenditure is still
positive, )AE = )G + )I = 200 – 100 = 100, and thus equilibrium income increases.

(4) (d) If the money demand equation were to change to L = 0.25Y, how would your
answer in (a) and (b) change?

If the demand for real balances changes to L = 0.25Y, then it would be

independent of the rate of interest (vertical) and we would be in the classical case.
The LM curve in this case is also vertical:

LM ö L = M/P ö 0.25Y = 400 ö Y = 1,600

Equilibrium income will then be determined only by the LM curve (i.e., the money
market) and fiscal policy will be completely ineffective. Therefore, equilibrium
income will remain unchanged at Y* = 1,600 after the increase in government
expenditure.

The equilibrium rate of interest will be as follows before and after the increase in
government expenditure.

Before the increase in government expenditure, the equation for the IS curve
could be written as i = 50 – 0.025Y, and therefore i* = 50 – 0.025Y* = 50 –
0.025(1,600) = 10.

After the increase in government expenditure, the equation for the IS’ curve could
be written as
i = 60 – 0.025Y, and therefore i* = 60 – 0.025Y* = 60 – 0.025(1,600) = 20.

Therefore, with the demand for real balances independent of the rate of interest,
the increase in government expenditure would cause equilibrium income and rate
of interests to change as follows: )i = +10 and )Y = 0. This means that )AE = )G +
)I = 0 and thus )G = -)I. Indeed, )I = -b)i = -20(10) = -200.
Page 6 of 10
PART III (40 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. In an open economy, an increase in the government budget deficit will necessarily cause a
decrease in private investment.

False.

In an open economy, private savings (S) are used for the financing of private
investment (I), the government budget deficit (G + TR - TA), and net exports (NX):

S = I + (G + TR – TA) + NX.

Therefore, if an increase in the budget deficit is accompanied by a similar

decrease (in absolute value) in net exports, investment would remain unchanged.

Therefore, the statement is false since an increase in the government budget

deficit does not necessarily cause a decrease in private investment.

Page 7 of 10
2. Consider the aggregate expenditure model for a closed economy as developed in class,
where taxes are independent of income (i.e., t = 0). A policy of lower taxes and unchanged
budget surplus will have an expansionary effect on the economy.

False.

A policy of lower taxes and unchanged budget surplus means that government
expenditure must decrease by the same amount as taxes have. Indeed,

BS = TA – (G + TR) ö )BS = )TA - )(G + TR) = )TA - )G - )TR = 0

Assuming )TR = 0, then )TA = )G; and since TA = T, )T = )G.

Fiscal policy will have an expansionary effect on the economy when it causes
aggregate expenditure (AE) to increase. In the aggregate expenditure model
developed in class, autonomous aggregate expenditure was equal to:

AE = C - cT + cTR + G + I.

In our case, the change in aggregate expenditure is equal to:

)AE = -c)T + )G = (1 – c))G

And )AE < 0 since (1 – c) > 0 and )G < 0, and therefore the statement is false: A
policy of lower taxes and unchanged budget surplus will have a contractionary
effect on the economy.

Page 8 of 10
3. In the fixed price model, expansionary fiscal policy is more effective when it is financed by
borrowing from the public than when it is financed by borrowing from the Bank of Canada.
(Show your answer graphically and explain the economics.)

False.

Assume the government increases its expenditure on goods and services (G).
Independently of how the increase in G is financed, this will cause aggregate
expenditure to increase and the IS curve to shift up to the right to IS’.

If the increase in G is financed by selling bonds to the public, no change in the

supply of money will occur and, therefore, no shift in the LM curve will take place.
Therefore, equilibrium income will increase to Y1 in this situation. Here there is
some crowding out since the rate of interest increases to i1.

If the increase in G is financed by selling bonds to the Bank of Canada, then the
supply of money will increase and the LM curve will shift down to the right.
Therefore, equilibrium income will increase to Y2 > Y1 in this situation. In this case
there is less crowding out since the rate of interest is lower than in the previous
case -- i2 < i1.

Therefore, the statement is false: expansionary fiscal policy is less effective when
it is financed by borrowing from the public than when it is financed by borrowing
from the Bank of Canada.

i
LM

LM’
i1
i2

i0

IS’

IS

Y0 Y1 Y2 Y

Page 9 of 10
4. 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 greater impact on Y when the LM is flatter (because the rate of interest
increases less and thus there is less crowding out).

LM(k’)

LM(k)

IS’

IS

Y0’ Y1’ Y0 Y1 Y

Page 10 of 10