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Economics 248 Assignment 2 (version B)
This assignment has a maximum total of 100 marks and is worth 10 percent of your total
grade for this course. You should complete it after completing your coursework for units
4, 5, and 6. Answer each question clearly and concisely.
1. The Canadian consumer confidence rebounded sharply in September 2012. This
is a significant rebound since the plunge in October 2008. According to some
analysts, the good news from Europe and the jump in the stock market appear to
have had an effect on Canadian consumer confidence.
(10 marks)
a. Explain the various factors that buoyed Canadian consumer confidence in
Factors that buoyed Canadian consumer confidence in 2012 included expectations
about the price level and expectations about inflation. Nit sure I understand – how dies
inflation make people happier?Consumers had a positive outlook of the economic climate
and believed it to be improved, and expected the economy to be in a much better state
than it was previously. Due to end of recession?This lead to people being more open to
buy ‘big ticket’ items such as cars. Jump in stock market – more wealth for Cdns?; more
(2 marks)
b. Explain and draw a graph to illustrate how a rise in consumer confidence can
change real GDP and the price level in the short run.
In the short run, a rise in consumer confidence would increase aggregate demand,
shifting the AD curve to the right. Before wages or resource prices have a chance to catch
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up, temporarily, price level would rise, and GDP would rise. Also now there is an
inflationary gap. See graph below.
(2 marks)
c. If the economy was operating at full-employment equilibrium, describe the
state of equilibrium after the increase in consumer confidence. In what way
might consumer expectations have a self-fulfilling prophecy?
If the economy is currently in full-employment and there is an increase in
consumer confidence, this would most likely lead to an increase in consumer spending of
disposable income. Economy moves to above full employment equilibrium as illustrated
on P. 635 Figure 26.9©The state of equilibrium after the increase in consumer confidence
may lead to an inflationary gap, and a period of low unemployment. Consumer
expectations have a self-fulfilling prophecy in the sense that if consumers think the
economy is doing well, and they have additional income to spend, they would save less
and spend more. Their expectations about the state of the economy would lead to them
taking actions, such as increasing their demand for good and services.
(2 marks)
d. Why do changes in consumer spending play such a large role in the business
0/2 Consumption largest component of GDP – see Table 20.1 on P. 469 of the textbook
Changes in consumer spending play a large role in the business cycle because
consumer spending will either increase or decrease aggregate demand and aggregate
expenditure. This will change the amount of output (real GDP) produced within an
economy, and the amount of unemployment there is, which will determine whether the
economy is in a recessionary gap, an inflationary gap or at full employment.
(2 marks)
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e. Explain how the economy can adjust in the long run to restore fullemployment equilibrium. Draw a graph to illustrate this adjustment process.
In the long run, the economy would adjust back to full-employment because
workers would notice the change in the price level and demand higher wages. Resource
prices may also increase, which would increase the cost of production for
producers/suppliers. As a result, the short-run aggregate supply would decrease, and the
curve shift to the left. Full-Employment would be restored, the AS, AD and LAS curves
would intersect at long-run equilibrium, but the price level would be higher.
(2 marks)
2. a. Differentiate between monetary policy instruments and monetary policy tools.
4/ 5
According to page 714 of the textbook, monetary policy instruments include the
interest rate, the quantity of money and the exchange rate.yes variables it can control The
Bank of Canada can decide to set any one of these three instruments but cannot set all
three at the same time, because a change in one of the instruments affects the other two.
For example, if the Bank raised the interest rate, the quantity of money would decrease
and the exchange rate would rise, as a result. It can select one instrument, or switch
amongst them; however, a popular monetary policy instrument to use amongst central
banks is a short-term interest rate, such as the overnight loans rate. Once a decision is
make on which instrument to use, the Bank of Canada achieves its goal by using
monetary policy tools. Variables used to achieve policy instrument targetThe two
monetary policy tools in Canada are the operating band and open market operations.
Monetary policy instruments are decided upon, and then monetary policy tools are used
to meet the policy aims of the Bank.
(5 marks)
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b. Describe the two key tools of monetary policy, and describe how they would
be used by the Bank of Canada to implement a contractionary monetary
The two monetary policy tools used by the Bank of Canada are the operating band
and open market operationsyes. The operating band is the target overnight loans rate plus
or minus 0.25 percentage points, and is created by setting the bank rate and the settlement
balances rate. Open market operations refer to a central bank’s buying and selling of
government bonds (securities), in the open market to influence the quantity of money in
the banking system. To implement a contractionary monetary policy during inflatioma
recession, the Bank would lowerraise the overnight loans rate to a new target by
sellbuying securities in the open market. This would lead to an increase in the quantity of
money and an increase in the supply of loanable funds. Real interest rates and the
exchange rate would fall. The lower interest rates would lead to higher consumption and
investment. Because of the lower exchange rate, net exports would increase. Aggregate
demand would increase, due to low interest rates and because it would be easier to obtain
loanable funds. Real GDP would increase, the price level would rise and the economy
would be sped up.
(5 marks)
3. The economy of Kenya is in recession, and the recessionary gap is large. The
World Bank hires you as its economist and asks you to do the following:
(10 marks)
a. Describe the discretionary and automatic fiscal policy actions that might
1/ 2.5
Discretionary fiscal policy actions are actions that are deliberately taken
by the government, by an act of Parliament, to change taxes and government expenditure.
They are a change in the law. Automatic fiscal policy action does not need to be
deliberately taken, as these policies are built in to the economy and take effect, or are
triggered, by a change in the economy. In a recessionary period, the government must
increase expenditure and/or reduce taxes to raise GDP or stimulate private investment.
yesThrough discretionary policy, they could pass a new bill or amendment doing so, in an
omnibus budget bill for example. For automatic policies, during a recession, this would
trigger unemployment benefits and transfer payments,how? Higher EI benefits/lower tax
collections and due to a fall in income, people would be put into a new income tax
bracket. This is all fiscal policy that would help in a recession.
(2.5 marks)
b. Describe a discretionary fiscal stimulation package that could be used that
would not bring a budget deficit.
A discretionary fiscal stimulation package that could be used would be aimed at
increasing aggregate demand. This may be a new law or budget bill passed to increase
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government spending and also an income taxincrease2.5/2.5 cut. However, it is important
that the government budget balance does not lead to a deficit because of government
spending and a lack of revenue coming in. Following this, the government can cut
expenditure and increase taxes; but it must be careful to time the policy so that it
coincides with an increase in investment and aggregate demand.
(2.5 marks)
c. Describe the risks of discretionary fiscal policy in this situation.
The risk is that this will lead to the government deficit spending. This means the
government is spending money that it doesn’t actually have, because it it borrowing it
from the loanable funds market. Not only would the government have a deficit and its
cumulative deficit would be growing, but the government may also potentially crowd-out
private investment by raising in the interest rate and by borrowing money that businesses
could have borrowed instead.
(2.5 marks)
d. Explain the argument that lower corporate tax rates can increase tax revenue
in Kenya. Consider the Laffer curve in your explanation.
Lower corporate tax rates can increase tax revenue in Kenya. This can be
explained using the Laffer curve, which shows the relationship between the tax rate and
the amount of tax collected. Taxable income changes in response to changes in the tax
rate. The curve goes from increasingwhat tax revenue? Rates? to reaching a maximum
point, to decreasing as the tax rate reaches a high point. Lower corporate tax rates would
hit the point of the Gaffer curve where tax revenue is increasing, because the amount of
taxable income available from private businesses is high. Taxing businesses too high can
lead to lower tax revenue because there is less taxable income available, and high taxes
also mean there would be little incentive to work and be productive. Lower tax rates in
Kenya can ensure that businesses keep growing, investing their income and being
productive, which would lead to the amount of taxable income collected being quite high
and sufficient. We would be hitting the “sweet spot” on the Laffer curve where tax
collected is at its increasing points. What direction are we moving? Right to left?
(2.5 marks)
4. a. Explain the concept of the multiplier, and explain the role of the marginal
propensity to save (MPS) in determining the size of the multiplier.
3/ 4 The larger the MPS – the lower the multiplier
The multiplier is the amount by which a change in the autonomous
expenditure within the economy is magnified or multiplied to determine the
change in expenditure equilibrium and the change in real GDP. The reason why
autonomous expenditure is multiplied when determining the change in real GDP
is due to increased induced consumption. As income increases, disposable income
increases. So the initial investment or export increase of autonomous expenditure
substantially raises the GDP. You can use either the MPC or MPS to determine
the size of the multiplier. The formula for determining the multiplier using MPS is
multiplier = 1/MPS. The formula for determining the multiplier using the MPC is
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multiple = (1/ 1 - MPC). The slope of the AE curve we are looking at is the MPC
in an economy with no imports or income taxes. MPS and MPC both equal 1, so
you can determine either if you have the value for one of them.
(4 marks)
b. Explain how the size of the multiplier will change when the role of the
marginal tax rate is brought in.
Income taxes would lead to a smaller multiplier. An increase in investment
??increases real GDP. If the marginal tax rate increases, this reduces the amount of
disposable income tand consumptionshat would have been available without the marginal
tax rate. Therefore, the larger the tax rate, the smaller the disposable income, the smaller
the change in GDP and ultimately the smaller the multiplier.
(2 marks)
c. Using the concepts in parts a and b above, calculate the slope of the AE curve
and the size of the multiplier if MPS = 0.28. Then calculate the revised slope
of the AE curve and the multiplier when you know that the imports and the
marginal tax rate will reduce the slope of the AE curve by another 0.15.
Multiplier = 1/MPS = 1/0.28 = 3.57
Slope of the AE curve = the marginal propensity to consume
= 1 - MPS
= 1 - 0.28 = 0.72
Revised Slope = 0.72 - 0.15 = 0.57
Revised Multiplier = 1/(1 - 0.57) = 2.325 = 2.33
(4 marks)
5. The economy has seen the unemployment rate decrease from 8.56 percent to 6.15
percent and the inflation rate increase from 1.4 percent to 3.2 percent. There has
also been a 17 percent increase in consumer spending and a 22.5 percent increase
in investment spending in the same time period.
(10 marks)
a. Given the above, what would you predict about the overall direction of the
economy? Explain your answer by referring to each of the indicators cited.
The overall direction of the economy looks like it’s heading towards an expansion
period in the business cycle. While inflation is rising, unemployment is decreasing, which
means that people are getting more jobs and the economy is heading towards the
direction of full employment. This is further supported by the increase in consumption
expenditure by 17% (most likely due to more incomes, and rising disposable income).
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Further, a 22.5% increase in investment is also a very positive sign that the economy is
heading towards a peak and expansion period. Increased investment means a rise in
aggregate expenditure, which will correlate with an increase aggregate demand and result
in an increase in real GDP.
(5 marks)
b. Describe the fiscal policy that will already be automatically operating, as well
as the appropriate discretionary fiscal policy that the government should
adopt, given the above situation.
Fiscal policy is the policy aimed at changes taxes and government spending to
impact aggregate demand in an economy. Since the economy is successful and heading
towards expansion, the fiscal policy that will automatically be operating lower EI
benefits/higher tax collectionis an expansionary fiscal policy, in which the government is
spending more and cutting taxes. However, expansionary fiscal policy raises the price
level (leading to inflation over time if price levels rise persistently), while increasing
employment. This is what is happening now, and aggregate demand might become too
much. As a response, the government will want to employ a contractionary fiscal policy
and decrease aggregate demand by limiting spending or increasing taxes,yes or do both,
in order to decrease rising inflation.
(3 marks)
c. 1.5/2Describe the appropriate monetary policy that the Bank of Canada should
be operating, given the above situation.
(2 marks)
Since the inflation rate is increasing, the Bank of Canada will want to exercise its
capacity with some type of contractionary monetary policy.by raising overnight rate
target This usually means reducing the money supply by decreasing bond prices and
also increasing the interest rate. This will incentives people to save more and spend
less on consumption, and even investment. Spending will decrease, prices will drop,
and it will be more expensive to borrow. This will control economic growth, which
will control inflation.
6. Describe the contrasting views of the Keynesians and the monetarists with regard
to an appropriate expansionary policy to bring an economy out of a period of high
unemployment caused by a weak aggregate demand.
Keynesian economists believe that if the economy is left to its own devices, the
economy would not usually operate at full-employment by itself. This school of thought
believes in fiscal and monetary involvement from the government via policy. According
to the Keynesians, fiscal and monetary policy should be used to stimulate demand to
restore full employment.
The Monetarists are similar to the classical economists in the sense that they
believe the economy is self-regulating and that the economy will normally operate at full
employment naturally. However, the monetarists differ because they believe that good
monetary policy is a crucial element that must be in place. They believe the pace of
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money growth must be kept stable. They would say that aggregate demand fluctuations
that lead to fluctuations in the business cycle are caused by errors in monetary policy.
This school of thought advocates for a low tax rate and and a steady supply of the
quantity of money; however, other than monetary policy, the government need not take
much action.
In a situation where an expansionary policy is needed to bring an economy back
to full employment, from high unemployment due to weak aggregate demand, the
Keynesians would advocate thatexpansionary? fiscal policy is necessary here. They
would say that government spending ought to increase iand lower taxesn this period to
increase aggregate demand. The government can spend on various projects, that would
could potentially increase investment and increase jobs (and thereby income, and then
consumption expenditure and shifting aggregate demand to the right).
The monetarists do not believe that government spending and fiscal policy would
be beneficial; in fact, they would find it to be detrimental, potentially crowding out
private investment. The monetarists would advocate for the Bank of Canada to increase
the quantity of money, which would increase investment, lower the interest rate and
increase consumption expenditure (shifting aggregate demand to the right). This would
enhance employment. However, monetary policy ought to only be used sparingly, and
decision makers would be wise not to over-do the intervention or let the money supply
get too high. And expansionary monetary policy?
(10 marks)
7. Suppose Canada can produce 1,500 tons of wheat or 500 tons of steel, and Brazil
can produce 1,000 tons of wheat or 1,500 tons of steel.
(10 marks)
a. What is the opportunity cost of one ton of wheat in Canada? Show your work.
1500 (1 w is 1/3 steel)
500 (1 s is 3 wheat)
1000 (1 w is 1.5 steel)
1500 (1 s is 0.6 wheat)
The opportunity cost of one ton of wheat in Canada is 500/1500 = 1/3 steel.
(2.5 marks)
b. What is the opportunity cost of one ton of steel in Brazil? Show your work.
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1500 (1 w is 1/3 steel)
500 (1 s is 3 wheat)
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1000 (1 w is 1.5 steel)
1500 (1 s is 0.6 wheat)
The opportunity cost of one ton of steel in Brazil is 1000/1500 = 0.6 wheat.
(2.5 marks)
c. Which country has a comparative advantage in producing steel? Explain why.
1500 (1 w is 1/3 steel)
500 (1 s is 3 wheat)
1000 (1 w is 1.5 steel)
1500 (1 s is 0.6 wheat)
Brazil has a comparative advantage in producing steel. This is because Brazil
has to give up less heart to produce one ton of steel, compared to Canada. To make one
ton of steel, Brazil only has to give up 0.6 tons of wheat. In comparison, to produce the
same ton, Canada would have to give up producing 3 whole tons of wheat. The underline
in the diagram shows whom has the comparative advantage in which good.
(2.5 marks)
d. Suppose that trade takes place between Canada and Brazil. Which good will
Brazil import from Canada? Explain why.
As shown in my answer in part (c), Brazil has a comparative advantage in
producing steel, and Canada has a comparative advantage in producing wheat. This is
because both countries have to give up less of the other good (less opportunity cost) to
produce the good they have the comparative advantage in. As such, Brazil will import
wheat from Canada. Brazil should not produce its own wheat, because its opportunity
cost of doing so is 1.5 tons of steel, while Canada’s opportunity cost is only 1/3 tons of
steel. Therefore, Brazil should specialize in making only steel, and import wheat from
Canada. Specialization in trade will make both countries better off.
(2.5 marks)
8. 5/5a. Describe an export subsidy, and explain the gains and losses that might
arise from such a practice.
An export subsidy is a payment by the government to the producer of an export
good. The costs of production decrease, so there is an increase in the supply of
exports. They are illegal under international agreements like NAFTA and by the
rules of the WTO. Export subsidies lead to gains for domestic producers; however,
they also lead to the inefficient overproduction of certain goods, especially food
products in richer countries, and underproduction in the rest of the world. Overall,
export subsidies create a loss for the world as a whole.
(5 marks)
b. Why are developing countries in Africa especially affected by export
subsidies in industrial countries?
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Developing countries in Africa are especially affected due to export subsides in
industrial countries because the subsides end up increasing domestic production in richer
countries; products which gets exported elsewhere. However, these exports make it hard
for producers in other countries, such as Africa or countries in Central America, to
compete in the global market. Essentially, the government is helping domestic producers
with their costs of production so they can produce more and sell on the word market. But
producers in other countries, who are probably not getting a subsidy, have to compete as
per usual, but in an inherently unfair environment. This is especially unfair for producers
in developing countries or countries which we consider to be poorer.
(5 marks)
9. In 2012, the Canadian dollar appreciated against the US dollar. Explain the effects
of this appreciation on each of the following.
(10 marks)
a. Canadian importers of goods from the United States
The Canadian dollar has appreciated, and therefore has strengthened in
relation to the US dollar. This means that the Canadian dollar will be able to buy more of
US currency, and therefore US goods. Importers in Canada benefit from this, as
purchasing US goods will now be cheaper for them. The demand for US goods by
Canadians will increase.
(2.5 marks)
b. Canadian firms that sold commodities to US buyers
Canadian firms that sold goods to US buyers now have goods that are more
expensive for US buyers to purchase. The Canadian dollar is more expensive for
Americans to buy so they can buy less of these commodities with the same amount of
money. As a result, there will be a decrease in demand for Canadian goods sold by
Canadian firms to US buyers.
(2.5 marks)
c. American tourists who came to Canada
American tourists who come to Canada will face the same issue as is
experienced in part (b). Their American dollars can now buy less Canadian dollars, and
their vacation to Canada will now be more expensive than if the Canadian dollar had not
appreciated against the US dollar. Most likely, the number of American tourists coming
to Canada will decrease, since it’s expensive for them.
(2.5 marks)
d. US investors who had purchased Canadian securities prior to this currency
US investors who had purchased Canadian securities will benefit. They hold
Canadian assets and the Canadian dollar is strong now. They will most likely continue to
hold their Canadian securities because it will give them better returns than US securities.
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US investors who hold Canadian assets benefit from the Canadian dollar appreciating, as
they own something that contains a greater value than securities bought in their own
(2.5 marks)
10. The Global Insight (GI) forecasting firm predicted that the Canadian economy
would bounce back by a stronger-than-expected 1.0 percent on an annualized
basis in the third quarter of 2012 and with a further 0.1 percent in the fourth
quarter of 2012. The firm also expected moderate growth overall in 2013.
(10 marks)
a. What evidence did GI present to support the view that Canada had entered a
The evidence that GI presents to support the view that Canada had entered a
recovery period is that the Canadian economy has been showing signs of growth;
specifically that the components that make up GDP (exports, investment, etc.) have
cumulatively increased and are expected to increase even further in the upcoming future.
The notion of moderate growth in 2013 tells us that if Canada wont be in the middle of a
full inflationary gap, it will at least be close to full employment and doing well. I believe
the statistics referred to in the paragraph are referring to real GDP, and that real GDP is
(2 marks)
b. Use a short-run Phillips curve to explain why the inflation rate may have
increased over the course of 2012.
The Phillips curve is the relationship between unemployment and inflation.
The inflation rate may have increased over 2012 due to the unemployment rate
decreasing. If the economy is doing well, and there is a lot of investment happening,
more people are able to have jobs. As a result, more people are employed and the
unemployment rate decreased. As the unemployment rate decreases and people have
jobs, they have more disposable income to spend on consumption. Investment and net
exports may also increase. Aggregate demand and aggregate expenditure increases,
which leads to an increase in real GDP and an increase in the price level. This ultimately
leads to an increase in inflation. There is a leftward movement along the short-run
Phillips curve, as follows.
Phillips Curve
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(4 marks)
c. Under what circumstances might the inflation rate not have increased during
2/ 4
decrease in the expected inflation rate or a decrease in the natural unemployment rate
The inflation rate may have not increased during 2012 if it was the case that
employment levels remained low. In this case, people would not have extra disposable
income to spend on consumption, which would increase GDP and the price level. When
unemployment decreases, the inflation rate necessarily increases. If unemployment
remained the same or unemployment had increased in 2012, then the inflation rate would
have not increased during that period. However, if an economy is moving away from a
recession phase towards an expansion, then the economy is moving in the direction of
inflation in the business cycle. Additionally, the government could have implemented
fiscal policy, or the Bank of Canada could have implemented monetary policy to control
the inflation rate so that it doesn’t rise too high. However, this is largely governed by the
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business cycle, and for the inflation rate to have not increased in 2012, unemployment
also ought to have not decreased.
(4 marks)
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