UNIVERSITY OF TORONTO
Faculty of Arts and Science
ECO102Y-L0101 and L0201- Principles of Macroeconomics
Term Test 2 - March 22nd 2019
Professor Loren Brandt
You have 80 minutes to do this evaluation. You are allowed to have a non-programmable
calculator and a ruler if you so need it. You can answer in pen or pencil as long as it is
legible enough for it to be marked. Make sure to not write or tear the QR codes on any of
the pages. There are a total of 115 points on this exam. The points for each part are in
parentheses.
Name:
UtorID:
Student email:
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1. (15) The Figure below shows aggregate demand for Country X last year (AD1 ) and
the aggregate demand for this year (AD2 ). If you were to advise the President of this
country on economic policy, how would you address the following?
(a) (4) How large is current output? How large is potential GDP? What is the
difference, if any, between the two?
Solution: Current output is 60 (this year’s output) and potential output is 80 (last year’s output) (2 points). There is a 20 point difference
between current and potential (2 points).
(b) (3) Is the country in a recession or boom?
Solution: From the previous question, we have that the economy is in
a recession, as current is less than potential.
(c) (4) Given your findings, should the president enact expansionary fiscal, contractionary fiscal policy, or no policy at all?
Solution: If the president wanted to get rid of the recession, they
would need to enact an expansionary fiscal policy.
(d) (4) What direction would the aggregate demand curve shift if the president used
contractionary fiscal policy?
Solution: If the president enacted a contractionary fiscal policy, it
would worsen the recession in the short-run.
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2. (25) The following balance sheets are for the Central Bank of a country and its sole
commercial bank. Citizens always hold $1000 in currency and the reserve requirement
is 10%. The commercial bank adheres to a strict policy of always lending out its excess
reserves.
(a) (5) Does the commercial bank initially satisfy the required reserve ratio? Explain
your answer.
Solution: It does as the reserve ratio of a bank is given by rr = reserves
deposits =
10%, which is the desired reserve ratio (3 points if they only get that
rr = resreves
deposits .
Suppose the Central Bank sells $5000 in government bonds to the commercial bank.
(b) (5) Show the immediate effect of this transaction on a new balance sheet for
both the Central Bank and the Commercial Bank.
Assets
Government
Bonds
Central Bank
Liabilities
6,000 Reserves
Currency in
Circulation
Total
6,000
Total
5,000
Assets
Reserves
Commercial Bank
Liabilities
5,000
Deposits 100,000
1,000
Loans
80,000
15,000
6,000
Government
Bonds
Total
100,000
Capital
0
Total
100,000
Solution: 1 point for each of the correct numbers in the table, 0.5 for
each correct total at the bottom.
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(c) (5) Given your answer in (b), describe the Commercial Bank’s problem. Be
explicit as possible. What are the options the Commercial Bank has for resolving
the problem?
Solution: The problem of a commercial bank is that now the reserve
are at 5% which is less than the target reserve ratio of 10% (2 points).
To resolve this, it can reduce the amount of loan to compensate for
the loss in reserves (3 points).
(d) (5) Show the new balance sheet for the Commercial Bank after it fully adjusts
to the sale of $5000 in government securities by the Central Bank.
Assets
Government
Bonds
Central Bank
Liabilities
6,000 Reserves
Currency in
Circulation
Total
6,000
Total
Commercial Bank
Liabilities
5,000
Deposits 50,000
5,000
Assets
Reserves
1,000
Loans
30,000
15,000
6,000
Government
Bonds
Total
50,000
Capital
0
Total
50,000
Solution: 1 point for each of the following: correct reserves, deposits,
loans, government bond and total for the commercial bank (-0.5 if
they don’t add up).
(e) (5) What happens to the money supply?
Solution: The money supply decrease by $50,000, which is also the
predicted change from the B of C selling $5000 in government bonds
when the target reserve ratio is 10%.
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3. (25) Consider the following fixed price economy, where YD is disposable income:
Consumption:
Investment
Government Expenditure:
Taxes:
Exports:
Imports:
Potential GDP (Full Employment):
9
C = 10 + 10
YD
I = 100
G = 90
T = 61 Y
X = 100
M = 14 Y
700
(a) (5) What is the expression for Aggregate Expenditure in terms of Y .
Solution:
1
1
AE = 10 + .9(Y − Y ) + 100 + 90 + 100 − Y
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4
1
= 300 + Y
2
(b) (4) What is equilibrium GDP? How does it compare to Potential GDP? Show
graphically.
Solution: In equilibrium, we have that Y eq = AE (2 points), which
means that Y eq = 300 + 12 Y eq and therefore Y eq = 600 (2 points).
(c) (4) What is the multiplier? What is the numerical effect of the inclusion of
imports on the multiplier?
1
1
Solution:The multiplier is (1−mps)
= (1−0.5)
= 2 (2 points). Imports
decrease the marginal propensity to spend by 25%, which effectively
reduce the multiplier effect by a half (2 points).
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(d) (4) What change in Government Expenditures will result in a trade balance
equal to zero?
Solution: We have that the current trade balance is X −M = 100−.25×
600 = 100−150 = −50 (1 point). By decreasing government expenditure,
we can decrease imports, which would reduce the trade balance. Note
that if G is decreased by 1, then Y eq goes down by 2, which decreases
imports by .5. Thus, to decrease imports by 50, we need to decrease
government expenditure by 100 (3 points for some variant of this
explanation). (Note that in this case, the government shouldn’t be
able to reduce it, by that much, but we shouldn’t penalize, anyone
who either points it out or not.)
(e) (4) China is a major destination of this country’s exports. Because of China’s
growth slowdown, exports are predicted to decline by 10%. What will be the
size of the impact on GDP of this economy? Please show your result graphically.
(Note: This question is independent of part (d).)
Solution: The decrease in exports will decrease the aggregate expenditure by 10 (2 points), which will lead to a decrease of GDP in the
economy of 20 (2 points).
(f) (4) A new administration in this country is proposing to promote economic
growth by cutting taxes and to pay for these tax cuts by cutting government
spending by exactly the same amount. What does our model say is the effect of
a tax cut paid for by an equal cut in government spending? Circle the correct
answer, and then explain briefly in words.
i. Decrease in equilibrium GDP (1 point)
ii. No change in equilibrium GDP
iii. Increase in equilibrium GDP
iv. GDP may increase or decrease
v. None of the above
Solution: It leads to a decrease in equilibrium GDP, because the effect
of a reduction in taxation will be tampered by the fact that consumers
do not consume the full increase in their income, whereas the decrease
in G will directly impact the AE. Hence, the increase in C doesn’t
offset the decrease in G (3 points for some variant of this explanation).
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4. (15) For each of the following changes, describe the affect on the AD curve, the SRAS
curve, and the LRAS (only). Identify whether the effect causes a shift of the curve
or a movement along the curve and identify the direction of the shift or movement.
Solution: For each question give 2 points for graph that illustrate the
correct shift, all other curves do not matter.
(a) (5) An increase in the money supply causes interest rates to fall.
Solution: The decrease in interest rate will lead to an increase in
Investment which will increase AE for all price levels. This will lead
to a shift to the right of the AD curve
(b) (5) There is a decrease in productivity in the country.
Solution: A decrease in productivity would be linked to a decrease in
potential GDP. Thus, the LRAS should go down.
(c) (5) Labor unions successfully negotiate an increase in nominal wages for their
workers.
Solution: This increases the price of production as labour is now more
expensive. This should shift the SRAS left (or up).
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Multiple Choice (15 points in total, 3 points each. All marks for choice.)
5. Assume an economy at full employment (i.e. at potential GDP). According to the
AS-AD model, what is the predicted long-run effect of a permanent increase in autonomous exports?
(a) Nominal wages will rise and the unemployment rate will remain constant.
(b) Nominal wages will fall and the unemployment rate will increase.
(c) Nominal wages will rise and the unemployment rate will fall.
(d) Real wages will rise and the unemployment rate will remain constant.
(e) Real wages will fall and the unemployment rate will increase.
6. Assume the Canadian economy is currently at potential GDP. If there is a sharp
decrease in Canadian autonomous exports due to higher U.S. trade barriers, what is
the likely stabilization policy implemented by the Bank of Canada?
(a) Increase autonomous government expenditures. Decrease taxes.
(b) It will increase the target overnight rate and sell government bonds.
(c) It will increase the target overnight rate and buy government bonds.
(d) It will decrease the target overnight rate and sell government bonds.
(e) It will decrease the target overnight rate and buy government bonds.
7. The Bank of Canada has an inflation target of 3%. It sees that the core rate of
inflation is consistently above its target. What monetary policy do you expect?
(a) Decrease autonomous government expenditures. Decrease taxes.
(b) It will decrease the target overnight rate and sell government bonds.
(c) It will decrease the target overnight rate and buy government bonds.
(d) It will increase the target overnight rate and sell government bonds.
(e) It will increase the target overnight rate and buy government bonds.
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8. The Governing Council of the Bank of Canada has decided that the overnight rate
should be 2%, rather than the current rate of 1.75 %. The appropriate open-market
action would be to
treasury bills to
money
.
(a) sell; decrease; demand
(b) sell; decrease; supply
(c) buy; decrease; supply
(d) buy; increase; demand
9. When actual output is above potential output over time, then in the long run:
(a) nominal wages will increase and the short-run supply curve will shift to the right.
(b) nominal wages will increase and the short-run supply curve will shift
to the left.
(c) the aggregate demand curve will shift to the right.
(d) the short-run aggregate supply curve will shift to the right.
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Short answer (20 points in total, 4 points each).
You can use graphs to complement your explanation in words.
10. Let the economy be at its potential output. Suppose that there is an increase in the
marginal propensity to save. What will happen to equilibrium GDP in the short-run?
In the long-run?
Solution: An increase in the marginal propensity to save leads to a decrease
in the marginal propensity to consume, which will decrease the AE for all
price level (1 point). This will lead to a shift left of the AD curve which
will lead to a lower equilibrium GDP in the SR (1 point). In the long-run
the recession will lead to a decrease of nominal wage, decreasing SRAS,
until the equilibrium GDP returns to its potential (2 points). (Graphs can
easily substitute some of the points here)
11. Assume the Canadian economy is initially at its potential GDP (Y ∗ ). It then sees
a change in net exports due to an increase in U.S. GDP. Assuming no change in
either fiscal or monetary policy, explain how the Canadian GDP returns to a longrun equilibrium according to the AS-AD model.
Solution: This increase in net exports leads to an increase of AE which
then leads to an increase in the AD curve. This leads to an inflationary
gap where unemployment is low and thus workers ask for higher (nominal) wages. This increase the cost of production, shifting the SRAS curve
left until the economy returns to its potential output. (While graph, can
explain, 2 points are dedicated to the proper explanation of the self correcting mechanism)
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12. Suppose that the Short-run Aggregate Supply is positively sloped. What is the spending multiplier effect of an increase in Exports (X) on Aggregate Demand (AD) and
equilibrium Y? Show graphically and explain in words.
Solution: Graphically should show the graph with AE curve goes up and
below the AD goes up (1 point). It should show that the change in AE
(dX) is less than the change in equilibrium output (dY) which then shifts
the AD by the multiplier effect times dX (2 points). This is due to the
fact that prices are flexible in an economy and thus the price adjustment
will decrease the effect of the spending multiplier (1 point).
13. If the interest rate on short-term guaranteed investment certificates (GICs) were to
fall significantly, how would this affect the money demand curve?
Solution: This decreases in the interest rate, leads to an increase in investment (1 point), which leads to an increase in income (1 point) which will
increase the money demand curve (2 points). It would also be okay to say
that the decrease in interest rate on GICs decrease the incentive to save,
which will increase equilibrium income in our model (2 points, replacing
the 2 first points).
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14. Suppose that the government currently operates with a deficit and that this deficit
grows by 4% per year. Furthermore, suppose that this economy initially has zero
debt until the government started operating with a deficit. The economy’s annual
economic growth rate is 5% per year. What will happen to the economy’s debt-toGDP ratio over time given this information? Assuming that costs of borrowing, i.e.
interest rates, remain fixed, what will happen to the costs of servicing the national
debt? Explain your answer fully.
−1 − 1 or about a
Solution: The debt to GDP ratio will go down by ( 1.04
1.05 )
bit less than 1% per year (2 points). As the interest rates are constant
the cost of servicing the debt will go down as the importance of the debt
becomes negligible with respect to the economy’s production (2 points).
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