SCARBOROUGH College, UNIVERSITY OF TORONTO
Department of Economics
ECMA05: Principles of Macroeconomics
Midterm #3: March 27, 2008
Duration – 1 Hour
Aids Allowed: Non-programmable calculators only
Time Allowed: 1 Hour
The total marks in this test are 50. The test is divided into two parts:
Part I - problem format - is worth 40 marks (40 of the total mark of 50)
Part II - multiple choice- is worth 10 marks (10 of the total mark of 50)
(5 multiple choice questions worth 2 marks each)
Show your work where applicable.
Please use pen instead of pencil.
Print your name and student number clearly on the front of the exam and on any loose pages.
(Family Name) (Given Name)
Student #: .
There are 5 pages to the exam.
Part I: Place your answers (and work where necessary) in the space provided.
Clearly label all axes, curves, and points.
1. Spending and Monetary Equilibrium: Fiscal Policy (10 marks)
Use an AE/Y, Md/Ms, and MEI diagram to show the impact on equilibrium income, the interest rate, and investment of an increase in government spending. Be sure to demonstrate ‘crowding out’.
Label your axes carefully and use different subscripts to distinguish between the original equilibrium (‘o’) and subsequent changes.
1 mark: initial equilibrium ro at intersection of vertical Ms and downward sloping Md
1 mark: initial equilibrium Io from downward sloping MEI at ro
1 mark: initial equilibrium Yo from intersection of positively sloped AEo and 450 line
1 mark: an initial increase in AE (AE1 say)
1 mark: increase in equilibrium Y to Y1 (say) > Yo at AE1 intersect the 45 degree line
1 mark: an increase in Money Demand
1 mark: an increase in r to r1 > ro at MD1 interesect Ms(Mo)
1 mark: I1 < Io from negatively sloped MEI at r1
1 mark: a fall back of AE between AEo and AE1
1 mark: Y (not shown) between Yo and Y1 from 45 degree line and the middle AE
2. Monetary Demand and Supply Equations (15 marks)
Suppose that the following equations describe an economy (r is in decimal form).
Money Demand: MD = 0.06Y – 600r Aggregate Expenditure: AE = 810 + I + 0.6Y Marginal Efficiency of Investment: I = 86 – 400r (
a) What is equilibrium Investment if the interest rate is 4% (i.e., 0.04)? (1 mark)
1 mark: I = 70 from 86 – 400(0.04)
b) What is equilibrium Y given your calculation of Investment? (2 marks)
1 mark: Y = 810 + 70+ 0.6Y (or Y = (810 + 70)/(1 – 0.6)
1 mark: Y = 2,200 [billion]
c) Suppose that Money Supply (MS) = $108 billion. What is equilibrium r given your equilibrium GDP (Y) from b)? (2 marks)
1 mark: setup: 108 = 0.06(2200) – 600r [or r = (0.06*2200 –108)/600
1 mark: answer: r = 0.04 (4%)
d) In the space below, graph the money supply/money demand diagram, the Marginal Efficiency of Investment diagram, and AE/Y diagram. Carefully label your diagrams, including the values for equilibrium interest, investment, and income and the intercepts for the Money, Investment, and Aggregate Spending axes. (4 marks)
1 mark: correct axes (somehow indicated): r and M(or M/P),
r and I (or real I); real AE and real Y (or GDP)(doesn’t have to be real for AE and Y)
1 mark: Money Supply = 108 and I and Y consistent with their answers above (hopefully 70 and 2200)
1 mark: MD intercept = 132, MEI intercept = 86
1 mark: AE intercept = 880
e) Ignore your answers from above but assume that the MD, MEI, and AE equations are the same and that the required reserve ratio is 8% (0.08). Suppose that GDP = $2,165 billion and Money Supply = $84.9 billion initially.
i) What is the equilibrium interest rate if the Central Bank (e.g. the Bank of Canada) sells $0.48 billion worth of government bonds? (Ignore Crowding Out) (2 marks)
1 mark: new Money Supply = $78.9 b (from 84.9 – 0.48/0.08)
1 mark: new interest rate = 0.085 (or 8.5%) from (r = (0.06*2165 – 78.9)/600)
ii) What is equilibrium investment and income (ignoring crowding out) given this Central Bank sale of $0.48 billion worth of government bonds? (2 marks)
1 mark: I = 52 from 86 – 400(0.085)
1 mark: Y = 2,155 (from Y = (810 + 52)/(1-0.6))
f) Assume that we have the original equations but Y = 2,190, MS = 101.4. What is equilibrium Y, r, and I if government spending increases by 12 ($billion)? Be exact and ignore crowding out. (4 marks)
1 mark: recognition that G causes a multiplier change in Y = +12/(1 – 0.6) or + 12*2.5
1 mark: r = 0.053 (5.3%) from r = (0.06(2,190 + 30) – 101.4)/600
1 mark: I = 86– 400(0.053) = 64.8
3. Aggregate Demand (15 marks)
The following equations describe an economy. There are no taxes in the economy
Consumption: C = 1380 + 0.8Yd – 5P
Investment: I = 240 + 0.1Y – 2P Exports: X = 520 – P
Government Spending: G = 660 Imports: IM = 60 + 0.15Y + 2P
a) What is the Aggregate Expenditure Equation with a price variable? (2 marks)
1 mark: two of three parts of AE correct (i.e., two of 1910, 0.75Y, and –10P)
(e.g., AE = 1380 + 0.8Y – 5P + 240 + 0.1Y– 2P + 660 + 520 – P – (60 + 0.15Y + 2P)
1 mark: AE = 2,740 + 0.75Y – 10P
IGNORE THE PREVIOUS PART OF THIS QUESTION
b) Suppose AE = 2,400 + 0.7Y – 9P. Give the equation for Aggregate Demand? (2 marks)
1 mark: recognition that Y = 2,400 + 0.7Y – 9P
1 mark: Y = 8000 – 30P
c) What is equilibrium Y if P = 140? (1 mark)
1 mark: = 3,800 (from either Y = 8000– 30(140) or Y = [2,400 – 9(140)]/(1 – 0.7)
d) What is the intercept of Aggregate Expenditure if P = 140? (1 mark)
1 mark: = 1,140 (from 2,400 – 9(140)) (or consistent with b)
e) Sketch two diagrams below: The AE/Y equation for P = 140 above and the appropriate Aggregate Demand function below given your answers. Label the axes clearly and specify the intercepts of the functions. (4 marks)
e) 1 mark: a positively sloped AE function with AE intercept = 1,140
1 mark: AE intersecting the 450 line at 3,800 (or the answer they have for f))
1 mark: downward sloping AD with Y intercept = 8000
1 mark: AD passes through P = 140 (vertical) and Y = 3,800.
f) 1 mark: upward sloping Supply through P = 140 and Y = 3,800 (or consistent)
g) 1 mark: AE shifts up
1 mark: AD shifts to the right by the amount of the muliplier change in Y, i.e. AE shifts horizontally (at the same P) to the Y determined by the intersection of AE and the 450 line.
1 mark: equilibrium at intersection of new AD and their SRAS but Y < the AE/Y equilibrium
f) Draw a Short-run Aggregate Supply function for this equilibrium. (1 mark)
g) What is Aggregate Demand given an increase in government spending of +6? (1 mark)
1 mark: AD = 8020 – 30P from 8000 + 6/(1-0.7) or Y = 2,400 + 6 + 0.7Y – 10P
h) Show the effect of the increase in government spending on your diagrams. (3 marks)
Part II: Multiple Choice: Circle the best answer
Each question is worth 2 marks. No marks deducted for wrong answers.
Suppose that an investment pays $7500 in 2 years and $8000 in 3 years. What is the present value of this investment if the interest rate is 6%?
a) $15,500 b) $14,950.79 c) $14,642.52 d) $13,794.45 e) $13,391.93
f) )$13,081.17 g) $13,014.10 h) $12,996.86 i) none of the above
Which of the following is true given our model ceteris paribus?
a) an increase in the interest rate increases the demand for money
b) an increase in government spending increases the supply of money
c) an increase in the interest rate increases the supply of money
d) an increase in currency in circulation increases the supply of money
e) an increase in the required reserve ration increases the supply of money
f) none of the above
3. Which of the following increases GDP (Y) and the interest rate in equilibrium?
a) Bank of Canada purchases of bonds
b) Bank of Canada sales of bonds
c) decrease in government spending
d) decrease in fixed taxes
e) decrease in fixed transfer payments
f) none of the above
4. Investors fear that the U.S. economy is entering a severe recession. What will be the effect on the Marginal Efficiency of Investment (MEI), real Investment (I), and the real GDP (Y) according to our theory for a given interest rate?
a) MEI, I, Y b) MEI, I, Y c) MEI, I, Y d) MEI, I, Y
e) MEI, I, Y f) MEI, I, Y g) MEI, I, Y h) MEI, I, Y
i) none of the above
5. Suppose that an economy is originally at long-run Price and real GDP (Y) equilibrium. What is the long-run effect of a decrease in exports on the price level and real GDP?
a) decrease in the price level and decrease in real GDP
b) decrease in the price level and increase in real GDP
c) increase in the price level and decrease in real GDP
d) increase in the price level and increase in real GDP
e) no change in the price level and no change in real GDP
f) no change in the price level and decrease in real GDP
g) no change in the price level and increase in real GDP
h) decrease in the price level and no change in real GDP
i) decrease in the price level and decrease in real GDP
j) decrease in the price and increase in real GDP
k) none of the above
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