Test 1 - Department of Economics - University of Toronto
Department of Economics University of Toronto
Prof. Gustavo Indart June 14, 2013
ECO 209Y – L0101 MACROECONOMIC THEORY Term Test #1
SOLUTIONS LAST NAME FIRST NAME STUDENT NUMBER
INSTRUCTIONS: 1. 2. 3.
The total time for this test is 1 hour and 50 minutes. Aids allowed: a simple calculator. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I
/20
Part II
/20
Part III 1.
/10
2.
/10
3.
/10
4.
/10
TOTAL
/80 Page 1 of 13
PART I
(20 marks)
Instructions: Enter your answer to each question in the table below. Only the answer recorded in the table will be marked. Table cells left blank will receive a zero mark for that question. Each question is worth 2 marks. No deductions will be made for incorrect answers.
1
2
3
4
5
6
7
8
9
10
D
C
C
E
A
C
A
B
C
E
1. Jim’s Nursery produces and sells $1,400 worth of flowers. Jim uses $200 in seeds and
fertilizer, pays his workers $700 in wages, pays $100 in taxes, pays $200 in interest on a business loan, and makes a profit of $200. Jim’s contribution to GDP is A) $900. B) $1,000. C) $1,100. D) $1,200. E) none of the above. 2. Consider an economy without depreciation of the capital stock, without government transfer payments, and where personal income tax is the only source of government revenues. If GDP is $980 billion, consumption is $650 billion, private savings is $120 billion, government purchases is $180 billion, and net exports is -$30 billion, which of the following is true in this economy? A) Disposable income is $860. B) Investment is $120. C) The budget deficit is -$30. D) Personal income tax is 250. E) None of the above.
Use this space for rough work.
Page 2 of 13
3. Suppose that the government collects $3 million in taxes, pays $2 million in Social Security benefits, pays $0.5 million in interest on the national debt, and pays workers $1 million in wages. The government contribution to GDP is A) $0. B) $0.5 million. C) $1 million. D) $3 million. E) $3.5 million. 4. Consider the fixed-price, aggregate expenditure model of the economy. Which one of the following will not be true when the marginal tax rate increases? A) The aggregate expenditure curve becomes flatter. B) Equilibrium output falls. C) Disposable income decreases. D) Consumption decreases. E) Savings increase. 5. Consider a closed economy with fixed prices and a balanced government budget at the initial equilibrium situation. A drop in government purchases will cause A) the level of consumption to fall, business inventories to rise, and a government surplus. B) business inventories to rise and a government deficit, but no change in the level of consumption. C) business inventories and the level of consumption to fall, but no change in the government budget balance. D) both the level of consumption and business inventories to fall, and a government deficit. E) none of the above.
Use this space for rough work.
Page 3 of 13
6. If a Canadian construction company built a road in Kuwait, this activity would be A) fully included in both Kuwait’s GDP and Canada’s GNP. B) fully included in both Canada’s GDP and Kuwait’s GNP. C) included in Canada’s GNP only for that portion that was attributable to Canadian capital and labour. D) included in Canada’s GDP but not in Canada’s GNP. E) included in Kuwait’s GNP only for that portion that was attributable to Kuwait’s labour. 7. Consider a closed economy with fixed prices. If the MPCYD = 0.8 and there is a $0.375 tax levied on each dollar of income, a $40 increase in government purchases will cause the budget surplus to
decrease by A) $10. B) $20. C) $30. D) $35. E) none of the above. 8. Consider the fixed-price model of a closed economy. Considering its impact on equilibrium national income, an increase in the interest-sensitivity of investment will make A) fiscal policy more effective. B) fiscal policy less effective and monetary policy more effective. C) fiscal and monetary policy less effective. D) fiscal and monetary policy more effective. E) fiscal policy more effective and monetary policy less effective.
Use this space for rough work.
Page 4 of 13
9.
A decrease in the interest sensitivity of money demand will A) make the LM-curve flatter. B) make the IS-curve flatter. C) increase the size of the monetary policy multiplier. D) decrease the size of the monetary policy multiplier. E) make fiscal policy more effective.
10. There is a general consensus that household and business confidence must be restored for the recessionary gap to be eliminated. Which one of the following will most likely contribute to increase household and business confidence? A) The central bank raises the interest rate to reduce fears of inflation. B) The government reduces the deficit to eliminate fears of higher future taxes. C) The government reduces the government debt to increase its international credit rating. D) The government finances a national infrastructure project by raising new taxes. E) The government finances a national infrastructure project by creating new debt.
Use this space for rough work.
Page 5 of 13
PART II
(20 marks)
Consider the following model of an open economy without capital mobility: C = 10 + 0.8YD I = 80 – 10i + 0.1Y G = 20 TA = 0.25Y TR = 0 X = 20 Q = 10 + 0.2Y
L = 120 + 0.5Y – 10i M = 150 P=1
a) What is the equation for the AE curve in this model? (2 marks) What is the aggregate expenditure multiplier in this model? (1 mark) AE = C + I + G + X – Q = (10 + 0.8 YD) + (80 – 10 i + 0.1 Y) + (20) + (20) – (10 + 0.2 Y) = 120 + 0.8 (Y – 0.25 Y) – 0.1 Y – 10 i = 120 + 0.5 Y – 10 i
AE = 1 / (1 – Marginal Propensity to Spend) = 1 / (1 – 0.5) = 1 / 0.5 = 2
b) What is the equation for the IS curve in this model? (2 marks)
In equilibrium, Y = AE Y = 120 + 0.5 Y – 10 i 10 i = 120 – 0.5 Y and thus the equation for the IS curve is: i = 12 – 0.05 Y
Page 6 of 13
c) What is the equation for the LM curve in this model? (2 marks) In equilibrium: M/P = L 150 = 120 + 0.5Y – 10i 10i = – 30 + 0.5 Y and thus the equation for the LM curve is: i = – 3 + 0.05 Y
d) What are the equilibrium levels of income and interest rate? (2 marks) In equilibrium: IS = LM 12 – 0.05Y = – 3 + 0.05 Y 0.1 Y = 15 Y* = 150 i* = 12 – 0.05 Y* = 12 – 0.05 (150) = 12 – 7.5 = 4.5
Page 7 of 13
e) In a neat and fully labelled diagram, show below the equilibrium of part d). (1 mark) i 12.5
LM
12 LM’
4.75 4.5
IS’
IS –3.0
150 155 160
240
250
Y
–3.5
f) If government expenditure increases by 5, what would be the new equilibrium levels of income and interest rate? (2 marks) Show this new equilibrium in the diagram above. (1 mark) The expression for the new AE curve would be AE = 125 + 0.5 Y – 10 i, and thus the expression for the new IS curve would be: Y = 125 + 0.5 Y – 10 i 10 i = 125 – 0.5 Y i = 12.5 – 0.05 Y Therefore, the new equilibrium will be: IS = LM 12.5 – 0.05 Y = – 3 + 0.05 Y 0.1 Y = 15.5 Y* = 155 And thus i* = 12.5 – 0.05 (155) = 12.5 – 7.75 = 4.75
Page 8 of 13
g) Suppose that at the same time that government expenditure increases by 5, the central bank increases the money supply in order to keep the rate of interest unchanged at the level of the initial equilibrium of part d). What would be the new equilibrium level of income? (3 marks) Show this new equilibrium in the diagram above. (1 mark) If the rate of interest remains at 4.5, then the new equilibrium will be determined by the point of intersection of the new LM curve with the IS curve. Therefore, by plugging i = 4.5 into the equation for the IS curve we obtain the value of the new equilibrium: 4.5 = 12.5 – 0.05 Y 0.05 Y = 8 Y* = 8 / 0.05 = 160.
h) By how much must the nominal supply of money increase to achieve the equilibrium of part g)? (3 marks) M/P = L M = 120 + 0.5 Y* – 10 i* = 120 + 0.5 (160) – 10 (4.5) = 120 + 80 – 45 = 155.
Page 9 of 13
PART III
(40 marks)
Instructions: Comment on the following statements in the space provided. In all cases, consider the fixed-price model of a closed economy. Each question is worth 10 marks.
1. A decrease in the income sensitivity of money demand will have an expansionary effect on the level of equilibrium income. (Show your answer with the help of a diagram and explain the economics.) Fiscal policy will have a greater impact on the level of equilibrium income the larger the fiscal policy multiplier is. Therefore, given FP = 1 / [1 c(1 t) + bk / h], we see that the fiscal policy multiplier increases when the income sensitivity of the demand for real balances (k) falls, and thus the effectiveness of fiscal policy increases. The economic explanation is as follows. The smaller is the income sensitivity of the demand for real balances, the smaller will be the increase in the demand for money as a result of any given increase in income and, therefore, the smaller will be the increase in the rate of interest and thus also the smaller the crowding out effect. The smaller the crowding out effect, of course, the larger will be the impact of fiscal policy on equilibrium income. The following diagram also shows this result. The expression for the LM curve is given by i = (M/P)/h + (k/h)Y and, therefore, the smaller k is the flatter the LM curve will be. Suppose that the initial equilibrium is at (Y0, i0), and let’s consider two different values for k and thus two different LM curves. Let’s consider the impact of an increase in G. As G increases, the IS-curve shifts up to the right and a situation of excess demand arises in the goods market. As output starts to increase to eliminate the excess demand, the demand for money also starts to increase and the rate of interest rises. Note that the adjustment is always along the LM curve since the money market is always in equilibrium by assumption. Well, the larger k is, then the greater is the increase in the rate of interest as depicted by the movement up the LM1 curve compared to the movement up along the LM2 curve. Therefore, the greater is the crowding out effect (i.e., the decrease in investment) the larger k is and thus Y increases less in this case after G has increased. The statement is, therefore, true: a decrease in k will have an expansionary effect on the level of equilibrium income. LM1 (k1)
i
k 1 > k2
i2
LM2 (k2)
i1 i0
IS’ IS
Y0
Y1
Y2
Y Page 10 of 13
2. A responsible government should always try to keep a balanced budget. Therefore, it should reduce expenditures when running a budget deficit and decrease taxes when running a budget surplus. First of all, there is nothing intrinsically wrong (or right, for that matter) with budget deficits. During the business cycle it is expected that governments will run deficits during periods of recession and surpluses during periods of economic boom. Therefore, a responsible government should know when to spend more and when not to. In short, a responsible government should run a balanced budget over the business cycle where the surpluses of the boom years would offset the deficits of the recession years. The conservative proposition that governments should always run balanced budgets would have the unfortunate effect of exacerbating recessions by further reducing aggregate demand when the latter is already weak. That is, it would create more unemployment and greater excess productive capacity during recessions instead of contributing to their reduction. Of course, decreasing taxes during periods of economic boom would also create additional inflationary pressure when aggregate demand is already very strong. This proposition of balance budgets at all times has an ideological root and aims to reducing the economic role of the state to its minimum. The claim is that government expenditure should be reduced in period of recession to balance the budget, and taxes should be reduced in periods of boom for the same reason. The long run result would be to minimize the economic and social role of the government. Structural budget deficits — that is, deficits during periods of economic boom — are a different matter. Here it could be claimed that government deficits would crowd out private investment and create inflationary pressure. If that’s the case, then the proposition should be that governments should try to run balanced budgets over the business cycle but not at all times. In short, a deficit in any one year doesn’t say much unless we look at it into the context of the business cycle. A deficit in a year of recession is something to be expected. What we must look at is what the full employment budget surplus (or deficit) would be. If at the level of potential output we could determine that the government would be running a surplus, then the best policy for the government might be to use expansionary fiscal/monetary policy instead of contractionary fiscal policy even though the fiscal deficit would increase in the short-run. This could be seen in the diagram below, where we are assuming that government expenditure (G + TR) is determined exogenously, and taxes are proportional to income. There is a deficit at the level of equilibrium income Y1, but the economy is producing below full employment income (Yfe). In the diagram it is assumed that, ceteris paribus, the government would be running a surplus at the level of potential output. Therefore, instead of reducing government expenditure to reduce the deficit at equilibrium income Y1, it would be best for the government to use expansionary fiscal policy to reduce the gap between current income and potential income, even at the cost of further increasing the deficit in the short run. BS
BS BS’ Y1
●
ΔG
●
●
Yfe
Y
Page 11 of 13
3. According to the standard IS-LM model, monetary policy cannot change real output if investment is independent of interest rates. (Show your answer with the help of a diagram and explain the economics.) Monetary policy may be defined as the control of the money supply in order to affect the rate of interest in the economy. Changes in the rate of interest will have a real impact in the economy only if some of the components of AE is sensitive to these changes. In our model, only investment is sensitive to changes in the rate of interest, and the parameter b measures the sensitivity of investment to changes in the rate of interest. Now, if investment is also independent of the rate of interest — i.e., if b = 0 — then monetary policy will be completely ineffective. An increase in the money supply, for instance, will translate into a decrease in the rate of interest, but this lower rate of interest will not cause any increase in investment or in any other component of AE. Therefore, the equilibrium level of output will not be affected by monetary policy. If b = 0, then the investment curve as a function of the rate of interest will be a vertical line (i.e., measuring investment on the horizontal axis and the rate of interest on the vertical axis). The corresponding IS curve will also be a vertical line, and changes in money supply will only change the level of the rate of interest but not the level of equilibrium output.
I i
i
IS
LM LM’
i1
i1
i2
i2
I1
I
Y1
Y
Page 12 of 13
4. If the private sector of the economy decides to increase its saving, then output will increase and the rate of interest will fall. (Show your answer with the help of a diagram and explain the economics.)
i LM
A i1 i2
B IS IS’
Y2
Y1
Y
This statement is false. If the private sector of the economy decides to increase its saving, then autonomous consumption will fall and so will AE. Graphically, this decrease in AE at each level of income will cause the IS curve to shift down to the left — i.e., a situation of excess supply (Y > AE) will arise in the economy. Indeed, as shown in the diagram, the economy was initially in equilibrium at point A which lies above curve IS’, and thus it represents a situation of excess supply. Therefore, firms will start accumulating inventories in a manner which was not planned and this will give them the signal that production should be adjusted downward. As output decreases, so will income. A corresponding decrease in the demand for money will ensue as Y falls and the domestic rate of interest will also fall. This process will continue until the excess supply in the goods market is eliminated and a new equilibrium is established, i.e., when Y falls to Y2 and the rate of interest falls to i2. Since the money market is always in equilibrium by assumption, note that the adjustment path is represented by a movement down along the LM curve. Therefore, if the private sector decides to increase saving, the outcome will be a reduction in equilibrium income and also a fall in the equilibrium rate of interest.
Page 13 of 13
Prof. Gustavo Indart June 14, 2013
ECO 209Y – L0101 MACROECONOMIC THEORY Term Test #1
SOLUTIONS LAST NAME FIRST NAME STUDENT NUMBER
INSTRUCTIONS: 1. 2. 3.
The total time for this test is 1 hour and 50 minutes. Aids allowed: a simple calculator. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I
/20
Part II
/20
Part III 1.
/10
2.
/10
3.
/10
4.
/10
TOTAL
/80 Page 1 of 13
PART I
(20 marks)
Instructions: Enter your answer to each question in the table below. Only the answer recorded in the table will be marked. Table cells left blank will receive a zero mark for that question. Each question is worth 2 marks. No deductions will be made for incorrect answers.
1
2
3
4
5
6
7
8
9
10
D
C
C
E
A
C
A
B
C
E
1. Jim’s Nursery produces and sells $1,400 worth of flowers. Jim uses $200 in seeds and
fertilizer, pays his workers $700 in wages, pays $100 in taxes, pays $200 in interest on a business loan, and makes a profit of $200. Jim’s contribution to GDP is A) $900. B) $1,000. C) $1,100. D) $1,200. E) none of the above. 2. Consider an economy without depreciation of the capital stock, without government transfer payments, and where personal income tax is the only source of government revenues. If GDP is $980 billion, consumption is $650 billion, private savings is $120 billion, government purchases is $180 billion, and net exports is -$30 billion, which of the following is true in this economy? A) Disposable income is $860. B) Investment is $120. C) The budget deficit is -$30. D) Personal income tax is 250. E) None of the above.
Use this space for rough work.
Page 2 of 13
3. Suppose that the government collects $3 million in taxes, pays $2 million in Social Security benefits, pays $0.5 million in interest on the national debt, and pays workers $1 million in wages. The government contribution to GDP is A) $0. B) $0.5 million. C) $1 million. D) $3 million. E) $3.5 million. 4. Consider the fixed-price, aggregate expenditure model of the economy. Which one of the following will not be true when the marginal tax rate increases? A) The aggregate expenditure curve becomes flatter. B) Equilibrium output falls. C) Disposable income decreases. D) Consumption decreases. E) Savings increase. 5. Consider a closed economy with fixed prices and a balanced government budget at the initial equilibrium situation. A drop in government purchases will cause A) the level of consumption to fall, business inventories to rise, and a government surplus. B) business inventories to rise and a government deficit, but no change in the level of consumption. C) business inventories and the level of consumption to fall, but no change in the government budget balance. D) both the level of consumption and business inventories to fall, and a government deficit. E) none of the above.
Use this space for rough work.
Page 3 of 13
6. If a Canadian construction company built a road in Kuwait, this activity would be A) fully included in both Kuwait’s GDP and Canada’s GNP. B) fully included in both Canada’s GDP and Kuwait’s GNP. C) included in Canada’s GNP only for that portion that was attributable to Canadian capital and labour. D) included in Canada’s GDP but not in Canada’s GNP. E) included in Kuwait’s GNP only for that portion that was attributable to Kuwait’s labour. 7. Consider a closed economy with fixed prices. If the MPCYD = 0.8 and there is a $0.375 tax levied on each dollar of income, a $40 increase in government purchases will cause the budget surplus to
decrease by A) $10. B) $20. C) $30. D) $35. E) none of the above. 8. Consider the fixed-price model of a closed economy. Considering its impact on equilibrium national income, an increase in the interest-sensitivity of investment will make A) fiscal policy more effective. B) fiscal policy less effective and monetary policy more effective. C) fiscal and monetary policy less effective. D) fiscal and monetary policy more effective. E) fiscal policy more effective and monetary policy less effective.
Use this space for rough work.
Page 4 of 13
9.
A decrease in the interest sensitivity of money demand will A) make the LM-curve flatter. B) make the IS-curve flatter. C) increase the size of the monetary policy multiplier. D) decrease the size of the monetary policy multiplier. E) make fiscal policy more effective.
10. There is a general consensus that household and business confidence must be restored for the recessionary gap to be eliminated. Which one of the following will most likely contribute to increase household and business confidence? A) The central bank raises the interest rate to reduce fears of inflation. B) The government reduces the deficit to eliminate fears of higher future taxes. C) The government reduces the government debt to increase its international credit rating. D) The government finances a national infrastructure project by raising new taxes. E) The government finances a national infrastructure project by creating new debt.
Use this space for rough work.
Page 5 of 13
PART II
(20 marks)
Consider the following model of an open economy without capital mobility: C = 10 + 0.8YD I = 80 – 10i + 0.1Y G = 20 TA = 0.25Y TR = 0 X = 20 Q = 10 + 0.2Y
L = 120 + 0.5Y – 10i M = 150 P=1
a) What is the equation for the AE curve in this model? (2 marks) What is the aggregate expenditure multiplier in this model? (1 mark) AE = C + I + G + X – Q = (10 + 0.8 YD) + (80 – 10 i + 0.1 Y) + (20) + (20) – (10 + 0.2 Y) = 120 + 0.8 (Y – 0.25 Y) – 0.1 Y – 10 i = 120 + 0.5 Y – 10 i
AE = 1 / (1 – Marginal Propensity to Spend) = 1 / (1 – 0.5) = 1 / 0.5 = 2
b) What is the equation for the IS curve in this model? (2 marks)
In equilibrium, Y = AE Y = 120 + 0.5 Y – 10 i 10 i = 120 – 0.5 Y and thus the equation for the IS curve is: i = 12 – 0.05 Y
Page 6 of 13
c) What is the equation for the LM curve in this model? (2 marks) In equilibrium: M/P = L 150 = 120 + 0.5Y – 10i 10i = – 30 + 0.5 Y and thus the equation for the LM curve is: i = – 3 + 0.05 Y
d) What are the equilibrium levels of income and interest rate? (2 marks) In equilibrium: IS = LM 12 – 0.05Y = – 3 + 0.05 Y 0.1 Y = 15 Y* = 150 i* = 12 – 0.05 Y* = 12 – 0.05 (150) = 12 – 7.5 = 4.5
Page 7 of 13
e) In a neat and fully labelled diagram, show below the equilibrium of part d). (1 mark) i 12.5
LM
12 LM’
4.75 4.5
IS’
IS –3.0
150 155 160
240
250
Y
–3.5
f) If government expenditure increases by 5, what would be the new equilibrium levels of income and interest rate? (2 marks) Show this new equilibrium in the diagram above. (1 mark) The expression for the new AE curve would be AE = 125 + 0.5 Y – 10 i, and thus the expression for the new IS curve would be: Y = 125 + 0.5 Y – 10 i 10 i = 125 – 0.5 Y i = 12.5 – 0.05 Y Therefore, the new equilibrium will be: IS = LM 12.5 – 0.05 Y = – 3 + 0.05 Y 0.1 Y = 15.5 Y* = 155 And thus i* = 12.5 – 0.05 (155) = 12.5 – 7.75 = 4.75
Page 8 of 13
g) Suppose that at the same time that government expenditure increases by 5, the central bank increases the money supply in order to keep the rate of interest unchanged at the level of the initial equilibrium of part d). What would be the new equilibrium level of income? (3 marks) Show this new equilibrium in the diagram above. (1 mark) If the rate of interest remains at 4.5, then the new equilibrium will be determined by the point of intersection of the new LM curve with the IS curve. Therefore, by plugging i = 4.5 into the equation for the IS curve we obtain the value of the new equilibrium: 4.5 = 12.5 – 0.05 Y 0.05 Y = 8 Y* = 8 / 0.05 = 160.
h) By how much must the nominal supply of money increase to achieve the equilibrium of part g)? (3 marks) M/P = L M = 120 + 0.5 Y* – 10 i* = 120 + 0.5 (160) – 10 (4.5) = 120 + 80 – 45 = 155.
Page 9 of 13
PART III
(40 marks)
Instructions: Comment on the following statements in the space provided. In all cases, consider the fixed-price model of a closed economy. Each question is worth 10 marks.
1. A decrease in the income sensitivity of money demand will have an expansionary effect on the level of equilibrium income. (Show your answer with the help of a diagram and explain the economics.) Fiscal policy will have a greater impact on the level of equilibrium income the larger the fiscal policy multiplier is. Therefore, given FP = 1 / [1 c(1 t) + bk / h], we see that the fiscal policy multiplier increases when the income sensitivity of the demand for real balances (k) falls, and thus the effectiveness of fiscal policy increases. The economic explanation is as follows. The smaller is the income sensitivity of the demand for real balances, the smaller will be the increase in the demand for money as a result of any given increase in income and, therefore, the smaller will be the increase in the rate of interest and thus also the smaller the crowding out effect. The smaller the crowding out effect, of course, the larger will be the impact of fiscal policy on equilibrium income. The following diagram also shows this result. The expression for the LM curve is given by i = (M/P)/h + (k/h)Y and, therefore, the smaller k is the flatter the LM curve will be. Suppose that the initial equilibrium is at (Y0, i0), and let’s consider two different values for k and thus two different LM curves. Let’s consider the impact of an increase in G. As G increases, the IS-curve shifts up to the right and a situation of excess demand arises in the goods market. As output starts to increase to eliminate the excess demand, the demand for money also starts to increase and the rate of interest rises. Note that the adjustment is always along the LM curve since the money market is always in equilibrium by assumption. Well, the larger k is, then the greater is the increase in the rate of interest as depicted by the movement up the LM1 curve compared to the movement up along the LM2 curve. Therefore, the greater is the crowding out effect (i.e., the decrease in investment) the larger k is and thus Y increases less in this case after G has increased. The statement is, therefore, true: a decrease in k will have an expansionary effect on the level of equilibrium income. LM1 (k1)
i
k 1 > k2
i2
LM2 (k2)
i1 i0
IS’ IS
Y0
Y1
Y2
Y Page 10 of 13
2. A responsible government should always try to keep a balanced budget. Therefore, it should reduce expenditures when running a budget deficit and decrease taxes when running a budget surplus. First of all, there is nothing intrinsically wrong (or right, for that matter) with budget deficits. During the business cycle it is expected that governments will run deficits during periods of recession and surpluses during periods of economic boom. Therefore, a responsible government should know when to spend more and when not to. In short, a responsible government should run a balanced budget over the business cycle where the surpluses of the boom years would offset the deficits of the recession years. The conservative proposition that governments should always run balanced budgets would have the unfortunate effect of exacerbating recessions by further reducing aggregate demand when the latter is already weak. That is, it would create more unemployment and greater excess productive capacity during recessions instead of contributing to their reduction. Of course, decreasing taxes during periods of economic boom would also create additional inflationary pressure when aggregate demand is already very strong. This proposition of balance budgets at all times has an ideological root and aims to reducing the economic role of the state to its minimum. The claim is that government expenditure should be reduced in period of recession to balance the budget, and taxes should be reduced in periods of boom for the same reason. The long run result would be to minimize the economic and social role of the government. Structural budget deficits — that is, deficits during periods of economic boom — are a different matter. Here it could be claimed that government deficits would crowd out private investment and create inflationary pressure. If that’s the case, then the proposition should be that governments should try to run balanced budgets over the business cycle but not at all times. In short, a deficit in any one year doesn’t say much unless we look at it into the context of the business cycle. A deficit in a year of recession is something to be expected. What we must look at is what the full employment budget surplus (or deficit) would be. If at the level of potential output we could determine that the government would be running a surplus, then the best policy for the government might be to use expansionary fiscal/monetary policy instead of contractionary fiscal policy even though the fiscal deficit would increase in the short-run. This could be seen in the diagram below, where we are assuming that government expenditure (G + TR) is determined exogenously, and taxes are proportional to income. There is a deficit at the level of equilibrium income Y1, but the economy is producing below full employment income (Yfe). In the diagram it is assumed that, ceteris paribus, the government would be running a surplus at the level of potential output. Therefore, instead of reducing government expenditure to reduce the deficit at equilibrium income Y1, it would be best for the government to use expansionary fiscal policy to reduce the gap between current income and potential income, even at the cost of further increasing the deficit in the short run. BS
BS BS’ Y1
●
ΔG
●
●
Yfe
Y
Page 11 of 13
3. According to the standard IS-LM model, monetary policy cannot change real output if investment is independent of interest rates. (Show your answer with the help of a diagram and explain the economics.) Monetary policy may be defined as the control of the money supply in order to affect the rate of interest in the economy. Changes in the rate of interest will have a real impact in the economy only if some of the components of AE is sensitive to these changes. In our model, only investment is sensitive to changes in the rate of interest, and the parameter b measures the sensitivity of investment to changes in the rate of interest. Now, if investment is also independent of the rate of interest — i.e., if b = 0 — then monetary policy will be completely ineffective. An increase in the money supply, for instance, will translate into a decrease in the rate of interest, but this lower rate of interest will not cause any increase in investment or in any other component of AE. Therefore, the equilibrium level of output will not be affected by monetary policy. If b = 0, then the investment curve as a function of the rate of interest will be a vertical line (i.e., measuring investment on the horizontal axis and the rate of interest on the vertical axis). The corresponding IS curve will also be a vertical line, and changes in money supply will only change the level of the rate of interest but not the level of equilibrium output.
I i
i
IS
LM LM’
i1
i1
i2
i2
I1
I
Y1
Y
Page 12 of 13
4. If the private sector of the economy decides to increase its saving, then output will increase and the rate of interest will fall. (Show your answer with the help of a diagram and explain the economics.)
i LM
A i1 i2
B IS IS’
Y2
Y1
Y
This statement is false. If the private sector of the economy decides to increase its saving, then autonomous consumption will fall and so will AE. Graphically, this decrease in AE at each level of income will cause the IS curve to shift down to the left — i.e., a situation of excess supply (Y > AE) will arise in the economy. Indeed, as shown in the diagram, the economy was initially in equilibrium at point A which lies above curve IS’, and thus it represents a situation of excess supply. Therefore, firms will start accumulating inventories in a manner which was not planned and this will give them the signal that production should be adjusted downward. As output decreases, so will income. A corresponding decrease in the demand for money will ensue as Y falls and the domestic rate of interest will also fall. This process will continue until the excess supply in the goods market is eliminated and a new equilibrium is established, i.e., when Y falls to Y2 and the rate of interest falls to i2. Since the money market is always in equilibrium by assumption, note that the adjustment path is represented by a movement down along the LM curve. Therefore, if the private sector decides to increase saving, the outcome will be a reduction in equilibrium income and also a fall in the equilibrium rate of interest.
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