1. According to the Labour Force Survey, in July 1996 there were 1488 thousand unemployed people in Canada and 13641 thousand employed people. The employment ratio was was 58.4 percent.

(a) How many adults were not in the labour force?
(b) What was the participation rate?
(c) What was the unemployment rate?

2. Suppose that the interest rate on a Canada Savings Bond is 6%, and the tax rate on interest income is 30%.

(a) If the expected inflation rate is 2% then what is the expected, after tax rate of return?
(b) If expected inflation falls to 1%, to what value must the interest rate fall in order for the after-tax rate of return to be unaffected?

3. [Hint: Reading parts of chapter 8 will make this question easy to do.] Baljinder's current income is y =10000. Her future income is y ^f= 30,000. There are only two time periods. Her plan is to set consumption at the same value in each year: c=c ^f.

(a) If the interest rate is 5 percent, what value of consumption spending can she afford?
(b) Suppose that the interest rate rises to 7 percent. Now what value of consumption spending can she afford?
(c) Suppose now that future income is less than current income: y=30000 and y ^f=10000. Find the values of consumption for each of the two possible interest rates.
(d) Are your results consistent with the theory about the effect of a change in interest rates on saving and consumption?

4. In a closed economy, suppose that there are two time periods, denoted 1 and 2. In each time period, GDP is given by Y₁=Y₂=200. This question studies the effects of fiscal policy in the first time period. Suppose that consumption depends on current and future after-tax income, as follows: C₁ = 0.45{Y₁-T₁ + (Y₂-T₂)/(1+r)}. Taxes in the first period are denoted T₁ and taxes in the second period are denoted T₂, while r is the real interest rate. To make this question simple, we'll suppose that the interest rate is fixed at 10%. (Question 6 examines the effect of fiscal policy on the interest rate.)

(a) If G₁=20, T₁=20 and T₂=0 solve for C₁, S_pvt and S_govt.
(b) Now suppose instead that the government has cut taxes to T₁=15. It financed its deficit by borrowing 5, and then introduces a tax in the second period of T₂=5(1+r) in order to pay off its loan. Solve for C₁ under the new tax policy.
(c) As a third scenario, suppose that the government instead spent G₁=30, and financed the increased spending by taxes. What is the effect on C₁, S_pvt, and national saving of this change?

5. To rent or to buy? Dr. Gasthaus--Maison is considering purchasing a house. She currently pays rent of $500 each month or $6000 each year. She plans to purchase a house if the expected user cost is less than her current rent.
The `revenues' from owning a house are not taxable, nor is the capital gain on a principal residence. The real interest rate is 8 percent. She expects houses to appreciate in market value over the coming year by 5 percent (i.e. d = -0.05).

(a) What is the most expensive house she should buy?
(b) If instead she expects house prices not to change during the coming year, then what is the most expensive house she should buy?
(c) In the U.S., mortgage interest is tax-deductible, so that the effective interest rate is r(1-tau ) where tau is an income tax rate. Suppose that this change in the tax law were introduced in Canada. If tau =0.30 and d = -0.05 then what is the most expensive house Dr. Gasthaus--Maison should buy?
(d) What effect would you expect mortgage-interest deductibility to have on house prices?

6. Imagine a closed economy in which Y=100 and G=10. Households set consumption according to C ^d = 12 + 0.8Y - 200r, and firms plan investment according to I ^d = 0.1Y - 300r, where r is the real interest rate.

(a) Solve for r, C, and I in equilibrium when desired saving equals desired investment.
(b) Suppose that because of a natural disaster G rises to 15. What is the effect on r, C, and I?

1. (a) N = 8229 thousand.
(b)64.8%
(c) 9.84%

2. (a) 2.2%
(b) 4.57%; notice that the pre-tax interest rate must adjust by more than the inflation rate if inflation is not to affect real returns.

3. (a) 19756.1
(b)19661.8
(c) 20243.9 and 20338.2
(d) Yes. According to the theory, borrowers save more and consume less when the interest rate rises; that is found in parts (a) and (b). According to the theory, the effect of a change in r is ambiguous for lenders (because the income and substitution effects run in opposite directions); in this example we find an increase in r decreases Baljinder's saving. The aggregate effect probably is that an increase in r increases saving slightly.

4. (a) C₁ = 162.8; S_govt = 0; S_pvt = 17.2.
(b) C₁ = 162.8; S_govt = -5; S_pvt = 22.2. This is an example of Ricardian equivalence.
(c)C₁ = 158.3; S = 11.7; notice that the increase in government spending comes partly from a fall in consumption and partly from a fall in saving. (Incidentally, it also is predicted to affect the interest rate in a large economy -- which we have ignored by fixing r = 0.10 -- an effect we'll see in question 6.)

5. (a) 200,000
(b) 75,000
(c) 1,000,000
(d) Since this provision increases the demand for houses, it will raise house prices. This is an example of how a tax deduction becomes capitalized in asset values.

6. (a) r = 2.4%, C = 87.2, I = 2.8.
(b) r = 3.4%, C = 85.2, I = -0.2.