1. In the country of Pannonia, economists measured inflation rates, growth rates of real income, and growth rates of the money supply, and found the following decade averages (in percentages):

	(Change in M) /M	(Change in Y) /Y	Inflation Rate
1970's	14.0	3.0	11.0
1980's	7.0	2.0	4.0

(a) Does the quantity theory of money hold in Pannonia over this period?
(b) Did velocity change, and if so, what was the most likely cause?

2. The early 1970s saw a slowdown in productivity and in output, and also an increase in inflation. This question examines how those might have been related. Suppose that Canadian money demand is described by: (M^d/P) = Y^0.8.

(a) What is the income elasticity of money demand?
(b) On the inside back cover of the textbook, you will find values for Canadian Y and M. Tabulate (Change in Y) / Y and (Change in M) / M for 1971, 1972, 1973, 1974, and 1975. What are the predicted inflation rates?
[Note: Growth rate of X = (Change in X) / X = (X_t - X_t-1) / X_t-1]
(c) Tabulate the actual inflation rates. Is the theory a useful guide?

3. (a) How much more severe was the Great Depression than the most recent recession? Provide some statistical evidence on duration and amplitude.
(b) What might have prevented a recurrence of a depression since the 1930s?

4. In this question we examine whether the index of leading indicators (D99947) provided advance warning of the onset of the last recession. We shall measure the recession using employment (D767608) and the unemployment rate (D767611).

(a) Retrieve and tabulate these series for 1990.
(b) Statistics Canada dates the beginning of the recession at April 1990. Did the index of leading indicators forecast this? Did it forecast changes in employment and the unemployment rate? Were these labour-market measures leading, coincident, or lagging?

5. Use the IS-LM-FE model to analyze the following statement, and show what would happen in the long run if such advice were followed by the Bank of Canada: "The increase in values in the stock market has increased people's wealth. As a result, their consumption now is increasing, increasing aggregate demand and output. The Bank of Canada should increase the money supply, because with higher income, people's demand for real money balances will be higher."

6. Consider the following model of a closed economy:

C^d = 1000 + 0.9(Y - T) - 500r
I^d = 500 - 225r
(M^d/P) = Y - 30i

The expected inflation rate is 3 percent, and r and i are in percentage points. Government purchases are G = 250 and the money supply is M = 2400. Full employment output is given by Y^eq = 750. The government balances its budget every year, so T = G.

[B (a) Find the equilibrium values of the real interest rate, consumption, investment, and the price level.
(b) Suppose that a new government reduces spending to G = 150. What happens to the values in part (a)?
Find both the short-run and the long-run results. [Hint: Use 2 or 3 decimal places.]
(c) Draw a diagram illustrating your results.

7. Suppose that the nominal exchange rate for Canada is 74 U.S. cents. The domestic price level is 100, and the U.S. price level is 80.

(a) What is the real exchange rate?
(b) A forecasting firm predicts that the Canadian inflation rate will be 1 percent, while the U.S. inflation rate will be 4 percent. If the nominal exchange rate does not change (as in a fixed exchange-rate system) then what will happen to the real exchange rate?
(c) What would be the likely consequences for Canadian net exports and employment of the change in the real exchange rate that you found in part (b)?
(d) Suppose instead that the real exchange rate is constant (because of purchasing power parity). What forecast for the nominal exchange rate now is implied by the two inflation forecasts? [If you wish you can compare this to the forecasts of Canadian bank economists, via our web site.]

8. It is widely expected that the Fed will soon tighten U.S. monetary policy, raising short-term interest rates. Make predictions for the effects on Canada under three different scenarios:

(a) prices in both countries are perfectly flexible;
(b) prices in both countries are slow to adjust;
(c) prices in both countries are slow to adjust, and the Bank of Canada maintains a fixed exchange rate with the U.S.

1. (a) It appears to hold for the 1970s, since (Change in M)/M =(Change in Y)/Y + Inflation Rate, but not for the 1980s.
(b) Velocity fell from the 1970s to the 1980s, probably because of lower nominal interest rates, an influence on money demand which the quantity theory omits.

2. (a) 0.8
(b) To make predictions, we use
Predicted Inflation Rate = (Change in M)/M - 0.8 (Change in Y)/Y

			Inflation	Rate
	(Change in Y)/Y	(Change in M)/M	Predicted	Actual
1971	5.71	13.18	8.61	3.4
1972	5.75	15.53	10.93	5.6
1973	7.71	14.28	8.11	8.9
1974	4.41	9.56	6.03	14.4
1975	2.60	13.42	11.34	9.9

(c) From the theory, if output growth falls (say due to the productivity slowdown) and money growth does not then inflation should rise. From 1971 to 1972 inflation did rise, apparently due to a rise in money growth. But then from 1972 to 1973 and 1973 to 1974 inflation rose again even though money growth fell more than income growth; the predicted inflation declined in those two years. Then in 1975 inflation fell, while predicted inflation rose.
Conclusion: The productivity growth slowdown, along with a stable money demand function, does not seem to explain the inflation of the early 1970s.

3. (a) Duration can be measured from Table 9.1. The Great Depression (part I) lasted 47 months, while the 1990-1992 recession lasted 22 months. Amplitude can be measured with various macroeconomic variables. Output fell about 1 percent from 1990 to 1992 and 27 percent from 1929 to 1933. From 1990 to 1992 the unemployment rate rose about 40 percent (from 8.1 to 11.3), while from 1929 to 1933 it rose 570 percent, (from 3.8 to 25.4).

(b) Potential explanations include built-in stabilizers (like unemployment insurance), macroeconomic policy (like monetary policy), bank regulation (to prevent failures and bank runs), a more diversified economy, and international policy coordination. To be sure about how to avoid a depression, one would have to know what caused the Great Depression. That remains a controversial subject for economic historians.

4. (a)

	ILI	E	u
Jan	145.0	13214	7.8
Feb	145.1	13226	7.6
Mar	144.5	13209	7.1
Apr	142.6	13247	7.4
May	142.8	13187	7.7
Jun	143.3	13193	7.6
Jul	142.3	13196	7.9
Aug	141.4	13163	8.3
Sep	139.2	13157	8.6
Oct	139.1	13117	9.0
Nov	137.1	13050	9.2
Dec	137.7	12994	9.5

(b) The ILI peak was in February 1990, while the E peak was in April and the u peak was in March. So the ILI forecasted these peaks and the overall peak as dated by Statistics Canada. Employment was coincident, while the unemployment rate was leading by one month.

5. Assuming resources are fully utilized, there will be no increase in output. Higher wealth will reduce saving, shifting the IS curve to the right. Increasing the money supply shifts the LM curve to the right also. But general equilibrium will require the LM curve to shift to the left. So the price level must rise, and it rises even more due to the monetary policy suggested by the statement. The correct monetary policy for preventing inflation is to reduce, not increase, the money supply.

6. (a) The initial equlibrium is a long-run or general equilibrium, at Y ^*=750: r=2, I=50, C=450, P=4.
(b) In the short run, P is unchanged, and we need to find the intersection of the IS and LM curves.
The two curves are:
0.1Y + 725r = 1515
0.1Y - 3r = 69
At the intersection, r=1.987, Y=749.5, P=4, C=546.5 I=52.9 (you may have slightly different answers due to rounding).
In the long run Y rises back to 750. r=1.986; P=3.99; C=546.8; and I=53.2.
(c) [Diagram shows IS shift left, then LM shift down.]

7. (a) the real exchange rate is 92.5
(b) a 3 percent real depreciation
(c) increases (subject to J-curve)
(d) a 3 percent nominal appreciation, to 76.22 cents U.S.

8. (a) If prices are completely felxible then the U.S. LM curve does not shift, and no U.S. real variables change. The U.S. inflation rate will fall. The Canadian nominal exchange rate will fall, (see the end of p381) but the real exchange rate will be unaffected.

(b) If prices are slow to adjust then we have the case discussed in the textbook (pp 379-381): the effect on Canadian net exports is ambiguous under a floating exchange rate, because U.S. output will fall as U.S. interest rates rise. One could discuss both possibilities for Canadian net exports, and distinguish short-run from long-run effects.

(c) If the Bank of Canada wants to fix the nominal exchange rate, then it will contract at the same time as the U.S. to prevent a depreciation. That will deepen any recession in Canada that might be induced by a U.S. recession, since now the depreciation will not mitigate the effect of reduced U.S. output on Canadian net exports.