Econ 222
Fall 1999
Final Exam Answer Guide

1.

1. The "Classical" approach is associated with the assumption that prices adjust quickly and easily to market disturbances, in particular to aggregate disturbances. The Keynesian approach incorporates the assumption that prices are slow to adjust.
2. Monetary neutrality results when the aggregate price level adjusts quickly and easily in response to disturbances of the money supply, thus it is often associated with the assumptions of the "Classical" models.

1. In a diagram, show that contractionary monetary policy implies a leftward shift of the foreign economy LM curve. This implies an increase in the foreign interest rate and a decrease in the foreign national income.
• foreign economy- in the Short Run: In the, NX falls as r rises. But NX rises as Yf falls. We assume the interest rate effect dominates and NX falls. The r and Y effect both tend to increase the exchange rate of the foreign country.
• Small economy- in the Short Run: opposite to the large economy, NX rises, exchange rate falls . The IS curve shifts right. National income rises and the interest rate rises.
• In the long run, The price level falls in the large economy which restores the original equilibrium. The price level in the small economy may rise (as Y is larger than Yf) . Together, these price movements restore the original real exchange rate between the two countries. NX return to their pre-shock levels.
2. In this case, the Mundell Fleming small open economy must accept the world interest rate and this is the IS curve. As the foreign interest rate rises and falls, so does the small economy IS curve. Nothing of substance is changed, but the short run effects on NX may be larger.

3.

1. S = Y-C-G or Y = C+I+G

   Y = 250 -500r +0.8(Y-20 - .25Y)

   +200 - 500 r

   Y = 650 - 1000r +.6Y-16

   1000r = 634 -.4Y

   IS curve: r = .634 - 0.4(Y/1000)

2. Y= 1500; r = .634 - .4 (1.5) = .034

   M/P =1070/P= 0.4(1500) - 300(.034) = 600-10.2 = 590.8

   P=1.81

3. If G increases, the IS shifts up and we expect higher P and higher r.

   IS curve is up by 100: r=.734-0.4(Y/1000) = .734-.6=.134

   P = 1070/[600-300(.134)] = 1070/559.8 = 1.91

4.

1. When the foreign country increases its money supply this reduces the value of its currency and therefore increases the exchange value of the domestic country's currency.  The fundamental value of the domestic exchange rate rises, and thus relative to the previous "official" value the official exchange rate is now undervalued.  This is an upwards shift of the FV curve.
2. To reduce the fundamental value of the domestic exchange rate back down to the "official" value the domestic country could now expand its own money supply.  Domestic inflation would result and, in this sense, inflation may be transmitted at the international level.

5.

1. The IS equation is derived as follows.

   Y = C^d + I^d + NX

   Substituting for C^d , I^d , NX, we obtain the IS equation

   0.4 Y = 150 - 609 r

   In a recession, Y = 280, the interest rate obtained from the IS curve is r = 0.0624. The real exchange rate is e = 20.95.

   Given the real interest rate, the real money supply is M/P = 280-200(0.062)=267.521.

2. With the import restrictions, the new IS curve is given by

   0.4 Y = 150 + x - 609 r

   The new short run equilibrium is given by the intersection of the new IS curve and the LM curve:

   From the LM curve, using Y=300, we get the new real interest rate, r = 0.1623.

   From the IS curve, using r=0.1623, we get the required x, x = 68.9

   The new real exchange rate is e = 77.65

   The real interest rate and the real exchange rate has increased.

  Part B:

6. The asset market:

1. A more variable inflation rate increases the risk of holding money so money demand falls, and r falls. (Substitute to longer term assets to get the average rate of return.). Graphically, Md/P curve shift down the Ms/P curve.
2. Because the US dollar is declared acceptable by the banks, it can be used in a significant proportion of transactions and hence increases the money supply. Ms/P shifts right and r falls.
3. Whatever the return on X's bonds, the World Bank backing reduces the risk associated with them. Money demand will fall as X's bond demand rises. Md/P falls and r falls.
4. For the month of December, we expect more transactions than usual and hence an increase in demand for money. Md/P increases and so does the r.
5. If national income is unchanged then it now costs more for the same output; the price level must rise and the real money supply falls. Ms/P falls (moves left) and the r rises.

7.

1. If inflation is anticipated then costs incurred are shoe leather costs and menu costs. Shoe leather costs are all those costs associated with trying to avoid the loss of purchasing power of the currency. These include extra shopping time (search costs) to get the best price as well as resources allocated to financial intermediaries to mitigate the risk of inflation. Menu costs are costs of resources associated with changing prices on goods and services. If inflation is unanticipated, there are distributional effects in which borrowers are better off and lenders worse off (if inflation increases) as well as efficiency effects because the price system does not convey accurate information about real relative costs. The efficiency effect becomes worse as inflation increases.
2. Training, reducing bureaucracy (regulations), UI reform, stimulating the economy even if it risks inflation. Each has been proposed but at an empirical level none have to been proven to be of great benefit. Training is supposed to increase employability but it is difficult to choose what training will be demanded in the market. Reducing regulations is desireable if it increases the flexibilty of the labour market. Reducing UI benefits makes unemployment less attractive but puts a heavier burden on those who cannot help themselves.

8.

1. An increase in interest rates means that the returns from saving have increased relative to other uses for income (i.e. consumption today), thus savings rates will tend to rise. This is the "substitution effect". On the otherhand, higher interest rates mean higher returns from any accumulated past savings (wealth) and thus an effectively higher level of future income. This tends to reduce the incentive for saving and thus savings rates may decline. This is the "income effect". The income effect and the substitution effects may be offsetting.

2. Desired investment depends upon the relative costs and benefits of purchasing new capital. The costs increase with the interest rate due to the costs of borrowing to finance the investment (and/or using an opportunity cost argument). The benefits are associated with the actual production potential of the capital (modeled via a production function) which is not thought of as a function of the interest rate but is assumed to decline as the amount of capital (per labour) increases. If the interest rate rises, costs rise, and less capital on the margin will be demanded. That is, desired investment falls. If the interest rate declines, a greater capital stock (implying a lesser marginal product) can be justified and desired investment will rise. There is no ambiguity implied in this interest rate -- desired investment relationship.

9.

1. Aggregate economic activity: Business cycles are defined broadly as fluctuations of aggregate economic activity rather than fluctuations of a single aggregate economic variable or of a single sector of the economy.

2. Expansions and Contractions: The course of business cycle includes an expansion of economic activity reaching a peak and then followed by a contraction of economic activity which ends in a trough before returning to a period of expansion, thus a cycle.

3. Comovement: Following the definition in a), many separate aggregate economic variables move together over the course of a business cycle, this tendency for these variables to move coincidentally is called comovement.

4. Recurrent but not periodic: While we call them business cycles, these movements in economic variables do not display the regularity that we often associate with the concept of cycles. They are cycles in the sense that contraction is followed by expansion on a repeated or recurrent basis, but the intervals between these events are essentially random and thus business cycles are not predictable or periodic.

5. Persistance: This is a tendency for declines in economic activity to be followed by further declines and likewise for expansions. The turnarounds associated with peaks and troughs are less likely at any given time than the chance of remaining in the current situation.

10.

1. The sources of economic growth are: (1) growth in labour; (2) growth in capital stock; and (3) growth in total factor productivity. (Ok if they talk about it in terms growth in inputs and technological change.)

   This is derived from the production function.

2. Draw the diagram with the world interest rate at the point where the desired saving curve intersects the desired investment curve. At this point, the country runs a balanced current account. Now, with the introduction of RRSPs, consumers save more since this implies a fall in the rate savings are taxed. So, the desired saving curve shifts to the right and upwards, so that at the world interest rate, the country now runs a current account surplus. As well, since the government collects less taxes, it now runs a budget deficit.

  Part C:

11.

1. Md=40,000-10,000(rb-rm-4) if rm=1% or

   Md=40,000-10,000(rb-rm) +40,000

   Md=80,000-10,000(rb-rm)

   Note that in a rough diagram one has the point (rb-rm)=4%, and Md=40,000. The slope from the advice is -$10,000 per (rb-rm) and the line is easily found.

   Bd=W-Md=W-80,000+10,000(rb-rm)

   =20,000 + 10,000(rb-rm)

2. Ms=20,000=Md=80,000-10,000(rb-rm)

   10,000(rb-rm)=60000; rb-rm=6%; rb=7%

12.

1. A figure can be drawn and we can use the Phillips curve as

   p-p^e = -2(u-u_N)

   u = u_N - .5(p-p^e)/

   Year	Inflation	Expected Infl.	Unempl, U
   0	5	5	7.5
   1	1	4	7.5+1.5
   2	1	3	7.5+1
   3	1	2	7.5+0.5
   4	1	1	7.5

2. Hysteresis, if it occurred would tend to make some unemployed persons less able to work and would increase the natural rate of unemployment. The process might stop after 3 periods with u=8%
3. The cold turkey approach is advocated if the monetary authority has credibility. It announces the 1% inflation policy and if the economy as a whole believes the announcement, plans are made based on an expected rate of 1%. The SRPC shifts down in one period with no costs in unemployment.

13. Labour employed is determined by the equilibrium condition: MPL = w, where

1. Labour market equilibrium: w = 16, N = 42, Y = 2436
2. c=2148.8, S=Y-C-G=277.2, I=30, NX=S-I=247.2
   w=20, N=40, Y=2400, C=2120, S=270, I=30, NX=240

14.

1. Currency holdings = .2(150,000)=30,000; Deposits = .8(150,000)=120,000. So cu=.0.25D. The money multiplier is (1+cu)/(res+cu) = 1.2 5/ 0.55 = 2.1818.

Money supply is 2.5 (150,000) = 327,273 units.

2. First compute the nominal rate of return of the British bond in terms of Canadian currency.

1. 1000 Canadian dollars is worth 1000*2.5 = 400 British pounds today.
2. 400 British bonds yield 8%*400 in interest in a year. You get back 432 pounds in a year.
3. 432 British pounds is worth 432/2.45 = 1058.4 Canadian dollars in a year's time.
4. The nominal yield on British bond is 5.84%.

15.

1. (i) unemployment rate is 0.25. (ii) participation ratio is 0.8. (iii) employment ratio is 0.6.
2. (i) Short spells: 20 per month * 12 months = 240
   
   Long spells: 50 * 3 times a year = 150
   
   Total spells = 390.
   

   (ii)Total duration = 240* 1month + 150* 4 months = 840 months
   
   Average duration = 840/390 = 2.15 months
   

   (iii)On any given date, 20 short and 50 long.
   

    

   END