QUEEN'S UNIVERSITY

FACULTY OF ARTS AND SCIENCE

DEPARTMENT OF ECONOMICS

ECONOMICS 222

SECTIONS A AND C

FINAL EXAMINATION - DECEMBER 1998

Ryan Davies, Lawrence McDonough

Instructions:

Non-programmable calculators are permitted.

Please read the questions carefully.

This exam is divided into two sections. Each section is of equal value.

Answer 5 questions in each section.

Part I : Answer only 5 of the following 10 questions in this section. Each question is of equal value (10).

1. Suppose the government of the Netherlands finds that the guilder is overvalued against other European currencies. Describe the possible actions the government can undertake to maintain the high value of its currency. (10)

2. Use the closed economy IS-LM model to determine the effects of each of the following on the general equilibrium values of the real wage, employment, output, the real interest rate, consumption, investment, and the price level.

(a) An influx of working-age immigrants increases labour supply (ignore any other possible effects of increased population). (5)

(b) The introduction of automatic teller machines reduces the demand for money. (5)

3. Business cycles in the United States and Canada can be related to each other. Using the open economy FE-IS-LM framework, analyze how a monetary contraction in the United States impacts the economies of the United States and Canada. (10)

4. What are the main explanations for the rise in the Canadian natural rate of unemployment over the past twenty-five years? (10)

5. (a) Explain the relationship between the production function and the demand for labour. (5)

(b) Explain how changes in wealth and changes in population can affect labour supply. (5)

6. (a) What are the major costs associated with a given level of inflation. (3)

(b) What are the major costs associated with reducing the inflation rate? Explain. (4)

7. (a) Suppose that the government sells bonds to finance an increase in expenditures. Explain how this will affect the investment-savings equilibrium. (4)

(b) Suppose the government announces an increase in expenditures to be financed by increased taxes. How will this affect the investment savings decision. (4)

8. (a) Consider a two country world which engages in trade and is currently in equilibrium. Explain and show the nature of the equilibrium in terms of savings, investment and the current accounts of each country. (3)

(b) Suppose that one of these countries experiences a supply side shock which will increase its capital productivity. Show and explain how the equilibrium will change in each country. (7)

9. (a) What critical analytical feature is implied by the term "small open economy"? How can this feature be captured in an open economy IS curve. (3)

(b) Examine the effectiveness of expansionary fiscal policy in a small open economy under flexible exchange rates. (7)

10. Discuss the Classical - Keynesian debate as it applies to the use of monetary and fiscal policy for income stabilization.(10)

Part II: Answer only 5 of the following 10 questions in this section. Each question is of equal value (10).

11. Suppose that the expectations-augmented Phillips curve is given by:

where is the natural rate of unemployment, and is the expected rate of inflation. The subscript t counts time periods (years). Suppose also that: = 0.09, and so that people expect the inflation rate this period to be whatever value it took last period. Finally, suppose that initially (at time 1) pi₁ = pi₀ = 0.05.

(a) Calculate the sequence of unemployment rates u₁, u₂, u₃, u₄ under a cold-turkey disinflation, in which ₂ = 0 and all subsequent inflation rates are zero. (2)

(b) Calculate the sequence of unemployment rates under a gradual disinflation, in which ₂=0.025, ₃=0, and all subsequent inflation rates are zero. (2)

(c) Advocates of the cold-turkey approach would argue that this experiment overstates the unemployment resulting from a rapid disinflation. Explain their argument. (3)

(d) Would your answers be affected if there is hysteresis in the natural rate of unemployment? (3)

12. Suppose that the real money demand function is

where Y is real output, r is the real interest rate, and pi^e is the expected rate of inflation. Real output is constant over time at Y=150. The real interest is fixed in the goods market at r=0.05 per year.

(a) Suppose that the nominal money supply is growing at the rate of 10% per year and that this growth rate is expected to persist forever. Currently, the nominal money supply is M=300. What are the values of the real money supply and the current price level? (Hint: What is the value of the expected inflation rate that enters the money demand function?) (4)

(b) Suppose that the nominal money supply is M =300. The central bank announces that from now on the nominal money supply is going to grow at the rate of 5% per year. If everyone believes this announcement, and if all markets are in equilibrium, what are the values of the real money supply and the current price level? Explain the effects on the real money supply and the current price level of a slowdown in the rate of money growth. (6)

13. Explain how each of the following transactions would enter the Canadian balance of payments accounts. Discuss only the transactions described. Do not be concerned with possible offsetting transactions. (10)

(a) The Canadian government sells (new) military equipment to a foreign government.

(b) A London bank sells yen to, and buys Canadian dollars from, a Swiss bank.

(d) A Canadian bank receives the interest on its loans to Brazil.

(e) A Canadian collector buys some ancient artifacts from a collection in Egypt.

(f) A Canadian oil company buys insurance from Lloyds of London to insure its oil rigs in the Beaufort Sea.

(g) A Canadian company borrows from a U.S. bank.

14. Consider a Keynesian consumption function (consumption depends up on income only) with desired consumption equal to 0.9Y, where Y is income. Government purchases are $1000, net exports are zero, and desired investment varies with the real interest rate according to the following schedule:

r I^d

5% $3000

4% $3500

3% $4000

2% $4500

Assume the interest rate adjusts so that the economy gets to equilibrium. Equilibrium output at full employment is $50,000.

(a) Find the values of consumption, investment, and the real interest rate at full-employment equilibrium. (3)

(b) Suppose the level of equilibrium income increases by $10,000. Calculate the new equilibrium interest rate. (3)

15. The city of Hope has a labour force of 1000. Twenty people lose their jobs each month and remain unemployed for exactly one month before finding jobs. On January 1, May 1, and September 1 of each year 50 people lose their jobs for a period of four months before finding new jobs.

(a) What is the unemployment rate in any given month? (2)

(b) How many unemployment spells are there in a year? (2)

(d) On any given date, how many people are undergoing short spells, and how many people are undergoing long spells? (4)

16. You are to purchase 5000 shirts. You may buy exactly the same shirt in Canada, Great Britain, or Japan. The nominal exchange rate with Great Britain is 0.4 Pounds and with Japan is 900 Yen. The price of shirts is $50 in Canada, 18 Pounds in Great Britain, and 350 Yen in Japan.

(a) Where is the cheapest place to buy the shirts and what will be the cost in Canadian dollars. (5)

(b) Suppose that the nominal exchange rate in Britain for Japanese Yen is 4000 Yen. Show how this might change your decision. (5)

17. State the following statistical information for Canada : GDP, C, I, G, NX, Exports, Inflation Rate, Bank Rate, Unemployment Rate, Participation Rate. (10)

18. Explain the following concepts:

(a) the beachhead effect (5)

(b) leading, lagging and coincident indicators (5)

19. Given the following information: GNP=1000; Government Purchases of Goods and Services=200; Government Deficit=50; National Savings=200, Investment=150; NFP=25

Find the value of the following:

(a) Consumption (2)

(b) Private Savings (2)

(d) Gross Domestic Income (2)

(e) Net Exports (2)

20. Explain what is meant by interest rate parity and provide an empirical example to illustrate. (10)

Selected Answers

1. It can restrict transactions using taxes or controls. But that will discourage trade in goods and capital. It can buy
guilders (intervention). But the overvaluation will require an ongoing purchase, and the government eventually will run out of
reserves. It can tighten monetary policy to raise interest rates and bring the fundamental value up to the official value. Or it can
convince other central banks (in countries with which it has a fixed exchange rate) to loosen their monetary stances.

3. A monetary contraction could cause a U.S. recession in the short run. The reduction in Ms causes the LM curve to
shifts back (left or up). In the short run (IS-LM intersection) income falls and the interest rate rises causing imports to fall and
capital inflows to rise. Both tend to cause an appreciation in the US dollar (or the $C depreciates). A primary effect of falling
US imports is also falling Canadian exports. If the J-curve is important then US NX could rise in the short run. In that case,
Canadian NX fall (income effect and J curve effect) and our IS curve shifts back, bringing recession to Canada and lowering
Canadian r. If the J curve effect does not occur, the US appreciation reduces U.S. net exports. Thus Canadian net exports rise,
and the IS curve shifts out. In the longer run, the US recession causes US prices (and wages) to fall which shifts the US LM
curve to its original position. Canadian IS returns to its original position also. (Price changes msy also occur in Canada as a
result of the increase or decrease in NX).
Thus a recession in the US might cause a recession or boom in Canada.

4. Discuss four: demographic composition (but also unemployment has risen within each group); structural change;
hysteresis; the tax - benefit system.

5. (a) The production function exhibits diminishing returns to scale. The more labour is used, the lower is the marginal
product. The MPN is the benefit to the firm; P*MPN is the dollar value to the firm and W is the cost to the firm of the last init
of labour. The demand for labour requires MPN=W/P and MPN falls as N is increased.
(b) Changes in wealth affect labour supply because more wealth means that more of all goods can be bought, including
leisure. Thus less labour income is desired with increased wealth and less labour will be supplied. Increases in the population
imply more persons in the workforce and hence increased numbers of persons willing to work at any real wage. Either effect
would shift labour supply to the right.

6. (a) shoe leather costs, menu costs, distortion of relative prices
(b) Induced unemployment and potential Hysteresis. The effect depends upon the the curvature of the SRPC (increasing
cost as inflation falls) and the length of the adjustment period.

8. (a) S-I=CA for each country and a surplus in one is the deficit in the other. This occurs a a given equilibrium interest rate.
Show in a S and I diagram.
(b) The direct effect of the shock is to shift the I curve to the right or the S-I to the left. If this occurs to the country with a
deficit (I>S) then the deficit becomes larger. There is a excess demand for investment which drives up the world interst rate.
The interest rate rises until the surplus and deficit of each country are again equalized. A similar arguement applies if the affected
country has the surplus.

9. (a) Very interest rate sensitive capital flows, leading to interst sensitive NX and hence very flat IS curve; horizantal IS in
the limit.
(b) Using FE-IS-LM analysis, FE is not affected, but the IS shifts up (savings fall and r rises in the goods market). In the
short run (IS-LM intersection) this shift is very small because a small change in r causes a large change in e and NX. To the
extent that income is increased beyond the full employment level, prices will eventually rise and LM will shift back. In the long
run output is at the full employment level. Fiscal policy is ineffective at changing the level of output under flexible rates even in
the short run.

10. Classical - no intervention; Keynesian - intervention is useful
a. All policies have short run effects. The issue is how long is the short run. If prices do adjust slowly, it may well be
beneficial to use expansionary policy for short run reductions in unemployment. This argument is stronger when coupled with the
hysteresis arguement.
b. Where is the natural rate of unemployment? If the natural unemployment rate is perceived to be less than actual then
policies to expand employment are doomed to failure.

11. (a) 9.0, 11.5, 9.0, 9.0
       (b) 9.0, 10.25, 10.25, 9.0
       (c) Advocates of cold turkey disinflation argue that a credible announcement of disinflation (backed by an independent
central bank say) can lower inflation expectations. In that case, the unemployment rate can remain near the natural rate as
inflation falls rapidly.
       (d) Hysteresis means that the natural rate of unemployment tends to rise when the actual rate does. In this case, both
sets of unemplyoment rates would be higher and the rate could be permanently higher under either disinflation.

12. (a) pi^e = 10%; i = 15%; M/P = 10; P = 30
(b) pi^e = 5%; i =10%; M/P = 15; P = 20
The slowdown in money growth reduces expected inflation, increasing real money demand, thus lowering the price level.

13. (a) + entry in current account
(b) no entry
(c) + entry in capital account
(d) + entry in current account
(e) - entry in capital account
(f) - entry in current account
(g) + entry in capital account

15. (a) 7%
       (b) Short spells: 240; Long spells: 150; Total spells: 390.
       (c) Average duration = 840 / 390 = 2.15 months
       (d) Short: 20; Long: 50

19. GDP = GNP-NFP=1000-25=975
      GDP=C+I+G+NX; 975=C+150+200+NX
      S=I+CA=I+NFP+NX; 200=150+25+NX; NX=25
      C=975-150-200-25=600
      Spvt+Sgov=National Savings; Spvt +(-50)=200; Spvt=250
      Disposable Y=GNP-Taxes; G-T=deficit; 200-T=50; T=150
                           = 1000-150=850