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                       QUEEN'S UNIVERSITY
                       FACULTY OF ARTS AND SCIENCE

                       APRIL 1995
           
                       ECONOMICS 222

                       SECTION D

                       Gregor Smith

Instructions:  You may use a hand calculator.

           
Answer six (6) of the ten questions in Part A.
Each question in Part A is worth six (6) marks.
           
Answer four (4) of the six questions in Part B.
Each question in Part B is worth sixteen (16) marks.
           
Read the questions carefully.

 
 
 
 
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            PART A
            Answer six (6) of the following ten questions.
            Each question is worth six (6) marks.
          

1. Suppose that the federal debt is 400 billion, the nominal
interest rate is 7%, and the growth rate of nominal GDP is 5%.
If the federal government wants zero growth in the debt-GDP ratio
what primary deficit must it run?
           
2. What are the main reasons (give at least three) that
Ricardian equivalence might not hold?
           
3. If the Canadian inflation rate is 1%, the U.S. inflation
rate is 3%, and the Canadian dollar is depreciating by 5% against
the U.S. dollar then what is happening to the real exchange rate?
What effect will this have on the Canadian trade balance?
           
4.  An economist argues as follows: it Canadian real
interest rates are high, relative to those in other countries,
because the Canadian current account has been persistently
in deficit.  Does this make any sense?
           
5. Suppose the government of the Netherlands finds that the guilder
is overvalued against other European currencies.  Describe three
methods it can use to maintain the high value of its currency.
           
6.  Who bears the burden of the government debt?
Explain why.  Under what circumstances is there no burden to be borne?
           
7. Magog banks currently have 1 million dinars and a system of 100% reserve
banking.
The government passes a law allowing fractional reserve banking
and a minimum reserve-deposit ratio of 10%.  Assuming people hold
no currency, after the full process of multiple expansion of loans
and deposits had worked itself out, what would the country's
money supply be?
           
8. What factor or factors may explain the apparent instability of
the Canadian Phillips curve during the 1970s?
           
9.  Explain how a drawdown by the Bank of Canada affects the
monetary base and the monetary aggregates.  Will this transaction affect
the Bank rate?
           
10.  What are the main explanations for the rise in the Canadian
natural rate of unemployment over the past twenty-five years?

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            PART B
            Answer four (4) of the following six questions.
            Each question is worth sixteen (16) marks.
           
1. Suppose that all workers place a value on their leisure
of 75 goods per day.  The production function relating
output per day Y to the number of people working per day N is:
Y = 500N - 0.4N^2.
A 25% tax is levied on wages.

(a) Find the marginal product of labour, MPN, as a function of N.

(b) What is output per day?

(c) In terms of lost output, what is the cost of the
distortion introduced by this tax?

(d) In this example, the marginal and average tax rates
are equal.  In general terms, what types of average and
marginal tax rates would least discourage labour supply?
Briefly explain the poverty trap.

2. Suppose that the expectations-augmented Phillips curve is
given by:
pi_t = pi^e_t - 2.0 (ut- u),
where  u is the natural rate of unemployment, and
pi^e_t is the expected rate of inflation.
The subscript t counts time periods (years).
Suppose also that:
 u = 0.09, and  pi^e_t = pi_t-1
so that people expect the inflation rate this period to be
whatever value it took last period.  Finally, suppose that
initially (at time 1) pi_1 = pi_0 = 0.05.

(a) Calculate the sequence of unemployment rates u_1,u_2,u_3,u_4
under a cold-turkey
disinflation, in which pi_2 = 0 and all subsequent inflation
rates are zero.

(b) Calculate the sequence of unemployment rates under a
gradual disinflation, in which pi_2=0.025, pi_3=0,
and all subsequent inflation rates are zero.

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

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

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3. To some extent, business cycles in Canada are caused
by business cycles in the United States.  Use the two-country
version of the IS-LM-FE model to describe what happens in each
country in the following scenarios:

(a) A fiscal contraction in the U.S. brings about a recession there.

(b) A monetary contraction in the U.S. brings about a recession there.

(c) Would a fixed exchange rate reduce the effect of the U.S.
policies on Canada?

4. Consider the following model of an open economy.
        Y = 100
        C=0.8Y
        I=20-100r
        G=10
        NX = 20-200r-0.18Y
        M/P = 0.5Y- 125r
        M = 45

The economy can influence its own interest rate.

(a) Solve for real output and the real interest rate in
long-run equilibrium.

(b) Suppose that to limit the growth of its debt the government
reduces spending on goods and services to G=8.  Find the effect on real
output and the real interest rate, assuming the price level does not change.
(Assume that the implied reduction in taxes does not affect labour supply.)

(c) What is the effect of the fiscal contraction if prices
are completely flexible?

(d) What are the long-run implications of the contraction for
national wealth?

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5. Suppose that the government of a small open economy can influence 
its real interest rate in the short run but not in the long run.
The world real interest rate is r^w=0.04.  Suppose the world
price level is P^w = 1.  The domestic economy is described by:
        M/P = 0.5Y- 200(r+pi^e)
        NX = 60-40e
        I=10    C=70    G=10
        e=0.75 + (r-r^w)
        Y=120

Assume throughout that expected inflation is constant at pi^e=0.

(a) Suppose that M=52.  Solve for the following variables
in general equilibrium: r, P, e, e_nom.

(b) The central bank unexpectedly raises the money supply to
M=54.  In the short run prices do not adjust to this change.
Find the effects on the four variables you studied in part (a).

(c) What are the long-run effects of the policy?

6. This question studies how we might assess the causes of the 1990-1992
recession in Canada, which also occurred in other countries.
Suppose that there are two competing explanations of the recession.
Under explanation it S, the temporary rise in world oil prices
was a negative productivity shock which reduced world output.
Under explanation it M tight monetary policy by central banks
caused the recession.

(a) Compare the effects of shocks it S and it M on the world
economy (viewed as a large closed economy, say).  Are there any
observable variables that behave differently under the two shocks
and so would allow us to distinguish between the rival explanations?

(b) The recession was more severe in Canada than in the U.S., so
possibly Canada experienced a more severe supply shock or more
restrictive monetary policy.  What evidence might be used to
distinguish between these two explanations?

These answers were used as a marking guide.  They are not necessarily
model answers and, in particular, do not include any graphs.

1. 8 billion surplus

2. borrowing constraints; myopia; no bequests; non-lump-sum taxes

3.  This is a 7% real depreciation.  The result will probably be
an increase in the trade balance with the U.S.  But also discuss the
J-curve and the beachhead effect.

4.  For intertemporal external balance we need a real depreciation.
But then by real interest parity Canadian real interest rates exceed foreign
rates to offset the expected depreciation.

5. 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.

6. If taxes must be raised then the distortions are a burden
to future generations.  The redistribution may be a burden.
If debt reduces national saving then investment and net foreign assets
will be lower, wheich means a lower standard of living for future generations.
But if taxes are lump-sum and Ricardian equivalence holds then there is
no burden.

7. The money supply would be 10 million dinars.

8. Supply shock: causes expected inflation and raises natural
rate of unemployment; demographic change: probably raises
natural rate; wage and price controls: may change expected inflation.

9. In a drawdown the Bank moves government deposits from banks to
the Bank.  The banks pay for that by lowering their clearing balances.
That lowers high-powered money.  Then interest rates tend to rise
as banks compete for reserves.  You can think of the banks as reducing their
assets (loans and investments) to restore their reserves.  And you can think
of money-holding declining because demand falls with the rise in
interest rates.  The transaction may affect the Bank rate if the
increase in interest rates affects the 91-day T-bill rate.

10. There are four: demographic composition (but also unemployment
has risen within each group); structural change; hysteresis; UI.


1. (a) The marginal product of labour is:
 MPN = 500 - 0.8N.

(b) Output per day is Y=150,000.  Note that equilibrium employment is 
N=500 and the pre-tax real wage is 100 so the after-tax wage is 75.

(c) Without the tax, output would be higher by 2734.

(d) Low marginal and high average would encourage labour supply.
The poverty trap is the reverse.

2. (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.

3. (a) With a fiscal contraction U.S. output falls and
interest rates fall, as the IS curve shifts back.  Prices fall
(or inflation slows) so that the LM curve shifts down to restore
full employment output.  The fall in r and in Y lead to
offsetting effects on the nominal exchange rate; but most likely
NX rises.

Meanwhile, in Canada, our NX then fall so our IS curve shifts
back too.  This transmits the recession (and decline in interest
rates) internationally.  Inflation slows as the LM curve shifts
down.  [Note: The fiscal contraction also could shift the FE line
left, due to the effect on labour supply.]

(b) If the U.S. recession is caused by monetary contraction,
then the LM curve shifts back so clearly there is an appreciation.
If the J-curve is important then NX could rise.  In that case,
Canadian NX fall and our IS curve shifts back, bringing recession
to Canada and lowering Canadian r.

In the opposite case, the appreciation reduces U.S. net exports.
Thus Canadian net exports rise, and the IS curve shifts out.
In either case the only long-run effect would be on nominal variables.
[We also could desribe how interest rates need not be equal due to UIP.]

(c) With a fixed exchange rate, in the monetary contraction Canada
would have to contract its M too, to maintain the nominal exchange rate.
Hence that would bring the recession to Canada automatically.

In the fiscal contraction the effect on the nominal exchange rate
is ambiguous.  If the U.S. contraction tended to cause an
appreciation of the U.S. dollar then Canada would have to
contract its money supply.
But if a contraction lead to a U.S. depreciation then
Canada would have to increase its money supply.

Only in this last case, then, would a fixed exchange rate cushion
Canadian output from the effects of U.S. macroeconomic policies.
But note we've assumed Canada targets the rate.  If the U.S. does
also then it may not undertake the policy changes in the first place,
which will lead to more stable output, in the absence of other shocks.


4. (a) Y=100 r=0.04

(b) The LM curve is:  45=0.5Y-125r
and the IS curve is:  48-300r = 0.38Y.
Try graphing these two curves.
The intersection gives: r=0.034 and Y=98.7.

(c) If prices adjust, then we can ignore the LM curve as we know
that Y=100.  Then r=0.03333.

(d)  We can use part (c) as the long run.  Then there has been
crowding in of net exports and of net investment.  Hence the
two components of national wealth will be higher in the long run.

5. (a) Initially, r=0.04, e=0.75, e_nom=0.75, and P=1.

(b) When M rises to 54: r=0.03, e=0.74, e_nom=0.74, and P=1.

(c) In the long run prices rise: r=0.04, e=0.75, e_nom=0.7225,
and P= 1.038.   Hence only nominal quantities are affected in the
long run.

6. (a) Use diagrams.  Under an it S shock we find ourselves
to the right of the FE line.  Output falls, prices rise, and
real interest rates rise in the world economy.  Output is permanently
lower or grows more slowly, and real interest rates are higher.
Under an it M shock we find ourselves to the left of the FE line.
Prices fall (or inflation is slower) as output rises back towards its
original level.  The world real interest rate rises here too, but then
falls back to its original level.

(b) Under both shocks we should have higher interest rates
and lower output than the U.S.  Hence our net exports should decline
and real exchange rate appreciate in both cases.  So this does not
really provide any additional information.  But our (surprise)
disinflation was greater than that in the U.S., which suggests 
explanation M.