Economics 112* -Assignment #2 Suggested Solutions

True, False, or Uncertain [48 marks -6 marks each]

Explain why each of the following statements is True, False, or Uncertain according to theeconomic theory you have learned. A diagram and/or a few lines of explanation should besufficient. Unsupported answers will receive no marks. It is the explanation that is important.

A2-1. In a closed economy an increase in government spending increases the rate ofeconomic growth in the long run.

False.

The increase in government spending must be financed through taxation or governmentborrowing. If it is financed through taxation, household disposable income is decreased andboth consumption and saving decrease. If the government uses debt financing, national saving(private plus government saving) is reduced. Therefore regardless of which method is chosen,the supply of saving shifts to the left from S toS’. This results in an increase in the real interestrate and a decrease in investment spending from I to I’.

This crowding out of investment spending has an effect on economic growth since today’sinvestment is the addition to the capital stock of the economy, a primary determinant of futureoutput. Because investment is important for long-run economic growth, an increase in government spending reduces the economy’s growth rate in the long run.

A2-2. A $100 million investment in capital in a poor country will increase GDP inthat country by a similar investment in a rich country.

False.

The aggregate capital stock in a poor country is much lower than the aggregate capital stock in a rich country. In the Neoclassical growth theory, the aggregate production isassumed to display diminishing marginal returns when either of the factors ofproduction is increased while holding other factors constant. Therefore, the neoclassical aggregate production function implies that the marginal productivity ofcapital in a poor country is higher than the marginal productivity of capital in a richcountry. This means a $100 investment in capital in a poor country should increase GDP by a higher amount compared to the increase in GDP by a similar investment ina rich country, assuming that both the poor and rich country have the sameneoclassical aggregate production function.

A2-3. Both long-and short-run economic growth are determined by the same set ofconsiderations.

False.

The four fundamental determinants of long-run economic growth are: growth in the labor force, growth in human capital, growth in physical capital and technological change. On the other hand, the short-run economic growth is mainly determined by the changes in the factor utilization rate.

Changes in the economy’s supply of labor, physical capital and human capital occuronly gradually, but over period of many years the growth is considerable. As a result, changes in the factor supply are important for explaining long-run changes in output, but relatively unimportant for explaining short-run changes. Similarly, the economy’s level of productivity changes only gradually from year to year, but grows substantially over period of many years. As a result, productivity growth is very important forexplaining long-run changes in output, but less important for explaining short-run changes.

The factor utilization rate, the fraction of the total supply of factors that is actuallyused or employed at any time, fluctuates in response to short-run changes in output caused by aggregate demand or aggregate supply shocks. Therefore, changes in thefactor utilization rate are important for explaining short-run changes in GDP. But after factor prices have fully adjusted, GDP returns to its potential level (Y*) and factorutilization rate returns to its “normal” level (the factor utilization rate which prevailsat the natural rate of unemployment). As a result, changes in the factor utilization rateare not important for explaining long-run changes in GDP.

A2-4. The increased availability of credit cards in recent years has increased themoney supply.

False/Uncertain

Credit cards are a source of (pre-approved) credit, not a form of money. When you pay forsomething with a credit card, the bank (or other card issuer) promises to pay the merchant.You promise to pay the bank. At the end of the month, the bank pays the merchant and you pay the bank (or carry a loan with interest). Therefore credit cards are not really aform of money, but rather a form of credit.

Nevertheless, availability of credit cards affects the amount of cash balances people carry.If less cash is carried (and more held at the bank) overall money supply is affected(money multiplier effect will be bigger).

A2-5. An increase in the price of a bond is a decrease in interest rates.

True.

The present value of a bond is negatively related to the market interest rate. Inaddition, a bond’s equilibrium market price will be equal to its present value. Thesetwo relationships imply that an increase in the market interest rate leads to a fall in the price of any given bond. See page 698 and 699 for a detailed explanation andnumerical examples.

A2-6. An increase in the rate of growth of the money supply will lead to an increase inthe rate of growth of GDP.

False.

Figure A2-6 shows the AD-AS model. Initially the economy is in a long-run equilibrium at E0, at its potential output, Y*, and price level P0. An increase in the money supply leads to a decrease in the interest rate. A decrease in the interest rate, inturn, stimulates investment resulting in a shift in the aggregate demand to the right from AD0 to AD1. Thus the Canadian economy moves to a short-run inflationary equilibrium at E1, with income Y1 and price level P1. As real GDP rises above potential, unemployment falls. Wages rise in response to the excess demand of labor. The short-run aggregate supply curve (SRAS) would therefore shift upward fromSRAS0 to SRAS1, as the higher wages led to increased unit costs. The economy thenwould move along the new AD curve AD1, with rising prices and falling output, until the inflationary gap was removed and real GDP was restored to potential, Y*. Thuseconomy moves to a new long-run equilibrium at E2, with real GDP Y* and price level P2. This means there is no growth in real GDP in the long-run. Therefore, an increase in money supply can increase the rate of growth in real GDP only in theshort-run, not in the long-run. Since economic growth is mainly a long-run issue, we can conclude that the statement is false.

A2-7. Taxes that vary with national income act as an automatic stabilizer.

True.

Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Taxes which vary with income are considered to be automatic stabilizers. When the economy goes into a rescission, the amount of taxes collected by the government falls automatically. A fall in tax burden stimulates aggregate demand and, thereby, reduces the magnitude of economic fluctuations.

A2-8. In a closed economy, an expansionary monetary policy has a larger effect on national income if investment is very interest rate responsive, than if it is less responsive.

False.

An increase in the money supply has a lower effect on national income if money demand is very responsive to changes in interest rate, than if money demand is less responsive.

Figure A2-8(a) illustrates the money market. MS

1

is the money supply curve. Consider

two types of money demand -one is very responsive to changes in the interest rate (elastic money demand) and the other is less responsive to changes in the interest rate (inelastic money demand). MD

1

is the elastic money demand and MD

2

is the inelastic

money demand. Assume that the initial equilibrium is at E0 with equilibrium interest rate at i0 and equilibrium quantity of money at M0. The money supply curve shifts rightward to MS

2

, as the Bank of Canada increases the money supply. This increase in

money supply leads to a decrease in interest rate to i1 if money demand is elastic and to i2 if money demand is relatively inelastic. This means the interest rate declines by a higher amount if the money demand is relatively less responsive to changes in interest rate.

Figure A2-8(b) shows a desired investment expenditure function. The level of investment expenditure is I0 when the interest rate is i0. A decrease in interest rate to i1

and i2 makes borrowing cheaper. As a result the level of investment expenditure increases to I1 and I2, respectively. This means investment expenditure increases by a higher amount due to an increase in money supply if money demand is relatively inelastic.

Figure A2-8(c) shows the AD-AS model. At the beginning the economy is in a recessionary equilibrium at E0, with the equilibrium level of real GDP, Y0, and price level P0. With an elastic money demand curve investment expenditure increases to which in turn shifts the AD curve to the right from AD0 to AD1. This moves equilibrium to E1, with real GDP Y1 and price level P1. On the other hand, with an inelastic money demand curve investment expenditure increases by a higher amount to I2, which in turn shifts the AD curve to a further right from AD0 to AD2. This moves equilibrium to E2, with real GDP at its potential level Y* and price level P2.

This shows that an increase in the money supply has a larger effect on real GDP if money demand is very responsive to changes in the interest rate, than if money demand is less responsive.

I1

Problems [52 marks -marks for each part as shown]

A2-9. Analyze the effects each of the following events would have on the Canadian economy in both the short-and long-run. Be sure to explain what happens to output, theprice level, and unemployment in the short-run, and in the adjustment to a new long-run equilibrium. In each case, begin with a short-run aggregate supply and aggregate demand (SRAS-AD) equilibrium that is also a long-run aggregate supply and aggregate demand (LRAS-AD) equilibrium.

(a) The US economy goes into recession. [4]

Figure A2-9(a) shows the AD-AS model. Initially the economy is in a long-run equilibrium at E0, at its potential output, Y*, and price level P0. As the US economy goes into recession, the demand for Canadian exports declines. This is because the USis the major trading partner of Canada. As a result, the aggregate demand of Canadian economy decreases and the AD curve shifts to the left from AD0 to AD1. Thus the Canadian economy moves to a short-run recessionary equilibrium at E1, with income Y1 and price level P1. As real GDP falls below potential, unemployment rises. Wages fall in response to the excess supply of labor. The short-run aggregate supply curve (SRAS) would therefore shift downward from SRAS0 to SRAS1, as the lower wages led to reduced unit costs. The economy then would move along the new AD curveAD1, with falling prices and rising output, until real GDP was restored to potential, Y*Thus economy moves to a new long-run equilibrium at E2, with real GDP Y* and price level P2. If wages are flexible, the economy will move quickly from E1 to E2 and thus eliminate the recessionary gap. However, if wages are sticky downward, theeconomy will move slowly from E1 and to E2.

Therefore, if the US economy goes into recession, in the short-run both the price level and real GDP of Canadian economy will decrease and unemployment will increase. But in the long-run there will be no change in real GDP and unemployment. Onlyprice level will decrease in the long-run.

(b) The Canadian government increases its spending so that instead of running asurplus, the government’s budget is balanced. [4]

Figure A2-9(b) shows the AD-AS model. Initially the economy is in a long-run equilibrium at E0, at its potential output, Y*, and price level P0. As the Canadian government increases it’s spending, the aggregate demand of Canadian economyincreases and the AD curve shifts to the right from AD0 to AD1. Thus the Canadian economy moves to a short-run inflationary equilibrium at E1, with income Y1 andprice level P1. As real GDP rises above potential, unemployment falls. Wages rise inresponse to the excess demand of labor. The short-run aggregate supply curve (SRAS) would therefore shift upward from SRAS0 to SRAS1, as the higher wages led to increased unit costs. The economy then would move along the new AD curve AD1, with rising prices and falling output, until the inflationary gap was removed and realGDP was restored to potential, Y*. Thus economy moves to a new long-run equilibrium at E2, with real GDP Y* and price level P2.

Therefore, if the Canadian government increases its spending, in the short-run both the price level and real GDP will increase and unemployment will decrease. But in thelong-run there will be no change in real GDP and unemployment. Only price level will increase in the long-run.

(c) An expansion of the labour force occurs when many people choose not to retire. [4]

Figure A2-9(c) shows the AD-AS model. Initially the economy is in a long-run equilibrium at E0, at its potential output, Y1

*

, and price level P0. A rapid expansion of the labour force leads to an increase in both the short-run aggregate supply and the level of potential output. The SRAS curve shifts to the right from SRAS0 to SRAS1

and the long-run supply curve shifts to the right from LRAS0 to LRAS1. Thus the Canadian economy moves to a short-run recessionary equilibrium at E1, with income Y1 and price level P1. E1 is a recessionary equilibrium because the new potentialoutput Y2

*

is higher than Y1. Since real GDP at E1 is below potential, unemployment rises. Wages fall in response to the excess supply of labor. The short-run aggregate supply curve (SRAS) would therefore shift downward from SRAS1 to SRAS2, as the lower wages led to reduced unit costs. The economy then would move along AD0, with falling prices and rising output, until real GDP was increased to new potential,Y2

*

. Thus economy moves to a

new long-run equilibrium at E2, with real GDP Y2

*

and price level P2. If wages are flexible, the economy will move quickly from E1 to E2 and thus eliminate the recessionary gap. However, if wages are sticky downward, the economy will moveslowly from E1 and to E2.

Therefore, if there is a rapid expansion of the labour force, in the short-run the price level will decrease and real GDP will increase. Unemployment will also increase inthe short-run. However, in the long-run the unemployment rate will return to its natural level, the price level will decrease and real GDP will increase.

(d) An increase in the world price of oil leads to an increase in net exports and anincrease in producer costs. [4]

Figure A2-9(d) shows the AD-AS model. Initially the economy is in a long-run equilibrium at E0, at its potential output, Y*, and price level P0. An increase in net exports leads to an increase in aggregate demand and the AD curve shifts right fromAD1 to AD2. On the other hand, an increase in producer costs leads to a decrease inthe short-run aggregate supply and the SRAS curve shifts leftward from SRAS0 toSRAS1. Depending on the magnitude of the shifts in the AD and SRAS curves, wecan have the following three cases.

CASE 1: Figure A2-9(d1) shows Case 1 where the AD and SRAS curves shift inequal magnitude. If the rightward shift in the AD curve is completely offset by theleftward shift in the SRAS curve, the economy will move directly form the initiallong-run equilibrium E0 to the new long-run equilibrium at E2, with higher price level P2 and potential output Y*.

CASE2: Figure A2-9(d2) shows Case 2 where the magnitude of the leftward shift inSRAS curve is higher than the magnitude of the rightward shift in the AD curve. Inthis case economy first moves from the initial long-run equilibrium E0 to a short-run recessionary equilibrium at E1, with a higher price level P1 and output Y1. As real GDP falls below potential, unemployment rises. Wages fall in response to the excesssupply of labor. The short-run aggregate supply curve (SRAS) would therefore shiftdownward from SRAS1 to SRAS2, as the lower wages led to reduced unit costs. The economy then would move along the new AD curve AD1, with falling prices and rising output, until real GDP was restored to potential, Y*. Thus economy moves to anew long-run equilibrium at E2, with real GDP Y* and price level P2. If wages are flexible, the economy will move quickly from E1 to E2 and thus eliminate the recessionary gap. However, if wages are sticky downward, the economy will move slowly from E1 and to E2.

Therefore, in this case, in the short-run the price level and unemployment will increase and real GDP will decrease. But in the long-run there will be no change in real GDP and unemployment. Only price level will increase in the long-run.

CASE3: Figure A2-9(d3) shows Case 3 where the magnitude of the leftward shift inSRAS curve is lower than the magnitude of the rightward shift in the AD curve. Inthis case economy first moves from the initial long-run equilibrium E0 to a short-run inflationary equilibrium at E1, with a higher price level P1 and higher output level Y1. As real GDP rises above potential, unemployment falls. Wages rise in response to theexcess demand of labor. The short-run aggregate supply curve (SRAS) would therefore shift upward from SRAS1 to SRAS2, as the higher wages led to increased unit costs. The economy then would move along the new AD curve AD1, with rising prices and falling output, until the inflationary gap was removed and real GDP wasrestored to potential, Y*. Thus economy moves to a new long-run equilibrium at E2, with real GDP Y* and price level P2.

Therefore, in this case, in the short-run the price level and unemployment will increase and real GDP will decrease. But in the long-run there will be no change in real GDP and unemployment. Only price level will increase in the long-run.

A2-10. Suppose the Bank of Canada is worried about inflation and conducts contractionary monetary policy. Using appropriate diagrams, analyze the effects this action has on:

(a) the money market. [4]

Figure A2-10(a) illustrates the money market. The money supply ( MS

1

) curve is vertical. The money demand curve (MD) is downward sloping, indicating that firms and households decide to hold more money if the interest rate falls. Assume that theinitial equilibrium is at E0 with equilibrium interest rate at i0 and equilibrium quantity of money at M0. The money supply curve shifts leftward to MS

2

, as the Bank of Canada reduces the money supply. At the initial interest rate i0, there is now excess demand for money. Individuals will try to sell bonds to add to their money balances. At any moment, the economy’s total supply of money and bond is fixed. Thus, as everyone tries to sell bonds, an excess supply of bondsdevelops. Like any other good or service, an excess supply of bond causes a fall in theprice of bonds. A fall in the price of bonds implies an increase in the interest rate. As the interest rate rises, people economize on money balances because the opportunitycost of holding such balances is rising. Eventually, the interest rate will rise enoughthat people will no longer be trying to add to their money balances by selling bonds. At that point, there is no longer an excess supply of bonds (or an excess demand formoney), and the interest rate will stop rising. The demand for money again equalssupply, as at point E1 in Figure A210(a). Thus because of the contraction of the money supply, the economy moves to new equilibrium E1 with a higher interest rate at i1 and an equilibrium quantity of money at M1.

(b) the level of investment spending. [4]

Figure A2-10(b) shows a desired investment expenditure function. The level of investment expenditure is I0 when the interest rate is i0. An increase in interest rate to i1 makes borrowing expensive. As a result the level of investment expendituredecreases to I1.

(c) the aggregate expenditure function. [4]

Figure A2-10(c) illustrates the aggregate expenditure model. At the beginning, theeconomy is at an inflationary equilibrium E0, with aggregate expenditure function AE0, price level P0 and real GDP Y0, which is above the potential real GDP Y*. As the investment expenditure decreases to I1, aggregate expenditure function shifts downward to AE1, holding the price level fixed at P0. Thus the economy moves to a new short-run equilibrium at E1 and the equilibrium level of real GDP decreases to Y1. Over time price will start decreasing because of the lower aggregate expenditure. Ifprice decreases to P1, the value of privet-sector wealth will increase. This in turn will contribute to an increase in aggregate expenditure to AE2. Thus, the economy moves to long-run equilibrium at E2, with real GDP at its potential Y* and price level P1.

(d) the short-run equilibrium in aggregate demand and aggregate supply space [4]

Figure A2-10(d) shows the AD-AS model. Initially the economy is in an inflationary equilibrium at E0, with the equilibrium level of real GDP, Y0, and price level P0. As the investment expenditure decreases to I1, the AD curve shifts

to the left from AD0 to AD1. This moves equilibrium to E2, with potential real GDP Y* and price level P1, and closes the inflationary gap.

Note that point E1 on the AD1 curve corresponds to the equilibrium at E1 in part (c), which is illustrated in Figure A2-10(c).

A2-11. Suppose the consolidated balance sheet of the banking system is given below(figures in Billions of $). Assume in what follows that individuals choose to hold all of theirmoney in the bank.

(a) What quantity of reserves are the banks holding? If we assume that the banking system is in equilibrium, what is the desired reserve ratio of the banks?What is the current money supply? [3]

Reserves are the sum of currency held within the banking system and deposits by thebanks at the Bank of Canada (B of C). Therefore, initial reserves = 1+ 4 = 5. If the system is in equilibrium, then the banks are holding their desired reserve ratio givenby DRR = Reserves/Deposits = 5/100 = 5%.

Assets: Liabilities:

1 Deposits 100 Currency Deposit at the Bank of Canada

4

Government Bonds 5 Loans Outstanding 90 Total 100 Total 100

Since it is assumed that individuals hold all of their money in banks, the currentmoney supply is equal to the demand deposits held in the banks. Therefore, thecurrent money supply is 100.

(b) Suppose the Bank of Canada purchases $5 B of government bonds from thebanks. Show the initial effect on the balance sheet. What effect does thistransaction have on the money supply? [Hint: Note the change to the balancesheet before the banks make any new, or call-in any old, loans.]

[3]

A purchase of government bond results in an increase in reserves held by the bankingsystem. Deposits at the Bank of Canada are increased by 5 and government bondholdings on asset side are decreased by 5. The initial effects on the balance sheet aresummarized as follows:

A 1 00

100

ssets: Liabilities: Currency Deposits 1Deposits at the Bank of 9 Canada Government Bonds 0 Loans Outstanding 90

Total 100 Total

Since initially there is no change in the demand deposits, the money supply willremain unchanged.

(c) Assuming that the desired reserve ratio is unchanged, determine the eventualeffect of the above transaction on the balance sheet of the banking system and on the money supply. Briefly explain the adjustment process that leads the bankingsystem back into equilibrium. [6]

The banking system has reserves of 10 that support 100 of deposits (10%). As a result ofthe purchase of government bonds by the B of C, the reserve ratio rises above 5% that the banking system was holding in the equilibrium.

In order to increase the reserve ratio back to its original level (5%), the banking systemwill start making new loans. The banking system starts by issuing 5 billion dollars worth of new loans that are required to decrease the reserves.

Since individuals hold all money in the banks, demand deposits increase by 5. Thus, thenew reserve ratio becomes 10/105=9.5%, which is still higher than desired 5%. Thebanking system continues to make additional loans. At every stage loans outstandingand demand deposits increase resulting in expansion of money supply. This processcontinues until reserve ratio reaches 5%.

The final effect on money supply can be calculated using the money multiplier, which isdefined as 1/drr = 1/0.05=20.

Thus, an increase of reserves by 5 billion would result in an increase of loan outstandingby 5*money multiplier = 5*20=100. The demand deposits and money supply will alsoincrease by 100. The new money supply will be 200. The final balance sheet is asshown below.

Assets: Liabilities: Currency 1 Deposits 200Deposits at the Bank of Canada

9

0

Government Bonds Loans Outstanding 190

Total 200 Total 200

Would such a transaction be part of an expansionary or contractionary monetary policy? [3]

Expansionary monetary policy

What factors could have triggered such a transaction in the Bank of Canada waspursing an inflation targeting monetary policy? [5]

The Bank of Canada monitors real GDP for signs of any output gaps that could drive theinflation rate outside the target range. Recessionary gaps trigger expansionary monetarypolicy (see Fig 29-4). In this way, inflation targeting can act as a stabilizing policy.