m08-part2 - III(8 points The Bank of Canada is concerned...

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Unformatted text preview: III (8 points) The Bank of Canada is concerned that the economy may experience a recession as a result of the slowdown in the US economy, which is Canada’s major trading partner. a) If the Bank of Canada purchases $1 million of government securities on the open market, will this increase or reduce the money supply? If the target reserve ratio of commercial banks is 10 percent (and there is no cash drain), what will be the change in the money supply? Why? b) If the government increases the money supply, what will happen to the interest rate? Why? c) If the Bank of Canada lowers the interest rate, would the expansionary impact on Aggregate Demand be greater if Canada were a closed economy (and did not trade with other countries)? Explain. IV (8 points) An economy with flexible prices is in long-term equilibrium at full-employment. a) If there is a sharp increase in the demand for this economy’s exports, what happens to the level of real GDP and the price level in i) the short run? ii) the long-run? (Illustrate your answers with an appropriate graph.) b) If the increase in the US. demand for Canadian exports is $10 million, and if the simple multiplier is 2, will the increase in Canadian’s real GDP in the short-run be more or less than $20 million? Explain your answer. V (4 points) You buy a ticket to a concert at a discount price of $50. You plan to take public transportation which costs $2. On the day of the concert, there is a power failure, and the only way you can attend the concert is by taking a taxi, which costs $30. It is too late to try to sell your ticket. a) Should you pay for the taxi and go to the concert? Explain your answer. b) Suppose that you decide to go to the concert (and pay the $30 cost of the taxi), but upon arriving discover that you have left your ticket at home. You can buy a new ticket for the full price of $60. Should you purchase the ticket? Page 14 of 26 PART III To Be Answered by students in Professor Indart’s Section L0201 Use a Separate Exam Booklet Each for Part A and for Part B Part A - Short Answer Questions [18% of the total exam mark] Answer ALL of the SIX questions. Each question is of equal value. Kathleen spends her income on only two goods — Video games [X-axis product] and books [Y-axis product]. The price of Video games decreases and Kathleen now purchases fewer video games. Statement: Kathleen’s decision is not consistent with consumer behaviour analysis. Position: Do you agree with this statement? Draw a consumer indifference curve diagram to analyze this situation and indicate, with reasons, whether you agree or disagree with this statement. A firm in the short run production period generates the following information at its current level of output: the industry price is $40; the marginal revenue is $20; the average total cost is $44; the marginal cost is $20; and average fixed cost is $12. Statement: This firm is not in a perfectly competitive market and should shut down production to minimize its economic losses. Position: Do you agree with this statement? Use a proper diagram to analyze this situation and indicate, with reasons, whether you agree or disagree with this statement. A perfectly competitive industry [Industry Z, which produces Product Z] is in long run equilibrium with ‘n’ identical firms. The industry has a constant cost long run supply curve. Disposable incomes increase. Product Z has negative income elasticity. Statement: In the new long run equilibrium, the industry price would be unchanged; industry output would increase; each firm would produce a smaller output; and firms would enter the industry. Position: Do you agree with this statement? Use a proper diagram to analyze this situation and indicate, with reasons, whether you agree or disagree with this statement. A single-price monopolist is in long-run equilibrium making economic profits. The monopolist’s average revenue curve is above the minimum of the average cost curve. The government implements an average-cost pricing policy. Statement: This interventionist action will result in the elimination of the monopolist’s economic profits and the achievement of allocative efficiency. Position: Do you agree with this statement? Use a proper diagram to analyze this situation and indicate, with reasons, whether you agree or disagee with this statement. Page 15 of 26 Using the expenditure approach to measure GDP, calculate the specific changes in each component of GDP (i.e, consumption, investment, etc.) when the following transactions are considered: 1) Canada imports 1 000 major computers from Japan for $10 000 Canadian each; 2) six hundred of these computers are sold to consumers in Canada for $14 000 each; 3) one hundred of these computers are re-exported to Europe for $12 000 each; and 4) the remaining three hundred computers are held in inventory at their imported price. All the above figures are in Canadian dollars. The Bank of Canada has two alternative approaches for implementing its monetary policy — it can target either the money supply or the rate of interest. Briefly explain the transmission mechanism when the Bank of Canada follows each of these two approaches. Page 16 of 26 Part B — Lon Answer uestions [32% of the total exam mark] Answer only 4 of the following 5 questions; if you answer all 5 questions, only the first 4 will be graded. All questions are of equal weight. Use a separate examination booklet(s) for this section. Question 1 Assume a typical household has $3 00 per month to spend on consumption of electricity and entertainment. Further assume that the income elasticity of electricity is zero. Suppose that the price of a kilowatt hour (kwh) of electricity is $0.10, while a unit of entertainment costs $1.00. In its initial equilibrium, the household is consuming 2000 kwh of electricity and 100 units of entertainment. a) In a clearly labelled diagram, draw a typical household’s initial budget line indicating all relevant points. Place “electricity” on the x-axis. Show the initial utility-maximizing equilibrium in your diagram (label it point E A), but do not draw any indifference curve yet. b) The government decides to promote conservation of electricity and imposes a tax of $0.05 per kwh, and thus the price of electricity increases to $0.15 per kwh. The typical household responds by changing its consumption of electricity to 1400 kwh. Draw the new budget line indicating all relevant points. Show the new utility-maximizing equilibrium in your diagram (label it point EB), but do not draw any indifference curve yet. c) Assuming smooth and convex indifference curves, clearly show in your diagram the substitution and the income effects measured in kwh of electricity. Assume that entertainment and electricity are both normal goods. [Now you can and must draw the appropriate indifference curves.] d) Given the information in your diagram, draw another diagram with a typical household’s demand curve for electricity. Question 2 Corn is produced by a constant cost, perfectly competitive industry which is initially in long-run equilibrium. Each firm has traditional U-shaped cost curves. a) Use interrelated diagrams to show the initial equilibrium for a representative firm and the corn industry. (Use subscripts P1, Q1, ql, etc.) What are the profits of each firm? b) Now suppose that producers form a cartel that sets quantity limits for each firm. What benefit for each producer is the cartel designed to achieve? Explain the quantity that should be established for each firm to maximize that benefit. Using your diagrams, show all the elements of this solution, using subscripts P2, Q2, etc. c) If a single individual producer were able to cheat (i.e., produce a different quantity) without being caught, what condition would determine this producer’s optimum quantity? What would be the outcome if every producer followed the same strategy? (Answer with brief statements; do NOT add anything to your diagrams.) d) If the cartel is effective, what concern arises for the members of the cartel in the long run? (Answer with brief statements; do NOT add anything to your diagrams.) Page 17 of 26 Question 3 Suppose the Canadian banking system is characterized as follows: 1) there is only one chartered bank; 2) the desired reserve ratio is 10% against demand deposits; 3) the chartered bank does not hold any reserves above the desired level; 4) there is no currency drain from the banking system. Considering only the M1 definition of money supply answer the following questions: ,a) 1)) Suppose the of Canada purchases $1 billion in Government Bonds from the public. What is the change in the reserves of the chartered bank? What is the total (final) change in the money supply? What is the change in bank loans as a result of this open market operation? Suppose that the Bank of Canada sells $1 billion in Government of Canada bonds to the chartered bank. What is the change in the reserves of the chartered bank? What is the total (final) change in the money supply? What is the change in bank loans as a result of this open ' market operation? Suppose now that the government borrows $1 billion from the Bank of Canada to finance its deficit (that is, the government sells $1 billion in bonds to the Bank of Canada). Assume that the government first borrows the money and then spends it. How are the reserves of the chartered bank affected? How is the money supply affected? How is the level of bank loans affected? Question 4 Consider an economy defined by the following behavioural equations: Consumption C = 100 + 0.8 YD Disposable Income YD = Y — TA Taxes TA = 100 + 0.125 Y Investment I = 460 Government Expenditure G = 400 Exports X = 200 Imports IM = 100 + 0.1 Y Full employment GDP Yfe = 2 800 What is the equilibrium level of GDP [Y]? What is the value of the marginal propensity to spend? What is the value of the expenditure multiplier? Is the government budget balanced? If not, what is the size of the deficit or surplus? Is there a recessionary or inflationary gap? If there is one, what is the size of the recessionary or inflationary gap? What will happen to the equilibrium level of national income if the government were to reduce lump-sum taxes (that is, a reduction of those taxes that are independent of Y) by 50? What is the balance in the government budget now? Page 18 of 26 Question 5 The Republic of Canelones produces only two goods, wool and lumber. Given the current level of technology, 1 unit of resources can produce either 1 unit of wool or 2 units of lumber in this small country. Canelones has a total resource endowment of 1 000 units. The wool and lumber industries are both constant cost industries. (a) What is the opportunity cost of producing 1 unit of lumber in Canelones? And of producing 1 unit of wool? (b) In a carefully labelled diagram, draw this country’s production possibility curve measuring the quantity of lumber on the horizontal axis. If Canelones is presently producing 800 units of lumber, how many units of wool might it be producing as well? Identify this point on your production possibility curve (point A). (c) What is the consumption possibility curve of this country under autarky? Briefly explain. (d) Now Canelones starts trading in the world market where 1 unit of wool exchanges for 4 units of lumber. What good will this country sell (export) in the international market? Explain. (e) Suppose now that Canelones changes its production bundle according to its comparative advantage. What combination of wool and lumber will it produce? Identify this point on your production possibility curve (point B). (f) Draw in your diagram this country’s new consumption possibility curve. How many units of wool will Canelones end up consuming if it chooses to consume 1 600 units of lumber? Identify this point on you consumption possibility curve (point C). Page 19 of 26 PART IV To be answered by students in Professor Carr’s section (LO301) ANSWER ALL QUESTIONS. Section I (25 Marks) 1. (13 Marks) In the early 1990’s Canada entered into a free trade agreement with the United States and Mexico (North American Free Trade Agreement — NAFTA). Currently there are politicians in the US considering the possible elimination of NAFTA. Suppose NAFTA was cancelled. at) (4 marks) Is it true that with the cancellation of NAFTA both Canada and the US will gain by the elimination of competition from a low wage country such as Mexico? b) (5 marks) Will the elimination of NAFTA result in an increase in the price of exports from the US to Canada, increasing the competitiveness of Canadian manufacturers and resulting in an overall gain to the Canadian economy. c) (4 marks) Is there any groups in the US who will gain from the elimination of NAFTA? Will the US be better off from the elimination of NAFTA? 2. (12 Marks) Some economists have argued that the strong economic growth taking place in China and India has resulted in high and rising commodity prices (i.e. the prices of oil, nickel, gold, etc.). Suppose these economists are correct. a) (4 marks) There are a number of economists who are predicting that there will be a worldwide recession. If these economists are also correct, what will happen to the price and output of commodities? Explain. b) (4 marks) Canada is a major producer of nickel. Suppose Canada had a monopoly in nickel production. Would this monopoly protect Canadian nickel producers from a worldwide recession? Explain. c) (4 marks) If Canada had a monopoly on nickel production would it ever pay Canada to charge a lower price for nickel to low income countries than it charges to high income countries such as the United States. Page 20 of 26 Section II (25 Marks) Answer the following questions TRUE, FALSE or UNCERTAIN. Give a brief explanation of your answer. Marks are given entirely for the explanation. I. In the past couple of years there has been a substantial increase in the price of gasoline. This fact alone should result in a higher price for automobiles. 2. Central banks around the world are significantly increasing their lending to chartered and commercial banks. Such a policy will result in a reduction in the money supply and ultimately (i.e. - in the long-run) to an increase in interest rates. 3. A free enterprise economy is essentially an economy where there is no planning. 4. It is socially beneficial to build an additional runway at Pearson International Airport provided that the extra revenue generated from the additional planes using the runway exceeds the costs of building the runway. 5. In a simple model of income determination with a fixed price level and unemployed resources, no government and no foreign sector, it is observed that whenever incomes increases by $100, consumption increase by $75. In such a model, if investment increases by $100, then consumption will increase by $150. Page 21 of 26 PART V To be answered by students from Professor Wolfson’s section (L5101) DO 2 QUESTIONS IN PART A AND 2 QUESTIONS IN PART B (Each question is worth 12.5 marks, for a total of 50 marks) PART A DO 2 OF 3 QUESTIONS Question One Lily, a lawyer, can freely vary the number of hours she chooses to work over a 5-day work week. Her wage rate is $ 100 per hour. Leisure is a normal good for Lily and the Substitution Effect from a wage change exceeds the Income Effect. Initially, Lily chooses to work 50 hours per week. 1.1 With the aid of a fully labelled diagram, show Lily’s initial equilibrium using indifference theory. What is the value of the Marginal Rate of Substitution (MRS) at the equilibrium? 1.2 There is a complaint about Lily’s services. To settle the matter, the Law Society (the “regulator”), requires Lily to provide 10 hours per week of free legal advice as a community service. Show her new equilibrium in your diagram. State clearly what has happened to Lily’s level of satisfaction as compared to the initial equilibrium. 1.3 Redraw the original equilibrium of 1.1 where Lily works 50 hours. (There is no requirement to provide community service). The wage rate increases to $120 per hour. Now show the substitution effect and the income effect for Lily between these two wage rates. 1.4 Using a diagram related to 1.3, show Lily’s supply curve of legal services. Question Two [Note that there are two different parts to Question 2] 2.1 Consider a typical monopoly. a) Explain why, at every quantity, Average Revenue exceeds Marginal Revenue. b) At the current production point, Marginal Cost = $20 and Marginal Revenue = $18. What should a profit-maximizing monopolist do? Explain your answer. 0) The market demand schedule is P = 120 —— 0.2Q. The monopolist has a long-run constant average cost of $20 per unit. Calculate the profit—maximizing price, quantity, profits, and consumer surplus. What is the price elasticity of demand at the equilibrium point? Page 22 of 26 2.2 b) d) Demonstrate the impact in the market for Good X of each of the events below, taken separately. Assume positively-sloped Supply and negatively-sloped Demand for the initial equilibrium. Label the initial equilibrium as D1, 81, P1 and Q1 and the new equilibrium as D2, 82, etc. as needed. The description of Good X is provided, followed by the event to be analyzed. Only a diagram is required. Label the axes as appropriate. X is the quantity of foreign exchange in the foreign exchange market (with a flexible exchange rate); the bitter Canadian winter causes more Canadians to take vacations in warm and sunny Florida. X is foreign exchange as above in part a); there is an increase in capital inflows. X is an agricultural product; an effective price floor is established. X is initially a legal good; then the government decrees that both the production and consumption of X is illegal, yet a market in X continues to exist. Question Three 3. Corn is produced by a constant cost, perfectly competitive industry which is initially in long-run equilibrium. Each firm uses two inputs, land (fixed in the short run) and labour (variable), with traditional U-shaped cost curves. Use interrelated diagrams to show the initial equilibrium for a representative firm and the corn industry. (Use subscripts P1, Q], m etc.). What are the prOfits of each firm? Now suppose that the price of land rises. Using your diagrams from part a), show all the elements of this solution in the short run, using P2, Q2 etc. Be sure to show the profit position of the representative firm. What happens to the number of firms in the short run? Provide a brief explanation of your answer to part b) i.e., how did you determine the short-run equilibrium price and quantity for the industry? What is the meaning of the term “constant cost industry”? In a single diagram of the industry, redraw the initial long-run equilibrium, showing P1 and Q1. Now show the new long—run equilibrium. (Use subscripts P3, Q3). What happens to the number of firms in the long run, compared to your answer to part b)? Page 23 of 26 PART B ' DO 2 OF 3 QUESTIONS Question Four [Note that there are two different parts to Question 4] 4.1 Below are data (in dollars) from the national accounts for a country. Assume that all relevant items you need have been provided. 0 s s 4 1m 280 40110 105 Use the above data to compute the following six items: 2 U] O \] O 00 \] a) Gross Domestic Product (GDP) b) Imports (M) 0) Balance of Trade (ET) (1) Personal Disposable Income (PDI) e) Net Domestic Product (NDP) f) Gov’t Budget Surplus or Deficit (GS or GD). 4.2 The macro economy of Utopia operates according to the following equations: Consumption C = 26 + 0.8Yd Gov’t Spending G = 20 Exports X = 50 Investment 1: 10 + 0.2Y Personal Taxes T = 20 Imports M = 10 + 0.25Y Disposable Income Yd = Y — T Full Employment Y1: = 368 Use the “constant-price model” to answer the following: a) What is the value of equilibrium GDP? Show your work. b) What is the value of the GDP Gap? What is the value of the Deflationary Gap? c) What is the value of the government spending multiplier (K5)? (1) Using the “variable-price model” and assuming positively-sloped short-run Aggregate Supply, explain why the value of the multiplier you calculated in part c) above may need to be adjusted. Page 24 of 26 Question Five 5. b) 0 Event One: 0 Event Two: 0 Event Three: 0) d) Below is the “consolidated” balance sheet showing the aggregate position of all banks in the country of Concord (in $millions, but you can ignore that and use the figures as shown). Banks act always to maintain the reserve ratio, and the balance sheet below reflects that proposition. Individuals and firms carry out money transactions through demand deposits at banks (i.e., there is no currency drain). There are always willing borrowers to take up loans banks might offer. Currency in circulation outside the banks is $6,000. Assets Liabilities Reserves (R) $6,000 Demand Deposits (DD) $100,000 Loans (L) $94,000 What is the value of the M1 Money Supply? What is the desired reserve ratio? Consider each of the events below, taken separately. For each one, provide the new value Of the Money Supply. [Note: you are being asked for the new value, not the change] A company in Concord buys $300 of government bonds in the open market; these bonds are sold by the Central Bank of Concord. Retail merchants in Concord begin to accept debit cards even for small purchases less than $10. Consumers find that they have less need for cash, and they collectively deposit $1,200 in cash into their chequing accounts at banks in Concord. All the banks in Concord decide to operate at a new reserve ratio of 5%. Consider now a different country, Lexington. It operates under the same banking assumptions as Concord, including the reserve ratio of Event Three (5%). You have no information about the consolidated balance sheet (i.e., ignore the table above). Using balance sheets (T-accounts), explain why you agree or disagree with the following statement: If the Balanced Budget Multiplier has a value of 1/2 (KBBM = 0.5) and the government makes a balanced budget expenditure of $600M to build a new highway, the money supply will grow by $300M. Suppose the “constant-price” Keynesian model can be used to describe the macro economy of Lexington. Further, the MPC in Lexington has a value of 0.6. In a single fully-labelled diagram, show the impact of the events in part c) above on the “goods/output market”. Now provide a single diagram of the money market to Show the impact on the rate of interest. Page 25 of 26 Question Six 6. The economy in the country of Cambridge is slowing down. The Central Bank intervenes with an appropriate change in monetary policy designed to adjust the rate of interest in order to increase GDP. a) In what direction does the Central Bank wish to move the rate of interest? Identify two ways that the Central Bank could implement an appropriate change in policy. (Do not describe these in detail; i.e., there is no need for balance sheets). b) Using the “variable-price model” with a positively-sloped short—run Aggregate Supply, show an original equilibrium (Point A) and then a new equilibrium after the monetary policy is implemented (Point B). c) Let’s move now to the “constant-price” Keynesian model. In a set of interrelated diagrams, show the usual impact of the monetary policy pursued by the Central Bank on the rate of interest and on the level of GDP. (1) Continuing with the “constant-price model”, let’s consider an unusual outcome of monetary policy: it does not have any impact at all. Using a single diagram of the “money market”, show how this result could occur. REMINDERS: Be sure that your name and student number are on the front cover of every answer booklet. Indicate on the front cover that you are in the Wolfson Section. Please indicate the questions you have answered on the front cover of the outside booklet. Be sure you have your name and student number on the Scantron sheet, and all MC answers are on the Scantron sheet. Page 26 of26 ...
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This note was uploaded on 03/25/2010 for the course ECONOM ECO100 taught by Professor Pesando during the Spring '09 term at University of Toronto.

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m08-part2 - III(8 points The Bank of Canada is concerned...

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