a05 - UNIVERSITY OF TORONTO Faculty of Arts and Science...

Info iconThis preview shows pages 1–10. Sign up to view the full content.

View Full Document Right Arrow Icon
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Background image of page 2
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Background image of page 4
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Background image of page 6
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Background image of page 8
Background image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Background image of page 10
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: UNIVERSITY OF TORONTO Faculty of Arts and Science AUGUST EXAMINATIONS 2005 EC0202Y1Y Macroeconomics, Theory and Policy Masoud Anjomshoa Exam Duration: 2:00 hours. Examination Aid: Only Regular Calculators. Using programmable calculators or calculators with capabilities of storing graphs, or texts are prohibited. All communication or recording devices in any form, including cellular phones, and cameras must be turned off, and kept out of reach during the exam. Instructions: 0 This exam consists of 6 questions in 10 pages including the cover page, and the Bank of Canada Monetary'Policy Report, as attachment. 0 It is crucial to write your name, Student number, and section on your booklets. 0 Answer all questions on the exam booklet. 0 Answers must be brief and to the point, for a successful time management. Good Luck. Sections: L0101 (Tu 1-4) L5101 (Tu 6-9) Page 1 oflO 1- Answer the following questions briefly. (Total 18 points) a)- Suppose a country has pegged exchange system, has 10% inflation. Assume the foreign country has 4% inflation rate. If this country wants to increase its competitive edge, by making its goods 3% cheaper than foreign goods, what exchange rate policy should it take, and how much? (Assume that the Marshal— Lerner condition holds.) (6 points) b)- Suppose in a country, when real exchange rate depreciates by 15% , the export increases by 10.5%, and import falls by 3.75%. Check if Marshal-Lerner condition holds. Do you recommend a policy, which leads to real depreciation in order to improve the trade balance of the country? Why? (6 points) c)- Consider an open economy, with flexible exchange rate regime, in its medium run equilibrium, where output is fixed, and money supply growth rate is 10% per year every year. What would be the changes of real and nominal interest rates, real and nominal investment, real and nominal exchange rates, inflation and expected inflation over time (Find values)? Why? (6 points) 2- Using the attached Bank of Canada Monetary Policy Report (MPR July 2005), answer following questions briefly. (Total 12 points) a)- Using one of the charts in the report, summarize the monetary policy status in Canada, and the US for years 2001—05, in ONLY three or four sentences. Mention how you figure it out. (4 points) b)— How much are these variables (only one word or one value)? Inflation rate target midpoint. Expected inflation rate. Bank of Canada assumptions for labor productivity growth rate and potential output growth rates. (2 points) c)- Based on the Bank predictions for second half of 2005 and 2006, how private consumption, investment, government spending, import, and export will change, and why? (Only M sentence per case). (6 points) 3— Suppose there is no money in the economy, and people only have bonds. One day the Central Bank buys $4000 bonds, and pays cash to the sellers. Suppose people keep 10% cash, and commercial banks keep 10% excess reserves. The Central Bank sets required reserves ratio at 20%. (Total 15 points) a)— Calculate the total deposits, required and excess reserves, loans, and cash? (10 points) b)- What would be the size of the high—powered money (money base) , and its components? (2 points) c)- What would be the total money supply, andits components. (2 points) d)- Calculate the size of money multiplier, using parts b and c (not any memorized formula). (1 point) Page 2 of 10 4- Suppose interest rate is 6% a year. Answer following questions. (Total 20 points, 4 points apiece) a)— What is the price of a perpetuity, which pays $2500 a year, starting 5 years from now. b)— What is the price of a 30 year annuity, which pays $800 a year, starting 4 years from now. c)— A project needs $30,000 initial investment. Then it will pay back $1,000 next year, which will be growing 2% a year, every year forever. Is this project profitable? d)- A retiree has two options to receive her retirement payments: (l)- An annuity due, which pays 20 payments of $35,000 a year. (2)- A lump sum payments of $400,000. Which option should she choose? e)- In part (d), which option should she choose, if interest rate goes up to 8%? Why? Present value of an N-year annuity, which Present value of a perpetuity, which pays pays A dollars a year, starting next year: A dollars a year, starting next year: 1 A 1—(1+i)N 'PVZT PV 2 A 1 5- Suppose Phillips Curve is given by m = ntc + 16% — 2 u, , where u is markup. We assume that mc = it“. The unemployment rate is initially equal to natural rate of unemployment, and inflation rate is m=10%. (Total 10 points) a)— Write the Phillips curve in standard form, and find the natural rate of unemployment, and NAIRU. b)- The authorities decide to decrease inflation to 2%, by keeping unemployment 2% above the natural level. How long should the authorities continue the policy? (Show your work.) c)- Now suppose half the people really believe that the authorities can implement the disinflation policy, and reduce the inflation to 2%, while half the people are not sure that the authorities can stick to the policy. How long should the authorities continue the policy to reduce inflation to 2%, in this case? d)— Now suppose everybody believes that the authorities can implement the disinflation policy, and reduce the inflation to 2%. How long should the authorities keep the policy to reduce inflation to 2%, in this case? Page 3 of 10 6- Consider an economy with the production function: Y= 4KO‘2 (AN)°‘8 (Total 25 points) Suppose, A, the productivity of labor (technological progress), rises at 4% per year, N, labor force grows at 1% a year, depreciation rate is 11%, and saving rate is 50%. a)- Derive the per effective worker production function. b)- Write the dynamic equation of capital accumulation (fundamental Solow equation) for this economy, in terms of per effective worker variables. c)- Draw a well-marked graph with all curves, which shows the steady state equilibrium of the economy. Calculate the steady state per effective worker capital, output and consumption. d)— What are the growth rates of per effective worker capital, and output in steady state? Why? e)— What are the growth rate of per worker capital, and output in steady state? Why? f)— What are the growth rates of total capital, and output in steady state? Why? g)- Find the golden rule per effective worker capital, per effective worker output, and saving rate. h)— Given the result of part (g) about the golden rule saving rate, to increase the welfare of this economy, do you suggest an increase in saving rate or decrease? Why? i)— Starting from part (c), suppose the saving rate increases. By drawing a new graph show how the steady state variables change. (Only a graph, and one sentence explanation) j)- While the economy in the steady state equilibrium, suppose because of a war in the neighboring country, refugees come and stay in this country. By drawing a new graph show how the steady state variables change. (Only a graph, and one sentence explanation) k)- Starting from part (c), suppose the technological growth rate increases. By drawing a new graph show how the steady state variables change. Are people better off? (Only a graph, and a few sentences of explanation) Page 4 of 10 BANK OF CANADA MONETARY POLICY REPORT UPDATE — July 2005 — This text is a commentary of the Governing Council of the Bank of Canada. It presents the Bank’s updated outlook based on information received up to 11 July 2005. Introduction The update on global and Canadian economic developments presented in this Report highlights three issues. First, the bal- ance of information on capacity pressures indicates that the Canadian economy is op- erating close to its production limits. Sec— ond, over the past several months, further progress has been made across sectors of the Canadian economy in adjusting to glo- bal developments. Third, while the risks to the outlook through 2006 appear balanced, the medium—term risks related to global im— balances are increasing. On the whole, the Bank's outlook for output and inflation in Canada through to the end of 2006 is little changed from the scenario outlined in the April Monetary Policy Report. V The global economy has been. unfold- ing broadly as expected, and prospects re— main favourable for growth of about 4 per cent this year and next. However, growth has been less balanced than expected across economic zones, with the momentum stronger in Asia but weaker in Europe. In Canada. strong growth in final do— mestic demand continues to offset the drag from net exports. The Bank's base—case projection calls for growth of real GDP to be 2.7 per cent in 2005 and to rise to 3.3 per cent in 2006. The Canadian economy is thus expected to remain near its production ca— pacity through the period, and inflation is projected to return to 2 per cent by the end of next year. Highlights The economy is operating close to its production capacity. The Bank’s outlook is little changed from the April Monetary P01icy Report, with growth projected to be 2.7 per cent in 2005 and 3.3 per cent in 2006. With the economy thus projected to continue to operate near its production capacity, inflation is expected to return to 2 per cent by the end of next year. In line with this outlook, some reduction of monetary stimulus will be required in the near term. Risks to the outlook through 2006 appear balanced. but over the medium term, risks related to global imbalances are increasing. Page 5 of 10 MONETARY POLICY REPORT UPDATE: JULY 2005 Chan 1 Target for the Overnight Rate and Target for the US. Federal Funds Rate Daily Target for the US. Target for federal funds rate 1 the overnight rate 200 l 2002 2003 To support aggregate demand, the Bank has held the target for the overnight rate unchanged at 2 1/2 per cent since October 2004 (Chart 1). However, in line with the Bank's outlook, some reduction in the amount of monetary stimulus will be required in the near term to keep aggregate demand and supply in balance and infla- tion on target. Risks to the outlook over the next four to six quarters relate primarily to the future path of oil and non—energy commodity prices, the pace of growth in China, and the ongoing adjustment of the Canadian econ- omy to global developments. These risks appear balanced. , _ Over the medium term, there is increas- ing risk that the correction of global current account imbalances could involve a period of weakness in world aggregate demand. Medium-term risks will be more fully addressed in the October Monetary Policy Report, when the Bank's projection horizon is extended to include 2007. Overview of Recent Economic and Financial Developments Canada's real GDP rose at an annual rate of 2.3 per cent in the first quarter of 2005, very close to the 2.5 per cent rate expected at the time of the April Report. However, at 5.8 per cent, the expansion of final domestic Chart 2 Contribution to Real GDP Growth Percentage points, quarterly at an annual rate Final domestic demand investment demand was stronger than anticipated in the April Report, while reductions in both net exports and inventory investment weighed more negatively on growth than expected (Chart 2). There is further evidence that the Cana- dian economy is continuing to adjust to global developments. The strong gains in final domestic demand generated further solid output growth in 'sectors with a low exposure to foreign competition. In con— trast, since the end of 2004, there has been a small reduction in the overall level of activity in non-commodity‘producing industries highly exposed to international competition. While production also declined in commodity—producing industries during the first quarter, this largely reflected tem- porary production disruptions at an oil sands facility, the impact of adverse weath— er conditions on oil and gas drilling, and reduced foreign demand for lumber. These industries staged a partial recovery in April. The results from the Bank's summer Business Outlook Survey also show that the Canadian economy is adjusting to global developments. For example, capital spend- ing is expected to increase particularly strongly in commodity-producing industries and in many areas of the services sector. The Survey also suggests that employment Page 6 of 10 MONETARY POLICY REPORT UPDATE: JULY 2005 growth will continue to be concentrated . . d d.t d . Chart} 1n SGI‘VICB an commo 1 Y‘Pro umng Conventional Estimate of the Output Gap and Response to industries Business Outlook Survey Question on Capacity Pressures Based on available information, it ap- Output gap" , . . Some or Significant pears that the Canadlan economy grew by (giflélcult3:*’ . e scae) about 2.3 per cent 1n the second quarter. fl. Current indicators suggest that final do- I mestic demand continued to rise solidly. Moreover, several developments point to the prospect of a pickup in the pace of ac— tivity in the second half of the year. A fur- illllliltiflliilillllflli 2001 2003 2004 2005 ther decrease in the rate of inventory ‘ Difference between actual output and estimated potential output based accumulation in the second quarter should 23532:“953322‘22231“; $3313;'12212'331251’219‘5.5321“. leave inventory levels and sales better ” (Paetrgzzgggfifszifims indicating that they would have either some or aligned. Momentum appears to be building significant difficulty meeting an unanticipated increase in demand/sales in capital spending, and employment growth has picked up. The Bank’s conventional estimate of supply in the second quarter of 2005 the output gap indicates that the economy (Chart 3). Based on its assessment of all was operating with a slight amount of excess indicators, it is the Governing Council's Pressures on Capacity The Bank’s conventional measure of potential output was revised down slightly from the estimate used in the April Report, reflecting the downward revision to Statistics Cana- da's estimates of real GDP over the period from 2002 to mid-2004. With GDP growth in the last three quarters of 2004 revised upwards, however, the level of real GDP at the end of 2004 was left unchanged. Consequently;the-Bank‘s conventional measure of the output gap suggests that the economy was operating at its capacity limits in the first quarter of 2005, instead of very slightly below its production capacity as projected in the last Report. With economic growth likely to have been 2.3 per cent in the second quarter, a slight amount of economic slack is expected to have emerged by mid-2005. Statistics Canada's measure of capacity utilization in the non-farm, goods—producing sectorl suggests greater pressure on production capacity than the Bank's conventional estimate of the output gap. ' ‘ Other indicators, however, point to less pressure. For instance, wage increases have remained quite moderate, and core inflation. on average, has been below 2 per cent since mid-2003. Similarly, the proportion of companies reporting labour shortages in the summer Busi— ness Outlook Survey remained lower than average, while the percentage of firms reporting dif- ficulties meeting an unanticipated increase in demand was slightly higher than average. Capacity constraints are felt most strongly in the construction and commodity—produc— ing sectors, as well as in transportation services. Evaluating the level and growth of potential output is complicated by the sectoral shifts associated with the adjustment of the Canadian economy to higher commodity prices and the appreciation of the Canadian dollar. 1. While that measure has been revised upwards. the revision chiefly reflected a change in Statistics Can— ada's methodology for estimating potential output in the oil and gas extraction industry. Page 7 of 10 MONETARY POLICY REPORT UPDATE: JULY 2005 Chart 4 Consumer Price Index Year-over-year percentage change Total CPI Target range Target midpoint Core CPI‘ l996 l997 I998 I999 2000 200i 2002 2003 2004 2005 * CPI excluding the eight most volatile components and the effect of changes in indirect taxes on the remaining components judgment that the economy was operating with slightly more excess supply at mid- year than the conventional measure suggests, but was still close to its capacity limits. (See box on page 3.) The 12—month rate of increase in the consumer price index has continued to exhibit considerable volatility, rising to 2.4 per cent in April and falling to 1.6 per cent in May (Chart 4). This is largely due to fluctuations in gasoline prices. In contrast, the core rate of inflation has remained relatively stable, fluctuating in a range between 1.6 and 1.9 per cent since the beginning of the year. Since late May, world oil prices have strengthened further. Current oil futures contracts indicate that the West Texas Inter— mediate (WTI) price of oil will average around US$60 per barrel over the projec- tion period. This scenario for oil prices is somewhat higher than that used in the last Report, especially for 2006. The External Environment On balance, the global economy has been unfolding largely as expected at the time of the April Report, with prospects for growth essentially unchanged at about 4 per cent in both 2005 and 2006. U.S. real GDP grew by 3.8 per cent at an— nual rates in the first quarter of 2005, in line with expectations. Monthly indicators for the second quarter point to solid growth in domestic demand. As a result, the base-case outlook for U.S. economic growth in 2005 is essentially the same as in the April Report, which called for robust growth in 2005. Output growth is projected to remain strong in the United States in 2006. The projection assumes a gradual slowing in household spending and a rise in net exports. Growth has been less balanced than an— ticipated across other economic zones, with momentum stronger than expected in Asia but weaker in Europe. In this regard, growth in China's real GDP has remained very strong, and the first-quarter rebound in Japan's real GDP was larger than expected. In contrast, in the euro area, evidence sug— gests slightly slower growth than that incorporated in the April Report. Financial Conditions The Canadian dollar has traded in a range of about 79 to 83 cents U.S. since the time of the April Report, as it has since the beginning of the year. However, with the U.S. dollar appreciating against other ma- jor currencies, the Canadian dollar has risen modestly on a trade—weighted basis. Yields on short-term government bonds in Canada have remained relatively stable since the April Report, while comparable yields in the United States have moved somewhat higher, reflecting actual and an- ticipated increases in the federal funds rate. Long-term government bond yields in both countries have fallen by between 20 and 30 basis points. This decline has been part of a global phenomenon, with longer—term yields in most industrial coun- tries at very low levels. While this may partly reflect several technical factors, the low yields would be consistent with strong desired global savings relative to business investment. Risk premiums on corporate bonds are also very low. Page 8 of 10 MONETARY POLICY REPORT UPDATE: JULY 2005 Domestic Economic Prospects In Canada, solid growth in final domes— tic demand is expected to continue to con— tribute importantly to economic activity over the remainder of this year and through 2006 (Table 1). Various factors sug— gest further substantial gains in business investment. These include the high rate of capacity utilization in a number of indus— tries, the global economic expansion and the associated relatively high level of com- modity prices, continued favourable finan— cial conditions, buoyant profit levels. and earlier reductions in the prices of imported machinery and equipment. ‘ Following a strong advancein the first quarter of 2005, consumer spending is expected to rise solidly over the projection period. This reflects further gains in real in— comes, the continued effects of past mone- tary stimulus, and a relatively high level of consumer confidence. In contrast, invest— ment in housing is expected to be little changed, on balance, over this period. The current outlook incorporates somewhat higher growth in government spending than in the April Report. Nevertheless, ex— penditures by all levels of government are still projected to rise broadly in line with revenues. as governments continue to strive to maintain fiscal balance. Ongoing solid global economic growth, particularly in the United States, is expected to boost the demand for Canadian exports, while imports will be bolstered by strong investment in machinery and equip- ment. The earlier appreciation of the Cana— dian dollar is expected to continue to dampen Canada's export growth and to stimulate imports, but this effect should lessen considerably next year. The negative contribution of net exports to real GDP growth appears to have peaked and is ex- pected to fall to zero in 2006 (Table 1). The Bank's base-case projection calls for economic growth, on an average annual basis, to be 2.7 per cent in 2005 and to rise to Table 1 Contributions to Annual Real GDP Growth1 Percentage points Consumption 1.9 2.2 1.8 (1.9) (2.0) (1.9) Housing 0.5 0.2 -0.2 (0.5) (0.1) (-0.1) Government 0.6 0.8 1.0 (0. 6) (0. 7) (0. 9) Business fixed 0.7 0.9 0.8 investment (0.7) ( .0) (0.8) 3 7 1 Subtotal: Final 4.1 3.4 domestic demand (3.. 7) (3.8) (3. 5) 19 . 1.4 2.2 (1.9) (0.9) (2.2) —2.7 -23 -2.2 (v2. 7) (-2.0) (-2. 4) Subtotal: Net exports -0.8 -l.4 0 (-0.8) (-1.!) (~02) 0 0 -0.1 (-0.1) (-0.1) 2 7 Exports Imports Inventories (0) GDP 2.9 . 3.3 (2.8) (2.6) (3.3) 1. Figures in parentheses are estimates used for the scenario in the April Report. 3.3 per cent in 2006. This outlook for both 2005 and 2006 is essentially the same as in the April Report. The Bank projects that real GDP growth will increase to about 3 per cent. on average, in the second half of 2005 and 3.4 per cent over the four quarters of 2006 (Chart 5, Ta- ble 2). Based on an assumed rate of growth of potential output of 3 per cent, this out- look implies that the economy will be oper— ating at capacity in the second half of 2006. Labour productivity in the first quarter of 2005 was up 1 per cent from its year-ear— lier level, following two years of surpris— ingly low growth. While the rebound is encouraging, productivity growth remains below the Bank's assumption for trend growth in productivity of 1 3/4 per cent. Page 9 of 10 MONETARY POLICY REPORT UPDATE: JULY 2005 Chan 5 Real Gross Domestic Product for Canada" Quancr—ovcr—quancr percentage change. [ at annual rates Year-ovcr-ycar L— pcrccnlagc change 2002 2003 2004 2006 ‘ Dashed line/bar denOIes projeclion. The Bank will continue to assess productiv- ity developments for indications of growth in potential output. The Outlook for Inflation The factors governing the outlook for inflation are the same as those described in the April Report. The core rate of inflation is expected to remain close to 1.7 per cent over the re- mainder of this year. With the economy projected to operate near its full production capacity, and with inflation expectations remaining well anchored. the core rate is projected to rise gradually to 2 per cent by the end of next year (Table 2). The outlook for the 12—month rate of in- crease in the total CPI will continue to be im— portantly affected by developments in the market for crude oil. Based on an average of recent oil—price futures, total CPI inflation is expected to move up to about 2.5 per cent in late 2005. By the end of 2006, total CPI in— flation is expected to have moved back down to the target rate of 2 per cent. Table 2 Projection Summary“ 2005 E Real GDP 2.3 2.7 3.3 .5 (quarter-over-quarter percentageChange) (2.5) (2.7) (3.3) (3.5) (3. Real CDP 2.6 2.4 2.6 3.1 . (year-over-year percentage change) (2. 4) {2.4) (2. 7) (3.1) Core inflation 1.6 1.7 1.7 1.8 (year~over~year percentage change) {1. 6) (1.7) (I. 7) (1.8) Total CPI 1.9 2.2 2. 2.5 (year-over-year percentage change) (2. l) (2.3) (2.3) (2.2) 53 6 (56‘) ‘ Figures in parentheses are from the April Monetary Policy Report. ” Assumption for the price of West Texas Intermediate crude oil (USS per barrel). based on an average of futures contracts over the two weeks ending 7 July 2005 Copies of the-Monetary Policy Report and the Update can be obtained by contacting the Bank at: Telephone: (613) 782-8248: email: publications@bankofcanadaca Website: http://www.bankofcanada.ca Page 10 of10 ...
View Full Document

This note was uploaded on 04/10/2010 for the course ECO ECO202 taught by Professor Masoudanjamshoa during the Spring '10 term at University of Toronto- Toronto.

Page1 / 10

a05 - UNIVERSITY OF TORONTO Faculty of Arts and Science...

This preview shows document pages 1 - 10. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online