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2007W - Solution to Test 2 _ECO209_ - December 7, 2007

2007W - Solution to Test 2 _ECO209_ - December 7, 2007 -...

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Page 1 of 9 Department of Economics Prof. Gustavo Indart University of Toronto December 7, 2007 ECO 209Y MACROECONOMIC THEORY AND POLICY Term Test #2 LAST NAME FIRST NAME STUDENT NUMBER Circle the section of the course in which you are registered : L0101 L0301 L0401 M – 2-4 W – 2-4 R – 2-4 INSTRUCTIONS : 1. The total time for this test is 1 hour and 50 minutes. 2. This question booklet has 9 pages. 3. Answer all questions in the space provided on question sheet; if space is not sufficient, continue on the back of the previous page. 4. Aids allowed: a simple , non-programmable calculator. 5. Use pen instead of pencil . DO NOT WRITE IN THIS SPACE Part I 1. /12 2. /12 3. /12 4. /12 Part II /16 Part III /16 TOTAL /80 SOLUTION
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Page 2 of 9 PART I (48 marks) Instructions : Answer all questions. Each question is worth 12 marks. 1. Assuming perfect capital mobility and fixed exchange rates, explain the impact on the Canadian economy of an increase in the price level in the U.S. In your answer, clearly indicate the final effect on equilibrium income, equilibrium rate of interest, the balance in the current account, and the balance in the capital account. (Show your answer with help of an IS-LM-BP diagram and explain the economics.) Ceteris paribus, an increase in the American price level increases the real exchange rate, thus making Canadian goods relatively less expensive than American goods. Therefore, desired NX increases and an excess demand arises in the goods market (i.e., AE > Y). The increase in desired NX is shown in the diagram below by the shift of the IS curve to IS’. The actual increase in NX creates a surplus in the foreign exchange market, thus exerting downward pressure on the nominal exchange rate. To prevent a depreciation of the nominal exchange rate, the Bank of Canada buys foreign currency and thus the domestic supply of money increases and the LM curve starts shifting to the right. The increase in the supply of money causes the domestic rate of interest to fall below the international rate of interest, and thus an outflow of capital ensues. The increase in NX creates a situation of excess demand in the goods market and output will have to increase to restore equilibrium. Indeed, since AE > Y, firms start selling more than they are actually producing and their inventories start to fall, giving firms the signal that production should be adjusted upwards. As production increases, output and income start to increase, the real demand for money also starts to increase and the domestic rate of interest rises towards the equilibrium level (equal to the international rate of interest). This process continues until the excess demand in the goods market is completely eliminated, i.e., when the LM curve shifts all the way to LM’ as shown in the diagram below. The adjustment path is represented by a leftward movement along the BP curve (i.e., the money market is always in equilibrium and the intervention of the Bank of Canada in the exchange market ensures that the external sector remains always in equilibrium as well).
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