2007W - Solution to Test 3 _ECO209_ - March 14, 2008

2007W - Solution to Test 3 _ECO209_ - March 14, 2008 -...

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Page 1 of 10 Department of Economics Prof. Gustavo Indart University of Toronto March 14, 2007 ECO 209Y MACROECONOMIC THEORY AND POLICY Term Test #3 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 10 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. /10 2. /10 3. /10 4. /10 Part II /17 Part III /18 TOTAL /75 SOLUTION
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Page 2 of 10 PART I (40 marks) Instructions : Answer all questions. Each question is worth 10 marks. 1. “With nearly 80 per cent of Canadian exports dependent on the U.S. economy — and 90 per cent here in Ontario — it is hard to imagine that this country could escape a recession in the U.S.,” reads a recent editorial in The Toronto Star . Comment on this statement using the model developed in class that allows for gradual adjustments to the economy once a disturbance has taken place. Show your answer with help of the corresponding AD-AS diagram and explain the economics. In you answer you must address both the short-run and long-run economic impacts of this disturbance assuming that the economy is initially at full-employment. As the U.S. economy moves into a recession, then American aggregate expenditure might be falling — including their expenditure on imports from Canada. Therefore, Canadian NX would fall and Canada’s AD curve would shift down to AD’ in period 1 — i.e., at each price level the quantity demanded on goods and services would be lower. In the short-run, therefore, the Canadian economy would also move into a recession and output would fall to Y 1 and the price level would fall to P 1 in period 1. The adjustment on the supply side of the economy is as follows: 1) as P falls, the demand for labour also falls; 2) the supply of labour remains unchanged since workers do not observe the fall in P in period 1; 3) the level of employment drops as a result of the decrease in labour demand; and 4) the level of output also falls to Y 1 as N falls. Note that both W and P fall, but P falls faster than W and thus W/P rises (and thus firms demand a smaller quantity of labour). As P falls in period 1, workers and firms negotiate lower wages at all levels of N in period 2 — workers do not see the change in prices in the current period but become aware of these price changes in the following period. Therefore, unit labour costs fall and the AS curve shifts down to AS 2 given the assumption that firms set prices as a constant mark-up over unit labour costs. With no further changes in AD (i.e., assuming that the initial fall in NX is permanent), the equilibrium in period 2 is at a higher level of output (Y 2 ) and a lower price level (P
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2007W - Solution to Test 3 _ECO209_ - March 14, 2008 -...

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