W2008 - Solution to Test 3 - ECO209 - February 13, 2009

W2008 - Solution to Test 3 - ECO209 - February 13, 2009 -...

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Page 1 of 11 Department of Economics Prof. Gustavo Indart University of Toronto February 13, 2009 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. Aids allowed: a simple , non-programmable calculator. 3. Use pen instead of pencil . DO NOT WRITE IN THIS SPACE Part I 1. /10 2. /10 3. /10 4. /10 Part II /18 Part III /42 TOTAL /100 SOLUTIONS
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Page 2 of 11 PART I (40 marks) Instructions : Indicate whether each of the following statements is true, false or uncertain. Marks will be given entirely for your explanation. All questions are of equal weight. 1. Determine whether the following statement is true, false, or uncertain: “In a fixed-price, open economy with flexible exchange rates and imperfect capital mobility, an increase in government expenditure will lead to an increase in equilibrium income, a rise in the equilibrium rate of interest, a deterioration in the current account, and an improvement in the capital account.” (Show your answer with the help of a diagram and explain the economics.) True Initially the economy is in equilibrium at point A, i.e., initially the goods market, the money market, and the external sector are all in equilibrium at point A. An increase in G causes the IS curve to shift to the right (to IS’ in the diagram below). At point A now the money market and the external sector are in equilibrium, but there is an excess demand in the goods market. Therefore, Y will start to increase to eliminate this excess demand in the goods market. As Y increases, the demand for real balances also increases and the rate of interest rises to maintain equilibrium in the money market. In turn, the increase in the rate of interest causes an improvement in the balance of the capital account and the domestic currency starts to appreciate. The appreciation of the domestic currency causes NX to fall and thus the IS curve starts shifting back to the left. At the same time, the appreciation of the domestic currency (i.e., depreciation of the exchange rate) causes the BP curve to start shifting up (i.e., the deterioration of the current account has to be offset by an improvement of the capital account). This process continues as long as the excess demand in the goods market remains. A new equilibrium is eventually achieved at point B, where the excess demand in the goods market is eliminated and thus the goods market, the money market, and the external sector are all once again in equilibrium. The statement is thus true: 1) equilibrium income increases to Y 2 and the equilibrium rate of interest also increases to i 2 ; 2) the increase in the rate of interest improves the balance in the capital account; and 3) the initial improvement in the capital account causes the domestic currency to appreciate, and thus the balance in the
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W2008 - Solution to Test 3 - ECO209 - February 13, 2009 -...

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