Department of Economics Intermediate Macroeconomics I 2022 Winter Assignment 1. Due at 6:00 pm on February 11 2022 Total 2 pages with 7 questions Note: Students should show the step-by-step answers to the questions above. If only final answers were provided, no marks will be counted for the question. Question 1. (12 points, 3 points each) Table 1: Quantity Consumed and Price of Good Base Year Later Year Price of good A 100 200 Quantity of good A 100 200 Price of good B 100 100 Quantity of good B 100 100 In the table above, the citizens of country XYZ come to desire more of good A. As a result, the quantity and price of the good both rise. a. Compute nominal GDP in the base year and later year. (3 points) b. Compute real GDP in the base and later years (in base-year prices). (3 points) c. Compute the GDP deflator in the later year, using your answers to parts a and b. (3 points) d. Compute a fixed-weight price index (for example, CPI) for the later year, using the base-year quantities as weights. (3 points) Answer: a. Base-year nominal GDP = 20,000. Later-year nominal GDP = 50,000. b. Real GDP in base year = 20,000. Real GDP in later year = 30,000. c. GNP deflator in later year = 1.667. d. Fixed-weight index = 1.50. Question 2 (16 points, 4 points each). Assume that GDP (Y) is 5,000. Consumption (C) is given by the equation C = 1,000 + 0.3(Y – T). Investment (I) is given by the equation I = 1,500 – 50r, where r is the real interest rate in percent. Taxes (T) are 1,000 and government spending (G) is 1,500. a. What are the equilibrium values of C, I, and r? 1 b. c. d. What are the values of private saving, public saving, and national saving? Now assume there is a technological innovation that makes business want to invest more. It raises the investment equation to I = 2,000 – 50r. What are the new equilibrium values of C, I, and r? What are the new values of private saving, public saving, and national saving? Suppose a government moves to reduce a budget deficit. Question 3 (12 points). A. Using the long-run model of loanable funds market developed in Chapter 3, graphically illustrate the affect of reducing a government’s budget deficit by increasing (lump-sum) taxes on household income. In the question, we assume that saving does not depend on interest rates. Be sure to label: i. the axes ii. the curves iii. the initial equilibrium values iv. the direction curves shift v. the terminal equilibrium values. b. State in words what happens to: i. the real interest rate 2 ii. national saving iii. investment iv. consumption v. output. a. b. i. real interest rate decreases ii. national saving increases iii. investment increases iv. consumption decreases v. output is unchanged, fixed because it is determined by the factors of production Question 4 (10 points). Assume that the demand for real money balance (M/P) is M/P = 0.6Y-100i, where Y is national income and i is the nominal interest rate. The real interest rate r is fixed at 3 percent by the investment and saving functions. The expected inflation rate equals the rate of nominal money growth. If Y is 1,000, M is 100, and the growth rate of nominal money is 1 percent, what must i and P be? Question 5 (12 points, 6 points each). Consider a money demand function that takes the form (M/P)d = Y/(3i), where M is the quantity of money, P is the price level, Y is real output, and i is the nominal interest rate (measured in percentage points). a. What is the velocity of money if the nominal interest rate is constant? 3 b. How will the level of the velocity of money change if there is a permanent (one time) increase in the nominal interest rate, holding other factors constant? Explain your answer based on the relationship between money demand and the nominal interest rate. Answer: a. MV=PY, then V = PY/M = 3i b. A one-time increase in the nominal interest rate will increase velocity by reducing the demand for money. Money demand depends negatively on the nominal interest rate i, i is the opp. cost of holding money. An increase in the nominal interest rate represents the increase in the opportunity cost of holding money rather than bonds, and would motivate the typical consumer to hold less of his/her wealth in the form of money, and more in the form of bonds (or other interest-earning assets). Question 6 (18 points). An economy begins in long-run equilibrium, and then a change in government regulations allow banks to start paying interest on chequing accounts. Recall that the money stock is the sum of currency and demand deposits, including chequing accounts, so this regulatory change makes holding money more attractive. a. How does this change affect the demand for money (5 points)? b. What happens to the velocity of money (6 points)? c. If the central bank keeps the money supply constant, what will happen to output and prices in the short run and in the long run (7 points)? Answer: a. Interest-bearing checking accounts make holding money more attractive. This increases the demand for money. b. The increase in money demand is equivalent to a decrease in the velocity of money. Recall the quantity equation M/P = kY, where k = 1/V. For this equation to hold, an increase in real money balances for a given amount of output means that k must increase; that is, velocity falls. Because interest on checking accounts encourages people to hold money, dollars circulate less frequently. c. If the Bank of Canada keeps the money supply the same, the decrease in velocity shifts the aggregate demand curve downward, as in Figure 9–6. In the short run when prices are sticky, the economy moves from the initial equilibrium, point A, to the short-run equilibrium, point B. The drop in aggregate demand reduces the output of the economy below the natural rate. Over time, the low level of aggregate demand causes prices and wages to fall. As prices fall, output gradually rises until it reaches the natural-rate level of output at point C. 4 Question 7. (20 points) Using the models learned in class, graphically illustrate and explain the impact of the following policy and explain your answer. Suppose the Bank of Canada reduces the money supply by 5%. a. (6 points) What happens to the aggregate demand curves? b. (7 points) What happens to the level of output and the price level in the short run and in the long run? c. (7 points) What happens to the real interested rate in the short run and in the long run? Answer: 5 6 c. 7 8 ECON 2000 Intermediate Macroeconomics Midterm Exam Winter 2022 Short-answer questions Note: You should show your step-by-step answers to the questions below. If only final answers were provided, no marks will be counted for the question. Question 1. (9 points) Suppose City A has the following values in its labour market. Adult population = 50 million, the number of the unemployed = 2.5 million, and the number of the employed = 35 million. What are the values of the following indicators? a. (3 points) The labour force b. (3 points) The unemployment rate c. (3 points) The labour force participation rate Question 2. (6 points) The overall level of prices in an economy can be measured by either consumer price index (CPI) or the GDP deflator. What are the differences between these two indicators? Question 3 (11 points). Suppose an economy has the following Cobb-Douglas production function Y = AK a L1-a where α = 0.3, A represents the level of technology, K = the level capital and L = the level of labour. What are the shares of total income for the owners of capital (K) and the owners of labour (L)? What is the economic profit in the economy? Question 4 (21 points) Consider a competitive economy in which factor prices adjust to keep the factors of production fully employed and the interest rate adjusts to keep the supply and demand for goods and services in equilibrium. The economy can be described by the following set of equations: Production function: Y = AKa L(1 – a) Income: Y=C+I+G Consumption: C = C(Y – T) Investment: I = I(r) where Y is income, K is capital, L is Labour, C is consumption, I is investment, G is government spending, T is taxes paid, and r is interest rate. Now suppose the government increases government spending (G). a. (9 points) How does the increase in government spending, holding other factors constant, affect the level of public saving, private saving, and national saving? b. (12 points) Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of the increase in government spending. Be sure to label the axes, the curves, the initial equilibrium values, the direction curves shift, and the terminal equilibrium values. State in words what happens to (1) the real interest rate; (2) investment; (3) consumption; (4) Total output Page 1 Question 5. (16 points) Suppose a country has a money demand function (M/P)d = kY, where k is a constant parameter. The money supply grows by 12% per year, and real income grows by 4% per year. a. What is the average inflation rate? Explain. (5 points) b. How would inflation be different if real income growth were higher? Explain. (5 points) c. What is the velocity of money in the economy? Explain. (6 points) Question 6. (18 points) Suppose that an economy is initially in long-run equilibrium. Assume that the aggregate demand curve is Y = 3(M/P) and M = 2,000. The long-run aggregate supply curve is vertical at Y = 3,000 while the short-run aggregate supply curve is horizontal at P = 2.0. a. If M decreases to 1,000, what are the short-run values of P and Y? (4 points) b. Once the economy adjusts to long-run equilibrium at M = 1,000, what are P and Y? (4 points) c. Use a chart with curves of aggregate demand and aggregate supply (both short run and long-run aggregate supply curves) to show the impact of the increase of M on P and Y. (10 points) Question 7. (19 points). Answer the following two questions related to the 1970s oil shock (oil prices rose significnalty). Please illustrate and explain your answers by using figures with aggregate demand and supply curves. a. (10 points). Use aggregate demand and supply models to examine the impact of the 1970s oil shock on output and the price level in both the short run and the long run. b. (9 points). If the cenrtral bank used monetary policy to combat the effects of the oil shock, should the central bank increase or decrease money supply? Use aggregate demand and supply models to examine the impact of this stabilization policy on the price level and output. Page 2

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