ECON 102 REVIEW SESSION

SPRING 2015 MIDTERM 2 - SOLUTIONS BY BENJI HUANG

HOW TO PASS GATEMAN’S EXAMS:

Assume nothing! If you have to assume, state your assumptions clearly. WHEN YOU READ THE QUESTION: Don’t panic. Take a deep breath. Start by defining the question. WHEN YOU ARE STUCK: Move on! The test is long. Prioritize strengths. HOW WOULD I KNOW? I got 100% in his course last year :)

Did I get perfect on every single question? No. Did I do better than most other people? You bet.

TABLE OF CONTENTS

Part 1 – Terms Part 2 – Chapter 24/25 Part 3 – Chapter 26 Part 4 – Chapter 27 Part 5 – Chapter 28/29

DON’T ASSUME

YOU’LL FAIL

PART 1 – TERMS (BOLDED WORDS IN THE GBOOK) Know them ALL. Here are a few to practise: Automatic stabilizer:

elements of the tax-and-transfer system that reduces responsiveness of real GDP to changes in autonomous expenditure

Gross tuning:

the use of macroeconomic policy to stabilize the economy such that large deviation from potential output do not persist for extended periods of time

Human capital: the set of skills workers acquire through formal education and on-the-job training Law of diminishing marginal returns:

the hypothesis that if increasing quantities of a variable factor are applied to a given quantity of fixed factors, the marginal product of the variable fracture will eventually decrease

Embodied technological change: technical change that Ascension 6 to the particular capital goods in use Commercial bank:

a privately owned, profit-seeking institution that provides a variety of financial services, such as accepting deposits and making loans and other investments

Bank run:

situation in which many depositors rush to withdraw their money, possibly leading to a bank’s financial collapse

Present value:

the value now of one or more payments or receipts made in the future (discounted present value)

Classical Dichotomy:

classical belief that the money side of the economy is independent from the real side of the economy in the long run

Hysteresis: the hypothesis that the path of real GDP may influence the value of potential GDP * the above definitions are taken from Macroeconomics, Thirteenth Canadian Edition by Ragan and Lipsey

PART 2 – CHAPTER 24/25 1) After learning about the adjustment process, Tony reasons that following an AD or AS shock, actual GDP will eventually return to its potential level. He wonders if GDP always returns back to the level it was at before, how can economic growth possibly occur? Tony is confusing between the long run and the short run in the analysis of macroeconomics. Following an aggregate demand / aggregate supply shock in the short run, the adjustment process will bring actual GDP back towards potential GDP. In the short and medium run, the potential GDP stays constant. However potential GDP grows steadily in the long run, pulling the actual GDP along as actual GDP fluctuates around the potential GDP. 2) Sally wants to know how the Philips Curve reflects the second asymmetry of the aggregate supply curve. Explain to Sally using a diagram showing the Philips Curve in its original form. *Diagram was demonstrated during the review session and will not be reproduced here.

Philips curve is a function that relates unemployment rate to the rate of change in money wages. The curve is downward sloping but becomes flatter towards the right (towards higher unemployment) especially after the curve moves past the natural rate of unemployment and dips below the x-axis into the the negative range. In the portion of the curve above the x-axis where unemployment is below the natural rate (meaning actual GDP > potential GDP since factors of production are being “over-employed”), a small decrease in unemployment leads to a big increase in the rate of wage raise . However, in the portion of the curve below the y-axis (where corresponding GDP < potential GDP), the same increase in unemployment only leads to a much smaller increase in the rate of wage drop. This reflect the second AS curve asymmetry wherein factor prices change more rapidly upward (in response to an inflationary gap) than downward (in response to a recessionary gap). This has to do with the idea of wage stickiness: there is usually much greater resistance from employees when a company tries to cut wages in response to a downturn in business.

3) Peter was astonished to learn that even without government intervention, an economy in recession will fix itself back to its original state. Using the after-effect of a negative supply shock caused by an increase in oil prices to illustrate to Peter how he is only partially correct. Hint: why wouldn’t the economy be back to exactly the original state? Aggregate supply curve shifts left and up. Actual GDP falls below potential GDP, a recessionary gap opens and price level increases (inflation). During the recession, excess supply of labour eventually pushes wages downward which decreases input prices over time. Aggregate supply curve shifts down and right as GDP moves back towards potential GDP. In the new state of the economy following the adjustment process the price of gasoline is still higher than before however wages has dropped to compensate for the rising gas prices. 4) Wages are often slow to decrease following a negative supply shock. Without government intervention, what is another natural mechanism that might help to move GDP back to its potential level? The business cycle and businesses’ expectation for the future is a mechanism that can help increase aggregate expenditure and move aggregate demand function to close a recessionary gap. As an economy contracts business downturn results in a loss of confidence causing firms to cut back on production which leads to a further decrease in GDP. However businesses from experience have learned that recessions usually do not last forever. Furthermore capital replacement that were postponed during the recession has reached the limit beyond which businesses can no longer put off upgrading obsolete equipment and plant. The same analysis can be applied to households as well. The resulting increase in C and I sends a signal to businesses that the economy is entering recovery. With increased confidence, major investments take place as firms prepare for increases in demand for their products and services. This self-fulfilling prophecy shifts the aggregate demand curve right to close the recessionary gap. 5) The housing market is heating up in the city where Tom lives. From what he learned in Econ 102 Tom expects that the government will implement a contractionary fiscal policy soon to counter the possibility of an inflationary gap. Assuming that the housing bubble is not expected to persist for too long, explain why it is not likely that the government would intervene. There are practical limitations to discretionary fiscal policy. First, there is decision lags, which is the delay between recognizing there is an inflationary gap and creating the legislation to implement a fiscal policy. Second there is execution lag which is the time it takes before the legislation is enacted and when it is executed. Finally it takes time before the economy reacts to the fiscal policy. Thus by the time it comes into effect the housing bubble might have already dissipated. Further contraction forced by the policy will cause an overshoot and open up a recessionary gap.

6) Mary is very puzzled when the president advises the people to increase spending when the country is in a recession. Mary thinks that when the economy is down, it is best to save to protect against hard times to come. Explain to Mary why although saving might be a wise decision for one, it is not a wise decision for an entire country in recession. The concept has to do with the paradox of thrift. When people collectively reduce on spending, C decreases and AE shifts down causing the AD curve to shift left, worsening the recessionary gap. To aid with recovery, the president is trying to increase consumer confidence and persuade them to increase spending instead, hoping that the resulting rightward shift of the AD curve can at least help prevent the recession from getting worse. 7) Mary has understood your explanation above, but she becomes confused once again after reading a study showing how countries that embrace greater savings generate greater economic growth over time. Why does this study seem contradictory to what the president was trying to do to increase GDP during the recession? This is to do with the difference between short run and long-run. In the short run, increased consumption can temporarily increase aggregate expenditure and shift the aggregate demand curve right leading to increase in the actual GDP. However the adjustment process will eventually bring GDP back to the potential level. But in long run, reduced consumption will result in greater savings. With a greater availability of credit (loanable funds), businesses can borrow cheaply to invest in plant and equipment which over time brings economic growth and growth in potential GDP. 8) Explain the basic idea behind the accounting for GDP growth using the three components of GDP that we learned in Econ 102 and illustrate how each of the three components affect GDP in the short run or long run. GDP = F * Fe/F * GDP/Fe GDP = factor supply * factor utilization rate * productivity Factor supply is total supply of factors of production (capital, labour, land, etc). Growth in factor supply takes place in the long run. For instance capital growth results from accumulation of business investment in plants and equipment over time. Labour supply grows with immigration and better health and living standard (postponed retirement), which also takes a long time to take effect. Productivity improves in the long run with better education level and technological improvement to production processes. Factor supply and productivity determines changes in potential GDP. Factor utilization rate fluctuates in the short run due to AD and AS shocks. Note the denominator is the normal rate of utilization (for labour, it is normal rate of unemployment and for capital, it is the normal capacity utilization).

PART 3 – CHAPTER 26 1) Tally is a staunch supporter of economic growth (her father is a successful banker and her mother is in the show business). Down the street from her lives Jack who completely disagrees with Tally. He thinks that economic growth has done nothing good to his life (both his parents are recently laid off after their employers bought new machines to automate the assembly line in response to increased product demand). What are the arguments that Tally and Jack would most likely use if they were to debate with each other about the pros/cons of economic growth? Tally would point out that economic growth has led to a rise in the average standard of living. Both her parents are working in the service industry. In a developed countries, there is a shift towards consumption of services and her family has clearly benefited from this trend. Tally would probably also talk about how with higher income her family buys only organic and certified green products to help the environment. Jack on the other hand would argue that there is a social cost to economic growth. Both his parents fell victim to economic growth as their skills were rendered obsolete when the factory bought machines in a push for more efficient output. Tally would probably argue back by saying that the social benefits Jack’s family is getting is only possible due to economic growth. 2) Tally is deciding who to vote for in an upcoming presidential election. She has decided that long term economic growth is her first political priority. Explain to Tally using the long run model for interest rates what her ideal political candidate would advocate for? *Diagram was demonstrated during the review session and will not be reproduced here.

Long run interest rate and loanable funds are decided by the equilibrium in the market for loanable funds, which is the intersection between the investment demand curve and the national savings curve. Two movements of the curves can result in more funds being invested. Greater investment means faster capital accumulation and greater economic growth. One, the ideal candidate should promise to reduce G and create policies to incentivize greater savings (increasing tax). NS curve will shift right. Lower interest rate means business will borrow more. At the same time, the ideal candidate should promise to put into place government tax incentives (or subsidy) that encourages investment. The investment demand curve will shift right.

3) Sam wants to know the different effects of (a) labour-force growth without capital accumulation, (b) capital accumulation without labour-force growth, and (c) simultaneous growth in both labour-force and capital on the material standard of living of an economy? Material standard of living is GDP per capita. GDP per capita is increasing in almost every country in the world. The aggregate production function is expressed as the following: GDP = FT (N,K) where K is capital and N is labour combined with human capital. When N increases in the absence of changes in K due to growth in population, the law of diminishing marginal return kicks in. Successive addition of people into the work force generates less output per person. GDP per capita falls. When K changes in the absence of changes in N, total output increases and so does GDP per capita, however the rate of increase will slow down overtime due to the diminishing marginal return from capital. When both K and N increase at the same time, constant return to scale is observed and GDP per capita remains the same. 4) Betty keeps hearing Professor Gateman talking about “too many people.” Explain to Betty using the Solow model in the G-book why a decrease in population growth rate is favorable for increasing the material standard of living of a country. *Diagram was demonstrated during the review session and will not be reproduced here.

The function y=f(k) relates capital per worker (k) to output per worker (y). y, which is really just productivity, is thus directly related to GDP per capita. When k remains constant, y remains constant (in the absence of technological changes). This is a steady state equilibrium. However as capital depreciates over time and as new workers enter the workforce, new capital needs to be created. When savings equal required investment, k remains constant and thus y stays the same. This is a stable equilibrium. Required investment per capita is determined by population growth n and deprecation rate d. Required investment = (n+d)*K. Where the required investment per capita curve intersects with the savings per capita curve or sy, k is stable. However, a decrease in n means that that the (n+d)*K curve grows flatter and intersects with sy curve further to the right. The corresponding point in the y=f(k) curve shows that output per worker is now greater.

PART 4 – CHAPTER 27 1) What is milling, and why was it once a wide-spread practice? Was it able to cure all problems that could lead to the debasement of a coin currency in the past? If no, explain why not. Milling is minting coins with rough edges or fine grooves on the edges. It is meant to combat clipping (the practice of shaving bits off the edge of a coin). In the old days, coins had intrinsic value as a currency. The face value is a promise of the amount of a certain precious metal contained in the coin. Removing a bit off the coin will reduce the coin’s real value without changing its face value. The resulting coins are worth less than their face value promises – i.e. debasement. With milling, it becomes very easy to tell if a coin has been tempered with. However members of the royal family who minted the coins often melt in cheap metal to produce more coins than the number they collected from the people for the reminting process. This caused a debasement in the currency that milling can’t combat. 2) Using examples from your daily life, illustrate the three functions of money. Money as a medium of exchange: I want to buy a computer from a store and I am willing to offer my iPhone 6 in return. However the store doesn’t want my iPhone six. Instead I sell my iPhone on eBay in exchange for money which I than use to buy the laptop. Money acts as the medium of exchange. Money as a store of value: I worked a four hour shift at a local Café. My work has value and I need to be compensated. Instead of taking home a cart load of cakes which spoil easily, I take home a pay check which I then deposit. Money can store for a long time. Money as a unit of account: I won a prize of $20 which gives me the right to buy anything from a store and get $20 taken off the price I need to pay. 3) What are the major roles performed by Bank of Canada? Explain the significance of each role. Banker to commercial banks: the central bank accepts deposit and makes loans to commercial banks. Commercial banks often find themselves with extra cash than they need so central bank is the safest place to put it while earning an interest. Banker to the federal government: the government deposits tax money into its account with the central bank. The central bank also helps finance the government in times of need by buying newly issued government bonds. Regulator of money supply: the central bank is the only legal institution that can print currency, and by changing the amount of reserve it holds, the central bank can also affect the supply of money. Regulator and supporter of financial market: the central bank steps into prevent commerce banks from going under when they are strapped for cash even though their investment decisions are sound.

4) What are the three distinct types of commercial banks in Canada? Schedule I: Chartered Banks (pre-1980) Schedule II: Foreign banks’ subsidiaries in Canada and small Canadian banks. Schedule III: branches of foreign banks 5) Paul wants to know how the fractional reserve system adopted by commercial banks creates money. Explain, using terms learned in Econ 102, the process of money recreation following an inflow of $100 brought into Canada by a new immigrant. Fractional-reserve system is when commercial banks only keep a fraction of their deposits in cash or on deposit with the central bank. The rest is turned into loans. When the $100 is brought into Canada, its owner will likely deposit a portion into a commercial bank. The portion not deposited is termed cash drain, or c. Of the amount deposited into the 1st round bank, a fraction is kept as cash in the vault, or the reserve ratio, r. The rest becomes loans to a business. The business pays out the borrowed money to its employ who then takes some of his earnings to a 2nd round bank and the process repeats until all of the original $100 ends up as reserve held at some commercial bank. In the process the total increase in deposit money can be calculated by $100/(c+r). 6) Three economists disagree over their estimates of Canada’s total money supply but then quickly realized that they are using different definitions of money supply. Economist A, B and C, follow the M1, M2 and M2+ definitions respectively. Whose estimate is likely the largest, and whose is likely the smallest? All money supply is defined as currency in circulation plus bank deposits of some kind. M1 = currency in circulation + chequable deposits in chartered banks. M2 = M1 + non-chequable deposits in chartered banks. M2+ = M2 + deposits at other financial institutions Thus economist A likely has the smallest estimate and economist C likely has the largest. 7) Kelvin received a scholarship from UBC paid to him in the form of a cheque. While sitting through Professor Gateman’s lecture, Kelvin wonders if that cheque should be classified as near money or money substitute. Explain to Kelvin which classification is correct. Near money is a liquid asset without significant risk of a loss in value. Near money can’t act as a medium of exchange though they can store value in the short term. Money substitute serves as a medium of exchange but it doesn’t store value. A cheque is better categorized as money substitute because it is fine medium of exchange, but as a cheque doesn’t have value in and of itself, (note that cheque is very different from an IOU such as a bond).

PART 5 – CHAPTER 28/29 1) Jenny bought a Government of Canada Bond a face value of a $1000 five years ago at par. The bond has a maturity of 10 years and makes annual interest payments of $100 at the end of every year starting from the purchase date. Today, Jenny checks the bond listing and sees that the same bond is now selling at a yield of 6%. On the spur of the moment, she calls her broker to sell the bond immediately. Did she make a wise decision? Why or why not? What would have happened instead if she were to hold the bond until maturity? Jenny purchased the bond at par which means coupon rate = yield to maturity. The yield at purchase was thus 10% per year. An decrease in the market yield meant a rise in the present value of bonds that offered the relatively higher yield rate from 5 years ago. The selling price of Jenny’s bond would thus be above $1000. Her decision to sell resulted in a capital gain. In this sense, it was a good choice. If Jenny were to hold on to the bond until it matures, she would earned a yield of 10% per year over the period of 10 years without making a capital gain or a capital loss. Changes in the market yield doesn’t affect her at all in this case. 2) Jacob needs some help valuing a bond (i.e. determining the worth of bond). A private company started by his relative plans to issue a new 10-year bond very soon with a face value of $1000 and yearly coupon payments of $170. The company, called Tate Ltd is planning to sell the bond at par. Jacob knows little about the company but he is able to find out about another bond issued by the same company a while back and its current market price along with the pricing information for 2 types of Government of Canada Bonds as they are listed on a financial newspaper today: Issuer Coupon(%) Maturity Price Yield(%) Canada 5 in 3 yrs 973 6 Canada 16 in 10 yrs 1023 15 Tate 10 in 3 yrs 952 12 Are there good reasons for whether Jacob should or should not buy Tate Ltd’s soon to be issued bond? Jacob should not buy. The reasoning lies in the term structure of interest rates. Bonds with the all the same characteristics except a longer maturity is consider more risky and should thus promise a higher yield rate in return for the extra risk. If we compare Government of Canada bonds due in three years with Tate’s bond that is also due in three years we can clearly see that Tate’s bond’s YTM is 6% higher. If a Government of Canada Bond due in 10 yrs is selling at a yield of 15% we should at least expect to get a 21% YTM from Tate’s 10 year bond. However we can see this is clearly not the case as the new to be issued bond only promises a YTM of 17%.

3) Julia avidly reads the economics news. Since she started following Bank of Canada’s policy decisions she has become very confused (she didn’t take Econ 102 with Professor Gateman). Explain to Julia the main idea behind why Bank of Canada choses to control the interest rate instead of the money supply, and finally what Bank of Canada uses as a target to guide its decisions. Bank of Canada makes decisions about money policies based on the target inflation rate (as measured using core CPI) which the Bank strives to keep between 1 and 3 percent. In response to changes in inflation rates, the Bank will chose between a) no action, b) expansionary monetary policy, or c) contractionary monetary policy. In the latter two cases, the Bank needs to influence interest rate and money supply. In Canada, the central bank chooses to control the interest rate and accommodate resulting changes to money supply. It does so for three reasons. One, the Bank has complete control over the ONR. Two, this method works even if the bank has no clue about the slope and the position of the monetary demand curve. Three, an announcement about planned interest rate change is lot easier to understand to the public. To accommodate changes to money supply, the Bank utilizes a combination of open market operation, buyback operation, and shifting. 4) Bank of Canada wants to increase interest rate. Which type of monetary policy will the Bank consider? What will happen to the economy? Use a nicely labeled diagram to illustrate your answers. Assume that the economy was originally at its long run equilibrium (label that as A). Label the new equilibrium as B. *Diagram was demonstrated during the review session and will not be reproduced here.

P

Y The Bank is implementing a contractionary monetary policy. A higher interest rate deters investment. Investment decreases and causes AE function to shift down and the AD curve to shift left. Higher interest rate also increase the attractiveness of Canadian bonds less attractive. There will be a rush to buy Canadian dollars. This capital inflow will cause the Canadian dollar to appreciate which will hamper export since Canadian made goods are now relatively more expensive. A drop in net export shifts AD further to the left. The new equilibrium is established at a lower GDP and a lower price level.

Special question: if you can get this you are more than ready! 5) Bank of Canada has traditionally set a target inflation rate at 2%. What are the arguments for systematically targeting inflation rate? 1) High inflation is harmful to society because it erodes wealth (and assets) that are fixed in nominal terms. The people most effected are retires on pension income that isn’t sufficiently indexed to inflation. 2) High inflation is usually accompanied by high volatility. This volatility disrupts market signals. Producers will find it hard to tell whether a product’s high price is due to its demand or inflation. 3) The volatility will also lead to arbitrary distribution of income. For instance if the employer and employees of firm agrees on a 5% wage increase for the coming year and if the actual increase in price level is 10%, then the employees would be worse off while the employer would be better off. But that was purely because of chance. In addition, volatility also makes it difficult lend money because a big increase in price level will eat away the real return from the interests. During the 2009 worldwide recession, Bank of Canada took some drastic actions and for a period of time brought the ONR rate to near 0%. However the effects were mild. The economy did get a boost but not as much as many would have liked there to have been. Following the recession, some critics argued that the issue laid in the Bank’s low inflation target of just 2%. They suggested that the inflation target should be higher in order for monetary policies to be more effective in the future against recessions. Why? Nominal interest rate = real interest rate + inflation. By keeping inflation low, the Bank is effectively also keeping nominal interest rate low. This is the reason why ONR as well as other interest rates in Canada tend to be on the low side. Recall what the Bank does to counter a recession. It implements an expansionary policy and tries to desperately reduce interest rate to encourage investment in the private sector. However even with ONR near 0% and large scale open-market operation, interest rates in the market can only go down so little before they also hit 0%. However, if inflation was much higher to begin with. Nominal interest rate would have been much higher. Then during a recession, there are much greater rooms for the Bank to pull the interest rates down by. And since for businesses, the only thing that concerns their borrowing decisions is the nominal rate, the result would be a much great boost to investment and consumption in the private sector. The critics mentioned in the question therefore believe that higher inflation helps to bank to revitalize the economy during a recession. __________________________________________________________________________________ DISCLAIMERS: The above questions are only meant to help you solidify your Econ 102 understanding and to help you get a feel for the level of difficulty that you might be reasonably expected to encounter on an actual Gateman exam. However the real exam might take any format and might include: T/F, multiple choice, short answers, calculations, problems, articles, etc. As always, knowledge comes first. Exam-taking finesse comes second.