1. Suppose actual output is less than potential output for the Canadian economy.
a. Draw a diagram which includes the AD, SRAS and LRAS curves to illustrate this situation. Show the output gap – is it a recessionary or an inflationary gap? Both axis, the output gap and all curves must be clearly labelled.
b. Discuss 3 fiscal policy options available to the government to try moving the economy back to long-run macroeconomic equilibrium. Which of these policy options would be most effective in closing the output gap and why? Illustrate the effects of the appropriate fiscal policy on real GDP and the price level in your diagram. If you shift a curve, clearly show the direction of shift using an arrow.
c. Redraw your diagram from part (a). If the government did not intervene, explain and illustrate what would happen to real GDP and the price level in the long run.
d. Why might the government want to intervene rather than wait for the economy to self-correct? Discuss the role of downward-wage stickiness in your answer.
e. Discuss two disadvantages of the government intervening in the economy in an attempt to close the output gap?
2. Consider an economy where the government’s budget surplus has risen consistently over the past several years. Two economists disagree about the reasons for this happening. One argues that the rising budget surplus has resulted from the expanding economy; the other argues that it has resulted from of the government following contractionary fiscal policy. With no other information available, is it possible to tell which economist is right? What effect could the expanding economy and what effect could contractionary fiscal policy be having on the budget?
Part B – The Foreign Exchange Market
1. Canada is a net exporter of oil to the U.S., and as you know the world price of oil has fallen recently. Explain why the lower oil price has resulted in a depreciation of the Canadian dollar against the U.S. dollar. Given that the demand for Canadian oil from the U.S. continues to rise, wouldn’t we expect an increase in the demand for Canadian dollars, causing an appreciation of our dollar? (hint: consider the elasticity of demand for oil)
Draw a diagram of the foreign exchange market to illustrate why the Canadian dollar has depreciated in response to falling oil prices. Clearly label both axis and curves and for any shifts in curves, indicate the direction using an arrow.
2. Go to the Bank of Canada website to answer the following questions: http://www.bankofcanada.ca/en/rates/exchange.html
- On what date was the value of the Canadian dollar the LOWEST in terms of the US dollar? To four decimal places, how many Canadian dollars were needed to buy 1 US dollar on that date?
- On what date was the value of the Canadian dollar the HIGHEST in terms of the US dollar?
Part C – The Monetary System and Monetary Policy: Chapters 10 & 15
1. Suppose the Bank of Canada believes that the Canadian economy is currently producing beyond its potential level of output and responds with contractionary monetary policy. However, the Bank has underestimated the level of potential output and the economy is actually in long-run macroeconomic equilibrium
- Illustrate the short-run effects of the Bank’s policy in the money market (liquidity preference model) and in the output market (AD-AS model). Show what happens to the interest rate, real GDP and the price level. Has the Bank created an inflationary or a recessionary gap? Clearly label the gap in your diagram.
- What happens to the interest rate, real GDP and the price level in the long run i.e. how will the economy respond to the output gap created by the Bank in the long run? Illustrate the long-run effects of the contractionary monetary policy in the money market and in the output market. What is the only effect of the contractionary monetary policy in the long run?
2. The Bank of Canada announced on May 27th that it is keeping its target for the overnight rate at ¾ percent. Given this announcement, what does the Bank likely believe will happen to the inflation rate in the near future? Explain your answer. Given this target for the overnight rate, what interest rate is the Bank currently paying commercial banks on their deposits with the Bank? What interest rate is the Bank currently charging commercial banks for loans?