MGEA06 Midterm Answer Key

Winter 2017

Policy for Regrade

If you want to regrade your midterm, please follow the instructions below:
1) If there are addition errors, please inform Arif Toor, our course coordinator, or
Professor Au immediately.
2) Regrade will NOT be done for penciled answer.
3) Carefully compare your answer to the answer key. If you want have your exam
regrade, then you MUST SUBMIT A TYPED REQUEST for regrade.
4) The request for regrade must be in HARD COPY (electronic submission will NOT
be accepted). Your request must include the following information:
 Name & student number
 Date of submission
 The question(s) you asked for regrade plus DETAILED EXPLANATION WHY
YOU DESERVED A REGRADE.
 Your original exam
5) When you submit a request for regrade, please keep in mind the WHOLE EXAM
will be regarded and YOUR MARK MAY INCREASE, DECREASE, OR
REMAIN UNCHANGED after the regrade.
6) You will be informed about the result within 2 weeks after you have submitted your
request.
Deadline for submitting a request for regrade (strictly enforced): Friday, March 10,
2017, 12:00pm.

MGEA06 Midterm Solution – Winter 2017 Iris Au 1

Questions 1 – Question 2: An economy can be described by the circular-flow model, and the circular
flow diagram for this economy is shown below.

Question 1
What is the government budget balance? Be sure to show your work.

Budget balance = $150 – $20 – $200 = – $70

Government budget balance:
Deficit of $70 or – $70

__FALSE__ (True/False) The government finances all of its spending by raising taxes only.

Question 2
What are the total flows of funds into the households? Be sure to show your work.

Inflows of funds = $1000 + $20

= $1020
The total flows of funds into the households:
$1020

__TRUE__ (True/False) Consumption represents 70% of the country’s GDP.

MGEA06 Midterm Solution – Winter 2017 Iris Au 2

Question 3:
Classify each of the following items to the components – consumption (C), Investment (I), Government
spending (G), or Net Exports (NX) – of Gross Domestic Product (GDP). If the item is not included in
GDP, label it as not applicable (NA).

_NET EXPORTS_____ An exported dollhouse.

_CONSUMPTION____ A domestically manufactured personal computer.

_NOT APPLICABLE__ Babysitting paid for in cash and unreported.

_NOT APPLICABLE__ Canada Pension Plan Payments.

Question 4
Consider an economy that has three firms only: CAN Cotton Co., which grows the cotton needed for
the production of fabric; CAN Fabric Co., which produces various fabric used in clothing production;
and CAN Clothing Ltd., which produces clothing for consumption use. The following table
summarizes all the transactions carried by these firms. Complete the following table.
CAN Cotton Co. CAN Fabric Co. CAN Clothing Ltd.
Value of sales $15,000 $40,000 $100,000
Intermediate goods $0 $15,000 $40,000
Wages $6,000 $15,000 $35,000
Interest payments $1,000 $3,000 $6,000
Rent $3,000 $4,000 $3,000
Profit $5,000 $3,000 $16,000
Value added per firm $15,000 $25,000 $60,000

Question 5
Rayistan is a small nation that produces only one good, the gadget. The table shows production and
prices of gadgets for two consecutive years, as well as the population of Rayistan.
2010 (base year) 2011
Gadget production (units) 4,000 4,400
Gadget price ($) 500 600
Population 10,000 12,000

__DECREASE___ Has Rayistan's standard of living, as measured by real GDP per capita,
increased, decreased, or stayed the same? Be sure to show your work below.

$500 ×4000
RGDP per capita2010 = = $200
10000

$500 ×4400
RGDP per capita2011 = = = 183⅓
12000

MGEA06 Midterm Solution – Winter 2017 Iris Au 3

Question 6
Structural unemployment is caused by wage rigidities. Name two factors that contribute to wage
rigidities.

1) ____Minimum wages _______________________________________________________

2) ____Efficiency wages _______________________________________________________

3) ____Labour unions _________________________________________________________

4) ____Side effects of government policy such as EI _________________________

5) ____ Mismatch between employers and employees ________________________

Question 7
The following table summarizes the labour market statistics for a hypothetical economy.
Adult population Labour force Full time workers Part time workers Discouraged workers
185 million 125.8 million 93 million 13 million 4.3 million
Find the employment rate and the unemployment rate for this economy. Be sure to show your work
and rounded your answer to 2 decimal places if needed.

93 mill + 13 mill
Employment rate = × 100% = 57.30%
185 mill

125.8 mill - 106 mill

Unemployment rate= × 100% = 15.74%
125.8 mill

Employment rate (in % terms): Unemployment rate (in % terms):

57.30% 15.74%

Question 8
Determine whether each of the following statements is true or false.

__TRUE___ An employer can encourage its workers to work hard by paying an efficiency wage.

__TRUE___ People who actively looked for a job during the last 6 months, but not the last four
weeks are considered as not in the labour force.

__TRUE___ Individuals who are involuntarily working part-time are considered to be

underemployed.

__TRUE___ Jack volunteers 10 hours a week at his children’s school and does no other work. He
sends his resume to 10 potential employers daily. Jack is considered as unemployed.

MGEA06 Midterm Solution – Winter 2017 Iris Au 4

Question 9
Suppose a bank wishes to make a 5% rate of return on a one-year loan but expects the inflation over the
course of the loan will be 3%. Determine whether each of the following statements is true or false.

__FALSE__ As long as the bank charges a nominal interest rate of at least 5%, it will earn its
expected return.

__FALSE__ If the bank charges an interest rate of 8% or higher, this will guarantee it to earn the
expected return.

__FALSE__ If the bank charges 8% and the inflation rate is more than 3%, then the bank will have
earned a higher rate of return than expected.

Question 10
In 2000, an economy’s average income was $15,000. According to the rule of 70, in which year that
economy’s average income will increase to $240,000 if the average income is increasing at 4% per
annum? Be sure to show your work.

70
Rule of 70: # of years needed to double = = 17.5 years
4

For income  by 16 times  #of years = 17.5 years  4 = 70 years

Year for income to be $240,000 = 2000 + 70 = 2070

Year that average income increases to $240,000
2070

Question 11
Use the diagram below to answer Question 11.  The effect of an increase in the quality (as well
as quantity) of public health measures is most
likely demonstrated by the movement from

point ___B___ (A, B, or C) to point ___C___

(A, B, or C) on the diagram.
 The effect of excessive government intervention
that results in a decline in property rights over
time is most likely demonstrated by the

movement from point ___C___ (A, B, or C) to

point ___B___ (A, B, or C) on the diagram..

MGEA06 Midterm Solution – Winter 2017 Iris Au 5

Question 12
Suppose the per-worker production function is given as follow:
y = 6k1/3h2/3 where k = capital per worker, h = human capital per worker
If the economy has 27 units of capital per worker and 64 units of human capital per worker, find the
marginal products of physical and human capital (per worker). Be sure to show your work and round
your answer to 2 decimal places if necessary.

MPk = 2(27)-2/3(64)2/3 = 3.56

MPh = 4(27)1/3(64)-1/3 = 3
Marginal product of physical capital: Marginal product of human capital:
3.56 3

Question 13
Determine whether each of the following statements is true or false.

__FALSE__ Diminishing returns to physical capital suggest that physical capital increases lead to
drops in productivity when the amount of human capital per worker and the state of
technology are fixed.

__TRUE___ Some argue that the outdated infrastructure in Toronto would lower the city’s long-term
economic growth.

__FALSE__ Political and social instability would have no effect on the accumulation of capital.

Question 14
An investment project requires investor to incur a cost of $680 immediately. The investor also needs
pay another $240 and $170 in year 1 and year 2 respectively. The investment project will generate a
stream of revenues as follows: $500 in year 1, $425 in year 2, $350 in year 3. The project does not
have any residual value after year 3. Write down the stream of (net) cash flows of this investment
project in the table blow. Keep your answer to 2 decimal places if needed.

Now Year 1 Year 2 Year 3

– $680 $500 – $240 = $425 – $170 = $350

$260 $255

 If the current market interest rate is 6%, the net present value of this project is ___$86.10_____.

MGEA06 Midterm Solution – Winter 2017 Iris Au 6

Question 15 – Question 16: The market for loanable funds for a closed economy can be described by
the following equations:
Demand for loanable funds: DF = 150 – 75i
Supply of loanable funds: SF = 70 + 125i
where i = interest rate (interest rate is expressed in decimal form; i.e., if i = 0.1, then i is 10%)
The initial equilibrium levels of interest rate and investment are 0.4 (i.e., 40%) and 120 respectively.

Question 15
A recent study shows that there will be a slowdown of the future GDP growth. As a result,
autonomous investment changes by 10%. Find the change in the equilibrium level of investment. You
need to decide whether autonomous investment increases or decreases. Be sure to show your work and
rounded your answer to 3 decimal places if necessary.

New DF: D1F = 135 – 75i

Equilibrium: 70 + 125i = 135 – 75i

i* = 0.325 I* = 135 – 75(0.325) = 110.625
I* = 110.625 – 120 = – 9.375

Change in the equilibrium level of investment:

– 9.375 or  by 9.375

Question 16
Return to the initial equilibrium (i.e. skip Question 15). Suppose the government wants to lower the
equilibrium level of interest rate by half via a change in government budget balance. Find the change
in government budget balance that would achieve this goal. Be sure to show your work and rounded
your answer to 2 decimal places if necessary.

New i*: 0.4  0.5 = 0.2 (20%)

GBB: 150 – 75(0.2) = 70 + 125(0.2) + GBB

135 = 95 + GBB
GBB = 40

Change in government budget balance:

40 or  by 40

MGEA06 Midterm Solution – Winter 2017 Iris Au 7

Question 17
Determine the effects of each of the following events on the loanable funds market.
Shift in supply curve Equilibrium level of
(right, left, or no interest rate
shift) (, , or no change) Event
LEFT  An increase in government transfer payments to
households.
RIGHT  A fall in the stock market index.

Question 18 – Question 20: In this question, interest rate and prices are held fixed, and the economy
can be described by the income-expenditure model.
Consumption: C = 1100 + 0.6YD; where YD = disposable income
Planned investment: IPlanned = 300 – 500i, where i = 0.04 (i.e., 4% & it is held fixed)
Taxes: T = 280
Transfers: TR = 100
Government spending: G = 160

Question 18
Compute for the equilibrium level of national savings. Be sure to show your work and keep your
answer to 2 decimal places if necessary.

C = 1100 + 0.6(Y – 280 + 100) = 992 + 0.6Y

AEPlanned = (992 + 0.6Y) + (300 – 500  0.04) + 160

AEPlanned = 1432 + 0.6Y

Equilibrium: 1432 + 0.6Y = Y

Y* = 3580

SNational = 3580 – (992 + 0.6  3580) – 160 = 280

Output: National savings:

3580 280

MGEA06 Midterm Solution – Winter 2017 Iris Au 8

Question 19
The economy is initially in its equilibrium as shown in Question 18. Suppose there is a fall in
consumer confidence; as a result, autonomous consumption changes by 10%. You need to determine
whether autonomous consumption rises or falls.
 In the diagram to the left, show the effect of
AEPlanned AEPlanned = Y
this change in consumer confidence. Be sure
to identify the new equilibrium.
AE0Planned
 Immediately after the change in consumer
1
AE Planned confidence index, firms find their inventories

___RISES____ (rises/falls) unexpectedly.

 Immediately after the change in consumer

confidence index, the level of unplanned
45°
Y investment is equal to ____110____.
Y*,1 Y*,0

Question 20
(Continued from Question 19) Find the change in change equilibrium levels of output and national
savings.

1
Y* = AE0  M = – 110  = – 110  2.5 = – 275
1−0.6

New C = (1100 × 0.9) + 0.6(Y – 280 + 100) = 882 + 0.6Y

New AEPlanned: AE1Planned = 1322 + 0.6Y

Equilibrium: 1322 + 0.6Y = Y

Y* = 3305
Y* = 3305 – 3580 = – 275

S1National = 3305 – (882 + 0.6  3305) – 160 = 280

Y* = 280 – 280 = 0
Change in output: Change in national savings:
– 275 or  by 275 0 or no change

MGEA06 Midterm Solution – Winter 2017 Iris Au 9

Question 21
The economy has 10 people and consists of 3 types of people: A, B, and C. There are 3 people belongs
to type A, 3 people belongs to type B and 4 people belongs to type C. The following table shows how
their consumption varies as their current disposable income changes.
Rank the marginal propensity to consume for
Disposable income Disposable income
these 3 types of people from the largest to the
= $10,000 = $11,000
smallest.
Type A $7250 $7930
1) ____Type C___(MPC = 0.74)___
Type B $8000 $8580
2) ____Type A___(MPC = 0.68)___
Type C $7460 $8200
3) ____Type B___(MPC = 0.58)___
Find the aggregate marginal propensity to consume. Show your work and keep your answer to 3
decimal places if necessary.
($680 × 3) + ($580 × 3)+($740 ×4)
Aggregate MPC = = 0.674
$1000 × 10
Aggregate marginal propensity to consume:
0.674

Question 22
Determine the effect of the following events on autonomous consumption (AC) and/or autonomous
investment (AI). If the event has an impact on the autonomous term(s), indicate which term changes
and to the direction. If the event has no effect on AC and/or AI, put down not applicable (NA).
Autonomous Component
(AC, AI, or NA) Event
AC Households expect an increase in the minimum wage in the future.

NA An increase in income taxes paid by households

AI The reduction of a tax credit on investment.

AI A relatively high existing stock of physical capital.

Question 23
Determine whether each of the following statements about the AD curve is true or false.

__FALSE__ According to the wealth effect of a change in aggregate price level, when prices
decrease, the purchasing power of assets decreases and consumer spending decreases.

__FALSE__ According to the interest rate effect of a change in the aggregate price level, an increase
in the price level causes people to increase their money holdings, which decreases
interest rates and increases investment spending.

__FALSE__ Holding all else constant, when the American government imposes a 20% import tariff,
this will cause the aggregate demand for Canadian goods to shift to the right.

MGEA06 Midterm Solution – Winter 2017 Iris Au 10

Question 24 – Question 25: Consider a closed economy that can be described by the AD-AS model.
In addition, prices can adjust to a change in aggregate demand or aggregate supply.

Planned aggregate expenditure: AEPlanned = 820 – 2P + 0.8Y

W
Short-run aggregate supply (SRAS): P = (0.1Y + 90)   , where W = wage
 60 

Question 24
If the initial wage is 65, find the equilibrium levels of output and price. Be sure to show your work and
keep your answer to 2 decimal places if necessary.

AD: Y = 820 – 2P + 0.8Y

P = 410 – 0.1Y or Y = 4100 – 10P
65
Equilibrium: 410 – 0.1Y = (0.1Y + 90)( )
60
Y* = 1500 P* = 260
Output: Price:
1500 260

Question 25
The level of output found in Question 24 is the long-run level of output. Complete the following
sentence when the autonomous expenditure falls by 50. Be sure to show your work and keep your
answer to 2 decimal places if necessary.

New AD: Y = (820 – 50) – 2P + 0.8Y

P = 385 – 0.1Y or Y = 3850 – 10P
65
Equilibrium: 385 – 0.1Y = (0.1Y + 90)( )
60
Y* = 1380 P* = 385 – 0.1(1380) = 247
P = 247 – 260 = – 13
Y − YFE 1380 − 1500
Output gap = = = – 0.08
YFE 1500

This economy has a _RECESSIONARY_ (inflationary/recessionary) gap of ___8%___ (size

of the output gap in % terms). The change in the short-run equilibrium level of price is ___ – 13___.
This is the end of the exam.

MGEA06 Midterm Solution – Winter 2017 Iris Au 11