Economic Growth and Aggregate Supply

1.
Draw the Solow growth model for a catch-up economy.
A catch-up economy will have a higher growth rate than an economy that is closer to the
biological growth rate. Economies that are closer to the biological growth rate will not be able to move
much more than they already have, but a catch-up economy has more room to move.
2.
Does the Solow growth model predict that the real GDP of an economy will eventually stop
growing? Explain your answer.
Yes and no because eventually the economy can only grow up to its biological growth rate; anything
more than that will eventually go back to this point because that means that the savings are less than
depreciation. But with new technology the PPC shifts outward, increasing production, and increasing our
savings, and therefore our growth rate increases and the biological growth rate shifts right.
3.
Use either the Production Possibilities Curve or the Solow growth model to explain how an
economy can grow over time.

4.
Use the Solow Growth Model to explain the effects of an increase in the average propensity to
save.

5
Show how a change in technology affects the steady state in the Solow model. Explain the
adjustment process.

6.

Explain how the Aggregate Supply curve and the Production Possibilities Boundary are related.

The maximum potential output (aggregate supply) is the Production possibilities curve for the economy.
Aggregate Demand
1.
Investment spending includes the production or purchase of capital goods. List the variables that
affect investment and indicate whether an increase in each variable causes investment to rise or fall.
Ig=f(tech, L, T, K, Pe, Ye, We, i, )
+ + + 2.

+ -

- +

What are the determinants of desired consumption spending?

C=f(Y, Tx, W, i, P, Ye, Txe, Pe)

+ - + ? - + 3.
Explain why the Keynesian consumption function may not be utility maximizing.
It is not utility maximizing because consumption will fluctuate from week to week with this model.

4.
Show how an unexpected increase in income affects consumption differently in each of the
Modigliani and Friedman models.

5.
What is the fundamental difference between the Keynesian, Life-Cycle and Permanent Income
models of consumption?
The difference between the three theories is the size of the marginal propensity to consume. Keynes
theory says that it is quite large, Life-cycle suggests that the mpc is smaller and the permanent theory
suggests that the mpc may be negligible for transitory or temporary changes in income.
6.
What would happen to desired investment spending if the rate of depreciation increased? Explain.
NOT DONE!
The desired investment spending would decrease. This is because the cost of the investment is basically
increasing due to increased rate of depreciation, which means firms will not spend as much.
7.

What are the major determinants of net exports?

Foreign Income
Domestic Prices
Foreign Prices
Exchange rates
Tariffs and other trade barriers
8.

State and explain the three reasons that the Aggregate Demand curve is downward sloping.

Real wealth effect, real balance effect and the terms of trade effect. . As the price level increases,
aggregate spending decreases which is why the AD curve is downwards sloping.
9.
With the use of an AS-AD diagram, illustrate the effect of a US recession on the Canadian
unemployment rate.

MONEY AND BANKING

1.

State and explain the three uses of money

A medium of exchange
A store of value
A standard unit of account
2.

What are the 6 characteristics that a commodity must possess to function as money?

Easily standardized
Distinguishable
Generally accepted
Divisible
Durable
Portable

3.
Use an example to clearly demonstrate that you understand the difference between brassage and
seignorage.
Brassage is the fee charged to mint coins. Example: It takes 1 cent to print a $20 bill.
Seignorage is government revenue. It is the difference between producing fiat money and its declared
value. Example: Printing a $20 bill will give the government income of $19.99.
4.
Use an example to illustrate Greshams Law.
Bad money drives out good money. When the government over values one type of money and
undervalues another, the undervalued money will leave the country or disappear from circulation into
hoards, while the overvalued money will flood into circulation.
5.
Derive the transaction demand for money from the Quantity Theory of Money.
M = 1/V * PY or

M^d = kPY

6.
How does the Cambridge Approach differ from the Quantity Theory of Money? Which predicts
the more elastic demand for money?
7.
What is a liquidity trap?
When government injects money into the private banking system, but is unable to lower interest rates.
This is due to people hoarding cash fearing adverse economical effects in the future.
8.
What are the major functions of the Bank of Canada?
Monetary policy, financial system management, currency issuance, funds management.
9.
Show how a $100 increase in the monetary base affects the money supply if the target reserve
ratio is 10%.
$100 x 1/10%=$1000 increase in money supply.
10.
Explain the shape of the money supply curve in Canada, and why it is that way.

EXCHANGE RATES
1.
Show the relationship between the circular flow and the determination of the exchange rate.

2.
Indicate the variables that influence the exchange rate and state in which direction they change the
exchange rate.

3.

Show that you understand the Interest Rate Parity Theorem.

The interest rate should be the same internationally speaking, after taking exchange rate into account.
Example: If the Canadian interest rate is 11% and the exchange rate is 1.1 CDN for 1 USD, then the US
interest rate should be 10%.
4.
Show that you understand the Purchasing Power Parity Theorem.
The price of the products should be the same internationally speaking, after taking the exchange rate into
account. Example: If the Canadian price is $11 and the exchange rate is 1.1 CDN for 1 USD, then the US
price should be $10.
5.
Explain what happens to a fixed exchange rate when a country runs out of foreign reserves.
The home currency will be forced to depreciate against foreign currency. The reason why they run out of
foreign reserves is because the demand for foreign currency is much greater than supply, which indicates
that the home currency is too expensive.
FISCAL AND MONETARY POLICY
1.

Use a circular flow diagram to illustrate the multiplier effect as it pertains to fiscal policy.

2.
In theory, why does a $100 million increase in government spending have a greater stimulative
effect than a $100 million tax cut?
There is a money multiplier, which increases the quantity of money supply when government injects
money into the economy. The tax cut does not have that multiplier effect and therefore will always be less
effective.
3.
Use an AS-AD model to show the effect of expansionary fiscal policy.

4.

Show how an increase in the governments budget deficit may crowd out private spending.

5.
Why would have Keynes suggested to President Roosevelt that he fund the construction of
pyramids in the US during the depression?
By increasing government spending there will be more people employed and people will have increased
disposable income, which in turn will increase aggregate demand and thus revive economic growth.

6.
List all the conditions in the Keynesian monetary transmission that must be true for monetary
policy to be effective.

7.
How does a change in the Bank of Canadas target overnight rate influence the Aggregate Demand
Curve?

8.

Does monetary policy work better with flexible or fixed exchange rates. Explain your answer.

It works better with flexible exchange rate. In order to fix the exchange rate, the government must control
the money supply to make sure that the home currency is neither overvalued or undervalued against a
foreign currency. By doing this, the government loses the ability to freely inject money into the economy
to encourage growth. The flexible exchange rate will not have such a problem.
9.

List and explain 4 lags the exist when using fiscal policy.

Recognition lag - Before any policy action can be pursued, the existence of the actual problem must be
identified. It takes time to collect and analyze economic data.
Decision lag - Once government policy makers have identified the problem, they need to decide on a
suitable course of action, then pass whatever legislation, laws, or administrative rules are necessary.
Implementation lag - After a particular policy has been selected, steps then need to be taken to
implement the policy.
Impact lag - The time it takes any change initiated by a government policy to impact the producers and
consumers in the economy