ECON 102 REVIEW SESSION
SPRING 2015 FINAL
BY BENJI HUANG
DON’T
YOU’LL
ASSUME
FAIL
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 30/31
Part 3 – Chapter 33
Part 4 – Chapter 34
Part 5 – Chapter 35
PART 1 – TERMS (BOLDED WORDS IN THE GBOOK/TEXTBOOK)
Know them ALL. Here are a few to practise:
Rational expectations:
People understand how the economy works and quickly learn from their mistakes so that
systematic errors in estimating future inflation doesn’t occur
Acceleration hypothesis:
Hypothesis that when actual GDP is held above potential, the persistent inflation gap will
cause inflation to accelerate
Dumping:
Selling a commodity at a lower price in the export market than in the domestic market for
reasons unrelated to the difference in cost of servicing the two markets
Efficiency wage:
Actual wages paid by employers tend to be higher than wage necessary to keep workers
NAIRU:
Abbreviation for non-accelerating inflation rate of unemployment
Lowest level of sustained unemployment consistent with a non-accelerating rate of inflation
Absolute advantage:
When one country can produce some commodity at lower absolute cost than another country
Learning by doing:
Reduction in unit cost that often results as workers learn through repeatedly performing the
same tasks; it causes a downward shift in the average cost curve
Exchange rate :
Number of units of domestic currency required to purchase one unit of foreign currency
Purchasing power parity:
The theory that over the long term, the exchange rate between two currencies adjusts to
reflect relative price levels
Managed float:
The central bank intervenes in the foreign-exchange market to smooth out some of the large,
short-term fluctuations in a country’s exchange rate, while allowing the market to determine
the exchange rate in the longer term
* the above definitions are adapted from from Macroeconomics, Thirteenth Canadian Edition by
Ragan and Lipsey
PART 2 – CHAPTER 30/31
1) What causes a change in money wages? Explain how the component causes interact to create in
a change.
Change in nominal wage = out-put gap effect + expectation effect. Out-put gap effect puts pressure
on wages to changes during the adjustment process following an AD/AS shock. For instance, when a
negative AS shock brings Y below Y*, U will exceed U*. Competition for jobs gives firms greater power
in setting wages. Wages decreases. Expectation effect results from people’s prediction of future
inflation. This expectation forms the basis of their wage negotiations. Since people almost always
expect inflation to exist, expectation effect puts upward pressure on wages. The direction and
magnitude of both effects combine to result in a net change to money wages.
2) How does the way people form their expectations about future inflation affect the speed of
recovering from a recessionary gap caused by a contractionary monetary policy?
When Bank of Canada implements a contractionary monetary policy (increasing interest rates to
discourage investment and export), Y falls below Y*. The adjustment process begins. The out-put gap
effect puts pressure on wages to decrease. However wage is especially sticky downward (slow to
decrease). One reason is because people tend to expect a positive inflation and will therefore bargain
for nominal wage increases. If people are forward looking (i.e. they understand macroeconomics
policies and their effects) they will know that inflation is bound to decrease judging from Bank of
Canada’s policies. They will be less resistant to nominal wage decreases. However if people are
backward looking (i.e. they form expectations based on what has happened in the previous years)
they will continue to expect high inflation and will thus be very reluctant to accept nominal wage
decreases. To the extent that people are backward looking, the adjustment process will be slow, and
the recessionary gap will take a long time to close.
3) Illustrate what condition(s) must be met in order to achieve constant inflation with a diagram.
Constant inflation means that the increase in price level from year to ear is constant. In order for this
to occur, two conditions must be met:
- Constant expectation
- Monetary validation
When inflation has been constant for some time, people will naturally expect future inflation to be
same. Employees will bargain for wage increases equal to expected inflation, and employers will
concede to the demand because if wage increases = expected inflation, real wage will still be the
same. AS curve shifts upward. However, the AS shift alone is not enough to fulfil the expected
inflation. Bank of Canada must also relax monetary supply to induce the AD curve to shift upward. The
result of both shifts will push the price level just high enough to be consistent with expectation.
4) Many people fear deflation because recessions have traditionally been associated with deflation.
Is this fear justified? Why or why not.
Not justified. Recession causes deflation, not the other way around. When there is substantial
deflation, the purchasing power of money will be much greater tomorrow than today. People might
postpone current consumption or investment, causing Y to decrease. However a steady and low
deflation will not provide enough incentive to induce a holding back of consumption.
5) If a government is keen on keeping Y above Y*, is this feasible in the short term? If so, how?
What are dangers of such an attempt in the longer term.
Yes, it is feasible, through continuous monetary validation. Suppose a positive AD shock shifts AD to
the right and Y is now above Y*. The inflationary gap puts pressure on wages to increase. AS curve will
then shift upward. Y will move left toward Y*. If the government wishes to keep Y above Y*, it would
validate the the shock by increasing the money supply to shift the AD curve upward at the same pace
as the AS curve. This keeps the equilibrium Y constant at a level above Y*. However the danger is
accelerated inflation. The out-put gap puts upward pressure on wages in addition to expected
inflation. Soon, the combined effect gets built into expectation. Though out-put gap effect will still be
the same the expectation effect will have grown. Inflations accelerates.
6) “Sustained inflation is everywhere and always a monetary phenomenon.” Evaluate this
statement.
Causes of sustained inflation is monetary:
(1) Inflation can be caused by a positive demand shock (demand inflation)
(2) Inflation can be caused by a negative supply shock (supply inflation)
(3) Unless Bank of Canada validates the shock, inflation lasts only until Y returns to Y*
The consequences of sustained inflation is also monetary:
(1) In the short run, demand inflation tends to be accompanied by Y>Y*
(2) In the short run, supply inflation tends to be accompanied by Y<Y*
(3) Unless Bank of Canada validates the shock, in the long run Y will return to Y*
7) Population and unemployment rate over the last three years have remained constant. However
employment rate has decreased by 5%. Use the gross flow of employment to illustrate what might
have happened.
In the absence of any change to the population, a reduction in the employment rate means a net
outflow of people from the employed bracket. Since unemployment rate remained unchanged, the
ratio of people in the unemployed bracket to the combined number of people in the employed plus
unemployed bracket must have remained constant. Therefore there must have also been a net
outflow of people from the unemployed bracket. In conclusion there must have been a net inflow into
the not-in-the-labour-force bracket. Put in another way, the labour force has shrunk.
8) Differentiate between the new classical theory and the new Keynesian theory in how the two
theories address unemployment in the labour market.
New classical theory assumes that the labour market always clears and that wages and prices are
perfectly flexible. As a result, there is never unemployment in the labour market. Anyone who isn’t
employed is by default unemployed voluntarily. In the short run, there is no output gap because AS
curves adjusts immediately to bring Y back to Y*.
New Keynesian theory on the other hand assumes that wages and prices adjust slowly and because of
this, the labour market doesn’t always clear. Involuntary unemployment occurs due to cyclical
unemployment as people who are willing to work at the going rate are not able to find work because
none is available. In the short run there is output gap because wages do not adjust fast enough to
bring Y back to Y*.
However both theories predicts that in the long run, Y* changes due to technology and preferences.
9) What are some of the causes that the new Keynesian theory puts forth to explain why wages do
not adjust instantly?
Employers and employees are engaged in a long-term employment relationship. Long term contracts
and benefits and smoothing out of pay reduce the responsiveness of wages to market signals
There is a high menu cost to switching wages constantly. In the short run, companies might respond
to changes in demand by scaling up or down production rather than changing prices/wages.
Firms often pay efficiency wages, meaning they pay more than the market price necessary to keep or
hire a worker. The belief is that by paying more, workers run a higher risk if they slack and get caught.
Union bargaining also limits the responsiveness of wages. In highly unionized labour markets, unions,
representing currently employed workers bargain for wages. Outsiders (unemployed people) gets left
out of the picture. They have no influence on the market wage rate.
10) It is predicted that in 10 years, the percentage of youth or women in the work force will
increase tremendously. How will this shift in the composition of the work force affect NAIRU?
If you don’t know, state your assumptions and answer based on your assumptions.
Young workers tend to try out different jobs before settling into one. They have a higher rate of
unemployment because (frictional unemployment). Women have a lower unemployment rate than
men. Thus a shift towards more women might lead to a reduction in unemployment rate. In
combination, the two forces will reduce the effect of each other. The net result depend on which one
of the two shifts is more prominent.
11) How can a government reduce unemployment?
Cyclical unemployment can be reduced if the government uses stabilization policies to keep Y at
potential.
Frictional unemployment can be reduced by reducing the safety net for unemployed workers. This
forces unemployed workers to search for jobs more aggressively. Or alternatively, make
administration of EI more selective to ensure that those who should be able to get back to work easily
don’t live off EI for too long.
Structural unemployment can be reduced by one of two ways: resisting change or assisting
adjustment. Resisting change by protecting declining industries is not a viable solution in the long run
and it drains the tax revenue. Assisting adjustment by subsidizing retraining, education or relocation
expenses, as well as increasing the ease of access to job postings will help reducing structural
unemployment in the long run.
PART 3 – CHAPTER 33
1) Explain the gains from trade assuming there are only two countries in the world: country A and
country B.
Gains from trade refers to the increased output attributable to the specialization according to
comparative advantage that is made possible by trade. When trade is not possible. Each country must
produce everything itself and be self-sufficient (a closed economy called autarky). However there
might be things that country A has a comparative advantage in producing. With trade, each country
can specialize in the commodities that they have a comparative advantage in. The result is an
increased total output that is greater than if each country produces everything by itself.
Assuming trade is possible between the two countries. The only two types of commodities are M
and N. Country A has a comparative advantage in M. Use a diagram to illustrate country A’s
production possibility boundaries (using a solid line) as well as its trade line (using a broken line).
M
N
2) How is it possible that with a greater volume of trade, a country’s comparative advantage in
producing a commodity might further increase over time.
As trade volume increases, a country increases the production of something that it already has a
comparative advantage in producing. As a result two things might happen. Production cost might
decrease as the scale of output increases – economies of scale (possible through finer division of
labour). As output increases, workers might accumulate experience which helps them become more
efficient at producing something – learning by doing. Both effects increase comparative advantage
even further.
3) Is it possible for a government to alter a country’s comparative advantage? If so, how?
Yes. Amongst the sources of comparative advantage: factor endowment (including climate), human
capital, and acquired comparative advantage, the last source can be altered through government
intervention. In particular, industries that depend more on human capital and technology can acquire
a comparative advantage over time. Government subsidy and strategic protection of infant industries
can help a certain industry develop a comparative advantage where there wasn’t one previously.
However it might not always work out because a government might not know the right way to go
about it and often a government has other agendas to follow that might conflict with its plan to
develop a comparative advantage in a certain industry.
4) Why is a concave production possibilities boundary more realistic than a straight one?
By allocating more and more resources to producing a certain commodity A, the country will
eventually run into diminishing marginal returns. Increasingly, more and more of another commodity
must be given up in order to achieve an additional unit of commodity A.
Given the context of a concave production possibilities boundary, how does a change in
international relative prices change the optimal bundle of commodities a country should produce.
Illustrate with a diagram.
A
B
The optimal bundle a country should produce is the point on its production possibilities boundary that
is tangent to the international relative price line. Producing at the optimal point and then trading
along the slope of the international relative price line results in the best possible combinations of
both products A and B. As the international relative price change, the slope of the line changes and
the point of tangency moves as well.
PART 4 – CHAPTER 34
1) How and when is it possible for a country to improve the terms of trade through protection?
Terms of trade is the ratio of the average price of a country’s exports to the average price of its
imports. Protection can change the price of imports when a country has market power in a
commodity and thus can influence the total demand of of that commodity significantly. For example,
if US imports 80% of Canada’s oil, it has a huge influence in the demand for Canadian oil. By setting a
tariff, the US can increase the price paid by domestic consumers on Canadian oil but also reduce the
price received by Canadian producers of oil (tax incident). The difference is tariff that goes to the US.
The reduction in the price received by Canada is therefore a terms-of-trade improvement for the US.
2) Maximizing national income is not always the political priority of a government. What are some
reasons to engage in trade protectionism that don’t involve maximizing national income?
Diversification might be important to small countries that don’t want their economy to be too reliant
on a single source of export. Diversification reduces the risk that changes in the world prices will
result in large swings in national income.
The wellbeing of specific groups within a country might be prioritized, so protection might be used to
increase the income of the protected groups. Protection can increase the demand for the protected
groups by increasing the relative cost of their foreign counterparts. Tariffs on imported low-skill
products effectively drive up the price of foreign low skill labour in the domestic market. As a result
domestic low skill workers can earn a higher income.
3) Why is the argument that protection creates domestic jobs (leading to an improved economy)
unjustified?
It is true that protection creates domestic jobs, especially in industries where the country has a
comparative disadvantage, more jobs will be destroyed elsewhere, especially in industries where the
country has a comparative advantage. For instance, a tariff can increase domestic demand for
domestically produced goods that aren’t as competitive as foreign products. However as domestic
import decreases, foreign countries will have less money to spend on domestic goods that are very
competitive internationally. The result goes against specialization and gains from trade is reduced.
The overall effect is a drop in living standards.
4) Explain why tariffs are more preferable for the importing country than quotas using a diagram.
P
Q
Both tariffs and quotas increase the domestic price and reduce the quantity imported. However in the
case of a quota, the increase in price (surplus) goes entirely to foreign exporters, whereas in the case
of a tariff, the increase in price (surplus) is collected as revenue for the domestic government.
5) What is countervailing duties and how can they be abused as a method of protection?
A government often justifies levying a duty on a foreign import that is suspected to have been heavily
subsidized by a foreign government. This is done to protect domestic producers from the effects of
foreign subsidies to create a more “level playing field”. However this is often abused because what
qualifies as “subsidy” is often very vague. It leaves significant room for a government to claim that
some sort of subsidy exists and immediate begins to levy duties when the true intention is really
protectionist. In addition, the idea of a level playing field is often very biased because domestic
subsidy to domestic producers is ignored when making decisions about levying countervailing duties
on subsidized imports.
6) how does trade diversion reduce the benefits that an importing country can gain from trade?
Trade diversion happens to the importing country when domestic consumers replace imports from
countries that are not members of a free-trade agreement (and thus are subject to tariffs) with
imports from countries that are members (and thus not subject to tariffs). If the pre-tariff prices of
non-members’ exports are actually lower than the tariff-free prices of members’ exports, the
importer is worse off as a whole because some of the tariff revenue is lost.
PART 5 – CHAPTER 35
1) If a country has a current account surplus, what can you conclude about the said country’s capital
account? Why? Explain as if you are explaining to someone who has no econ knowledge.
There must be a capital account deficit. Because the balance of trade must balance. For example if
country A imported $70 worth of goods but exported $100 worth of goods, then there is a current
account surplus. However, the foreign countries will not have enough domestic currencies to buy all
$100 worth of goods from country A. Foreigners are $30 short. Country A can either lend $30 to
foreigner through the purchase of foreign assets such as bonds/stocks, or the central bank can buy
foreign currencies (i.e. sell domestic currencies). Either way, there will be a capital account deficit.
Now in addition you know that the net change in investment abroad is less than the net change in
foreign investment in the said country. What can you conclude about the Official Financing
Account? What can you conclude about the Official Reserve?
Net change in investment abroad is capital outflow. Net change in foreign investment in the said
country is capital inflow. Thus we can conclude that the capital account excluding the official financing
account is also in a surplus. Thus the Official Financing Account must be in a deficit. In other words,
the central bank is drawing down its foreign currencies (reducing its Official Reserve) to finance the
surplus.
2) Given that the central bank doesn’t intervene in the foreign exchange market, how will a relative
increase in the domestic price of aluminum (a major export of a country) affect the said country’s
exchange rate?
The exchange rate is the number of units of domestic currency required to purchase one unit of
foreign currency. An increase in the relative price of domestic aluminum will reduce foreign countries’
purchase of aluminum (assuming the market for aluminum is price elastic), and will thus reduce
foreign countries’ demand for domestic currency. This leads to a depreciation in domestic currency
and the exchange rate increases.
3) How can the central bank influence the exchange rate using monetary policy?
Both an expansionary and a contractionary monetary policy will cause in a change to the interest rate.
A change in interest rate will then affect the foreign demand for domestic assets such as bonds. The
demand for domestic asset will affect the demand for domestic currency which will affect the
exchange rate. This is one of the steps in the monetary transmission process.
4) A country’s central bank believes that the market determined value of the domestic currency is
usually “correct” in the long run. However from time to time the central bank wishes to stabilize
the short run fluctuations. What type of system will the central bank use to achieve this goal.
Managed float.
5) Define mercantilism and explain why the concept of mercantilism no longer applies today in
analysing the foreign exchange market.
Mercantilism is a doctrine stating that a current account surplus is favourable and that a current
account deficit is unfavourable. The concept was developed at a time when nations (in Europe) were
more concerned about the political and military power of the states than the standards of living of the
people. A current account surplus means that the nation is exporting more than importing. The result
is an acclamation of assets (gold in the past). The stock of assets can then be used to strengthen the
military. However today, the objective shifted towards national income. The volume of trade is more
important, because trade allows specialization in areas where a country has a comparative advantage.
The products produced can be traded in the international market in return for a bigger bundle of
goods than was possible before. The state of the current account has no bearing on this objective.
6) What is the equation that can help to determine the current account balance. Use the equation
to illustrate what happens to the current account balance when the government reduces taxation.
CA = (S-I) + (T-G)
An reduction in taxation when all else is held constant will lead to an decrease in the current account
balance. To simplify, we assume that private saving is just enough satisfy private investment. (T-G) is
the government surplus or budget balance. If the government taxes less while spending is held
constant, less of the surplus will be able to find its way into purchase of foreign assets such as foreign
stocks or bonds (since we assume all domestic investments needs have already been satisfied by
private savings). This reduction in capital outflow will lead to an increase in the capital account
balance (more positive). A capital account increase must be balanced by a current account decrease.
7) Using the purchasing power parity concept explain how inflation can lead to an increase in
exchange rate.
eppp = Pc/Pe
Inflation means an increase in domestic price level. The purchasing power parity theory predicts that
in the long run the same basket of goods would be sold for the same price in all countries that
engages in trade. Thus an inflation must be accompanied by a depreciation of the domestic currency,
otherwise, the relative price of domestic goods would be too high. A depreciation in domestic
currency means an increase in exchange rate.
8) In an attempt to encourage export (a current account surplus), a country can choose to fix
exchange rates above that of the natural market equilibrium. How can this be done? Illustrate with
a diagram.
Pegging an exchange rate above that of the natural equilibrium means that the excess supply of
foreign currency must be soaked up by the government. In other words, artificial demand is created
for the foreign currency by the central bank.
What might be a danger of pegging the exchange rate?
Without its flexibility, the exchange rate can’t act as a shock absorber in the event of an AD or AS
shock. Normally AD or AS shocks will result in a change to the exchange rate that works against the
shock. Therefore when the exchange rate is fixed, GDP suffers from greater instability. Also, in a bid to
fix the exchange rate, the central bank must engage in the active purchase and sales of foreign
currencies using the domestic currency. This affects the domestic money supply which means the
government can’t have full control over the monetary policies.
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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.
Most of the questions above are designed by the author based on his past experience with Gateman’s exams, with the
notable exception of starred (*) questions which are taken with permission from professor Alfred Kong’s Econ 102 sample
exam. Starred questions are included by the author based on the judgement that they are reasonably similar to the types
of question that Gateman has asked before.
As always, knowledge comes first. Exam-taking finesse comes second.