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Assignment Package 2(Modules 6-11) Total Marks 29
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Assignment Package 2(Modules 6-11) Total Marks 29

Q1Which of the following is not true?

(a)Unemployment is at the natural rate when output equals potential output, and workers are working at normal intensity.

(b) The output gap is the percentage difference between actual and potential output:

Output gap = Ỹ = (Y-Y*)/Y*, Where Y* refers to potential output, and Y refers to actual output

(c)Okun’s Law states that the output gap falls by 2 percentage points when unemployment rises 1 point above the natural rate.

(d)If the natural rate of unemployment (U*) is 4% and U increases to 6%, then the output gap is= –5%


Q2 Please select the right statement(s)

(a)An increase in the real interest rate, r(ex-ante real interest rate= the nominal rate minus expected inflation), reduces aggregate expenditure, AE

(b)A higher real interest rate encourages saving and lower consumption, especially spending for durable goods.

(c)A higher real interest rate makes it more expensive to finance investment projects, reducing investment expenditure (expenditure on machines and equipment use in production) by corporations.

(d) All of the above

(e)Only ‘a’ and ‘b’ are correct










Q3 Which one of the following is not valid statement (Consult PowerPoints for module 6)








Real Interest rate








Text Box: Output, Y                                                                              AE

                                                 Y                Y*               Y’


Figure 6.1

The shift in AE(aggregate expenditure) to the right(as shown above) can be the result of

(a)A decrease in the real interest rate by the Central bank

(b)The advent of new technologies, which increase investment by the production units in these technologies

(c) Improvement in Consumers’confidence

(d)Cut in taxes

(e) Increase in government spending





Q4 Which of the following is(are) true

(a)Suppose the economy experiences (Positive) expenditureshock (as shown in the above figure 6.1). If, in response, the Central bank raises interest ratewith a view to stabilize output at Y*, it is called Countercyclical monetary policy (meant to offset expenditure shocks).

(b)When an autonomous component of Aggregate expenditure(C or I or G or Net exports) changes, equilibrium output (Y) will change. Normally, the change in output will be even larger than the initial change in Aggregate Expenditure (AE). This result for the change in Y to be greater than the initial change in Aggregate Demand is known as the multiplier effect.

(c)The Central bank will lower interest rate to offset the effect of negative expenditure shock (use the above figure 6.1 and imagine a downward shift in AE) on output.

(d)All of the above

(e) only ‘a’ and ‘b’ are correct














Q5Which of the following statement is not true(Consult PowerPoints for module 6, figure 12.19 and slides around this figure)






      Real Interest rate



                                                                                           Aggregate expenditure(AE)






                                                                  Output, Y

          Inflation rate            

                                                                                           Phillips Curve








       Output, Y

 (a)The interest rate chosen by the Central bank determines output in the economy through the AE curve (first figure above). The level of output relative to potential output(Y*) determines the inflation rate on the Phillips curve.

(b) Higher real rate will lower output and inflation. But the cost of lowering inflation is the resultant lower output and lower employment.

(c) If government cut taxes, or there is an increase in consumer confidence, there will be resulting expenditure shock, which will increase the inflation rate.

(d)If the Central government does not change the real interest rate, when adverse supply shock occurs (which means Phillips curve shift upward, figure 12.19), it is called accommodative monetary policy (permitting inflation above the expected level)

(e) An accommodative monetary policy is a decision by the central bank to adjust the interest rate to offset a supply shock and keep inflation constant.


Q6 Select the correct statement(s)

(a)In the long run, monetary policy cannot permanently change real variables (like Potential output Y*, long-run unemployment). Monetary policy can change only inflation and nominal variables. It is called monetary neutrality in the long run

(b)The neutral real interest rate (rn) is the real interest rate that makes output equal potential output, given the aggregate expenditure curve.

(c)Hysteresis is the time-based dependence, meaning that the short run path of a variable affects its long-run level.

(d) All of the above

(e)Only ‘a’ and ‘b’ are correct


Q7 The following statements are correct except

(a)An increase in asset prices(prices of equities, bonds, home equity) has the effect of shifting aggregate expenditure (AE) to the right

(b) Higher asset prices increase the values of collateral and net worth, so banks are more willing to lend.

(c)Credit Crunch (a sharp fall in banks’ lending) may result from (i) increased risk perceptions about payments defaults, and ( ii) bank capital requirement constraint.

(d)Monetary policy (change in the target interest) affect the economy immediately(without time lag).











Q8 Interpret the following transmission process, illustrating your answer by taking the opposite example of Federal funds rate (Bank of Canada’s target overnight rate) ↓  (3marks)



Q9 Liquidity trap refers to a situation

(a)When conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero.

(b)In a liquidity trap, bonds pay little or no interest (since the interest rate is near zero) , which makes them nearly equivalent to cash.

(c)if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates, since people will  like hold money (as people expect deflation)as an asset instead of buying bonds. This is shown in figure below

(d)All of the above

(e)only ‘a’ and ‘c’ are correct











Money Supply (Ms)

Nominal Interest rate



             0                                                                   Money Demand







M1  M1’   (Money Supply)

Figure 8.1

(See figure, 14.9 in the book)


Q10Fill in the blank.

Real interest rate, r,cannot fall below--------


Q11 Find the incorrect statement

(a) The Taylor rule is a monetary policy rule linking the level of the policy rate to deviations of inflation from its target and of output from its potential (the output gap).

(b)Under inflation targeting, a central bank sets a target for the inflation rate to be achieved over some period

(c)The target is usually specified as a target band, such as 0 to 2 percent

(d)Monetary policy does affect potential output or employment in the long run as well as in the short run.








Q12 Suppose the economy is thought to be 2 percent above potential (i.e., the output gap is 2 percent), when potential output grows 4 percent per year. Suppose the Fed is following the Taylor rule, with an inflation rate of 2 percent over the past year. The federal funds rate is currently 3 percent. The equilibrium real fed funds rate is 3 percent and the weights on the output gap and inflation gap are 0.5 each. The inflation target is 1 percent. Is the fed funds rate(Bank of Canada’s overnight rate) currently too high or too low? By how much? Show your work

(Hint, use the following formula

r = rn+ (output gap weight)Ỹ+ (Inflation gap weight) (π πT)

Current (equilibrium)Fund rate=rn

Ỹ=output gap

(π πT)=Inflation gap



Q12A benefit to policymakers of following rules rather than discretion is


they could employ a larger staff of economists.


they will contribute to the formation of an expectations trap.


they would not be able to pursue time-inconsistent policies.


they would gain flexibility in case the economy's structure changed.


Q13 Fill in the blank

--------------is a monetary policy that is adjusted at each point in time based on the judgment of the central bank



Q14 Fill in the blank

--------------problem arises, when a decision maker, especially a policy maker, prefers one policy in advance but a different one when the time to implement arrives. Knowing this, others will not find the commitment to the first policy credible.





Q15 which of the following action(s) the Central banks can use to control movements in exchange rates

(a)Interest-rate adjustments

(b)Foreign-exchange interventions

(c)Capital controls(through regulations that restrict capital inflows or outflows).

(d) All of the above


Q16 Write the matching pairs(See Module 11)(3 Marks)

(a)Adverse selection

(i)Harmonizing and strengthening  securities regulation in Canada through enhanced inter-provincial cooperation


(ii)Afinancial risk that arisesif borrowers use the loan irresponsibly after they have already obtained it.

(c)Canadian Securities Administrators (CSA)

(iii)Aprovision in a loan contract that restricts the actions of the borrower

(d)Moral hazard problem.


(iv)Borrowers who are the worst credit risks (with least stable income, for example) tend to seek out loans most actively. 

(e) Debt Overhang

(v)The institutions are forced to sell illiquid assets at prices below their true value.

(f)Liquidity crisis

(vi)Businesses and consumers facing plunge in their asset prices, may be unwilling to borrow even at low interest rate

(g)liquidity trap

(vii) When the net-worth of borrowers decline, they cut back spending in order to reduce their debt and rebuild assets      




Q17 Read the following article, and answer the following questions;  (3 marks)

(a)What is MBS?

An MBS is a bond whose payments are based on the payments of a collection of individual mortgages

(b)What are  Alt-A loans?

Alt-A loans are issued to borrowers that appear to have good credit, but these loans do not meet the definition of prime or conforming. Often Alt-A loans are issued to borrowers with limited or no income and asset verification.

(c)What is  Re-securitization?.

Re-securitization consist of two things;

  1. CDO’s – Collateralized Debt Obligations
  2. SIV’s – Structured Investment Vehicles


CDO’s are similar to MBS except that the assets are bonds or other assets.

Structured Investments Vehicles “SIV’s” are similar to CDO’s, the difference between the two is essentially in the type of debt they issue. The SIV’s are structures backed by pools of assets, such as MBS and CDO bonds. SIV’s issue short to medium-term debt rather than the longer-term debt of most CDO’s



Q18. Read the following articles and describe

(a) What is a ‘Credit Easing’ policy?

(b) What Credit-easing tools have been used in response to the current financial crisis?

For Credit Easing:

For Credit-easing tools






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