Question

Question 3 - 48 marks Answer the following true, false, or uncertain with an explanation motivating your answer (you may use graphs and math to support your answer). 1. Suppose that the central bank follows an inflation-targeting rule. Then monetary policy makes income more stable against demand shocks while it makes income more unstable against supply shocks. [8 marks] 2. Under capital budgeting, the federal government selling a highway to the province of Nova Scotia and using the proceeds to retire federal debt would affect the federal budget deficit. [8 marks] 3. If neither investment nor consumption depends on the interest rate, then the IS curve is vertical and monetary policy has no effect on output. [8 marks] 4. Regulators can solve the moral hazard problem of rescuing a financial firm (by the government) in the midst of a financial crisis if they allow firm’s equity holders be wiped out, but protect firm’s creditors. [8 marks] 5. The Bank of Canada has complete control over the size of the money supply in Canada. [8 marks] 6. Fiscal policy has a relatively long inside lag, but short outside lag. In contrast, monetary policy has a relatively short inside lag but long outside lag. This is an argument for passive policy. [8 marks]

Only Answer part 3, 4, 5, 6

Answer 1

3.  The IS curve represents the relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. That is, it describes the combinations of income and the interest rate that satisfy the equation Y = C(Y – T) + I(r)+G. If investment does not depend on the interest rate, then nothing in the IS equation depends on the interest rate; income must adjust to ensure that the quantity of goods produced, Y, equals the quantity of goods demanded, C + I + G. Thus, the IS curve is vertical at this level.

4. True, the only way to solve the moral hazard problem is to bring in more regulation. Steps that needs to be taken to reduce the likelihood of failure must comprise of direct regulation from banks as to the rate of investment,rate of capital financial institutions must hold etc.

5. False, Bank of Canada does not have a complete control od money supply in Canada. The monetary policy of the government of Canada does not allow so.

6.False