ECO336Y

Solutions for Sample Questions

The following solutions will give you an idea of the level of detail your

answers would have to provide in order to get full marks. [In places, I have

added additional comments dealing with background issues.] Please read through

these carefully. If anything isn’t clear, have a word with me. More sample

questions to follow…

1a What is the second largest category on the expenditure side of

government? (2006 numbers) (1 point)

A Education

B Health

C Social welfare

D Debt servicing

Answer: B

1b The personal income tax accounted for what percentage of government

revenues in 2006? (1 point)

A 12

B 23

C 32

D 47

Answer: C

2. Please define Gross Domestic Product (GDP). [one sentence] (1 point)

Gross domestic product is defined as the total value of all goods and services

produced in the country in one year.

3. In Canada, what percentage of GDP is accounted for by government

spending, to the nearest one percent? (2006 numbers are fine here.) (2 points)

In Canada, government spending accounts for around 38 percent of GDP.

4. Please define the notion of a direct tax carefully, and give an

example. [two sentences] (2 points)

A direct tax is one that is paid by the individual on whom the tax is levied.

An example of such a tax would be the personal income tax.

5. Please explain clearly one problem with using government expenditures

as a percentage of GDP as a measure of the size of government. (Examples would

be useful here.) [three sentences] (3 points)

[This is relevant to the first assignment question.]

6. Please read the whole of the following question before answering: the

parts are related.

6a The federal government needs to raise money for the expansion of

Canada's university system. To do this, suppose it issues $60 million of

non-indexed debt in 2002 that matures in 2005. (In other words, the principal

has to be paid back in 2005.) If inflation turns out to be 2 percent in 2003

and 3 percent in 2004, what will the real value of the outstanding debt be by

the end of 2004 (measured in 2002 dollars)? (3 points)

The real value of outstanding debt is given by

60/((1.02)(1.03)) = $57.1 million at the end of 2004.

6b Suppose the government instead issued $60 million of debt that was

indexed to the rate of inflation. What will the real value of the outstanding

debt be by the end of 2004 (measured in 2002 dollars)? (2 points)

In this case, the real value of the outstanding debt would be $60 million by the

end of 2004. [Aside: by indexing, the government commits to paying back the

original $60 million, compensating investors exactly for any erosion in the

value of the debt principal due to inflation. In nominal terms, investors would

be paid back a sum

60(1.02)(1.03) = $63.04 million in 2002 dollars. Please have a word if you

don’t see why.]

6c Does the issuing of debt that is not indexed to the rate of inflation

create any adverse incentives for the government? Please explain. [two

sentences] (3 points)

6d Why do some governments issue debt denominated in real terms (i.e.

indexed to the rate of inflation)? Please explain carefully. (Hint: your

answer should mention the word "credibility".) [three sentences] (5 points)