Copenhagen Business School, Birthe Larsen, Exam in Macroeconomics, IB and IBP, Answers.

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1 Copenhagen Business School, Birthe Larsen, Exam in Macroeconomics, IB and IBP, Answers. 4hoursclosedbookexam. 18 March 201 Question A Regard the following model for a closed economy 1. E = C + I + G, 2. C = (Y T ),. Y = E, where Y is output and income, C is consumption, I is investments, G government spending, T is taxes, og E is planned expenditure. 1. Describe the model by explaining the equations and write which variables are exogenous and which are endogenous: The first equation gives planned expenditure equal to consumption, investment and government spending. It is an identity. The second equation is a behavioural equation, stating consumption depends positively on an autonomous part, 200, and disposible income, Y T, how affected consumption is, depends on the marginal propensity to consume, which is 0.5. The last equation is an equilibrium condition, giving that production=output is equal to planned expenditure. The exogenous variables are T, G and I, the endogenous variables are Y, C and E. 2. Assume that I = 100, T = 00, and G = 00. Derivetheplannedexpenditure curve and draw this together with the curve representing equilibrium into a diagram. Indicate the equlibrium: Insert equation 2 into equation 1: E = (Y 00) = Y. Then draw this curve, interception 450, and slope 0.5 into a Y,E diagram together with the 45 degree line representing equation. Figure 1. Find the value of income, planned expenditure and consumption. Insert the above curve for planned expenditure into equation : Y = Y, Y =2 450 = 900 Then planned expenditure is E = Y = 900 and C = (900 00) =

2 4. Let government spending, G, increasetog = 400. Calculate the new values of the endogenous variables. We now obtain Y = Y, Y =2 550 = 1100 Then planned expenditure is E = Y = 1100 and C = ( ) = Explan verbally how the increase in government spending affects the endogenous variables. Higher government spending increases planned expenditure, equation 1, which increases output, equation (equation ), then consumption increases (equation 2), Higher consumption increase planned expenditure again (equation 1) and then output again, equation 1, etc. The impact gets smaller and smaller in each round until then new equilibrium is reached. This is the multiplier effect inducing that the total impact on output is larger than the change in government spending. Question B Let the model from Question A change to become 1. E = C + I + G 2. C = (Y T ),. I = r, 4. Y = E, 5. (M/P ) d = Y 1000r, 6. M/P =(M/P) d, where Y is output and income, C is consumption, I is investments, G government spending, T is taxes, E is planned expenditure, (M/P ) d is money demand and M/P is money supply. Let T = G = 00, P =1and M = Derive the IS curve and the LM curve. The IS gives combinations of output and the interet rate, for which we have equilibrium in the goods market. The IS curve is derived by substituting equations 2 and into 1, and then equation 1into4,andsolvefortheinterestrateasafunctionofoutput: Y = (Y 00) r + 00, r = Y. The LM curve curve shows combinations of Y and r for which there is equilibrium in the money market. The LM curve is found from equation 5 and 6: 800/1 =Y 1000r, r =0.001Y Draw the IS curve and the LM curve into a diagram. Derive and indicate the equilibrium. Draw into a Y,r diagram. The equilibrium is Y = 0.001Y 0.8, 1.5 = Y, Y = 900 2

3 and the interest rate is r = =0.1. Suppose in this case that government spending increases to G = 400. Which curve is shifting? The IS curve is shifting outwards to: Y = (Y 00) r + 400, r = Y. The LM curve is not affected. The new equilibrium is found by inserting the new value for G and becomes: Y = 0.001Y 0.8, 1.45 = Y, Y = r = =0, Explan verbally how the increase in government spending affects the endogenous variables: Higher government spending increases planned expenditure, equation 1, which increases output, equation (equation 4), then consumption increases (equation 2), Higher consumption increase planned expenditure again (equation 1) and then output again, equation 1, etc. However, higher output also increases money demand, equation (5), which increases the interest rate, as the money supply is fixed. This reduces investments, equation (), which then reduces planned expenditure, equation (1) and therefore output, equation (4), This crowding out efffect modifies the increase in output. 5 Compare the result obtained in this question to the result obtained in Question A. Here the impact on output is smaller, as the higher income increases money demand and therefore the real interest (equation 5 and 6), therefore investment falls which reduces the effect on planned expenditure and output. Question C Consider a small open economy. 1. Which are the neccesary assumptions for a small economy to face a real interest rate which is equal to the world interest rate. The assumptions are 1) domestic and foreign bonds are perfect substitutes, 2) perfect capital mobility, if also ) the economy is small: it cannot affect the world interest rate, so it becomes exogenous for the small open economy. 2. Explain the impact of monetary policy in the short run for a small open economy with fixed exchange rates and perfect capital mobility: if the CB increases money supply, the result will be a tendency towards a reduction of the real interest rate, as now money supply is higher than demand. This will result in capital outflow and a lower demand for domestic currency and thereby the exchange rate will tend to fall. The CB therefore needs to intervene, reduce M again, in order to get the real interest rate and thereby the exchange rate back. Hence monetary policy cannot be used under fixed exchange rates and perfect capital mobility. A graph may be used to illustrate this.. Give some arguments for fixed exchange rate policy for a small open economy: it avoids uncertainty and volatility, making international transac-

4 tions easier. It disciplines monetary policy to prevent excessive money growth and hyperinflation. 4. Explain what needs to be the case for it being optimal for the small open economy to join a currency area, that is to give up its own currency: 1) Countries face symmetric shocks. And/or 2) Perfect labour mobility: labour migrate to where it is the most productive. Hence, higher labour market mobility reduces the stability costs and increases the efficiency gains from monetary union. ) Fiscal Transfers: If fiscal policy is independent, then policy can respond to asymmetric shocks. Fiscal federalism means there is a union-wide political structure that permits interstate transfers. The presence of fiscal transfers reduces the stability costs of joining a monetary union. 5. Read the attached article from the economist about the ECB and the currency area: the Euro-zone. Why is it written about the decision to keep the eurozone together At this point, that decision is looking less like heroism than sadism. The point is that the ECB does not want to conduct expansive monetary policy (as it is so focused on keeping the inflation rate low) which could reduce unemployment European economies. Open question, there may be different ways of answering this question. Question D Suppose the rate by which an unemployed worker obtains a job is f =0.27 and the rate by which an employed worker loses his or her job is s =0.0. Let the labour force be equal to L, consisting of both employed, Eand unemployed U, hencel = E + U. 1 Find the equilibrium unemployment rate U/L. In equilibrium inflows has to be equal to outflows, hence in equilibrium we have that the flow out of unemployment is equal to the flow into unemployment: f U = s E, f U = s (L U), U L = s s+f = =0.1, which corresponds to an unemployment rate of 10 percent. 2 Suppose the economy introduces more job centres and thereby improves the job finding rate to f = 0.7. Find the new equilibrium unemployment rate, U/L new and explain the change. The unemployment rate falls to U L = = hence 7.5 percent. This is the case as it becomes easier for aworkertofindajobandthereforeunemploymentfalls. Explain verbally why reduced firing costs may reduce equilibrium unemployment, using the model. Reduced firing costs will increase job separations, hence s increases. However, reduced firing costs may also increase the job finding rate as now firms become less reluctant towards hiring a worker, as if a recession arrives it becomes easier to fire the worker. Hence, if the positive impact on the job finding rate is higher than the positive impact on the separation rate, then unemployment may fall. 4

5 4 Explain the impact of unemployment insurance on equilibrium unemployment: Unemployment insurance, UI, pays part of the worker s former wages for alimitedtimeafterlosinghisorherjob. Unemploymentinsuranceincreases search unemployment as it reduces the opportunity cost of being unemployed and the urgency of finding a job. However, a potential benefit of Unemployment insurance is that it allows the worker to search more which may lead to better matches between worker and job (potentially higher productivity and income). 5 Explain why efficiency wages may increase unemployment: Theories in which higher wages increase productivity by a) attracting high quality of job applicants, b) increase worker effort c) reduce shirking, d) reducing turnover, e) improve health. This implies firms willingly pay above equilibrium wages to raise productivity, but the result is higher unemployment. A graph could be drawn to illustrate this. 5

Retake Exam in Macroeconomics, IB and IBP

Copenhagen Business School, Department of Economics, Birthe Larsen Question A Retake Exam in Macroeconomics, IB and IBP Answers 4hoursclosedbookexam 14th of August 2009 All questions, A,B,C and D are weighted