This paper is not to be removed from the Examination Halls UNIVERSITY OF LONDON

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1 ~~EC2065 ZB d0 This paper is not to be removed from the Examination Halls UNIVERSITY OF LONDON EC2065 ZB BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences, the Diplomas in Economics and Social Sciences and Access Route Macroeconomics Monday, 13 May 2013 : 2.30pm to 5.30pm Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from Section A (5 marks each) and THREE from Section B (20 marks each). Candidates are strongly advised to divide their time accordingly. If more questions are answered than requested, only the first answers attempted will be counted. PLEASE TURN OVER UL13/0032 Page 1 of 7

2 SECTION A Answer eight questions from this section (5 marks each). 1. The practice of paying efficiency wages can be a cause of classical unemployment. True or false? Briefly explain your answer. 2. The Solow growth model assumes a production function with decreasing returns to scale and constant marginal returns to capital. True or false? Briefly explain your answer. 3. If the demand for money does not depend on income then the LM curve is vertical. True or false? Briefly explain your answer. 4. In a closed economy, an increase in the government budget deficit must be matched by higher private saving, lower investment, or both. True or false? Briefly explain your answer. 5. If menu costs were the only cost of inflation then it would be best to have a zero rate of inflation. True or false? Briefly explain your answer. 6. A desirable feature of any theory of economic growth is that it predicts the ratio of the capital stock to output is stable in the long run. True or false? Briefly explain your answer. 7. If the central bank pays interest on reserves then this will reduce seigniorage revenues. True or false? Briefly explain your answer. 8. Uncovered interest parity predicts that domestic and foreign interest rates are always equal. True or false? Briefly explain your answer. 9. Action lags are generally shorter for monetary policy than for fiscal policy. True or false? Briefly explain your answer. 10. If there is conditional convergence between economies then there must be a negative relationship between a country s initial level of GDP per person and its subsequent growth rate of GDP per person once other factors have been controlled for. True or false? Briefly explain your answer. UL13/0032 Page 2 of 7

3 SECTION B Answer three questions from this section (20 marks each). 11. Consider an economy where nominal wages are fixed by long-term contracts and where workers would be willing to supply more labour at the prevailing wage. Prices are flexible and profitmaximizing competitive firms hire labour and produce output subject to a production function with diminishing marginal returns to labour. Write down the condition that determines firms demand for labour and show how the short-run aggregate supply (SRAS) curve is derived, explaining why this curve is upward sloping. Consider an economy where the central bank follows a policy of inflation targeting (interpret this to mean the central bank adjusts the money supply to keep the price level constant). Now suppose the economy is hit by a negative shock to confidence that reduces firms demand for investment (a reduction in autonomous investment demand). Use the AD/AS model to find the effects of the confidence shock on output and unemployment, and explain whether inflation targeting is a desirable monetary policy for an economy facing this type of shock. Consider again an economy where the central bank follows a policy of inflation targeting, but now suppose the economy is hit by a negative productivity shock instead (a reduction in the marginal product of labour at each level of employment). Find the effect of productivity shock on the SRAS curve and explain what happens to unemployment. Can you suggest a monetary policy that delivers a better outcome for unemployment following this shock than inflation targeting? 12. Consider the Fisher model of consumption choice (with two time periods representing the present and the future). An individual receives income Y 1 in the first period and income Y 2 in the second period, and can save or borrow at real interest rate r. The individual chooses a plan for current consumption C and future consumption C 2 to maximize utility. 1 Write down an equation for the individual s life-time budget constraint and interpret the equation. Draw a diagram illustrating how the optimal consumption plan is found and justify your answer. Consider an economy where the real interest rate falls. What is the effect of a lower interest rate on the life-time budget constraint in the diagram from part? Assuming an individual was initially a borrower, use the diagram to deduce whether the fall in interest rates increases or decreases the borrower s utility. Explain whether a borrower would ever find it rational to start saving when interest rates fall. In a newspaper report discussing the consequences of low interest rates, a woman is quoted as saying that she now needs to save even more for my retirement. Draw indifference curves to illustrate that the woman is not being irrational by saving more when interest rates fall. Explain your answer in terms of income and substitution effects and discuss whether all savers would be expected to behave in this way. UL13/0032 Page 3 of 7

4 13. Consider an open economy with fixed prices and wages, and perfect capital mobility. Goods-market equilibrium is where output Y is equal to the sum of consumption C, investment I, government spending G, and net exports NX. The consumption and investment functions are: C C0 c( Y T), I I 0 bi where i is the domestic interest rate. Government spending and taxes are exogenously fixed at G G 0 and T T0. Net exports are given by: NX NX 0 my ae where e is the nominal exchange rate (defined as the foreign currency price of domestic currency). Money-market equilibrium is represented by the equation: M s P M ky hi 0 s where M is the money supply, P is the price level, and the right-hand side of the equation is the demand for money. Given perfect capital mobility, the balance of payments is in equilibrium only if i i, where i is the foreign interest rate. In this question, assume that the central bank follows a flexible exchange rate policy. Suppose the central bank increases the money supply. Find the effects on the exchange rate and output. Now suppose that money-market equilibrium is represented by the following equation: s c M P M ky hi 0 c c where P is the consumer price level. The consumer price level P is an average of the price of domestically produced goods P (which is fixed) and the domestic-currency price P / e of foreign-produced goods. While P is fixed, any change in the exchange rate e will lead to a change in the domestic price at which imports are sold. Considering again the expansion of the money supply analysed in part, find the effect on output and compare the size of the effect to that found in part. Return to the original money-market equilibrium condition with P, but now suppose that capital mobility is imperfect. The capital account KA of the balance of payments is given by the equation: KA KA0 f ( i i ) where f is a positive constant. How does this change the BP curve representing balance-ofpayments equilibrium? Considering again the monetary expansion from part, find the effect on output and compare the size of the effect to that found in part. UL13/0032 Page 4 of 7

5 14. Consider the Solow model of economic growth in the case of no exogenous technological progress ( g 0 ). There is a production function Y F( K, L), where Y is output, K is the capital stock, and L is the labour force. The labour force grows at a constant rate n, the capital stock depreciates at a constant rate, and the saving rate is s. Let y Y / L and k K / L denote output per person and capital per person. The per-person production function is y f (k), and the dynamics of the capital stock per person are described by the equation: k sf ( k) ( n) k. Show how the steady-state stock of capital per person is found using a diagram, explaining what assumption is needed for the per-person production function f (k) to have a concave shape. Using the diagram, find the effects of a rise in the saving rate on steady-state capital per person and output per person. Consider an economy where both output Y and the capital stock K are measured in terms of the quantity of computers. Assume each worker requires a computer in order to produce any output (new computers), but cannot use more than one computer at the same time. Assume also that it takes two workers to produce one new computer. These assumptions mean that the per-person production function is f ( k) k / 2 if k lies between 0 and 1, and f ( k) 1/ 2 if k is larger than 1, as illustrated below: Assume that the population grows by 2.5% every year, while 10% of computers become obsolete every year (10% is the depreciation rate of the capital stock). Suppose that the saving rate is 40%. Find the steady-state capital stock per person and output per person. (Hint: start your analysis by adding the saving and depreciation lines to the diagram above.) Define the Golden-rule level of the capital stock. Now find the Golden-rule capital stock per person for the economy described in part, and say whether the saving rate of 40% is too low or too high to reach the Golden rule. Determine the saving rate needed to take the economy to the Golden-rule level of capital. UL13/0032 Page 5 of 7

6 d 15. Suppose the demand for money M is given by the equation M d L( Y, i) P where P is the price level and L ( Y, i) is an increasing function of real income Y and a decreasing function of the nominal interest rate i. Explain carefully why money demand should be negatively related to the nominal interest rate and what happens to the demand for money when the nominal interest rate falls to zero. Use your answer to derive the LM curve, illustrating the shape of the LM curve at a zero nominal interest rate. Now suppose there is a negative shock to demand (for example, a fall in autonomous consumption expenditure). Using the IS/LM model, show that if the nominal interest rate remains positive, an increase in the money supply can partially reverse the effect of the shock on output. If the nominal interest rate falls to zero, show what happens to the LM curve when the money supply is increased, and explain why the increase in the money supply may have no effect on output. In recent years, nominal interest rates have fallen close to zero in several countries. A number of economists have suggested monetary policies that would create higher expectations of future inflation as a way of getting out of the liquidity trap. Write down the Fisher equation that links the nominal and real interest rates and use this equation to explain why an increase in inflation expectations would raise output for an economy in a liquidity trap. Suppose the central bank proposes to raise inflation expectations by committing to a future monetary expansion if unemployment remains high. Use the AD/AS model to study the effects of this policy on the price level if the economy remains in the liquidity trap. Comment on the credibility of the policy in light of your answer. UL13/0032 Page 6 of 7

7 16. Answer each of the following questions. Consider a closed economy where consumption and investment are given by the Keynesian consumption and investment demand functions (so consumption depends positively on disposable income and investment depends negatively on the interest rate). Money demand is positively related to income and negatively related to the interest rate. Using the IS/LM model, find the effect of an increase in the price level on output and thus derive the aggregate demand (AD) curve. Suppose the government cuts taxes and finances this by issuing bonds. Using the IS/LM model with the Keynesian consumption function, find the effect of this tax cut on output. Now suppose that the Fisher model of consumption is assumed instead of the Keynesian consumption function. Briefly explain why Ricardian equivalence holds when using the Fisher model, and describe the effects of a tax cut (financed by issuing bonds) in this case. It is sometimes argued that there is a real balance effect of the price level on aggregate demand in addition to the effect found in part. The argument is that an increase in the price level reduces the real value of money, which decreases the real wealth of households and reduces their consumption demand accordingly. Households also hold government bonds, and the real value of these is also reduced when the price level increases. Explain whether you think we should expect a real balance effect of the price level on consumption because households hold government bonds in their portfolios. (Hint: think about whether government bonds are net wealth according to the Ricardian equivalence proposition.) END OF PAPER UL13/0032 Page 7 of 7