This paper is not to be removed from the Examination Halls

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1 ~~EC2065 ZA 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 Wednesday, 7 May 2014 : 10:00 to 13:00 Candidates should answer ELEVEN of the following FOURTEEN questions: all 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 University of London 2014 Page 1 of 7 D1

2 SECTION A Answer all eight questions in this section (5 marks each). 1. In Tobin s theory of the speculative demand for money, money is held because it is a safe asset. True or false? Briefly explain your answer. 2. If the rate at which the unemployed find jobs decreases then frictional unemployment increases. True or false? Briefly explain your answer. 3. An increase in expected inflation increases the demand for (real) money balances, all else equal. True or false? Briefly explain your answer. 4. If an economy begins with a capital stock above that required for the Golden rule then the Golden-rule capital stock can be reached without a temporary sacrifice of consumption. True or false? Briefly explain your answer. 5. The nominal interest rate cannot be less than zero. True or false? Briefly explain your answer. 6. The Keynesian multiplier is larger when the marginal propensity to consume is lower. True or false? Briefly explain your answer. 7. Okun s law states that inflation rises when unemployment falls. True or false? Briefly explain your answer. 8. The Solow model of economic growth predicts that if one country has a lower capital stock (per worker) than another (but they are identical in all other respects such as saving, depreciation, and population growth rates) then it will grow more slowly than the other country during a transitional period. True or false? Briefly explain your answer. Page 2 of 7 Page 2 of 7

3 SECTION B Answer three questions from this section (20 marks each). 9. Consider a small open economy with fixed prices and wages. Goods-market equilibrium is where output Y is equal to the sum of consumption C, investment I, government spending G, and net exports N X. The consumption and investment functions are: C = C 0 +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 = T 0. 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 0 +ky hi where M s is the money supply, P is the price level, and the right-hand side of the equation is the demand for money. Balance-of-payments equilibrium is where the sum of the current account CA (assumed equal to net exports NX) and the capital account KA is zero. Capital mobility is imperfect, and capital flows are given by the equation: KA = KA 0 +f(i i ) where i is the foreign interest rate. (a) [6 marks] In the IS-LM-BP model, explain why the BP (balance of payments) curve is upward sloping when capital mobility is imperfect. What is the effect on the BP curve of an appreciation of the exchange rate? How would your answers differ in the case of perfect capital mobility? (b) [7 marks] Suppose that the domestic economy is increasingly perceived by foreign investors as a safe haven for their wealth. Foreign investors thus want to purchase more domestic assets, so all else equal, capital inflows rise (the term KA 0 increases). Assuming the economy has a flexible exchange rate, find the effects of these capital inflows on output, the current account, and national saving. (c) [7 marks] Find what difference a policy of fixing the exchange rate would make when faced with increased capital inflows. Suppose the central bank would like to stabilize output, avoiding both recessions and booms. What type of exchange-rate policy would you recommend? Justify your answer. Page 3 of 7 Page 3 of 7

4 10. Consider the Solow growth model. Suppose there are two economies, the North andthe South. The North hasasavingrateof10%(s = 0.1)andthe South hasa saving rate of 30% (s = 0.3). They are identical in all other respects. They have the same population and labour force L, no population growth (n = 0), no technological progress (g = 0), and a 10% depreciation rate (δ = 0.1). Both economies have the same production function Y = K 1/2 L 1/2, where Y is output and K is the capital stock. Let y = Y/L and k = K/L denote output per worker and capital per worker. The per-worker production function is y = k, and the dynamics of the capital stock per worker are described by the equation k = s k δk. (a) [6 marks] Show how the equation for k is derived. Suppose both North and South have reached their steady states ( k = 0). Confirm that the North has a capital-worker ratio of 1 and an income per worker of 1. Find the levels of capital and income per worker in the South. (b) [7 marks] Now suppose North and South are reunified to become one single country. They are now one economy where capital and labour can operate anywhere in the country. Immediately after the countries join together, what is the capital-worker ratio of the combined economy? Now find income per worker for the combined economy immediately after reunification. Explain why income per worker of the combined economy is not simply the average of income per worker in the North and South prior to reunification. (c) [7 marks] Suppose the combined economy has a saving rate of 20% (the average of the saving rates of the North and the South when they were separate countries). Find the steady-state capital stock per worker of the combined economy. How does this compare to the average capital-worker ratio of the North and South prior to reunification? Use your answer to deduce what will happen to GDP growth following reunification. What is the steady-state income per worker of the combined economy and how does this compare to average income per worker prior to reunification? Page 4 of 7 Page 4 of 7

5 11. Consider the Fisher model of consumption. There are two time periods for simplicity: the current period (1) and the future period (2). Incomes (before tax) in the current and future periods are Y 1 and Y 2, and (lump-sum) taxes are T 1 and T 2. The levels of government spending in the current and future periods are G 1 and G 2. The real interest rate is r. (a) [6 marks] Write down the life-time budget constraints for the household and for the government, assuming both can save or borrow at the same real interest rate r. Use these life-time budget constraints to justify the Ricardian equivalence proposition. Explain what effects (if any) a deficit-financed tax cut (with no change in government spending plans) has on current consumption, private saving, and national saving. (b) [7 marks] Now suppose that government spending G 1 increases. Assuming this is temporary (G 2 is unaffected), what does the Fisher model predict will happen to current consumption and national saving? How would your answers change if the increase in government spending were permanent (G 1 and G 2 both increase by the same amount)? (c) [7 marks] Now consider the deficit-financed tax cut from part (a). Suppose households initially would like to borrow at the interest rate r, but no-one is willing to lend to them at any interest rate. Find the effects of the tax cut on current consumption, private saving, and national saving. Page 5 of 7 Page 5 of 7

6 12. Consider the Baumol-Tobin model of money demand. Suppose a household receives real income Y (nominal income = PY) at the beginning of a month and plans to spendalltheincomeduringthemonthataconstantrate. Thehouseholdhasabank account paying interest rate i on any money deposited (interest is not compounded for simplicity). Income is initially paid into the household s bank account. Spending requires cash, and each withdrawal of cash from the bank account has a (real) transaction cost of c. Cash pays no interest. (a) [7 marks] Suppose the household makes n (equally sized) withdrawals from the bank account during the month. What is the total transaction cost incurred? What is the average amount of cash held during the month and how much extra interest could have been received if this cash had not been withdrawn? Using your answers, find the optimal number of withdrawals for the household (for simplicity, assume that n does not need to be a whole number). (b) [6 marks] Derive a formula for the optimal level of money demand (on average) during the month in terms of real income Y, the price level P, the nominal interest rate i, and the transaction cost c. What are the elasticities of money demand with respect to the price level, real income, and the nominal interest rate? Now suppose that over time, transaction costs rise with real income, that is, c = ay for some positive constant a. What effect, if any, does this have on the elasticities of money demand with respect to income, the price level, and the interest rate? (c) [7 marks] Now suppose that the bank makes no charge for withdrawals (c = 0), but time is needed to go to the bank. The value the household puts on the time spent going to the bank (which could otherwise be used for work or leisure) is bn 2 /2 for some positive constant b. Find the optimal number of withdrawals n and the level of money demand. How do the elasticities of money demand differ from the standard Baumol-Tobin model? Page 6 of 7 Page 6 of 7

7 13. Answer each of the following: (a) [6marks]Supposethemoneysupplyisfixed. ShowhowtheLMcurveisderived from the equilibrium of the money market. Explain what is meant by the term open-market operations, and demonstrate the effect of a contractionary openmarket operation on the LM curve. (b) [7 marks] Suppose that banks are subject to reserve requirements r, and that these are binding. Assuming holdings of cash are a fraction c of bank deposits, derive the money multiplier (the ratio between the broad money supply and the monetary base). Interpreting the money demand curve as a demand for broad money, find the effect of an increase in reserve requirements r on the LM curve (assume the monetary base is fixed). (c) [7 marks] Explain what is meant by the term discount rate as a monetary policy instrument. Suppose the central bank now offers unlimited access to a discount facility where banks can obtain loans at discount rate i d using bonds as collateral. What are the implications for the money supply curve and the LM curve? Find the effect on the LM curve of raising the discount rate i d. 14. Consider the worker misperceptions model of the short-run aggregate supply(sras) curve. Profit-maximizing firms produce output Y by hiring labour L subject to the production function Y = F(L), which is increasing and concave. Output is sold at price P and workers are hired at wage W. Firms are fully informed about both W and P when they make their hiring decisions. Workers are assumed to want to supply more labour when they think real wages w = W/P are higher, but workers only observe their money wage W, not the price level P. Workers have a rationally formed expectation P e of the price level. (a) [6 marks] Write down an equation for firms labour demand and draw the corresponding labour demand curve. Show how a labour supply curve can be derived given the accuracy of workers expectations as measured by P/P e, the ratio of the actual and expected price levels. Using your answer, show how the short-run aggregate supply curve (SRAS) is derived for a given level of price expectations P e. (b) [7 marks] Suppose the central bank increases the money supply unexpectedly (expectations P e do not react). Find the effect on output, the price level, the expected real wage, and the actual real wage. Now consider the case where the money supply increase is announced in advance, and the announcement is credible. How do your earlier answers change? (c) [7 marks] Now suppose that the economy is subject to unexpected shocks to the autonomous level of money demand. Compare the effects of following a monetary policy that targets the money supply to those from targeting interest rates. Explain why the policy ineffectiveness proposition does not imply that the choice of monetary policy is irrelevant for real variables in this case. END OF PAPER Page 7 of 7 Page 7 of 7