Kotebe Metropolitan University

Faculty of Business and Economics

Department of Economics
M.Sc. Program in Economics
Advanced Macroeconomics I (Econ 5012) Group Assignment

1. Consider the following classical macroeconomic model

(1) Y = F(K, N) FK, FN > 0; FKK, FNN < 0, FKN > 0
(2) w/p = FN
(3) NS = NS(w/p, r-p) NSw/p > 0, NSr-p > 0
(4) N = NS
(5) I = I(r- π) Ir- π < 0
(6) C = C(Y – T) 1 > C’> 0
(7) Y = C + I + G
(8) M/p = m(r, Y) mr < 0, my > 0
Where Y is GNP, K is the capital stock, N is employment, w is the money wage, NS is the supply
of labor, p is the price level, r is the interest rate, π is the anticipated inflation rate, I is
investment, C is consumption, G is government expenditures, T is taxes net of transfers. The
endogenous variables are Y, N, NS, w, p, r, C and I. The exogenous variables are M, K, G, T and
p.

Determine the effects on Y, p, r and N of

i. An increase in M,
ii. An increase in π. Does an increase in π leave the real rate of interest unchanged?
iii. Does the main claim of the neoclassical Quantity Theory of Money hold for this model?

2. Consider the following Keynesian macroeconomic model

(1) Y = F(K, N) FK, FN > 0; FKK, FNN < 0, FKN > 0

(2) FN = w/p
(3) I = I(r- π) Ir- π < 0
(4) C = C(Y – T) 1 > C’> 0
(5) Y = C + I + G
(6) M/p = m(r, Y) mr < 0, my > 0

Where Y is GDP, K is the capital stock, N is employment, w is the money wage, p is the price
level, r is the interest rate, π is the anticipated inflation rate, I is investment, C is consumption, G
is government expenditures, T is taxes net of transfers. The endogenous variables are Y, N, p, r,

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C and I. The exogenous variables are M, K, G, T, w and π. Determine the effect of expansionary
monetary policy on the interest rate, output and price level. (15pts).

3. Given the DAD-DAS basic model as

i. Construct the aggregate supply and demand equations using the above information
ii. Suppose the economy is at the long-run equilibrium. Then a positive aggregated
demand shock hits the economy for five successive periods (ε > 0), and then goes
away (ε = 0). How will the economy be affected in the short run? How will the
economy adjust over time?

4. Consider a Dornbusch model which has a hybrid short-run features as the Mundell-Fleming
model and long-run features as in the Monetary Model. Discuss the impact of contractionary
monetary policy in the model (the short run impact and adjustment to the long run). (See the
building blocks of the model from the reading material provided to you).

5. Consider an open economy IS-LM model with perfect capital mobility. Assume that we
extend the IS-LM model by introducing international trade. Assume furthermore that the price
level is fixed (say P = P0) and that domestic and foreign bonds are perfect substitutes. The
extended model is given by:

(1) Y=C+I+G+X
(2) C = C(Y − T) 0 < CY −T < 1
(3) I = I(R) IR < 0
(4) T = T(Y) 0 < TY < 1
(5) M/P = k(Y) + l(R)
(6) X = EX (E) − IM (E, Y) EXE > 0, IME < 0, IMY > 0
(7) ̇
𝑅 = 𝑅 ∗ 𝐸/𝐸

Where Y, C, I, G, T, and R are, respectively, output, consumption, investment, government

consumption, taxes, and the interest rate. Furthermore, R* is the foreign interest rate, EX is
exports, IM is imports, E is the exchange rate (domestic per unit of foreign currency), and X is
net exports. Use this model to answer the following questions. Assume that the expectations
regarding the exchange rate are perfectly inelastic (so that there is no speculation on the market
for foreign exchange and the 𝐸/𝐸̇ term can be put equal to zero).

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 i. Interpret the equations.
ii. Determine the effect of devaluation in the model (using comparative statistics analysis)
iii. Can the government of a less-than-fully employed economy boost employment without
putting pressure on the interest rate (and the foreign exchange rate)? Show how the
government can engineer an appreciation of the currency without harming employment.
Distinguish the two cases of fixed and flexible exchange rates. (You may use IS LM
graphs).
iv. Explain why a small open economy with fixed exchange rates is extremely sensitive to
shocks in world trade. Is it possible to use monetary or fiscal policy to counter the effects
of world trade shocks? (You may use IS LM graphs).

6. Consider the following two-period economy. A two-period lived agent wants to maximize the
value of utility defined over consumption in two periods, c1 and c2, respectively. Utility is
represented by u(c1) + βu(c2), with β<1 and u(c) = lnc. The (exogenous) endowments of income
in each period are y1 and y2 respectively. The agent can freely borrow and lend in financial
markets in the first period at the interest rate r.

(a) Write the intertemporal budget constraint of the consumer. Solve the consumer’s problem
and find an expression for the level of savings as a function of incomes and the interest
rate.
(b) Under what conditions on income in period 1, y1, and income in period 2, y2, is the
consumer going to borrow; under what condition is he/she going to save? Explain.

7. Consider the following intertemporal choice problem. An agent wants to maximize the value
of utility defined on consumption, ct, over periods t = 1, ..., T:
𝑇
1
∑ 𝑢(𝑐𝑡)
(1 + 𝜌)𝑡
𝑡=1

With ρ> 0 and u(c) = lnc. The (exogenous) endowments of income in each period are denoted as
yt. The agent can freely borrow and lend in financial markets at the one-period interest rate r, but
debt at the end of period T cannot be positive.

i. Derive (you may use the case T = 2) the problem of optimal intertemporal choice by
setting up a maximization condition.
ii. Assume r = ρ = 0. Derive an expression for consumption as a function of current and
future income.
iii. Explain why this model is consistent with the life-cycle/permanent-income hypothesis.