This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

279 0065 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences, the Diploma in Economics and Access Route for Students in the External Programme

Macroeconomics

Wednesday, 28 May 2008 : 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.

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SECTION A Answer eight questions from this section (5 marks each).

1.

In the Solow model, a country is able to reach its steady-state level of capital more quickly by saving a higher fraction of its income. True or false? Briefly explain your answer.

2.

If a component of government expenditure is automatically increased when output falls then the AD curve becomes steeper. True or false? Briefly explain your answer.

3.

The introduction of employment protection legislation (making it harder for firms to dismiss workers) lowers the rate of unemployment. True or false? Briefly explain your answer.

4.

An economy undergoing deflation cannot have a negative real interest rate. True or false? Briefly explain your answer.

5.

Okuns law states that there is a negative relationship between changes in the growth rate of GDP and changes in the unemployment rate. True or false? Briefly explain your answer.

6.

If there is a real balance effect then the classical dichotomy and the neutrality of money cannot hold. True or false? Briefly explain your answer.

7.

If Ricardian Equivalence holds then an increase in the governments budget deficit as a result of a tax cut has no effect on the countrys current account. True or false? Briefly explain your answer.

8.

If the velocity of money is constant then the rate of inflation is the same as the rate of growth of the money supply. True or false? Briefly explain your answer.

9.

Observing that interest rates are 2% in the U.S. and 4% in the euro area demonstrates that capital is not perfectly mobile. True or false? Briefly explain your answer.

10.

Inflation is still costly even when it is fully anticipated. True or false? Briefly explain your answer.

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SECTION B Answer three questions from this section (20 marks each).

11.

Consider the Solow growth model. (a) Assume positive population growth ( n > 0 ) and technological progress ( g > 0 ). Derive analytically the steady-state growth rates of output and capital, and the steady-state levels of output and capital per efficiency unit of labour. Illustrate your answer graphically and briefly discuss the economic intuition. (6 marks) Describe the short-term, long-term and transitional effects of the following on the capital, output, and consumption per worker. You may assume g = 0 in your answers. i. ii. A decrease in the saving rate. A one-off increase in the labour force as a result of greater female labourmarket participation. How would your answers differ if expressed in per capita terms rather than per worker? (7 marks)

(b)

(c)

In what sense is steady-state output growth in the Solow model exogenous? Briefly outline how some other models make such growth endogenous. (7 marks)

12.

Answer each of the following: (a) Use the Fisher model of intertemporal consumption choice to illustrate the effect of an anticipated increase in future income on current consumption. Be careful to state clearly any assumptions required. (6 marks) Consider each of the following changes and describe how it might affect firms investment decisions. Be sure to indicate which theory/theories of investment you are using in your answers. i. ii. iii. iv. (c) an earthquake destroys part of the capital stock; an increase in stock prices; the depreciation rate rises because information technology becomes obsolete more quickly; the price of capital goods is expected to rise in the future. (7 marks) (7 marks)

(b)

Tax cuts should increase consumption. Evaluate this statement.

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13.

Consider a closed economy with fixed wages and prices. Suppose the consumption function takes the form C = 130 + 0.4(Y T ) , where C is consumption, Y is income, and T is taxes. The investment function I = 200 20r , where I is investment and r is the real interest rate. Government spending is G = 570 . Tax revenue is T = 50 + 0.5Y , derived from lump-sum taxes of 50 and a proportional income tax of 50%. (a) Explain the forms taken by the consumption and investment functions, and depict the equilibrium of the economy graphically. Suppose the central bank sets interest rates so that the real interest rate is r = 4 . Show that the equilibrium level of output Y is 1000. Calculate the size of the governments budget deficit D = G T . (6 marks)

(b)

Now suppose the central bank raises interest rates to the point where the real interest rate is r = 6 . Calculate the new equilibrium level of output Y and the size of the governments budget deficit D . Explain intuitively why the budget deficit changes. (6 marks) Consider the same change in interest rates from r = 4 to r = 6 , but now suppose that government is bound by a fiscal rule that states the budget deficit D cannot exceed 25. The government proposes to raise lump-sum taxes by the difference between the deficit found in part (b) and the limit 25. Calculate the equilibrium level of output for this new level of lump-sum taxes when r = 6 . Calculate the new budget deficit and check whether the fiscal rule is met. Provide an intuition (8 marks) for your answer.

(c)

14.

Answer each of the following: (a) Explain how the demand for money is determined in the Baumol-Tobin model and use the model to derive the effect on money demand of lower transactions (6 marks) costs in exchanging money and financial assets. Is it possible for an increase in the growth rate of the money supply to reduce interest rates in the short run but raise them in the long run? Explain your answer. (7 marks) What is the time-inconsistency problem in the context of monetary policy? (7 marks) Discuss some of the proposed solutions to this problem.

(b)

(c)

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15.

Answer each of the following: (a) What are the main components of unemployment? What is the natural rate of (6 marks) unemployment? Suppose the government or central bank announces a low inflation target, and that the actual rate of inflation is on target in a particular year. Using some of the theories that have been put forward to explain the short-run Phillips curve, discuss how the level of unemployment in the short term could be affected by the following: i. ii. iii. whether inflation was high or low in previous years; the government or central bank has systematically failed to meet past inflation targets; the implementation of structural reforms that remove some labour-market rigidities. (7 marks)

(b)

(c)

What is hysteresis? Give two explanations of how hysteresis in unemployment could occur. (7 marks)

16.

Consider a small open economy with fixed wages and prices, and assume perfect capital mobility. (a) Describe analytically, and illustrate graphically, the internal and external equilibria of the economy. Be careful to state any assumptions clearly. (6 marks) Suppose that households in the economy decrease the amount they want to save. Describe the effects on output, the current account and the exchange rate, analysing separately the flexible and fixed exchange-rate regimes. (7 marks) Suppose that the rate of inflation prevailing in the economys trading partners decreases. Describe the effects on output, the current account, the nominal exchange rate and the real exchange rate, analysing separately the flexible and fixed exchange-rate regimes. How would your answers change if those trading partners used the opportunity of lower inflation to cut interest rates? (7 marks)

(b)

(c)

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