Answer ALL questions. There is a total of 40 marks. Each question carries the number of marks as indicated. You have 10 minutes of reading time and 120 minutes to answer the questions.

Section A: Multiple Choice

Answer all questions in this section on the Multiple Choice Answer sheet. Each question is worth 2 marks, implying a total of 10 marks for this section.

1.  In the New-Keynesian model studied in classes, households are forward looking.  Therefore, the future has effects on today’s decisions.  The key equation that dictates the household’s inter-temporal behaviour is:

A.   the inter-temporal budget constraint that states that it is optimal to spend all lifetime income.

B.   the intra-temporal optimality condition of labour supply (leisure-consumption decision).

C.   the Euler equation that equalises the marginal dis-utility of saving with the (discounted) marginal utility of future consumption.

D.    Both B and C are correct.

2.  Using the AD-AS model with fully sticky prices (P = ), what is the effect on labor Nt  and wages wt  of an increase in current productivity At ?

A.   Higher productivity increases w and N .

B.   Higher productivity decreases w and N .

C.   Higher productivity has no effect on w and N .

D.   Higher productivity increases w and decreases N .

3.  Monetary policy can have re-distributive effects. Through which mechanism can an increase in the RBA’s cash rate increase inequality?

A.   A higher cash rate reduces inflation, which then reduces the wage of poor.

B.   A higher cash rate increases the income of savers and reduces the income of borrowers.

C.   A higher cash rate reduces the income of savers and increases the income of borrowers.

D.   A higher cash rate reduces consumption and investment, which then reduces GDP and then reduces the wage of poor.

4.  Unconventional monetary policy is defined as:

A.   the central bank actions that adjust the money supply and short-term interest rates to stabilise output.

B.   the purchase of short-term government debt as to affect short-term interest rates.

C.   forward guidance to affect the future expected path of interest rates, and the purchase of long-term assets (quantitative easing) to affect asset prices and yields.

D.   cutting corporate taxes to boost firms’ investment.

5. What does the concept granularity mean in macroeconomics?

A.   That small firms enter and exit markets in a way that amplifies business cycle fluctuations.

B.   That large firms are less volatile therefore mitigating aggregate fluctuations.

C.   That shocks to large firms drive a large fraction of aggregate fluctuations.

D.   That firm-level shocks cannot drive aggregate fluctuations as they die out quickly with aggregation.

Section B: AD-AS model with sticky prices: The Phillips Curve

Answer ALL questions. Answer them in the answer booklet provided. Justify all answers. You need not waste time explaining your notations as long as you are using the notations we have developed in class. Graphs do not have to be drawn to scale as long as all critical points (e.g., intercepts, kinks, tangency points, intersections, etc.) are clearly marked.

Question B1 (15 marks total)

Suppose that the economy is well described by the micro-founded AD-AS model with partially sticky prices. Keep in mind consumers’ and firms’ optimal decisions that give rise to the AD-AS model. Therefore, in all your answers explain how and why agents’ decisions change.

(a)  (4 marks)  We are in 2050 and suddenly all companies become more productive (robots figured out a way in which all factors of production can produce more). There is persistent increase in At , meaning that the new A persists until period t ＋ 1 (At  < A = A+1 ). Analyse the effects on output, prices, wages, employment, consumption and investment.

(b)  (4 marks) Suppose that the economy is now back to its flexible price equilibrium. However, a negative oil price shock increases the price of intermediate inputs by 80%. In our model, this is expressed by  = 1.8 t . Analyse the effects on output, prices, wages, employment, consumption and investment.

(c)  (4 marks)  Based on question part (b), discuss whether in this case the “divine coincidence” holds or not.  That is, can the Central Bank stabilise output and prices simultaneously? More generally, when does the “divine coincidence” hold?

(d)  (3 marks)  Finally, suppose that the economy is mainly driven by oil price type shocks to   . What can you say about the “Phillips Curve”?  In this environment, how useful is the “Phillips Curve” to inform policy makers?