Answer all of the following questions:

1)  A consumer has an income of £100 in period 1 and no income in period 2. In scenario I   the interest rate is 10%, while in scenario II it is 5%. Based on this information, which of the following statements must be correct? (5 marks)

a.   The consumer is able to consume more in period 2 under scenario I than under scenario II, as her savings earn a higher interest in the former than in the latter.

b.   The consumer consumes less in period 1 under scenario II than under scenario I, as she is less impatient under scenario II.

c.   The substitution and income effects of the interest rate rise partially offset each other, resulting in lower consumption in period 1 under scenario II.

d.   The consumer is unambiguously worse off in scenario I, because the interest rate is higher.

2)  Which of the following statements regarding asset price bubbles is correct? (5 marks)

a.   Market participants can easily find out whether or not there is a bubble by comparing the market price with the fundamental value of the asset.

b.   Bubbles occur only when investors disagree about the fundamental value of an asset.

c.   According to the efficient market hypothesis, bubbles cannot occur.

d.   It is irrational to buy or sell an asset when there is a bubble.

3)  Consider a scenario where the Bank of England views the UK economy to be overheating and is attempting to slow the economy down using monetary policy. Which of the            following statements regarding the effects of an interest rate rise is correct? (5 marks)

a.   It leads to the UK exports becoming cheaper and imports becoming more expensive.

b.   It will bring inflation down and stimulate the economy.

c.   It has opposing effects on the UK’s aggregate demand (AD): it discourages investment, which lowers AD, but results in cheaper imports, which boosts AD.

d.   It leads to higher demand for GBP, which results in an appreciation of the GBP.

4)  Which of the following statements about the new Keynesian model of monetary policy is correct? (5 marks)

I. The Taylor principle states that the Central Bank must respond sufficiently aggressively to a recession in order to keep inflation under control.

II. The new Keynesian Phillips curve can be thought of as an aggregate supply equation. It describes the effect of output on inflation.

a.   Both statements are true.

b.   Statement I is true, statement II is false.

c.   Statement I is false, statement II is true.

d.   Both statements are false.

5)  Consider the two period model studied in class. Which of the following statements is correct? (5 marks)

a) The twin deficits can arise only if Ricardian Equivalence does not hold

b) The twin deficits cannot arise if the Ricardian Equivalence holds and the fiscal deficit is due only to increased government spending

c) The twin deficits cannot arise if the Ricardian Equivalence holds and the fiscal deficit is due only to a decrease in current taxes.

d) The Ricardian equivalence implies that fiscal deficits can never occur

6)  A terms-of-trade shock is: (5 marks)

a) equivalent to an interest rate shock

b) equivalent to an uncertainty shock

c) equivalent to an endowment shock

d) equivalent to an investment shock

7)  The country Pancraziland exports a large quantity of pizzas and does not import any good or service. Also, Pancraziland has issued a large quantity of government bond, which are held by international investors. Finally, Pancraziland does not hold any assets, its net international compensation of employees is zero, and its net unilateral transfers are zero.  Which of the following statements is true? (5 marks)

a) Pancraziland’s current account is surely positive.

b) Pancraziland’s current account is surely negative.

c) Pancraziland’s current account is surely equal to zero.

d) None of the above

8)  Consider a two-period production small open economy as studied in class. Assume that    the instantaneous (i.e. per-period) utility function of consumers is logarithmic. A decrease of uncertainty about future productivity implies: (5 marks)

(a) Lower Consumption in the current period

(b) Higher Consumption in the current period

(c) An improvement of the trade balance in the current period

(d) No changes in consumption in both periods

Section B

Answer BOTH of the following questions

[QUESTION 1]

In this question, you are asked to think about the macroeconomics of the Covid- 19 pandemic.

a)  Most industries and firms suffered from the pandemic, experiencing sharp drops in profits

and employment. However, some firms benefited from it. As an example, think of relatively  new technologies for video meeting software, like Zoom, Teams or Skype. Because these       technologies are complementary with working from home, demand for them rose                    dramatically when lockdowns started, and their stock prices soared, see e.g. the stock price of Zoom Video Communications Inc in the figure below. An investor decides that, despite this spectacular performance of the stock, not to invest in this company, because she believes there to be a bubble. Do you agree there may be a bubble in Zoom’s stock price? Why (not)?  Does the fact that the pandemic increased sales make it more or less likely that a bubble

developed? Why? (10 marks)

Figure 1. Stock price of Zoom Video Communications Inc

We now turn to the policy response to the pandemic, in particular the response of the Central  Bank. For the remainder of this question, please assume that the economy is well described by the new Keynesian model, as summarised by the following three equations:

yt  = y ∗ − e(it − Et 几t+1 − r∗ ) + Etyt+1 + vt

几t = FEt 几t+1 + K(yt − y∗ ) + ut

it  = p0 + p冗几t + pyyt + et

where yt is output, 几t is inflation, and it is the nominal interest rate, vt and ut are shocks, and the remaining letters are parameters of the model.

b)   Some economists have argued that the Covid- 19 pandemic should be thought of as a supply shock, whereas others argued it was shock to demand. Give at least one reason for each viewpoint. Why does the difference matter for monetary policy? Explain your answer referring to the equations of the new Keynesian model above. (10 marks)

c)   Interest rates affect consumption through a substitution effect and an income (or wealth) effect. Usually, we assume the substitution effect dominates. Suppose instead that the income effect dominates. How would this affect the policy response of the Central Bank to the pandemic? (10 marks)

[QUESTION 2]

Consider a two-period model of a small open economy with a single good each period and no investment. Let preferences of the representative households be described by the following utility function.

U(C1  , C2  ) = ln(C1  ) + ln(C2  ),

The representative household has initial net foreign wealth equal to 0, i.e. B0(p) = 0, where B0(p)

denotes net foreign wealth of private agents. The household is endowed with Q1   = 10 units of good in period 1 and Q2   = 10 units of good in period 2. The world interest rate paid on assets held from period 1 to period 2 is 10%, that is r ∗  = 0.1, and there is free international capital mobility.

a) Calculate the equilibrium levels of consumption in period 1, C1  , consumption in period

2, C2  , the trade balance in period 1, TB1 , and the current account in period 1, CA1 .

[7 marks]

b)  Suppose now that the government imposes capital control that requires the country’s net foreign asset position at the end of the period 1 to be non-negative, i.e. B1(p)  ≥ 0. Is the representative household’s optimal choice affected? If yes, why? If no, why? [5 marks]

c) Now assume that instead there is uncertainty on period 2 endowment. Specifically, Q2   = 10 + e with probability 0.5  and  Q2   = 10 − e with probability 0.5.  e is  a positive number. Is the trade balance in period 1 affected? If yes, why? If no, why?  [6 marks]

Now let’s go back to the case with no uncertainty, that is   Q2   = 10, but we introduce fiscal policy.  Let  C1  and  C2  denote the  consumption tax rates  in period  1  and  2, respectively. The government starts period 1 with no outstanding assets or liabilities, i.e. B0(g)  = 0. It taxes consumption at the same rate in both periods, i.e. C1=C2, and consumes 1  units  of goods  in  each  period.  That  is,  G1=G2 = 1,  where  G1   and  G2   denotes government  consumption  in period  1  and  2,  respectively.  Like  the  household,  the government has access to the world financial market.

d) Start  with  the  equilibrium  condition  when  there  are  consumption  taxes  and  the intertemporal budget constraint of the household, to find the optimal consumption plan as a function of the tax rate. [4 marks]