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EC1080

Summer Examinations 2020/21

Macroeconomics 1

Section A: Answer ALL questions

1. There are a number of statistics computed to measure the price level of an economy, such as the GDP deflator and the CPI. The choice of which of these measures to use depends in many cases on the specific question you are interested in. For each of the following situations, explain whether the CPI or the GDP deflator is a more appropriate measure to use and explain why the statistic is preferred.

(a) The government is interested in whether increases in defence spending are affecting the price level. (5 marks, 50 words max)

(b) An economic consulting firm is investigating the impact on the aggregate price level of more computers and electronic technology used in production. (5 marks, 50 words max)

2. In consumption theory, what is meant by the expression “consumption smoothing”? Why is consumption smoothing a key element of the life-cycle hypothesis and permanent income hypothesis? (10 marks, 100 words max)

3. Derive and explain the Marshall-Lerner condition. If the Marshall-Lerner condition does not hold, explain and show graphically the dynamics of the trade balance in response to a real appreciation. (10 marks, 100 words max, excluding equations)

4. In the Financial Times’ article “How the pandemic is worsening inequality” (31 Dec 2020) we can read:

“About 600m people work globally in the hardest-hit sectors such as hospitality and retail [...]. In addition, the informal economy has been hard-hit – and that is where some of the world’s most vulnerable workers are employed. [...] At the height of the pandemic-induced surge in unemployment, joblessness among people aged 15 to 24 in OECD countries was 7.5 percentage points higher than the start of this year, whereas among those aged 25 and over it rose by 3.2 percentage points. Pandemic-induced job losses have potentially long-lasting consequences: people who start their career during a recession experience lower earnings for a decade after graduation.

[...] Around the world, relatively privileged workers have avoided the worst of the pandemic’s economic impact. Up to 40 per cent of those in the ILO’s top income bracket were able to work from home during the pandemic, more than double the proportion among the lowest earners.

[...]The 10 richest billionaires in the world increased their wealth by $319bn in 2020”

Considering the world as a whole, explain inequality pre- and post-pandemic, using a Lorenz curve. (10 marks, 100 words max excluding the graph)

5. At the monetary policy meeting in February 2021, the central bank of Mexico cut its policy rate for the first time since September in an effort to stimulate the economy. However, after the United States’ government announced in March 2021 the introduction of a new financial stimulus package to boost the US economy, the Governor of the Mexican central bank announced that the board would consider the impact of the US fiscal stimulus in the Mexican economy, and whether it is necessary to change their monetary response. Explain how a US fifiscal stimulus may affect the Mexican economy and why the central bank may respond to it. (10 marks, 100 words max)

Section B: Answer TWO questions

6. In the Financial Times’ article “Why the UK inflation risk after lockdown is hard to assess” (15 March 2021) we can read:

The question [...] is whether broader inflation pressures will build as the UK economy reopens – with many consumers ready to spend amassed savings and many businesses still unable to operate at full capacity.

So far, price rises have been patchy. [...]. Research [...] shows that prices have been more volatile in the past year than at any point in the last 20. But the measure of consumer price inflation targeted by the Bank of England stood at just 0.7 per cent in January, even after adjustments by the ONS to take account of the way lockdowns have skewed spending.

The BoE is unlikely to worry about temporary mismatches of demand and supply as the economy reopens. [...] the risk is of a more persistent hit to supply, if structural changes such as the shift to remote working and online retail leave people with the wrong skills for the jobs available, or if companies’ capital is tied up in the wrong locations.

[...] What is clear is that the headline rate of inflation is increasingly unlikely to reflect individuals’ experience. This is not only because essentials such as food and energy make up a bigger share of spending for poorer households, while those on higher incomes spend more on services.

(a) Represent the UK labour market in a Wage-Setting/Price-Setting graph. (5 marks)

(b) Explain what are the future challenges for the BoE (Bank of England) in making monetary policy decisions and explain how the potential structural changes mentioned in the article may affect different groups of the UK income distribution. (20 marks, 300 words max)

7. In the Financial Times’ article “Fed signals no rate rise until at least 2024 despite growth upgrade” (17 March 2021), we can read:

“Federal Reserve officials signalled that they expect to keep interest rates close to zero until at least 2024, even as they sharply upgraded their US growth forecasts because of a massive fiscal stimulus and an accelerating vaccine rollout.

[...] The upgrades to the forecasts from Fed officials were significant: whereas in December they predicted 4.2 per cent growth this year, that estimate was bumped up to 6.5 per cent, which would be the fastest economic expansion since 1984.

Meanwhile, the unemployment rate is now forecast to fall to 4.5 per cent by the end of the year instead of 5 per cent. [...] inflation [...], is expected to rise to 2.2 per cent and above the central bank’s 2 per cent target, compared with the smaller rise to 1.8 per cent predicted in December.

[...] The Fed has pledged to maintain rock-bottom interest rates until the US reaches full employment, with inflation hitting 2 per cent and being on track to exceed that target.”

(a) Represent the US economy in a three-equation model. (5 marks)

(b) Explain how the fiscal stimulus affect the economy, the potential multiplier effect of this stimulus considering the US current situation, and the potential limitations (if any) ofthe US policy mix adopted. (20 marks, 300 words max)

yt = At − art−1 (1)

πt = [χπT + (1 − χ)πt−1] + 0.5(yt − ye) (2)

L = (yt − ye) 2 + β(πt − π T ) 2 (3)

in which equation (1) represents the equilibrium in the goods market, equation (2) the supply side of the economy, and equation (3) is the Central Bank’s loss function. y is output; r is policy rate; π and π T are actual and target inflation, respectively; χ and β are parameters for central bank’s credibility and inflation aversion respectively.

The values for χ and β for Economy A are χ = 0.8 and β = 1.

The values for χ and β for Economy B are χ = 0.5 and β = 1.5.

(a) Derive the central banks’ best response for both economies.

(5 marks, show all the steps of the calculations)

(b) Represent these economies in a graph and explain how the central banks would respond to a positive temporary aggregate demand shock, emphasising the key differences between the two economies. (20 marks, 250 words max excluding graphs)