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ECO2003

Semester 1 2019/2020

Economic Modelling

Section A

You should attempt BOTH questions in this Section.  

1. a. Define the nominal exchange rate and the real exchange rate.

[20% of marks]

b. “Traveling to Japan is more expensive than last year”, says a friend. “Last year a pound bought 145 Japanese yen; this year, because of the depreciation brought about by Brexit, a pound buys only 135 Japanese yen.” Is your friend right or wrong? Given that inflation was 4% in the UK and 1% in Japan, has it become more or less expensive to travel to Japan? Write your answer using a concrete example – such as fish and chips vs. sushi. Also, write your answer using the concept of the real exchange rate.

[45% of marks]

c. According to the theory of Purchasing Power Parity, if the UK has higher inflation than Japan, what should happen to the nominal exchange rate between the pound and the Japanese yen? Explain  [35% of marks]

2. a. The Trump administration has placed tariffs on imports from major trading partners. Using the Mundell-Fleming model, discuss the economics of such a policy. In particular, how would the policy affect the US net exports, savings, investment and the interest rate? How would it affect the exchange rate? Do you think this proposal will resolve the trade deficit problem?

b. The Trump administration has also cut taxes. Discuss the effect of such a measure using the same model you employed in your answer to (a).

Section B

You should attempt ONE question in this Section.

3. a. Write and explain the Quantity Equation.  [40% of marks]

b. Set out the Quantity Theory of money. After the financial crisis, Milton Friedman’s idea of “helicopter money” gained traction again among prominent economists. Use the Quantity Theory to explain why such a measure might be needed, not just in the US, but in other countries as well.

[60% of marks]

4. Suppose an economy described by the Solow model has the following production function:

where the notation is that used in lectures and seminars.

a. For this economy use the production function to determine output per effective worker, , where  capital per effective worker.

[20% of marks]

b. Use your answer to part (a) to solve for the steady state value of  as a function of  = savings rate,  = population growth,  = technological progress and  = depreciation rate.  [40% of marks]

c. In the Solow model, what determines the steady-state rate of growth of capital per worker and income per worker? Explain your answer carefully. At what rate does total output grow? Explain.  [40% of marks]