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ECO2003

SEMESTER 1

2020/2021

ECONOMIC MODELLING

# Section A

Answer both questions from this section

1. a. Use the Solow model with no technological progress to explain in detail why countries with high rates of population growth tend to be poor. Make sure you explain how population growth affects the level and growth rate of both GDP per person and total GDP. Use equations and diagrams to support your answer. How does your answer change if you add technological progress?

b. Use the following facts about a hypothetical economy to assess whether the level of the saving rate in this economy is appropriate. Explain your logic in detail using equations and diagrams.

i. The capital stock is 10 times one year’s GDP: K = 10Y

ii. About 20% of GDP is used to replace depreciating capital: δK = 0.2Y

iii. Capital income is about 70% of GDP: MPK × K = 0.7Y

iv. The country’s real GDP grows an average of 4% a year.

If the savings rate is not at the appropriate level, do you envisage any problems with the implementation of a policy that would take the savings rate in the right direction? Support your answer using a diagram.

2. a. Use the IS-LM model to predict the short-run effects of each of the following shocks on income, the interest rate, consumption, and investment.

i. Brexit uncertainty reduces demand for investment.

ii. Some economists argue that the inflation target of the central bank should be raised to make it easier to avoid a deflation trap. Analyse the effect of appointing a ‘dovish’ Governor of the Bank of England. [Hint: such an appointment would increase expected inflation.]

b. Use the linked IS-LM and AD-AS diagrams to show what happens in the long run in each of the two cases above.

# Section B

Answer one of the questions in this section.

3. a. Use diagrams, equations and words to explain the slopes of the IS and LM functions in the closed economy (make sure you derive the two curves graphically).

b. Use the closed economy IS-LM model to explore potential reasons why interest rates have been so low since the financial crisis of 2007/2008. Use the equations and diagrams of the IS-LM model to explain your hypotheses in detail.

4. a. What are the short run effects of an increase in the money supply in an open economy with a floating exchange rate? Explain in detail with the help of equations and diagrams. Some people think that printing more money is an easy way to increase standards of living. Use the model to assess this view making sure you also consider the long run implications of increasing the money supply.

b. Can the government stimulate the economy using fiscal policy measures if the exchange rate is allowed to float? Justify you answer. Explain in detail how expansionary fiscal policy works, supporting your answer with equations and diagrams.