A32209 LI Macroeconomics 2021
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Department of Economics
Degree of BSc.
08 29189
LI Macroeconomics
Final Examination 2021
Section A
For Section A: It is not necessary to derive any formulae or diagrams you use to answer the questions. You will not get credit for such derivation. However, you should explain why you are using such formulae and diagrams and discuss in detail the resulting analysis. You may use additional reading specified in the ResourceLists@Bham page for the module but will not get any credit for using material outside of these sources.
1. According to the Long-run Equilibrium Model what are the factors that determine the real exchange rate of a small open economy? [70%] Identify how important you think each of these factors will be for the real exchange rate of an economy with which you are familiar. [30%]
2. Using the model of the money supply discussed in the lectures, and the quantity theory of money, explain how increasing the use of mobile phones for payments will impact on the long-run equilibrium price level of the economy. [70%] What do you think will be the macroeconomic effects of the use of mobile technology more generally for financial decision-making? [30%]
3. Using Endogenous growth models to provide a foundation for your analysis, explain the reasons why the government might subsidise basic research and development. [70%] Discuss whether such subsidies are necessary. [30%]
4. Using the short run model of the small open economy (the Mundell Fleming Model) explain how an increase in government expenditure financed by monetary creation will impact on output and the real exchange rate of the small open economy that is currently operating below the long run level of output. [70%] What should the policy response be in the long run? [30%]
Section B
For Section B: You may use additional reading specified in theResourceLists@Bham page for the module and, where relevant, other high quality data sources to support your answers.
5. Consider the following equation for the short-run aggregate supply (SRAS) curve, expressed in terms of real output ():
= + ( − ) (1)
where is the ‘natural’ level of real output, is the general price level, is the expected future general price level and is a parameter (>0).
a. Describe how equation (1) can be obtained from either the ‘sticky price model’ or the ‘imperfect information model’ (n.b. you only need to consider one of these models). Discuss the factors which determine the slope of the SRAS curve in your chosen model. [50%]
b. Use equation (1) to derive an equation for the ‘modern form Phillips curve’ . In the context of this expression, define the ‘natural rate hypothesis. ’ How might this idea be challenged? Use relevant examples from a country, or countries, of your choice to support your answer. [50%]
6. The ‘Dynamic Model of Economic Fluctuations’ consists of the following five
equations:
= − ( − ) + (2)
= − +1 (3)
= −1 + ( − ) + (4)
+1 = (5)
= + + ( − ) + ( − ) (6)
where is real output, is the ‘natural’ level of real output, is the real interest rate, is the nominal interest rate, +1 is the expected rate of inflation, is the actual rate of inflation, is the inflation target and and are shocks which take a mean value of zero. The remaining terms (, , , and , all >0) are parameters.
a. Present a diagram to show the model in a long-run equilibrium position. Starting from this long-run state, suppose the economy is hit by a temporary (one-period), positive demand shock at time t. Use your diagram and the
information provided in the table below to explain the importance of the
magnitude of the parameter to the subsequent path of inflation. [60%]
Quarterly UK Data, 1972q3-1997q1 (excluding 1987q2 |
|
|||
Time Period |
|
|
Average Inflation Rate (%) |
Standard Deviation of Inflation Rate |
1972q3-1976q2 |
-0.86 |
0.59 |
15.62 |
6.78 |
1976q3-1979q1 |
-0.38 |
0.00 |
12.27 |
3.81 |
1979q2-1987q1 |
-0.62 |
0.15 |
8.70 |
5.26 |
1992q4-1997q1 |
0.27 |
0.47 |
2.52 |
0.68 |
Notes: The coefficient estimates in the second and third columns have been generated by applying appropriate econometric techniques to UK data. The statistics in the fourth and fifth columns have been calculated from the quarterly Retail Prices Index (percentage change over the last 12 months). You may take all of the coefficient estimates presented above to be statistically significant. |
Sources: Nelson (2000) and ONS
b. Outline two shortcomings of the Dynamic Model of Economic Fluctuations as a framework for analysing the economies of the UK, the US or the Eurozone following the Global Financial Crisis and Great Recession of 2007-09. [40%]
7. Assume that the central bank currently operates with unfettered discretion . Now suppose that the government has decided to issue the central bank with an inflation target. The government is deliberating between a target of perfect price stability – i.e. an inflation target of 0% – and an inflation target of 2%.
Assume that the central bank is able to choose the actual rate of inflation and that the rate of unemployment is then determined by the following equation:
= − ( − ) (7)
where and represent the actual and natural rates of unemployment, respectively; represents the actual rate of inflation; represents the expected future rate of inflation and is a constant parameter (>0).
Further assume that the social cost of unemployment and inflation is given by the
following ‘loss function’:
(, ) = + 22 (8)
Given this information, address the following questions:
a. Consider the current situation in which the central bank is allowed to set monetary policy with unfettered discretion. Derive an expression for the ‘optimal’ inflation rate that the central bank will choose in this case and show the resulting loss to society. Explain your steps and assume that the central bank acts benevolently. [40%]
b. Suppose that the central bank is able to credibly commit to its new inflation target. Which of the two candidate inflation targets should the government choose for the central bank and why? Continue to assume that the government acts benevolently. [10%]
c. Compare the loss to society incurred under discretion in part (a) with the loss incurred under the inflation target chosen in part (b). Use the ‘time consistency problem’ to explain your findings. [50%]
8. The government budget constraint under the assumption that the government controls the central bank is given by:
+ ∆ + ∆ = + (9)
where is tax revenue, ∆ is the change in public debt, ∆ is the change in the money supply (the monetary base), is government spending and is the nominal interest rate that the government must pay to borrow from financial markets.
a. Present an expression for the ‘equilibrium debt-to-GDP ratio’. Explain the factors which determine whether the government is a debtor or a creditor in equilibrium when the government controls the central bank . [30%]
b. How can a government exploit its monopoly power over money creation and why might this be problematic over longer time periods? [30%]
c. What steps can be taken to prevent the government from using money creation to its short-term advantage? Use relevant examples from a country, or countries, of your choice to support your answer. [40%]
2022-01-13