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EC0202, SECTION L0201

Macroeconomic Theory and Policy

(1) [20 points] Consider a Solow economy with the production function  Yt  = AKL The capital      share,  , is equal to 0.3. The depreciation rate,  , is equal to 10 percent.  The labor force is constant over time.

(a) [3 points] Suppose that in period t = 0 (and perhaps many periods before that), the economy is in a steady state where A = 3 and the saving rate is equal to 30%.  Compute steady-state capital per worker, output per worker, and consumption per worker.


(b) [3 points] Suppose that in period  ,   rises to 4 and the saving rate rises to 40%.  Compute capital per worker,   output per worker, and consumption per worker in the steady state associated with these new parameter values.


(c) [3 points] Use a Solow diagram to illustrate the old and new steady state levels of capital per worker.  Use single stars (*) to label the old steady-state variables, and use double stars (**) to label new steady-state variables.


(d) [3 points] Compute capital per worker, output per worker, and consumption per worker in periods t=1, 2, and 3.


(e) [3 points] Draw a time-series graph (time on the x-axis, economic variables on the y-axis) illustrating the dynamics of output per worker from period 0 onward.


(f) [5 points] What would happen to consumption per worker in the long run if the saving rate rose from 30% to 40% but TFP did not change? Would consumption per worker rise or fall? Explain.

(2) [7 points] Consider the following graph, which depicts nominal interest rates on U.S. government bonds and Eurobonds (government bonds issued by the European Central Bank).  Given the data in   the graph, would you expect the USD-Euro nominal exchange rate to depreciate or appreciate            between 2008 and 2013?  Explain your reasoning.


(3) [10 points] In writing assignment 2, you were asked to read an article describing some economic research that indicates investment is less sensitive to interest rate changes than standard theory      assumes.  These findings suggest that investment may even fall when the central bank lowers the     interest rate, not rise as we assume in the IS-MP and AS-AD models.  Some commenters have

criticized these findings for inadequately controlling other factors that may influence both interest rates and investment.

Consider the standard IS-MP model, in which investment responds to interest rates in the way that we usually       assume ( It  / Yt  = ai  − b(Rt  − r ) ) and the economy is initially in a steady state ( a = 0 , Rt  = r , and Yt  = 0 ).  Suppose

that the advent of more efficient production technology raises the marginal product of capital, r , by 3%.  In                 response, the central bank raises the interest rate by 1.5%.  Use an IS-MP diagram to illustrate what happens to           short-term output.  Does investment move in the same direction as interest rates, or the opposite direction?  Explain.

(4) [10 points] Recent data indicates that investment responds less to changes in the interest rate than it did in the past. This question concerns the implications of this trend for monetary                policymakers.

(a) [5 points] If true, would this make monetary policy more effective or less effective in mitigating the effects of demand shocks? Explain.


(b) [5 points] The Federal Reserve has kept interest rates low since the Great Recession even though the U.S.              economy has performed well. Some economists have argued that this is a bad idea because it does not give the Fed  much room to lower interest rates further (because of the zero lower bound) if a recession occurs. Does the reduced sensitivity of investment to interest rates strengthen or weaken these economists’ argument? Explain.

(5) [10 points] The U.S. Federal Reserve just lowered interest rates by 50 basis points (one half of one percent) due to concerns that the Coronavirus will cause a recession. Use the open-economy version   of the AS-AD model to determine how this would affect Canada’s economy, assuming that the Bank of Canada does not take any monetary policy action in response.

(6) [10 points]  In 1960, Thailand and South Korea had similar levels of economic development. Thai real GDP per capita in 1960 was $1,118, while South Korean real GDP per capita was $1,175.  Since   then, the two countries have grown at very different rates.  In 2010, Thai real GDP per capita was      $13,109, while South Korean real GDP per capita was $32,327.

(a) [6 points] Compute the annualized growth rates of Thai and South Korean real GDP per capita between 1960 and 2010.


(b) [4 points] Propose an explanation for why South Korea’s economy grew so much faster than Thailand’s during this period.

(7) [5 points] Consider the figure below, which shows the U.S. unemployment rate as a solid line.


(a) [2 points] What economic concept does the dashed line represent?


(b) [3 points] Based solely on the data, was the period 1981– 1985 an expansion or a recession?  Explain.

(8) [7 points] Explain why the law of one price might not hold for some types of goods.  Give three examples of goods for which the law of one price is likely not to hold .

(9) [7 points] Consider an economy in which the following activities occur during a given year:

•    A steel company pays its workers $95,000 to mine iron ore and process it into 1000 kilograms of steel.

•    A car manufacturer purchases the steel for $113 per kilogram, and pays its workers $27,000 to produce 38

cars, which it sells to final consumers for $6,300 per car.

(a) [5 points] Compute GDP in this economy.


(b) [2 points] Suppose that in the next year, the quantities of steel and cars are the same, wages paid by both       companies are the same, but the price of steel is now $128 kilograms and the price of a car is $5,900. What is the growth rate of real GDP between the first year and the next?

(10) [7 points] Consider a version of the open-economy AS-AD (or IS-MP; it doesn’t matter in this case) in which the interest rate does not affect investment (so that the parameter  = 0). Does   domestic monetary policy have affect short-run GDP? Explain why or why not.

(11) [7 points] Consider a version of the open-economy AS-AD (or IS-MP; it doesn’t matter in this  case) in which the interest rate does not affect investment (so that the parameter       = 0). Does domestic monetary policy have affect short-run GDP? Explain why or why not.