Answer any eight questions from section A and any three questions from section B.
40% of the total mark is allocated to section A and 20% to each question from section B. Explain your answers clearly. There will be no credit without explanation.
Time allowed: 1 hour 10 minutes for Section A and 1 hour 50 minutes for Section B.
Section A
1. The conduct of discretionary policy under static expectations leads to time inconsistency problem. True or false? Explain.
Marking scheme.
False. Discretionary policy, static expectations – definition. (1p.). Time inconsistency-def and explanation (2 p.) Forward looking behavior– necessary condition for time inconsistency(2),
2. If government purchases depend positively on income, AD curve would be flatter. True or false? Explain.
Marking scheme.
Intuitively: when price level falls increased real money supply leads to excess supply of money and results in a fall in interest rate. As a result investment goes up, planned spending increases and there is EDgoods, which result in output expansion. Note that if planned spending increases by one unit, output increases with multiplier effect. When not only consumption but also government purchases depend on income, multiplier effect is stronger due to increased induced changes in planned spending. Thus overall change in income would be larger for the same initial fall in price level, which means that AD curve becomes flatter. (3 p.) Graphical analysis. (2 p.)
3. If we have the liquidity trap, then fiscal policy multiplier is the same as the expenditure multiplier. True or false? Explain your answer.
Marking scheme.
True. Intuitively: interest rate is not affected at liquidity trap as agents are willing to keep all financial wealth in form of cash. As a result output changes by the full value of expenditure multiplier as there is no crowding out effect. (2 p.) Graph with comments.(3 p.)
4. The sacrifice ratio is smaller if monetary policy announcements are more credible. True or false? Explain your answer.
Marking scheme.
Yes. Sacrifice ratio (def). Intuitive explanation. (3 p.) Graph (2 p.).
5. Assume an economy is characterized by production function 
. The capital stock is 3000 and the current net investment is 120. If the growth rate of total factor productivity is zero, and growth rate of labor is 1%, what is the current growth rate of per person output? Explain.
Marking scheme.
Output decomposition: 
. (2 p.)
As 
and 
, we have 
(1 p.).
(1 p.) and
. (1 p.)
6. A balanced-budget rule helps to stabilize the level of output. True or false? Explain your answer.
Marking scheme.
False as balanced-budget rule makes the economy more responsive to shocks. Revenues are procyclical (increases in booms and falls in recession) (2 p.). To stabilize the economy expenditures must be increased or taxes- decreased when output is above full employment and vice versa, but balanced budget rule makes it impossible (3 p.).
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7. In the neoclassical (Solow) growth model, a permanent rise in the growth rate of population results in lower steady state per capita output. True or false? Explain your answer.
Marking scheme.
True. Graph. (3 p.). Comments. (2 p.)
8. Suppose in Ruritania the average unemployment rate has been very high for the last 20 years. Do you agree that the high unemployment rate may be due to tight monetary policy conducted by the Central Bank?
Marking scheme.
Monetary policy directly affects cyclical unemployment, but it is unlikely that the effect is sustained for 20 years. In the long run economy operates at natural rate. So we deals with high natural rate of unemployment (1) But cyclical unemployment may affect natural via hysteresis effect (2 p.). Explanations of hysteresis: insider/outsider model, loss of skilles. (2 p.)
9. The end of hyper-inflation is always and everywhere a fiscal phenomenon. True or false? Explain.
Marking scheme.
True. During hyperinfalation inflation rate is high due to high growth of money supply (used to finance BD). (1 p.) The end of hyper-inflation is a fiscal phenomenon in a sense that the credibility of monetary restrictions requires legally binding fiscal reform, requires an independent CB that is not obliged to finance BD.(4 p.)
10. Fiscal expansion changes output composition even if it was fully anticipated and so policy ineffectiveness proposition does not work in case of fiscal policy. True or false?Explain your answer.
Marking scheme.
False. Fiscal expansion do change output composition even if it is perfectly anticipated: both AD and AS curves shifts up and output stays the same at full employment level but its composition is different: in closed economy 
if fiscal expansion works through G, 
and 
. Thus we observe complete crowding out of private investment.Graph.(2 p.)
But although composition of output is affected the PIP is satisfied as it does not say about composition of output. PIP stays that under market clearing and rational expectations anticipated monetary and fiscal policies will be ineffective in a sense that they have no effect on output. (3 p.)
Section B
11. Consider closed economy with sticky wages. Assume that production function is characterized by constant marginal product of labor.
(a) What is the effect of an investment subsidy on equilibrium amount of investment in this economy?
(b) How (if at all) would your answer to part (a) change if wages are flexible?
Marking scheme.
(a) As MPL is constant, then Ld is horizontal. Under labor contracts, employment is determined by Ld and as a result SRAS is horizontal and output is determined by AD. (2 p.) Thus we have to look at IS-LM model.
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With investment subsidy, planned spending goes up and result in ED of goods, which stimulates firms to expand output.(In terms of IS-LM model this brings rightward shift of IS). Increase in income results in an increase in transaction demand for money and leads to EDmoney, which is eliminated by the increased return on bonds, i.e. interest rate goes up and results in crowding out of private investment. Thus we have to compare increase in autonomous investment with the crowding out effect. (4 p.)
In equilibrium 
. As 
and 
(0<mpc<1), then 
.(4 p.)
(b) If wages are flexible, then employment is given by intersection of Ld and Ls. The corresponding AS is vertical and so 
. (2 p.) As 
and 
, then 
, i.e. interest rate increase result in full crowding out of initial expansion. (4 p.) Graphs. (3 p.) Overall impression. (1p.)
12. (a) Derive the balance of payments curve in case of zero capital mobility. Determine the effect of a devaluation of domestic currency on the balance of payments curve in this case.
(b) Consider a small open economy with fixed prices and wages and perfect capital mobility. Analyze the effect of an expected (not actual) devaluation of domestic currency on output and its composition.
Marking scheme.
(a) BP curve (definition). Equation (as there is no capital mobility BP=NX=0). Explanation of determinants of NX (Marshall-Lerner condition). Vertical BP, graph. (3 p.)
Nominal exchange rate (def). Devaluation of domestic currency means an appreciation of foreign currency. Thus when foreign currency appreciates, domestic goods become less expansive, thus real exchange rate (R=epf/p) goes up and trade balance improves due to increased competitiveness of domestically produced goods. (2 p.)
Thus at any point along original BP we have BP surplus, which is eliminated by increased import, which is the case with larger domestic income. Thus BP curve shifts to the right. (3 p.)
Overall impression (1 p.)
(b) Consider a small open economy with fixed prices and wages and perfect capital mobility. Analyze the effect of an expected (not actual) devaluation of domestic currency on output and its composition.
Expected devaluation shifts BP upwards (explanation).(2 p.)
(5 p.)
Foreign assets become more attractive, huge capital outflow results in ED for foreign currency, to keep exchange rate constant CB intervenes and sells foreign currency, Reserves goes down, supply of domestic currency goes down, ED at money market results in an increase in domestic interest rate at every level of output (LM shifts upwards) until returns on domestic and foreign assets are equalized. (3 p.)
13. Consider the neo-classical Solow growth model, with positive and constant population growth rate 
and technology growth 
.
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(a) Assume that 
, 
, 
, 
, 
. Find steady state consumption per efficient labor unit. Is consumption per efficient labor unit maximised in the steady state?
(b) Let 
. Does a permanent fall in saving rate always lead to a fall in steady-state level of per capita consumption?
Marking scheme.
(a) 
and 
, 
or 
or 
and 
. 
(5)
. Thus economy operates to the left from golden rule and consumption per efficient worker is not maximised. (3 p.) Graph. (2 p.).
(b) No. Intuition: on one hand with lower saving rate, steady state capital per worker falls and as a result per capita output is lower, but on the other hand marginal greater share of this output is consumed. Thus consumption fall due to fall in per capita income but rise due to increase in marginal propensity to consume. (2 p.)
Golden rule (def). If economy is to the left from golden rule (or at golden rule), then decrease in s results in fall of consumption 
. As 
, then 
if 
, i.e. economy operates to the left from golden rule. (graph).(4 p.)
If economy operates to the right from golden rule, then small reduction in s results in increase in consumption (while sharp fall in s such that new steady state appears to the left from golden rule may result in fall of consumption). Graph. (4 p.)
Glossary
| 1. Aggregate demand in closed economy: IS-LM model | |
| Keynesian Cross model | Модель Кейнсианского креста |
| Expenditure multiplier | Мультипликатор автономных расходов |
| Planned aggregate expenditures | Планируемые совокупные расходы |
| Autonomous expenditures | Автономные расходы |
| Paradox of thrift | Парадокс бережливости |
| Crowding out effect | Эффект вытеснения |
| Liquidity trap | Ликвидная ловушка |
| Fiscal expansion | Фискальная экспансия |
| Monetary expansion | Кредитно-денежная экспансия |
| Fiscal contraction | Жесткая фискальная политика |
| Monetary contraction | Жесткая кредитно-денежная политика |
| Policy mix | Смешанная политика |
| 2. Aggregate demand in an open economy: the IS-LM-BP model | |
| Balance of payments | Платежный баланс |
| Current account | Счет текущих операций |
| Capital account | Счет движения финансового капитала |
| External equilibrium | Внешнее равновесие |
| Balance of Payments (BP) curve | Кривая равновесия платежного баланса (кривая ВР) |
| Internal equilibrium | Внутреннее равновесие |
| Country risk | Страновой риск |
| Exchange rate risk | Риск по обменным курсам валют |
| Floating exchange rate regime | Гибкий (плавающий) обменный курс |
| Fixed exchange rate regime | Фиксированный обменный курс |
| Perfect capital mobility | Абсолютная мобильность капитала |
| Imperfect capital mobility | Несовершенная мобильность капитала |
| Absence of capital mobility | Отсутствие мобильности капитала |
| 3. Aggregate supply and aggregate demand | |
| Aggregate demand curve | Кривая совокупного спроса |
| Keynes effect | Эффект Кейнса |
| Trade balance effect | Эффект торгового баланса |
| Real wealth effect | Эффект реального богатства |
| Aggregate supply curve | Кривая совокупного предложения |
| Sticky wages model | Модель негибкой заработной платы |
| Worker misperception model | Модель неверных представлений работников |
| Imperfect information model | Модель несовершенной информации |
| Sticky price model | Модель с негибкими ценами |
| Menu costs | Издержки меню |
| Static expectations | Статические ожидания |
| Adaptive expectations | Адаптивные ожидания |
| Phillips curve | Кривая Филлипса |
| Okun’s law | Закон Оукена |
| 4. Demand management policy | |
| Discretionary policy | Дискреционная политика |
| Non-discretionary policy (policy rules) | Нормативная политика |
| Inside lags | Внутренние лаги |
| Recognition lag | Лаг распознавания |
| Decision lag | Лаг принятия решений |
| Action lag | Лаг действия |
| Outside lag | Внешний лаг |
| Time-inconsistency | Динамическая несогласованность |
| Rational expectations | Рациональные ожидания |
| Lucas critique | Критика Лукаса |
| 5. Unemployment and inflation | |
| Natural rate of unemployment | Естественный уровень безработицы |
| Frictional unemployment | Фрикционная безработица |
| Structural unemployment | Структурная безработица |
| Classical (real wage) unemployment | Классическая безработица |
| Cyclical unemployment | Циклическая безработица |
| Job finding rate | Уровень найма на работу |
| Job separation rate | Уровень увольнения |
| Efficiency wage theories | Теории эффективной заработной платы |
| Hysteresis | Гистерезис |
| Expected inflation | Ожидаемая инфляция |
| Unexpected inflation | Непредвиденная инфляция |
| Policy ineffectiveness proposition | Утверждение о неэффективности экономической политики |
| Sacrifice ratio | Соотношение потерь |
| 6. The neoclassical (Solow) growth model | |
| Neoclassical (Solow) growth theory | Неоклассическая теория роста (Солоу) |
| Solow residual | Остаток Солоу |
| Output per worker | Производительность труда |
| Capital per worker | Капиталовооруженность |
| Labour augmenting technological progress | Трудосберегающий технический прогресс |
| Efficiency labour units | Эффективные единицы труда |
| Capital accumulation equation | Уравнение накопления капитала |
| Absolute convergence | Абсолютная конвергенция |
| Conditional convergence | Относительная конвергенция |
| Golden rule level of capital accumulation | Золотое правило накопления капитала |
| Exogenous growth theory | Теория экзогенного экономического роста |
| Endogenous growth theory | Теория эндогенного экономического роста |
| 7. Microfoundations of aggregate consumption | |
| Keynesian consumption function | Кейнсианская функция потребления |
| Consumption puzzle | Парадокс потребления |
| Marginal propensity to consume | Предельная склонность к потреблению |
| Average propensity to consume | Средняя склонность к потреблению |
| Fisher’s model of intertemporal consumption | Многопериодная модель потребления Фишера |
| Permanent income theory | Теория перманентного дохода |
| Life cycle theory | Теория жизненного цикла |
| Liquidity constraint | Ограничение ликвидности |
| Ricardian equivalence | Эквивалентность Рикардо |
| Bequest motive | Мотив наследства |
| 8. Microfoundations of aggregate investment | |
| Business fixed investment | Инвестиции в основной капитал |
| Residential investment | Инвестиции в жилищное строительство |
| Inventory investment | Инвестиции в запасы |
| Neo-classical model of investment | Неоклассическая модель инвестиций |
| Rental cost of capital | Рентные издержки капитала |
| Net present value approach | Критерий чистой приведенной стоимости |
| Simple accelerator model | Модель простого акселератора |
| Flexible accelerator model | Модель гибкого акселератора |
| Tobin’s q theory of investment | Теория инвестиций q Тобина |
| Fundamental value of a stock | Фундаментальная цена акции |
| Speculative bubbles | Спекулятивный пузырь |
| 9. Demand for money | |
| Transaction demand | Трансакционный спрос |
| Precautionary demand | Спрос из предосторожности |
| Speculative demand | Спекулятивный спрос |
| Portfolio theories | Портфельные теории |
| Transaction costs | Трансакционные издержки |
| Costs of illiquidity | Издержки отсутствия ликвидности |
| 10. Money supply | |
| Cash-deposit ratio | Отношение наличности к депозитам |
| Reserve-deposit ratio | Отношение резервов к депозитам |
| Required reserves | Обязательные резервы |
| Reserve requirement | Норма обязательного резервирования |
| Excess reserves | Избыточные резервы |
| Monetary base (high-powered money) | Денежная база |
| Money multiplier | Денежный мультипликатор |
| Open market operations | Операции на открытом рынке |
| Discount rate | Ставка рефинансирования |
| Federal funds rate | Ставка межбанковского кредита |
| Sterilisation | Стерилизация |
| Monetization of budget deficit | Монетизация бюджетного дефицита |
[1] Assume perfect capital mobility