UNIVERSITY OF MELBOURNE

DEPARTMENT OF ECONOMICS

SEMESTER 2 ASSESSMENT, 2019

ECON20001 INTERMEDIATE MACROECONOMICS

Draft solution

Reading Time: 15 minutes

Writing Time: 2 hours

This examination paper contributes 60 percent to the assessment in ECON20001.

The PAPER and RESPONSE SHEET should both be inserted in the back of the examination

booklet at the end of the examination. For the multiple-choice questions, you may use the

examination script books to draw diagrams or make notes to help you. These diagrams or notes

will not be taken into account for your assessment.

The following items are authorised in the exam room:

– Print dictionary that translates English into a foreign language.

– The approved calculator is the Casio FX82 (any suffix). No equivalent models of calculators

will be permitted.

This exam has 19 pages.

There are a total of 60 marks for this examination.

This paper is not to be removed from the exam room.

This paper will not be held in the Baillieu Library.

SECTION A: ANSWER ALL QUESTIONS

This part contributes 20 marks to this examination.

Suggested time allocation: 40 minutes.

Answer all questions. For each question, using a 2B pencil, fill in the appropriate small circle on

the RESPONSE SHEET. Please follow the SAMPLE RESPONSE SHEET for details required

on the formal RESPONSE SHEET. All questions are equally weighted. Incorrect answers, no

answer or more than one answer, will all receive a zero mark.

SECTION B: ANSWER TWO OUT OF THREE QUESTIONS

This part contributes 20 marks to this examination.

Suggested time allocation: 40 minutes.

Answer the questions in the examination booklet(s) provided.

SECTION C: ANSWER TWO OUT OF THREE QUESTIONS

This part contributes 20 marks to this examination.

Suggested time allocation: 40 minutes.

Answer the questions in the examination booklet(s) provided.

Page 1 of 19

SECTION A

This section is compulsory and contains 12 multiple-choice questions. Suggested

time allotment: 40 minutes for the section, slightly over 3 minutes per response.

All questions are equally weighted.

A1. Consider a closed economy. When *C *= *c*0 + *c*1*Y**D*, a decrease in *c*1 will cause which of the

following to decrease?

(a) equilibrium income

(b) equilibrium disposable income

(c) the multiplier

*(d) all of the above

A2. In the IS-LM model, when the nominal interest rate approaches zero, which of the following

is false?

(a) monetary policy can be ineffective

*(b) people are indifferent between money and bonds

(c) the LM curve is flat

(d) fiscal policy can be effective

A3. Which of the following does not belong to unconventional monetary policy?

(a) forward guidance

(b) central bank’s purchases of long-term government bonds

*(c) central bank’s purchases of short-term government bonds

(d) central bank’s purchases of asset-backed securities

A4. Suppose the Phillips curve equation is given by *π**t **− **π**t e *= 0*.*2 *− *5*u**t*. A *γ *fraction of the

workers have indexed labor contracts such that *π**e*

*t *= *γπ**t *+ (1 *− **γ*)*π**t**−*1. Which of the

following is true when the value of *γ *increases?

*(a) inflation is more sensitive to changes in unemployment

(b) the natural rate of unemployment is higher

(c) the natural rate of unemployment is lower

(d) inflation is less sensitive to changes in unemployment

Page 2 of 19

A5. Consider the long run equilibrium in the dynamic AS-AD model. Which of the following

is false if the central bank has a wrong belief about the natural real interest rate?

(a) the output will be at its natural level

*(b) the inflation rate will be at its target

(c) the real interest rate will be at its natural level

(d) all of the above

A6. Consider the dynamic AS-AD model. Which of the following is false concerning the

monetary policy parameters?

(a) a higher value of *θ**π *leads to a flatter DAD curve

(b) a higher value of *θ**Y *leads to a steeper DAD curve

(c) a higher value of *θ**π *implies less variability of inflation

*(d) a higher value of *θ**Y *implies more variability of output

A7. In the basic Solow model with production function *Y *= *K*1*/*3*N *2*/*3, saving rate of 40% and

depreciation rate of 10%, which of the following is false?

*(a) an increase in the saving rate will increase steady state consumption per worker

(b) steady state capital per worker is 8

(c) an increase in the saving rate will not affect the long run growth rate of capital per

worker

(d) steady state capital to output ratio is 4

A8. Consider the endogenous growth model with production function *Y *= *AK*. Suppose

two economies are identical except that economy 1 has a higher initial capital stock than

economy 2 has. Which of the following is true on the balanced growth path?

(a) the growth rate of output is higher in economy 1

(b) the growth rate of capital is higher in economy 1

*(c) the level of output is higher in economy 1

(d) the capital to output ratio is higher in economy 1

Page 3 of 19

A9. Consider the human capital accumulation model with production function *Y *= *AK**α**H*1*−**α*.

Which of the following is false on the balanced growth path?

(a) physical capital grows at the same rate as human capital

(b) physical capital grows at the same rate as output

*(c) output grows at the same rate as productivity

(d) physical capital to human capital ratio remains constant

A10. Suppose the production function is *Y *= *AK**α**N *1*−**α*. If *g**Y *= 0*.*05, *g**N *= 0*.*02, *g**K *= 0*.*02

and *α *= 1*/*3, what is the value of *g**A *according to growth accounting?

(a) 0.01

*(b) 0.03

(c) 0.02

(d) 0.06

A11. The existence of the J-curve suggests that a real appreciation will cause

*(a) an initial increase in net exports

(b) a final increase in the demand for domestic goods

(c) a final increase in net exports

(d) an initial increase in exports

A12. In the model of monetary policy rules versus discretion, which of the following is true if

the central bank puts more weight on inflation in the loss function?

(a) when the central bank follows the rule, the equilibrium inflation rate should be lower

in response to putting more weight on inflation in the loss function

*(b) when the central bank follows discretion, the equilibrium inflation rate should be

lower in response to putting more weight on inflation in the loss function

(c) when the central bank follows the rule, the equilibrium unemployment rate should be

lower in response to putting more weight on inflation in the loss function

(d) when the central bank follows discretion, the equilibrium unemployment rate should

be lower in response to putting more weight on inflation in the loss function

Page 4 of 19

SECTION B

This section is compulsory and is worth 20 marks. Answer two of the following

three questions. Each question is worth 10 marks. Suggested time: 40 minutes.

B1. *IS-LM model. *Consider an IS-LM model with the central bank controlling the interest

rate. The consumption and investment functions are

*C *= 40 + 0*.*5(*Y **− **T*)

and

*I *= 20 + 0*.*2*Y **− *1000*i*

Suppose *G *= 10 and the government runs a balanced budget. Let the money demand

function be

*M/P *= 2*Y **− *1000*i*

and let *i *= 0*.*05.

(a) Solve for the equilibrium values of output *Y *and real money supply *M/P*. (2 points)

(b) Suppose that the government wants to increase government spending to *G *= 16 but

still maintains a balanced budget. With the change in fiscal policy, solve for the

equilibrium values of output *Y *and real money supply *M/P*. Is the fiscal policy

contractionary or expansionary? Explain. (3 points)

(c) Following the fiscal policy in part (b), if the central bank wants to keep output

unchanged as in part (a), what is the interest rate chosen by the central bank? What

happens to real money supply *M/P*? What is the policy mix used by the government

and the central bank? (3 points)

(d) Now suppose that the demand for real money balances depends on disposable income

*Y **− **T*. That is, the money demand function is *M/P *= 2(*Y **− **T*) *− *1000*i*. Keeping

*i *= 0*.*05, *G *= 10 and a balanced fiscal budget, solve for the equilibrium values of

output *Y *and real money supply *M/P*. Explain the effects of the change in money

demand function. (2 points)

[Total: 10 marks]

(a) Using goods market equilibrium condition, we have

*Y *= *C *+ *I *+ *G *= 40 + 0*.*5(*Y **− *10) + 20 + 0*.*2*Y **− *1000*i *+ 10

It follows that 0*.*3*Y *= 65 *− *1000*i*. Since the central bank sets *i *= 005, we have

*Y *= 50. Using the money market equilibrium condition, we solve for

*M/P *= 2*Y **− *1000*i *= 50

Page 5 of 19

(b) When the government increases *G *and *T *to 16, we rewrite the goods market equilibrium condition as

*Y *= *C *+ *I *+ *G *= 40 + 0*.*5(*Y **− *16) + 20 + 0*.*2*Y **− *1000*i *+ 16

It follows that 0*.*3*Y *= 68 *− *1000*i*. As *i *= 0*.*05, we find *Y *= 60. The money market

equilibrium condition gives *M/P *= 70. The fiscal policy is expansionary as output

increases as a result of the fiscal policy. When *G *and *T *increase by the same amount,

the increase in *G *has an expansionary effect, while the increase in *T *only partially

decreases consumption. Therefore, despite the government has a balanced budget,

output increases.

(c) If the central bank keeps *Y *constant as in part (a), we can use the goods market

equilibrium derived in part (b) to find the required interest rate

0*.*3 *× *50 = 68 *− *1000*i*

The interest rate should be 0.053. The real money supply is *M/P *= 47. The policy

mix is an expansionary fiscal policy and a contractionary monetary policy.

(d) When the money demand function changes, it does not affect the goods market equilibrium condition we derived in part (a). Therefore, *Y *= 50 is not affected. However,

the real money supply is now *M/P *= 2(50 *− *10) *− *1000 *× *0*.*05 = 30 because real

money demand depends on disposable income. As disposable income is less than total

income, real money demand decreases and real money supply also decreases.

Page 6 of 19

B2. *Solow growth model. *Consider the production function *Y *= *K**α*(*AN*)1*−**α*. The aggregate

capital stock accumulates according to

*K**t*+1 *− **K**t *= *sY**t **− **δK**t*

where *s *is the saving rate and *δ *is the depreciation rate. Suppose that the growth rate

of productivity is *g**A *where *A**t*+1 = (1 + *g**A*)*A**t *and the growth rate of employment is *g**N*

where *N**t*+1 = (1 + *g**N*)*N**t*.

(a) Write down the condition that determines steady state capital per effective worker.

Use a diagram to illustrate how steady state capital per effective worker is determined

in this economy. Carefully label your diagram. Is the steady state a stable steady

state? Explain. (3 points)

(b) When capital per effective worker is in steady state, what are the growth rates of

(i) capital per worker, (ii) aggregate capital stock, and (iii) capital to output ratio?

(2 points)

(c) In the middle of the fourteenth century, an epidemic known as the Black Death killed

about a third of Europe’s population. Suppose capital per effective worker was in

the steady state in Europe before this tragedy. With the help of a diagram, illustrate

how this tragedy affects capital per effective worker in Europe in the short run and

in the long run. (2 points)

(d) Following part (c), while the Black Death was an enormous tragedy, the macroeconomic consequences might surprise you: over the next century, wages are estimated

to have been higher than before the Black Death. Explain why wages increased after

the Black Death in Europe. What would happen to the real interest rate after the

Black Death? In the long run, what would be the growth rates of wages and the real

interest rate? (3 points)

[Total: 10 marks]

(a) The condition that determines the steady state capital per effective worker is

*sk**α*

*t *= (*δ *+ *g**A *+ *g**N*)*k**t*

In the diagram, investment per effective worker is concave and effective depreciation

is a straight line. The intersection of investment per effective worker and effective

depreciation determines the steady state capital per effective worker *k**∗*. This steady

state is a stable steady state. If *k**t *is less than *k**∗*, investment per effective worker

is higher than effective depreciation, *k**t *should increase over time till it reaches *k**∗*.

Similarly, if *k**t *is more than *k**∗*, investment per effective worker is less than effective

depreciation, *k**t *should decrease over time till it reaches *k**∗*. So the steady state is a

stable steady state.

Page 7 of 19

2019 final

B2 (a)

B2 (c)

C2 (a)

>>>>>><<<<<

Investment,

depreciation

𝑠𝑠𝑠𝑠(𝑘𝑘𝑡𝑡)

(𝛿𝛿 + 𝑔𝑔𝐴𝐴 + 𝑔𝑔𝑁𝑁)𝑘𝑘𝑡𝑡

𝑘𝑘

𝑡𝑡

𝑘𝑘∗

<<<<<<<

Investment,

depreciation

𝑠𝑠𝑠𝑠(𝑘𝑘𝑡𝑡)

(𝛿𝛿 + 𝑔𝑔𝐴𝐴 + 𝑔𝑔𝑁𝑁)𝑘𝑘𝑡𝑡

𝑘𝑘

𝑡𝑡

𝑘𝑘

𝑘𝑘∗ 0

Figure 1: Solow model

(b) When capital per effective worker is in the steady state, the growth rate of capital

per worker is *g**A*. The growth rate of aggregate capital stock is *g**A *+ *g**N*. The growth

rate of capital to output ratio is 0 because both output and capital grow at the same

rate *g**A *+ *g**N *along the balanced growth path.

(c) The Black Death can be modeled as a one-time decrease in *N*. When *N *decreases,

capital per effective worker *k*0 increases on impact. In the diagram, as capital per

effective worker is higher than the steady state value, investment per effective worker

should be less than effective depreciation, which causes capital per effective worker to

fall over time. Eventually, capital per effective worker should return to the original

steady state.

2019 final

B2 (a)

B2 (c)

C2 (a)

>>>>>><<<<<

Investment,

depreciation

𝑠𝑠𝑠𝑠(𝑘𝑘𝑡𝑡)

(𝛿𝛿 + 𝑔𝑔𝐴𝐴 + 𝑔𝑔𝑁𝑁)𝑘𝑘𝑡𝑡

𝑘𝑘

𝑡𝑡

𝑘𝑘∗

<<<<<<<

Investment,

depreciation

𝑠𝑠𝑠𝑠(𝑘𝑘𝑡𝑡)

(𝛿𝛿 + 𝑔𝑔𝐴𝐴 + 𝑔𝑔𝑁𝑁)𝑘𝑘𝑡𝑡

𝑘𝑘

𝑡𝑡

𝑘𝑘

𝑘𝑘∗ 0

Figure 2: Solow model: a decrease in *N*

Page 8 of 19

(d) Suppose firms are competitive. Capital and labor are paid their marginal product.

We have

*w *= *MPL *= (1 *− **α*)*K**α*(*AN*)*−**α**A *= (1 *− **α*)*AK**α*

(*AN*)*α *= (1 *− **α*)*Ak**α*

After the Black Death, capital per effective worker increases, which leads an increase

in the wage rate. Intuitively, a lower labor supply makes the marginal product of

labor increases. As for the real interest rate,

*r *= *MPK *= *αK**α**−*1(*AN*)1*−**α *= *αk**α**−*1

It shows that the increase in capital per effective worker after the Black Death tends

to decreases the real interest rate. The lower labor supply drives down the marginal

product of capital. Over time, as capital per effective worker increases, the real

interest rate also increases. In the long run, the growth rate of wage is *g**A *and the

growth rate of the real interest rate is 0.

Page 9 of 19

B3. *Goods market in an open economy. *Consider the following open economy. The real exchange rate is fixed and equal to 1. Consumption is given by *C *= 100 + 0*.*5(*Y **− **T*),

investment is *I *= 50, taxes are *T *= 10, and government spending is *G *= 15. Imports and

exports are given by *IM *= 0*.*1*Y *and *X *= 0*.*02*Y **∗ *where *Y **∗ *is foreign GDP.

(a) Solve for the equilibrium *Y *in the domestic economy for any given *Y **∗*. (2 points)

(b) What is the government purchases multiplier in this economy? If we were to close the

economy – so exports and imports were identically zero – what would the multiplier

be? Why are the open and closed economy multipliers different? (3 points)

(c) Assume that foreign GDP is 5 times as large as domestic GDP. What is the equilibrium

value of domestic GDP *Y *? If the foreign economy experiences a boom and its GDP

increases by 10%, what is the new equilibrium value of domestic GDP *Y *? (2 points)

(d) Suppose that the foreign economy wants to improve its trade balance by imposing

tariffs on its imports. This change of trade policy leads to a decline of foreign demand

for domestic goods. In particular, *X *= 0*.*01*Y **∗*. With this new export demand, solve

for the equilibrium values of domestic GDP *Y *and foreign GDP *Y **∗ *assuming again

foreign GDP is 5 times as large as domestic GDP. How does the trade protection by

the foreign economy affect domestic and foreign GDP? Explain. (3 points)

[Total: 10 marks]

(a) Using the goods market equilibrium condition, we have

*Y *= *C *+ *I *+ *G *+ *X **− **IM *= 100 + 0*.*5(*Y **− *10) + 50 + 15 + 0*.*02*Y **∗ **− *0*.*1*Y*

After rearranging, we find 0*.*6*Y *= 160 + 0*.*02*Y **∗*.

(b) The government purchases multiplier is 1*/*0*.*6 = 5*/*3. If we were to close the economy,

the multiplier is 1*/*0*.*5 = 2. The multiplier with a closed economy is larger because a

one unit increase in autonomous spending will lead to a one unit increase in output

through the direct effect. The increase in output will raise consumption through the

multiplier effect. Overall, output should increase by two units.

With an open economy, the same one unit increase in autonomous spending can

increase output by one unit. The increase in output will raise consumption and

imports. Since imports represent income flow to the foreign economy, there is a

leakage of income in the open economy. Overall, the multiplier effect is smaller. We

have a smaller multiplier in the open economy.

(c) When *Y **∗ *= 5*Y *, we have 0*.*6*Y *= 160 + 0*.*1*Y *. It gives *Y *= 320 and *Y **∗ *= 1600. If the

foreign economy experiences a 10% increase in GDP, we have *Y **∗ *= 1760. Using the

result in part (a), we find 0*.*6*Y *= 160 + 0*.*02 *× *1760. It follows *Y *= 325*.*3.

(d) When the foreign economy imposes imports tariff, we can rewrite the goods market

equilibrium condition as

*Y *= *C *+ *I *+ *G *+ *X **− **IM *= 100 + 0*.*5(*Y **− *10) + 50 + 15 + 0*.*01*Y **∗ **− *0*.*1*Y*

Page 10 of 19

Then we have 0*.*6*Y *= 160 + 0*.*01*Y **∗*. Using *Y **∗ *= 5*Y *, we solve for *Y *= 290*.*91 and

*Y **∗ *= 1454*.*55. Notice that the trade protection implemented by the foreign economy

leads to a lower GDP in both economies. When foreign economy imports less from

domestic economy, it leads to a lower domestic output. As foreign GDP also depends

on domestic imports, a lower domestic GDP leads to lower imports. Foreign GDP

also falls. The trade protection hurts both economies in terms of their output.

Page 11 of 19

SECTION C

This section is compulsory and is worth 20 marks. Answer two of the following

three questions. Each question is worth 10 marks. Suggested time: 40 minutes.

C1. *Labor market flows. *Suppose the change in unemployment *u**t *is given by

*u**t*+1 *− **u**t *= *s*(1 *− **u**t*) *− **fu**t*

(a) Solve for the steady-state unemployment rate. If the economy goes into a recession

and the job separation rate *s *increases, would you expect to find that the proportion

of long-term unemployed workers is higher or lower? Explain. (2 points)

(b) Suppose now that *f*(*θ**t*) = *Aθ**t *1*/*2. Labor market tightness *θ**t *is defined as *θ**t *= *v**t**/u**t*

where *v**t *is the job vacancy rate. Derive the Beveridge curve and explain how *v**t *and

*u**t *are related. (2 points)

(c) Suppose that firms post vacancies until the vacancy filling rate *q*(*θ**t*) satisfies *q*(*θ**t*)*J *=

*c*, where *q*(*θ**t*) is the vacancy filling rate, *J *is the value of a filled position and *c *is the

cost of creating a vacancy. Solve for the equilibrium labor market tightness *θ**∗ *and

the steady-state unemployment rate and vacancy rate. (2 points)

When considering the job creation decision, the value of a filled vacancy is given by *J*. Now

suppose that *J *depends on two factors: output produced by the worker-firm match and

the wage paid to the worker. Once a vacancy is filled by a worker, the match can produce 1

unit of output. Moreover, the wage paid to the worker is given by *w*(*u*) = 1*/*(1+*u*), where

*u *is the unemployment rate. In this case the value of a filled vacancy can be expressed as

*J *= 1 *− **w*(*u*).

(d) Use the job creation decision and the Beveridge curve to find the equilibrium unemployment rate. (2 points)

(e) How does the equilibrium unemployment rate depend on the matching efficiency

parameter *A*? How does the wage rate depend on the matching efficiency parameter

*A*? Give intuition for your answers. (2 points)

[Total: 10 marks]

(a) Steady state unemployment is *u *= *s/*(*s *+ *f*). The duration of unemployment is given

by 1*/f*. Given that *f *does not change, the proportion of long-term unemployment

workers remains the same.

(b) The Beveridge curve is given by

*v**t *=

*s*2(1 *− **u**t*)2

*A*2*u**t*

Page 12 of 19

Notice that the numerator on the right-hand-side of the Beveridge curve is decreasing

in *u**t *and the denominator on the right-hand-side of the Beveridge curve is increasing

in *u**t*. It implies that *v**t *is negatively related to *u**t*.

(c) The job creation decision gives *q*(*θ**t*)*J *= *c*. The vacancy filling rate *q*(*θ*) can be found

by

*q*(*θ*) = *f*(*θ*)*/θ *= *Aθ**t **−*1*/*2

Using the job creation decision,

*q*(*θ*)*J *= *Aθ**t **−*1*/*2*J *= *c*

The equilibrium labor market tightness is *θ**∗ *= (*AJ/c*)2. Using the steady state

unemployment equation

*u**∗ *= *s*

*s *+ *f*(*θ*) =

*s*

*s *+ *A*2*J/c *=

*sc*

*sc *+ *A*2*J*

The equilibrium vacancy rate is *v**∗ *= *θ**∗**u**∗ *= (*sA*2*J *2)*/*(*sc*2 + *A*2*Jc*)

(d) The job creation decision implies that

*q*(*θ*)*J *= *Aθ**t **−*1*/*2(1 *− **w*(*u*)) = *Aθ**t **−*1*/*2(1 *− *1

1 + *u*

) = *c*

and the steady state unemployment rate gives

*u *=

*s*

*s *+ *Aθ*1*/*2

From the job creation decision, we can express *θ*1*/*2 as

*θ*1*/*2 = *A *1+ *uu*

*c*

Plugging it back into the steady state unemployment equation, we can solve for *u*

*u *= *sc *+ *scA*21*/*2

(e) From the solution in part (d), unemployment is decreasing in *A*. Since the wage rate

is a decreasing function of the unemployment rate, the wage rate is increasing in *A*.

Intuitively, when the economy is more efficient in matching unemployed workers and

vacant firms, more matches will be formed. The unemployment rate decreases as a

result. Since the wage rate depends negatively on the unemployment rate, the lower

unemployment rate leads to a higher wage rate.

Page 13 of 19

C2. *Dynamic AS-AD model. *Consider a dynamic AS-AD model with DAS curve

*π**t *= *π**t**−*1 + 0*.*4(*Y**t **− *100)

and with DAD curve

*Y**t *= 100 *− *0*.*5(*π**t **− *3) + 0*.*5*t*

The output equation is

*Y**t *= 100 *− *(*r**t **− *2) + *t*

(a) Solve for inflation as a function of lagged inflation and demand shocks. Use a diagram

to illustrate how inflation depends on lagged inflation. If inflation deviates from its

target level, does inflation return to its target according to the equation you have

derived? Explain. (2 points)

Suppose that the economy is initially in the long run equilibrium and then at time *t *= 1

the government cuts its spending by having 1 = *−*3 for just one period. That is, 1 = *−*3

and *t *= 0 for all subsequent *t*.

(b) Compute the values of output, inflation, nominal interest rate and real interest rate

at time *t *= 1. (2 points)

(c) With the help of a diagram, explain qualitatively the subsequent time paths of output

and inflation after the negative demand shock ends. Carefully label your diagram.

How does monetary policy respond to the negative demand shock? Explain. (3 points)

(d) Now suppose that the negative demand shock is permanent. With the help of a

diagram, explain how a permanent negative demand shock affects the economy over

time. Would inflation return to its target and output return to its natural level in

the long run? Why or Why not? (2 points)

(e) Following part (d), what could the central bank alter to achieve the original long run

equilibrium? Explain. (1 point)

[Total: 10 marks]

(a) Using the DAD equation, we have

*Y**t **− *100 = *−*0*.*5(*π**t **− *3) + 0*.*5*t*

Substituting output gap into the DAS equation, we have

*π**t *= *π**t**−*1 *− *0*.*2(*π**t **− *3) + 0*.*2*t*

It gives 1*.*2*π**t *= *π**t**−*1 +0*.*6+0*.*2*t*. If we graph *π**t *as a function of *π**t**−*1, the intersection

of *π**t *with the 45-degree line gives the steady state inflation rate. If inflation deviates

from the steady state, it always return its target. From the diagram, if inflation is

below its taget, it will increase till it reaches its target. Similarly, if inflation is above

its target, it will decrease till it reaches its target.

Page 14 of 19

C2 (c)

C2 (d)

>>>>>>>>> <<<<<<<<<<

𝜋𝜋

𝑡𝑡

𝜋𝜋

𝑡𝑡(𝜋𝜋𝑡𝑡−1)

45-degree line

𝜋𝜋

𝑡𝑡−1

𝜋𝜋∗

𝐷𝐷𝐷𝐷𝐷𝐷

3

𝐷𝐷𝐷𝐷𝐷𝐷

2

3

C

B

𝐷𝐷𝐷𝐷𝐷𝐷

0,1

A

output

inflation

𝐷𝐷𝐷𝐷𝐷𝐷

0,2

𝐷𝐷𝐷𝐷𝐷𝐷

1

100

Figure 3: Inflation dynamics

(b) If 1 = *−*3, we can calculate *π*1 = 2*.*5. Using the DAD equation, *Y*1 = 98*.*75. Using

the output equation, *r*1 = 0*.*25. From the Fisher equation, we find *i*1 = 2*.*75.

(c) The temporary negative demand shock shifts the DAD curve to the left on impact.

The economy moves from A to B. Both output and inflation decrease. As inflation

decreases, the DAS curve begins to shift down at time *t *= 2. Since the demand shock

disappears at time *t *= 2, the DAD curve shifts back at *t *= 2. The economy moves

to C. Inflation at *t *= 2 rises. From time *t *= 3, only the DAS curve shifts up while

the DAD curve remains unchanged. Overtime, the economy returns to its long run

equilibrium. C2 (c)

C2 (d)

>>>>>>>>> <<<<<<<<<<

𝜋𝜋

𝑡𝑡

𝜋𝜋

𝑡𝑡(𝜋𝜋𝑡𝑡−1)

45-degree line

𝜋𝜋

𝑡𝑡−1

𝜋𝜋∗

𝐷𝐷𝐷𝐷𝐷𝐷

3

𝐷𝐷𝐷𝐷𝐷𝐷

2

3

C

B

𝐷𝐷𝐷𝐷𝐷𝐷

0,1

A

output

inflation

𝐷𝐷𝐷𝐷𝐷𝐷

0,2

𝐷𝐷𝐷𝐷𝐷𝐷

1

100

Figure 4: A transitory demand shockl

Page 15 of 19

In response to the negative demand shock, monetary policy requires the nominal

interest rate to decreases and the real interest rate to decreases. As inflation rises

over time back to its target, both the real interest rate and the nominal interest rate

rise back to their long run equilibrium levels.

(d) If the demand shock is permanent, the DAD curve will not shift back at time *t *= 2.

The economy moves from B to C. Therefore, the DAS curve will keep shifting down

as inflation decreases. Eventually, the DAS curve shifts to the positive such that

*Y *= *Y *¯. The economy reaches the new long run equilibrium where output is at its

natural level, but inflation does not return to its target. The permanent negative

demand shock effectively lowers the long run inflation rate.

C3 (a)

C3 (c)

𝐷𝐷𝐷𝐷𝐷𝐷

2

3

C

B

𝐷𝐷𝐷𝐷𝐷𝐷

0,1

A

output

inflation

𝐷𝐷𝐷𝐷𝐷𝐷

0

𝐷𝐷𝐷𝐷𝐷𝐷

1

100

*IS*

*Y*

domestic interest rate

*i*

domestic interest rate

Interest parity

*LM*

*IS’*

output

*Y’ E*

exchange rate

Figure 5: A permanent demand shock

(e) The permanet negative demand shock reduces the long run inflation rate. If the

central bank wants to achieve the original inflation target, it can set a higher target

inflation rate. In this way, the long run inflation rate can be restored at the original

inflation target.

Page 16 of 19

C3. *Mundell-Fleming model. *Consider an open economy with a flexible exchange rate. Suppose

the domestic central bank keeps a target interest rate.

(a) Suppose that the foreign economy experiences a recession and its demand falls. With

the help of a diagram, show how the decrease in foreign demand affects domestic

output *Y *and the nominal exchange rate *E*. (2 points)

(b) If the domestic government and central bank want to stabilize output in response to a

fall of foreign demand, discuss the policy option(s) available for the domestic economy.

Suppose the domestic economy pursues a fixed exchange rate regime. What should

be the policy option(s) to stabilize domestic output? (2 points)

Now we modify the uncovered interest rate parity (UIP) condition as

1 + *i**t *=

(1 + *i**∗ **t*)*E**t*

*E**e*

*t*+1

+ *x*

where *x *captures factors that might affect the relative demand for domestic assets

and foreign assets.

(c) Suppose that for some reasons, people are more willing to hold foreign assets. Should

*x *increase or decrease to reflect this shift of preferences towards foreign assets? How

does this change of the UIP condition affect domestic output *Y *and the nominal

exchange rate *E*? Explain with the help of a diagram. (2 points)

(d) Suppose that due to the recession in the foreign economy, people feel that there are

more risks in the foreign financial market. Should *x *increase or decrease to reflect

more risks in the foreign financial market? How does this change of the UIP condition

affect domestic output *Y *and the nominal exchange rate *E*? Explain with the help

of a diagram. (2 points)

(e) Following part (d), what should the central bank do if the domestic economy adopts

a fixed exchange rate regime? How will the combination of domestic monetary policy

and the change of the UIP condition affect domestic output? Explain with the help

of a diagram. (2 points)

[Total: 10 marks]

(a) In the Mundell-Fleming model, the decrease in foreign demand shifts the domestic IS

curve to the left without changing the interest parity condition. Therefore, domestic

output falls and the nominal exchange rate is not affected.

(b) If the domestic economy wants to stabilize output, it can use either an expansionary

monetary policy or an expansionary fiscal policy. The expansionary fiscal policy can

shift the IS curve back to its original position to stabilize output without affecting

the exchange rate. With an expansionary monetary policy, the LM curve shifts down

and the exchange rate will depreciates. When the domestic economy pursues a fixed

exchange rate regime, it cannot use monetary policy to stabilize output. Using an

expansionary fiscal policy is the only option.

Page 17 of 19

C3 (a)

C3 (c)

𝐷𝐷𝐷𝐷𝐷𝐷

2

3

C

B

𝐷𝐷𝐷𝐷𝐷𝐷

0,1

A

output

inflation

𝐷𝐷𝐷𝐷𝐷𝐷

0

𝐷𝐷𝐷𝐷𝐷𝐷

1

100

*IS*

*Y*

domestic interest rate

*i*

domestic interest rate

Interest parity

*LM*

*IS’*

output

*Y’ E*

exchange rate

Figure 6: A decrease in foreign demand

(c) When people have preferences towards foreign assets, it means that people would

require a higher return to hold domestic assets. In this case, *x *should increase.

A higher *x *shifts the UIP condition left and the exchange rate depreciates. The

depreciation makes the IS curve shift to the right. Overall, domestic output increases

and the exchange rate depreciates.

C3 (d)

C3 (e)

*IS’*

*E’*

*Y*

domestic interest rate

*i*

domestic interest rate

Interest parity

*LM*

*IS*

output

*Y’ E*

exchange rate

Interest parity (higher x)

*E’*

*IS *Interest parity (lower x)

*Y’*

domestic interest rate

*i*

domestic interest rate

Interest parity

*LM*

*IS’*

output

*Y E*

exchange rate

Figure 7: An increase in *x*

(d) When there are more risks associated with foreign assets, people would require a lower

return to hold domestic assets. In this case, *x *should decrease. The UIP condition

shifts to the right and the exchange rate appreciates. The appreciation makes the

IS curve shift to the left. Overall, domestic output decreases and the exchange rate

Page 18 of 19

appreciates.

C3 (d)

C3 (e)

*IS’*

*E’*

*Y*

domestic interest rate

*i*

domestic interest rate

Interest parity

*LM*

*IS*

output

*Y’ E*

exchange rate

Interest parity (higher x)

*E’*

*IS *Interest parity (lower x)

*Y’*

domestic interest rate

*i*

domestic interest rate

Interest parity

*LM*

*IS’*

output

*Y E*

exchange rate

Figure 8: A decrease in *x*

(e) With an appreciation, the central bank should pursue an expansionary monetary policy to lower domestic interest rate to keep the exchange rate fixed. The expansionary

monetary policy tends to increase output, while the change in the UIP condition

tends to lower output. Overall, the nominal exchange rate is unchanged. Since the

interest rate is lower, output should be higher.

*LM’*

Interest parity (lower x)

*IS*

*Y’*

domestic interest rate

*i*

domestic interest rate

Interest parity

*LM*

output

*Y E*

exchange rate

Figure 9: A decrease in *x *with fixed exchange rate

END OF EXAMINATION

Page 19 of 19

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