Discussion on economics

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 = c0 + c1YD, a decrease in c1 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 πt πt e = 0.2 5ut. A γ fraction of the
workers have indexed labor contracts such that πe
t = γπt + (1 γ)πt1. 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 θπ leads to a flatter DAD curve
(b) a higher value of θY leads to a steeper DAD curve
(c) a higher value of θπ implies less variability of inflation
*(d) a higher value of θY implies more variability of output
A7. In the basic Solow model with production function Y = K1/3N 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 = AKαH1α.
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 = AKαN 1α. If gY = 0.05, gN = 0.02, gK = 0.02
and α = 1/3, what is the value of gA 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 + 0.2Y 1000i
Suppose G = 10 and the government runs a balanced budget. Let the money demand
function be
M/P = 2Y 1000i
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) 1000i. 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 + 0.2Y 1000i + 10
It follows that 0.3Y = 65 1000i. Since the central bank sets i = 005, we have
Y = 50. Using the money market equilibrium condition, we solve for
M/P = 2Y 1000i = 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 + 0.2Y 1000i + 16
It follows that 0.3Y = 68 1000i. 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 1000i
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 = Kα(AN)1α. The aggregate
capital stock accumulates according to
Kt+1 Kt = sYt δKt
where s is the saving rate and δ is the depreciation rate. Suppose that the growth rate
of productivity is gA where At+1 = (1 + gA)At and the growth rate of employment is gN
where Nt+1 = (1 + gN)Nt.
(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
skα
t = (δ + gA + gN)kt
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 kt is less than k, investment per effective worker
is higher than effective depreciation, kt should increase over time till it reaches k.
Similarly, if kt is more than k, investment per effective worker is less than effective
depreciation, kt 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 gA. The growth rate of aggregate capital stock is gA + gN. The growth
rate of capital to output ratio is 0 because both output and capital grow at the same
rate gA + gN 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 k0 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)Kα(AN)αA = (1 α)AKα
(AN)α = (1 α)Akα
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 = αKα1(AN)1α = αkα1
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 gA 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 = 0.1Y and X = 0.02Y 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 = 0.01Y . 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 + 0.02Y 0.1Y
After rearranging, we find 0.6Y = 160 + 0.02Y .
(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 = 5Y , we have 0.6Y = 160 + 0.1Y . 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 0.6Y = 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 + 0.01Y 0.1Y
Page 10 of 19
Then we have 0.6Y = 160 + 0.01Y . Using Y = 5Y , 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 ut is given by
ut+1 ut = s(1 ut) fut
(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(θt) = t 1/2. Labor market tightness θt is defined as θt = vt/ut
where vt is the job vacancy rate. Derive the Beveridge curve and explain how vt and
ut are related. (2 points)
(c) Suppose that firms post vacancies until the vacancy filling rate q(θt) satisfies q(θt)J =
c, where q(θt) 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 θand
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
vt =
s2(1 ut)2
A2ut
Page 12 of 19
Notice that the numerator on the right-hand-side of the Beveridge curve is decreasing
in ut and the denominator on the right-hand-side of the Beveridge curve is increasing
in ut. It implies that vt is negatively related to ut.
(c) The job creation decision gives q(θt)J = c. The vacancy filling rate q(θ) can be found
by
q(θ) = f(θ)= t 1/2
Using the job creation decision,
q(θ)J = t 1/2J = c
The equilibrium labor market tightness is θ= (AJ/c)2. Using the steady state
unemployment equation
u= s
s + f(θ) =
s
s + A2J/c =
sc
sc + A2J
The equilibrium vacancy rate is v= θu= (sA2J 2)/(sc2 + A2Jc)
(d) The job creation decision implies that
q(θ)J = t 1/2(1 w(u)) = t 1/2(1 1
1 + u
) = c
and the steady state unemployment rate gives
u =
s
s + 1/2
From the job creation decision, we can express θ1/2 as
θ1/2 = A 1+ uu
c
Plugging it back into the steady state unemployment equation, we can solve for u
u = sc + scA21/2
(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
πt = πt1 + 0.4(Yt 100)
and with DAD curve
Yt = 100 0.5(πt 3) + 0.5t
The output equation is
Yt = 100 (rt 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
Yt 100 = 0.5(πt 3) + 0.5t
Substituting output gap into the DAS equation, we have
πt = πt1 0.2(πt 3) + 0.2t
It gives 1.2πt = πt1 +0.6+0.2t. If we graph πt as a function of πt1, the intersection
of πt 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 π1 = 2.5. Using the DAD equation, Y1 = 98.75. Using
the output equation, r1 = 0.25. From the Fisher equation, we find i1 = 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 + it =
(1 + it)Et
Ee
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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