A32209 Calculators permitted but must not be used to store

text. Calculators with the ability to store text should

have their memories deleted prior to the start of the
examination.

Department of Economics

Degree of BSc.

08 29189

LI Macroeconomics

Final Examination 2021

Time Allowed: 2 hours

Answer FOUR questions - TWO questions from Section A

and TWO questions from Section B.

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Section A
Answer TWO out of the following four questions

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%]

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Section B
Answer TWO out of the following four questions

For Section B: You may use additional reading specified in the ResourceLists@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 (𝑌):

𝑌 = 𝑌̅ + 𝛼 (𝑃 − 𝐸𝑃) (1)

where 𝑌̅ is the ‘natural’ level of real output, 𝑃 is the general price level, 𝐸𝑃 is the
expected future general price level and 𝛼 is a parameter (𝛼>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:

𝑌𝑡 = 𝑌̅𝑡 − 𝛼 (𝑟𝑡 − 𝜌) + 𝜖𝑡 (2)

𝑟𝑡 = 𝑖𝑡 − 𝐸𝑡 𝜋𝑡+1 (3)
𝜋𝑡 = 𝐸𝑡−1 𝜋𝑡 + 𝜙(𝑌𝑡 − 𝑌̅𝑡 ) + 𝑣𝑡 (4)
𝐸𝑡 𝜋𝑡+1 = 𝜋𝑡 (5)
𝑖𝑡 = 𝜋𝑡 + 𝜌 + 𝜃𝜋 (𝜋𝑡 − 𝜋𝑡∗ ) + 𝜃𝑌 (𝑌𝑡 − 𝑌̅𝑡 ) (6)

where 𝑌𝑡 is real output, 𝑌̅𝑡 is the ‘natural’ level of real output, 𝑟𝑡 is the real interest rate,
𝑖𝑡 is the nominal interest rate, 𝐸𝑡 𝜋𝑡+1 is the expected rate of inflation, 𝜋𝑡 is the actual
rate of inflation, 𝜋𝑡∗ is the inflation target and 𝜖𝑡 and 𝑣𝑡 are shocks which take a mean
value of zero. The remaining terms (𝛼, 𝜌, 𝜙, 𝜃𝜋 and 𝜃𝑌 , 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

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information provided in the table below to explain the importance of the

magnitude of the parameter 𝜃𝜋 to the subsequent path of inflation. [60%]

Quarterly UK Data, 1972q3-1997q1 (excluding 1987q2-1992q3)

Standard
Average
Deviation of
Time Period 𝜽𝝅 𝜽𝒀 Inflation
Inflation
Rate (%)
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:

𝑢 = 𝑢𝑛 − 𝛼 (𝜋 − 𝐸𝜋) (7)

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where 𝑢 and 𝑢𝑛 represent the actual and natural rates of unemployment, respectively;
𝜋 represents the actual rate of inflation; 𝐸𝜋 represents the expected future rate of
inflation and 𝛼 is a constant parameter (𝛼>0).

Further assume that the social cost of unemployment and inflation is given by the
following ‘loss function’:

𝐿(𝑢, 𝜋) = 𝑢 + 2𝜋 2 (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:

𝑇 + ∆𝐵 + ∆𝑀 = 𝐺 + 𝑖𝐵 (9)

where 𝑇 is tax revenue, ∆𝐵 is the change in public debt, ∆𝑀 is the change in the money
supply (the monetary base), 𝐺 is government spending and 𝑖 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%]

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