Download January Examinations 2011

EC2024
January Examinations 2011
No. of Pages:
2
No. of Questions:
5
Subject
ECONOMICS
Title of Paper
EC2024 – FOUNDATIONS OF MACROECONOMIC THEORY
Time Allowed
One and a Half Hours (1½ Hours)
Instructions to candidates
Answer ONE question from Section A and ONE question from Section B
Each question carries equal marks.
An approved calculator (that is, Casio FX83 or FX85) may be used.
SECTION A
Answer ONE Question
A1. Use a closed economy macroeconomic model to illustrate the neutrality of money in the mediumterm. Make sure to provide clear intuition and to illustrate all the relevant mechanisms that describe
the economy’s adjustment from the short-run to the medium-run equilibrium, following changes in
monetary policy. Does money neutrality necessarily imply that monetary policy cannot be used to
affect the adjustment of output from the short- to the medium-run?
A2. “Under fixed exchange rates, fiscal policy is more powerful than it is under flexible exchange
rates”.
Discuss the short-run equilibrium relations that describe the Mundell-Fleming model, and use the
model so as to evaluate this statement. In each exchange rate regime make sure that you describe the
effect of fiscal policy on the other components of aggregate demand such as consumption,
investment and net exports.
A3. Derive equilibrium unemployment in the labour market using the “wage setting” and the “price
setting” relations and making sure to give all the relevant economic assumptions. Illustrate and
describe the effect on the natural rate of unemployment of the following: (a) an increase in
unemployment benefits; and (b) a weakening of antitrust legislation. Derive the short-run aggregate
supply curve.
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EC2024
SECTION B
Answer ONE Question
B1.
i.
Consider a closed-economy that is in short-run equilibrium. Now, suppose that there is a change
in economic policy. In the new short-run equilibrium, output and consumption have not been
affected but investment has fallen. Use intuitive reasoning to describe the changes in the
different economic policy instruments that have led to the new equilibrium. Illustrate these
effects in an IS-LM diagram. [35%]
ii.
An economy is described by the following model:
Consumption function: C 120 0.6(Y T )
Investment function: I 120 0.3Y 480i
Government spending: G 240
Taxes: T 180
MD
1.2Y 2400i
Money demand function:
P
Nominal money supply: M S 3600
Price level: P 3
Obtain the IS and LM relationships and use them to derive the equilibrium values for the interest
rate ( i ) and output ( Y ). Subsequently, calculate equilibrium consumption ( C ) and investment
( I ). [35%]
iii.
Consider an economy in which the government’s budget is described by the difference between
public spending and income-proportional tax revenues. Can monetary policy affect the
government’s budget in the short-term? Explain why. [30%]
B2.
i.
Consider an economy in which the expectations-augmented Phillips curve is given by
πt πte 0.7 8.75ut . Suppose that the government sets a permanent target of 6% for the
unemployment rate. Assuming πte
0 , explain the intuition behind the relationship between
unemployment and inflation, and obtain the inflation rate in periods t , t 1 and t 2 . Is the
mechanism through which individuals form expectations rational? Explain why. [30%]
ii.
Suppose that from period t 3 onwards, expectations are formed according to
πte i xπt i 1 (1 x)πt i , i =3,4,5,...
Setting x 0.8 , obtain the inflation rate in periods t 3 and t 4 . Is the mechanism through
which individuals form expectations rational? Explain why. [35%]
iii.
Suppose that from period t 5 onwards, it is x 0 . What are the implications for the
government’s ability to retain its unemployment target? Explain intuitively. [35%]
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