2010 Sample Examination (P-2)

ECONOMICS
ESSAYS: A. Climate change has now become the biggest threat to human civilization. In this essay you want to use your knowledge of microeconomics to analyse the causes of climate change and assess various measures that are suggested to deal with this problem. a. It is now agreed that excessive quantities of green house gases (GHG), which are generated while producing other goods and services (for example, electricity produced using coal) has been the reason for climate change. However, markets are generally believed to lead to optimal supply of goods and services. Explain why there continues to be demand for energy that leads to excessive emissions of GHG. Can you draw a supply-demand graph to demonstrate your argument? b. Two important measures that are suggested to reduce GHG supply are carbon tax and cap and trade. Under the latter, a limit is set on the total emission of GHG and individual producers that emit GHG are allowed to trade among themselves the permit to emit GHG, while ensuring that the total of such permits does not exceed the limit. It has been claimed that these two measures can produce the same outcome. Examine the validity of this claim and draw graphs to prove your conclusion.

c. Coase Theorem tells that even in presence of externalities, private agents, under certain conditions, can enter into contracts among themselves yielding outcomes that are optimal. Discuss why the theorem did not prove valid in the case of GHG emissions. d. Coase Theorem further tells that distribution of initial rights does not matter in producing optimal outcome. Examine this proposition with regard to initial allocation of permit under cap and trade scheme mentioned in (b) above. In what ways the initial allocation matter or does not matter?

B. Before the global economic crisis, both economists and policy makers expressed concern over the widening of current account imbalances across major economies. Also in the aftermath of the crisis, these imbalances remain a concern. As shown in the figure below, over the past decade (and also in preceding decades), these imbalances featured persistent deficits of the United States, matched by surpluses generated in particular by Japan, China and a number of other developing countries in Asia, as well as by major oil-exporters in the Middle East.

2010 Sample Examination (P-2)

ECONOMICS
Figure: Current account balances of major economies, 2002-2010 (in billions of United States dollars)
1500

1000 billions of US dollars

Other Middle East Developing Asia Japan Euro Area United States

500

-500

-1000 2002 2003 2004 2005 2006 2007 2008 2009 2010

In your essay: a. Discuss why economists and policy makers alike are concerned about these global imbalances. b. Explain how the vast amounts of international reserves accumulated by China and a number of other developing countries are associated with the pattern of global imbalances. c. Discuss the role of exchange rate policy in adjusting the global imbalances. d. Discuss whether the fiscal stimulus packages adopted by the United States and China in response to the global crisis would have helped reduce the global imbalances in the short run or not.

C. In the current economic environment, the notion of a liquidity trap has again moved to the forefront. a. Explain and illustrate the policy problem that is referred to as a liquidity trap using the IS-LM framework. Describe and critically evaluate three macroeconomic policy options that could be effective in reviving economic activity in the presence of a liquidity trap.

b.

2010 Sample Examination (P-2)

ECONOMICS
QUESTIONS: 1. A number of countries have experienced an increase in their foreign exchange reserves. a. Explain two possible reasons as to why countries might try to accumulate foreign exchange reserves. b. Outline two policy challenges that result from the existence of sizable foreign exchange reserves. 2. a. Many have complained that repayment rates of micro credit are high because lenders do not show leniency even when borrowers face unexpected hazards (such as an accident or bad weather leading to income losses). Creditors on the other hand argue that showing such leniency may only encourage future default. As an economist how would you characterize this problem? Provide another example of this problem. Can you suggest any remedy for the problem in the case of the example you cited? b. Micro financing institutions are now expanding from lending to providing insurance. In doing so, they often try to include all of their pervious loan clients (i.e. borrowers) in the newly introduced insurance program. What is the problem they are trying to avoid by including all? Provide another example of this problem. Can you suggest any remedy for the problem in the case of the example you cited? 3. In explaining economic success, economists recently have been emphasizing the importance of knowledge. Answer the following questions to explain the special importance of knowledge. a. b. Define non-excludability and non-rivalness. Use these criteria to classify goods and services into four categories. To which of these categories does (disembodied) knowledge belong, and why? Write down the marginal condition for optimal supply of a public good. How can your result in (c) provide an argument for subsidizing research?

c. d.

4. Trade theory shows that countries whose relative factor productivities differ across industries specialize in the production of different goods and can derive gains from trading with other countries from this specialization. In the simplest framework with 2 countries (A and B), 2 goods (X and Y) and labour as the only factor of production (labour), productivity is measured by the number of hours of labour needed to produce one unit of each good (unit labour requirement). Suppose a situation where the relative international price of goods X and Y is equal to one and the unit labour requirements (a) (in hours) are: aX = 1 and aY = 2 in country A, and a*X = 6 and a*Y = 3 in country B. a. Identify each countrys absolute advantage in production and indicate what determines this. b. Why would absolute advantage alone not determine the pattern of trade between the two countries? c. What should countries A and B produce to gain from trading between themselves and why?
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2010 Sample Examination (P-2)

ECONOMICS
d. If country B exchanges something it took more hours of labour to produce for something that country A produced with less hours of labour, the doctrine of unequal exchange would argue that trade exploits country B and makes it worse off. Why would you agree or disagree? The answer can use information from the answer to question c. 5. In the 1980s, the United States had large government deficits and large trade deficits. In the late 1990s, the government deficit was eliminated but the large trade deficit remained. During the 2000s, the worlds largest economy moved again towards triple deficits: government budget, private sector and trade deficits. Using the link between net exports, savings, and investment, explain why the trade deficit could remain so large when the government deficit was eliminated in the 1990s and subsequently how the country could have significant triple deficits in the 2000s? 6. Suppose that new macroeconomic estimates indicate that the expected inflation rate is 2 per cent in the United States and 5 per cent in Mexico. The real interest rate is 3 per cent in both countries. Assume further that purchasing power parity in the peso/dollar exchange rate determination holds. a. What is the nominal interest rate in each country? b. What are the expected changes in the real and nominal exchange rates? c. If the Central Bank of Mexico increases the money supply and inflation expectations rose to 10 percent in Mexico, how would this change affect the expected changes in the real and nominal exchange rates? If you had planned to invest money in Mexico, would this policy change affect your decision? 7. Agricultural reforms initiated in 1978 were one of the factors that helped promulgate Chinas remarkable economic growth performance of the past few decades. In history similar cases have been found where agricultural reforms played an important role in growth accelerations. a. b. Explain how an agricultural reform can help induce fast industrial growth. The transition from an originally agriculturally based society to one where showing fats industrial growth often also is accompanied by a rise in income inequality. Give at least one reason why.

8. Some low-income countries rely heavily on foreign aid to supplement limited domestic savings and finance economic growth and development. The optimistic view of aids role in economic growth emerged during the 1960s. Aid would supplement domestic savings, allowing higher investment which (through a Harrod-Domar equation) would result in higher growth. This idea was challenged later on. For example, in his 1970 study, Keith Griffin presented cross-country, econometric estimates of the equation presented below, and for one of the estimated specifications the slope coefficient was found to be -0.84:

S = + A + Y Y
1 2 i i

where, S = savings, Y = income, A = aid, and subscript i refers to countries.

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2010 Sample Examination (P-2)

ECONOMICS
a. Why would Griffins results challenge the optimistic view about aids effectiveness in increasing growth? b. How could increased aid inflows undermine export competitiveness and economic growth as a result?