This Paper Is Not To Be Removed From The Examination Halls

~~EC2065 ZA d0
This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON
EC2065 ZA
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route
Macroeconomics
Monday, 13 May 2013 : 2.30pm to 5.30pm
Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from
Section A (5 marks each) and THREE from Section B (20 marks each). Candidates are
strongly advised to divide their time accordingly.
If more questions are answered than requested, only the first answers attempted will be counted.
PLEASE TURN OVER

University of London 2013
UL13/0031
Page 1 of 7
D1
SECTION A
Answer eight questions from this section (5 marks each).
1.
If shoe-leather costs were the only cost of inflation then it would be best to target an inflation rate
consistent with a zero nominal interest rate. True or false? Briefly explain your answer.
2.
A desirable feature of any theory of economic growth is that it predicts the capital-labour ratio is
stable in the long run. True or false? Briefly explain your answer.
3.
The Keynesian consumption function (with a positive level of autonomous consumption expenditure)
is inconsistent with the empirical finding that the average propensity to consume is approximately
constant over time. True or false? Briefly explain your answer.
4.
The Marshall-Lerner condition implies that a fall in the price of domestically produced goods relative
to foreign-produced goods leads to a deterioration in the trade balance. True or false? Briefly explain
your answer.
5.
If two economies converge to the same long-run growth rate of GDP per person then they must
converge to the same level of GDP per person. True or false? Briefly explain your answer.
6.
If interest rates are constant then the Keynesian balanced-budget fiscal multiplier is less than one.
True or false? Briefly explain your answer.
7.
If consumption expenditure does not depend on current disposable income then the IS curve will be
horizontal. True or false? Briefly explain your answer.
8.
An expected increase in the price of capital goods raises investment according to the neoclassical
theory of investment. True or false? Briefly explain your answer.
9.
In an open economy where the government always runs a balanced budget, a larger current account
surplus must be matched by higher private saving, higher investment, or both. True or false? Briefly
explain your answer.
10.
The AK model of economic growth predicts that there will be conditional convergence between
economies over time. True or false? Briefly explain your answer.

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SECTION B
Answer three questions from this section (20 marks each).
11.
Suppose the demand for money M d is given by the equation

Md
L(Y , i )
P
where P is the price level and L(Y , i) is an increasing function of real income Y and a decreasing
function of the nominal interest rate i .
(a)
Explain carefully why money demand should be negatively related to the nominal interest rate
and what happens to the demand for money when the nominal interest rate falls to zero. Use
your answer to derive the LM curve, illustrating the shape of the LM curve at a zero nominal
interest rate.
(6 marks)
(b)
Now suppose there is a negative shock to demand (for example, a fall in autonomous
consumption expenditure). Using the IS/LM model, show that if the nominal interest rate
remains positive, an increase in the money supply can partially reverse the effect of the shock on
output. If the nominal interest rate falls to zero, show what happens to the LM curve when the
money supply is increased, and explain why the increase in the money supply may have no
effect on output.
(7 marks)
(c)
In recent years, nominal interest rates have fallen close to zero in several countries. A number of
economists have suggested monetary policies that would create higher expectations of future
inflation as a way of getting out of the liquidity trap.
Write down the Fisher equation that links the nominal and real interest rates and use this
equation to explain why an increase in inflation expectations would raise output for an economy
in a liquidity trap.
Suppose the central bank proposes to raise inflation expectations by committing to a future
monetary expansion if unemployment remains high. Use the AD/AS model to study the effects
of this policy on the price level if the economy remains in the liquidity trap. Comment on the
credibility of the policy in light of your answer.
(7 marks)

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D1
12.
Consider the Solow model of economic growth in the case of no exogenous technological progress
( g 0 ). There is a production function Y F ( K , L) , where Y is output, K is the capital stock, and
L is the labour force. The labour force grows at a constant rate n , the capital stock depreciates at a
constant rate , and the saving rate is s .
Let y Y / L and k K / L denote output per person and capital per person. The per-person
production function is y f (k ) , and the dynamics of the capital stock per person are described by the
equation: k sf (k ) ( n)k .
(a)
Show how the steady-state stock of capital per person is found using a diagram, explaining what
assumption is needed for the per-person production function f (k ) to have a concave shape.
Using the diagram, find the effects of a rise in the saving rate on steady-state capital per person
and output per person.
(6 marks)
(b)
Consider an economy where both output Y and the capital stock K are measured in terms of the
quantity of computers. Assume each worker requires a computer in order to produce any output
(new computers), but cannot use more than one computer at the same time. Assume also that it
takes four workers to produce one new computer. These assumptions mean that the per-person
production function is f (k ) k / 4 if k lies between 0 and 1, and f (k ) 1 / 4 if k is larger than
1, as illustrated below:
Assume that the population grows by 2% every year, while 8% of computers become obsolete
every year (8% is the depreciation rate of the capital stock). Suppose that the saving rate is 50%.
Find the steady-state capital stock per person and output per person. (Hint: start your analysis by
adding the saving and depreciation lines to the diagram above.)
(7 marks)
(c)
Define the Golden-rule level of the capital stock. Now find the Golden-rule capital stock per
person for the economy described in part (b), and say whether the saving rate of 50% is too low
or too high to reach the Golden rule. Determine the saving rate needed to take the economy to
the Golden-rule level of capital.
(7 marks)

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13.
Answer each of the following questions.

(a)
Consider a closed economy where consumption and investment are given by the Keynesian
consumption and investment demand functions (so consumption depends positively on
disposable income and investment depends negatively on the interest rate). Money demand is
positively related to income and negatively related to the interest rate. Using the IS/LM model,
find the effect of an increase in the price level on output and thus derive the aggregate demand
(AD) curve.
(6 marks)
(b)
Suppose the government cuts taxes and finances this by issuing bonds. Using the IS/LM model
with the Keynesian consumption function, find the effect of this tax cut on output.
Now suppose that the Fisher model of consumption is assumed instead of the Keynesian
consumption function. Briefly explain why Ricardian equivalence holds when using the Fisher
model, and describe the effects of a tax cut (financed by issuing bonds) in this case.
(7 marks)
(c)
It is sometimes argued that there is a real balance effect of the price level on aggregate demand
in addition to the effect found in part (a). The argument is that an increase in the price level
reduces the real value of money, which decreases the real wealth of households and reduces their
consumption demand accordingly.
Households also hold government bonds, and the real value of these is also reduced when the
price level increases. Explain whether you think we should expect a real balance effect of the
price level on consumption because households hold government bonds in their portfolios.
(Hint: think about whether government bonds are net wealth according to the Ricardian
equivalence proposition.)
(7 marks)
14.
Consider the Fisher model of consumption choice (with two time periods representing the present and
the future). An individual receives income Y1 in the first period and income Y2 in the second period,
and can save or borrow at real interest rate r . The individual chooses a plan for current consumption
C1 and future consumption C 2 to maximize utility.
(a)
Write down an equation for the individuals life-time budget constraint and interpret the
equation. Draw a diagram illustrating how the optimal consumption plan is found and justify
your answer.
(6 marks)
(b)
Consider an economy where the real interest rate rises. What is the effect of a higher interest rate
on the life-time budget constraint in the diagram from part (a)? Assuming an individual was
initially a saver, use the diagram to deduce whether the rise in interest rates increases or
decreases the saverss utility. Explain whether a saver would ever find it rational to start
borrowing when interest rates rise.
(7 marks)
(c)
In a newspaper report discussing the consequences of high interest rates, a man is quoted as
saying that his retirement savings are earning such a high return that I am actually reducing how
much I contribute to my pension. Draw indifference curves to illustrate that the man is not
being irrational by saving less when interest rates rise. Explain your answer in terms of income
and substitution effects and discuss whether all savers would be expected to behave in this way.
(7 marks)

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15.
Consider an open economy with fixed prices and wages, and perfect capital mobility.
Goods-market equilibrium is where output Y is equal to the sum of consumption C , investment I ,
government spending G , and net exports NX . The consumption and investment functions are:
C C0 c(Y T ),
I I 0 bi
where i is the domestic interest rate. Government spending and taxes are exogenously fixed at
G G0 and T T0 . Net exports are given by:
NX NX 0 mY ae
where e is the nominal exchange rate (defined as the foreign currency price of domestic currency).
Money-market equilibrium is represented by the equation:
M s P M 0 kY hi
where M s is the money supply, P is the price level, and the right-hand side of the equation is the
demand for money. Given perfect capital mobility, the balance of payments is in equilibrium only if
i i * , where i * is the foreign interest rate.
In this question, assume that the central bank follows a flexible exchange rate policy.
(a)
Suppose the central bank increases the money supply. Find the effects on the exchange rate and
output.
(6 marks)
(b)
Now suppose that money-market equilibrium is represented by the following equation:

M s P c M 0 kY hi
where P c is the consumer price level. The consumer price level P c is an average of the price of
domestically produced goods P (which is fixed) and the domestic-currency price P * / e of
foreign-produced goods. While P * is fixed, any change in the exchange rate e will lead to a
change in the domestic price at which imports are sold.
Considering again the expansion of the money supply analysed in part (a), find the effect on
output and compare the size of the effect to that found in part (a).
(7 marks)
(c)
Return to the original money-market equilibrium condition with P , but now suppose that capital
mobility is imperfect. The capital account KA of the balance of payments is given by the
equation:
KA KA0 f (i i * )
where f is a positive constant. How does this change the BP curve representing balance-ofpayments equilibrium? Considering again the monetary expansion from part (a), find the effect
on output and compare the size of the effect to that found in part (a).
(7 marks)

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16.
Consider an economy where nominal wages are fixed by long-term contracts and where workers
would be willing to supply more labour at the prevailing wage. Prices are flexible and profitmaximizing competitive firms hire labour and produce output subject to a production function with
diminishing marginal returns to labour.
(a)
Write down the condition that determines firms demand for labour and show how the short-run
aggregate supply (SRAS) curve is derived, explaining why this curve is upward sloping.
(6 marks)
(b)
Consider an economy where the central bank follows a policy of inflation targeting (interpret
this to mean the central bank adjusts the money supply to keep the price level constant). Now
suppose the economy is hit by a negative shock to confidence that reduces firms demand for
investment (a reduction in autonomous investment demand). Use the AD/AS model to find the
effects of the confidence shock on output and unemployment, and explain whether inflation
targeting is a desirable monetary policy for an economy facing this type of shock.
(7 marks)
(c)
Consider again an economy where the central bank follows a policy of inflation targeting, but
now suppose the economy is hit by a negative productivity shock instead (a reduction in the
marginal product of labour at each level of employment). Find the effect of productivity shock
on the SRAS curve and explain what happens to unemployment. Can you suggest a monetary
policy that delivers a better outcome for unemployment following this shock than inflation
targeting?
(7 marks)
END OF PAPER

UL13/0031
Page 7 of 7
D1
~~EC2065 ZB d0
This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON
EC2065 ZB
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route
Macroeconomics
Monday, 13 May 2013 : 2.30pm to 5.30pm
Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from
Section A (5 marks each) and THREE from Section B (20 marks each). Candidates are
strongly advised to divide their time accordingly.
If more questions are answered than requested, only the first answers attempted will be counted.
PLEASE TURN OVER

UL13/0032
Page 1 of 7
D1
SECTION A
1.
The practice of paying efficiency wages can be a cause of classical unemployment. True or false?
Briefly explain your answer.
2.
The Solow growth model assumes a production function with decreasing returns to scale and constant
marginal returns to capital. True or false? Briefly explain your answer.
3.
If the demand for money does not depend on income then the LM curve is vertical. True or false?
4.
In a closed economy, an increase in the government budget deficit must be matched by higher private
saving, lower investment, or both. True or false? Briefly explain your answer.
5.
If menu costs were the only cost of inflation then it would be best to have a zero rate of inflation.
6.
A desirable feature of any theory of economic growth is that it predicts the ratio of the capital stock to
output is stable in the long run. True or false? Briefly explain your answer.
7.
If the central bank pays interest on reserves then this will reduce seigniorage revenues. True or
false? Briefly explain your answer.
8.
Uncovered interest parity predicts that domestic and foreign interest rates are always equal. True or
9.
Action lags are generally shorter for monetary policy than for fiscal policy. True or false? Briefly
explain your answer.
10.
If there is conditional convergence between economies then there must be a negative relationship
between a countrys initial level of GDP per person and its subsequent growth rate of GDP per person
once other factors have been controlled for. True or false? Briefly explain your answer.

UL13/0032
Page 2 of 7
D1
SECTION B
11.
12.
Consider an economy where nominal wages are fixed by long-term contracts and where workers
would be willing to supply more labour at the prevailing wage. Prices are flexible and profitmaximizing competitive firms hire labour and produce output subject to a production function with
diminishing marginal returns to labour.
(a)
Write down the condition that determines firms demand for labour and show how the short-run
aggregate supply (SRAS) curve is derived, explaining why this curve is upward sloping.
(6 marks)
(b)
Consider an economy where the central bank follows a policy of inflation targeting (interpret
this to mean the central bank adjusts the money supply to keep the price level constant). Now
suppose the economy is hit by a negative shock to confidence that reduces firms demand for
investment (a reduction in autonomous investment demand). Use the AD/AS model to find the
effects of the confidence shock on output and unemployment, and explain whether inflation
targeting is a desirable monetary policy for an economy facing this type of shock.
(7 marks)
(c)
Consider again an economy where the central bank follows a policy of inflation targeting, but
now suppose the economy is hit by a negative productivity shock instead (a reduction in the
marginal product of labour at each level of employment). Find the effect of productivity shock
on the SRAS curve and explain what happens to unemployment. Can you suggest a monetary
policy that delivers a better outcome for unemployment following this shock than inflation
targeting?
(7 marks)
Consider the Fisher model of consumption choice (with two time periods representing the present and
the future). An individual receives income Y1 in the first period and income Y2 in the second period,
and can save or borrow at real interest rate r . The individual chooses a plan for current consumption
C1 and future consumption C 2 to maximize utility.
(a)
Write down an equation for the individuals life-time budget constraint and interpret the
equation. Draw a diagram illustrating how the optimal consumption plan is found and justify
your answer.
(6 marks)
(b)
Consider an economy where the real interest rate falls. What is the effect of a lower interest rate
on the life-time budget constraint in the diagram from part (a)? Assuming an individual was
initially a borrower, use the diagram to deduce whether the fall in interest rates increases or
decreases the borrowers utility. Explain whether a borrower would ever find it rational to start
saving when interest rates fall.
(7 marks)
(c)
In a newspaper report discussing the consequences of low interest rates, a woman is quoted as
saying that she now needs to save even more for my retirement. Draw indifference curves to
illustrate that the woman is not being irrational by saving more when interest rates fall. Explain
your answer in terms of income and substitution effects and discuss whether all savers would be
expected to behave in this way.
(7 marks)

UL13/0032
Page 3 of 7
D1
13.
Goods-market equilibrium is where output Y is equal to the sum of consumption C , investment I ,
government spending G , and net exports NX . The consumption and investment functions are:
C C0 c(Y T ),
I I 0 bi
where i is the domestic interest rate. Government spending and taxes are exogenously fixed at
G G0 and T T0 . Net exports are given by:
NX NX 0 mY ae
where e is the nominal exchange rate (defined as the foreign currency price of domestic currency).
Money-market equilibrium is represented by the equation:
M s P M 0 kY hi
where M s is the money supply, P is the price level, and the right-hand side of the equation is the
demand for money. Given perfect capital mobility, the balance of payments is in equilibrium only if
i i * , where i * is the foreign interest rate.
(a)
Suppose the central bank increases the money supply. Find the effects on the exchange rate and
output.
(6 marks)
(b)
Now suppose that money-market equilibrium is represented by the following equation:

M s P c M 0 kY hi
where P c is the consumer price level. The consumer price level P c is an average of the price of
domestically produced goods P (which is fixed) and the domestic-currency price P * / e of
foreign-produced goods. While P * is fixed, any change in the exchange rate e will lead to a
change in the domestic price at which imports are sold.
Considering again the expansion of the money supply analysed in part (a), find the effect on
output and compare the size of the effect to that found in part (a).
(7 marks)
(c)
Return to the original money-market equilibrium condition with P , but now suppose that capital
mobility is imperfect. The capital account KA of the balance of payments is given by the
equation:
KA KA0 f (i i * )
where f is a positive constant. How does this change the BP curve representing balance-ofpayments equilibrium? Considering again the monetary expansion from part (a), find the effect
on output and compare the size of the effect to that found in part (a).
(7 marks)

UL13/0032
Page 4 of 7
D1
14.
Consider the Solow model of economic growth in the case of no exogenous technological progress
( g 0 ). There is a production function Y F ( K , L) , where Y is output, K is the capital stock, and
L is the labour force. The labour force grows at a constant rate n , the capital stock depreciates at a
constant rate , and the saving rate is s .
Let y Y / L and k K / L denote output per person and capital per person. The per-person
production function is y f (k ) , and the dynamics of the capital stock per person are described by the
equation: k sf (k ) ( n)k .
(a)
Show how the steady-state stock of capital per person is found using a diagram, explaining what
assumption is needed for the per-person production function f (k ) to have a concave shape.
Using the diagram, find the effects of a rise in the saving rate on steady-state capital per person
and output per person.
(6 marks)
(b)
Consider an economy where both output Y and the capital stock K are measured in terms of the
quantity of computers. Assume each worker requires a computer in order to produce any output
(new computers), but cannot use more than one computer at the same time. Assume also that it
takes two workers to produce one new computer. These assumptions mean that the per-person
production function is f (k ) k / 2 if k lies between 0 and 1, and f (k ) 1 / 2 if k is larger than
1, as illustrated below:
Assume that the population grows by 2.5% every year, while 10% of computers become
obsolete every year (10% is the depreciation rate of the capital stock). Suppose that the saving
rate is 40%. Find the steady-state capital stock per person and output per person. (Hint: start
your analysis by adding the saving and depreciation lines to the diagram above.)
(7 marks)
(c)
Define the Golden-rule level of the capital stock. Now find the Golden-rule capital stock per
person for the economy described in part (b), and say whether the saving rate of 40% is too low
or too high to reach the Golden rule. Determine the saving rate needed to take the economy to
the Golden-rule level of capital.
(7 marks)

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D1
15.

Md
L(Y , i )
P
where P is the price level and L(Y , i) is an increasing function of real income Y and a decreasing
function of the nominal interest rate i .
(a)
Explain carefully why money demand should be negatively related to the nominal interest rate
and what happens to the demand for money when the nominal interest rate falls to zero. Use
your answer to derive the LM curve, illustrating the shape of the LM curve at a zero nominal
interest rate.
(6 marks)
(b)
Now suppose there is a negative shock to demand (for example, a fall in autonomous
consumption expenditure). Using the IS/LM model, show that if the nominal interest rate
remains positive, an increase in the money supply can partially reverse the effect of the shock on
output. If the nominal interest rate falls to zero, show what happens to the LM curve when the
money supply is increased, and explain why the increase in the money supply may have no
effect on output.
(7 marks)
(c)
In recent years, nominal interest rates have fallen close to zero in several countries. A number of
economists have suggested monetary policies that would create higher expectations of future
inflation as a way of getting out of the liquidity trap.
Write down the Fisher equation that links the nominal and real interest rates and use this
equation to explain why an increase in inflation expectations would raise output for an economy
in a liquidity trap.
Suppose the central bank proposes to raise inflation expectations by committing to a future
monetary expansion if unemployment remains high. Use the AD/AS model to study the effects
of this policy on the price level if the economy remains in the liquidity trap. Comment on the
credibility of the policy in light of your answer.
(7 marks)

UL13/0032
Page 6 of 7
D1
16.

(a)
Consider a closed economy where consumption and investment are given by the Keynesian
consumption and investment demand functions (so consumption depends positively on
disposable income and investment depends negatively on the interest rate). Money demand is
positively related to income and negatively related to the interest rate. Using the IS/LM model,
find the effect of an increase in the price level on output and thus derive the aggregate demand
(AD) curve.
(6 marks)
(b)
Suppose the government cuts taxes and finances this by issuing bonds. Using the IS/LM model
with the Keynesian consumption function, find the effect of this tax cut on output.
Now suppose that the Fisher model of consumption is assumed instead of the Keynesian
consumption function. Briefly explain why Ricardian equivalence holds when using the Fisher
model, and describe the effects of a tax cut (financed by issuing bonds) in this case.
(7 marks)
(c)
It is sometimes argued that there is a real balance effect of the price level on aggregate demand
in addition to the effect found in part (a). The argument is that an increase in the price level
reduces the real value of money, which decreases the real wealth of households and reduces their
consumption demand accordingly.
Households also hold government bonds, and the real value of these is also reduced when the
price level increases. Explain whether you think we should expect a real balance effect of the
price level on consumption because households hold government bonds in their portfolios.
(Hint: think about whether government bonds are net wealth according to the Ricardian
(7 marks)
END OF PAPER

UL13/0032
Page 7 of 7
D1
Examiners commentaries 2013

EC2065 Macroeconomics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201213. In 2014 the format of the examination will change to:
Candidates should answer ELEVEN of the following FOURTEEN questions: All EIGHT from
Section A (5 marks each) and THREE from Section B (20 marks each). Candidates are strongly
advised to divide their time accordingly.
The format and structure of the examination may change again in future years, and any such
changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refers to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of this course and having completed the Essential reading and activities you should be
able to:
define and analyse the determinants of business cycles, long run economic growth,
unemployment, inflation
use and apply a wide range of economic models to analyse contemporary and historical
microeconomic events, and formulate and propose appropriate microeconomic policies.
Format of the examination

Section A comprises eight questions, all of which must be answered (accounting for 40% of the total
marks). Section B comprises six questions from which three must be answered (accounting for 60%
of the total marks).
Short questions (Section A) have a True/False? Briefly explain your answer format. You are
expected not only to provide an answer but also briefly to justify it on the basis of the relevant
theory. Full formal derivation of the relevant model is not expected, and often a graphic or
descriptive (non-analytical) answer is sufficient. On average, only nine minutes should be allocated
to any individual short question.
Long questions (Section B) are subdivided into at least three parts. There is a mixture of
essay-based questions and questions requiring a more analytical model-based approach. In this
section you are to be as precise as possible in your answers, and often formally to derive the relevant
models, possibly in addition to a graphical or descriptive approach. On average, only 36 minutes
should be allocated to any individual long question.
Essential reading
The readings given in these Examiners commentaries refer to the latest edition of the subject guide
(2011) and the following textbooks:
Blanchard, O. Macroeconomics. (Prentice Hall, 2009) fifth edition [ISBN 9780132079631]
Dornbusch, R., S. Fischer and R. Startz Macroeconomics. (McGraw-Hill, 2008) tenth edition
[ISBN 9780071259248]
Mankiw, N.G. Macroeconomics. (Worth, 2010) seventh edition [ISBN 9781429218870].
Key steps to improvement
You need to be flexible in your ability to apply macroeconomic ideas and models in new or
unfamiliar contexts. Merely memorising the exposition of a model may not help you to
answer a question. Developing your ability to apply macroeconomic ideas takes practice.
You need to ensure that your answers remain focused and to the point of the question.
Spend a little more time initially thinking about the most relevant arguments before you
actually start writing. A shorter but well thought through answer is superior to a longer
answer that does not address the question.
You need to manage your time well in the examination. Try to ensure that you allocate your
time in proportion to the marks allotted to the questions.
Question spotting
Many candidates are disappointed to find that their examination performance is poorer
than they expected. This can be due to a number of different reasons and the Examiners
commentaries suggest ways of addressing common problems and improving your performance.
We want to draw your attention to one particular failing question spotting, that is,
confining your examination preparation to a few question topics which have come up in past
papers for the course. This can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but
you need to be aware that Examiners are free to set questions on any aspect of the syllabus.
This means that you need to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the section of the VLE dedicated
to this course. You should read the syllabus very carefully and ensure that you cover sufficient
material in preparation for the examination.
Examiners will vary the topics and questions from year to year and may well set questions that
have not appeared in past papers every topic on the syllabus is a legitimate examination
target. So although past papers can be helpful in revision, you cannot assume that topics or
specific questions that have come up in past examinations will occur again.
If you rely on a question spotting strategy, it is likely you will find yourself in
difficulties when you sit the examination paper. We strongly advise you not to
adopt this strategy.

Important note

section.
Comments on specific questions Zone A

Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from Section
A (5 marks each) and THREE from Section B (20 marks each). Candidates are strongly
Section A
Question 1
If shoe-leather costs were the only cost of inflation then it would be best to
target an inflation rate consistent with a zero nominal interest rate. True or false?
Reading for this question
Subject guide, Chapters 4 and 11.
Blanchard, Chapter 25.
Dornbusch, Fischer and Startz, Chapter 7.
Mankiw, Chapter 4.
Approaching the question

The statement is TRUE.
Shoe-leather costs are said to be incurred when time and/or resources are consumed in avoiding
holding large amount of money. Households and firms would choose to incur such costs so as to
avoid the opportunity cost of holding money, namely the difference between the return on bonds
and the zero return on money. This means that the opportunity cost of holding money is the
nominal interest rate. If the inflation rate is set so as to be consistent with a zero nominal
interest rate (for a given real interest rate) then shoe-leather costs would be eliminated because
there would be no incentive to incur any costs to reduce holdings of money.
Question 2
A desirable feature of any theory of economic growth is that it predicts the
capital-labour ratio is stable in the long run. True or false? Briefly explain your
answer.
Subject guide, Chapter 5.
Mankiw, Chapter 8.
The statement is FALSE.
The Kaldor stylised facts of growth include the finding that the capital-labour ratio K/L grows
at an approximately constant rate over time. Since it is desirable that theories are consistent
with well-established empirical regularities, a theory of economic growth should not predict that
the capital-labour ratio is stable.
Question 3
The Keynesian consumption function (with a positive level of autonomous
consumption) is inconsistent with the empirical finding that the average propensity
to consume is approximately constant over time. True or false? Briefly explain your
answer.
Dornbusch, Fischer and Startz, Chapters 9 and 13.
Mankiw, Chapters 10 and 17.
The Keynesian consumption function is
C = Ca + cY,
where Ca > 0 is the positive level of autonomous consumption and c is the marginal propensity
to consume. The average propensity to consume is defined as the ratio C/Y of consumption to
income, and it can be seen that the Keynesian consumption function implies this is given by:
C
Ca
=
+ c.
Y
Y
As income increases, the equation demonstrates that the average propensity to consume will
decline. Since income has been growing over time, but the average propensity to consume has
not been declining, this implication is not supported by the data.
Question 4
The Marshall-Lerner condition implies that a fall in the price of domestically
produced goods relative to foreign-produced goods leads to a deterioration in the
trade balance. True or false? Briefly explain your answer.
The Marshall-Lerner condition is a requirement that the sums of the elasticities of exports and
imports with respect to the terms of trade are greater than one. This condition means that the
volume effect will dominate the value effect, and hence the trade balance will improve when there
is a fall in the relative price of domestically produced goods to foreign-produced goods.
Question 5
If two economies converge to the same long-run growth rate of GDP per person
then they must converge to the same level of GDP per person. True or false?
Mankiw, Chapter 8.
While it is true that the convergence in levels of gross domestic product (GDP) per person does
imply convergence in growth rates, it is not true in general that convergence in growth rates
implies convergence in levels of GDP per person. This is best explained by example. In the
Solow growth model, suppose two countries share the same rate of technological progress, but
have different saving rates. These economies will converge to a steady state where growth in
GDP per person is equal to the common rate of technological progress. However, because of the
difference in saving rates, they do not converge to the same level of GDP per person.
Question 6
If interest rates are constant then the Keynesian balanced-budget fiscal multiplier
is less than one. True or false? Briefly explain your answer.
The balanced-budget multiplier refers to the ratio of the change in output to the change in
government spending in the case where both government spending and taxes are changed by the
same amount. Higher government spending boosts demand and thus income, but when taxes rise
by the same amount, there is no effect on disposable income and thus no effect on consumption
demand. With no change in interest rates, there are no other effects on demand, so the change in
output is equal to the change in government spending. This means that the multiplier is equal to
one.
This conclusion can be demonstrated more rigorously by solving the goods-market equilibrium
condition for output. Using the standard consumption and investment functions, the expression
for output is:
C0 + I0 + G0 cT0 br
.
Y =
1c
Since G0 and T0 increase by the same amount, the change in the numerator is (1 c)G0 , hence
Y = G0 , confirming that the balanced-budget multiplier is equal to one.
Question 7
If consumption expenditure does not depend on current disposable income then the
IS curve will be horizontal. True or false? Briefly explain your answer.
Mankiw, Chapter 10.
The IS curve is normally downward sloping because some component of demand (investment, or
consumption) depends negatively on interest rates. A horizontal IS curve would mean that the
effect of a small change in interest rates on demand is extremely large, which could happen either
because demand is perfectly interest elastic, or the Keynesian multiplier is extremely large. The
Keynesian multiplier is determined by the feedback effect from income to consumption. However,
if consumption does not depend on income then the multiplier effect does not operate, which
means that the IS curve would be steeper than normal. Hence it is not possible to explain a
horizontal IS curve with the assumption that consumption does not depend on current disposable
income.
Question 8
An expected increase in the price of capital goods raises investment according to
the neoclassical theory of investment. True or false? Briefly explain your answer.
Mankiw, Chapter 18.
The neoclassical theory of investment predicts that firms should invest in capital up to the point
where the marginal product of capital is equal to the user cost of capital. The user cost of capital
is the real interest rate, plus the depreciation rate, and minus the expected change in the
(relative) price of capital goods. An expected increase in the price of capital thus reduces the
user cost of capital, and so lower marginal-product investments are now profitable, which means
that investment increases.
Question 9
In an open economy where the government always runs a balanced budget, a larger
current account surplus must be matched by higher private saving, higher
investment, or both. True or false? Briefly explain your answer.
Mankiw, Chapter 5.
In an open economy, national saving SN is equal to the current account CA plus investment I.
National saving is defined as the sum of private saving SP = Y T C and government saving
SG = T G, the latter being the negative of the budget deficit D = G T . If the government
balances its budget, national saving is simply equal to private saving SP and hence:
CA = SP I.
This accounting identity shows that an increase in CA could be matched by a rise in SP , or an
increase in CA could be matched by a fall in I, or some combination of both.
Question 10
The AK model of economic growth predicts that there will be conditional
convergence between economies over time. True or false? Briefly explain your
answer.
Mankiw, Chapter 8.
The feature of the AK model of economic growth that distinguishes it from the Solow model is
that it does not assume the marginal product of capital is diminishing. As a result, the model
generates endogenous growth in the sense that long-run growth rates will depend on variables
such as the saving rate.
Conditional convergence means that countries will converge to steady states, but those steady
states may depend on variables such as saving rates. But the AK model predicts that differences
in saving rates will lead to differences in long-run growth rates rather than differences in steady
states, so it does not predict conditional convergence.
Section B
Question 11
Md
= L(Y, i)
P
where P is the price level and L(Y, i) is an increasing function of real income Y and a
decreasing function of the nominal interest rate i.
(a) Explain carefully why money demand should be negatively related to the
nominal interest rate and what happens to the demand for money when the
nominal interest rate falls to zero. Use your answer to derive the LM curve,
illustrating the shape of the LM curve at a zero nominal interest rate.
(6 marks)
(b) Now suppose there is a negative shock to demand (for example, a fall in
autonomous consumption expenditure). Using the IS/LM model, show that if
the nominal interest rate remains positive, an increase in the money supply can
partially reverse the effect of the shock on output. If the nominal interest rate
falls to zero, show what happens to the LM curve when the money supply is
increased, and explain why the increase in the money supply may have no effect
on output.
(7 marks)
(c) In recent years, nominal interest rates have fallen close to zero in several
countries. A number of economists have suggested monetary policies that would
create higher expectations of future inflation as a way of getting out of the
liquidity trap.
Write down the Fisher equation that links the nominal and real interest rates
and use this equation to explain why an increase in inflation expectations would
raise output for an economy in a liquidity trap.
Suppose the central bank proposes to raise inflation expectations by committing

to a future monetary expansion if unemployment remains high. Use the AD/AS
model to study the effects of this policy on the price level if the economy
remains in the liquidity trap. Comment on the credibility of the policy in light
of your answer.
(7 marks)

Blanchard, Chapters 4, 5, 7, 14 and 22.
Dornbusch, Fischer and Startz, Chapters 5, 10 and 11.
Mankiw, Chapters 4, 911 and 14.
(a) Money pays no interest, while the nominal interest rate is the (nominal) return on holding
bonds. Thus, the difference between the return on holding wealth in the form of bonds and
the return if it is held as money is the nominal interest rate. This means that the nominal
interest rate represents the opportunity cost of holding money, in the sense of the foregone
interest that could have been earned if bonds were held instead of money. However, since
money is more liquid than bonds (it is accepted more readily for payments), individuals may
hold money even though bonds offer a higher return. But the higher the nominal interest
rate, the greater the opportunity cost of holding money, and the less attractive holding
money becomes. Money demand thus depends negatively on the nominal interest rate. Note
that at a zero nominal interest rate, there is no opportunity cost of holding money, so
individuals are always willing to substitute money for bonds in their portfolios without
limit. This makes the demand for money perfectly interest-elastic at zero interest rates.
The LM curve represents the combinations of output and the nominal interest rate
consistent with equilibrium in the money market, given the level of the money supply. To
derive the LM curve, note that an increase in output increases the demand for money (more
transactions must be made), shifting the money demand curve to the right. Money demand
curves for three levels of output (Y1 , Y2 , and Y3 ) are depicted in the left panel of the
diagram below. The money-market diagram has the real quantity of money on the
horizontal axis and the nominal interest rate (the opportunity cost) on the vertical axis.
The money demand curves are downward sloping as explained above, and become perfectly
elastic (horizontal) at a zero nominal interest rate. The fixed money supply is depicted as
the vertical money supply curve in the diagram. The intersection between money demand
and supply determines the nominal interest rate.
10
As can be seen from the diagram, higher levels of output imply that the money market now
generally clears at a higher nominal interest rate. This shows that money-market
equilibrium implies a positive relationship between output and the nominal interest rate,
that is, an upward-sloping LM curve. At a zero nominal interest rate, money demand is
perfectly interest elastic, so even a rightward shift of money demand does not necessarily
increase in the interest rate (although a sufficiently large increase in output should). This
means that the LM curve has a horizontal section at zero interest rates.
(b) The negative shock to consumption demand shifts the IS curve to the left from IS0 to IS1 .
With no change in monetary policy, this would lead to a fall in output. However, it is
possible to avoid this fall in output through a monetary expansion, as long as the interest
rate remains positive. The left panel of the diagram below shows how expansionary
monetary policy stabilises the economy by shifting the LM curve to the right from LM0 to
LM1 . By generating a sufficiently large fall in the interest rate, this policy can avoid any fall
in output.
However, at a zero interest rate, a monetary expansion simply extends the horizontal section
of the LM curve. Intuitively, the extra money is willingly held with no change in the interest
rate because it is a perfect substitute for bonds at the margin. This logic is demonstrated in
the diagram below. In the left panel, the monetary expansion shifts the money supply to the
right, but if the interest rate was initially zero then the money supply curve continues to
intersect the money demand curve where it is perfectly elastic at a zero interest rate.
11
Therefore, if IS1 intersects LM0 at a zero interest rate (on the horizontal section of LM0 , a
monetary expansion will have no effect because the IS curve continues to intersect the new
LM curve (LM1 ) at a zero interest rate. Basically, the monetary stimulus has no effect on
demand because none of the interest-sensitive components of demand are affected. This is
the case depicted in the right panel of the earlier diagram.
(c) The Fisher equation that connects the nominal interest rate i, the real interest rate r, and
inflation expectations e is:
i = r + e .
This equation implies the real interest rate is given by r = i e , so an increase in inflation
expectations e reduces the real interest rate at any given nominal interest rate i. Since the
interest-sensitive components of demand (e.g. investment) depend on the real interest rate,
higher inflation expectations should increase demand at each nominal interest rate, shifting
the IS curve to the right (in an IS-LM diagram where the interest rate on the vertical axis is
the nominal interest rate). As the IS curve shifts to the right, output will increase.
In the AD-AS diagram, an economy in a liquidity trap features an AD curve with a vertical
section (which becomes downward sloping if the price level is sufficiently high). Suppose in
the future that the economy still has high unemployment and is still in the liquidity trap.
As promised, the central bank then expands the money supply. However, an increase in the
money supply only shifts the downward-sloping section of the AD curve to the right, while
simply extending the vertical section. When the economy is in the liquidity trap, the
intersection between the AD and SRAS curves is on the vertical section of the AD curve.
Thus, extending the vertical section of the AD curve does not raise output or the price level.
Thus, the credibility of the policy might be in doubt because this analysis shows that it may
fail to achieve its stated goal of raising inflation. In that case, agents may not change their
inflation expectations when the policy is announced.
12
Question 12
Consider the Solow model of economic growth in the case of no exogenous
technological progress (g = 0). There is a production function Y = F (K, L), where Y
is output, K is the capital stock, and L is the labour force. The labour force grows
at a constant rate n, the capital stock depreciates at a constant rate , and the
saving rate is s.
Let y = Y /L and k = K/L denote output per person and capital per person. The
per-person production function is y = f (k), and the dynamics of the capital stock per
person are described by the equation: k = sf (k) ( + n)k.
(a) Show how the steady-state stock of capital per person is found using a diagram,
explaining what assumption is needed for the per-person production function
f (k) to have a concave shape. Using the diagram, find the effects of a rise in the
saving rate on steady-state capital per person and output per person.
(6 marks)
(b) Consider an economy where both output Y and the capital stock K are
measured in terms of the quantity of computers. Assume each worker requires a
computer in order to produce any output (new computers), but cannot use
more than one computer at the same time. Assume also that it takes four
workers to produce one new computer. These assumptions mean that the
per-person production function is f (k) = k/4 if k lies between 0 and 1, and
f (k) = 1/4 if k is larger than 1, as illustrated below:
13
Assume that the population grows by 2% every year, while 8% of computers

become obsolete every year (8% is the depreciation rate of the capital stock).
Suppose that the saving rate is 50%. Find the steady-state capital stock per
person and output per person. (Hint: start your analysis by adding the saving
and depreciation lines to the diagram above.)
(7 marks)
(c) Define the Golden rule level of the capital stock. Now find the Golden rule
capital stock per person for the economy described in part (b), and say whether
the saving rate of 50% is too low or too high to reach the Golden rule.
Determine the saving rate needed to take the economy to the Golden rule level
of capital.
(7 marks)
Mankiw, Chapter 7.
(a) The steady-state stock of capital per person is the level of k = K/L at which k would
remain constant over time. Mathematically, this means that the change in k is zero
(k = 0). From the equation given in the question, this requires:
sf (k) = ( + n)k.
The left-hand side of the equation is the saving rate s multiplied by the level of output per
person y = f (k). Geometrically, the per-person production function f (k) is an increasing
and concave function of k. The saving line sf (k) multiplies this production function by s
(scaling it down because s < 1), which thus has the same general shape as the production
function. The right-hand side of the equation is the sum of the depreciation rate and
population growth rate n multiplied by capital per person. Geometrically, this depreciation
line is an upward-sloping straight line. The saving and depreciation lines are illustrated
in the diagram below. The solution of the equation (steady-state capital per person k ) is
found where these two lines cross. Steady-state output per person y is then found from the
height of the production function at this level of capital per person.
14
The production function f (k) has a concave shape when the gradient f 0 (k) of the
production function decreases as k increases. The gradient represents the marginal product
of capital. When capital per person k increases, this says that the use of capital K in
production increases by more than labour L. Under the assumption of diminishing marginal
returns to capital, this means the marginal product of capital would fall, implying that f 0 (k)
falls as k increases. Thus, the assumption of diminishing marginal returns to capital justifies
the concave shape of the production function f (k).
An increase in the saving rate from s0 to s1 scales up the saving line. As the diagram below
shows, it now intersects the depreciation line at a higher level of capital per person (k1
instead of k0 ). An increase in capital per person leads to a movement to the right along the
production function up to the new steady state for output per person (y1 instead of y0 ).
(b) The saving line is simply a scaled-down version of the production function, so it has the
same shape as that of f (k) depicted in the question. Between k = 0 and k = 1, the
production function has gradient 1/4, so with s = 0.5, the gradient of the saving line in this
range is 0.5 0.25 = 0.125. To the right of k = 1, the saving line is flat like the production
function. The depreciation line is an upward-sloping straight line as usual. Its gradient is
the sum of the depreciation rate and the population growth rate n, that is,
0.08 + 0.02 = 0.1. This is less than the gradient of the saving line to the left of k = 1.
Therefore, the shapes of all the relevant lines are as shown in the diagram below.
It can be seen from the diagram that the depreciation line intersects the saving line at the
flat section of the latter. The height of the flat section of the saving line is
0.5 0.25 = 0.125. Since the depreciation line is 0.1k, the steady-state level of capital per
15
person is found by solving the equation:

0.125 = 0.1k
hence
k=
0.125
= 1.25.
0.1
With k = 1.25 to the right of k = 1, the steady-state level of output per person is the
height of the flat section of the production function, that is, y = 0.25.
(c) The Golden-rule capital stock is defined as the stock of capital per person where
steady-state consumption per person is maximised. The Golden rule thus represents the
highest sustainable level of consumption possible. Consumption per person is given by
income per person that is not saved, that is, c = f (k) sf (k) = (1 s)f (k). In a steady
state, it must be the case that sf (k) = ( + n)k, which means that steady-state
consumption is c = f (k) ( + n)k. Geometrically, this is the vertical distance between the
production function f (k) and the depreciation line ( + n)k. The Golden-rule capital stock
is thus determined by finding the level of k that maximises the gap between f (k) and
( + n)k. From the diagram below it can be seen that the Golden rule is at the kink of the
production function at k = 1.
In part (b) it was seen that a saving rate of 50% led to a steady-state capital stock per
person of 1.25. Relative to the Golden rule, this is too high, and hence the saving rate of
50% needs to be reduced. It is also clear from the earlier diagram that the only way to
achieve a steady-state k equal to 1 is to have a saving line that overlaps the depreciation line
between k = 0 and k = 1. This is illustrated below.
To achieve that outcome, the gradient of the saving line must be the same as that of the
depreciation line in the range between k = 0 and k = 1. The latter gradient is 0.1, while the
16
gradient of the saving line is 0.25 s for a saving rate s. The required saving rate is then
the solution of the equation:
0.25s = 0.1
hence
s=
0.1
= 0.4.
0.25
A reduction of the saving rate to 40% is therefore required to reach the Golden rule level of
capital.
Question 13
(a) Consider a closed economy where consumption and investment are given by the
Keynesian consumption and investment demand functions (so consumption
depends positively on disposable income and investment depends negatively on
the interest rate). Money demand is positively related to income and negatively
related to the interest rate. Using the IS/LM model, find the effect of an
increase in the price level on output and thus derive the aggregate demand
(AD) curve.
(6 marks)
(b) Suppose the government cuts taxes and finances this by issuing bonds. Using
the IS/LM model with the Keynesian consumption function, find the effect of
this tax cut on output.
Now suppose that the Fisher model of consumption is assumed instead of the
Keynesian consumption function. Briefly explain why Ricardian equivalence
holds when using the Fisher model, and describe the effects of a tax cut
(financed by issuing bonds) in this case.
(7 marks)
(c) It is sometimes argued that there is a real balance effect of the price level on
aggregate demand in addition to the effect found in part (a). The argument is
that an increase in the price level reduces the real value of money, which
decreases the real wealth of households and reduces their consumption demand
accordingly.
Households also hold government bonds, and the real value of these is also
reduced when the price level increases. Explain whether you think we should
expect a real balance effect of the price level on consumption because
households hold government bonds in their portfolios? (Hint: think about
whether government bonds are net wealth according to the Ricardian
(7 marks)
Subject guide, Chapters 3, 9 and 13.
Blanchard, Chapters 7 and 26.
(a) The first point to note is that the demand for money is a demand for real money balances
because moneys usefulness depends on its real value. This means that changes in the price
level, which affect the real supply of money given a fixed nominal supply, will change the
17
equilibrium of the money market. For a fixed nominal money supply, a higher price level
reduces the real supply of money, which given income and interest rates would lead to there
being excess demand in the money market. Given the level of output, the interest rate rises
to restore equilibrium. Since the LM curve represents the set of output and interest rate
combinations consistent with money-market equilibrium, this logic demonstrates that the
LM curve must shift upwards when the price level rises, as shown in the left panel of the
diagram below.
Using the IS-LM diagram, a leftward shift of LM leads to lower output and higher interest
rates as the economy moves up the IS curve. Hence, there is a negative relationship between
the price level and the demand for output (as determined by IS-LM), and thus a
downward-sloping AD curve, as depicted in the right panel of the diagram above.
(b) The tax cut increases current disposable income, which increases consumption demand
according to the Keynesian consumption function. An increase in consumption demand
shifts the IS curve to the right. The IS-LM analysis thus predicts that the demand for
output increases, along with the interest rate. This outcome is depicted in the left panel of
the diagram below.
With the Fisher model of consumption choice, Ricardian equivalence holds because
households make current consumption decisions based on their lifetime budget constraint
and understand the implications of the governments lifetime budget constraint for future
taxes. Without a change in the governments spending plans, a tax cut today implies the
need for tax rises in the future of an equal present value. Thus, there is no change in
households present discounted value of lifetime income after taxes and so they do not
change their consumption demand. This means that households will save all the extra
disposable income to pay for the future tax increase and so there will be no shift of the IS
18
curve in this case and thus no effect on output. This case is depicted in the right panel of
the diagram above.
(c) The Ricardian equivalence proposition predicts that households do not see government
bonds as net wealth. This is because they must be repaid with future taxes that
households will ultimately bear. If government bonds do not constitute net wealth then
changes in their real value have no wealth effect on household consumption. Households do
not feel any better or worse off because the value of the taxes they will face move exactly in
line with the value of the bonds. Consequently, there would not be a real balance effect
working through holdings of nominal government bonds. If Ricardian equivalence is
violated, though, households may act as if government bonds were net wealth, and thus a
real balance effect might operate in that case.
Why is it that there might be a real balance effect for holdings of money, but not for
holdings of government bonds? (even though both are assets with a fixed monetary value).
The difference between money and bonds is that money can be net wealth because the
government does not need to raise future taxes to repay money, unlike bonds. Intuitively,
money is valued for its liquidity/transactions role rather than because it will be redeemed
by the government in the future.
Question 14
Consider the Fisher model of consumption choice (with two time periods
representing the present and the future). An individual receives income Y1 in the
first period and income Y2 in the second period, and can save or borrow at real
interest rate r. The individual chooses a plan for current consumption C1 and future
consumption C2 to maximize utility.
(a) Write down an equation for the individuals life-time budget constraint and
interpret the equation. Draw a diagram illustrating how the optimal
consumption plan is found and justify your answer.
(6 marks)
(b) Consider an economy where the real interest rate rises. What is the effect of a
higher interest rate on the life-time budget constraint in the diagram? Assuming
an individual was initially a saver, use the diagram to deduce whether the rise
in interest rates increases or decreases the saverss utility. Explain whether a
saver would ever find it rational to start borrowing when interest rates rise.
(7 marks)
(c) In a newspaper report discussing the consequences of high interest rates, a man
is quoted as saying that his retirement savings are earning such a high return
that I am actually reducing how much I contribute to my pension. Draw
indifference curves to illustrate that the man is not being irrational by saving
less when interest rates rise. Explain your answer in terms of income and
substitution effects and discuss whether all savers would be expected to behave
in this way.
(7 marks)
Mankiw, Chapter 17.
19
Approacing the question

(a) The lifetime budget constraint is
C1 +
C2
Y2
= Y1 +
.
1+r
1+r
The left-hand side of this equation is the sum of current consumption and the present
discounted value of future consumption. The right-hand side is the sum of current income
and the present discounted value of future income. If the individual is free to borrow or
save, current consumption can differ from current income, but the presented discounted
value of all current and future consumption cannot be more than the present discounted
value of all current and future income (and would not be less given that the individual
would always like more consumption either now or in the future). Note that the question
does not ask for the lifetime budget constraint to be derived. It is sufficient to write down
the equation and explain the meaning of the terms appearing in the equation.
The optimal consumption plan is determined using a diagram that contains two elements:
the lifetime budget constraint and the indifference curves of the individual. The equation for
the lifetime budget constraint is given above. This equation is linear in the consumption
levels C1 and C2 , so geometrically it is a straight line. Furthermore, given income Y1 and Y2 ,
higher C2 is only possible if C1 is reduced, so the equation is represented by a
downward-sloping line. For every unit less of current consumption, the increase in saving
that earns real return r allows 1 + r units of future consumption to be purchased. Thus, the
line has slope (1 + r). Since C1 = Y1 and C2 = Y2 is consistent with the equation, the line
always passes through the point (Y1 , Y2 ), which is usually referred to as the endowment
point, or income point.
The second element of the diagram is the set of indifference curves. Each indifference curve
represents a collection of points (C1 , C2 ) where each point is a consumption plan that offers
the same level of utility to the individual. Indifference curves are downward sloping because
if C1 is reduced, C2 must be increased to compensate the individual if they are to receive
the same level of utility as before. Furthermore, it is assumed that the indifference curves
are convex. This means that reducing current consumption when current consumption is
low requires a very large increase in future consumption to compensate, whereas only a
small increase in future consumption would be necessary if current consumption was
initially very high.
The individual maximises utility by choosing a point on the highest attainable indifference
curve subject to satisfying the lifetime budget constraint. This corresponds to the tangency
point between an indifference curve and the budget constraint. If the consumption plan
20
were not at a tangency point, it would be possible to get to a higher indifference curve by
moving either left or right along the budget constraint.
(b) The budget line has gradient (1 + r). A fall in the real interest rate r thus makes the
budget constraint flatter. Notice that whatever is the interest rate, the budget constraint
always passes through the endowment point (Y1 , Y2 ). Hence, the fall in the interest rate
leads to the budget constraint pivoting anti-clockwise around the endowment point, as
shown in the diagram below.
The question then asks about the effect of this fall in the interest rate on someone who
would have chosen to be a borrower at the original interest rate. Individuals who choose
current consumption C1 above current income Y1 are borrowers: this means choosing a
consumption point to the right of the endowment point, such as the one in the diagram on
the indifference curve I. It can be seen from the diagram that the pivoting of the budget
constraint would leave the borrower able to afford the original consumption point and also
able to afford new consumption points on higher indifference curves, such as the one on
indifference curve I 0 . Thus, the fall in the interest rate must increase the borrowers utility.
Intuitively, lower interest rates reduce the cost of borrowing, which is a good thing from the
perspective of borrowers.
Observe from the diagram that a borrower would never find it rational to start saving
following the fall in the interest rate. Becoming a saver means choosing a consumption point
to the left of the endowment point. At the original interest rate, the borrower rejected this
option and chose to be a borrower. At the new low interest rate, the feasible consumption
points where the individual becomes a saver are below those consumption points available to
savers at the original interest rate. Since those were rejected, it would not be rational now
to choose an even worse option.
(c) In this part of the question, it is important to consider separately income and substitution
effects of the fall in the interest rate. The substitution effect is defined as the response to
the new interest rate, after hypothetically giving (or taking away) an amount of income that
allows the individual just to afford a consumption point on the original indifference curve.
In the diagram, the substitution effect is found by locating the point on the original
indifference curve where the gradient is equal to the new gradient of the budget constraint.
Since the budget constraint becomes flatter owing to the lower interest rate, the substitution
effect implies a movement down the indifference curve, which means an increase in current
consumption. Intuitively, low interest rates make future consumption relatively more
expensive than current consumption by reducing the return to saving, thus discouraging
saving and now encouraging spending.
21
The income effect is defined as the response to removing the hypothetical increase or
decrease of income that was used to calculate the substitution effect. Thus, by definition,
the sum of the income and substitution effects is equal to the overall response to the change
in interest rates. The nature of the income effect depends on whether the individual was
initially a borrower or a saver. In this question, the woman is a saver, so the initial
consumption point is to the left of the endowment point. As a result of the lower interest
rate, the budget constraint pivots anti-clockwise around the endowment point. This shows
that there must be a hypothetical increase in income to calculate the substitution effect
(otherwise it would not be possible to remain on the original indifference curve I). This
corresponds to the dashed budget line with the same gradient as the new budget line, but in
a higher position that allows a consumption point on the original indifference curve to be
affordable. Calculating the income effect means obtaining the effect of removing this
hypothetical increase in income, that is, the effect of the parallel shift of the budget
constraint from the dashed line to the one passing through the endowment point. This is a
downward shift, and given the assumption that consumption is a normal good, the response
of current consumption to this shift is negative. With a negative income effect (IE) and a
positive substitution effect (SE), the overall response of current consumption C1 (and thus
saving S = Y1 C1 ) is ambiguous.
In the diagram above, the womans indifference curves are drawn as highly curved, which
can be seen to imply a small substitution effect. Thus, the income effect dominates and
overall, consumption falls and saving increases. This example demonstrates that it is not
irrational for a saver to behave in this way following a fall in interest rates. However, not all
savers would necessarily behave in this way. If an individual had indifference curves that
were less curved the substitution effect would be larger and might then be larger than the
income effect, meaning that consumption would rise and saving would decrease. This case is
illustrated in the diagram below.
22
Question 15
Goods-market equilibrium is where output Y is equal to the sum of consumption C,
investment I, government spending G, and net exports N X. The consumption and
investment functions are:
C = C0 + c(Y T ) ,
I = I0 bi
where i is the domestic interest rate. Government spending and taxes are
exogenously fixed at G = G0 and T = T0 . Net exports are given by:
N X = N X0 mY ae
where e is the nominal exchange rate (defined as the foreign currency price of
domestic currency). Money-market equilibrium is represented by the equation:
Ms
= M0 + kY hi
P
where M s is the money supply, P is the price level, and the right-hand side of the
equation is the demand for money. Given perfect capital mobility, the balance of
payments is in equilibrium only if i = i , where i is the foreign interest rate.
(a) Suppose the central bank increases the money supply. Find the effects on the
exchange rate and output.
(6 marks)
(b) Now suppose that money-market equilibrium is represented by the following
equation:
Ms
= M0 + kY hi
Pc
where P c is the consumer price level. The consumer price level P c is an average
of the price of domestically produced goods P (which is fixed) and the
domestic-currency price P /e of foreign-produced goods. While P is fixed, any
23
change in the exchange rate e will lead to a change in the domestic price at
which imports are sold.
Considering again the expansion of the money supply analysed in part (a), find
the effect on output and compare the size of the effect to that found in part (a).
(7 marks)
(c) Return to the original money-market equilibrium condition with P , but now
suppose that capital mobility is imperfect. The capital account KA of the
balance of payments is given by the equation:
KA = KA0 + f (i i )
where f is a positive constant. How does this change the BP curve representing
balance-of-payments equilibrium? Considering again the monetary expansion
from part(a), find the effect on output and compare the size of the effect to that
found in part (a).
(7 marks)
Blanchard, Chapters 1820.
Mankiw, Chapter 12.
(a) The economy is in equilibrium when IS, LM, and BP curves intersect. The IS curve
represents goods-market equilibrium; the LM curve money-market equilibrium; and the BP
curve balance-of-payments equilibrium (effectively equilibrium in the market for foreign
exchange). With perfect capital mobility the BP curve is a horizontal line at the foreign
interest rate i . Equilibrium of the economy is reached through adjustment of interest rates
and output as in the standard IS-LM model (internal equilibrium is where the goods and
money markets are in equilibrium, that is, where IS and LM intersect), together with
adjustment of the exchange rate that has the effect of shifting the IS curve by affecting the
demand for exports and imports (allowing external equilibrium to be achieved, that is,
where the balance of payments is also in equilibrium). For example, a depreciation of the
exchange rate makes domestic goods more competitive, which boosts net exports and shifts
the IS curve to the right.
The economy starts initially in internal and external equilibrium at i = i and Y = Y0 . The
increase in the money supply has the effect of shifting the LM curve to the right. Internal
equilibrium (the intersection between the IS and LM curves) is now at i1 and Y1 . Since i1 is
less than the foreign interest rate i , the internal equilibrium is below the BP curve, which
means this is not a point of balance-of-payments equilibrium. With perfect capital mobility
there would be a huge outflow of capital, which means there would be more sellers of the
domestic currency than there would be buyers, so the market for foreign exchange is not in
equilibrium. With a flexible exchange rate, this selling of the domestic currency leads to a
depreciation of the exchange rate. The depreciation improves competitiveness, shifting the
IS curve to the right. This process continues until the selling pressure on the domestic
currency is alleviated, which only occurs when the domestic interest rate has risen all the
way back to the foreign interest rate i . In other words, the depreciation must be large
enough to shift the IS curve sufficiently far to the right (IS2 ) that it intersects LM1 at
i = i . Once this point is reached, the IS, LM, and BP all intersect, and equilibrium in all
markets is restored. Output is thus seen to rise, and the exchange rate to depreciate.
24
(b) In this part of the question there is an addition effect to add to the analysis from part (a),
which is otherwise unchanged. When the exchange rate depreciates (meaning that e, defined
as the foreign-currency price of domestic currency falls), the domestic-currency price of
imports P /e rises. The consumer price index P c is defined as some average of the price P
of domestically produced goods and the price P /e of imports. The exchange-rate
depreciation thus raises P c . Given the equation for money-market equilibrium, a rise in P c
reduces the real money supply, shifting the LM curve to the left.
Following the initial increase in the money supply, the LM curve shifts to the right as in
part (a). At the new internal equilibrium, there is a balance-of-payments deficit as before,
and the exchange rate depreciates to restore external equilibrium. However, now the
depreciation has two effects. First, the IS curve shifts to the right as competitiveness
improves, as in part (a). Second, the LM curve shifts to the left as the higher cost of
imports raises the consumer price level and reduces the real money supply, as described
above. The new equilibrium is where the IS curve shifting to the right from IS0 to IS2 meets
the LM curve shifting to the left from LM1 to LM2 . It is clear that output must rise (Y2 is
above Y0 ), but by less than in part (a) where the shift from LM1 to LM2 did not occur. The
exchange rate depreciates, but with a smaller rightward shift of the IS curve, it is clear that
a smaller depreciation is needed to restore balance-of-payments equilibrium than in part (a).
25
(c) In this part of the question, the BP curve becomes upward sloping as a result of imperfect
capital mobility. Intuitively, higher output increases the demand for imports, which worsens
the current account. The capital account must improve for the balance of payments to
remain in equilibrium, and now this requires higher interest rates to attract capital that
would otherwise flow to other economies. Furthermore, the BP curve now shifts when the
exchange rate moves, unlike the case of perfect capital mobility. An exchange rate
appreciation shifts BP upwards. The reason is again that a worsening of the current account
(caused now by domestic goods being less competitive) requires higher interest rates to
attract capital flows and maintain balance-of-payments equilibrium, all else equal. An
exchange rate depreciation shifts the BP curve downwards using the same logic.
Now consider again an increase in the money supply that shifts the LM curve from LM0 to
LM1 . The intersection of the IS curve and the new LM curve is below the BP curve, so
there would be a balance-of-payments deficit at the internal equilibrium (Y1 , i1 ). Selling
pressure then causes the exchange rate to depreciate. This leads to two effects. First, just as
in part (a), the depreciation improves the competitiveness of domestically produced goods,
causing the IS curve to shift to the right. Second, the depreciation shifts the BP curve
downwards, as the improvement in the current account means that smaller capital inflows
are required for balance-of-payments equilibrium (and hence interest rates do not need to be
as high to attract foreign capital). The new equilibrium is reached where the IS curve
shifting from IS0 to IS2 , and the BP curve shifting from BP0 to BP2 meet at a point on the
new LM curve LM1 . It is clear that output must rise (Y2 is above Y0 ).
This leaves the question of whether output rises by more or less than in part (a). There, the
BP curve was a horizontal line, so the final level of output increased by an amount equal to
the horizontal shift of the LM curve. Here, the shift of the LM curve is the same, so whether
output rises by more or less depends on whether the interest rate rises or falls. Suppose the
interest rate were to rise. From the equation for the capital account, it is clear this would
increase capital inflows and thus raise KA. However, the analysis has shown that the
current account improves owing to the exchange-rate depreciation (to be more precise, lower
investment because of the higher interest rate and higher national saving because of higher
output, together with the equation CA = SN I, implies that the current account rises).
But it is not possible to have a balance-of-payments equilibrium if both the current account
and the capital account have increased. This argument demonstrates that it is impossible
for interest rates to rise. Since a fall in interest rates is the only other possibility, it must be
the case that output rises by less than in part (a).
26
Question 16
Consider an economy where nominal wages are fixed by long-term contracts and
where workers would be willing to supply more labour at the prevailing wage. Prices
are flexible and profit-maximizing competitive firms hire labour and produce output
subject to a production function with diminishing marginal returns to labour.
(a) Write down the condition that determines firms demand for labour and show
how the short-run aggregate supply (SRAS) curve is derived, explaining why
this curve is upward sloping.
(6 marks)
(b) Consider an economy where the central bank follows a policy of inflation
targeting (interpret this to mean the central bank adjusts the money supply to
keep the price level constant). Now suppose the economy is hit by a negative
shock to confidence that reduces firms demand for investment (a reduction in
autonomous investment demand). Use the AD/AS model to find the effects of
the confidence shock on output and unemployment, and explain whether
inflation targeting is a desirable monetary policy for an economy facing this
type of shock.
(7 marks)
(c) Consider again an economy where the central bank follows a policy of inflation
targeting, but now suppose the economy is hit by a negative productivity shock
instead (a reduction in the marginal product of labour at each level of
employment). Find the effect of productivity shock on the SRAS curve and
explain what happens to unemployment. Can you suggest a monetary policy
that delivers a better outcome for unemployment following this shock than
inflation targeting?
(7 marks)
(a) Firms maximise profits by hiring labour up to the point where the marginal product of
labour MPL is equal to the real wage w:
MPL = w.
The labour demand curve is thus the marginal product of labour, which leads to a
downward-sloping demand curve because the marginal product is diminishing as
employment L increases.
The outcome in the labour market is not given by the intersection between labour demand
and labour supply because wages are fixed by long-term contracts that do not adjust to
clear the market. It is assumed that wages are at a high enough level that workers are
willing to supply whatever amount of labour is demanded by firms. The outcome in the
labour market is thus found by reading off the level of employment from the labour demand
curve given the prevailing real wage. This real wage is the contractually fixed nominal wage
divided by the price level P . Prices are flexible, so the real wage can adjust as a result of
W
price level changes even though the nominal wage is sticky. An increase in the price level
/P1 to W
/P2 , which leads to a movement down
from P1 to P2 reduces the real wage from W
27
the labour demand curve, increasing employment from L1 to L2 . This is shown in the right
panel of the diagram below.
The labour supply curve is not shown. Instead, the vertical line LF indicates the size of the
labour force. The assumption is that workers are willing to supply any amount of labour up
to LF and, as suggested in the question, LF is above L1 and L2 . (If an upward-sloping
labour supply curve were drawn, it makes sense to assume that it intersects the labour
demand curve to the right of L1 and L2 so that workers are actually willing to supply the
extra labour demanded.)
Higher employment leads to an increase in the supply of output given that other factors of
production are fixed. Hence, the increase in the price level from P1 to P2 leads to an
increase in output supplied from Y1 to Y2 . The supply of output at each price level P is
represented by the short-run aggregate supply curve (SRAS). The short run in the name of
the SRAS curve refers to the time during which nominal wages are fixed by contracts, with
scope for renegotiation of those contracts in the long run. The points (Y1 , P1 ) and (Y2 , P2 )
both lie on the SRAS curve, and since (Y2 , P2 ) is to the north east of (Y1 , P1 ), the SRAS
curve is seen to be upward sloping, as depicted in the left panel of the diagram.
(b) In the AD-AS model, the price level P adjusts to ensure that aggregate demand (AD) is
equal to the aggregate supply (AS) of output Y . Assume the economy starts from a point
where the central bank would meet its inflation target at price level P . The question states
that the economy is hit by a negative demand shock that shifts the AD curve to the left
(and has no effect on the SRAS curve). As shown in the left panel below, the effect of a
leftward shift of the AD curve from AD0 to AD1 is a fall in output from Y0 to Y1 and a fall
of the price level from P to P1 . The implications for the labour market of the economy
moving down the SRAS curve with a lower price level are shown in the right panel of the
diagram. Prices falling from P0 to P1 increase the real wage and reduce employment as
explained in part (a). Unemployment (the difference between the labour force LF and
employment L) thus increases from u0 to u1 .
28
This outcome is clearly inconsistent with the inflation target, which requires a price level
equal to P . Therefore, a central bank targeting inflation would respond to downward
pressure on the price level by increasing demand through a monetary expansion. Increasing
the money supply boosts demand, shifting the AD curve to the right. As can be seen from
the diagram, the inflation target can only be met if the AD curve returns to its original
position. This determines the size of the monetary expansion, shifting AD to the right until
it reaches AD2 , which is in the same position as the original AD0 . As a result of this policy
intervention, there is no change in output and no change in the price level from its original
level P . In the labour market diagram in the right panel, because there is no change in the
price level, there is no change in the real wage, and hence no change in labour demand.
Unemployment does not increase (unemployment u2 is the same as its original level u1 ),
unlike in the case where the central bank allowed the price level to fall to P1 . Therefore
inflation targeting performs well when the economy is faced with a shock of this type (that
is, a demand shock).
(c) The negative productivity shock reduces the marginal product of labour at each level of
employment. This shifts the labour demand curve downwards. As can be seen in the right
panel of the diagram below, this leads to lower employment at any given real wage. For
/P that prevails when the price level is equal to P .
example, consider the real wage W
Employment falls from L0 to L2 , increasing unemployment from u0 to u2 . The lower
employment leads to lower output (as does the fall in productivity directly), with output
falling from Y0 to Y2 in the left panel of the diagram. Such a fall in output occurs at each
price level, so the SRAS curve shifts to the left from SRAS0 to SRAS1 .
The leftward shift of the SRAS curve puts upward pressure on the price level. If the
aggregate demand curve remained at AD0 , the price level would rise from P to P1 . This is
inconsistent with inflation targeting, so a central bank with an inflation target would need
to use monetary policy to reduce demand. A reduction in the money supply shifts the AD
curve to the left from AD0 to AD2 . The size of this shift is such that P returns to the level
P consistent with the inflation target. With P remaining at P , the outcomes in the
labour market have already been described, that is, a fall in employment to L2 and a rise in
unemployment to u2 . In this case, inflation targeting leads to a poor outcome for
unemployment.
Now consider an alternative monetary policy that targets the money supply. In this case,
the central bank effectively fixes the money supply, which means that the aggregate demand
curve remains at AD0 . Following the negative productivity shock that shifts the SRAS
curve to the left, this policy leads to a rise in the price level to P1 . In the labour market
/P1 , which entails a smaller rise
diagram, the higher price level reduces the real wage to W
in unemployment (u0 to u1 ) than inflation targeting (u0 to u2 ). The policy achieves a better
outcome for unemployment, though this is not without cost because inflation now rises
following the negative productivity shock, unlike in the case of inflation targeting. Whether
or not this is better is debatable, but inflation targeting does have the consequence that the
29
whole burden of adjusting to a productivity shock falls on unemployment, rather than the
price level. Notice that for the demand shock in part (b), inflation targeting led to a better
outcome for both unemployment and inflation than the policy of targeting the money
supply. Thus, the merits of different monetary policies may depend on whether the economy
is faced with demand or supply shocks.
30

Important note

section.
Comments on specific questions Zone B

Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from Section
A (5 marks each) and THREE from Section B (20 marks each). Candidates are strongly
Section A
Question 1
Firms that pay efficiency wages can be a cause of classical unemployment. True
or false? Briefly explain your answer.
Mankiw, Chapter 6.
31

Classical unemployment is caused by real wages being too high in the sense that workers would
like to supply more labour at the prevailing real wage than firms would be willing to hire. To
bring demand into line with supply, the real wage would need to fall. Efficiency wages are paid
to increase the productivity of the workforce, for example, by providing an incentive not to shirk.
When firms have an incentive to pay efficiency wages, firms may be unwilling to cut wages even if
workers would accept jobs at a wage lower than the prevailing one. Consequently, unemployment
does not exert downward pressure on wages, so these remain above their market clearing level.
Question 2
The Solow growth model assumes a production function with decreasing returns to
scale and constant marginal returns to capital. True or false? Briefly explain your
answer.
The assumptions given in the statement are the wrong way around. The Solow model assumes
constant returns to scale, not decreasing returns to scale, and assumes diminishing marginal
returns to capital, not constant returns to capital.
Constant returns to capital would mean that output increases by 1% if capital is incresed by 1%
while other factors are held constant. Decreasing returns to scale would mean that output
increases by less than 1% if all factors of production are increased by 1%. Notice that there is a
contradiction between assuming decreasing returns to scale (i.e. to all factors) and constant
returns to capital (i.e. to only one factor).
Question 3
If the demand for money does not depend on income then the LM curve is vertical.
Mankiw, Chapter 10.
32
The LM curve represents the combinations of interest rates and output where the money market
is in equilibrium. If money demand does not depend on income then no shift of the money
demand curve occurs when income changes, unlike the usual case, and thus there is no change in
the interest rate required to achieve money-market equilibrium. This means that the same
interest rate results in the money market being in equilibrium irrespective of the level of output.
Geometrically, this implies that the LM curve is a horizontal line, not a vertical one.
Question 4
In a closed economy, an increase in the government budget deficit must be matched
by higher private saving, lower investment, or both. True or false? Briefly explain
your answer.
Mankiw, Chapter 3.
In a closed economy, national saving SN is equal to investment I. National saving is defined as
the sum of private saving SP = Y T C and government saving SG = T G, the latter being
the negative of the budget deficit D = G T . The budget deficit is therefore related to private
saving and investment as follows:
D = SP I.
From this accounting identity it follows that an increase in D could be matched by a rise in SP ,
or an increase in D could be matched by a fall in I, or some combination of both.
Question 5
If menu costs were the only cost of inflation then it would be best to have a zero
rate of inflation. True or false? Briefly explain your answer.
Mankiw, Chapter 4.
Menu costs refer to the (physical) costs of changing price labels, lists, and catalogues. In the
presence of positive inflation, money prices would have to be adjusted to keep them in line with
costs and competitors prices. This is wasteful because it is unrelated to any fundamental reason
why relative prices need to be adjusted. Note that deflation (negative inflation) would also imply
a need to adjust money prices, just as a positive inflation rate would. Therefore, the best
inflation rate to avoid menu costs is zero.
33
Question 6
A desirable feature of any theory of economic growth is that it predicts the ratio of
the capital stock to output is stable in the long run. True or false? Briefly explain
your answer.
Mankiw, Chapter 8.
An approximately constant capital-output ratio K/Y is one of the Kaldor stylised facts of
growth. It is desirable that a theory of economic growth be consistent with such a
well-established empirical regularity.
Question 7
If the central bank pays interest on reserves then this will reduce seigniorage
revenues. True or false? Briefly explain your answer.
Mankiw, Chapter 4.
The key feature of money that gives rise to seigniorage is that it does not pay interest. This
means that central banks can issue money without having to worry about servicing a debt that
must be repaid in the future. As an example, if the central bank expands the money supply
through an open-market operation, it buys bonds with money. These bonds will earn interest for
the central bank, but it will not need to pay any interest on the money it issues. On the other
hand, reserves (a component of the monetary base) that pay interest are essentially the same as
government bonds in that they are a debt that must be serviced. This means that paying interest
on reserves reduces seigniorage revenues.
Question 8
Uncovered interest parity predicts that domestic and foreign interest rates are
always equal. True or false? Briefly explain your answer.
34
Mankiw, Chapter 12.

Uncovered interest parity (UIP) predicts that the domestic nominal interest rate is equal to the
foreign nominal interest rate plus the expected depreciation of the domestic currency relative to
the foreign currency. Intuitively, investors in foreign assets must be compensated for any
expected capital loss resulting from exchange-rate movements they anticipate. Unless the
expected exchange rate in the future is exactly the same as its level today, UIP will therefore not
predict that domestic and foreign interest rates are the same.
Question 9
Action lags are generally shorter for monetary policy than for fiscal policy. True or
Mankiw, Chapter 15.
An action lag is the time between a policy decision and its actual implementation. Open-market
operations or changes to the discount rate can be implemented immediately once the decision to
do this has been made. This is because such actions involve transactions with banks or other
financial intermediaries that take place very frequently whenever financial markets are open. On
the other hand, changes to tax policy or government spending generally take effect much more
slowly. For example, tax rates may be difficult to change until a new fiscal year begins, and
government spending projects (such as infrastructure investment) will require planning before the
work can begin.
Question 10
If there is conditional convergence between economies then there must be a
negative relationship between a countrys initial level of GDP per capita and its
subsequent per-capita growth performance once other factors have been controlled
for. True or false? Briefly explain your answer.
Mankiw, Chapter 8.
35
Conditional convergence means that countries would in the long-run converge to their steady
states, but those steady states may depend on characteristics of the countries, such as saving
rates and population growth rates. To converge to a steady state, it is necessary that growth is
faster when the country is below the steady state than when it is at its steady state. The initial
level of GDP per capita (after controlling for other variables) measures how far a country is
below its steady state. Hence, if there is a zero or a positive correlation between subsequent
growth rates and initial GDP per capita then convergence would fail to occur.
Section B
Question 11
Consider an economy where nominal wages are fixed by long-term contracts and
where workers would be willing to supply more labour at the prevailing wage. Prices
are flexible and profit-maximizing competitive firms hire labour and produce output
subject to a production function with diminishing marginal returns to labour.
(a) Write down the condition that determines firms demand for labour and show
how the short-run aggregate supply (SRAS) curve is derived, explaining why
this curve is upward sloping.
(6 marks)
(b) Consider an economy where the central bank follows a policy of inflation
targeting (interpret this to mean the central bank adjusts the money supply to
keep the price level constant). Now suppose the economy is hit by a negative
shock to confidence that reduces firms demand for investment (a reduction in
autonomous investment demand). Use the AD/AS model to find the effects of
the confidence shock on output and unemployment, and explain whether
inflation targeting is a desirable monetary policy for an economy facing this
type of shock.
(7 marks)
(c) Consider again an economy where the central bank follows a policy of inflation
targeting, but now suppose the economy is hit by a negative productivity shock
instead (a reduction in the marginal product of labour at each level of
employment). Find the effect of productivity shock on the SRAS curve and
explain what happens to unemployment. Can you suggest a monetary policy
that delivers a better outcome for unemployment following this shock than
inflation targeting?
(7 marks)
(a) Firms maximise profits by hiring labour up to the point where the marginal product of
labour MPL is equal to the real wage w:
MPL = w.
36
The labour demand curve is thus the marginal product of labour, which leads to a
downward-sloping demand curve because the marginal product is diminishing as
employment L increases.
The outcome in the labour market is not given by the intersection between labour demand
and labour supply because wages are fixed by long-term contracts that do not adjust to
clear the market. It is assumed that wages are at a high enough level that workers are
willing to supply whatever amount of labour is demanded by firms. The outcome in the
labour market is thus found by reading off the level of employment from the labour demand
curve given the prevailing real wage. This real wage is the contractually fixed nominal wage
divided by the price level P . Prices are flexible, so the real wage can adjust as a result of
W
price level changes even though the nominal wage is sticky. An increase in the price level
/P1 to W
/P2 , which leads to a movement down
from P1 to P2 reduces the real wage from W
the labour demand curve, increasing employment from L1 to L2 . This is shown in the right
panel of the diagram below.
The labour supply curve is not shown. Instead, the vertical line LF indicates the size of the
labour force. The assumption is that workers are willing to supply any amount of labour up
to LF, and as suggested in the question, LF is above L1 and L2 . (If an upward-sloping
labour supply curve were drawn, it makes sense to assume that it intersects the labour
demand curve to the right of L1 and L2 so that workers are actually willing to supply the
extra labour demanded.)
Higher employment leads to an increase in the supply of output given that other factors of
production are fixed. Hence, the increase in the price level from P1 to P2 leads to an
increase in output supplied from Y1 to Y2 . The supply of output at each price level P is
represented by the short-run aggregate supply curve (SRAS). The short run in the name of
the SRAS curve refers to the time during which nominal wages are fixed by contracts, with
scope for renegotiation of those contracts in the long run. The points (Y1 , P1 ) and (Y2 , P2 )
both lie on the SRAS curve, and since (Y2 , P2 ) is to the north east of (Y1 , P1 ), the SRAS
curve is seen to be upward sloping, as depicted in the left panel of the diagram.
(b) In the AD-AS model, the price level P adjusts to ensure that aggregate demand (AD) is
equal to the aggregate supply (AS) of output Y . Assume the economy starts from a point
where the central bank would meet its inflation target at price level P . The question states
that the economy is hit by a negative demand shock that shifts the AD curve to the left
(and has no effect on the SRAS curve). As shown in the left panel below, the effect of a
leftward shift of the AD curve from AD0 to AD1 is a fall in output from Y0 to Y1 and a fall
of the price level from P to P1 . The implications for the labour market of the economy
moving down the SRAS curve with a lower price level are shown in the right panel of the
diagram. Prices falling from P0 to P1 increase the real wage and reduce employment as
explained in part (a). Unemployment (the difference between the labour force LF and
employment L) thus increases from u0 to u1 .
37
This outcome is clearly inconsistent with the inflation target, which requires a price level
equal to P . Therefore, a central bank targeting inflation would respond to downward
pressure on the price level by increasing demand through a monetary expansion. Increasing
the money supply boosts demand, shifting the AD curve to the right. As can be seen from
the diagram, the inflation target can only be met if the AD curve returns to its original
position. This determines the size of the monetary expansion, shifting AD to the right until
it reaches AD2 , which is in the same position as the original AD0 . As a result of this policy
intervention, there is no change in output and no change in the price level from its original
level P . In the labour market diagram in the right panel, because there is no change in the
price level, there is no change in the real wage, and hence no change in labour demand.
Unemployment does not increase (unemployment u2 is the same as its original level u1 ),
unlike in the case where the central bank allowed the price level to fall to P1 . Therefore
inflation targeting performs well when the economy is faced with a shock of this type (that
is, a demand shock).
(c) The negative productivity shock reduces the marginal product of labour at each level of
employment. This shifts the labour demand curve downwards. As can be seen in the right
panel of the diagram below, this leads to lower employment at any given real wage. For
/P that prevails when the price level is equal to P .
example, consider the real wage W
Employment falls from L0 to L2 , increasing unemployment from u0 to u2 . The lower
employment leads to lower output (as does the fall in productivity directly), with output
falling from Y0 to Y2 in the left panel of the diagram. Such a fall in output occurs at each
price level, so the SRAS curve shifts to the left from SRAS0 to SRAS1 .
The leftward shift of the SRAS curve puts upward pressure on the price level. If the
aggregate demand curve remained at AD0 , the price level would rise from P to P1 . This is
inconsistent with inflation targeting, so a central bank with an inflation target would need
to use monetary policy to reduce demand. A reduction in the money supply shifts the AD
curve to the left from AD0 to AD2 . The size of this shift is such that P returns to the level
P consistent with the inflation target. With P remaining at P , the outcomes in the
labour market have already been described, that is, a fall in employment to L2 and a rise in
38
unemployment to u2 . In this case, inflation targeting leads to a poor outcome for

unemployment.
Now consider an alternative monetary policy that targets the money supply. In this case,
the central bank effectively fixes the money supply, which means that the aggregate demand
curve remains at AD0 . Following the negative productivity shock that shifts the SRAS
curve to the left, this policy leads to a rise in the price level to P1 . In the labour market
/P1 , which entails a smaller rise
diagram, the higher price level reduces the real wage to W
in unemployment (u0 to u1 ) than inflation targeting (u0 to u2 ). The policy achieves a better
outcome for unemployment, though this is not without cost because inflation now rises
following the negative productivity shock, unlike in the case of inflation targeting. Whether
or not this is better is debatable, but inflation targeting does have the consequence that the
whole burden of adjusting to a productivity shock falls on unemployment, rather than the
price level. Notice that for the demand shock in part (b), inflation targeting led to a better
outcome for both unemployment and inflation than the policy of targeting the money
supply. Thus, the merits of different monetary policies may depend on whether the economy
is faced with demand or supply shocks.
Question 12
Consider the Fisher model of consumption choice (with two time periods
representing the present and the future). An individual receives income Y1 in the
first period and income Y2 in the second period, and can save or borrow at real
interest rate r. The individual chooses a plan for current consumption C1 and future
consumption C2 to maximize utility.
(a) Write down an equation for the individuals life-time budget constraint and
interpret the equation. Draw a diagram illustrating how the optimal
consumption plan is found and justify your answer.
(6 marks)
(b) Consider an economy where the real interest rate falls. What is the effect of a
lower interest rate on the life-time budget constraint in the diagram? Assuming
an individual was initially a borrower, use the diagram to deduce whether the
fall in interest rates increases or decreases the borrowers utility. Explain
whether a borrower would ever find it rational to start saving when interest
rates fall.
(7 marks)
(c) In a newspaper report discussing the consequences of low interest rates, a
woman is quoted as saying that she now needs to save even more for my
retirement. Draw indifference curves to illustrate that the woman is not being
irrational by saving more when interest rates fall. Explain your answer in terms
of income and substitution effects and discuss whether all savers would be
expected to behave in this way.
(7 marks)
Mankiw, Chapter 17.
(a) The lifetime budget constraint is
C1 +
Y2
C2
= Y1 +
.
1+r
1+r
39
The left-hand side of this equation is the sum of current consumption and the present
discounted value of future consumption. The right-hand side is the sum of current income
and the present discounted value of future income. If the individual is free to borrow or
save, current consumption can differ from current income, but the presented discounted
value of all current and future consumption cannot be more than the present discounted
value of all current and future income (and would not be less given that the individual
would always like more consumption either now or in the future). Note that the question
does not ask for the lifetime budget constraint to be derived. It is sufficient to write down
the equation and explain the meaning of the terms appearing in the equation.
The optimal consumption plan is determined using a diagram that contains two elements:
the lifetime budget constraint and the indifference curves of the individual. The equation for
the lifetime budget constraint is given above. This equation is linear in the consumption
levels C1 and C2 , so geometrically it is a straight line. Furthermore, given income Y1 and Y2 ,
higher C2 is only possible if C1 is reduced, so the equation is represented by a
downward-sloping line. For every unit less of current consumption, the increase in saving
that earns real return r allows 1 + r units of future consumption to be purchased. Thus, the
line has slope (1 + r). Since C1 = Y1 and C2 = Y2 is consistent with the equation, the line
always passes through the point (Y1 , Y2 ), which is usually referred to as the endowment
point, or income point.
The second element of the diagram is the set of indifference curves. Each indifference curve
represents a collection of points (C1 , C2 ) where each point is a consumption plan that offers
the same level of utility to the individual. Indifference curves are downward sloping because
if C1 is reduced, C2 must be increased to compensate the individual if they are to receive
the same level of utility as before. Furthermore, it is assumed that the indifference curves
are convex. This means that reducing current consumption when current consumption is
low requires a very large increase in future consumption to compensate, whereas only a
small increase in future consumption would be necessary if current consumption was
initially very high.
The individual maximises utility by choosing a point on the highest attainable indifference
curve subject to satisfying the lifetime budget constraint. This corresponds to the tangency
point between an indifference curve and the budget constraint. If the consumption plan
were not at a tangency point, it would be possible to get to a higher indifference curve by
moving either left or right along the budget constraint.
(b) The budget line has gradient (1 + r). A fall in the real interest rate r thus makes the
budget constraint flatter. Notice that whatever is the interest rate, the budget constraint
always passes through the endowment point (Y1 , Y2 ). Hence, the fall in the interest rate
40
leads to the budget constraint pivoting anti-clockwise around the endowment point, as
shown in the diagram below.
The question then asks about the effect of this fall in the interest rate on someone who
would have chosen to be a borrower at the original interest rate. Individuals who choose
current consumption C1 above current income Y1 are borrowers: this means choosing a
consumption point to the right of the endowment point, such as the one in the diagram on
the indifference curve I. It can be seen from the diagram that the pivoting of the budget
constraint would leave the borrower able to afford the original consumption point and also
able to afford new consumption points on higher indifference curves, such as the one on
indifference curve I 0 . Thus, the fall in the interest rate must increase the borrowers utility.
Intuitively, lower interest rates reduce the cost of borrowing, which is a good thing from the
perspective of borrowers.
Observe from the diagram that a borrower would never find it rational to start saving
following the fall in the interest rate. Becoming a saver means choosing a consumption point
to the left of the endowment point. At the original interest rate, the borrower rejected this
option and chose to be a borrower. At the new low interest rate, the feasible consumption
points where the individual becomes a saver are below those consumption points available to
savers at the original interest rate. Since those were rejected, it would not be rational now
to choose an even worse option.
(c) In this part of the question, it is important to consider separately income and substitution
effects of the fall in the interest rate. The substitution effect is defined as the response to
the new interest rate, after hypothetically giving (or taking away) an amount of income that
allows the individual just to afford a consumption point on the original indifference curve.
In the diagram, the substitution effect is found by locating the point on the original
indifference curve where the gradient is equal to the new gradient of the budget constraint.
Since the budget constraint becomes flatter owing to the lower interest rate, the substitution
effect implies a movement down the indifference curve, which means an increase in current
consumption. Intuitively, low interest rates make future consumption relatively more
expensive than current consumption by reducing the return to saving, thus discouraging
saving and now encouraging spending.
41
The income effect is defined as the response to removing the hypothetical increase or
decrease of income that was used to calculate the substitution effect. Thus, by definition,
the sum of the income and substitution effects is equal to the overall response to the change
in interest rates. The nature of the income effect depends on whether the individual was
initially a borrower or a saver. In this question, the woman is a saver, so the initial
consumption point is to the left of the endowment point. As a result of the lower interest
rate, the budget constraint pivots anti-clockwise around the endowment point. This shows
that there must be a hypothetical increase in income to calculate the substitution effect
(otherwise it would not be possible to remain on the original indifference curve I). This
corresponds to the dashed budget line with the same gradient as the new budget line, but in
a higher position that allows a consumption point on the original indifference curve to be
affordable. Calculating the income effect means obtaining the effect of removing this
hypothetical increase in income, that is, the effect of the parallel shift of the budget
constraint from the dashed line to the one passing through the endowment point. This is a
downward shift, and given the assumption that consumption is a normal good, the response
of current consumption to this shift is negative. With a negative income effect (IE) and a
positive substitution effect (SE), the overall response of current consumption C1 (and thus
saving S = Y1 C1 ) is ambiguous.
In the diagram above, the womans indifference curves are drawn as highly curved, which
can be seen to imply a small substitution effect. Thus, the income effect dominates and
overall, consumption falls and saving increases. This example demonstrates that it is not
irrational for a saver to behave in this way following a fall in interest rates. However, not all
savers would necessarily behave in this way. If an individual had indifference curves that
were less curved the substitution effect would be larger and might then be larger than the
income effect, meaning that consumption would rise and saving would decrease. This case is
illustrated in the diagram below.
42
Question 13
Goods-market equilibrium is where output Y is equal to the sum of consumption C,
investment I, government spending G, and net exports N X. The consumption and
investment functions are:
C = C0 + c(Y T ) ,
I = I0 bi
where i is the domestic interest rate. Government spending and taxes are
exogenously fixed at G = G0 and T = T0 . Net exports are given by:
N X = N X0 mY ae
where e is the nominal exchange rate (defined as the foreign currency price of
domestic currency). Money-market equilibrium is represented by the equation:
Ms
= M0 + kY hi
P
where M s is the money supply, P is the price level, and the right-hand side of the
equation is the demand for money. Given perfect capital mobility, the balance of
payments is in equilibrium only if i = i , where i is the foreign interest rate.
(a) Suppose the central bank increases the money supply. Find the effects on the
exchange rate and output.
(6 marks)
(b) Now suppose that money-market equilibrium is represented by the following
equation:
Ms
= M0 + kY hi
Pc
where P c is the consumer price level. The consumer price level P c is an average
of the price of domestically produced goods P (which is fixed) and the
domestic-currency price P /e of foreign-produced goods. While P is fixed, any
43
change in the exchange rate e will lead to a change in the domestic price at
which imports are sold.
Considering again the expansion of the money supply analysed in part (a), find
the effect on output and compare the size of the effect to that found in part (a).
(7 marks)
(c) Return to the original money-market equilibrium condition with P , but now
suppose that capital mobility is imperfect. The capital account KA of the
balance of payments is given by the equation:
KA = KA0 + f (i i )
where f is a positive constant. How does this change the BP curve representing
balance-of-payments equilibrium? Considering again the monetary expansion
from part(a), find the effect on output and compare the size of the effect to that
found in part (a).
(7 marks)
Blanchard, Chapters 1820.
Mankiw, Chapter 12.
(a) The economy is in equilibrium when IS, LM, and BP curves intersect. The IS curve
represents goods-market equilibrium; the LM curve money-market equilibrium; and the BP
curve balance-of-payments equilibrium (effectively equilibrium in the market for foreign
exchange). With perfect capital mobility the BP curve is a horizontal line at the foreign
interest rate i . Equilibrium of the economy is reached through adjustment of interest rates
and output as in the standard IS-LM model (internal equilibrium is where the goods and
money markets are in equilibrium, that is, where IS and LM intersect), together with
adjustment of the exchange rate that has the effect of shifting the IS curve by affecting the
demand for exports and imports (allowing external equilibrium to be achieved, that is,
where the balance of payments is also in equilibrium). For example, a depreciation of the
exchange rate makes domestic goods more competitive, which boosts net exports and shifts
the IS curve to the right.
The economy starts initially in internal and external equilibrium at i = i and Y = Y0 . The
increase in the money supply has the effect of shifting the LM curve to the right. Internal
equilibrium (the intersection between the IS and LM curves) is now at i1 and Y1 . Since i1 is
less than the foreign interest rate i , the internal equilibrium is below the BP curve, which
means this is not a point of balance-of-payments equilibrium. With perfect capital mobility
there would be a huge outflow of capital, which means there would be more sellers of the
domestic currency than there would be buyers, so the market for foreign exchange is not in
equilibrium. With a flexible exchange rate, this selling of the domestic currency leads to a
depreciation of the exchange rate. The depreciation improves competitiveness, shifting the
IS curve to the right. This process continues until the selling pressure on the domestic
currency is alleviated, which only occurs when the domestic interest rate has risen all the
way back to the foreign interest rate i . In other words, the depreciation must be large
enough to shift the IS curve sufficiently far to the right (IS2 ) that it intersects LM1 at
i = i . Once this point is reached, the IS, LM, and BP all intersect, and equilibrium in all
markets is restored. Output is thus seen to rise, and the exchange rate to depreciate.
44
(b) In this part of the question there is an addition effect to add to the analysis from part (a),
which is otherwise unchanged. When the exchange rate depreciates (meaning that e, defined
as the foreign-currency price of domestic currency falls), the domestic-currency price of
imports P /e rises. The consumer price index P c is defined as some average of the price P
of domestically produced goods and the price P /e of imports. The exchange-rate
depreciation thus raises P c . Given the equation for money-market equilibrium, a rise in P c
reduces the real money supply, shifting the LM curve to the left.
Following the initial increase in the money supply, the LM curve shifts to the right as in
part (a). At the new internal equilibrium, there is a balance-of-payments deficit as before,
and the exchange rate depreciates to restore external equilibrium. However, now the
depreciation has two effects. First, the IS curve shifts to the right as competitiveness
improves, as in part (a). Second, the LM curve shifts to the left as the higher cost of
imports raises the consumer price level and reduces the real money supply, as described
above. The new equilibrium is where the IS curve shifting to the right from IS0 to IS2 meets
the LM curve shifting to the left from LM1 to LM2 . It is clear that output must rise (Y2 is
above Y0 ), but by less than in part (a) where the shift from LM1 to LM2 did not occur. The
exchange rate depreciates, but with a smaller rightward shift of the IS curve, it is clear that
a smaller depreciation is needed to restore balance-of-payments equilibrium than in part (a).
45
(c) In this part of the question, the BP curve becomes upward sloping as a result of imperfect
capital mobility. Intuitively, higher output increases the demand for imports, which worsens
the current account. The capital account must improve for the balance of payments to
remain in equilibrium, and now this requires higher interest rates to attract capital that
would otherwise flow to other economies. Furthermore, the BP curve now shifts when the
exchange rate moves, unlike the case of perfect capital mobility. An exchange rate
appreciation shifts BP upwards. The reason is again that a worsening of the current account
(caused now by domestic goods being less competitive) requires higher interest rates to
attract capital flows and maintain balance-of-payments equilibrium, all else equal. An
exchange rate depreciation shifts the BP curve downwards using the same logic.
Now consider again an increase in the money supply that shifts the LM curve from LM0 to
LM1 . The intersection of the IS curve and the new LM curve is below the BP curve, so
there would be a balance-of-payments deficit at the internal equilibrium (Y1 , i1 ). Selling
pressure then causes the exchange rate to depreciate. This leads to two effects. First, just as
in part (a), the depreciation improves the competitiveness of domestically produced goods,
causing the IS curve to shift to the right. Second, the depreciation shifts the BP curve
downwards, as the improvement in the current account means that smaller capital inflows
are required for balance-of-payments equilibrium (and hence interest rates do not need to be
as high to attract foreign capital). The new equilibrium is reached where the IS curve
shifting from IS0 to IS2 , and the BP curve shifting from BP0 to BP2 meet at a point on the
new LM curve LM1 . It is clear that output must rise (Y2 is above Y0 ).
This leaves the question of whether output rises by more or less than in part (a). There, the
BP curve was a horizontal line, so the final level of output increased by an amount equal to
the horizontal shift of the LM curve. Here, the shift of the LM curve is the same, so whether
output rises by more or less depends on whether the interest rate rises or falls. Suppose the
interest rate were to rise. From the equation for the capital account, it is clear this would
increase capital inflows and thus raise KA. However, the analysis has shown that the
current account improves owing to the exchange-rate depreciation (to be more precise, lower
investment because of the higher interest rate and higher national saving because of higher
output, together with the equation CA = SN I, implies that the current account rises).
But it is not possible to have a balance-of-payments equilibrium if both the current account
and the capital account have increased. This argument demonstrates that it is impossible
for interest rates to rise. Since a fall in interest rates is the only other possibility, it must be
the case that output rises by less than in part (a).
46
Question 14
Consider the Solow model of economic growth in the case of no exogenous
technological progress (g = 0). There is a production function Y = F (K, L), where Y
is output, K is the capital stock, and L is the labour force. The labour force grows
at a constant rate n, the capital stock depreciates at a constant rate , and the
saving rate is s.
Let y = Y /L and k = K/L denote output per person and capital per person. The
per-person production function is y = f (k), and the dynamics of the capital stock per
person are described by the equation: k = sf (k) ( + n)k.
(a) Show how the steady-state stock of capital per person is found using a diagram,
explaining what assumption is needed for the per-person production function
f (k) to have a concave shape. Using the diagram, find the effects of a rise in the
saving rate on steady-state capital per person and output per person.
(6 marks)
(b) Consider an economy where both output Y and the capital stock K are
measured in terms of the quantity of computers. Assume each worker requires a
computer in order to produce any output (new computers), but cannot use
more than one computer at the same time. Assume also that it takes two
workers to produce one new computer. These assumptions mean that the
per-person production function is f (k) = k/2 if k lies between 0 and 1, and
f (k) = 1/2 if k is larger than 1, as illustrated below:
Assume that the population grows by 2.5% every year, while 10% of computers
become obsolete every year (10% is the depreciation rate of the capital stock).
Suppose that the saving rate is 40%. Find the steady-state capital stock per
person and output per person. (Hint: start your analysis by adding the saving
and depreciation lines to the diagram above.)
(7 marks)
(c) Define the Golden rule level of the capital stock. Now find the Golden rule
capital stock per person for the economy described in part (b), and say whether
the saving rate of 40% is too low or too high to reach the Golden rule.
Determine the saving rate needed to take the economy to the Golden rule level
of capital.
(7 marks)
47

Mankiw, Chapter 7.
(a) The steady-state stock of capital per person is the level of k = K/L at which k would
remain constant over time. Mathematically, this means that the change in k is zero
(k = 0). From the equation given in the question, this requires:
sf (k) = ( + n)k
The left-hand side of the equation is the saving rate s multiplied by the level of output per
person y = f (k). Geometrically, the per-person production function f (k) is an increasing
and concave function of k. The saving line sf (k) multiplies this production function by s
(scaling it down because s < 1), which thus has the same general shape as the production
function. The right-hand side of the equation is the sum of the depreciation rate and
population growth rate n multiplied by capital per person. Geometrically, this depreciation
line is an upward-sloping straight line. The saving and depreciation lines are illustrated
in the diagram below. The solution of the equation (steady-state capital per person k ) is
found where these two lines cross. Steady-state output per person y is then found from the
height of the production function at this level of capital per person.
The production function f (k) has a concave shape when the gradient f 0 (k) of the
production function decreases as k increases. The gradient represents the marginal product
of capital. When capital per person k increases, this says that the use of capital K in
production increases by more than labour L. Under the assumption of diminishing marginal
returns to capital, this means the marginal product of capital would fall, implying that f 0 (k)
falls as k increases. Thus, the assumption of diminishing marginal returns to capital justifies
the concave shape of the production function f (k).
An increase in the saving rate from s0 to s1 scales up the saving line. As the diagram below
shows, it now intersects the depreciation line at a higher level of capital per person (k1
instead of k0 ). An increase in capital per person leads to a movement to the right along the
production function up to the new steady state for output per person (y1 instead of y0 ).
48
(b) The saving line is simply a scaled-down version of the production function, so it has the
same shape as that of f (k) depicted in the question. Between k = 0 and k = 1, the
production function has gradient 1/2, so with s = 0.4, the gradient of the saving line in this
range is 0.4 0.5 = 0.2. To the right of k = 1, the saving line is flat like the production
function. The depreciation line is an upward-sloping straight line as usual. Its gradient is
the sum of the depreciation rate and the population growth rate n, that is,
0.1 + 0.025 = 0.125. This is less than the gradient of the saving line to the left of k = 1.
Therefore, the shapes of all the relevant lines are as shown in the diagram below.
It can be seen from the diagram that the depreciation line intersects the saving line at the
flat section of the latter. The height of the flat section of the saving line is 0.4 0.5 = 0.2.
Since the depreciation line is 0.125k, the steady-state level of capital per person is found by
solving the equation:
0.2
= 1.6
0.2 = 0.125k hence k =
0.125
With k = 1.6 to the right of k = 1, the steady-state level of output per person is the height
of the flat section of the production function, that is, y = 0.5.
(c) The Golden-rule capital stock is defined as the stock of capital per person where
steady-state consumption per person is maximised. The Golden rule thus represents the
highest sustainable level of consumption possible. Consumption per person is given by
income per person that is not saved, that is, c = f (k) sf (k) = (1 s)f (k). In a steady
state, it must be the case that sf (k) = ( + n)k, which means that steady-state
consumption is c = f (k) ( + n)k. Geometrically, this is the vertical distance between the
production function f (k) and the depreciation line ( + n)k. The Golden-rule capital stock
is thus determined by finding the level of k that maximises the gap between f (k) and
49
( + n)k. From the diagram below it can be seen that the Golden rule is at the kink of the
production function at k = 1.
In part (b) it was seen that a saving rate of 40% led to a steady-state capital stock per
person of 1.6. Relative to the Golden rule, this is too high, and hence the saving rate of 40%
needs to be reduced. It is also clear from the earlier diagram that the only way to achieve a
steady-state k equal to 1 is to have a saving line that overlaps the depreciation line between
k = 0 and k = 1. This is illustrated below.
To achieve that outcome, the gradient of the saving line must be the same as that of the
depreciation line in the range between k = 0 and k = 1. The latter gradient is 0.125, while
the gradient of the saving line is 0.5 s for a saving rate s. The required saving rate is then
the solution of the equation:
0.5s = 0.125
hence
s=
0.125
= 0.25
0.5
A reduction of the saving rate to 25% is therefore required to reach the Golden rule level of
capital.
50
Question 15
Md
= L(Y, i)
P
where P is the price level and L(Y, i) is an increasing function of real income Y and a
decreasing function of the nominal interest rate i.
(a) Explain carefully why money demand should be negatively related to the
nominal interest rate and what happens to the demand for money when the
nominal interest rate falls to zero. Use your answer to derive the LM curve,
illustrating the shape of the LM curve at a zero nominal interest rate.
(6 marks)
(b) Now suppose there is a negative shock to demand (for example, a fall in
autonomous consumption expenditure). Using the IS/LM model, show that if
the nominal interest rate remains positive, an increase in the money supply can
partially reverse the effect of the shock on output. If the nominal interest rate
falls to zero, show what happens to the LM curve when the money supply is
increased, and explain why the increase in the money supply may have no effect
on output.
(7 marks)
(c) In recent years, nominal interest rates have fallen close to zero in several
countries. A number of economists have suggested monetary policies that would
create higher expectations of future inflation as a way of getting out of the
liquidity trap.
Write down the Fisher equation that links the nominal and real interest rates
and use this equation to explain why an increase in inflation expectations would
raise output for an economy in a liquidity trap.
Suppose the central bank proposes to raise inflation expectations by committing
to a future monetary expansion if unemployment remains high. Use the AD/AS
model to study the effects of this policy on the price level if the economy
remains in the liquidity trap. Comment on the credibility of the policy in light
of your answer.
(7 marks)
Blanchard, Chapters 4, 5, 7, 14 and 22.
(a) Money pays no interest, while the nominal interest rate is the (nominal) return on holding
bonds. Thus, the difference between the return on holding wealth in the form of bonds and
the return if it is held as money is the nominal interest rate. This means that the nominal
interest rate represents the opportunity cost of holding money, in the sense of the foregone
interest that could have been earned if bonds were held instead of money. However, since
money is more liquid than bonds (it is accepted more readily for payments), individuals may
hold money even though bonds offer a higher return. But the higher the nominal interest
rate, the greater the opportunity cost of holding money, and the less attractive holding
money becomes. Money demand thus depends negatively on the nominal interest rate. Note
51
that at a zero nominal interest rate, there is no opportunity cost of holding money, so
individuals are always willing to substitute money for bonds in their portfolios without
limit. This makes the demand for money perfectly interest-elastic at zero interest rates.
The LM curve represents the combinations of output and the nominal interest rate
consistent with equilibrium in the money market, given the level of the money supply. To
derive the LM curve, note that an increase in output increases the demand for money (more
transactions must be made), shifting the money demand curve to the right. Money demand
curves for three levels of output (Y1 , Y2 , and Y3 ) are depicted in the left panel of the
diagram below. The money-market diagram has the real quantity of money on the
horizontal axis and the nominal interest rate (the opportunity cost) on the vertical axis.
The money demand curves are downward sloping as explained above, and become perfectly
elastic (horizontal) at a zero nominal interest rate. The fixed money supply is depicted as
the vertical money supply curve in the diagram. The intersection between money demand
and supply determines the nominal interest rate.
As can be seen from the diagram, higher levels of output imply that the money market now
generally clears at a higher nominal interest rate. This shows that money-market
equilibrium implies a positive relationship between output and the nominal interest rate,
that is, an upward-sloping LM curve. At a zero nominal interest rate, money demand is
perfectly interest elastic, so even a rightward shift of money demand does not necessarily
increase in the interest rate (although a sufficiently large increase in output should). This
means that the LM curve has a horizontal section at zero interest rates.
(b) The negative shock to consumption demand shifts the IS curve to the left from IS0 to IS1 .
With no change in monetary policy, this would lead to a fall in output. However, it is
possible to avoid this fall in output through a monetary expansion, as long as the interest
rate remains positive. The left panel of the diagram below shows how expansionary
monetary policy stabilises the economy by shifting the LM curve to the right from LM0 to
LM1 . By generating a sufficiently large fall in the interest rate, this policy can avoid any fall
in output.
52
However, at a zero interest rate, a monetary expansion simply extends the horizontal section
of the LM curve. Intuitively, the extra money is willingly held with no change in the interest
rate because it is a perfect substitute for bonds at the margin. This logic is demonstrated in
the diagram below. In the left panel, the monetary expansion shifts the money supply to the
right, but if the interest rate was initially zero then the money supply curve continues to
intersect the money demand curve where it is perfectly elastic at a zero interest rate.
Therefore, if IS1 intersects LM0 at a zero interest rate (on the horizontal section of LM0 , a
monetary expansion will have no effect because the IS curve continues to intersect the new
LM curve (LM1 ) at a zero interest rate. Basically, the monetary stimulus has no effect on
demand because none of the interest-sensitive components of demand are affected. This is
the case depicted in the right panel of the earlier diagram.
(c) The Fisher equation that connects the nominal interest rate i, the real interest rate r, and
inflation expectations e is:
i = r + e .
This equation implies the real interest rate is given by r = i e , so an increase in inflation
expectations e reduces the real interest rate at any given nominal interest rate i. Since the
interest-sensitive components of demand (e.g. investment) depend on the real interest rate,
higher inflation expectations should increase demand at each nominal interest rate, shifting
the IS curve to the right (in an IS-LM diagram where the interest rate on the vertical axis is
the nominal interest rate). As the IS curve shifts to the right, output will increase.
53
In the AD-AS diagram, an economy in a liquidity trap features an AD curve with a vertical
section (which becomes downward sloping if the price level is sufficiently high). Suppose in
the future that the economy still has high unemployment and is still in the liquidity trap.
As promised, the central bank then expands the money supply. However, an increase in the
money supply only shifts the downward-sloping section of the AD curve to the right, while
simply extending the vertical section. When the economy is in the liquidity trap, the
intersection between the AD and SRAS curves is on the vertical section of the AD curve.
Thus, extending the vertical section of the AD curve does not raise output or the price level.
Thus, the credibility of the policy might be in doubt because this analysis shows that it may
fail to achieve its stated goal of raising inflation. In that case, agents may not change their
inflation expectations when the policy is announced.
Question 16
(a) Consider a closed economy where consumption and investment are given by the
Keynesian consumption and investment demand functions (so consumption
depends positively on disposable income and investment depends negatively on
the interest rate). Money demand is positively related to income and negatively
related to the interest rate. Using the IS/LM model, find the effect of an
increase in the price level on output and thus derive the aggregate demand
(AD) curve.
(6 marks)
54
(b) Suppose the government cuts taxes and finances this by issuing bonds. Using
the IS/LM model with the Keynesian consumption function, find the effect of
this tax cut on output.
Now suppose that the Fisher model of consumption is assumed instead of the
Keynesian consumption function. Briefly explain why Ricardian equivalence
holds when using the Fisher model, and describe the effects of a tax cut
(financed by issuing bonds) in this case.
(7 marks)
(c) It is sometimes argued that there is a real balance effect of the price level on
aggregate demand in addition to the effect found in part (a). The argument is
that an increase in the price level reduces the real value of money, which
decreases the real wealth of households and reduces their consumption demand
accordingly.
Households also hold government bonds, and the real value of these is also
reduced when the price level increases. Explain whether you think we should
expect a real balance effect of the price level on consumption because
households hold government bonds in their portfolios? (Hint: think about
whether government bonds are net wealth according to the Ricardian
(7 marks)
(a) The first point to note is that the demand for money is a demand for real money balances
because moneys usefulness depends on its real value. This means that changes in the price
level, which affect the real supply of money given a fixed nominal supply, will change the
equilibrium of the money market. For a fixed nominal money supply, a higher price level
reduces the real supply of money, which given income and interest rates would lead to there
being excess demand in the money market. Given the level of output, the interest rate rises
to restore equilibrium. Since the LM curve represents the set of output and interest rate
combinations consistent with money-market equilibrium, this logic demonstrates that the
LM curve must shift upwards when the price level rises, as shown in the left panel of the
diagram below.
55
Using the IS-LM diagram, a leftward shift of LM leads to lower output and higher interest
rates as the economy moves up the IS curve. Hence, there is a negative relationship between
the price level and the demand for output (as determined by IS-LM), and thus a
downward-sloping AD curve, as depicted in the right panel of the diagram above.
(b) The tax cut increases current disposable income, which increases consumption demand
according to the Keynesian consumption function. An increase in consumption demand
shifts the IS curve to the right. The IS-LM analysis thus predicts that the demand for
output increases, along with the interest rate. This outcome is depicted in the left panel of
the diagram below.
With the Fisher model of consumption choice, Ricardian equivalence holds because
households make current consumption decisions based on their lifetime budget constraint
and understand the implications of the governments lifetime budget constraint for future
taxes. Without a change in the governments spending plans, a tax cut today implies the
need for tax rises in the future of an equal present value. Thus, there is no change in
households present discounted value of lifetime income after taxes and so they do not
change their consumption demand. This means that households will save all the extra
disposable income to pay for the future tax increase and so there will be no shift of the IS
curve in this case and thus no effect on output. This case is depicted in the right panel of
the diagram above.
(c) The Ricardian equivalence proposition predicts that households do not see government
bonds as net wealth. This is because they must be repaid with future taxes that
households will ultimately bear. If government bonds do not constitute net wealth then
changes in their real value have no wealth effect on household consumption. Households do
not feel any better or worse off because the value of the taxes they will face move exactly in
line with the value of the bonds. Consequently, there would not be a real balance effect
working through holdings of nominal government bonds. If Ricardian equivalence is
violated, though, households may act as if government bonds were net wealth, and thus a
real balance effect might operate in that case.
Why is it that there might be a real balance effect for holdings of money, but not for
holdings of government bonds? (even though both are assets with a fixed monetary value).
The difference between money and bonds is that money can be net wealth because the
government does not need to raise future taxes to repay money, unlike bonds. Intuitively,
money is valued for its liquidity/transactions role rather than because it will be redeemed
by the government in the future.
56

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~~EC2065 ZA d0

This paper is not to be removed from the Examination Halls

Monday, 13 May 2013 : 2.30pm to 5.30pm

PLEASE TURN OVER

University of London 2013

Suppose the demand for money M d is given by the equation

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University of London 2013

Answer each of the following questions.

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Now suppose that money-market equilibrium is represented by the following equation:

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University of London 2013

This paper is not to be removed from the Examination Halls

Monday, 13 May 2013 : 2.30pm to 5.30pm

PLEASE TURN OVER

University of London 2013

University of London 2013

Now suppose that money-market equilibrium is represented by the following equation:

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University of London 2013

Suppose the demand for money M d is given by the equation

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Answer each of the following questions.

University of London 2013

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Information about the subject guide

Format of the examination

Blanchard, O. Macroeconomics. (Prentice Hall, 2009) fifth edition [ISBN 9780132079631]

Mankiw, N.G. Macroeconomics. (Worth, 2010) seventh edition [ISBN 9781429218870].

Key steps to improvement

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Information about the subject guide

Comments on specific questions Zone A

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Approaching the question

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Suppose the central bank proposes to raise inflation expectations by committing

Reading for this question

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Assume that the population grows by 2% every year, while 8% of computers

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person is found by solving the equation:

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Approacing the question

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Information about the subject guide

Comments on specific questions Zone B

Approaching the question

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Mankiw, Chapter 12.