Foundations of Modern

Macroeconomics
Second Edition

Exercise and Solutions Manual

BEN J. HEIJDRA
LAURIE S. M. REIJNDERS
and
WARD E. ROMP

OXPORD
UNIVERSITY PRESS
Contents

Preface ix

1 Who is who in macroeconomics? 1

1 Short questions 1
2 The Cobb-Douglas production function 1
3 The AS-AD model 2
4 Consumption tax 3
5 Tax incidence 3
6 The Keynesian cross model 4
7 The import leakage 5
8 The liquidity trap 5
9 The IS-LM-AS model with inflation 6

2 Dynamics in aggregate demand and supply 25

1 Short questions 25
2 The Keynesian cross model (continued) 25
3 The IS-LM model with capital accumulation 26
4 Stability of the IS-LM model 26
5 The Blinder-Solow model 27
6 Ricardian equivalence in the Blinder-Solow model 27
7 The Blinder-Solow model with capital accumulation 28
8 Adaptive expectations in a monetarist model 29
9 More on adaptive expectations 29
10 Optimization and computation 30
11 The multiplier-accelerator model 31

3 Rational expectations and economic policy 65

1 Short questions 65
2 Stabilization of demand shocks 65
3 Overlapping wage contracts and the REH 66
4 A variation on the Muth model 67
5 Expectational difference equations 68
6 The Cagan model 68
7 Fiscal policy under rational expectations 69
8 The labour market 69
9 Liquidity trap 70
10 PIP meets the Pigou effect 71
11 PIP and the output gap 72
VI

12 Contemporaneous information 72
13 Sticky prices 73
14 Automatic stabilizer 73
4 Anticipation effects and economic policy 109
1 Short questions 109
2 The IS-LM model with sticky prices 110
3 Leaning against the wind Ill
4 The term structure of interest rates Ill
5 Fiscal policy with fixed nominal wages and
perfect foresight 112
5 The government budget deficit 143
1 Short questions 143
2 Tax smoothing 143
3 The two-period model with tax smoothing 144
4 Ricardian equivalence 145
5 Ricardian equivalence in the two-period model 145
6 A closer look at the labour market 157
1 Short questions 157
2 Two-sector model with a skill-biased productivity shock 157
3 Progressive taxation 158
4 Indivisible labour 159
5 Efficiency wages 159
7 Trade unions and the labour market 173
1 Short questions 173
2 Smalltalk 173
3 The Blanchard-Summers model 174
4 Variable unemployment benefits 174
5 The two-sector labour market model 174
8 Search in the labour market 181
1 Short questions 181
2 Search unemployment 181
3 A CES matching function 182
4 Downward real wage rigidity 183
5 Dynamics of unemployment and vacancies 183
9 Macroeconomic policy, credibility, and politics 199
1 Short questions 199
2 Capital taxation and income inequality 199
3 Choice of policy instrument 200
4 Rules versus discretion 201
5 Political business cycles 202
 Vll

10 The open economy 217

1 Short questions 217
2 The Mundell-Fleming model 217
3 The Dornbusch model 218
4 The Buiter-Miller model 219
5 Dynamics of foreign reserves 220
6 Price flexibility in the Mundell-Fleming model 221

11 Money 253
1 Short questions 253
2 Optimal money growth 253
3 Monetary superneutrality 255
4 Cash-in-advance constraint in continuous time 256
5 Cash-in-advance with labour supply 257
12 New Keynesian economics 279
1 Short questions 279
2 Cost function for a Dixit-Stiglitz technology 279
3 The multiplier when taxes are distortionary 280
4 Consumers in the New Keynesian model 280
5 Producers in the New Keynesian model 281
6 Monetary policy in the New Keynesian model 283

13 Exogenous economic growth 305

1 Short questions 305
2 The Harrod-Domar model 306
3 The production function 306
4 The wage-rental ratio 307
5 The Solow-Swan model 307
6 The Pasinetti model 308
7 The Solow-Swan model with population growth 308
8 Some mathematics 309
9 Optimal investment 309
10 Welfare of future generations 310
11 The savings function 310
12 The savings ratio in the Ramsey model 311
13 Technological change 311
14 Constant marginal utility 312
15 Intertemporal substitution 313
14 Endogenous economic growth 349
1 Short questions 349
2 Endogenous growth 349
3 Minimum consumption and endogenous growth 350
4 Asymptotic endogenous growth 351
5 External effect and endogenous growth 351
6 Asymptotic capital fundamentalist model 352
vm

15 Real business cycles 369

1 Short questions 369
2 Small open economy model 369
3 The non-market sector 370
4 A general RBC model . . . . ^ 372
5 Government spending shocks in the unit-elastic model 373
6 No wealth effect in labour supply 373
16 Overlapping generations in continuous time 395
1 Short questions 395
2 The Buiter model 395
3 Endogenous growth 396
4 The Blanchard - Yaari model without insurance 397
5 Technological change 397
6 Mandatory retirement 399
7 Public infrastructure 400

17 Overlapping generations in discrete time 431

1 Short questions 431
2 Capital fundamentalism in an OLG model 431
3 Welfare effects of debt 432
4 Lifetime uncertainty in a two-period model 433
5 Pensions in the Diamond-Samuelson model 434
6 Consumption taxation and redistribution 434

Bibliography 457