THE UNIVERSITY OF SUSSEX MA EXAMINATION IN ECONOMICS 2008/09 ECONOMIC ANALYSIS II ???? Candidates must attempt THREE questions 1.

You are given the following data for an economy that is operating a fixed but adjustable exchange rate: Price elasticity for exports = 0.4 Price elasticity for imports = 0.4 The value of exports is 50% of the value of imports Would a devaluation in this case raise or lower (a) aggregate demand, (b) the rate of change of foreign currency reserves? Comment on the policy implications of your results. 2. If the US should be about to experience a period of price deflation, as some have forecast, in what ways would this affect US real aggregate demand (and its components)? 3. What is involuntary unemployment? Give some examples of ways in which it can arise as an equilibrium phenomenon, in each case explaining what factors determine how much unemployment of this kind there will be. 4. High inflation rates seem to be associated with relatively unfavourable short-run inflation-unemployment tradeoffs (i.e. unemployment responds relatively little to changes in the rate of inflation). Does this finding imply that we should prefer the menu cost model of nominal rigidities to Lucass islands model? 5. In Fischers overlapping wage contracts model, explain (a) the relation between the persistence of shocks and the effectiveness of monetary policy, and (b) how policy should respond to demand and supply shocks respectively. 6. Beans model of inflation targetting is based on the following two equations for the determination of real output, y, and inflation : y = -ar-1 + by-1 + = -1 + cy-1 + ????

In these equations, a, b and c are positive constants, r is the real rate of interest (the Central Banks instrument), the subscript -1 indicates a one-year lag, and and are independent random shocks. When the Central Bank chooses the current r, it is assumed to have observed the current values of y and . The target for is zero. (a) Show how the equations can be used to derive an expression for +2 as a function of time-zero expectations of +1 and y+1 together with future shocks, and interpret this expression carefully. (b) Illustrate the concept of constrained discretion by analysing optimal Central Bank behaviour in this model. 7. Define Ricardian Equivalence and identify a set of conditions under which it will hold true. Under these conditions, is it conceivable that an unexpected cut in government expenditure could cause a rise in aggregate demand, and if so how? 8. Explain, in the costly state verification model of credit markets how the likelihood of a firm being able to gain access to credit depends on (a) the expected return of the firms project, (b) the safe rate of interest, and (c) the wealth of the firms owner. What insights does this model give us into how monetary tightening affects an economy?