EC210

Macroeconomic Principles
Sample Exam
2008/2009 syllabus not suitable for re-sit students

Instructions to candidates
Time allowed: 3 hours
This paper contains sixteen questions. Answer EIGHT short questions out of ten
from Section A and THREE long questions out of six from Section B and C (with at
least ONE question from each section). Each short question carries 5 marks and
each long question carries 20 marks.
Do not spend a disproportionate amount of time on any one question.
Calculators are not allowed.

LSE 2009/EC210 (sample exam)

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SECTION A Answer EIGHT questions, 5 marks per question

Using the search model of unemployment, illustrate which factors can

potentially explain differences in equilibrium unemployment between two
countries. Which of these factors, if any, can explain differences in
unemployment between the US and continental European countries?

There is a concern that the increase in the price of oil may slow down
economic growth. Use the Solow model to explain the growth effects of an
increase in oil price.

3.

In a famous article published in 1990, an economist asked why doesnt

capital move from rich countries to poor countries? Explain why this fact is
puzzling, and why human capital might help to solve this puzzle.

4.

What is Tobins q? Explain why firms should invest if q>1. How is this related
to the idea that firms should invest if the future marginal product of capital is
greater than the user cost of capital?

5.

Suppose government wants to raise revenue to build a new airport. Some

economists argue that the outcomes of tax-financing or debt-financing
policies are the same. Use a simple 2-period model to support this argument.
Give one reason why this argument might not hold in reality.

6.

Why does the presence of increasing returns to scale in production imply that
the equilibrium of an economy could be influenced by sunspots?

7.

What is the effect of a temporary TFP shock on employment in the Keynesian

sticky price model? Explain intuitively and compare with the real business
cycle model.

8.

Suppose that the following data are obtained from the yield curve:
Maturity (years)
Yield

1
2%

2
2.25%

3
2.5%

4
2.25%

5
2%

Calculate the path of expected short-term (1-year) interest rates over the next
five years assuming that the expectations theory of interest rates is correct.
9.

Show that maintaining a fixed exchange rate after a permanent decrease in

government spending requires a loss of foreign exchange reserves. Would
imposing capital controls help stem the loss of reserves?

10.

Show how the Phillips curve is derived in the Friedman-Lucas money surprise
(misperceptions) model. What is the effect of an increase in inflation
expectations?

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SECTIONS B & C Answer THREE questions, 20 marks per question

SECTION B Answer at least ONE question

11.

12.

Consider an economy with an aggregate production function Yt=BKtN1-,

where, 0<<1, Yt and Kt are output and capital stock at time t, N is number of
workers. Assume N and B are constants and this is a closed economy.
(a)

Use the Solow model to derive the steady state for this economy.
Explain the economic meaning of the equations and the graph that you
used in your answer. [7 marks]

(b)

This economy carried out a series of economic reforms during 1980s

which increased the production efficiency. What are the predictions of
the Solow model on its growth rate and level of output per worker in the
1990s and in the long run? Explain using the equations and graph you
used in part (a). You can assume the economy is in a steady state
before the reforms. [5 marks]

(c)

Suppose =1. Show that output per worker grows at a constant rate in
the long run. How is this related to Romers learning-by-doing model?
Explain the economic meaning of the equations you used. [8 marks]

Ricardian equivalence says that if the present value of the government

spending remains the same, then the timing of taxes does not matter and how
much debt the government raises does not matter.
(a)

Use the life-cycle theory of consumption to explain Ricardian

equivalence. [10 marks]

(b)

Explain why Ricardian equivalence might not hold if consumers face a

borrowing constraint or consumers only care about the present. Explain
these arguments. [10 marks]

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13.

The government is considering how to raise tax revenue to fully finance a

project. The alternatives are (i) a tax on capital income, or (ii) a tax on labour
income.
(a)

Economist A argues that increasing labour income tax rate does not
always result in higher tax revenue. Explain the rationale behind this
argument. [5 marks]

(b)

Explain the meaning of the term time inconsistency. Use capital

taxation as an example to illustrate it. [5 marks]

(c)

Economist B argues against capital tax because he is concerned about

economic growth. Use a simple Solow growth model to explain the
rationale behind his argument. [6 marks]

(d)

Economist C is concerned about the evolution of the debt to GDP ratio.

Assume the real interest rate is fixed. What would her suggestion be? [4
marks]

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SECTION C Answer at least ONE question

14.

15.

Consider an economy hit by a temporary positive TFP shock.

(a)

Using the real business cycle model, find the effects of the shock on
output, employment, the real wage, the real interest rate, and average
labour productivity. [9 marks]

(b)

Now suppose that firms are subject to a wages-in-advance constraint,

and that households face a cash-in-advance constraint and are limited in
their financial market participation to one transaction per time period.
Suppose also that households and firms choose the level of banking
services they will use prior to learning about the TFP shock. What are
the effects of the shock on the variables considered in part (a) and how
do your results compare to those in part (a)? [7 marks]

(c)

What open market operation does the central bank need to carry out in
the economy described in part (b) to achieve a level of aggregate output
equal to that found in part (a)? Why should the central bank want to do
this? [4 marks]

Consider the Diamond-Dybvig model of banks.

(a)

Show how the optimal deposit contract is determined and explain how
the existence of banks allows households to achieve a higher level of
expected utility. [10 marks]

(b)

Explain why a bank run can occur as an equilibrium outcome. [5 marks]

(c)

Now suppose the central bank offers to act as a lender of last resort to
the banking system. In particular, it allows banks to borrow from it using
the discount window (i.e. it makes discount loans at a known interest
rate taking as collateral the claims to the projects that banks have
invested in). Does this solve the problem of bank runs? [5 marks]

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16.

Consider an economy where households face a cash-in-advance constraint

on making consumption purchases. Households can either pay for goods with
cash, or by using costly banking services.
(a)

Suppose the total cost of using banking services X (in real terms) is
H(X). Write down the first-order condition for the representative
households use of banking services. Explain how this generates a
demand for money, stating which variables the demand for money
depends on (you do not need to give an algebraic derivation). [6 marks]

(b)

Now suppose that the money supply in the economy is growing at rate x
over time, which leads to inflation equal to x. Explain how the cash-inadvance constraint modifies the representative households first-order
condition for the choice between consumption and leisure. Give an
intuition for your answer. [6 marks]

(c)

Explain why a positive rate of inflation is inefficient in this economy.

What is the optimal inflation rate? [4 marks]

(d)

Now also suppose that firms face a wages-in-advance constraint (they

must have cash on hand or use banking services to pay their wage bill).
Explain how the first-order condition for the representative firms
demand for labour is affected. Would your answer to part (c) change as
a consequence of adding the wages-in-advance constraint? [4 marks]

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