Advanced Macroeconomics

Problem Set
Answer the following questions.
1. Write short note on the following.
a) Liquidity trap. E. The Marshall-Lerner condition h.
Crowding out
b) Monetary transmission mechanism f. Neutrality of money i. Possible causes of
inflation
c) Sterilization g. Devaluation j. Types of
unemployment
d) Rational expectation

2. Consider an economy with the following aggregates:

Consumption function: C = 50+0.8Yd, where Yd is disposable income
Autonomous investment: I =70
Government expenditure: G=200
Government transfer: TR=100
Tax rate: t=0.20
where r is interest rate.
a) Calculate the equilibrium level of income, the multiplier, and the budget surplus in this
model.
b) Suppose that the marginal propensity to consume increased permanently to 0.9. What is
the impact of this increase on the level of equilibrium income and the multiplier?
c) Suppose that the tax rate t increases to 0.25. Calculate the new equilibrium level of
income, the budget surplus, and the multiplier.
3. What would be the shape of:
a) The IS curve if investment does not depend on the interest rate?
b) The LM curve if the demand for money does not depend on interest rate?
c) The LM curve if the demand for money does not depend on income?
d) The LM curve if the demand for money is extremely sensitive to the interest
rate?
e) Discuss the effectiveness of fiscal and monetary policies in each of the above
cases.
4. Consider an economy with a different level of aggregates as follows:
Consumption function: C = 0.8 (1- t) Y
Tax rate: t = 0.25
Investment: I = 900 - 50r
Government expenditure: G=800
Demand for money: L = 0.25Y - 62.5r
Money supply: M = 1000
Price level: P = 2
a) Derive the IS and LM equations.
b) Determine the equilibrium levels of income and interest rate.
c) Calculate the government spending multiplier.
d) By how much income and interest change for a unit change in government spending?
e) How do you account for the difference between the value of the government spending
multiplier in (b) and the change in income in (d)? (Hint: What happens to investment?)
5. In question number 4 above, suppose that government spending increased to 900 from its
initial value of 800.
a) Calculate the new equilibrium levels of income and interest rate.
b) What would be the level of income at the initial equilibrium interest rate and how does
this compare to the full multiplier income?
c) Account for the difference between the full multiplier level of income and the actual
equilibrium level of income.
6. In question 5, suppose that, all other things being equal, the first round of policy measure
increased price level to 4.
a) Calculate the new equilibrium level of income and interest.
b) Derive the aggregate demand function.

7. Suppose that a government seeks an advice on how to achieve an increase in investment

without overheating the economy. Using your knowledge of the IS-LM framework, show
how you could advise the government on the policy mix.
8. Suppose the government of a typical developing country increased the salary of civil servants
at a time when there is bumper harvest due to timely rainfall. What will happen to prices?
Discuss using your knowledge of AD-AS framework.
9. Explain why trade off exists between inflation and unemployment.
10.
11. Consider the Solow model with technology. Suppose that saving rate increases from s to s’.
Demonstrate using graphs and quantitative methods how this shock affects
a) Level of per capita income.
b) Level of capital per effective worker.
c) Growth rate in per capita income.
12. The Solow exogenous growth model with augmented population growth and technological
progress is a dynamic model that allows us to see how our endogenous variables are being
affected and that describes how the economy moves toward a stable equilibrium position.

a) Assuming the Cobb-Douglas production function per effective labor is:

Calculate the Golden rule and the Steady state level of capital per effective labour and
interpret the result.
b) Mathematically prove that output per worker grows by the growth rate of technology (g),
and total output grows by the summation of the growth rates of population (n) and
technology (g).
13. Suppose that the economy is open to external trades, using the Mundell-Fleming model
evaluate the effectiveness of
a) Fiscal and monetary policies under fixed exchange rate regime.
b) Fiscal and monetary policies under flexible exchange rate regime when there is high
capital mobility.
14. Suppose that we have an overlapping generation model and the utility is
U t =ln C 1t +Bln C 2 t +1, and the production function is given as: F ( K t , Lt )= A K αt L1−α
t .
a) Find the appropriate first order conditions.
b) Solve the worker’s saving rate.
c) Find the Golden rule level of capital stock.
d) Compute the steady state saving that is required to maintain golden rule level of capital
stock.
e) Under what condition on the model parameters will the saving exceed the golden rule
level.