UNIVERSITY OF MELBOURNE

DEPARTMENT OF ECONOMICS
SEMESTER 2 ASSESSMENT, 2015
ECON20001 INTERMEDIATE MACROECONOMICS

Reading Time: 15 minutes

Writing Time: 2 hours

This examination paper contributes 60 percent to the assessment in ECON20001.

The PAPER and RESPONSE SHEET should both be inserted in the back of the examination
booklet at the end of the examination. For the multiple-choice questions, you may use the
examination script books to draw diagrams or make notes to help you. These diagrams or notes
will not be taken into account for your assessment.

The following items are authorised in the exam room:

– Print dictionary that translates English into a foreign language.
– Calculators which do not accept plain text.
This exam has 10 pages.
There are a total of 60 marks for this examination.
This paper is not to be removed from the exam room.
This paper will not be held in the Baillieu Library.

SECTION A: ANSWER ALL QUESTIONS

This part contributes 20 marks to this examination.
Suggested time allocation: 40 minutes.
Answer all questions. For each question, using a 2B pencil, fill in the appropriate small circle on
the RESPONSE SHEET. Please follow the SAMPLE RESPONSE SHEET for details required
on the formal RESPONSE SHEET. All questions are equally weighted. Incorrect answers, no
answer or more than one answer, will all receive a zero mark.

SECTION B: ANSWER TWO OUT OF THREE QUESTIONS

This part contributes 20 marks to this examination.
Suggested time allocation: 40 minutes.
Answer the questions in the examination booklet(s) provided.

SECTION C: ANSWER TWO OUT OF THREE QUESTIONS

This part contributes 20 marks to this examination.
Suggested time allocation: 40 minutes.
Answer the questions in the examination booklet(s) provided.

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 SECTION A

This section is compulsory and contains 12 multiple-choice questions. Suggested

time allotment: 40 minutes for the section, slightly over 3 minutes per response.
All questions are equally weighted.

A1. Consider an economy with just two firms. A steel company (firm #1) has sales revenue of
$160 (million) and labor expenses of $120m. A car company (firm #2) has sales revenue
of $420m, pays $160m for steel and has labor expenses of $150m. What is GDP in this
simple economy?

(a) $580 million

(b) $150 million
(c) $420 million
(d) $270 million

A2. When the central bank conducts an open market sale of bonds:

(a) the national debt decreases

(b) money supply increases
(c) the interest rate rises
(d) the price of bonds rises

A3. Fiscal policy is more effective the smaller the induced change in and the
the response of to these interest rate changes.

(a) interest rates, smaller, investment

(b) output, larger, investment
(c) output, larger, consumption
(d) interest rates, smaller, money demand

A4. Consider a simple model of labor market fluctuations. A(n) in cost of creating a
job c equilibrium labor market tightness and equilibrium job vacancies.

(a) decrease, decrease, decrease

(b) increase, decrease, decrease
(c) decrease, increase, decrease
(d) increase, increase, increase

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A5. Consider the static AS-AD model. An expansionary monetary policy where PT increases
permanently implies that

(a) output falls in the short run

(b) output increases in the long run
(c) price level decreases in the short run
(d) price level increases in the long run

A6. Suppose that the Phillips curve is represented by the following equation: πt − πt−1 =
2.4% − 0.4ut , where π is the inflation rate and u is the unemployment rate. Given this
information, the natural rate of unemployment in this economy is

(a) 2.4%
(b) 6%
(c) 16.67%
(d) none of the above

A7. Which of the following is false? In the dynamic AS-AD model,

(a) The more reactive the central bank is to output, the steeper is the DAD curve
(b) There is no long-run tradeoff between output and inflation
(c) The Taylor principle is satisfied only if θπ > 1
(d) The Taylor principle requires that the nominal interest rate increases more than one
for one with inflation

A8. Which of the following statement is true? In the Solow model

(a) the higher the growth rate of the labor force, the higher the rate of effective depreci-
ation
(b) the long run growth rate of output is equal to the growth rate of productivity
(c) an increase in the saving rate increases the growth rate of output per worker in the
short run and in the long run
(d) none of the above

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 A9. Consider the Human Capital Accumulation model with a production function given by
Y = AK 1/2 H 1/2 , saving rates sK = 0.16 and sH = 0.09, a common depreciation rate
δ = 0.05 and A = 1. Which of the following is false?

(a) the long-run intensity of human capital relative to physical capital will fall when sH
falls
(b) the long run growth rate of physical capital will fall when sH falls
(c) the long-run intensity of human capital relative to physical capital is 9/16
(d) the long-run growth rate of physical capital is 0.12

A10. Suppose that production function is Y = K 1/3 (AN )2/3 and competitive firms hire capital
and labor to produce output. Let r be the return paid to capital and w be the real wage
paid to labor. Which of the following is true?

(a) a profit-maximizing firm hires capital and labor until average products equal factor
prices
(b) labor income share is 1/3
(c) real return to capital r grows at the rate of productivity growth
(d) real wages w grows at the rate of productivity growth

A11. Consider the bilateral exchange rate between Australia and Japan. Suppose 1 Australian
dollar buys 84 yen, the Australian price level is $100 and the Japanese price level is 7000
yen. Then the real exchange rate is

(a) 1.2
(b) 0.83
(c) 0.86
(d) none of the above

A12. Consider the Mundell-Fleming model with flexible exchange rates and domestic monetary
policy that is passive. Which of the following is true?

(a) contractionary foreign monetary policy will decrease domestic interest rates, increase
domestic output, and depreciate the domestic currency
(b) expansionary domestic fiscal policy will increase domestic interest rates, increase do-
mestic output, and appreciate the domestic currency
(c) contractionary domestic fiscal policy will decrease domestic interest rates, decrease
domestic output and appreciate the domestic currency
(d) expansionary foreign monetary policy will increase domestic interest rates, increase
domestic output, and depreciate the domestic currency

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 SECTION B

This section is compulsory and is worth 20 marks. Answer two of the following
three questions. Each question is worth 10 marks. Suggested time: 40 minutes.

B1. Labor market flows. Suppose the change in unemployment ut is given by

ut+1 − ut = s(1 − ut ) − f ut

(a) Solve for the steady-state unemployment rate. How does the steady-state unemploy-
ment rate depend on the job separation rate s? How does the steady-state unemploy-
ment rate depend on the job finding rate f ? (3 points)
(b) If the job separation rate s decreases, would you expect to find the proportion of long-
term unemployment workers is higher or lower than in part (a)? Explain. (2 points)
1/2
(c) Suppose now that f (θt ) = Aθt . The labor market tightness θt is defined as θt = vt /ut
where vt is the job vacancy rate. Derive the Beveridge curve and explain how vt and
ut are related. (3 points)
(d) The U.S. labor market flow data suggest that the U.S. Beveridge curve might shift
out in recent years. From your answer in part (c), what might explain the shift of
the U.S. Beveridge curve? Explain. (2 points)

[Total: 10 marks]

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B2. Rules versus discretion. A central bank likes low unemployment u and low inflation π. Its
loss function is
L(u, π) = 2u2 + 2π 2
The (short-run) policy trade-off facing the central bank is given by an expectations-
augmented Phillips curve
u − 0.06 = −(π − E(π))

(a) Suppose the central bank can credibly commit to a target inflation rate π. What
is the inflation rate in a rational expectations equilibrium under this commitment?
What is the associated unemployment rate? (2 points)
(b) Suppose now the central bank has policy discretion and so cannot commit to a target
inflation rate. Instead, the Bank tries to minimise its loss function taking the private
sector’s inflation expectations as given. Show how the inflation rate chosen by the
Bank depends on the private sector’s inflation expectations. (2 points)
(c) Calculate the inflation rate in a rational expectations equilibrium under discretion.
What is the associated unemployment rate? Is the central bank better off with
commitment or discretion? Explain. (3 points)
(d) Suppose now there are two candidates for the central bank governor. Candidate 1
has the loss function
L(u, π) = 2u2 + 4π 2
and candidate 2 has the loss function

L(u, π) = 2u2 + π 2

What is the outcome of inflation with each candidate’s loss function? If the federal
government of the day would like to appoint a central bank governor that can help
alleviate some of the problem with discretion, which candidate should the federal
government choose? Explain. (3 points)

[Total: 10 marks]

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B3. Goods market in an open economy. Consider the following open economy. The real ex-
change rate is fixed and equal to 1. Consumption is given by C = 50 + 0.5(Y − T ),
investment is I = 20, taxes are T = 10, and the government’s budget is balanced. Imports
and exports are given by IM = 0.2Y and X = 0.02Y ∗ where Y ∗ is foreign GDP.

(a) Solve for the equilibrium Y in the domestic economy for any given Y ∗ . (2 points)
(b) What is the government purchases multiplier in this economy? If we were to close the
economy - so exports and imports were identically zero - what would the multiplier
be? Why are the open and closed economy multipliers different? (3 points)
(c) Suppose that foreign GDP is 10 times as large as domestic GDP. What is equilibrium
domestic GDP? What is equilibrium foreign GDP? If foreign economy is hit by an
adverse demand shock and its GDP decreases by 10%, by how much does domestic
GDP fall? (3 points)
(d) Assume that the government in the domestic economy wants to restore the level of
domestic GDP to its level before foreign economy is hit by the adverse demand shock.
How much should G increase to achieve this target output? (2 points)

[Total: 10 marks]

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 SECTION C

This section is compulsory and is worth 20 marks. Answer two of the following
three questions. Each question is worth 10 marks. Suggested time: 40 minutes.

C1. IS-LM model. Consider an IS-LM model with the central bank controlling the interest
rate. The consumption and investment functions are

C = 200 + 0.25(Y − T )

and
I = 150 + 0.25Y − 1000i
and suppose G = 250 and T = 200. Let the money demand function be

M/P = 2Y − 8000i

and let i = i0 = 0.05.

(a) Solve for the equilibrium values of real output and real money supply. (2 points)
(b) Solve for the equilibrium values of C and I and verify the value you obtained for Y
by adding up C, I and G. (2 points)
(c) Now suppose that the interest rate, i0 , was cut to 0.03. Solve for the equilibrium
values of Y , M/P , C and I. What are the effects of an expansionary monetary
policy? Explain. (3 points)
(d) Set the interest rate back to 0.05. Now suppose that government spending increases to
G = 400. If the central bank keeps the interest rate unchanged, how should monetary
policy respond to the expansionary fiscal policy? What are the effects of this fiscal
expansion on Y and C? Explain. (3 points)

[Total: 10 marks]

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C2. Dynamic AS-AD model. Consider a dynamic AS-AD model with DAS curve

πt = πt−1 + 0.5(Yt − 100)

and with DAD curve

Yt = 100 − 0.5(πt − 2) + 0.5t
Suppose that the monetary policy rule is given by

it = 2 + πt + (πt − 2) + (Yt − 100)

(a) Compute the long run equilibrium values for output, inflation, nominal interest rate
and real interest rate. (2 points)

Now suppose that the economy is in the long run equilibrium from part (a) and then at
time t = 1 there is an adverse demand shock 1 = −2 that lasts for just one period before
reverting to zero. That is, 1 = −2 and t = 0 for all subsequent t.

(b) Compute the values of output, inflation, nominal interest rate and real interest rate
at time t = 1. (2 points)
(c) With the help of a diagram, explain qualitatively the subsequent time paths of output
and inflation after the adverse demand shock ends. Can inflation and output return
to their long run equilibrium values? Carefully label your diagram. (2 points)
(d) Suppose instead that the adverse demand shock 1 = −6. Again t = 0 for all
subsequent t. Recompute the values of output, inflation, nominal interest rate and
real interest rate. What challenges does this raise for the conduct of monetary policy?
(2 points)
(e) In practice the RBA cannot reduce the nominal interest rate below zero (the ‘zero
lower bound’). To ensure that the nominal interest rate always respects the zero lower
bound, what are the values of output, inflation and real interest rate at time t = 1?
(2 points)

[Total: 10 marks]

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C3. Solow growth model. Consider the production function Y = K 1/2 (AN )1/2 . Assume that
the savings rate s equals 30% and the depreciation rate δ equals 5%. Further, assume the
growth rate of the labor force gN is 4% and the growth rate of technological progress gA
is 3% per year.

(a) Find the steady-state values of (i) capital per effective worker, (ii) output per effective
worker, (iii) the growth rate of output per effective worker, (iv) the growth rate of
output per worker, and (v) the growth rate of output. (2 points)
(b) Calculate the savings rate s∗ that maximises steady state consumption per effective
worker. What is the maximum consumption per effective worker? (2 points)

Now we modify the basic Solow growth model by including government spending as follows.
The government collects taxes T to finance its government spending G in every period.
Government spending per worker is given by a constant g, where g = G/N . Workers
consume a fraction of disposable income C = (1−s)(Y −T ). Suppose that the government
has a balanced budget. Also assume that A = 1 and the growth rates of technological
progress and the labor force are zero, gA = gN = 0.

(c) Write down the capital accumulation equation. With the help of a diagram, illustrate
that there can be two steady-state values of capital per worker (k ∗ ). Carefully label
your diagram. (2 points)
(d) We can focus on the high k ∗ and ignore the low k ∗ because the low k ∗ is an unstable
steady state. What is the effect of an increase in g on k ∗ ? What are the effects of an
increase in g on aggregate consumption C? Explain. (2 points)
(e) Now we modify the way we define government spending. Suppose that government
spending G is proportional to aggregate output Y , where G = gY . That is, gov-
ernment spending is a fraction g of aggregate output Y . Are there two steady-state
values of capital per worker? What are the effects of an increase in g on capital per
effective worker k ∗ and aggregate consumption C? Explain. (2 points)

[Total: 10 marks]

END OF EXAMINATION

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