Advance Macroeconomics (603): Review Question 3

Compiled by Worku Gebeyehu (PhD)

1. Assume a Mundell-Fleming model, with IS-LM-BP with perfect mobility of capital

with perfect substitutability of domestic and foreign bonds. Prices are assumed to
be fixed.

Y =C +I +G+X
C=C 0 +c (Y −T ); 0<c <1
X =X 0 −mY ; 0<m<1
T =tY ; 0<t <1
I=I 0 −br ; b<0
M / P=k (Y )+I (r)
∂X ∂M ∂M
X =X ( E )−M ( E , Y ) E ; XE = >0 ; M E= >0 ; M Y = >0
∂E ∂E ∂Y
dE/dt
r=r∗+
E
where Y, C, I, G, T and X are defined in question 1 above; whereas r, r*, X, M, E
are domestic interest rate, foreign interest rate, export, import and nominal
exchange rate respectively. Assume dE/E is zero.
(a) Interpret the money market, net export and also the BP=0 equations?
(b) Derive and explain what is called the Marshall Lerner Equation and discuss
the possibility of Marshall Lerner condition to hold in the context of
developing countries such as Ethiopia.
(c) The effectiveness of fiscal and monetary policy in affecting real out in the
economy depends on a lot of assumptions: (a) Whether or not prices are
flexible; (b) Whether or not wages are flexible? (c) Whether or not
investment is sensitive to domestic interest rate changes; (d) Whether or not
speculative demand for money is sensitive to interest rate; e) Whether or not
capital inflow is sensitive to differences in domestic and foreign interest rate;
f) Whether or not there are capital inflow barriers; (g) Whether or not the
country follows fixed or flexible exchange rate regime; etc. Discuss the
possible effects of such assumptions on the effectiveness of fiscal and
monetary policy actions of government.
 (d) If the aggregate supply is non-classical or operating below full employment
level. If aggregate supply is horizontal, which policy (FP or MP) brings real
output change without affecting interest rate?
(e) If the aggregate supply is non-classical or operating below full employment
level. Which policy (FP or MP) brings real output change without affecting
interest rate and/or nominal exchange rate, and in which kind of exchange
rate regime?
(f) Given a flexible exchange rate regime, how can government implicitly affect
the exchange rate regime through its fiscal and monetary policies?
(g) Explain why a small open economy with fixed exchange rates is extremely
sensitive to world trade shocks. Is it possible to use monetary and fiscal
policy measures in a fixed exchange rate regime to lessen the effect of trade
deficit?
2. Given the Modigliani and Brumbrg (1954) Life Cycle Hypothesis, an individual
lives from 0 to T and her lifetime utility (V) is given by
T
V =∑ U (t)
t =0

C 1−θ
t
where U(t) is instantaneous utility; with U’(t)>0 and U’’(t)<0. U (t )= ,θ >0.
(1−θ)

The individual has an initial endowment of A 0 and income level of the household
at time t, Yt = Y0+bt for 0≤t ≤R and 0 for R<t ≤T . The individual retirement
age, R, satisfies 0<R<T. Assume there is no interest rate and uncertainty.

(a) What is the individual’s lifetime budget constraint?

(b) What is the individual’s utility maximizing consumption level?
(c) What do learn about the magnitude of consumption and saving over life time
of the individual?
3. Assuming an individual is living in a certain world tries to maximize his utility out
of consumption of goods Ct for a period spanning from year 1 to T years. His
instantaneous utility function is designated by what is called Constant-Relative-
Risk-Aversion, which is given as
θ T 1−θ
C 1− ¿
1 Ct
ut =
t
¿ U =∑
t=1 (1+ ρ) 1−θ ; where ρ is time preference of
t
1−θ The life -time utility is
the consumer;

The life-time budget constraint is given as

 T T
∑ (1+1 r )t C t ≤A 0+∑ (1+r
1
)t
.Yt
t=1 t=1

(a) Derive the optimal consumption level at time t that relates the optimal
consumption level at t+1, through what is called Euler Equation.
(b) What is the likely relationship between current consumption level on the
one hand and interest rate on the other hand?
(c) If the value of ρ >r, what will be the likely decision of the household on his
current consumption and saving levels?
(d) If T=2, and assuming that ρ=0, what would happen to consumption level at
time t=1, if time interest rate increases.
4. Discuss the similarities and differences of the different consumption
functions that you have learnt in class. Which school of thought is likely to
capture the consumption behavior of households in developing countries
and developed countries, and why?
5. Assume that an individual has an instantaneous utility -function, which
takes the form of a quadratic equation of the form
β
ut =C t − C2t
2

The household also has an initial wealth of Wo and an income flow of Yt for a
period of T years. The individual faces uncertain conditions, which are likely
to affect his consumption level. Try to capture the consumption function of
the individual and his optimal consumption levels using the relevant model
given the above utility function.

6. What are the major economic and non-economic factors that affect the
level of investment in a country and why? [Hint: Do not forget to discuss
the relationship between investment and saving and other economic
variables. What are the main motives of investment and what are the major
types of foreign direct investment?
7. Using a neoclassical model of investment such as the one discussed in class,
a) Derive the condition for the decision of the optimal investment.
b) Derive the user cost of capital and Tobin’s q and discuss what
determines the optimal capital stock.
 c) In your model, if you are given a Cobb-Douglass production function
that characterize the representative firm’s production technology, with
labour (L) and capital (K) being two critical inputs with a and b being
elasticity of output with respect to labour and capital respectively and a
technical progress parameter, A; recalculate the user cost of capital and
Tobin’s q.
d) If the aggregate demand increases what is likely to happen to
investment and capital stock? [Hint: assess the situation in the context
of different possibilities that investment modes entertain AD changes
and also the nature of the aggregate supply curve]
e) What is likely to happen on investment and capital stock if the price of
investment goods increases?
f) If tax is imposed by government on investment goods, what is likely to
happen on the optimal level of capital stock; show it mathematically?
g) If tax-credit is provided by government on investment goods, what is
likely to happen to investment?
h) If interest rate declines, what is the likely effect on investment and
capital stock? [Hint: explore the different possible tax reductions.
i) If the price of goods increases in a less extent than the price of
investment goods, what is the likely effect on investment and capital
stock of the firm.
j) If there is adjustment cost associated with investment at different
levels, what is its likely effect on the optimal level of capital stock?
Would it reduce or increase the level of capital stock as compared to
the situation where there is no adjustment cost.
k) If there are two investment types depending on the nature of activities
that firms are engaging with; Type 1 activity is undertaken by
irreversible type of investment and Type 2 is undertaken by a foot-
loose type of investment. What is the likely effect of an increase in
aggregate demand for one year in the two types of investment
ventures and why?

8. What are the most pressing macroeconomic problems of the Ethiopia today and
how grave are the problems (how do you indicate their intensity) and what do
you suggest to solve these problems using the theory that you have been
thought to-date?