UNIVERSITY OF SOUTHAMPTON ECON3008W1

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SEMESTER 2 EXAMINATIONS 2016-17

ECON3008 MACROECONOMIC POLICY 3

DURATION 120 MINS (2 Hours)

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This paper contains 5 questions

Answer TWO questions.

Each question carries 1/2 of the total marks for the exam paper. You should aim to
spend about 60 minutes per question.

An outline marking scheme is shown in brackets to the right of each question.

Only University approved calculators may be used.

A foreign language direct ‘Word to Word’ translation dictionary (paper version) ONLY
is permitted. Provided it contains no notes, additions or annotations.

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 2 ECON3008W1

1. Consider the following one-period model of sovereign default.

The government wants to maximise consumption, C. Output, Y, is
uniformly distributed on the interval [Y*–V, Y*], where 0 < V ≤ Y*.
The government borrows an amount L at the lending rate rL. If it
does not repay what it has borrowed, a fraction 0 < c < 1 of output
is lost. We assume loans are supplied by foreigners with access to
world capital markets at risk-free interest rate r. The government
decides whether to repay its debt after output is revealed.

(a) What is consumption equal to if the government decides to

repay? What is consumption equal to if it defaults? Using these
expressions, set up the optimization problem of the government,
and derive the repayment condition on output. What is the solution
for consumption that results from this problem? [15%]

(b) Draw a diagram showing how the repayment versus default

decision depends on output. Indicate the range of output values
for which the government repays, the range of output values for
which it defaults, and the optimal consumption schedule. [12%]

(c) Derive an expression for the probability of repayment. How is

the repayment probability related to the lending rate, rL? Would
you expect the lending rate to be above, below or equal to the risk-
free rate r? Explain. [8%]

(d) Some emerging market economies rely heavily on sovereign

borrowing in the form of debt denominated in foreign currency,
such as US dollars. Suppose now that the sovereign issues a
fraction λ of debt denominated in home currency (pesos) and a
fraction 1–λ denominated in US dollars.

Explain how the above model could be modified to account for

this. Find the new repayment condition and derive an expression
for the probability of default. Does the amended model help us to
understand the experience of emerging market economies with
pegged exchange rates who have been involved in sovereign
default crises set off by large home currency depreciations? [15%]

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2. Consider the following equations from the general monetary
model of exchange rates (we assume the UK is the home country
and that the US is the foreign country):
PUK = E£ / $ PUS (1)
d d
M UK M US
= L(iUK )YUK , = L(iUS )YUS (2)
PUK PUS
M UK = M UK
d
, M US = M US
d
(3)
e
E
1 + iUK = (1 + iUS ) £/$
(4)
E£ / $

where L(i) is a decreasing function (i.e. ∂L(i)/∂i < 0) and E£e / $ / E£ / $ is the
expected gross rate of depreciation of the home currency .

(a) Provide a brief economic interpretation for equations (1) to (4).

Assuming that the Pound floats, which variables in the model are
endogenous and which variables are exogenous? [12%]

(b) Show that the above equations can be combined to give the
fundamental equation of the general monetary model:
M UK / M US
E£ / $ =
L(iUK )YUK / L(iUS )YUS

Find an expression for the log exchange rate, e£ / $ = ln E£ / $ , under the

assumption that L(i) = exp(−η i) , where η > 0 is a constant. [6%]

(c) We now consider a rational expectations version of the model

in which investors have perfect foresight.

(i) Using your answer to (b) and a log-linear version of (4),

show that the log exchange rate follows a linear forward-looking
difference equation and that, if speculative bubbles in the
exchange rate are ruled out, the exchange rate solution is:
s −t
1 ∞  η 
e£ / $,t = ∑   [mUK ,s − yUK ,s − (mUS ,s − yUS ,s )]
1 + η s =t  1 + η 
[16%]

[Note: The lowercase versions of variables are natural logarithms.

You will need to introduce time subscripts for each variable so that
we may track how their values change over time.]

TURN OVER

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(ii). Now consider the case where YUK = YUS = MUS = 1, so that
yUK = yUS = mUS = 0. The exchange rate at date t is then:
s −t
1 ∞  η 
e£ / $,t = ∑   mUK ,s
1 + η s =t  1 + η 

Suppose it is announced at date 0 that on some future date T

the UK money supply will rise permanently from m to m ' .
That is to say,
mUK ,t = m for t < T
mUK ,t = m ' for t ≥ T

Find the solution for the exchange rate under this policy, and
draw a time series diagram showing its path from date 0
onwards. Comment briefly on how the exchange rate is
influenced by expectations about future policy. [16%]

3. Suppose the central bank of Andea is pegging the peso to the US

dollar at E = 1 pesos per dollar. In year 1, the money supply M is
4,320 pesos, reserves R are 1,820 pesos and domestic credit B is
2,500 pesos. To finance government spending, B is growing at 20%
per year. Purchasing power parity holds at all times. The US price
level is P* = 1, and the US interest rate is 5%. It is assumed that the
central bank of Andea engages in sterilization. Real money balances
in Andea are M/P = Y *exp(-1.823*i), where Y = 4732.272. The price
level, P, is initially equal to 1 and the interest rate is initially i = 0.05
(or 5%).

(a) What is the balance sheet of the central bank in year 1? [5%]
(b) For this part of the question, we assume investors are myopic.

(i). Compute domestic credit in years 1 to 5. At each date, also

compute reserves, money supply, and the growth rate of the
money supply since the previous period (in percent). [10%]

(ii). When will the peg break? Call this time T. What will the new
inflation rate be after time T? What will the new rate of
depreciation of the peso be after time T? By how much does
the peso depreciate at time T exactly? Draw time series graphs
showing domestic credit, reserves and the exchange rate in
years 1 to 5. [15%]

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(c). Suppose now that Andean investors have perfect foresight.
What are the implications of this for reserves, money supply and the
lifespan of the fixed exchange rate regime? At what date will the peg
break, and why? Call this time T1. What happens to the exchange
rate at time T1, and why does this differ from what you found for the
case of myopia? Compare the results to those obtained in (b) using
a time series graph. [12%]

(d). Why is the above model referred to as a model of fiscal

dominance? [8%]

4. Consider the following IS-LM-FX model of the UK economy:

yUK = cUK + invUK + g UK + nxUK (1)

iUK = iUS + e£e / $ − e£ / $ (2)
d
mUK − p = yUK − ηiUK (3)
mUK = mUK
d
(4)

where cUK = a + byUK , invUK = d − θ iUK , nxUK = f + χe£ / $ and e£ / $ is the natural
logarithm of the spot exchange rate (pounds per US dollar).

The UK money supply, mUK, is set by the Bank of England. All

parameters are positive and b lies between 0 and 1. The values of the
variables e£e / $ , gUK and iUS are given: e£e / $ = e0 , gUK = g 0 , iUS = i * .

(a). What do equations (1)-(4) represent? What is the variable nxUK , and
why is it positively related to the spot exchange rate? [8%]

(b). Solve the model under (i) the assumption that the Pound floats, and
(ii) the assumption that the Pound is pegged to the Dollar at e0 pounds
per dollar. Comment on how the money supply set by the Bank of
England will differ in the two cases. [12%]

(c). We now give the model the following parameter values: p = 1 , a = 1,

b = 0.8, d =1, θ = 0.4, f = 10, η = χ = 1, e0=10, m0 = 210, g0 = 20, and i*=0.25.

(i). Calculate the equilibrium values of the exchange rate, output and
interest rates under fixed and floating. [8%]

TURN OVER

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(ii). Now suppose the parameter d falls from 1 to 0.75. Calculate the new
equilibrium values under the assumption that there is no attempt to
stabilize output. In which regime is the change in output larger, and
why? Draw IS-LM-FX diagrams to illustrate the impact on output,
interest rates and the exchange rate. [12%]

(d). Now suppose monetary policy may be used to stabilize output when
d falls. Under floating, what money supply should the Bank of England
set to stabilize output at its initial value? Will the Bank of England be
able to stabilize output if the exchange rate is fixed? Would we reach a
different conclusion about output stabilization under a fixed exchange
rate if fiscal policy could be used for stabilization purposes? [10%]

5. Consider a small open economy which lasts for two periods

and has the following lifetime utility function:

U = u (C1 ) + ρu (C 2 ) , 0<ρ<1

where ∂u (C ) / ∂C > 0 and ∂ 2 u (C ) / ∂C 2 < 0 . Here, u (C1 ) is the utility of period

1 consumption, u (C 2 ) is the utility of period 2 consumption, and ρ
is the subjective discount factor.

The economy’s intertemporal budget constraint is given by

C2 Y
C1 + = Y1 + 2
1+ r 1+ r

where Y1 is the period 1 endowment, Y2 is the period 2 endowment,

and r > 0 is the world interest rate.

a. Set up the economy’s optimization problem and find the Euler

equation. Provide an economic interpretation this equation. [8%]

b. Provide a diagram which compares the optimal solution with the

outcome under autarky. State any assumptions you make in the
diagram. According to the model, are current account imbalances
optimal? If so, why? [10%]

c. Consider again the small open economy described in part (a).

We now assume that there is investment, It = Kt+1 – Kt for t =1,2, and

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that physical capital does not depreciate. Initial capital, K1, is given
(i.e. K 1 = K > 0 ), and we denote by K2 capital held into period 2.

The intertemporal budget constraint is now given by

C2 + I 2 Y
C1 + I 1 + = Y1 + 2
1+ r 1+ r

where Y1 is given and Y2 = F ( K 2 ) , with F ' ( K 2 ) > 0 and F ' ' ( K 2 ) < 0 .

Set up the economy’s optimization problem and derive the first-

order conditions. Provide a diagram that compares the outcome
under autarky with participation in international capital markets.
State any assumptions you make. What additional insights, if any,
does the model with physical capital give us? [12%]

d. We now consider a specific version of the model in (c) with:

(C1 )1−1 / σ (C 2 )1−1 / σ

U= +ρ and Y2 = [ K 2 ] β
1 − 1/ σ 1 − 1/ σ

where 0 < β < 1 and 0 < σ < 1.

Find algebraic solutions for consumption, capital and the current

account in periods 1 and 2 in the case of participation in
international capital markets. Is it optimal to invest in period 2?
Explain. [20%]

END OF PAPER

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Social Sciences Examination Feedback
2016/2017

Module Code & Title: ECON3008 Macro Policy 3

Module Coordinator: Michael Hatcher

Mean Exam Score: 62.1%

Percentage distribution across class marks:

UG Modules PGT Modules

1st (70% +) 32.9% 70% +
2.1 (60-69%) 33.0% 60-69%
2.2 (50-59%) 17.6% 50-59%
3rd (40-49%) 14.2% <50%
Fail (25-39%) 2.3%
Uncompensatable Fail 0%
(<25%)
Overall strengths of candidates’ answers:

Students performed well on the early parts of questions which focused on definitions and simple
algebra or calculations. Diagram questions were usually done well, with good labelling and
explanation. Most students made a good attempt to answer the more challenging questions towards
the end, and were able to pick up good marks as long as they showed their method and working.

Overall weaknesses of candidates’ answers:

In cases where answers are left blank, no marks can be awarded. Therefore, students are strongly
advised to write something even if they do not think they will be able to get to the right answer.

Pattern of question choice:

Questions 2 and 5 were the most popular. Questions 1 and 3 were also quite popular. Question 4
was the least popular choice.

Issues that arose with particular questions:

The final parts of Questions 1, 2 and 3 were sometimes left blank. This led to a significant loss of
marks. A common misconception was that Question 2c(ii) was about exchange rate overshooting.
However, the question does not fit into that framework because the increase in money supply is
anticipated (announced in advance) and the price level is not sticky in the general monetary model
(otherwise, PPP could not hold at all dates). In Question 5, timing was an issue for many students.
This caused some problems given that the final part of the question was worth 20 marks.

Further comments not covered above:

Some students ran out of time or had to rush on their second question. This was often due to giving
excessively long explanations in the early parts of a question. Since these parts account for a
relatively small fraction of the total marks, it would have been more effective to allocate time to
harder parts of the question with higher marks available. Even in cases where a final answer was not
reached, students were usually able to obtain a good number of marks for method and working.

Discipline vetting completed By (Name): Zacharias Maniadis Date:12/06/2017