1 ECON3008W1

UNIVERSITY OF SOUTHAMPTON ECON3008W1

SEMESTER 2 TAKE-HOME FINAL ASSESSMENT 2020-21

ECON3008 Macroeconomic Policy 3
Duration: 24 HOURS:
START: 10:00 am, xx/05/2021 - END: 10:00 am, xx/05/2021

This paper contains 4 questions. Answer ALL questions.

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

- Explain concisely all steps you undertake to answer the questions. Please write
clearly, only readable parts will be taken into account.
- This is an open book assignment. You may use notes, books, online resources or
software (e.g. Excel) when answering these questions. You must always use
your own words and calculations and you may not communicate to others or
get help from any person be it private or online.
- Once you have finished, you should upload your answers as a single pdf file on the
Assessment section of the ECONxxxx Blackboard site. A submission is only
complete with a submission number.
- The submission deadline is 10:00 am on May xxth. Your work must be up-
loaded onto the Blackboard website before this deadline.
- See blackboard for detailed submission instructions. Submission of this work
acknowledges that you have answered the questions individually and in accor-
dance with University guidance on Academic Integrity

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1. Consider the following unified monetary model of the exchange rate

where time is discrete and runs from period t = 0 onwards :
iU K,t = iU S + ee£/$,t+1 − e£/$,t (1)
MU K MU S
= exp(−ηiU K,t )YU K , = exp(−ηiU S )YU S (2)
PU K,t P US
∞  s
e 1 X η
eLR = [mU K − mU S + yU S − yU K ] (3)
1 + η s=0 1 + η

 P0
 in period t = 0
1 new
PU K,t = PU K,t−1 + T (P − P0 ) in periods 1 to T (4)
P new

in all later periods
where P0 = P > 0 is the initial UK price level.
The UK money supply MU K is given and MU S , YU K , YU S , P U S , η, T
are known positive constants. Lowercase versions of variables are
natural logarithms (e.g. mU K = ln(MU K )). The home exchange rate
in period t is e£/$,t, and ee£/$,t+1 is the expected future exchange rate.
We assume MU K is such that the UK interest rate (iU K ) is initially
equal to the US interest rate. Agents have rational expectations.
(a) Explain equations (1) and (2). What is Equation (4)? [10%]
(b) There is a permanent unanticipated increase in UK money supply
from M to M new in period 0. The new long run price level is given
new
by P new = MM × P , and we assume T = 2. Find an analytical
solution for the period 0 spot rate. [10%]
(c) We now repeat the experiment in (b) with numerical values:
η = 2, P =4, P U S =1.5, MU S =1.5, YU K =YU S =1.5, M = 4, M new =4.4.
Complete the table below. Does the exchange rate overshoot? [10%]
Period PU K iU K iU S eeLR e£/$
0 0.983 →
1
2

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2. Consider the following two-period model of the current account:

U = (1 − β)ln(C1 ) + βln(C2 )
C1 = Y1 − CA1 , C2 = Y2 + (1 + r)CA1
CA1 + CA2 = 0
where C is consumption, CA is the current account balance, and
r is the given world interest rate. Y1 , Y2 are given endowments in
periods 1 and 2 and 0 < β < 1 is a known parameter.
C2 Y2
(a) Show that the lifetime budget constraint is C1 + 1+r = Y1 + 1+r ,
and find analytical solutions for C1, C2, CA1, CA2. How would
1−σ 1−σ
these results differ, if at all, if U = (1 − β) C1−σ
1
+ β C1−σ
2
for σ > 0? [10%]
(b) We now set Y1 = 1, Y2 = 2, r = 0.1, β = 0.5. Find numerical
solutions for C1, C2, CA1, CA2 and lifetime utility, U . How would
these results differ, if at all, if U = C11−β C2β ? Explain. [10%]

3. Consider the following short run monetary exchange rate model:

iU K = iU S + ee£/$ − e£/$
MU K MU S
= exp(−ηiU K )YU K , = exp(−ηiU S )YU S
P P
ee£/$ = e

where P = 2 and η, e are known positive constants.

The variables MU K , MU S , YU K , YU S are the given money supplies and
real incomes at home and abroad. The home exchange rate is e£/$
(in natural logs), and ee£/$ is its expected future value.
(a) Find an analytical solution for the spot rate, e£/$. Does the spot
rate respond to policy announcements in this model? [10%]
(b) We now give the model parameter values: η=3, MU S =2, e= 0.3,
YU K = YU S = 5. UK money supply, MU K , is equal to 2 in periods
0 and 3, and to 1.5 in periods 1 and 2. Compute the spot rate
and home and foreign interest rates in periods 0 to 3. [10%]

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4. Consider the following model of sovereign default:

C R = Y − (1 + rL )L (5)
CD = Y − f Y (6)
where C R is consumption under repayment, and C D is consumption
under default (i.e. if the loan is not repaid).
Here 0 < f < 1 is given, and the positive parameters L and rL are
the loan and the interest rate charged by the lender. Output, Y , is a
continuous random variable drawn from a uniform distribution over
the interval [Y , Y ], where Y > 0 and Y > Y . The sovereign chooses
whether to repay or default after observing the level of output, Y .
Its aim is to maximize national utility: U (C) = 1 + 5C .
(a) Is sovereign default costly in this model? Provide an economic
justification for this assumption. [10%]
(b) Derive an analytical expression for the probability of default and
use it to complete the following table:
Prob(Default) Case
................. if YT < Y
................. if Y ≤ YT ≤ Y
................. if YT > Y

where YT is the (threshold) level of output at which the sovereign

is indifferent between default and repayment. [10%]
1−σ
(c) Now suppose the cost of default is not known and U (C) = C1−σ ,
with σ > 0. There are two possible outcomes: f = fhigh with
probability p, or f = flow with probability 1 − p. The sovereign
maximizes expected utility: U e = pU (C(fhigh)) + (1 − p)U (C(flow )).
Compute the probability of default when σ = 2, Y = 0.5, Y = 1.8,
p = 1/3, fhigh = 0.6, flow = 0.1, rL = 0.1 and L = 0.4. [10%]
END OF PAPER

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