EC2B3 Macroeconomics II

Summary and Revision Advice

Kevin Sheedy
LSE
Winter Term 2024
 Preparing for the exam
• How best to prepare for the exam?
• Everyone has own way of handling revision, but I recommend an
‘active’ rather than ‘passive’ strategy where possible
• Try to practise applying the ideas and concepts, rather than just reading
• Using additional questions for practice (see revision resources)
• By thinking about the macroeconomics you hear in the news
• What is examinable?
• The material that has been covered in lectures and classes
• Readings are not examinable in their own right
• They are suggested as a complement to the lectures
• Style of the exam questions is the same as weekly problem sets
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 Exam rubric
Instructions to candidates
This exam contains two sections. Answer ALL questions. The two short questions in Section A carry 15 marks
each, and the two long question in Section B carry 35 marks each.
Answers should be justified by showing work. Please write your answers in dark ink (black or blue) only.
Candidates must not take the question paper away with them after the examination. Please place the
question paper within your answer booklet at the end of the examination.

Time Allowed Reading Time: 15 minutes

Writing Time: 2 hours

You are supplied with: No additional materials

You may also use: No additional materials

Calculators: Calculators are not allowed in this exam

If during this exam you feel you need to make additional assumptions in order to proceed, then please do so by
stating your assumptions clearly.
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 Revision resources
• See the ‘Revision’ tab on the Moodle page
• Sample exam paper (and solutions)
• Practice questions
• 17 questions to use for practice, roughly equivalent to 4 exam papers
• Solutions will be released during the Spring Break
• Online discussion forum (ed) – see Moodle page for link
• Final online Q&A session: Thursday 28th March, 2-3pm
• Revision lecture: Week 1 of Summer Term – time TBA
• ST office hours of class teachers and me – schedule TBA
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 Framework for revising the course
• We’ve analysed a wide range of macro topics and questions
• But we have used the same basic tools repeatedly:
• Constrained optimization with indifference curve diagram
• Diamond-Dybvig model of banks: best deposit contract for risk-averse depositors
• Risk comes from uncertainty about how long people can wait to access their savings
• Portfolio choice model (to study QE): best risk-expected return trade-off
• Risk comes from uncertainty about asset returns
• Saving and borrowing decisions: best consumption plan given budget constraint
• Used to study gains from international trade in assets
• Supply and demand diagrams
• Markets for goods, labour, and money
• Understand special cases for shapes of demand and supply (perfectly elastic or inelastic)
• Mathematics (mainly used to derive constraints) 5
 Output demand curve
• Common to all the macroeconomic models we have used
• In closed economy, aggregate demand is sum of:
• Consumption
• Investment
• Government expenditure
• Consumption & investment negatively related to real interest rate
• Wealth effects change 𝐶 𝑑 and shift output demand curve
• In open economy, we include net exports:
• Shifts output demand curve
• With distinct domestic and foreign goods, and sticky prices, changes in
net exports are linked to exchange-rate movements, all else equal 6
 Labour supply curve
• Households choosing how much to work
• And more generally, whether to participate in labour market
• We ignore income effects of changes in wages and interest rates
• Aside from foreign ownership of domestic assets or distributional issues,
these income effects should net out when we look at whole economy
• Higher real wage has substitution effect on labour supply:
• Greater incentive to use time for work, so labour supply rises
• Real interest rate has substitution effect on labour supply:
• Greater incentive to save, and can save more by earning more
• Labour supply curve common to almost all the models we used
• But with wage rigidity, off labour supply curve (unemployment) 7
 Labour demand curve
• This varies with flexibility or stickiness of prices and market power
• Flexible prices, perfect competition: 𝑁 𝑑 is 𝑀𝑃𝑁
• Hire workers up to point where marginal product equals real wage 𝑤
• Flexible prices, firms with market power: 𝑁 𝑑 is 𝑀𝑅𝑃𝑁
• Firms do not want to supply so much that profit margin falls to zero
• Stop producing more and hiring workers before 𝑀𝑃𝑁 = 𝑤 is reached
• Desired profit margin is gap between 𝑀𝑃𝑁 and 𝑀𝑅𝑃𝑁
• Sticky prices (completely fixed, or partial price adjustment)
• Firms that do not change price cannot choose how much to sell
• Aggregate demand for labour limited by aggregate demand for goods
• Wage-inelastic labour demand (at least where 𝑤 ≤ 𝑀𝑃𝑁 ) 8
 Output supply curve
• Output supply curve represents production when all firms choose
how much to sell (i.e. prices are fully flexible)
• Derived from equilibrium of the labour market when firms choose
employment and output to maximize profits
• i.e. 𝑁 𝑑 is 𝑀𝑃𝑁 or 𝑀𝑅𝑃𝑁 depending on market power of firms
• Output supply is positively related to real interest rate because of
substitution effect on saving working through labour supply
• With sticky prices (completely fixed or partial price adjustment),
economy is off output supply curve (𝑌 𝑠 not relevant)

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 MM line
• As 𝑌 𝑠 is not relevant with sticky prices, real interest rate and real
GDP jointly determined by 𝑌 𝑑 and 𝑀𝑀 line
• 𝑀𝑀 is a description of how the central bank sets interest rates
• CB sets nominal interest rate, but that affects real interest rate when
prices are not completely flexible
• Horizontal 𝑀𝑀 represents constant interest rate policy
• We usually think that CB is reacting to what happens in economy:
• E.g., Taylor rule:
• CB reacts to business cycle: upward-sloping 𝑀𝑀 line
• CB reacts to inflation: 𝑀𝑀 shifts with inflation & inflation expectations
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 Phillips curve & 𝑌 𝑑 − 𝑀𝑀
• With partial price adjustment, those firms changing price aim to
restore their desired profit margins
• Raise prices if margins are too low (𝑤 > 𝑀𝑅𝑃𝑁 )
• Cut prices if margins are too high (𝑤 < 𝑀𝑅𝑃𝑁 )
• Since higher demand for 𝑌 raises 𝑁, which raises 𝑤 and lowers
𝑀𝑅𝑃𝑁 , real GDP is linked to inflation: Phillips curve
• Phillips curve also shifts with changes in expected future inflation
• Inflation and GDP also linked on demand side:
• Higher inflation leads CB to raise interest rates
• Higher real interest rates reduce aggregate demand

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 Finally…

Good luck with your revision and the exam!

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Course Survey

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