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TIME ALLOWANCE: as specified in the submission window

Answer all questions from Part A and all parts of the single question in Part B.

The coursework comprises 75 per cent of your final mark. Part A is worth 25 per cent and Part B is worth 50 per cent.


Answer all questions from this section. For each question, identify the statement as True,False, or Uncertain, and explain your reasoning (in a total of not more than 120 words). The maximum marks for each question will be given for a full and correct explanation. You may use written, diagrammatic, and mathematical arguments as appropriate.

A.1 Following the announcement that the amount of QE intervention by the central bank will be reduced going forward (also known as Quantitative Tightening), according to the UIP condition, an immediate appreciation of home’s nominal exchange rate would be observed. [4’]

A.2 The difference between the slopes of the IS and RX curves depends only on the sensitivity of net exports to the real exchange rate. [4’]

A.3 Consider a temporary positive inflation shock in a flexible exchange rate regime (with an inflation targeting central bank) and in a fixed exchange rate regime (where there is no policy intervention). Assume that both economies converge to a medium run equilibrium.Following the shock, inflation converges to its equilibrium value from above in both cases.[4’]

A.4 The central bank of a common currency area should not respond to a shock specific to one member. [4’]

A.5 Assume that workers supply effort based on their expected real consumption wage and consume a basket with a non-negligible component of imported goods and services. The government in an open economy implements a contractionary fiscal policy (from an initial medium-run equilibrium) motivated, for example, by its desire to reduce national debt.This leads to lower real wages and higher unemployment in equilibrium. Hint: you may want to compare this with the case in which the initial two assumptions do not hold. [5’]

A.6 In a 2-bloc world economy with flexible exchange rates, the same inflation shock affects both blocs. Tighter monetary policy in each bloc produces exchange rate appreciation.[4’]


Answer all sub-parts of part B in a total of not more than 1800 words (not including equations and figures). We do not expect you to use the full 1800 words. Answers must be typed. Figures and equations can be hand-written and pasted into the document. You will receive no points for figures or equations pasted from a textbook, lectures slides or any other external source.You may paste simulator output into your answer document. If you wish to refer to data, do not copy and paste from an external source. Use a standard referencing system if you wish to refer to other sources. It is not necessary to reference lecture notes or the textbook unless you make a direct quotation.

Term 1 Section [25’] Consider the two-period household-maximization model discussed in class. The model is modified in order to look at applications including credit constraints,interest-rate markups, and taxation. A representative household lives for two periods and maximizes utility of consumption in period 1 and in period 2. The utility is represented by log(c) where c denotes consumption. Assuming no discounting between period 1 and period 2. The maximization problem for the representative household can be written as
max{log c1 + log c2}
c1 + a1 = y1 − τ1 + (1 + r)a0
c2 = y2 − τ2 + (1 + r)a1

where y1 and y2 denote income levels in period 1 and period 2, τ1 and τ2 are taxes in the two periods, and a0 and a1 denote the assets of the households in each period. a0 is exogenously given. Assume the interest rate r = 0, and the government can borrow or save at the same interest rate so that its present-value budget constraint is given by
g1 + g2 = τ1 + τ2

where g1 and g2 are exogenous government expenditures in the two periods.

B1 (a). Explain what is meant by a representative household. Briefly explain the budget constraints of the representative households and of the government. Explain the role played by the assumption that the representative households lives for only two periods and the assumption of “no discounting”. [7’]
B1 (b). Show consumption c1 and c2 (you can use algebraic or graphical methods). In the answer, you should discuss whether a1 ≥ 0 or a1 < 0 and provide an economic interpretation. What determine(s) the sign of a1 and why? [6’]
B1 (c). Explain how a credit constraint can be modeled by a1 ≥ 0 and under this constraint how does your answer to B1(b) change? How does it change if there is a banking markup such that the borrowing interest rate is above the interest rate of r = 0 assumed earlier? Hint: try to relate your reasoning to the permanent income hypothesis. [6’]
B1 (d). Suppose a0 = A0/P1 where A0 ≥ 0 denotes the savings in nominal terms. Consider a supply-side shock that leads to a surprise significant increase of the price level only in period 1. Should the government change its tax plan if a1 ≥ 0 is imposed? [6’]

Term 2 Section [25’] In this section, the context is a large negative shock to autonomous consumption in an open economy. You may assume the economy is initially at a medium run equilibrium.
B2 (a) Aggregate demand can decline for many reasons. Give a specific example of when you would choose to model the onset of a recession by a fall in autonomous consumption and explain why. [7’]
B2 (b) Provide two different scenarios in which the macroeconomic policy response to the
shock in an open economy includes the use of expansionary fiscal policy. Explain your reasoning,the policy chosen and describe how the economy adjusts to medium-run equilibrium. Refer to real world examples. [18’]

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