Ec 210 Sample Exam

LSE 2009/EC210 (sample exam) Page 1 of 6

EC210

Macroeconomic Principles Sample Exam 2008/2009 syllabus – not suitable for re-sit students Instructions to candidates Time allowed: 3 hours This paper contains sixteen questions. Answer EIGHT short questions out of ten from Section A and THREE long questions out of six from Section B and C (with at least ONE question from each section) . Each short question carries 5 marks and each long question carries 20 marks. Do not spend a disproportionate amount of time on any one question. Calculators are not allowed.


SECTION A – Answer EIGHT questions, 5 marks per question 1 Using the search model of unemployment, illustrate which factors can

potentially explain differences in equilibrium unemployment between two countries. Which of these factors, if any, can explain differences in unemployment between the US and continental European countries?

2 There is a concern that the increase in the price of oil may slow down

economic growth. Use the Solow model to explain the growth effects of an increase in oil price.

3. In a famous article published in 1990, an economist asked “why doesn’t

capital move from rich countries to poor countries?” Explain why this fact is puzzling, and why human capital might help to solve this puzzle.

4. What is Tobin’s q? Explain why firms should invest if q>1. How is this related

to the idea that firms should invest if the future marginal product of capital is greater than the user cost of capital?

5. Suppose government wants to raise revenue to build a new airport. Some

economists argue that the outcomes of tax-financing or debt-financing policies are the same. Use a simple 2-period model to support this argument. Give one reason why this argument might not hold in reality.

6. Why does the presence of increasing returns to scale in production imply that

the equilibrium of an economy could be influenced by “sunspots”? 7. What is the effect of a temporary TFP shock on employment in the Keynesian

sticky price model? Explain intuitively and compare with the real business cycle model.

8. Suppose that the following data are obtained from the yield curve:

Maturity (years) 1 2 3 4 5 Yield 2% 2.25% 2.5% 2.25% 2%

Calculate the path of expected short-term (1-year) interest rates over the next

five years assuming that the expectations theory of interest rates is correct. 9. Show that maintaining a fixed exchange rate after a permanent decrease in

government spending requires a loss of foreign exchange reserves. Would imposing capital controls help stem the loss of reserves?

10. Show how the Phillips curve is derived in the Friedman-Lucas money surprise

(misperceptions) model. What is the effect of an increase in inflation expectations?


SECTIONS B & C – Answer THREE questions, 20 marks per question SECTION B – Answer at least ONE question 11. Consider an economy with an aggregate production function Yt=BKt

αN1-α, where, 0<α<1, Yt and Kt are output and capital stock at time t, N is number of workers. Assume N and B are constants and this is a closed economy.

(a) Use the Solow model to derive the steady state for this economy.

Explain the economic meaning of the equations and the graph that you used in your answer. [7 marks]

(b) This economy carried out a series of economic reforms during 1980s

which increased the production efficiency. What are the predictions of the Solow model on its growth rate and level of output per worker in the 1990s and in the long run? Explain using the equations and graph you used in part (a). You can assume the economy is in a steady state before the reforms. [5 marks]

(c) Suppose α=1. Show that output per worker grows at a constant rate in

the long run. How is this related to Romer’s learning-by-doing model? Explain the economic meaning of the equations you used. [8 marks]

12. Ricardian equivalence says that if the present value of the government

spending remains the same, then the timing of taxes does not matter and how much debt the government raises does not matter.

(a) Use the life-cycle theory of consumption to explain Ricardian

equivalence. [10 marks] (b) Explain why Ricardian equivalence might not hold if consumers face a

borrowing constraint or consumers only care about the present. Explain these arguments. [10 marks]


13. The government is considering how to raise tax revenue to fully finance a

project. The alternatives are (i) a tax on capital income, or (ii) a tax on labour income.

(a) Economist A argues that increasing labour income tax rate does not

always result in higher tax revenue. Explain the rationale behind this argument. [5 marks]

(b) Explain the meaning of the term “time inconsistency.” Use capital

taxation as an example to illustrate it. [5 marks] (c) Economist B argues against capital tax because he is concerned about

economic growth. Use a simple Solow growth model to explain the rationale behind his argument. [6 marks]

(d) Economist C is concerned about the evolution of the debt to GDP ratio.

Assume the real interest rate is fixed. What would her suggestion be? [4 marks]


SECTION C – Answer at least ONE question 14. Consider an economy hit by a temporary positive TFP shock.

(a) Using the real business cycle model, find the effects of the shock on output, employment, the real wage, the real interest rate, and average labour productivity. [9 marks]

(b) Now suppose that firms are subject to a wages-in-advance constraint,

and that households face a cash-in-advance constraint and are limited in their financial market participation to one transaction per time period. Suppose also that households and firms choose the level of banking services they will use prior to learning about the TFP shock. What are the effects of the shock on the variables considered in part (a) and how do your results compare to those in part (a)? [7 marks]

(c) What open market operation does the central bank need to carry out in

the economy described in part (b) to achieve a level of aggregate output equal to that found in part (a)? Why should the central bank want to do this? [4 marks]

15. Consider the Diamond-Dybvig model of banks.

(a) Show how the optimal deposit contract is determined and explain how the existence of banks allows households to achieve a higher level of expected utility. [10 marks]

(b) Explain why a bank run can occur as an equilibrium outcome. [5 marks] (c) Now suppose the central bank offers to act as a lender of last resort to

the banking system. In particular, it allows banks to borrow from it using the discount window (i.e. it makes discount loans at a known interest rate taking as collateral the claims to the projects that banks have invested in). Does this solve the problem of bank runs? [5 marks]


16. Consider an economy where households face a cash-in-advance constraint

on making consumption purchases. Households can either pay for goods with cash, or by using costly banking services.

(a) Suppose the total cost of using banking services X (in real terms) is

H(X). Write down the first-order condition for the representative household’s use of banking services. Explain how this generates a demand for money, stating which variables the demand for money depends on (you do not need to give an algebraic derivation). [6 marks]

(b) Now suppose that the money supply in the economy is growing at rate x

over time, which leads to inflation equal to x. Explain how the cash-in-advance constraint modifies the representative household’s first-order condition for the choice between consumption and leisure. Give an intuition for your answer. [6 marks]

(c) Explain why a positive rate of inflation is inefficient in this economy.

What is the optimal inflation rate? [4 marks] (d) Now also suppose that firms face a wages-in-advance constraint (they

must have cash on hand or use banking services to pay their wage bill). Explain how the first-order condition for the representative firm’s demand for labour is affected. Would your answer to part (c) change as a consequence of adding the wages-in-advance constraint? [4 marks]

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Ec 210 Sample Exam