SECTION A

Answer FIVE questions from this section ( 5 marks each).

1. 'An increase in the number of cash dispensers (ATM machines) will reduce the demand for
money, other things being equal7. True or false? Briefly explain your answer.

2. 'If investment is independent of the interest rate, the Aggregate Demand (AD) curve must
be vertical'. True or false? Briefly explain your answer.

3. 'The sticky wage model of aggregate supply predicts that real wages will be
countercyclical (i.e. that they will go down as output goes up)'. True or false? Briefly
explain your answer.

4. 'The outside lag is the time it takes for a policy to be designed and implemented'. True or
false? Briefly explain your answer.

5. 'The fact that there exists a business cycle means that the assumption of rational
expectations is incorrect7. True or false? Briefly explain your answer.

6. 'The sacrifice ratio is defined as the level of unemployment benefit divided by the average
wage'. True or false? Briefly explain your answer.

SECTION B

Answer THREE questions from this section (25 marks each).

7. Answer each of the following:

(a) Use the Fisher model of intertemporal consumption choice to explain why we
might expect the time-path of consumption to be smoother than that of income.
State carefully any assumptions you make.

(b) Empirically, consumption seems to be more volatile than a simple model of

(c) Suppose you are told that, due to unanticipated advances in medical science, your
life expectancy has increased significantly. Using the life cycle model of
consumption, show the probable impact on your current and future consumption
(assume that the retirement age and all other variables remain unchanged).

PLEASE TURN OVER

(a) Explain the concept of time-inconsistency and why it might help us understand the
existence of high rates of inflation.

(b) If high inflation rates are indeed due to a time-inconsistency problem, what
solutions are there?

(c) Apart from time-inconsistency, what are the practical problems associated with
conducting activist stabilization policy?

9. Consider a small open economy with fixed prices and wages and perfect capital mobility.

(a) Describe analytically, and illustrate graphically, the internal and external equilibria
of the economy. Be careful to state any assumptions clearly.

(b) Describe the effects of an increase in government spending on output,

(c) 'If there are more real shocks (i.e. shocks to the IS curve) than monetary shocks
(i.e. shocks to the LM curve) in an economy, then a regime of flexible exchange rates is
preferable to one of fixed exchange rates'. Explain the reasoning behind this statement.

10. Consider the Solow growth model.

(a) Assume positive population growth (n>O) and technological progress (g>O).
Derive analytically the steady-state growth rates of output and capital, and the steady-state
levels of output and capital per efficiency unit of labour. Illustrate your answer graphically
and briefly discuss the economic intuition.

(b) For simplicity, assume now that there is no technological progress (g=O, A=l).
Assume that Y = fifi,s=0.4, S =0.07, n=0.03, where Y , K and L are output, capital and
labour respectively, s is the savings rate and S is the depreciation rate. What are the steady-
-
state levels of capital, output and consumption per worker? Is consumption per worker
maximised in the steady state? What is the savings rate s* that maximises consumption in the
steady state?

(the question continues on the next page)

11. Answer each of the following:

(a) What are the main types of unemployment? Define the 'natural rate' of
unemployment.

(b) Why might the natural rate of unemployment rise after a severe recession?

(c) Describe some government policies that might help to reduce the natural rate.

12. Answer each of the following:

(a) What determines the relationship between the monetary base and the money
supply?

(b) What instruments can a central bank use to control the money supply?

(c) What is seigniorage? Does your answer suggest a link between fiscal policy and
inflation?

13. Consider a closed economy with fixed wages and prices and where the government is
running a budget deficit of size X (i.e. G-T=X). Assume initially that the government
controls monetary policy.

(a) Describe the initial equilibrium of the economy (i.e. illustrate it graphically and
explain the meaning of each curve).

(b) Suppose the government wishes to eliminate the budget deficit, and decides to do
so by raising taxes (i.e. G is held fixed and T rises by an amount X). However, the
government does not wish aggregate output Y to change. What must happen to monetary
policy and to the equilibrium interest rate? Which parameters determine the size of any
change in the interest rate?

(c) Now suppose that the central bank is independent and refuses to change the
money supply. Is there instead a combination of fiscal policies that the government can use to
balance the budget and still leave output unchanged? Describe such a combination in as
much detail as you can.

PLEASE TURN OVER

(a) What is the 'classical dichotomy'?

(b) Use the quantity equation to derive an equation for the rate of inflation. What
does the classical dichotomy suggest is most important for determining average inflation
rates? Are expectations important?

(c) Suppose Country A has nominal interest rates of lo%, while Country B has
nominal interest rates of 5%. Can this interest rate differential be consistent with perfect
international capital mobility? Does it tell us anything about any expected movement in the
exchange rate between the two countries' currencies? Does it tell us anything about expected
inflation rates in the two countries?

END OF PAPER