ECON20032

Exam Mode: Option A

UNIVERSITY OF MANCHESTER

Macroeconomics 4

Semester 2, 2020-21

Practice Exam

Candidates are advised that the examiners attach considerable importance to the clarity with which answers are expressed

Answer 2 out of 3 questions in Section A and ALL questions in Section B

Typed responses must be submitted to all questions

Graphs drawn by hand and scanned can be submitted, but graphs

drawn electronically are preferable

Section A

Questions (10 points each; total: 20 points)

        Answer BRIEFLY (in no more than 150 words each) two of the following three questions. All answers must be written in complete sentences. Do a word count and indicate the number of words after each answer.

Question A1. Using national accounts in an open economy, explain the notion of twin deficits.

Question A2. Explain Ricardian equivalence. What does it imply for the relationship between fiscal deficits and current account deficits?

Question A3. Explain the difference between covered and uncovered interest parity.

Section B

Problem (60 points)

        Answer all questions clearly and succinctly.

        Consider a small open economy producing a (composite) good which is an imperfect substitute for a foreign good. There are four categories of agents: firms, households, commercial banks, and the central bank (CB). The world price of the foreign good is taken as exogenous and normalized to unity. The nominal exchange rate is fixed at E.

    Output, Y, is produced by combining labour and capital:

(1) Y = N(K0),

where N is employment, K0 is the stock of capital at the beginning of the period and 0 < , < 1. The price of the domestic good is PD, and the nominal wage is fixed at W.

Question B1 [4 points]. Solve for labor demand, Nd , and the supply of goods, Ys , which maximize profits. What is the restriction needed, if any, on and to ensure a positive relationship between output and the domestic price? 

        Write the equation for the supply of goods, Ys , as equation (2).

        Investment, I, is financed by bank loans and is defined as

(3) I = I(iL),

where iL is the loan rate and I′ < 0.

    Households hold three categories of assets: domestic currency (which bears no interest), deposits with banks, and foreign-currency deposits abroad. All assets are imperfect substitutes. Total household financial wealth FH, is given by:

(4) FH = M + D + E•D*,

where M is currency holdings, and D (respectively D*) domestic (respectively foreign) bank deposits. Financial wealth is predetermined at FH0.

        The demand for deposits is

(5) D/M = v(iD),

where iD is the interest rate on domestic deposits and v′ > 0.

        The foreign-domestic deposit ratio depends on interest rate differential between these assets:

(6) E•D*/D = (iD - iW),

where iW is the interest rate on foreign-currency deposits, and ′ < 0.

        Household consumption, C, depends on factor income, interest rates, and wealth:

(7) C = 1Ys - 2(iD + iW) + 3(FH0/PD),

where 0 < 1 < 1, 2, 3 > 0, and FH0 is the beginning-of-period stock of household financial wealth.

        The balance sheet of commercial banks is

(8) L = D + LB,

where L = PDI denotes loans to firms, and LB borrowing from the central bank.

        The interest rate on domestic deposits is

(9) iD = iR,

where iR is the cost of borrowing from the CB, or the refinance rate.

        The interest rate on loans is

(10) iL = iR + θ,

where θ is a risk premium, defined as

(11) θ = θ(PDK0 - L0),

where K0 is the stock of capital held by firms, L0 beginning-of-period loans, and θ′ < 0.

Question B2 [3 points]. Explain the rationale underlying equations (10) and (11)..

        The equilibrium condition of the market for domestic goods is

(12) (1 - x)Ys = (1 - δ)C + I,

where 0 < x < 1 is the fraction of domestic output that is exported (assumed fixed), and δ the fraction of total consumption which is spent on imported goods (also fixed).

Question B3 [8 points, 4-4].

B3-1. Using equations (10) and (11), derive the financial equilibrium condition of the model, in terms of iL as a function FF(PD; iR).

B3-2. Explain intuitively the signs of the partial derivatives of the function FF.

Question B4 [12 points, 5-5-2].

    B4-1. Using equations (2), (3), (7), (9), and (12), derive the goods market equilibrium condition of the model, in terms of iL as a function GG(PD; iR). What is the restriction needed on x, δ, and 1 needed to ensure that the net supply effect is positive?

    B4-2. Explain intuitively the signs of the partial derivatives of the function GG.

    B4-3. Represent graphically the equilibrium of the economy in PD-iL space, state (without proof) the condition on the relative slopes of the equilibrium curves.

Question B5 [15 points, 6-6-3].

    B5-1. Examine, analytically and graphically, the impact of an increase in the refinance rate, iR.

    B5-2. Explain graphically how the financial accelerator effect operates.

    B5-3. Show graphically in a separate diagram, and explain analytically, what happens when θ′ = 0 in equation (10).

        The central bank imposes a financial tax on banks, L, which is passed on fully to borrowers. The loan rate is now given by, instead of (10),

(10′) iL = iR + θ + L.

Questions B6 [18 points, 6-6-2-4].

    B6-1. Using equation (10′), and in the general case where 2 > 0 in equation (7), analyse the impact of an increase in the financial tax, L, on macroeconomic equilibrium.

    B6-2. Explain movements in curves FF and GG, if any, and describe the transition from the initial equilibrium to the new equilibrium.

    B6-3. Is any other curve affected in the full diagram?

    B6-4. How does the adjustment process associated with the increase in L differ from what occurs with an increase in the refinance rate, iR?

END OF EXAMINATION