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LUBS2610

Intermediate Macroeconomics

Semester One 2022/2023

Answer both questions

1. Consider an IS-LM-PC model where output is equal to its natural rate and the real policy interest rate is positive and equal to its natural rate (r  = rn ). Due to a climate emergency some fossil fuel technology is permanently and immediately banned, and as a result there is a permanent and immediate rise in the mark-up (m) of firms i.e. firms’ costs rise. Exactly two years after this ban, a new and permanent reform that increases the bargaining power of workers (z) is announced and it will also come into effect immediately.

Explain the central bank’s response and its resulting economic outcomes in the following scenarios:

a)  If inflation expectations are anchored and the central bank immediately responds to shocks to keep inflation at its target rate versus if the central bank only responds to each individual shock after three years. Critically discuss the costs and benefits of both approaches. (25 marks)

b)  If inflation expectations are adaptive and the central bank immediately responds to shocks to stabilise inflation versus if the central bank only responds to each individual shock after three years. Critically discuss the costs and benefits of both approaches. (25 marks)

Explain each part of your answer using a three-panel graph of the IS-LM-PC model and a graph of inflation over time.

2. Consider two identical pre-industrial economies, A and B. Both begin in their steady state with a savings rate of 50 percent, they have the same low - but  positive - rates of capital depreciation and population growth, and no technological progress.

a)  Economy A now has an industrial revolution and a new, positive growth rate of technology. Economy B has no technological progress but wants to try to match the output per capita levels in Economy A by adjusting the savings rate. Using the two-panel Solow model diagram, illustrate, explain, and critically discuss what happens to both economies over time without reference to environmental sustainability. (25 marks)

b)  By the 21st  century, Economy A has developed into an advanced economy at its steady state but now with no population growth; however, its emissions are above safe levels and it is facing a climate emergency because it only uses “dirty” technology. Using the two-panel Solow model diagram, illustrate, explain, and critically discuss two solutions to the climate emergency that will reduce the emissions of Economy A to safe levels. (25 marks)