SECTION A

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

1. 'Classical unemployment is caused by nominal wage rigidity.' True or false? Briefly

explain your answer.

2. 'Other things being equal, the aggregate demand curve will be flatter if
consumption depends positively on real money balances.' True or false? Briefly
explain your answer.

3. 'If the velocity of money is constant, the rate of growth of nominal GDP is
controlled by the central bank.' True or false? Briefly explain your answer.

4. 'In the Solow model with no capital depreciation, countries with the same rate of
technological progress must have the same output per capita in steady-state.' True
or false? Briefly explain your answer.

5. 'In an open economy, any current account deficit must be matched by a

government budget deficit of the same size.' True or false? Briefly explain your
answer.

6. 'The Lucas model of short-run aggregate supply is not consistent with rational
expectations.' True or false? Briefly explain your answer.

SECTION B
Answer three questions from this section (25 marks each). Each subquestion carries
equal weight.

7. Answer each of the following:

(a) What are the main components of unemployment? What is the natural rate of
unemployment?

(b) Describe separately the effects on the natural rate of unemployment of (i) a
fall in the replacement ratio, and (ii) a rise in the geographical mobility of
labour.

(c) Imagine a country called Economica, where the average unemployment rate
has been very low for the last fifteen years. Suppose the Federal Reserve
Bank of Economica (the central bank) has been free to set the money supply
as it wishes. Evaluate the following statement: 'Econornica's low
unemployment rate may have been due to the central bank consistently
following a loose monetary policy.'

PLEASE TURN OVER

8. 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) In what sense does the Solow model predict 'convergence' of output levels
and growth rates across countries?

(c) Under what conditions will consumption be maximised in the steady-state?

9. Answer each of the following:

(a) Use the Fisher model of intertemporal consumption choice to illustrate the
concept of Ricardian Equivalence.

(b) Outline why Ricardian Equivalence might not hold if there are borrowing
constraints. When this is the case, analyse the implications for current
consumption of a cut in taxes.

(c) 'Given that all people die, Ricardian Equivalence is a concept of little
practical importance.' Evaluate this statement.

10. Consider a small open economy with fixed wages and prices, and assume perfect
international capital mobility.

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

(b) Suppose there is an increase in government spending. Describe the effects on

output, investment, consumption and net exports, analysing separately the
fixed and flexible exchange rate regimes.

(c) How, if at all, do your answers to (b) change if the increase in government
spending is funded by an equivalent increase in lump-sum taxes [i.e. it is a
'balanced-budget' fiscal expansion]?
11. Answer each of the following.

(a) 'The preferences of policymakers regarding economics outcomes just do not

change from week to week. Therefore the idea of time-inconsistency is of no
relevance.' Evaluate this statement.

(b) If time-inconsistency is in fact a problem in the arena of monetary policy,

what solutions are there?

(c) Explain the Policy Ineffectiveness Proposition.

Answer each of the following:

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

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

(c) Would it matter for the theory of monetary economics if paper were not
available to be used as a medium of exchange?

Consider a closed economy with fixed wages and prices. Suppose the consumption
function takes the form C = 450 + 0.2(Y-T), where C is consumption, Y is income,
and T denotes lump-sum taxes. Meanwhile the investment function takes the form I
= 340 - 30r, where I is investment and r is the real interest rate. The government is
running a balanced budget, with initial government spending G = T = 200.
Monetary policy is conducted by an independent central bank with a target for the
real interest rate: the central bank adjusts the money supply to keep the real interest
rate equal to 5.

(a) Explain the forms taken by the consumption and investment functions, and
depict the equilibrium of the economy graphically. Find the equilibrium level
of output.

(b) Suppose the government engages in a balanced-budget fiscal expansion, so

that both G and T increase to 250. What is the new value of equilibrium
output? What is the value of the 'balanced-budget multiplier' [Hint: this is the
increase in output divided by the increase in G and TI?

(c) Suppose now that the investment function takes the form I = 300 - 30r +0.3Y.
Find the equilibrium output level when G = T = 200, and analyse the effect on
output when G and T both rise to 250. Has the value of the balanced-budget
multiplier changed? Explain why or why not.
PLEASE TURN OVER
14. Answer each of the following.

(a) What are the main determinants of money demand?

(b) Suppose agents perceive an increase in the probability that the government
will default on its bond payments. What will be the effect on the LM curve,
other things being equal?

(c) 'A bond-financed fiscal expansion is always the best policy in a recession, no
matter how deeply indebted is the government.' Evaluate this statement in
light of your answer to (b).

END OF PAPER