Autumn 2016 v4

MSc Macroeconomics (ECONM1011)

Problem Sets for Tutorials and Exercise Lectures

Week commencing

10 October Tutorial Problem Set 1

24 October Tutorial Problem Set 2

7 November Exercise Lecture 1 Technical Questions

21 November Tutorial Problem Set 3 hand in by 14 Nov, 12 noon

Essay assignment submit electronically by 21 Nov, 4pm

28 November Exercise Lecture 2 Technical Questions

5 December Tutorial Problem Set 4 hand in by 5 Dec, 12 noon

Deadlines (summary)

14 Nov 12 noon Tutorial Problem Set 3 hand-in

21 Nov 4pm Essay assignment (see next page)

5 Dec 12 noon Tutorial Problem Set 4 hand-in

You should attempt all the questions in advance of the tutorials and Exercise Lectures. Your
answers will not count towards the final mark for the unit, but attempting the questions will
help to prepare you for the exam. Two of the tutorial problem sets should be handed in by the
deadlines given above in these cases, you could hand them in at the lecture.
 MSc Macroeconomics (ECONM1011)

Essay Assignment

You should choose one of the essay questions from those below. The questions are similar in
style and (broad) topics to questions that could be asked in the exam for this unit.

For relevant reading, please see the reading list distributed at the start of the course, which is
also available on Blackboard with links to online articles and dictionary entries.

Drawing on material taken indiscriminately from around the web is not a good idea, because
some sources are more reliable and well-informed than others (especially on macro topics).

Note that the mark for this essay will not count towards your final mark for the unit; that final
mark will be based entirely on the exam.

Once you have written your essay, for example in MS Word, you should save it as a PDF and
submit the PDF electronically, via the Essays button on the Blackboard page for the course.

Email submissions will not be accepted. The deadline is 4pm, Monday 21 November.

Your essay should be no more than 1400 words in length. You should try to answer the
question you choose in a structured and analytical way. Make use of diagrams and/or models
where appropriate, and explain clearly the main points and the relevant economic intuition.

1. Set out the assumptions and results of the Solow model, and outline how log-
linearization can be used to study the dynamics near the steady-state.

2. Is inflation best seen as primarily a monetary phenomenon, or a fiscal phenomenon?

Explain your answer.

3. Briefly explain the Rational Expectations version of the Permanent Income Hypothesis,
and Ricardian Equivalence, and discuss the connection between these two theories.

4. Explain some of the main principles underlying optimal monetary policy rules.

5. Set out the main principles and results of the Shapiro-Stiglitz model of unemployment.
Examine the consequences of an improvement in monitoring technology, which makes
it easier for employers to detect shirking.

6. Describe a model of a small open economy with a role for traded and non-traded
goods, and discuss some of its main implications.
 MSc Macroeconomics (ECONM1011)

Tutorial Problem Set #1

1. (Basic revision: Growth rates)

a) Consider a variable in discrete time, given by = 0 (1 + ) . What is the

growth rate of this variable? If is measured in years, what annual growth
rate does = 0.025 imply?

b) Now in continuous time, consider a variable () which is given by (0) .

Show that this variable grows at the rate g.

c) Some cross-section growth regressions, such as those of Mankiw et al. (QJE

1992), use log () log (0) as the dependent variable, where is the
number of years since time zero. How is this related to the growth rate?

d) Imagine a country sees income double over 10 years, and then halve again
over the next 10 years. What is its average annual growth rate over the
twenty-year period? What would the measure in part (c) say?

2. (Revision: Solow model / growth accounting.)

Consider a version of the Solow model with a Cobb-Douglas technology, in which

aggregate output (Y) depends on efficiency (A) and inputs of capital (K) and labour
(L), so that:

= ()1

Efficiency (A) grows at rate x and the labour force at rate n. The rate of change of the
capital stock is given by:

where s is the saving rate, and is the rate of depreciation. Define quantities per
efficiency unit of labour as / and /.

a) Show that y can be written as a function of k.

b) Show that the rate of change of k is given by:

= ( + + )

c) Show that growth in output per worker can be written as a weighted average of
growth in efficiency, and growth in capital per worker:

/
/
= (1 ) +
/ /

d) Now consider a more general version of the Solow model, with production
technology (, ). You should assume this function has constant returns to
scale. Explain how the answers to (a) and (b) would be modified.
3. (Taylor series and log-linearization)

a) Using a Taylor series approximation, show that, for 0,

log(1 + )

b) Now consider a differentiable function () where > 0.

What is its derivative with respect to log ?

c) (Now in two dimensions.) Log-linearize + where a is some constant, and

assuming that 0 and 0.

d) Briefly discuss the potential strengths and limitations of analyzing

macroeconomic models using linearization or log-linearization.

4. (Consumption and the intertemporal budget constraint)

Consider a consumer who lives for two periods; begins life with no assets; earns a
return on asset holdings at the end of period 1; and receives labour income in
period , where = 1,2. There is no uncertainty, and consumption in period will be
denoted by .

a) Show that the assumptions imply an intertemporal budget constraint:

2 2
1 + = 1 +
1+ 1+
b) How would this change if the consumer holds assets at the start of period 1?

c) Briefly discuss the form that would be taken by the intertemporal budget
constraint were the consumer infinitely lived, in the absence of uncertainty.
 MSc Macroeconomics (ECONM1011)

Exercise Lecture 1

1. (Log-linearization and conditional convergence)

a) In the Solow model, the rate of change of capital per efficiency unit of labour is
given by:

() = = () ( + + )

where is the rate of technical progress and other notation is standard.

Show that a first-order Taylor series approximation of the function () around
the steady-state value of , denoted by , leads to an expression of this form:

( )
() | (log log )
log =

b) Using the above expressions, show that

( )
(1 ) ( + + )(log log )
( )

and provide a brief description of what the above expression represents.

c) Explain how your result in part (b) could be used to derive a growth
regression.

d) Discuss the speed at which the economy converges to its steady-state

balanced growth path.

2. (Consumption and the intertemporal budget constraint)

a) Consider a consumer who lives for two periods and maximizes

1
(1 , 2 ) = (1 ) + (2 )
1+

subject to:
2 2
1 + = 1 +
1+ 1+
 Using a Lagrangian, show that:

1+
(1 ) = (2 )
1+

b) Provide a careful interpretation of the above result, and discuss the underlying
assumptions.

3. (Consumption under uncertainty.)

a) Provide an economic interpretation of the following Lagrangian:

1
= [ ( ) (+ )]
1+
=0

1 1
+ [(1 + ) + {( ) (+ ) ( ) (+ )}]
1+ 1+
=0

b) Using the first-order conditions with respect to and +1 show that:

1+
( ) = [(+1 )]
1+

c) Provide an economic interpretation of .

d) Now consider the important special case of CRRA utility (isoelastic or

power utility) in which:

1 1
( ) =
1

where > 0. Consider a consumption problem under certainty, so that:

1+
( ) = (+1 )
1+

Show that, for this special case of the utility function, and when 0 and
0 we can write:

log +1 log

e) Interpret the role of the parameter .

4) (Understanding Halls result.)

Consider a consumer who lives for two periods. Income in period 1 is known and equal
to 1 . In period 2, there are just two possible states of the world: income is in state
of the world A, and in state of the world B. The probability of state of the world A is
denoted and this probability is known to the consumer in period 1.

a) Explain why:

1+
(1 ) = ( ( ) + (1 )( ))
1+

where is second-period consumption in state of the world A, and is

second-period consumption in state of the world B.

b) Now consider the special case in which = and the utility function is
quadratic. Starting from the expression given in part (a), show that:

1 = + (1 )

and interpret your result.

c) If > , is consumption in period 1 increasing or decreasing in ? Explain

your answer fully.
 MSc Macroeconomics (ECONM1011)

Tutorial Problem Set #2

1) (Difficult.) Consider this difference equation for the ratio of debt to GDP:

+1 1
= +
+1 (1 + )(1 + )

where / is the ratio of debt to GDP and / is the ratio of the primary deficit to
GDP. The parameter (1 + )/((1 + )(1 + )) where is the nominal interest
rate, is the inflation rate, and is the growth rate.

Assume the government always follows a fiscal rule which sets the ratio of the
primary deficit to GDP as follows:

= 0 1

a) (Revision.) Consider a difference equation +1 = + . What condition on

is needed to ensure its stability, and what is the equilibrium value of in that
case?

b) Show that long-run stability of the debt-GDP ratio will be ensured if 1 is chosen
as follows:
1 +1
(1 + ) ( ) < 1 < (1 + ) ( )

c) Show that the steady-state ratio of debt to GDP is then given by:
0
(1 + )(1 + ) (1 + ) + 1

2) Consider per-period costs of raising tax revenues :

( ) = 1 + 0.52 2

where you should assume ( ) > 0. Assume the government minimizes the
present value of these costs:

(+ ) = ( ) + (+1 ) + 2 (+2 ) +
=0

where is the discount factor, and where the minimization is subject to a sequence
of per-period budget constraints, the first of which is:

+1 = +
 using standard notation. You should take the sequence of government spending
as given; the government chooses sequences , +1 , and +1 , +2, ,

a) Write down the Lagrangian for this problem.

b) Derive first-order conditions with respect to , +1 and +1 .

c) By combining those three first-order conditions, derive a difference equation

which links +1 to . Provide a condition under which this difference equation
is stable.

d) Show that, in the special case where = 1/(1 + ), then +1 = .

3) Consider a household which has the following per-period budget constraint:

+1 + +1 = + (1 + ) + (1 + )

where are holdings of government bonds, are holdings of other assets, is

household income, are lump-sum taxes, is consumption, and and are the
(real) returns on bonds and other assets respectively. All quantities are in real terms.

The government has the following budget constraint:

+1 = ( ) +

a) Show that, if the two equations were to be combined, the households per-
period budget constraint would depend on but not on or .

b) Briefly discuss the potential implications of this result for the consumption
choices of the household, and for fiscal policy.
 MSc Macroeconomics (ECONM1011)

Tutorial Problem Set #3

1) Consider an economy where a fraction of consumers 1 have quadratic utility and

smooth their consumption, and a fraction of consumers are hand to mouth
consumers who always just consume their current income. You should also assume
the discount rate equals the interest rate at which the fraction 1 of consumers with
quadratic utility can borrow or lend.

a) In this setting, explain why the following equation holds:

= 1 + ( 1 ) + (1 )

where is consumption per capita at time , is income per capita at time ,

and can be interpreted as a shock to permanent income at time .

b) Using US data, Campbell and Mankiw obtained estimates of that were

roughly in the range 0.4 to 0.5. Briefly discuss the implications of this result for
Halls version of the permanent income hypothesis.

c) Briefly discuss the implications of the value of for short-run fiscal policy.

2) Consider a policy-maker minimizing the following loss function:

1 1
= ( )2 + ( )2
2 2
subject to the aggregate supply curve:

= + ( )

where the notation is standard. You should assume > 0, > 0, > .

a) Briefly describe the outcome that would obtain under commitment.

b) Show that, under discretion, the equilibrium inflation rate would be:

= + ( )

c) Briefly explain, intuitively, the factors that determine the extent of the inflation
bias.

d) Show that the policy-maker would have preferred the outcome that obtains
under commitment.

3) Consider the following model with backward-looking dynamics:

= 1 +

= 1 + (1 1 )

= 1 +

= 1 +

=
where is log output, is the real interest rate, is the inflation rate, is the flexible-
price (or natural) level of log output, and is the Walrasian level of log output which
forms a policy-makers output target. You should assume that and are
independent white noise processes, and observed by the policy-maker at time ; and
that the parameters satisfy > 0, > 0, 0 < < 1, 0 < < 1 and > 0.

a) Define the output gap as follows: = . Discuss whether monetary

policy in period affects the output gap in period , the output gap in period +
1, or both.

b) Assume that the policy-maker seeks to minimize:

= [( )2 ] + [ 2 ]

where > 0. Assume that the optimal policy rule takes the form:

[+1 ] = +1

where the optimal choice of is given by (you should NOT try to show this):

+ ()2 + 4
=
2
Based on the above expression, show that > 0. Provide an interpretation of
this result.

c) Assume that it can be shown that the optimal rule for the real interest rate is
given by:

= [ ] + +

Define the nominal interest rate as = + (+1 ). Show that the implied rule
for the nominal interest rate implies a coefficient on the output gap that is
greater than and a coefficient on inflation that exceeds unity. Provide an
economic interpretation of the latter result.

d) (Difficult.) Show that the optimal coefficients on inflation and the output gap are
both increasing in and provide an economic interpretation.
 MSc Macroeconomics (ECONM1011)

Exercise Lecture 2

1. (Shapiro-Stiglitz)

Using the same assumptions and notation as in the lectures, consider the following
expressions for the flow returns to employment for shirkers and non-shirkers,
respectively:

= + ( + )( )

= + ( )

a) Briefly explain, in words, why the returns to employment take these forms.

b) Show that, if workers are not to shirk, the wage must satisfy:

+ ( + + )

c) Explain why this expression will hold with equality in equilibrium.

d) Briefly explain why the equilibrium wage in this model is likely to be above the
market-clearing level.

2. (Matching functions)

Consider an economy with L workers, and a matching function whereby the number of
matches between unemployed workers (U) and the number of vacancies (V) is
(, ).

a) Assume that (, ) = (, ) for any (real) x. What does this imply about the
returns to scale, and why might it simplify the analysis of a model with matching
frictions?

b) Now write the number of matches between unemployed workers and vacancies as
(, ) when the unemployment rate is u and the vacancy rate is v, in an economy
with L workers. Show that, under constant returns to scale, the rate at which vacancies
are met by workers can be written as (/, 1).

c) Define / and the function () ((1/),1). Show that the rate at which
vacancies are met by workers can be written as ().

d) Show that the rate at which unemployed workers are met by vacancies can be written
as ().

e) Provide an economic interpretation of / and use it to interpret your answers to

parts (c) and (d).

f) Using the same notation as in the lectures, write down an expression for the flow return
to opening a vacancy, relating it to the value to the employer of a filled job (J).
 g) How could your answer to (f) be modified if new workers had to be trained on hiring, at
a one-off cost to the firm of H?

3. (Nash bargaining)

In a matching approach to the labour marker, denote the value to a firm of a filled job
by , of employment to a worker by , and of unemployment to a worker by . The
firms outside option is 0. These assumptions imply that the total match surplus
available to a matched worker and firm is given by ( 0) + ( ). Flows are
discounted at a rate .

You should assume that / = (1/), / = 1/, / = 0 (why?)

The match surplus is divided between the firm and the worker by Nash bargaining, so
the wage is based on the following optimization problem at each instant:
1
max ( )

Show that the first-order condition for the optimization problem implies

= ( + )

and provide an economic interpretation of this expression, and of .

 MSc Macroeconomics (ECONM1011)

Tutorial Problem Set #4

1. (The Mundell-Fleming model)

Consider this three-equation system describing a small open economy:

IS: = ( + ) + +

LM: = +

BP: = + (+1 )

where all lower-case variables are in logarithms; is home output and is foreign
output; is the (fixed) money supply; the home and foreign price levels and are
also considered fixed; and the world interest rate is also exogenous. The nominal
exchange rate is denoted and government purchases are denoted by . The
endogenous variables are , and the home interest rate .

a) Consider a long-run equilibrium in which = . Show that the long-run

solution for the other endogenous variables, dropping time subscripts, will be:
1 1 +
= ( ) + ( ) ( ) + ( ) ( )

= +

b) Do the results given in part (a) suggest that fiscal policy will be effective or
ineffective? Explain your answer.

2. (Consumption in open economies)

Consider a representative household which seeks to maximize:

(+ )
=0

with respect to consumption + , net foreign assets + , and capital + , subject to

the open-economy budget constraint at each date:

( ) = + +1 (1 ) + +1 (1 + )

where ( ) is the production function and is the real return on foreign assets at
time , and other notation is standard. Quantities are in real terms.

a) By writing down a Lagrangian, or otherwise, show that:

( )
= (1++1 )
(+1 )

and that the marginal product of capital is given by:


(+1 ) = + +1

b) Discuss how the two expressions in part (a) contrast with the relevant
expressions for a closed economy.

c) Outline the convergence process for (i) GDP and (ii) GNP.

d) Discuss the role of a debt-elastic interest rate in open economy models.

3. (A two-sector small open economy model)

Consider a two-sector small open economy described by:

( ) =

[( ) ( ) ] =

( ) =

[( ) ( ) ] =

where the notation follows Lecture 8. You should assume perfect capital mobility
across countries, and that the price of the traded good is exogenous.

a) Explain why the second of these equalities takes the form that it does.

b) What do these four equations imply about the forces influencing the real
exchange rate?