1 This paper is not to be removed from the Examination Halls 1
UNIVERSITY OF LONDON
BSc degrees in Economics, Management, Finance and the Social Sciences,
the Diploma in Economics and Access Route for Students in the External
Programme
Wednesday, 14 May 2003 : 10.00ani to 1.00pm
Candidates should answer EIGHT of the following FOURTEEN questions: FIVE froin
Section A (5 nlarks each) and THREE fro111Section B (25 marks each). Candidates are
strongly advised to divide their time accordingly.
PLEASE TURN OVER
c University of Lolldoll 2003
ULO31483
SECTION A. Answer FIVE questions from this section (5 marks each)
1. The US interest rate in 1995 w a approximately at the same level of 1960, but the
ratio of money t o nominal income was half its 1960 level. How can this evidence be
reconciled with the money market equilibrium?
2. 'Interest rates can only differ across countries because of expected changes in the
exchange rates'. Comment.
3. 'The US cannot eliminate t,heir public deficit unless they eliminate their trade deficit'.
Comment.
4. Consider an economy with 30 million working age population, of which 15 million
are working, 3 million are searching for work, 3 million gave up searching, and the
remaining 9 million are not willing to work. Compute the labor force, the unemploy-
ment rate and the participation rate in this economy.
5. 'Higher taxes decrease the value of the Keynesian multiplier'. Discuss
6. An unexpected lot,tery prize of 20,0002 would have a stronger impact on current
savings than an annual increase in labour income by 1,0002 for 20 years. Comment.
SECTION B. Answer THREE questions from this section (25 marks each)
7. Consider a small open economy with flexible exchange rates and initial output equal
to the nat,ural level, in which the Central Bank decides t o permanently increase the
money supply.
a. Represent the short-run impact of such policy in the IS - LM and AD - A S
diagrams. Also say what happens to output, consumption, investment, net ex-
ports, prices, nominal and real interest rates, nominal and real exchange rates.
b. Represent in the same diagrams the long-run impact of such policy (once all
adjustments have taken place), and say what happens to all variables of point.
(a>.
c. Say briefly how your answers would be affected under a hed-exchange rate
regime.
PLEASE TURN OVER
8. Two count,ries i and j have t,he following identical aggregate product,ion function:
= AK:-~N:.~, where Kt is the aggregate capital stock in period t , and Nt is the
workforce in period t . Both economies save a constant fraction of income, capital
depreciates by 3% per period, and population grows by 2% per period.
a. Provide the per-capita production function in these economies.
b. Suppose that economy i saves 10% of income, and that its initial capit.al per
head is kio = 1. Economy j saves 20% of income, and that its initial ca.pita1per
head is k o= 0.5. Compute steady state income per head in each economy, and
the growth rate of capital per head between period t = 0 and t = 1.
c. Compare initial and steady state per-capitfa income levels across countries and
comment.
9. Consider an initially closed economy, which opens to international trade and capital
flows.
a. Explain what happens to the IS curve (its slope and shift factors).
b. Explain what happens t o the LM curve (its slope and shift factors).
c. Explain what, ha.ppens to the domestic interest rate.
10. Suppose that an economy can be described by the following system of equations:
where ut denotes the unemployment rate in year t , 7rt denotes the rate of inflation,
gmt denotes the rate of money growth, gyt denotes the growth rate of out,put. Sup-
pose that initially (at t = 0), the unemployment rate is equal to the NAIRU (non
accelerating inflation rate of unemployment), and inflation is 25%. The Central Bank
engages into a disinflationary program, which is meant to reduce the rate of inflation
by 5 percentage points each year for 4 consecutive years, starting from the initial
value of 25%.
a. Give an economic interpretation of equations (1):(2), (3). Compute the NAIRU
for this economy.
b. Provide a table containing data on the implied evolution of r t , ut, gyt, gmt for
t = 0, 1; ..., 6.
c. Provide an economic int,erpreta,t,ionfor the trajectory of each of these variables.
11. Explain each of the following and their importance in macroeconomics:
a. Menu costs.
b. Taylor's rule.
c. Seignorage.
12. Explain each of the follo~~ing
concepts:
a. Frictional unemployment.
b. Unemployment hysteresis.
c. Real wage unemployment.
The following quote is taken from "The General Theory" of J. M. Keynes: Profes-
sional investment m a y be likened to those newspaper competitions in mh,ich competi-
tors have t o pick out the six prettiest faces from a hundred photographs, the prize
being awarded t o the com,petitor whose choice most nearly corresponds to the average
preferences of the com,petitors as a whole; so that each competitor has to pick, not
those faces which h e h i m s e ~ f i n d sprettiest, but those he thinks likeliest to catch the
fancy of the other competitors, all of w h o m are looking at the problem from the same
point of view. It i s not a case of choosing those which, to the best of ones judge-
ment, are really the prettiest, n o r even those which average opinion genuinely thinks
the prettiest. W e have reached the third degree where we devote our intelligences to
anticipating what average opinion expects the average opinion to be.
a. What are the factors t,hat explain stock prices according to Keynes?
b. Outline a different theory for determining stock prices.
c. Assume that an asset paying zero dividend is being traded. If agents are rational,
the price of this asset is equal to zero. Comment.
14. Consider an economy represented by the AD/,4S model. Suppose that there is an
increase in the price of raw materials imported.
a. Represent the short- and long-run impact of such policy on output and prices.
PLEASE TURN OVER
b. Policy authorities wish to use demand-side policies in order to count,era.ct.the
effect of the supply-side shock. How could the Central Bank intervene, and what
would be the effect of the intervention?
c. How could the Government intervene, and what would be the effect of the in-
t ervelit ion?
END OF PAPER.
