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Section A
Answer all of the following questions:
1) A consumer has an income of £100 in period 1 and no income in period 2. In scenario I
the interest rate is 10%, while in scenario II it is 5%. Based on this information, which of
the following statements must be correct? (5 marks)
a. The consumer is able to consume more in period 2 under scenario I than under
scenario II, as her savings earn a higher interest in the former than in the latter.
b. The consumer consumes less in period 1 under scenario II than under scenario I,
as she is less impatient under scenario II.
c. The substitution and income effects of the interest rate rise partially offset each
other, resulting in lower consumption in period 1 under scenario II.
d. The consumer is unambiguously worse off in scenario I, because the interest rate
is higher.
2) Which of the following statements regarding asset price bubbles is correct? (5 marks)
a. Market participants can easily find out whether or not there is a bubble by
comparing the market price with the fundamental value of the asset.
b. Bubbles occur only when investors disagree about the fundamental value of an
asset.
c. According to the efficient market hypothesis, bubbles cannot occur.
d. It is irrational to buy or sell an asset when there is a bubble.
(Continued…/)
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3) Consider a scenario where the Bank of England views the UK economy to be overheating
and is attempting to slow the economy down using monetary policy. Which of the
following statements regarding the effects of an interest rate rise is correct? (5 marks)
a. It leads to the UK exports becoming cheaper and imports becoming more
expensive.
b. It will bring inflation down and stimulate the economy.
c. It has opposing effects on the UK’s aggregate demand (AD): it discourages
investment, which lowers AD, but results in cheaper imports, which boosts AD.
d. It leads to higher demand for GBP, which results in an appreciation of the GBP.
4) Which of the following statements about the new Keynesian model of monetary policy is
correct? (5 marks)
I. The Taylor principle states that the Central Bank must respond sufficiently
aggressively to a recession in order to keep inflation under control.
II. The new Keynesian Phillips curve can be thought of as an aggregate supply equation.
It describes the effect of output on inflation.
a. Both statements are true.
b. Statement I is true, statement II is false.
c. Statement I is false, statement II is true.
d. Both statements are false.
(Continued…/)
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5) Consider the two period model studied in class. Which of the following statements is
correct? (5 marks)
a) The twin deficits can arise only if Ricardian Equivalence does not hold
b) The twin deficits cannot arise if the Ricardian Equivalence holds and the fiscal deficit
is due only to increased government spending
c) The twin deficits cannot arise if the Ricardian Equivalence holds and the fiscal deficit
is due only to a decrease in current taxes.
d) The Ricardian equivalence implies that fiscal deficits can never occur
6) A terms-of-trade shock is: (5 marks)
a) equivalent to an interest rate shock
b) equivalent to an uncertainty shock
c) equivalent to an endowment shock
d) equivalent to an investment shock
7) The country Pancraziland exports a large quantity of pizzas and does not import any good
or service. Also, Pancraziland has issued a large quantity of government bond, which are
held by international investors. Finally, Pancraziland does not hold any assets, its net
international compensation of employees is zero, and its net unilateral transfers are zero.
Which of the following statements is true? (5 marks)
a) Pancraziland’s current account is surely positive.
b) Pancraziland’s current account is surely negative.
c) Pancraziland’s current account is surely equal to zero.
d) None of the above
(Continued…/)
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8) Consider a two-period production small open economy as studied in class. Assume that
the instantaneous (i.e. per-period) utility function of consumers is logarithmic. A decrease
of uncertainty about future productivity implies: (5 marks)
(a) Lower Consumption in the current period
(b) Higher Consumption in the current period
(c) An improvement of the trade balance in the current period
(d) No changes in consumption in both periods
(Continued…/)
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Section B
Answer BOTH of the following questions
[QUESTION 1]
In this question, you are asked to think about the macroeconomics of the Covid-19 pandemic.
a) Most industries and firms suffered from the pandemic, experiencing sharp drops in profits
and employment. However, some firms benefited from it. As an example, think of relatively
new technologies for video meeting software, like Zoom, Teams or Skype. Because these
technologies are complementary with working from home, demand for them rose
dramatically when lockdowns started, and their stock prices soared, see e.g. the stock price of
Zoom Video Communications Inc in the figure below. An investor decides that, despite this
spectacular performance of the stock, not to invest in this company, because she believes
there to be a bubble. Do you agree there may be a bubble in Zoom’s stock price? Why (not)?
Does the fact that the pandemic increased sales make it more or less likely that a bubble
developed? Why? (10 marks)
Figure 1. Stock price of Zoom Video Communications Inc
(Question 1 continues on the next page…/)
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We now turn to the policy response to the pandemic, in particular the response of the Central
Bank. For the remainder of this question, please assume that the economy is well described by
the new Keynesian model, as summarised by the following three equations:
௧ = ∗ − (௧ − ௧௧ାଵ − ∗) + ௧௧ାଵ + ௧
௧ = ௧௧ାଵ + (௧ − ∗) + ௧
௧ = ଴ + గ௧ + ௬௧ + ௧
where ௧ is output, ௧ is inflation, and ௧ is the nominal interest rate, ௧ and ௧ are shocks, and
the remaining letters are parameters of the model.
b) Some economists have argued that the Covid-19 pandemic should be thought of as a supply
shock, whereas others argued it was shock to demand. Give at least one reason for each
viewpoint. Why does the difference matter for monetary policy? Explain your answer
referring to the equations of the new Keynesian model above. (10 marks)
c) Interest rates affect consumption through a substitution effect and an income (or wealth)
effect. Usually, we assume the substitution effect dominates. Suppose instead that the income
effect dominates. How would this affect the policy response of the Central Bank to the
pandemic? (10 marks)
(Continued…/)
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[QUESTION 2]
Consider a two-period model of a small open economy with a single good each period
and no investment. Let preferences of the representative households be described by the
following utility function.
൫ଵ , ଶ ൯ = ln൫ଵ ൯ + ln(ଶ ),
The representative household has initial net foreign wealth equal to 0, i.e. ଴
௣ = 0, where ଴
௣
denotes net foreign wealth of private agents. The household is endowed with ଵ = 10 units
of good in period 1 and ଶ = 10 units of good in period 2. The world interest rate paid on
assets held from period 1 to period 2 is 10%, that is ∗ = 0.1, and there is free international
capital mobility.
a) Calculate the equilibrium levels of consumption in period 1, ଵ , consumption in period
2, ଶ , the trade balance in period 1, ଵ , and the current account in period 1, ଵ .
[7 marks]
b) Suppose now that the government imposes capital control that requires the country’s net
foreign asset position at the end of the period 1 to be non-negative, i.e. ଵ
௣ ≥ 0. Is the
representative household’s optimal choice affected? If yes, why? If no, why? [5 marks]
c) Now assume that instead there is uncertainty on period 2 endowment. Specifically, ଶ =
10 + with probability 0.5 and ଶ = 10 − with probability 0.5. is a positive
number. Is the trade balance in period 1 affected? If yes, why? If no, why? [6 marks]
Now let’s go back to the case with no uncertainty, that is ଶ = 10, but we introduce
fiscal policy. Let ଵ and ଶ denote the consumption tax rates in period 1 and 2,
respectively. The government starts period 1 with no outstanding assets or liabilities, i.e.
଴
௚ = 0. It taxes consumption at the same rate in both periods, i.e. ଵ=ଶ, and consumes
1 units of goods in each period. That is, ଵ=ଶ = 1, where ଵ and ଶ denotes
government consumption in period 1 and 2, respectively. Like the household, the
government has access to the world financial market.
d) Start with the equilibrium condition when there are consumption taxes and the
intertemporal budget constraint of the household, to find the optimal consumption plan
as a function of the tax rate. [4 marks]
(Question 2 continues on the next page…/)
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e) Use the government budget constraint to determine the resulting tax rate. What are the
equilibrium level of consumption, trade balance, private savings, the primary and
secondary fiscal deficits, and the current account in periods 1 and 2? [4 marks]
f) Suppose now that the government implements a stimulus package consisting in reducing
the tax rate by half in period 1, with government consumption unchanged in both periods.
How does this expansionary fiscal policy affect private consumption, the trade balance,
the current account, the primary and fiscal deficits in period 1 and the tax rate in period
2? Briefly explain your results. [4 marks]