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TERM 3, 2020-2021, Final Coursework
ECON0016: MACROECONOMIC THEORY AND POLICY
TIME ALLOWANCE: as specified in the submission window
Answer all questions
The coursework has 75 per cent of your final mark.
Part A: Answer all questions from this section. For each question, identify the statement as True,
False, or Uncertain, and explain your reasoning (in total of not more than 120 words not including
figures). The maximum marks for each question will be given for a full and correct explanation. You
may use written, diagrammatic, and mathematical arguments as appropriate.
1. The UIP condition predicts a negative correlation between the movement of the exchange
rate in the period when the announcement of a surprise tightening of domestic monetary
policy is made and its movement thereafter. Assume a one-period tightening. [4 points]
Answer.
True.
Statement of the UIP condition with explanation of variables [2]

On the announcement, the arbitrage condition requires an immediate appreciation of the home
exchange rate such that the interest gain from holding home bonds is exactly equal to the expected
capital loss from holding home currency for the duration of the expected interest rate differential. [1]
At the end of the period, when the interest differential disappears, the exchange rate must be equal
to its expected value. Hence it must depreciate following the initial appreciation. This is a negative
correlation as stated in the question. [1]
2. A different policy response accounts for the fact that the economic performance of oil-
importing countries following the oil shock in the 2000s was better than that following the oil
shock of 1979. [4 points]
Answer.
Uncertain.
In both cases, macroeconomic policy was non-accommodating [2]. However the context was very
different. In 1979, inflation was high and inflation targeting had not been introduced. The aftermath
was a period of high unemployment as the cost policymakers were willing to bear to bring inflation
down. [1] In the 2000s, inflation was low and inflation targeting was in place. Inflation expectations
were well-anchored. Real wage resistance was a less important phenomenon in the latter episode
partly due to the weaker role of trade unions in wage setting. The depressive demand side effect of
*
1log log
E
t ti i e e+- = -
2

the shock was mitigated in the 2000s by greater access of households to credit. The buoyancy of the
global economy in the 2000s also played a part. [1]
3. Suppose that home-country firms set the foreign currency price of goods sold in foreign
markets at the same level as the price set by firms producing similar products based in the
relevant export market. Such a strategy insulates home-country firms from losing market
share in foreign markets when there is an unexpected rise in costs at home. [4 points]
Answer.
False.

[2 for correct definitions] Although there may be a short term insulation as no price differential
emerges in the foreign market, home’s profit margins are squeezed by a rise in home costs and this
affects their ability to compete via non-price dimensions such as product quality. [2]

4. Because of its industrial structure and the specific impact of the pandemic, firms in country A
experience a permanent reduction in productivity that is not experienced elsewhere. Assume
wage-setting is based on the consumer price index and that the central bank targets inflation.
We would predict the following for country A in the post-shock medium-run equilibrium: [4
points]
Real exchange
rate
Real
(consumption)
wage
Inflation Unemployment
Post-shock
medium-run
equilibrium
Depreciated Lower Higher Lower


Answer
See the table.
Real exchange
rate
Real
(consumption)
wage
Inflation Unemployment
Post-shock
medium-run
equilibrium
Depreciated Lower Higher Lower
Solution Appreciated Lower Unchanged Higher

*
*
*
is unchanged by a change in home costs
Use to define competitiveness
XP P e
P eQ
P
ULC eRULC
ULC
=
º
º
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[2] for correct answers in the table.
Impact on the WS/PS(q) equilibrium: downward shift in PS; hence a lower equilibrium level of output.
This shifts the downward-sloping ERU curve to the left. At the new equilibrium, the real consumption
wage shown on the PS(q) is lower. [1] The implication (shown using AD/ERU diagram) is a new
medium-run equilibrium with an appreciated RER (explanation – for output demanded to equal the
new lower equilibrium output, and given r=r*, net exports must be lower and this is achieved via real
appreciation). At MRE, inflation is unchanged at the inflation target. Higher unemployment reflects
the lower level of output. [1]
Note on diagram: the appreciated RER implies that the PS(q) in the new MRE will reflect both the
appreciation and the lower productivity but must leave the real consumption wage lower than initially.

5. Consider a 2-bloc model of the world economy with initially identical blocs, each with an
inflation-targeting central bank. A simultaneous and identical positive supply shock occurs in
each bloc. Assume that the supply-side equilibrium relationship, the ERU curve, is vertical.
The real interest rate in the world and in each bloc is lower in the new medium run equilibrium
but real exchange rates are unchanged. [5 points]
Answer
True.
In the new MRE, output is higher in the world economy and by an equal amount in each bloc. The
world real interest rate and that in each bloc is lower. [2]
Since equilibrium output is higher, in order for aggregate demand to be at the higher level, the real
interest rate must be lower. [1] Since the blocs are identical and so is the shock, the change in the
real interest rate is identical for each [1]; there is no change in the RER because of the symmetry of
the shocks. [1]
The AD curve is right-shifted for each bloc because of the lower r*. Inflation is unchanged and at target.
Note for any comments about adjustment: ( not required in the question to get full points).
The only way the new lower world interest rate can occur is through the actions of the two central
banks.
Following the shock, each economy would experience lower inflation due to the down-shifted Phillips
curves. Each central bank would reduce the interest rate by the same amount according to the MR
curve. Since there is no interest rate differential, there is no change in the exchange rate and the RUIP
condition does not come into play. The adjustment to the new equilibrium takes place without any
change in the RER so it looks like a closed economy process for each bloc without any shift in the IS
curves taking place. (To show this in the AD/ERU diagram, adjustment takes place along the q=0 line
in each bloc.; the IS is the policy implementation curve not the RX.)


6. Excessive government debt was the trigger for elevated bond yields in Eurozone countries in
2010. [4 points]
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Answer.
False.
[2] for recognition that it was the banking crises and not government debt that triggered the rise in
bond yields. (If Greece is discussed specifically, then the answer is ‘uncertain’ and full points given
here.)
The trigger for the elevated bond yields was not excessive government debt. It was the collapse of
Lehman Brothers and the failure of large banks in small countries like Ireland that focused attention
of the market on bailouts by governments – and therefore on the solvency of governments. The risk
of government default became salient in the EZ because of the absence of a lender of last resort to
government, i.e. a national central bank. [1] A comparison between Spain and the UK in 2010
exemplifies the difference that a national central bank makes. Spain’s debt ratio was lower than the
UK’s but its 10 year bond yields were driven up well above those of the UK. [1]
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Part B. (on the theme of debt dynamics and fiscal policy) Answer all parts of question B in a total of
not more than 1800 words (not including equations and figures). Answers must be typed; Figures and
equations can be hand-written and pasted into the document; you may also paste data charts and
simulation output as appropriate.
[Context] Since the outbreak of the pandemic in 2020, we have seen rapid monetary and fiscal policy
responses. The Bank of England cut the policy interest rate to support business and consumer
confidence; it released the counter-cyclical buffer in bank lending to further support the ability of
banks to supply credit. The fiscal policy response was also decisive to contain and mitigate the adverse
impacts from the pandemic.
However, spending measures such as the furlough scheme and loans to small business mean that the
government debt increased rapidly. In May 2020, the UK government debt-to-GDP ratio exceeded
100% for the first time since the 1960s (See Figure 1). The Office for Budget Responsibility (OBR)
forecast a budget deficit of £373 billion in 2020/21 in their November 2020 Economic and Fiscal
Outlook. This is equivalent to 18% of GDP, the highest level since 1944/45. The OBR also forecast a
deficit equivalent to 16.7% of GDP if the second wave of infections is kept under control, and 21.7%
of GDP if the lockdown is extended and vaccines are ineffective in keeping the pandemic in check.
Figure 1: The UK government debt to GDP ratio over time

Source: Office for National Statistics & OBR
Figure 2: The 10-year government bond yields (%)

Source: Bank of England
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a) How does the government finance its budget deficit? Is there a conflict between monetary and
fiscal policy in response to the pandemic? You can compare the experience in 2020 with that
during the global financial crisis (2008-2009). [15 points]
Suggested answer:
A student can pass this component by explaining the methods by which the government can finance
its deficit. [8]

Taking the thought experiment of a combined monetary-fiscal authority, there are three ways of
financing: tax, issuing debt, and inflation (another form of tax). Given the independence of the
central bank, the fiscal authority can tax or issue debt.
In the context of the pandemic when there is the priority is to support aggregate demand, taxing
the economy is not appropriate, so the government needs to issue debt.
The central bank eases monetary policy to the ZLB and implements QE, purchasing bonds in the
secondary market. This keeps downward pressure on yields at the long end of the yield curve and
the government is able to borrow (in the primary market) at low interest rates (negative real rates
on COVID borrowing). In practice, coordination occurs through QE buying long-term government
debt from financial institutions, which push them to purchase newly issued government debt.
Reward extra points if one can notice that during the global financial crisis (2008-2009) the
dramatic fall of aggregate demand reduces inflation expectation and raises the real interest rate
for government debt financing. The central bank implements QE to anchor inflation expectation,
pushing down the cost of government financing. A similar pattern occurs during the pandemic,
but the quicker monetary-fiscal interactions generate a much smaller fall in inflation expectations
and smaller rise in interest rate in 2020.

In the context of the collapse in aggregate demand, inflation is not able to provide a way of
financing government spending. Monetary and fiscal policy coordinate to prevent deflation. [7]

b) Assume that the UK real economy in 2020/21 contracts by 10%; and that from 20/21 onwards,
the growth rate of real GDP is 2% p.a. and the primary deficit is 2% of GDP.
Using these assumptions together with the range of the OBR forecasts for the deficit in
2020/21 and the data presented in Figure 2 on the interest rate trend, calculate the UK
government’s debt-to-GDP ratios in 2021, 2022, and 2023.
Comment on your results and on whether an austerity program is needed to stabilize the
government debt to GDP ratio during this time period. [10 points]
Suggested answer:
A student can pass this component by correctly writing down and explaining the debt
dynamics equation. [4]

We will use the real rate -3% from the graph (although there will be variations in the rate read off
the graph), then we will apply the debt dynamic equation to calculate the UK government’s debt-
to-GDP ratios in 2021, 2022, and 2023.
First, the good scenario: = 16.7%; The debt-to-GDP ratio !!"!" = 100.9%, and the debt to
GDP ratio grows 16.7% + (−3%− (−10%))!!"!" = 23.76%, so in mid-2021, the debt-to-
GDP ratio will be !!"!# = 124.67%;
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In mid 2022, and 2023, we are back to normal years !!"!! = !!"!# + 2%+ (−3%− 2%)!!"!# = 120.44% !!"!$ = !!"!! + 2%+ (−3%− 2%)!!"!! = 116.42%

Second, the bad scenario: = 21.7%; The debt-to-GDP ratio !!"!" = 100.9%, and the debt
to GDP ratio grows 21.7% + (−3%− (−10%))!!"!" = 28.76%, so in mid-2021, the debt-
to-GDP ratio will be !!"!# = 129.66%;
In mid 2022, and 2023, we are back to normal years !!"!! = !!"!# + 2%+ (−3%− 2%)!!"!# = 125.18% !!"!$ = !!"!! + 2%+ (−3%− 2%)!!"!! = 120.92%

[3]

During the time period examined, consistent with a primary deficit, the debt ratio declines
due to the extent of the excess of the growth rate over the real interest rate. So in answer to
the question, it is not necessary to have an austerity programme (i.e. a primary surplus) in
order to stabilize the debt ratio over the years specified.

With interest rate of = −3% so much lower than the growth rate of 2%, it is easy to see
that the debt-to-GDP ratio can be (eventually) stabilized at 40%. But from the calculation you
can see that it will take decades to reach that level since the debt level is already high. And
the assumption of such a low real rate of interest over a long period of time is not justified.

It is possible that the high level of debt (or some other development in the economy) may
raise the interest rate above the growth rate, so an austerity plan for the future is useful to
replace the primary deficit by a surplus; however, doing this too soon would affect the growth
rate adversely. So, the road ahead is tough, and the subtle balance of deficit, interest rate and
growth needs to be constantly watched.
[3]

c) Now, consider an economy that belongs to a common currency area (CCA) and experiences a
large permanent country-specific negative aggregate demand shock. Your task is to compare the
policy response and economic outcomes in the CCA member with an otherwise identical
country that has a flexible exchange rate. Assume that the policy maker in each country has the
same loss function. The outcomes comparing the scenarios using the macroeconomic simulator
with a negative demand shock of 3% of GDP are provided for use in your answers. [15 points]
(i) Present a summary of the medium-run outcomes for the following aspects of
performance for each economy, highlighting similarities and differences: inflation, output, the
real exchange rate, the budget deficit, the debt to GDP ratio, and the trade balance. You can
refer to the simulation results, results from models or both.
(ii) Provide an interpretation of your results and what you learn from them about
stabilization policy in each exchange rate regime.
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(iii) Compare the adjustment process to the new equilibrium that takes place in the two
cases, explaining the policy measures implemented and commenting specifically on the role of
the nominal exchange rate.

Answer.
A student can get close to passing this component by accurately reporting on the
differences shown in the simulator output (i.e. (i) above). [5]

(i) and (ii) If the policy maker in each case has the same loss function, the medium run
outcome will differ because for the CCA member as compared with the flexible rate
economy, there will be a less depreciated real exchange rate, a lower rise in net exports and
higher government spending as stabilization is carried out using fiscal policy. Hence the
budget deficit will be higher in the medium run equilibrium and the debt to GDP ratio will be
rising. Full marks for being clear that success in targeting inflation is insufficient to prevent a
change in the real exchange rate with the associated implication that fiscal policy must
permanently fill the aggregate demand gap under fixed exchange rates. [5]

(iii) The insight that the real exchange rate depreciates by less in the fixed exchange rate
case because of the role of the jump nominal depreciation in the flexible exchange rate case
is key to getting very high marks for this question. [5]



d) What are the lessons for the management of public debt in Eurozone member countries in
the aftermath of the pandemic from the sovereign debt crisis in 2010-2012? [10 points]
Answer.
A student can pass this component by defining a sovereign debt crisis and connecting the EZ
sovereign debt crisis with the absence of a lender of last resort to the government in a member
country. [4]
The EZ’s sovereign debt crisis signalled the importance of a national lender of last resort in a
situation where doubts arise about the ability of the sovereign to service its debt. In the
pandemic levels of government debt rose dramatically across EZ members. The rapidly
corrected glitch in communication when Christine Lagarde suggested on March 12 2021 that
the ECB might not do ‘whatever it takes’ to prevent bond yields from rising highlighted the
continuing gaps in the EZ governance structure. This suggests that EZ members have to be
more mindful of the bond market and therefore more concerned about debt stabilization
and market expectations than is the case for an economy outside the EZ with its own CB.

Reward students who use their own research here. [6]

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ECON0016 Summer Assessment. Supplementary material provided to students.

This output is generated using the Macroeconomic simulator imposing a permanent negative
demand shock of 3% of GDP and comparing the results for a flexible and a fixed exchange rate
economy. In each case, the policy maker minimizes the same loss function.



















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