2019 Midterm Exam (solutions) PDF

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INTERNATIONAL MACRO

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INTERNATIONAL MACROECONOMICS SOLUTIONS - SYNTHESIS Exam – PARTIAL - MARCH 2019 – 45 MINUTES • The exam is worth 15/30. The exam is composed of 2 questions. Answer all questions. Each question is worth 7.5/30 points. To pass the exam the grade has to be at least 9/30. The final mark is the sum of the points assigned to each answer. Laude in the final mark is possible when the exam is outstanding. • Students cannot ask proctors any questions on the exam contents, and however any proctor answer on the exam questions is irrelevant. • You must always motivate your answers. Answers without explanation will not be evaluated. Any kind of mistake and/or omission and/or ambiguities is an error, that is worth at least 1 point. • Students must fill in the box on the top left corner with personal details and they must sign for acceptance the Rules of the Honor Code. Exams without personal details and signature will not be graded. • In order to withdraw from the exam, students must sign in the box on the top right corner. Students who do not sign in the appropriate space will have their grade registered. Students can decide to withdraw at any time. • Only students who intend to hand in the exam or withdraw may leave the room, but no student will be allowed to leave in the last 5 minutes before the end of the exam. To answer you must use only the sheets enclosed, by writing in the proper spaces with a blue or black ink pen (you can use a pencil only to draw graphs) and your handwriting must be readable. In the last sheet you will find a space useful to complete your answers. As rough copy you can use the back front of the sheets. The solutions will be posted on the blackboard. The paper show rules – including the date - will be communicated with the grades; students cannot call for postponing/anticipating the paper show or for sending clarifications by email and cannot delegate any person; no exceptions are allowed. Rules of conduct during exams or other tests. During exams, students must remain quiet and may not use any external support aids, whether paper or digital (e.g. manuals, lecture notes, personal papers, books, publications, calculators, cell phones, handheld computers or other electronic devices), if not expressly authorized by the teacher in class. In addition, students may not copy or look at other students’ exam paper or contact or attempt to contact other people in any way. Students must remain in the classroom for the whole of the time and only for the time needed to finish his or her exam, unless teachers in class give other orders. Students who have questions for the teacher must raise their hand and wait for the examiner to come to them. At the end of the exam, students must return the exam script and the exam paper to the examining faculty member and leave the room. Any breach of these regulations or any other orders given by the faculty member present at the time of the exam will result in the test being cancelled and an official report sent to the Disciplinary Board in all cases. All disciplinary sanctions will be recorded in the student’s academic career. Sanctions greater than a warning will result in forfeiture of benefits for the right to study (scholarships, housing etc.).The Honor Code and detailed regulations for taking exams and other tests are published on the University website http://www.unibocconi.eu/honorcode.

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QUESTION ONE A) In 2019 in Country Alpha the economy behaves consistently with our basic model with constant expectations (CE), which are equal to zero. All the usual assumptions hold, but four: the mark up level is equal to the 2018 level; the flexibility in the labour market is equal to one; the labour productivity is equal to one; the financial accelerator is zero. Derive step by step the supply curve and the demand curve, and finally the equilibrium values of both output growth and inflation. *) Supply Side: in this case inflation depends on both wage growth and uncertainty:

π =ω+u

(1)

Where π= rate of inflation; ω = wage growth; u = uncertainty. *) Labour market: the nominal wage is the market clearing price. The nominal wage depends on employment growth, taking into account that the rigidity factor is b = 1 . Therefore:

ϖ =n

(2)

Where n is the employment growth. *) Production Function: The output growth depends on both employment growth and capital growth:

y = αn + β k

(3)

With k=0 – i.e. medium run horizon - the relationship between output and employment is identified (α= productivity factor). Therefore the labour demand becomes - with the inefficiency factor ε=1/α = 1 in this case :

n= y Equation (2) becomes:

ϖ=y Equation (1) defines the relationship between the supply of goods and services and inflation:

y =π −u *) Demand side: the aggregate demand depends on two components, i.e. changes in: the “real” demand for goods and services; the real money growth:

y = a + (m − π )

(4)

The central bank controls monetary and banking policies: __

__

m=m

J=J

(5)

Therefore the equilibrium levels of both output growth and inflation are as follows: __

( a + m) − u y* = 2

(6)

__

( a + m) + u π* = 2

(7)

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B) “In 2019 in Country Alpha the central bank increases the money supply ; such change triggers i) an increase in the output growth; ii) an increase in inflation; iii) an increase in the nominal wage growth ”. True or false? Sign your answers and motivate them economically, using also a graphical explanation. Finally: define the Phillips Curve.

i) ii) iii)

O TRUE X O TRUE X O TRUE X

O FALSE O FALSE O FALSE

In an economy with CE monetary policy is effective, i.e. its changes cause changes in the aggregate demand, and then in the output growth, in the employment growth, in the nominal wage growth and finally in inflation. In fact from the equilibrium solutions (5) and (6) it is evident that a change in the money supply influences the output growth and the inflation, while from equations (3) and (2) it is evident that also the nominal wage growth will increase. Graphically:

AS π

π** π*

AD’ AD y y*

Finally: Phillips Curve

= the

y**

inflation rate is inversely correlated with the unemployment rate.

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QUESTION TWO A) In 2019 in Country Beta the economy behaves consistently with our basic model with rational expectations (RE). All the usual assumptions hold, but three: the flexibility in the labour market is equal to one; the labour productivity is equal to one; the “real” component of the aggregate demand for goods and services is equal to zero. Derive step by step the supply curve and the demand curve, and finally the equilibrium values of both output growth and inflation. *) Supply Side: in this case inflation depends on both costs (nominal wage growth) and completion in the markets for goods and services (mark- up change) :

π = ω + ( µ − 1) + u

(1)

Where π= rate of inflation; ω = wage growth; µ= rent factor;

u = uncertainty.

*) Labour market: with RE the real wage is the market clearing price. The real wage depends on employment growth, taking into account that the rigidity factor is b = 1 . Therefore:

ϖ −π = n

(2)

Where n is the employment growth. *) Production Function: The output growth depends on both employment growth and capital growth:

y = αn + β k

(3)

With k=0 – i.e. medium run horizon - the relationship between output and employment is identified (α= productivity factor). Therefore the labour demand becomes - with the inefficiency factor ε=1/α=1 in this case :

n= y Equation (2) becomes:

ϖ −π = y With RE equation (1) defines the output growth:

y* = 1 − µ − u *) Demand side: the aggregate demand depends on three components - i.e. changes in: the real money growth; the financial accelerator; expectations – and its pattern is as follow:

y = m + l − π (1 − φ )

(4)

Where the expectations sensibility is as usual 0 < φ < 1 The central bank controls monetary and banking policies: __

__

m=m

J=J

(5)

Therefore the equilibrium levels of both output growth and inflation are as follows:

y* = 1 − µ − u __

(6) __

( m+ l) − y * ( m+ l) − (1 − µ − u) π* = = (1 − φ) (1 − φ)

(7)

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B) “In 2019 in Country Beta the central bank increases the money supply; such change triggers i) an increase in the output growth; ii) an increase in inflation; iii) an increase in the real wage growth ”. True or false? Sign your answers and motivate them economically, using also a graphical explanation. Finally: define a Liquidity Trap.

iv) v) vi)

O TRUE O TRUE X O TRUE

O FALSE X O FALSE O FALSE X

In an economy with RE monetary policy is neutral, i.e. its changes cause changes in the aggregate demand, but then- given the output growth is supply driven – they influence just inflation. In fact from the equilibrium solutions (5) and (6) it is evident that changes in the money supply are associated with inflation only. From equations (2) and (3) it is evident that also the real wage growth doesn’t change. Graphically:

AS π

π** π*

AD’ AD y y*

Finally: Liquidity Trap = the AD pattern is independent from the interest rates.

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