Macroeconomics

'In an open economy, national saving is always equal to investment.' True or false? Briefly explain your answer.

FALSE.In equilibrium, output Y is equal to aggregate demand. In an open economy, aggregate demand is C + I + G + CA, where CA is the current account (the current account is treated as the same as net exports NX on this course). Therefore, the equation Y = C + I + G + CA must hold. National saving SN is defined as the sum of private saving Y - T - C (the amount of disposable income not consumed by households) and public saving T G (the negative of the government budget deficit). Hence, SN = (Y-T-C) + (T - G) and therefore: SN= Y - C - G = (C + I + G + CA) - C - G = I + CA. This shows that national saving is only equal to investment if CA = 0, so that the current account is exactly equal to zero (which means the capital account must also be exactly equal to zero). Of course, this is not generally true in an open economy, hence SN 6= I.

`A desirable feature of any theory of economic growth is that it predicts the ratio of the capital stock to output is stable in the long run.' True or false? Briefly explain your answer.

True. An approximately constant capital-output ratio K=Y is one of the Kaldor stylized facts of growth. It is desirable that a theory of economic growth be consistent with such a well-established empirical regularity.

`A fall in desired investment has a greater effect on output when there is a proportional income tax compared to the case where a fixed amount of tax is collected.' True or false? Briefly explain your answer.

False. A fall in desired investment at each and every interest rate implies a leftward shift of the IS curve, but has no effect on the LM curve. The vertical size of the shift is the same irrespective of the nature of the tax system. This is because the fall in interest rates sucient to offset the exogenous shift in investment demand and restore goods market equilibrium at the same level of output is the same in both cases. The IS curve is steeper with a proportional tax rate. This is because the multiplier eect is weakened by proportional taxation: a given rise in output now raises disposable income by less, leading to a smaller rise in consumption and hence aggregate demand. With the same vertical shift but a steeper slope, the new IS curve in the case of a proportional tax intersects the LM curve at a higher level of output, so output falls by less in this case.

`Faster growth of the money supply always increases the government's (real) seigniorage revenues.' True or false? Briefly explain your answer.

False. A faster growth rate of the money supply increases real seigniorage revenues to the extent that it does not induce an even larger rise in inflation, which reduces the value of newly created money. That might occur if the demand for real money balances falls sharply. Since faster money growth increases nominal interest rates (according to the Fisher equation), the opportunity cost of holding money increases, reducing real money demand. It is therefore possible to have an `inflation tax Laffer curve' where real seigniorage revenues may fall once the growth rate of the money supply becomes sufficiently high.

`If the price level is procyclical (that is, positively correlated with output) then this suggests that supply shocks are the dominant cause of economic fluctuations.' True or false? Briefly explain your answer.

False. A positive demand shock (rightward shift of AD) increases output and the price level, while a negative shock reduces both. The equilibria are all located on the upward-sloping AS curve,which remains in its original position, so output and price fluctuations would be positively correlated in this case. A positive supply shock (rightward shift of AS) increases output and reduces the price level, while a negative shock reduces output but raises prices. The equilibria are all located on the downward-sloping AD curve, which remains in its original position, so output and price fluctuations would be negatively correlated in this case.Thus, if the evidence indicates the price level is procyclical then this evidence would suggest that supply shocks are not the dominant cause of the business cycle.

`If two economies converge to the same long-run growth rate of GDP per person then they must converge to the same level of GDP per person.' True or false? Briefly explain your answer.

False. While it is true that the convergence in levels of gross domestic product (GDP) per person does imply convergence in growth rates, it is not true in general that convergence in growth rates implies convergence in levels of GDP per person. This is best explained by example. In the Solow growth model, suppose two countries share the same rate of technological progress, but have different saving rates. These economies will converge to a steady state where growth in GDP per person is equal to the common rate of technological progress. However, because of the difference in saving rates, they do not converge to the same level of GDP per person.

'If neither consumption nor investment depend on the interest rate then the IS curve is horizontal.' True or false? Briefly explain your answer.

False. With neither consumption nor investment depending on the interest rate, the level of aggregate demand C + I + G is independent of the interest rate. The IS curve represents the condition that output Y equals aggregate demand C + I + G. Thus, when solving the equation Y = C + I + G to find output in terms of the interest rate and other variables, the same level of output would be obtained for all interest rates. Alternatively, this equation can be represented graphically in the expenditure-income diagram (Keynesian cross diagram). Equilibrium is on the 45 line where expenditure E = C + I + G is equal to income Y. Since neither consumption nor investment depend on the interest rate the expenditure line E(Y, r) is in the same position for two different interest rates r1 and r2. The equilibrium level of income Y1 is the same in both cases.

`Action lags are generally shorter for monetary policy than for fiscal policy.' True or false? Briefly explain your answer.

True. An action lag is the time between a policy decision and its actual implementation. Open-market operations or changes to the discount rate can be implemented immediately once the decision to do this has been made. This is because such actions involve transactions with banks or other financial intermediaries that take place very frequently whenever financial markets are open. On the other hand, changes to tax policy or government spending generally take effect much more slowly. For example, tax rates may be difficult to change until a new fiscal year begins, and government spending projects (such as infrastructure investment) will require planning before the work can begin.

'If all prices and wages are fully flexible in the short run then the aggregate supply (AS) curve is vertical.' True or false? Briefly explain your answer.

It is possible to argue that this statement could be either TRUE or FALSE. With flexible wages and prices, the labour market will adjust to a point where labour demand is equal to labour supply (there is an equilibrium real wage w = W/P). In the case where all agents have perfect information and do not suffer from money illusion, the equilibrium real wage and employment level will be independent of the price level P. With employment independent of P, the supply of output is also independent of P. This means the aggregate supply function is vertical. When the information available to agents is imperfect, the aggregate supply function will be upward sloping even if wages and prices are fully flexible. For example, suppose workers do not observe the price level P, but firms do. In this case, workers must infer the real value of their nominal wage. This means the position of the labour supply curve depends on how the actual price level differs from workers' expectations (labour demand is unaffected if firms have full information). Given expectations, the price level changes equilibrium employment and hence output.

'The Ricardian equivalence proposition states that government spending has the same effect on the economy whether it is financed by issuing bonds (borrowing) or by taxes.' True or false? Briefly explain your answer.

Ricardian equivalence states that households internalise the government's lifetime budget constraint. Since the present discounted value of spending must equal the present discounted value of taxes, the total tax burden does not depend on the timing of taxes, just the total present discounted value of all current and future spending. Government spending financed by borrowing simply requires an increase in taxes of the same present value as the spending itself, so it makes no difference to households' consumption, and thus total spending in the economy, whether the spending is financed by current taxes or borrowing. A good answer to this question would write down the lifetime budget constraints of households and the government and combine these to show that it is not necessary to know the timing of taxes to determine which consumption plans are affordable to household

'Shocks to money demand will affect output when the central bank follows a policy of targeting the money supply, but not when it follows a policy of targeting inflation.' True or false? Briefly explain your answer.

True. When there are shocks to money demand, the LM curve will shift (for a fixed money supply), which implies a shift in the aggregate demand (AD) curve. This leads to a movement along the upward-sloping short-run aggregate supply curve (SRAS), which means there will be fluctuations in output. For a central bank to target inflation successfully it must adjust interest rates or the money supply such that the price level remains on a stable path. Using the AD/AS diagram, this means the central bank must act so that the AD curve always passes through the SRAS curve at the price level consistent with its inflation target, or equivalently act so that the effective AD curve is horizontal at the price level consistent with the inflation target. As long as the SRAS curve itself does not shift, this means output will also remain constant.

'A minimum wage law can be a cause of classical unemployment.' True or false? Briefly explain your answer.

A minimum wage that is binding pushes up the real wage above its market-clearing level. This means that more individuals would like to work than the number of jobs firms have an incentive to create. In other words, at the minimum wage, desired labour supply exceeds labour demand. Without the minimum wage or other rigidities, the real wage would fall to bring demand and supply into line. But the minimum wage prevents this adjustment, so the excess of desired labour supply above labour demand is classical unemployment. A good answer to this question would provide a clear definition of classical unemployment that distinguishes it from other types of unemployment.

'Deflation, even when fully anticipated, is costly because it leads to redistribution of wealth from borrowers to lenders.' True or false? Briefly explain your answer.

False. An unanticipated deflation would indeed raise the real burden of repayment of borrowers' nominal debts, and raise the real value of savers' assets, which would constitute a redistribution of real wealth. However, when the deflation is anticipated, since both borrowers and lenders care about the real return, the Fisher equation i = r + πe shows that i would move in line with inflation expectations πe. The ex-post real interest rate i - p would not then be affected by the deflation, so there would be no redistribution in that case.A good answer to this question requires a careful distinction to be made between ex-ante and ex-post returns, which is key to understanding the difference between expected and unexpected deflation (or inflation).

`Deflation need not be of concern to policymakers because consumers will spend more and rms will invest more when they expect prices to fall.' True or false? Briefly explain your answer.

False. Expectations that prices will fall are expectations of a negative inflation rate. The Fisher equation links nominal and real interest rates and inflation expectations as follows: i = r + πe This implies that the real interest rate is r = i - πe. So the more negative are inflation expectations, the higher is the real interest rate for a given level of the nominal interest rate. The IS curve is a relationship between the real interest rate and output because spending on investment (and consumption) depends on the real interest rate (it is positively related to the relative price of current goods in terms of future goods, as relevant for those deciding whether to invest or save). The LM curve is a relationship between the nominal interest rate and output because the nominal interest rate is the opportunity cost of holding money. Hence a reduction in inflation expectations shifts the IS curve to the left when the IS/LM diagram is drawn with the nominal interest rate on the vertical axis. This leads to a fall in output as investment and consumption spending are reduced.

'An increase in the level of money wages implies the aggregate supply (AS) curve shifts to the right.' True or false? Briefly explain your answer.

False. For a given price level P, an increase in money wages W raises the real wage w = W/P. Firms' incentives to hire labour are thus reduced, and employment is lower, moving down the labour demand curve (workers are assumed not to be on their labour supply curve because wages are sticky, so the labour market does not clear). Lower employment leads to lower output. Output is therefore reduced for each and every price level, so the short-run aggregate supply curve (SRAS) shifts to the left, not to the right. A full answer to this question requires an explanation of how the direction of the shift of the AS curve is determined.

'The Ricardian equivalence proposition states that a tax cut financed by issuing bonds (government borrowing) has no effect on the amount of disposable income saved by households.' True or false? Briefly explain your answer.

False. Household saving is SP = Y - T - C. Ricardian equivalence predicts that a tax cut financed by borrowing has no effect on consumption because households anticipate higher taxes of an equivalent present value in the future. Consumption does not change. However, given pre-tax income Y and constant consumption C, lower taxes T do increase household saving. Intuitively, households are increasing their saving so as to be able to pay the higher future taxes they anticipate.

`If the LM curve is horizontal then the economy is in a liquidity trap.' True or false? Briefly explain your answer.

False. If the economy reaches a section of the money demand curve where demand is perfectly elastic (where the curve is horizontal) then a change in income will not change the interest rate that clears the money market. This means that the LM curve would have a horizontal section (but should become eventually upward sloping for higher levels of output). However, the argument above is actually the converse of the statement given in the question: it shows that being in a liquidity trap implies the LM curve is horizontal. But unless the liquidity trap is the only way the LM curve can be horizontal, the statement will be false. Suppose that money demand does not depend on current income (perhaps depending on wealth instead). For a given money supply and price level, it follows that there is a constant interest rate at which the money market clears irrespective of the level of income. Thus, the LM curve is horizontal, but would shift down if the central bank increased the money supply, so the economy is not in a liquidity trap.

`In an open economy where the government always runs a balanced budget, a larger current account surplus must be matched by higher private saving, higher investment, or both.' True or false? Briefly explain your answer.

False. In an open economy, national saving SN is equal to the current account CA plus investment I. National saving is defined as the sum of private saving SP = Y - T - C and government saving SG = T - G, the latter being the negative of the budget deficit D = G - T. If the government balances its budget, national saving is simply equal to private saving SP and hence: CA = SP - I: This accounting identity shows that an increase in CA could be matched by a rise in SP , or an increase in CA could be matched by a fall in I, or some combination of both.

`Inflation targeting is inferior to money-supply targeting because the central bank cannot control inflation in the short run.' True or false? Briefly explain your answer.

False. It is correct to say that central banks cannot directly control inflation in the short run. In principle, they would be able to exert more direct short-run control over the money supply (or at least the money base, or reserves), which might suggest money-supply targeting is a more meaningful aim than targeting inflation. However, while the money supply could be controlled more precisely, this is not an end in itself. The central bank most likely cares about the money supply only to the extent that it influences its ultimate goals, such as price stability. Hence, if inflation cannot be controlled in the short run, then it cannot be controlled in the short run by keeping the money supply under tight control. Money supply targeting would only be superior if it offered a better route to long-run inflation control. It is far from clear it does (for example, because money demand may be unstable), and the statement in the question certainly does not suggest it does. Hence, the statement is not a coherent argument for monetary targeting.

`A large current-account decit should not be of concern to policymakers because such a decit is necessarily matched by a capital-account surplus of the same size.' True or false? Briefly explain your answer.

False. It is true that in equilibrium, the balance of payments must be zero, so any current account deficit is matched by a capital account surplus. However, the process by which the economy adjusts to reach this point may have undesirable consequences. For example, with a fixed exchange rate, a loss of international competitiveness causes a deterioration of the current account, which shifts the IS curve to the left. The BP line also shifts upwards (in the general case of imperfect capital mobility) because interest rates must rise to attract capital inflows sufficient to balance the current account deficit. The new intersection point between IS and BP features lower output. Defending the fixed exchange rate requires a reduction in the money supply that will leave the economy in a recession.

'Okun's law states that there is a negative relationship between unemployment and GDP growth because higher growth increases aggregate demand and thus leads to more job creation.' True or false? Briefly explain your answer.

False. Okun's law is based on the economy's production function, and hence it is a supply-side, not a demand-side, relationship (from the perspective of the goods market). For given levels of productivity and the capital stock, higher GDP growth is possible only with more employment, which reduces the unemployment rate for a given labour force. It was essential to indicate that the relationship between GDP growth and unemployment arises because the job creation is physically necessary to produce the extra output given the level of the capital stock and total factor productivity.

`Okun's law states that inflation rises when unemployment falls.' True or false? Briefly explain your answer.

False. Okun's law states that an increase in output relative to its trend reduces the unemployment rate. However, the statement in the question describes the (short-run) Phillips curve relationship between inflation and unemployment.

`The Keynesian multiplier is larger when the marginal propensity to consume is lower.' True or false? Briefly explain your answer.

False. Suppose an increase in aggregate demand raises aggregate income. The Keynesian multiplier effect occurs when higher income increases consumption demand, and thus further raises aggregate demand and incomes. This process then continues, with the initial increase in aggregate demand being magnified. The strength of the Keynesian multiplier effect depends on how much an increase in income raises consumption demand, or in other words, on the marginal propensity to consume from disposable income. The effect is larger when the marginal propensity to consume is higher.

`According to the life-cycle theory of consumption, an increase in life expectancy with no change in the retirement age will raise consumption.' True or false? Briefly explain your answer.

False. Suppose an individual expects to work for w years, and earns an average income Y during those years. Suppose his life expectancy is t years. Assuming a desire to smooth consumption and no bequests or initial assets, the individual would choose consumption c=(w/t)Y per year. An increase in life expectancy with no change in the retirement age means a rise in t with w constant. Therefore consumption per year falls.

`If the demand for money does not depend on income then the LM curve is vertical.' True or false? Briefly explain your answer.

False. The LM curve represents the combinations of interest rates and output where the money market is in equilibrium. If money demand does not depend on income then no shift of the money demand curve occurs when income changes, unlike the usual case, and thus there is no change in the interest rate required to achieve money-market equilibrium. This means that the same interest rate results in the money market being in equilibrium irrespective of the level of output. Geometrically, this implies that the LM curve is a horizontal line, not a vertical one.

'Since higher consumption means lower saving, the saving rate that leads to the Golden rule with the highest sustainable level of consumption is zero.' True or false? Briefly explain your answer

False. Taking income as given, it is the case that consumption and saving are negatively related. But in the long run, the capital stock depends on saving. Reducing the saving rate lowers the capital stock that can be sustained in the long run, and thus reduces income. Given that capital depreciates, at a zero saving rate, the long-run equilibrium level of capital is zero. Since some capital is essential for production, income would be zero, and thus consumption would also be zero even if no income was saved. The Golden-rule level of capital maximizes the long-run sustainable level of consumption, so the saving rate that supports the Golden rule cannot be zero.

`The real interest rate cannot be negative.' True or false? Briefly explain your answer.

False. The Fisher equation is i = r + πe, where i is the nominal interest rate, r is the real interest rate, and e is expected inflation. This can be rearranged to state the real interest rate as r = i - πe. While the nominal interest rate cannot be negative, the real interest rate can be negative if (expected) inflation exceeds the nominal interest rate. There is no reason in principle why this cannot happen (and there are many countries that have experienced this at some time).

'According to the Fisher model of intertemporal consumption choice, an increase in the real interest rate implies that current consumption must fall.' True or false? Briefly explain your answer.

False. The Fisher model can be studied using a diagram with current consumption C1 on the horizontal axis and future consumption C2 on the vertical axis. The lifetime budget constraint is a downward sloping line with gradient -(1+r), where r is the real interest rate. One unit less of consumption now allows more to be saved, and after taking account of the interest paid on saving, allows 1 + r extra units of future consumption to be purchased. A rise in the real interest rate raises the future price of current consumption (the budget line becomes steeper), and thus encourages substitution away from current consumption for all individuals. However, interest rate changes also have wealth effects. Borrowers are made worse off, while savers are better off. An agent who is now better off has the ability to increase consumption. It is possible that this income effect might outweigh the substitution effect, resulting in a rise in consumption for savers. So the Fisher model does not predict that current consumption must necessarily fall.

`The Golden rule level of saving maximises consumption per person in the short run.' True or false? Briefly explain your answer.

False. The Golden rule level of saving is defined as the level that supports the highest sustainable amount of consumption per worker. The Golden rule level of capital (and hence the required saving rate) is found by equating the marginal product of capital f'(k) to δ + n. The logic behind the Golden rule is that an increase in the saving rate has two effects on long-run consumption: reducing it because more of income is allocated to saving; and increasing it because more saving allows a higher capital stock to be permanently maintained, which provides more income from which to consume. In the short run, the second effect is absent because the stock of capital per worker is predetermined, so short-run consumption is maximized by saving nothing.

`An increase in the marginal propensity to consume implies a steeper IS curve.' True or false? Briefly explain your answer.

False. The IS curve can be derived graphically using the Keynesian cross diagram (expenditure plotted against income). Total expenditure E = C + I + G is a function of income Y and the interest rate r. Equilibrium is on the 45° line. An increase in the marginal propensity to consume increases the slope of the line depicting expenditure as a function of income. An increase in the interest rate reduces expenditure, shifting down the expenditure line. The vertical size of this shift is the same irrespective of the marginal propensity to consume. Starting at the same initial level of output, the steeper expenditure line (higher marginal propensity to consume) intersects the 45° line further to the left, so output falls by more in this case. It follows that the IS curve is flatter.

`If consumption expenditure does not depend on current disposable income then the IS curve will be horizontal.' True or false? Briefly explain your answer.

False. The IS curve is normally downward sloping because some component of demand (investment, or consumption) depends negatively on interest rates. A horizontal IS curve would mean that the effect of a small change in interest rates on demand is extremely large, which could happen either because demand is perfectly interest elastic, or the Keynesian multiplier is extremely large. The Keynesian multiplier is determined by the feedback effect from income to consumption. However, if consumption does not depend on income then the multiplier effect does not operate, which means that the IS curve would be steeper than normal. Hence it is not possible to explain a horizontal IS curve with the assumption that consumption does not depend on current disposable income.

`A desirable feature of any theory of economic growth is that it predicts the capital-labour ratio is stable in the long run.' True or false? Briefly explain your answer.

False. The Kaldor stylised facts of growth include the nding that the capital-labour ratio K=L grows at an approximately constant rate over time. Since it is desirable that theories are consistent with well-established empirical regularities, a theory of economic growth should not predict that the capital-labour ratio is stable.

'The aggregate demand (AD) curve is downward sloping because a higher price level reduces the real value of wages and thus lowers consumption, which is known as the Keynes effect.' True or false? Briefly explain your answer.

False. The Keynes effect refers to the following: An increase in the price level reduces the real money supply. This puts upward pressure on the interest rate to clear the money market, shifting the LM curve to the left. The higher interest rate reduces investment demand (a movement up the IS curve), which reduces output. A good answer would describe the Keynes effect and point out the differences between that and what is stated in the question. The standard Keynesian consumption function implies that consumption C depends on disposable Y-T. It does not refer to wages, hence the chain of logic in the statement is not the usual reason why consumption falls.

`The Marshall-Lerner condition implies that a fall in the price of domestically produced goods relative to foreign-produced goods leads to a deterioration in the trade balance.' True or false? Briefly explain your answer.

False. The Marshall-Lerner condition is a requirement that the sums of the elasticities of exports and imports with respect to the terms of trade are greater than one. This condition means that the volume effect will dominate the value effect, and hence the trade balance will improve when there is a fall in the relative price of domestically produced goods to foreign-produced goods.

`The Solow growth model assumes a production function with decreasing returns to scale and constant marginal returns to capital.' True or false? Briefly explain your answer.

False. The assumptions given in the statement are the wrong way around. The Solow model assumes constant returns to scale, not decreasing returns to scale, and assumes diminishing marginal returns to capital, not constant returns to capital. Constant returns to capital would mean that output increases by 1% if capital is incresed by 1% while other factors are held constant. Decreasing returns to scale would mean that output increases by less than 1% if all factors of production are increased by 1%. Notice that there is a contradiction between assuming decreasing returns to scale (i.e. to all factors) and constant returns to capital (i.e. to only one factor).

`If interest rates are constant then the Keynesian balanced-budget fiscal multiplier is less than one.' True or false? Briefly explain your answer.

False. The balanced-budget multiplier refers to the ratio of the change in output to the change in government spending in the case where both government spending and taxes are changed by the same amount. Higher government spending boosts demand and thus income, but when taxes rise by the same amount, there is no effect on disposable income and thus no effect on consumption demand. With no change in interest rates, there are no other effects on demand, so the change in output is equal to the change in government spending. This means that the multiplier is equal to one. Using the standard consumption and investment functions, the expression for output is: Y =(C0 + I0 + G0 - cT0 - br)/(1 - c). Since Since G0 and T0 increase by the same amount, the change in the numerator is (1 - c)G0, hence Y = G0, confirming that the balanced-budget multiplier is equal to one.

`An increase in expected inflation increases the demand for (real) money balances, all else equal.' True or false? Briefly explain your answer.

False. The demand for real money balances M/P = L(Y, i) is assumed to depend positively on real income, and negatively on the nominal interest rate, which represents the opportunity cost of holding money. The Fisher equation implies the nominal interest rate i is given by i = r + πe,where r is the real interest rate and e denotes expectations of inflation. Higher inflation expectations increase the nominal interest rate all else equal, which raises the opportunity cost of holding money, and thus reduces demand for real money balances.

`The Solow model of economic growth predicts that if one country has a lower capital stock (per worker) than another (but they are identical in all other respects such as saving, depreciation, and population growth rates) then it will grow more slowly than the other country during a transitional period.' True or false? Briefly explain your answer.

False. The fact that the two countries are identical in respect of saving, depreciation, and population growth rates implies that they share the same steady-state levels of capital and income per worker. However, they begin with different levels of capital per worker, and thus different levels of income per worker. The Solow model predicts that both countries will converge to the steady state over time, so ultimately they will both attain the same level of income per worker in the long run. Since the country with the lower capital stock per worker begins with a lower level of income per worker than the other, it must be the case that it grows faster during a transitional period (otherwise it would not be able to catch up with the other country in the long run).

`The AK model of economic growth predicts that there will be conditional convergence" between economies over time.' True or false? Briefly explain your answer.

False. The feature of the AK model of economic growth that distinguishes it from the Solow model is that it does not assume the marginal product of capital is diminishing. As a result, the model generates endogenous growth in the sense that long-run growth rates will depend on variables such as the saving rate. Conditional convergence means that countries will converge to steady states, but those steady states may depend on variables such as saving rates. But the AK model predicts that differences in saving rates will lead to differences in long-run growth rates rather than differences in steady states, so it does not predict conditional convergence.

`If the marginal product of capital is always positive then the real interest rate cannot be negative.' True or false? Briefly explain your answer.

False. The neoclassical theory of investment implies that rms should initiate investment projects up to the point where the marginal product of capital is equal to the user cost of capital. The user cost is the sum of the real interest rate plus the rate of depreciation (assuming that no change in the relative price of capital is expected), hence: MPK = r + δ. It follows that the real interest rate must be equal to: r = MPK - δ. Even if the marginal product of capital is never negative, as long as the depreciation rate is positive and larger than the marginal product of capital, the real interest rate can be negative.

'The shoe-leather cost of inflation is only incurred when inflation is unanticipated.' True or false? Explain

False. The shoe-leather cost of inflation refers to the costs incurred by households and firms to avoid holding money that is an inferior store of value to bonds. For example, households might make frequent trips to the bank to avoid holding significant amount of cash. The incentive to do this increases when the nominal interest rate because the nominal interest rate is the difference between the nominal return on bonds and the nominal return on money (zero) The Fisher equation indicates that the nominal interest rate will be higher when expected inflation increases, so there is an incentive to incur shoe-leather costs when inflation is expected

'In the AD/AS model, an increase in aggregate demand caused by higher government spending will lead to higher average labour productivity (output divided by labour used).' True or false? Briefly explain your answer.

False. The standard model of the upward-sloping aggregate supply (AS) curve assumes a production function with diminishing marginal returns to labour. As employment and output rise, productivity falls (marginal cost rises), and firms require higher prices (for given nominal wages) to supply the extra output. An increase in aggregate demand will shift the AD curve to the right. This raises output Y. Unless this increase in spending changes the production function of firms, average labour productivity will fall (government spending on infrastructure projects that directly improve firms' productivity can be an exception to this). The fall in productivity can be seen in a diagram by drawing a production function with diminishing returns to labour (which has a concave shape). Average labour productivity (Y/L) is the slope of the line joining the point the economy is at on the production function to the origin. An increase in Y occurs only with more labour input L, and this is seen to reduce the slope of this line, indicating a fall in productivity

`In a closed economy, the aggregate demand (AD) curve is downward sloping because households' incomes can purchase more goods when the price level is lower.' True or false? Briefly explain your answer.

False. There is no reason in general why the nominal value of incomes must be constant, so the logic for why a lower price level increases demand must be different. The standard argument is that a lower price level increases the real value of nominal money balances, so there is an excess supply of money. Portfolio reallocation towards bonds reduces interest rates (pushes up bond prices), which increases demand for interest-sensitive components of spending such as investment, which therefore raises aggregate demand.

'Tobin's q theory of investment predicts that stock prices and investment should be negatively correlated.' True or false? Briefly explain your answer.

False. Tobin's q theory of investment states that stock prices contain information about the market's valuation of the firm's capital stock. The argument is that firms should then make investment decisions by comparing their market valuation to the replacement cost of their capital stock. When this ratio rises, it is a signal that the firm should expand. Therefore, stock prices and investment should be positively correlated.

`Uncovered interest parity predicts that domestic and foreign interest rates are always equal.' True or false? Briefly explain your answer.

False. Uncovered interest parity (UIP) predicts that the domestic nominal interest rate is equal to the foreign nominal interest rate plus the expected depreciation of the domestic currency relative to the foreign currency. Intuitively, investors in foreign assets must be compensated for any expected capital loss resulting from exchange-rate movements they anticipate. Unless the expected exchange rate in the future is exactly the same as its level today, UIP will therefore not predict that domestic and foreign interest rates are the same.

'In the AK model of economic growth, an increase in the saving rate increases the economy's long-run growth rate.' True or false? Briefly explain your answer.

TRUE. The AK model of economic growth assumes that the marginal product of capital is not diminishing, so that growth through capital accumulation can continue even in the long run. A higher saving rate allows more capital accumulation to take place without running into diminishing returns, which leads to permanently faster output growth. In the standard Solow growth model that assumes a production function with diminishing marginal returns to capital, a higher saving rate provides only a transitory boost to growth. In spite of the differences in implications, the AK model can be analysed with a diagram similar to the one used for the Solow model. This diagram has capital per person k = K/L on the horizontal axis and output per person y = Y/L on the vertical axis. The AK production function is Y = AK, which implies y = Ak in per-person terms. This is a straight line, unlike the concave-shaped production function found in the Solow model (where the concave shape indicates diminishing returns to capital). The change in the capital stock is the difference between the 'saving' line (the production function scaled by the saving rate s) and the 'depreciation' line (a straight line with slope δ + n). Increasing the saving rate from s to s0 pivots the saving line upwards. This increases the gap between it and the depreciation line, implying more capital accumulation. Since both lines are straight (unlike the Solow model), the increase in capital accumulation persists into the future, so growth is permanently higher.

'An increase in a central bank's discount rate will reduce the monetary base.' True or false? Briefly explain your answer.

The discount rate is the interest rate charged by the central bank for loans of reserves. A higher discount rate discourages banks from borrowing reserves from the central bank through the discount window (because the amount they must repay has increased), thus fewer reserves will be created this way. Since reserves form part of the monetary base, the monetary base will be lower. A good answer to this question would start by giving a definition of the monetary base (reserves plus cash) and then explain the basics of the 'discount window' (discount facility) offered by central banks

'Output will fall by more after a negative aggregate supply (AS) shock in an economy with a policy of strict inflation targeting compared to an economy with a policy of targeting nominal GDP.' True or false? Briefly explain your answer.

True. A central bank pursuing strict inflation targeting must adjust interest rates or the money supply so that the economy's equilibrium price level is consistent with the central bank's inflation target. Changing monetary policy leads to shifts in the AD curve, so any shock to the aggregate supply curve requires a policy change to move the AD curve to a position where the equilibrium price level is unaffected by the shock. A successful monetary policy of this type effectively makes the AD curve a horizontal line at the price level consistent with the inflation target. Following this policy, after a shift in SRAS, the AD curve intersects the new SRAS curve at the same price level as previously. All the burden of adjusting to the supply shock thus falls on output. When the central bank targets nominal GDP, it must adjust interest rates or the money supply to ensure that the AD curve intersects the SRAS curve on a line where nominal GDP PY is constant. Lines where PY is constant are downward sloping. Thus, any shift in the position of the SRAS curve leads to some adjustment of prices and some adjustment of output. The same shock has a smaller effect on output than when the central bank is pursuing a strict inflation target.

`If the rate at which workers lose their jobs increases then frictional unemployment increases.' True or false? Briefly explain your answer.

True. A simple model of frictional unemployment has an equilibrium unemployment rate at which the flow into unemployment is equal to the flow out of unemployment, so the unemployment rate would have no tendency to change once it reaches its equilibrium value.The change in the unemployment rate in this period of time is given by: Δu = s(1-u) - fu. The equilibrium unemployment rate is such that Δu = 0. This requires s-(s+f)u = 0. This equation can be solved to obtain the equilibrium frictional unemployment rate u*: u*=s/(s+f)=1/(1+f/s) where the second expression is obtained by dividing numerator and denominator by s. A rise in s decreases the denominator of this expression and thus increases frictional unemployment u*.

`An expansionary open-market operation leaves banks and nancial institutions holding fewer bonds than before.' True or false? Briefly explain your answer.

True. An open-market operation is a purchase or sale of nancial assets by the central bank in exchange for money. Open-market operations are conventionally performed in the markets for (government) bonds with commercial banks and other nancial institutions as the counterparty. An expansionary open-market operation is one that increases the money supply. In this case, the central bank is acquiring bonds in exchange for money, so the institutions with which it trades must hold fewer bonds in equilibrium.

`Firms that pay "efficiency wages" can be a cause of classical unemployment.' True or false? Briefly explain your answer.

True. Classical unemployment is caused by real wages being too high in the sense that workers would like to supply more labour at the prevailing real wage than firms would be willing to hire. To bring demand into line with supply, the real wage would need to fall. `Efficiency wages' are paid to increase the productivity of the workforce, for example, by providing an incentive not to shirk. When firms have an incentive to pay efficiency wages, firms may be unwilling to cut wages even if workers would accept jobs at a wage lower than the prevailing one. Consequently, unemployment does not exert downward pressure on wages, so these remain above their market clearing level.

`If there is "conditional convergence" between economies then there must be a negative relationship between a country's initial level of GDP per capita and its subsequent per-capita growth performance once other factors have been controlled for.' True or false? Briefly explain your answer.

True. Conditional convergence means that countries would in the long-run converge to their steady states, but those steady states may depend on characteristics of the countries, such as saving rates and population growth rates. To converge to a steady state, it is necessary that growth is faster when the country is below the steady state than when it is at its steady state. The initial level of GDP per capita (after controlling for other variables) measures how far a country is below its steady state. Hence, if there is a zero or a positive correlation between subsequent growth rates and initial GDP per capita then convergence would fail to occur.

'If there are hysteresis effects then the economy's long-run unemployment rate will be directly affected by what happens to unemployment in the short run.' True or false? Briefly explain your answer.

True. Hysteresis effects do indeed refer to cases where the long-run fundamentals affecting the unemployment rate are not independent of the economy's history. There is no unique long-run outcome that will be reached irrespective of history. In the context of unemployment, examples include loss of skills or work ethic, and 'outsiders' not being represented in wage bargaining. In this question, it was not necessary to enter into a lengthy discussion of different theories of hysteresis. Some short examples were useful though for many candidates in demonstrating that they had properly understood the concept of hysteresis.

`An increase in default risk for bonds causes the LM curve to shift to the left.' True or false? Briefly explain your answer.

True. If there is an increased risk of default on bonds then these assets become less safe compared to money, which oers an absolutely certain nominal return of zero. This makes money more attractive to agents as a store of wealth. Thus, the demand for money increases at each interest rate, so its demand curve shifts to the right. For a given money supply (and holding other determinants of money demand constant, such as income), increased money demand requires higher interest rates to restore money-market equilibrium. Thus, the LM curve shifts upwards, or to the left.

`In a closed economy, an increase in the government budget decit must be matched by higher private saving, lower investment, or both.' True or false? Briefly explain your answer.

True. In a closed economy, national saving SN is equal to investment I. National saving is defined as the sum of private saving SP = Y - T - C and government saving SG = T - G, the latter being the negative of the budget deficit D = G - T. The budget deficit is therefore related to private saving and investment as follows: D = SP - I: From this accounting identity it follows that an increase in D could be matched by a rise in SP , or an increase in D could be matched by a fall in I, or some combination of both.

`If menu costs were the only cost of inflation then it would be best to have a zero rate of inflation.' True or false? Briefly explain your answer.

True. Menu costs refer to the (physical) costs of changing price labels, lists, and catalogues. In the presence of positive inflation, money prices would have to be adjusted to keep them in line with costs and competitors' prices. This is wasteful because it is unrelated to any fundamental reason why relative prices need to be adjusted. Note that deflation (negative inflation) would also imply a need to adjust money prices, just as a positive inflation rate would. Therefore, the best inflation rate to avoid menu costs is zero.

`In Tobin's theory of the speculative demand for money, money is held because it is a safe asset.' True or false? Briefly explain your answer.

True. Money earns a zero nominal return, while other assets generally have positive expected returns. Tobin's speculative demand model provides an explanation of why people are willing to hold some of their wealth as money, even if its expected return is worse than other assets. The advantage of holding money is that there is no uncertainty about its nominal return, while many other assets have uncertain returns and some risk of losses. Risk-averse investors will therefore accept (to some extent) a lower expected return in exchange for a reduction in risk, and are thus willing to hold some money.

`If purchasing power parity (PPP) holds then an increase in the rate of exchange-rate depreciation leads to an increase in the rate of inflation.' True or false? Briefly explain your answer.

True. Purchasing power parity is derived from the law of one price: the idea that goods must sell at the same price in dierent countries once those prices are expressed in terms of a common currency. If P is the price of domestic goods and e is the exchange rate (dened as the foreign price of domestic currency, so a rise in e is an appreciation of the domestic currency), then the equivalent foreign currency price of the goods sold domestically is eP . Purchasing power parity implies the foreign currency price P* should be equal to the domestic price expressed in terms of foreign currency, that is, eP . Therefore: eP/P*=1. Taking the behaviour of the foreign price level and the exchange rate as given, the domestic price level must be: P=P*/e. An increase in the rate of depreciation means that e is falling at a faster rate, so P should rise at a faster rate, that is, domestic inflation should increase.

`If the Ricardian Equivalence proposition is true, a permanent tax cut (with no corresponding reduction in government spending) is not feasible.' True or false? Briefly explain your answer.

True. Ricardian Equivalence depends on the government's lifetime budget constraint, which requires that the present discounted value of taxes is sucient to cover the present discounted value of government spending. In a simple two-period example: G1+G2/(1+r)=T1+T2/(1+r) With no change in spending G1 or G2, any cut in taxes T1 or T2 must be matched by a tax increase at some other point. Thus, it is not possible to satisfy the government budget constraint and have a permanent tax cut without a change in spending.

`If shoe-leather costs" were the only cost of inflation then it would be best to target an inflation rate consistent with a zero nominal interest rate.' True or false? Briefly explain your answer.

True. Shoe-leather costs are said to be incurred when time and/or resources are consumed in avoiding holding large amount of money. Households and firms would choose to incur such costs so as to avoid the opportunity cost of holding money, namely the difference between the return on bonds and the zero return on money. This means that the opportunity cost of holding money is the nominal interest rate. If the inflation rate is set so as to be consistent with a zero nominal interest rate (for a given real interest rate) then shoe-leather costs would be eliminated because there would be no incentive to incur any costs to reduce holdings of money.

`An increase in the price level raises the demand for (nominal) money balances, all else equal.' True or false? Briefly explain your answer.

True. Since money has a lower financial return than alternative assets such as bonds, it is held only to the extent that it provides some other services. This includes money's role in facilitating transactions. Here, the usefulness of money depends inversely on the price level (the amount of money needed for any given real quantity of transactions is directly proportional to the price level). This is why money demand is usually stated as a real demand M/P = L(Y,i). The nominal demand for money can then be written as M = PL(Y,i), so a higher price level increases the demand for (nominal) money balances.

`According to the life-cycle theory of consumption, an increase in the retirement age with no change in life expectancy will raise consumption.' True or false? Briefly explain your answer.

True. Suppose an individual expects to work for w years, and earns an average income Y during those years. Suppose his life expectancy is t years. Assuming a desire to smooth consumption and no bequests or initial assets, the individual would choose consumption C=(w/t)Y per year. An increase in the retirement age with no change in life expectancy means a rise in w with t constant. Therefore consumption per year rises.

`If an economy begins with a capital stock above that required for the Golden rule then the Golden-rule capital stock can be reached without a temporary sacrifice of consumption.' True or false? Briefly explain your answer.

True. Suppose the economy begins at a steady state where the capital stock is above that required for the Golden rule (the one that yields the highest sustainable level of consumption). The steady-state capital stock can be reduced by lowering the saving rate, with the economy converging over time to the new lower steady state. Once this steady state is reached, consumption will be higher than it was initially (this is the advantage of moving to the Golden-rule level of capital). Furthermore, because the saving rate is lowered, at the initial capital stock, which determines the initial level of income, the level of consumption is increased. Therefore, consumption is higher also in the short run than it would otherwise have been. The Golden rule can be reached without a temporary sacrifice of consumption in this case.

'IN the AK model of economic growth there is no convergence because there are constant returns to capital.' True or false? Briefly explain your answer.

True. The AK model of economic growth is identical to the Solow model except for the assumption that the marginal product of capital is not diminishing. In the Solow model, there are diminishing returns to capital, which implies the pre-worker production function is concave, and hence the model features convergence to a steady state. There is then (conditional) convergence between countries. With constant returns to capital, the per-worker production function is linear, so the AK model has no steady state, and therefore there will be no convergence in income between countries

`The Keynesian consumption function (with a positive level of autonomous consumption) is inconsistent with the empirical finding that the average propensity to consume is approximately constant over time.' True or false? Briefly explain your answer.

True. The Keynesian consumption function is C = Ca + cY where Ca > 0 is the positive level of autonomous consumption and c is the marginal propensity to consume. The average propensity to consume is defined as the ratio C=Y of consumption to income, and it can be seen that the Keynesian consumption function implies this is given by: C/Y=Ca/Y+ c: As income increases, the equation demonstrates that the average propensity to consume will decline. Since income has been growing over time, but the average propensity to consume has not been declining, this implication is not supported by the data.

`On the balanced growth path of the Solow model, the ratio of the capital stock to output is constant.' True or false? Briefly explain your answer.

True. The Solow model assumes a production function Y = F(K,AL) with constant returns to scale. This production function implies a relationship y = f(k) between output in effciency units y = Y=AL and capital in efficiency units k = K=AL. With diminishing returns to capital, there will be a steady state for k characterized by the equation: sf(k) = (δ + n + g)k. In the steady state, both k and y = f(k) are constant. Now note that k/y = (K/AL)/(Y/AL)=K/Y Since both k and y are constant in the steady state, this implies a balanced growth path on which the ratio of K to Y is constant.

`The inflation bias" can be eliminated by handing control of monetary policy to an agent who does not care about unemployment or GDP.' True or false? Briefly explain your answer.

True. The argument for the inflation bias depends on private agents expecting the policymaker controlling monetary policy to be tempted to engineer an inflation surprise to increase GDP and reduce unemployment. It is this which leads to private-sector inflation expectations being ratcheted up to the point that inflation itself becomes so costly that the policymaker is not tempted to push inflation any higher, even if it did deliver a demand stimulus. By directly giving control of policy to an individual or group who is not tempted to push inflation up, even when it is low (and hence probably not very costly), private agents do not expect inflation to be high. This allows there to be an equilibrium with low or zero inflation even if the policymaker is not bound by any commitments or rules.

'If the classical dichotomy holds then money is neutral.' True or false? Briefly explain your answer.

True. The classical dichotomy is the separation of the real equilibrium of the economy from the money market. If monetary variables have no effect on real income Y and the real interest rate r, the consequences of any change in the money supply must fall entirely on the price level. With money demand given by the equation. M/P = L(Y,r+πe) and no change in future inflation expectations, the price level P must rise in proportion to the money supply M. This means that money is neutral.

`If the central bank pays interest on reserves then this will reduce seigniorage" revenues.' True or false? Briefly explain your answer.

True. The key feature of money that gives rise to seigniorage is that it does not pay interest. This means that central banks can issue money without having to worry about servicing a debt that must be repaid in the future. As an example, if the central bank expands the money supply through an open-market operation, it buys bonds with money. These bonds will earn interest for the central bank, but it will not need to pay any interest on the money it issues. On the other hand, reserves (a component of the monetary base) that pay interest are essentially the same as government bonds in that they are a debt that must be serviced. This means that paying interest on reserves reduces seigniorage revenues.

`An expected increase in the price of capital goods raises investment according to the neoclassical theory of investment.' True or false? Briefly explain your answer.

True. The neoclassical theory of investment predicts that firms should invest in capital up to the point where the marginal product of capital is equal to the user cost of capital. The user cost of capital is the real interest rate, plus the depreciation rate, and minus the expected change in the (relative) price of capital goods. An expected increase in the price of capital thus reduces the user cost of capital, and so lower marginal-product investments are now profitable, which means that investment increases.

`The fact that consumption might depend on real money balances does not provide an explanation of why money is not neutral.' True or false? Briefly explain your answer.

True. The neutrality of money refers to the situation where real variables such as output are unaffected by a change in the level of the money supply, with the price level simply changing in proportion to the stock of money. The presence of a real balance eect on consumption implies that the IS curve as well as the LM curve is shifted to the right following an increase in real money balances. The AS curve is unaected, so in a case where it is vertical, for example because of fully flexible prices and wages, it remains so in the presence of the real balance eect. Thus, all that changes is the slope of the AD curve (flatter with the real balance eect) and the size of the horizontal shift (larger with the real balance eect); because the AS curve is unaffected, money remains neutral (the vertical shift of AD is unchanged, so the size of the price level change is the same in both cases).

`The nominal interest rate cannot be less than zero.' True or false? Briefly explain your answer.

True. The nominal interest rate is the rate of return on nominal bonds. Money (as physical cash) offers a guaranteed zero nominal return. Since it is always possible to hold wealth as physical cash, if the nominal interest rate on bonds were negative then money would clearly be preferable as an asset to bonds, offering a better return and being generally more liquid (more readily accepted for payments). No-one would be willing to hold bonds, and the bond market therefore cannot be in equilibrium at a negative nominal interest rate.

`The presence of a real balance effect (or `Pigou effect') implies that deflation is less harmful to an economy.' True or false? Briefly explain your answer.

True. The real balance effect (or `Pigou effect') implies that real money balances M=P have a positive influence on consumption through a wealth effect. A falling price level P increases the real value of M, leading to a rise in consumption and a rightward shift of the IS curve. The increase in aggregate demand helps to alleviate the deflationary pressure. This mechanism is operative even when the economy is in a liquidity trap where the LM curve is horizontal: thus the problem of deflation and the liquidity trap is less of a concern since deflation is self-correcting through the demand stimulus implied by the real balance effect.

`The sacrice ratio is greater when agents have adaptive rather than rational expectations.' True or false? Briefly explain your answer.

True. The sacrice ratio is dened as the cumulated loss of output (or increase in unemployment) that occurs per percentage-point permanent reduction in the inflation rate. Rational expectations means that agents use all available information eciently (including policy announcements) to forecast future inflation. Adaptive expectations means that agents use past inflation rates as their forecast of future inflation. Suppose the central bank announces it will bring down the inflation rate and acts on this immediately. With rational expectations (assuming the announcement is perceived to be credible), inflation expectations immediately adjust, shifting the Phillips curve downwards. Unemployment will not rise. With adaptive expectations, expectations of inflation do not immediately change because agents are looking only at past data. The economy moves down the Phillips curve and experiences higher unemployment, so the sacrice ratio is higher in this case. It is only once actual inflation has been observed to be lower that expectations will adjust and unemployment will fall back to where it was before.

'According to uncovered interest parity (UIP), a higher domestic nominal interest rate is associated with an expected depreciation of the domestic currency.' True or false? Briefly explain your answer.

True. Uncovered interest parity states that investors must receive the same expected return (adjusting for currency movements) whether they hold domestic or foreign bonds (because they are assumed to be risk neutral). The domestic-currency return on domestic bonds is i, while the foreign-currency return on foreign bonds is i*. Any appreciation of the domestic exchange rate Δe/e (as a percentage) decreases the domestic-currency return on foreign bonds, which is therefore i* - Δe/e. Mathematically, the UIP equation is i=i*-(Δe/e). An expected depreciation is a negative value of De/e, which increases the domestic interest rate i.