Macroeconomics

January 2016

Questions for Revision

1. How fast should China be expected to grow? (A Solow model perspective)
Consider the
Solow
growth model. Output Y is produced according to the production function
Y = (1/2) K AL, where K is the capital stock, L is the labour force (assumed equal to
the population), and A is the exogenous level of technology. Technology grows at rate g
(A/A = g), and the labour force grows at rate n (L/L = n). A constant fraction s of
output is saved, and these savings S = sY are invested in physical capital (investment equals
saving: I = S). Capital depreciates at a constant rate , so the change in the capital stock is
given by K = I K. Let y = Y /AL and k = K/AL denote output and capital in efficiency
units of labour.
Assume that two countries, the United States and China, have the same production functions
with the same level and growth rate of technology A, and the same saving rates s, depreciation
rates , and population growth rates n. The saving rate is 40% (s = 0.4), the depreciation
rate is 7% ( = 0.07), the population growth rate is 1% (n = 0.01), and the growth rate of
technology is 2% (g = 0.02). All growth rates are annual growth rates.
(a) Show that the change in k is k = sy ( + n + g)k, output
in efficiency units is
y = (1/2) k, and the marginal product of capital is y/k = 1/(4 k).
(b) Use a diagram to show that there is a steady state for capital and output in efficiency
units (i.e. a balanced growth path).
(c) Assume that the United States (US) has reached the steady state. Verify that kU S = 4
and yU S = 1.
(d) China (CN) starts below the steady state for capital in efficiency units of labour. Assume
that incomes per person are four times higher in the United States than China, and thus
yCN = 1/4. Find Chinas initial value of capital in efficiency units kCN .
(e) By how much does the Solow model predict that Chinas capital stock (in efficiency units)
increases in the current year (i.e. kCN )? What is the predicted growth rate of kCN this
year?
(f) Suppose that the change in output in efficiency units is approximated by y MPKk,
where MPK is the marginal product of capital. Use this to find the Solow models
prediction for the increase in output in efficiency units (i.e. yCN ). What is the predicted
growth rate of yCN this year?
(g) What are the Solow models predictions for the growth rates of incomes per person in
China and the United States? What fraction of the income gap between the two countries
is closed in one year?
(h) If China were to maintain the growth rate found in part (g), approximately how long
would it take for China to close the gap with the United States in incomes per person?
(i) What does the Solow model predict will happen to Chinas growth rate in future years
as it catches up with the United States? Is your answer to part (h) a sensible estimate
of how long it will actually take for China to close the gap with the United States?

2. Can capital controls make fiscal and monetary policy more effective? (An analysis
using the Mundell-Fleming model)
Consider a small open economy with fixed prices and wages (Mundell-Fleming/IS-LM-BP
model). Consumption C depends positively on disposable income Y T , investment I depends
negatively on the domestic interest rate i, government spending G is exogenous, and net
exports N X (equal to the current account) depend negatively on the exchange rate e (price
of domestic currency in terms of foreign currency) and negatively on income. Money demand
depends positively on income and negatively on the interest rate.
The foreign interest rate is i , and investors would like to move financial capital to whichever
economy has the highest interest rate. Initially, there are no restrictions on capital flows, so
capital mobility is perfect. Assume the economy begins in equilibrium with neither a surplus
nor a deficit on the current account (N X = 0).
(a) Explain the shape of the BP curve and list the factors that cause the IS, LM, and BP
curves to shift. Illustrate the economys equilibrium using a diagram.
(b) Suppose that government spending G is increased. Show that this leads to higher output
when the government has a fixed exchange rate policy, but has no effect on output when
the exchange rate is flexible.
(c) Suppose that the money supply M s is increased. Show that this leads to higher output
when the exchange rate is flexible, but has no effect on output when the government has
a fixed exchange rate policy.
(d) Now suppose the government is able to block all capital outflows (but not inflows). This
means that financial capital cannot flow out when foreign assets are more attractive
(i < i ).
i. How does the BP curve change when capital outflows are blocked?
ii. With a flexible exchange rate, does an increase in government spending become
effective at raising output if capital outflows are blocked?
iii. With a fixed exchange rate, does an increase in the money supply become effective
at raising output if capital outflows are blocked?
(e) Now suppose the government is able to block all capital inflows (but not outflows). This
means that financial capital cannot flow in when domestic assets are more attractive
(i > i ).
i. How does the BP curve change when capital inflows are blocked?
ii. With a flexible exchange rate, does an increase in government spending become
effective at raising output if capital inflows are blocked?
iii. With a fixed exchange rate, does an increase in the money supply become effective
at raising output if capital inflows are blocked?

3. Tax policies to escape the liquidity trap (An analysis of the zero lower bound
problem using the IS-LM model)
Consider a closed economy with sticky prices and wages in the short run (IS-LM model), and
assume that inflation expectations are zero (meaning that real and nominal interest rates are
equal). In this question, assume that consumption C depends positively on income Y and
negatively on the interest rate i. Investment is assumed to be exogenous (it does not depend
on interest rates), and government spending and taxes are exogenous.
All wealth is held by households as either bonds or money. Assume all money is cash in this
question. Money demand depends positively on income and negatively on the interest rate.
The money supply is exogenous.
(a) Explain intuitively why money demand depends negatively on the (nominal) interest
rate. Show how the LM curve is derived from the equilibrium of the money market, and
explain what happens to the LM curve and the equilibrium of the IS-LM model if the
money supply is increased.
(b) What feature does the money demand curve have when the nominal interest rate reaches
zero? Use your answer to explain why there should be a zero lower bound on the nominal
interest rate. What are the implications of the zero lower bound for the shape of the LM
curve?
(c) Assume the economy is in equilibrium where the IS and LM curves intersect at an interest
rate of zero. What happens if the central bank increases the money supply? Compare
your answer to part (a) and use it to explain the notion of a liquidity trap.
(d) The government is concerned that output is too low and would like to raise demand,
but the interest rate is already at the zero lower bound. Assume that because of worries
about the high level of government debt, a tax cut or an increase in government spending
is not an option. Instead, the government tries to encourage households to spend their
savings by introducing a one-off tax on unspent wealth. This means that a tax of rate
t% will be levied on any bonds held by households at the end of the year. Since holdings
of cash are anonymous, the government considers it impractical to try to tax wealth held
as money, so the wealth tax applies only to bonds.
i. In the absence of the wealth tax, the return on saving by holding bonds is equal to
the interest rate i. What is the return on bonds after the wealth tax is introduced?
What effect do you think this will have on consumption demand and thus the IS
curve?
ii. How does the wealth tax affect the demand for money and thus the LM curve?
(Remember that the tax applies only to wealth held as bonds, not as money.)
iii. Using the IS-LM model, will the wealth tax succeed in raising output in the short
run and allow the economy to escape from the liquidity trap?
iv. One economist suggests that the wealth tax might be more effective in raising shortrun output if it applies equally to all forms of holding wealth (both bonds and money).
How would your answers to (i)(iii) change in this case?
v. Another economist suggests that the wealth tax might be more effective in raising
short-run output if it applies only to wealth held as money. How would your answers
to (i)(iii) change in this case?
vi. The proposals in parts (iv) and (v) both require that holdings of money can be taxed.
Can you think of any practical ways governments might be able to do this?