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MPhil in Economics MPhil in Finance & Economics Candidates are required to answer one out of two questions. Write your candidate number (not your name) on your uploaded answers. 1 of 3 E200 MACROECONOMICS This is a two hour examination for which students are expected to begin at 12:00pm and submit by 2:20pm. The twenty minutes are added to the standard two hour time for answer uploadings. Detailed online examination guidelines are available on Moodle. Students are not allowed to consult or seek help from others. Write legibly. Illegible handwriting may be penalised. 1 Menu Costs, Sticky Prices and Covid-19 Shock In the second quarter of 2020, the Covid-19 pandemic led to a sharp decline in UK real gross domestic product (GDP) by nearly 20% and a rise in the GDP deflator of almost 7%, whereas the Consumer Price Index (CPI) remained quite stable. Consider the following menu cost model to analyze and discuss the conditions under which it is optimal for firms to keep their prices fixed in response to this large Covid-19 shock, and the macroeconomic implications this has. The representative consumer i ∈ [0, 1] maximizes utility Ui = Ci − 1 γ Lγi subject to the budget constraint Ci = Πi + W P Li where Ci denotes consumption, Li employment, with constant parameter γ > 1, W the nominal wage, P the aggregate price level, and Πi real profits. The profit-maximizing representative firm i ∈ [0, 1] operates under monopolistic competi- tion in the goods market and faces a small real menu cost Z ≥ 0 when it changes the price Pi of its good. Its real profits without menu costs equal Π˜i = Pi P Qi − W P Li where Qi denotes the production of good i. The production technology is described by Qi = ALi where A denotes productivity. The firm faces the following individual demand function with constant parameter η > 1: Qi = Y ( Pi P )−η where Y ≡ ∫ 1 0 Qidi denotes aggregate output, and P ≡ ∫ 1 0 Pidi. The aggregate demand relation is given by Y = M P where M denotes aggregate demand. The labour market is characterized by either (a) perfect competition, or (b) the following real wage function with constant, strictly positive parameters B and β: W P = BLβ where L ≡ ∫ 1 0 Lidi denotes aggregate employment. In your answer, carefully analyse and discuss: • The difference between the macroeconomic equilibrium with (i) flexible prices and (ii) fixed prices, for labour market conditions (a) and (b). • How the Covid-19 shock could be analysed in this model, and whether keeping prices fixed in response to such a large shock is a Nash equilibrium. 2 of 3 2 Secular stagnation and rates of return In recent decades there appears to have been a decline in trend output growth and in the rates of return on a broad class of assets. It has been argued that these patterns might stem from a decline in the rate of technological progress. (a) Carefully analyse and discuss these patterns and arguments from the perspective of the Solow model. (b) Now analyse and discuss these patterns from the perspective of the following closed endowment economy. Specifically, suppose a representative agent has period utility u(ct) = c1−σt − 1 1− σ with consumption ct in period t, parameter σ > 1 and time discount factor 0 < β < 1, and is endowed with a stream of income, yt, into the infinite future. Suppose further that the deterministic endowment process is such that yt+1 yt = G (with some given y0). • Set up the intertemporal optimization problem of the agent and derive his/her Euler equation when faced with a riskless gross real return on savings from t to t+ 1 of R ≡ 1 + r. • Show that in equilibrium there must be a connection between G and r, give intuition for its sign (i.e. positive or negative relationship) and explain how its magnitude depends on σ. • Briefly discuss whether this is consistent with the insights from part (a). (c) Some people have argued that rates of return have declined not only due to lower trend growth, but also from an increased desire to save. Carefully discuss this argument. END OF PAPER