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ECM9/ECM11
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.
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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.
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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