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Final Exam Guidelines ECON 6002
The final exam will be 2 hours (plus 10 minutes reading time and 30 minutes upload time) on Saturday,
26 June at 9am. The exam will be open book. Examinable Material and Expectations:
1. The exam will cover material from the whole course, although focusing mostly on material since the midterm.
Anything covered in class, in the tutorials, or in the problem sets is examinable.
2. In addition to the types of questions set out below that will require you to upload workings, there will also be short-answer
questions requiring only type-written answers, similar to the mid-semester exam, on material such as theory and
evidence for endogenous growth, rigidities, consumption behaviour, and unemployment. 3. I will provide relevant formulas such as
production functions helpful in answering a question (see questions below to see examples of what material will be provided and what you will be assumed to know). 4. You will be expected to understand the “economics” behind any equations provided. 5. In answering questions, be precise, showing all of the steps, and indicate if you are making any assumptions along the way. 6. I will not post solutions for the questions below because very similar questions may show up on the exam. You should be able to come up with your own solutions using the lecture slides, textbook, tutorial solution videos, and solutions to the problem set. Example Questions: 1. Consider the role of different frictions in explaining why monetary policy shocks have real effects. (a) In the imperfect competition/menu cost model of nominal rigidity, the flex-price equi- librium relative price is Pi/P = η η−1Y γ−1, where η > 1 is the elasticity of elasticity of demand for good i and 1/(γ − 1) is the elasticity of labour supply with γ > 1. Noting that Yi = Y and Pi = P in equilibrium, derive an expression for yi in terms of pi−E[p], γ, and η. (b) In the Lucas islands model, the Lucas supply curve is y = 1γ−1 σ2z σ2z+σ 2 m (p − E[p]), where σ2z > 0 is the variance of the good-specific taste shock and σ 2 m > 0 is the variance of the aggregate demand shock. Noting again that Yi = Y and Pi = P in equilibrium, use the Lucas supply curve to derive a comparable expression for yi in terms of pi−E[p], γ, and the signal-to-noise ratio λ ≡ σ2z σ2z+σ 2 m . (c) Suppose σm = 0 instead of σm > 0 and consider a one-unit aggregate demand shock such that pi −E[p] = 1, show that yi is higher for the Lucas economy than for the imperfect competition economy. Explain why. (d) Suppose instead that η → ∞ and, again, consider a one-unit aggregate demand shock such that pi − E[p] = 1, show that yi is lower for the Lucas economy than for the imperfect competition economy. Explain why. Page 1 of 3 2. Consider a simple Taylor rule with an inflation target of zero: it = r¯ + φpipit + φyy˜t, where it is the nominal interest rate, r¯ > 0 is the natural real interest rate, pit is inflation, and y˜t is the output gap. The aggregate demand and supply equations are given by y˜t = −β(rt−1 − r¯) + ρy˜t−1 + εDt and pit = pit−1 + αy˜t + εSt , where εDt and εSt are demand and supply shocks, respectively. The relationship between it and rt is given by the Fisher identity (assuming expected inflation is equal to current inflation): rt = it−pit. All parameters (r¯, φpi, φy, β, ρ, α) are > 0. Further, assume that the following parameters (α, β, ρ, φy < 1). Suppose that there is one-time 10% supply shock at time t = 0 so that εS0 = 0.1. There is no further demand or supply shock after t = 0. Assume that prior to t = 0, the economy was in steady state with i = r¯, pi = 0, y˜ = 0, and r = r¯. (a) Solve for inflation and the output gap at t = 0 and 1 (i.e., pi0, pi1, y˜0, y˜1) as functions of model parameters (or compute the exact values if available). (b) Suppose that φpi ≤ 1. Show that y˜1 ≥ y˜0 ≥ 0 and pi1 ≥ pi0 > 0. (c) Suppose that φpi > 1. Show that it is possible to stabilize inflation after only one period (i.e., pi1 = 0). At what value of φpi would this occur? (d) What can you say about the role of the value of φpi for inflation stabilization? But what is the cost of a higher ratio of φpi/φy? 3. Consider the delegation problem under discretionary policy. Suppose social loss minimization implies pi = pi∗ + b a+b2 (y∗ − yflex) + b2 a+b2 (pie − pi∗), while loss minimization for a “hawkish” central banker with a′ > a implies pi = pi∗ + b a′+b2 (y ∗ − yflex) + b2 a′+b2 (pi e − pi∗). Let pi∗, piEQ, and piEQ ′ be equilibrium inflation under rule-based policy with commitment, discretionary policy without delegation, and discretionary policy with delegation, respectively. (a) Show, mathematically, that pi∗ < piEQ′ < piEQ. (b) Show the result in (a) graphically. You should compute the precise slopes and intercepts (i.e., when pie = 0) for both discretionary policies (with and without delegation). (c) What value of a′ would imply that the equilibrium inflation rate under discretionary policy with delegation is equal to the inflation rate under rule-based policy with com- mitment? Would this be a good value if the true social loss function (i.e., the loss function corresponding to household preferences) has the relative weight on inflation stabilization equal to a? How does your answer depend on assumptions about shocks hitting the economy? (d) Suppose the central banker’s true preferences regarding inflation match the social welfare function (i.e., the parameter on squared inflation deviations in the loss function is a < a′), but private sector agents believe the central banker is “hawkish” with parameter a′ when inflation is determined. Is social welfare higher if the public is wrong about the central banker’s preferences or if the central actually is “hawkish”, as assumed in parts (a)-(c). Explain your reasoning. Page 2 of 3 4. Consider the “Q” model of investment with adjustment costs. Equilibrium suggests that capital K(t) evolves as K˙(t) = C ′−1(q(t) − 1) (normalizing the number of firms N = 1 and assuming no depreciation), while the marginal value of capital, q(t) evolves as q˙(t) = rq(t) − pi(K(t)), where r is the real interest rate. Note that the capital adjustment cost function, C(I(t)) satisfies C(0) = 0, C ′(0) = 0, and C ′′(·) > 0 and the real profit function, pi(K(t)), satisfies pi′(·) < 0. Assume the transversality condition limt→∞e−rtq(t)κ(t) = 0, where κ(t) is the representative firm’s capital stock. (a) Draw the phase diagram for this model, explaining the location of the saddle path. (b) Use the phase diagram to show what happens given a sudden permanent drop in demand for output in a given industry. Explain what happens to q and K in that industry. What happens to the relative price of the industry’s output, as well as profits and the market value of capital, both on impact and over time? (c) Compare your results in part (b) to what would happen if the drop in demand were only temporary. Does q jump by more or less than in the case of a permanent drop? Why can’t there be any anticipated jump in q after the initial fall? (d) Comparing the results for parts (b) and (c), what do they imply about the effects of future changes in output on current investment for this industry? (Hint: in which case is the accelerator effect larger?)