**SECTION A **

Choose and answer **ONLY ONE** question from this section. Questions carry the same weight of

**40 MARKS each**. Answer all parts of the chosen question. The overall word limit for the chosen question is of 800 words

1.Consider an economy in which the central bank sets the nominal interest rate according to the rule:

- 𝑖=𝑖*+𝛼(𝜋e−𝜋*)+𝛽(𝑌−𝑌𝑛)

In which parameters 𝛼>1 and 𝛽>0*, *and 𝑖* is the target interest rate, i is the interest rate chosen by the central bank, 𝜋e is the expected future inflation rate, 𝜋* the inflation target, Y is output and 𝑌𝑛 is the natural level of output.

- Define 𝑟=𝑖−𝜋e and 𝑟*=𝑖*−𝜋*. Use these definitions to express the interest rate rule in terms of real interest rates.
**(5 marks)**

- The IS relationship in a closed economy is given by 𝑌=𝐶(𝑌−𝑇)+𝐼(𝑌,𝑟)+𝐺. Graph the IS curve in a diagram with income (Y) on the horizontal axis and (
*r*) on the vertical axis. On the same diagram graph the interest rate rule that you have derived in part (a) for given values of 𝜋∗,𝜋e and 𝑌𝑛. Show the MP schedule for monetary policy. Indicate the slope and the intercept of the MP curve you have derived and discuss the factors that would make this curve shift.**(10 marks)**

- Using the diagram from part (b), show the effects of an increase in government spending on output and the real interest rate in the short run.
**(5 marks)**

- Using static expectations derive the AD and graph the curve in a diagram with income (Y) on the horizontal axis and inflation rate (𝜋) on the vertical axis.
**(10 marks)**

- Consider a change in the monetary policy rule. Suppose the central bank reduces its inflation target 𝜋*. Explain and illustrate how the fall in 𝜋* affects the MP line in the IS/MP diagram and the AD curve in the AD diagram. What happens to output, real interest rates and inflation?
**(10 marks)**

**Total 40 marks **

- A closed economy can be represented by the following relationships (where
*C*is consumption,*Y*income,*T*tax revenue,*i*the interest rate,*I*investment,*G*government spending, 𝜋 is the inflation rate and 𝜋* =2% is the targeted inflation rate,*Y**n*=900 is the natural level of income and i* = 5% is the long term equilibrium interest rate)

(2.1) 𝐶=250+0.6(𝑌−𝑇) Consumption equation

(2.2) 𝐼=150+0.02𝑌−3000𝑖 Investment equation

(2.3) 𝐺=200 Government spending

(2.4) 𝑇=0.2𝑌 Income Tax equation

(2.5) 𝑖=𝑖*+0.5(𝜋−𝜋*)+ 0.0001(𝑌−𝑌𝑛) Monetary policy (MP) equation

- Derive an expression for the IS equation for this economy. Use the MP equation to demonstrate that in equilibrium, Y=900 and i=i*, assuming that the inflation rate is at its target of 2%. Graph the two curves and indicate the equilibrium point.
**(15 marks)**

- What are the equilibrium values of consumption, investment and the fiscal balance?
**(5 marks)**

- What is the effect on
*Y*,*i*, and tax revenue of increasing government spending? Represent this change in the IS-MP diagram.**(5 marks)**

- How would the model be affected if the tax rate was cut? Represent this change in IS-MP diagram, indicating clearly the reason of the change.
**(5 marks)**

- Explain how the conclusions of your analysis in (c) and (d) could be different when prices are allowed to change and aggregate supply is taken into account, distinguishing short term effects (when the AS is flat and price do not move) and medium term effect (when the AS is upward sloping).
**(10 marks)**

**Total 40 marks **

**SECTION B **

Choose and answer **ONLY THREE** questions from this section. Questions carry the same weight of

**20 MARKS each**. Answer all parts of the chosen question. The overall word limit for each chosen question is of 600 words

- Macroeconomic consequences of the pandemic crisis.

- Use the AD/AS model of an open economy to analyse and illustrate the effects of the current global health crisis.
**(5 marks)**

- Discuss the risk of the deflationary trap and explain why the most troubling effect of deflation and of low inflation is on monetary policy. Indicate and critically evaluate reflationary policies and the use of unconventional monetary tools under a zero-rate policy.
**(10 marks)**

- Many people think that, once the pandemic is contained, major economies will face upwardly spiralling prices. A former chief economist at the International Monetary Fund, Olivier Blanchard, recently wrote, that a small probability of high inflation cannot be dismissed. Explain and illustrate this view.

**(5 marks)**

**Total 20 marks**

- Consider the AS-AD model, which is a framework for understanding the behaviour of output and the price level. Figure 1 displays the evolution of both variables after a shock (based upon a calibrated AS-AD model).

- Characterise the nature of the shock whose simulated effects are displayed in Figure 1 below.
**(10 marks)**

- Provide an explanation for the behaviour of output.
**(5 marks)**

- Provide an explanation for the behaviour of the price level.
**(5 marks)**

Figure 1:

**Total 20 marks**

- Consider and economy with a fixed exchange rate Ē (Ē = fixed exchange rate parity). The exchange rate is defined as the price of the domestic currency in terms of the foreign currency. Suppose that at time (t-1) financial market participants believe that the government is committed to the fixed exchange rate. At time t, however, financial market participants become fearful that the government will devalue or allow the exchange rate to float (which would, everyone believes, lead to a currency depreciation).

- At time t, what happens to the expected exchange rate, Ee(t+1)? Draw an IS-UIP diagram with UIP curves for time (t-1) and time t and explain why the UIP curve change at time t.
**(5 marks)**

- Suppose that the government decides to maintain Et= Ē . What must happen to the interest rate in order to achieve this? What happens to output?
**(5 marks)**

(c) Suppose that instead the government decides to devalue the currency, Et= Ee(t+1). What does this imply for the interest rate and output? **(5 marks)**

- How might expectations of a devaluation, even if they are unfounded, force a government to devalue? Why do we call such a devaluation a self-fulfilling exchange rate crisis?
**(5 marks)**

**Total 20 marks**

- Figure 2 below shows annual observations of inflation and unemployment, respectively, in Germany over the period 1980-2009 (one dot per year).

- Describe the relationship depicted in Figure 2 and interpret its economic significance.
**(10 marks)**

Figure 2

- It has been argued that the link between lower unemployment and higher inflation has flattened or has gone missing. Most of the rich world is enjoying a jobs boom even as central banks undershoot inflation targets. Indicate and discuss some possible reasons for the flattening of the Expectations-Augmented Phillips curve or for its disappearance and the possible consequences for monetary policy.
**(10 marks)**

**Total 20 marks**

- Yield curve, international interest rate and borrowing

(a) What is the (pure) expectations theory of the yield curve? Now suppose that inflation is expected to be unusually high this year and next year. According to this theory, would we expect the yield curve to slope upwards or downwards? **(5 marks)**

(b ) If the private sector in an open economy reduces its debt, what are the possible offsets? How would your answer change if the private sectors in most of the world are to reduce their debt at the same time? **(5 marks)**

(c )What is the difference between net national saving and the trade balance? What would a negative Current Account position of the Balance of Payment imply in terms of the country’s net indebtedness position? **(5 marks)**

(d) Why might a rise in international interest rates lead to hyperinflation in some highly-indebted countries? Why would this be less likely to happen in a country with a government that has the capacity to effectively raise taxes? **(5 marks)**

**Total 20 marks**

** ****END OF PAPER**