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THE UNIVERSITY OF SUSSEX

MA EXAMINATION IN ECONOMICS 2008/09

ECONOMIC ANALYSIS II

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Candidates must attempt THREE questions

1. You are given the following data for an economy that is operating a fixed but adjustableexchange rate:

Price elasticity for exports = 0.4Price elasticity for imports = 0.4

The value of exports is 50% of the value of imports

Would a devaluation in this case raise or lower (a) aggregate demand, (b) the rate ofchange of foreign currency reserves? Comment on the policy implications of your results.

2. If the US should be about to experience a period of price deflation, as some haveforecast, in what ways would this affect US real aggregate demand (and itscomponents)?

3. What is involuntary unemployment? Give some examples of ways in which it can arise asan equilibrium phenomenon, in each case explaining what factors determine how much

unemployment of this kind there will be.

4. High inflation rates seem to be associated with relatively unfavourable short-runinflation-unemployment tradeoffs (i.e. unemployment responds relatively little to changesin the rate of inflation). Does this finding imply that we should prefer the menu costmodel of nominal rigidities to Lucass islands model?

5. In Fischers overlapping wage contracts model, explain (a) the relation between thepersistence of shocks and the effectiveness of monetary policy, and (b) how policyshould respond to demand and supply shocks respectively.

6. Beans model of inflation targetting is based on the following two equations for thedetermination of real output, y, and inflation :

y = -ar-1 + by-1 + = -1 + cy-1 +

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In these equations, a, b and c are positive constants, r is the real rate of interest (theCentral Banks instrument), the subscript -1 indicates a one-year lag, and and areindependent random shocks. When the Central Bank chooses the current r, it is assumedto have observed the current values of y and . The target for is zero.

(a) Show how the equations can be used to derive an expression for +2 as a function oftime-zero expectations of +1 and y+1 together with future shocks, and interpret thisexpression carefully.

(b) Illustrate the concept of constrained discretion by analysing optimal Central Bankbehaviour in this model.

7. Define Ricardian Equivalence and identify a set of conditions under which it will holdtrue. Under these conditions, is it conceivable that an unexpected cut in governmentexpenditure could cause a rise in aggregate demand, and if so how?

8. Explain, in the costly state verification model of credit markets how the likelihood of afirm being able to gain access to credit depends on (a) the expected return of the firmsproject, (b) the safe rate of interest, and (c) the wealth of the firms owner. What insightsdoes this model give us into how monetary tightening affects an economy?

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