Sample Questions for Advanced Macroeconomics Midterm Exam

Answer: d) The level of capital per worker. In the Solow model, the capital per worker in the steady state is determined endogenously by the savings rate, population growth rate, and technological progress. It is not an exogenous factor affecting the steady state.

Answer: b) The economy tends to return to the natural rate of unemployment regardless of inflation. The natural rate hypothesis posits that there exists a natural rate of unemployment determined by real factors, and that policy attempts to keep unemployment below this rate will only result in accelerating inflation.

Answer: Ricardian equivalence, proposed by Robert Barro, suggests that consumers are forward-looking and perfectly anticipate the future implications of government budget constraints. According to this theory, when governments increase deficits (either through tax cuts or spending increases), rational consumers will increase their savings in anticipation of future tax liabilities to pay off government debt. This behavior negates the stimulative effects of expansionary fiscal policy, as increased government spending is offset by reduced private consumption. The implication is that, under certain assumptions, fiscal policy may be ineffective in influencing aggregate demand, as changes in government financing methods (taxes vs. debt) are seen as equivalent by households.

Answer: Real Business Cycle (RBC) theory views economic fluctuations as efficient responses to real shocks, primarily technology shocks. It assumes flexible prices and wages, rational expectations, and market clearing. RBC models suggest that business cycles represent optimal adjustments to changes in economic fundamentals and that government intervention is generally undesirable. In contrast, New Keynesian models emphasize nominal rigidities (sticky prices and wages), imperfect competition, and informational problems as sources of economic fluctuations. New Keynesians argue that market imperfections can lead to suboptimal outcomes, providing justification for stabilization policies. While RBC proponents view recessions as periods of voluntary leisure time, New Keynesians see them as periods of involuntary unemployment caused by coordination failures and price rigidities.

Answer: The Phillips curve, originally documented by A.W. Phillips in 1958, showed an inverse relationship between unemployment and wage inflation in the UK. Later economists extended this to a relationship between unemployment and price inflation, suggesting that policymakers faced a stable trade-off: lower unemployment could be achieved at the cost of higher inflation.

The stability of this trade-off was challenged in the 1970s when many economies experienced simultaneous high inflation and high unemployment (stagflation), contradicting the Phillips curve. Milton Friedman and Edmund Phelps independently introduced the expectations-augmented Phillips curve, arguing that there is no long-run trade-off between inflation and unemployment. They posited that the Phillips curve exists only in the short run when expectations are adaptive, and in the long run, unemployment returns to its natural rate regardless of inflation.

Modern macroeconomics incorporates rational expectations into the Phillips curve analysis, leading to the New Keynesian Phillips curve, which is derived from microfounded models with nominal rigidities. This version emphasizes the role of forward-looking inflation expectations and marginal costs.

The evolution of the Phillips curve has significant implications for monetary policy. The existence of a stable trade-off would allow policymakers to exploit it by accepting higher inflation for lower unemployment. However, the expectations-augmented version suggests that such exploitation yields only temporary gains and accelerates inflation in the long run. This understanding has influenced central banks to adopt rules-based approaches to monetary policy, focusing on anchoring inflation expectations and maintaining credibility, rather than attempting to fine-tune the real economy through discretionary policy.

Answer: The IS-LM (Investment Savings-Liquidity preference Money supply) model, developed by John Hicks in 1937 as an interpretation of Keynes's "General Theory," presents a short-run equilibrium in the goods market (IS curve) and the money market (LM curve). The IS curve shows combinations of interest rates and income that equilibrate savings and investment, representing equilibrium in the goods market. The LM curve shows combinations of interest rates and income where demand for money equals the money supply.

The AD-AS (Aggregate Demand-Aggregate Supply) model, while incorporating some elements of IS-LM, presents equilibrium in terms of price levels and output. The AD curve derives from IS-LM relations, showing the relationship between the price level and total spending. The AS curve represents firms' collective output decisions at different price levels.

Key differences include their treatment of price levels: the basic IS-LM model typically assumes fixed prices (short-run focus), while the AD-AS model explicitly incorporates price level adjustments. Policy implications also differ: IS-LM is particularly useful for analyzing monetary and fiscal policy effects on output and interest rates, while AD-AS provides a framework for examining supply shocks and inflation dynamics.

Limitations of IS-LM include its simplified treatment of expectations, lack of microfoundations, and difficulty in extending to an open economy. The AD-AS model faces criticism for its sometimes ambiguous derivation of the aggregate supply curve, particularly regarding the distinction between short-run and long-run aggregate supply.

Both models have evolved, with modern versions incorporating rational expectations, intertemporal optimization, and microeconomic foundations. Despite limitations, these frameworks remain valuable pedagogical tools and provide intuitive first-order approximations for analyzing policy effects in macroeconomic systems.

Answer:

a. To find equilibrium, we solve the IS and LM equations simultaneously.

IS equation: Y = C + I + G = 200 + 0.8(Y - 150) + (100 - 5r) + 150
Y = 200 + 0.8Y - 120 + 100 - 5r + 150
0.2Y = 330 - 5r
Y = 1650 - 25r (IS curve)

LM equation: M/P = 500/2 = 250 = 0.5Y - 10r
Solving: 10r = 0.5Y - 250
r = 0.05Y - 25 (LM curve)

Setting IS = LM:
1650 - 25r = 20(r + 25) = 20r + 500
1150 = 45r
r = 25.6%

Substituting back:
Y = 1650 - 25(25.6) = 1010

b. The autonomous spending multiplier = 1/(1 - MPC) = 1/(1 - 0.8) = 5

c. An increase in government spending of 50 would increase output by:
Y = multiplier G = 5 50 = 250
The new equilibrium output would be Y = 1010 + 250 = 1260

Answer: Hysteresis in macroeconomics refers to the phenomenon where temporary shocks can have permanent effects on economic variables. When applied to unemployment, hysteresis suggests that prolonged periods of high unemployment can lead to a permanent increase in the natural rate of unemployment.

Several mechanisms explain this phenomenon:

1. Skill depreciation: Long-term unemployment leads to atrophy of workers' skills and deterioration of work habits, making them less employable even when demand recovers.
2. Human capital effects: Extended unemployment may discourage investment in skills and knowledge by both workers (who see low returns to such investment) and firms (who may reduce training programs).
3. Insider-outsider dynamics: Employed "insiders" may use their bargaining power to keep wages high during recoveries, preventing unemployed "outsiders" from re-entering the labor market.
4. Employer discrimination: Long periods of unemployment may signal reduced productivity or skills decay to employers, creating a bias against hiring the long-term unemployed.
5. Capital scrapping: During deep recessions, capital that becomes unprofitable may be scrapped rather than mothballed, reducing the economy's productive capacity and potential employment levels.

The existence of hysteresis has significant policy implications:

• It suggests a stronger case for activist stabilization policies to prevent temporary downturns from becoming permanent increases in unemployment.
• Policies focused on maintaining labor market attachment (e.g., work-sharing programs, job retraining) become particularly important during recessions.
• There may be value in front-loading support during downturns to prevent the accumulation of long-term unemployment that becomes structural.
• Traditional policy trade-offs change if a temporary recession causes permanent economic damage, potentially justifying more aggressive policy intervention.