Department of Economics University of Maryland

Economics 325
Intermediate Macroeconomic Analysis
Final Exam
Professor Sanjay Chugh
Fall 2008
December 18, 2008

NAME:

The Exam has a total of five (5) questions and pages numbered one (1) through eleven (11).
Each question’s total number of points is shown below. Your solutions should consist of some
appropriate combination of mathematical analysis, graphical analysis, logical analysis, and
economic intuition, but in no case do solutions need to be exceptionally long. Your solutions
should get straight to the point – solutions with irrelevant discussions and derivations will be
penalized. You are to answer all questions in the spaces provided.

You may use two pages (double-sided) of notes. You may NOT use a calculator.

Question 1 / 15
Question 2 / 20
Question 3 / 35
Question 4 / 20
Question 5 / 10
TOTAL /100
1. A National Service Program (15 points). Consider the following radical policy proposal:
rather than taxes being levied on individuals and the proceeds of those taxes being used by the
government to fund various programs, suppose that every individual pays no taxes of any kind
but must give ten hours of his time every week to national service. Here you will analyze this
national service program in the context of the (one-period) consumption-leisure model we have
studied. Thus, there are now three uses of the individual’s time: work, leisure, and national
service (the mandatory 10 hours). Assume the following:
- Instituting the national service program has no effect on any prices or wages in the
economy.
- Any time spent voluntarily performing national service beyond the required 10 hours is
considered leisure.
a. (8 points) Using the notation we developed in Chapter 2 (i.e., c to denote consumption, n
to denote hours of work per week, l to denote hours of leisure per week, P to denote the
nominal price of consumption, and W to denote the nominal hourly wage), construct the
representative agent’s (weekly) budget constraint in this model with a national service
program. Recall that there are 168 hours in one calendar week. Provide brief economic
justification for your work.

b. (7 points) Now recall the standard consumption-leisure model with no national service
program and suppose that both the consumption tax rate is zero and the labor tax rate is zero.
How does the slope of the budget constraint in this economy compare with the slope of the
budget constraint in the economy with the national service program in part a? Provide brief
economic explanation.

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2. Monetary Policy in the MIU Model (20 points). In this question, you will analyze, using
indifference curve/budget constraint diagrams, the implications of alternative nominal interest
rates on the representative consumer’s choices of consumption and real money balances.

Recall that, with an instantaneous utility function u (ct , M t / Pt ) (where, as usual, ct denotes
consumption and M t / Pt denotes real money balances), the consumption-money optimality
condition (which we derived in Chapter 14) can be expressed as

umt (ct , M t / Pt ) it
= ,
uct (ct , M t / Pt ) 1 + it
where, again as usual, it is the nominal interest rate, uc (.) denotes the marginal utility of
consumption, and um (.) denotes the marginal utility of real money balances.

a. (6 points) Suppose the central bank is considering setting one of two (and only two) positive
nominal interest rates: it1 and it2 , with it2 > it1 . On the indifference map below, qualitatively
(and clearly) sketch relevant budget lines and show the consumer’s optimal choices of
consumption and real money under the two alternative policies. On the diagram below,
note the point on the vertical axis marked “FIXED” – this denotes a point that must lie
on EVERY budget constraint. Clearly label your diagram, including the slopes of the
budget lines.
consumption

FIXED

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Question 2 continued
b. (7 points) You are a policy adviser to the central bank, and any advice you give is based
only on the goal of maximizing the utility of the representative consumer. The central bank
asks you to help it choose between the two nominal interest rates it1 and it2 (and only these
two). Referring to your work in the diagram above, which nominal interest rate would you
recommend implementing? Briefly explain.

c. (7 points) Suppose instead the central bank is willing to consider setting any nominal
interest rate, not just either it1 or it2 . What would your policy recommendation be? Briefly
justify your recommendation, and also in the diagram in part (a) sketch and clearly label
a new budget line consistent with your policy recommendation.

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3. The Fiscal Theory of Exchange Rates (35 points). In this question, you will use the fiscal
theory of exchange rates to analyze some consequences of a fixed exchange rate system. The
model is just as we have studied in class – in particular, consumption is constant at c = 11 in
every period, real money demand is described by the function, M t / Pt = φ ( c , it ) , PPP holds, and
the foreign price level is equal to one in every period (i.e., Pt * = 1 in every period t ). The
domestic country runs a fiscal deficit of DEF = −5.5 (a negative deficit is a surplus…) every
period, and there is no political will to ever change this deficit. The real money demand function
is given by φ (c , it ) = c − 10 ⋅ it , and the exchange rate that the country is pegging (for as long as it
can) is E = 2 units of domestic currency per unit of foreign currency. Finally, the foreign real
interest rate is r* = 0.10 , the government starts period 1 with foreign reserves of B0G = 22 , and
foreign reserves can never go below zero.

a. (3 points) As long as the fixed exchange rate is in place and is expected to remain in place,
what is the numerical value of the domestic nominal interest rate? Briefly justify your
answer.

b. (3 points) As long as the fixed exchange rate is in place and is expected to remain in place,
what is the numerical value of the domestic country’s BOP surplus or BOP deficit? Briefly
justify your answer.

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Question 3 continued
c. (4 points) Based on your answer in part b, is the floating exchange rate higher than, lower
than, or equal to E = 2 ? Briefly justify your answer. (Note: You do not need to compute
any numerical values here.)

d. (5 points) If markets/investors for some reason never expect a change in the nominal
exchange rate, how many periods will the fixed exchange rate last? Briefly justify your
answer.

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Question 3 continued
The following applies to the remainder of this question: suppose the government of the domestic
country announces in period T-1 that in period T and forever beyond, the nominal exchange
rate will be 1.9 units of domestic currency per unit of foreign currency, and markets/investors
believe this announcement. For reference, note that 1.9 / 2 = 0.95.

e. (5 points) How does the domestic nominal interest rate in period T-1 compare to the
domestic nominal interest rate in period T-2 (i.e., is it smaller than, larger than, or equal)?
Briefly justify your answer, and provide economic intuition for what you find, including a
brief economic explanation for why iT −1 differs from r * if it does. (Note: You do not
need to compute any numerical values here.)

f. (5 points) Based on what you found in part e, is the domestic government’s seignorage
revenue in period T-1 larger than, smaller than, or equal to its seignorage revenue in period
T-2? Briefly justify your answer, and provide economic intuition for what you find,
including a brief economic explanation for why seignorage revenue differs from zero if
it does. (Note: You do not need to compute any numerical values here.)

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Question 3 continued
g. (5 points) Based on what you found in part f, is the domestic country’s BOP in period T-1
larger than, smaller than, or equal to its BOP in period T-2? Explain precisely, including
why,

h. (5 points) Does the expectation of a change in the exchange rate (from 2 units of domestic
currency per unit of foreign currency to 1.9 units of domestic currency per unit of foreign
currency, as described above) mean that the exchange rate system will last longer than
without this change in expectations, shorter than without this change in expectations, or is it
impossible to tell? Explain precisely your logic.

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4. Fiscal Policy (20 points). President-elect Obama and his primary economic advisers have
publicly stated that large fiscal stimuli will be put in place once the new administration takes
office. The precise details of the fiscal stimulus are still to be worked out, but they seem
likely to include both tax cuts as well as increased government spending in the next couple of
years.

Suppose it is early 2009, and the new administration has been seated. At the beginning of
2009, the lifetime consolidated budget constraint of the government is:

B2008 t − g 2010 t2011 − g 2011 t2012 − g 2012

= (t2009 − g 2009 ) + 2010 + + + ... PDV of fiscal
P2009 1 + r2010 (1 + r2010 )(1 + r2011 ) (1 + r2010 )(1 + r2011 )(1 + r2012 ) deficits
sr2010 sr2011 sr2012
+ sr2009 + + + + ...
1 + r2010 (1 + r2010 )(1 + r2011 ) (1 + r2010 )(1 + r2011 )(1 + r2012) PDV of
seignorage
The notation here is as in Chapter 15: t denotes real lump-sum tax collections, g denotes real
government spending, sr denotes real seignorage revenue, r denotes the real interest rate, B
denotes nominal (one-period) government bonds, and P denotes the nominal price level of
the economy (i.e., the nominal price of one basket of consumption). Subscripts indicate time
periods, which we will consider to be calendar years. Note, of course, the ellipsis (…) in
each line of the above equation.

As indicated above, the first line of the right-hand-side is the present discounted value of all
fiscal deficits the government will ever run starting from 2009 onwards, and the second line
of the right-hand-side is the present-discounted value of all seignorage revenue that will ever
result from the monetary policy actions of the Federal Reserve starting from 2009 onwards.

The primary economic advisers to President-elect Obama will be Treasury Secretary(-

designee) Timothy Geithner, National Economic Council Chairman Lawrence Summers, and
Council of Economic Advisers Chairwoman Christina Romer.

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Question 4 continued
a. (5 points) Geithner, because of his background as current President of the New York
Federal Reserve, is likely to advocate that, no matter what fiscal policy actions the new
administration takes, they should be designed in such a way as to have no effects on the
conduct of monetary policy whatsoever. If this is so, what type of fiscal policy – a Ricardian
fiscal policy or a non-Ricardian fiscal policy – would Geithner be advocating? Briefly
explain.

b. (5 points) The less even-keeled that he is, Summers may very well recommend that the new
fiscal stimulus measures should not take into account any consequences they may have for
the conduct of monetary policy. If some combination of tax cuts and government spending
increases is enacted and Summers’ advice is followed, what are likely to be the consequences
for the Federal Reserve’s monetary policy in 2009 and beyond? In particular, will the Fed
likely have to expand or contract the nominal money supply? Briefly explain.

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Question 4 continued
c. (5 points) The objective academic macroeconomist that she is, Romer is likely to point out
that because fiscal policy plans (for both t and g) will almost surely be revised as the years
unfold (that is, fiscal policy plans adopted in 2009 can be revised in later years), it may be
impossible to know beforehand what the eventual consequences for monetary policy of a
particular fiscal policy action adopted at the start of 2009 might be. In no more than three
sentences/phrases, use the government budget constraint presented above to interpret
what Romer’s statement means.

d. (5 points) If, after the announcement of the new fiscal plans in early 2009, the nominal price
level of the economy behaves as shown in the following diagram, which of the following is
most relevant explanations: the fiscal theory of the price level, the fiscal theory of inflation,
or the fiscal theory of exchange rates? Briefly justify your answer.

Jan. 2009 Time

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5. The Keynesian-RBC-New Keynesian Evolution (10 points). Here you will briefly analyze
aspects of the evolution in macroeconomic theory over the past 25 years. Address each of
the following in no more than three sentences each.

a. (5 points) Describe briefly what the Lucas critique is and how/why it led to the demise
of (old) Keynesian models.

b. (5 points) Briefly define and describe the neutrality vs. nonneutrality debate surrounding
monetary policy today. Which type of shock does this debate concern?

END OF EXAM

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