Intermediate Macroeconomics

B.A. (HONS.) ECONOMICS

SEMESTER – III
DEC-2016

Duration: 3 Hours Maximum Marks: 75

Instructions:
Attempt any two parts from each question.
Each part carries 7.5 marks.
All the notations have their standard interpretation.

1. (a) Given an economy with fixed prices, discuss the impacts of the following
factors on the effectiveness of Fiscal Policy and Monetary Policy:
(7.5)
(i) degree of sensitivity of money demand to income k  and
(ii) degree of the sensitivity of investment to rate of interest (b ).
(b) Consider two economies A and B identical in all respects. Starting with
medium run equilibrium, suppose both the economies face a permanent
decline in the price of oil. In economy A, government uses monetary
policy to keep output at original level in the short-run and does not
change nominal money supply thereafter. In economy B, government
takes no action. Using AS and AD curves show the impact on output and
prices in both economies in short run and medium run.
(7.5)
(c) Assume the following imaginary quotes “The Central Bank’s decision to
allow for higher money growth is the main factor behind the decline in
interest rates in the short-run”; and “Higher money growth will
eventually lead to higher inflation and higher interest rates.” Can the two
statements given above be reconciled? Provide full explanation for your
answer.
(7.5)

2. (a) Use IS-LM and AS-AD diagrams, to show how a reduction in the rate of
income tax will affect output and prices in the short-run and medium-
run. What would be the impact of this tax reduction on investment in the
medium run? Assume that the economy originally starts in the medium-
run at the natural level of output.
(7.5)
(b) It is said that adaptive expectations allows us to relate unobservable,
expected variables to the observed values of the same variable. Do you

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 agree? Explain. It is further said that adaptive expectations tend to
ignore useful information which leads to inefficient expectations. Give
two examples to justify this.
(7.5)
(c) Use the following equations of Okun’s law, ut  ut 1   0.4 g yt  3% to
answer the following questions:
(i) Calculate the rate of growth of output that will reduce the
unemployment rate by one percentage point in one year. Give two
reasons why the excess growth of output implied by your answer
is different from the decline in the unemployment rate.
(ii) Calculate the rate of growth of output again in case the labour
productivity is reduced by one percentage point. Further; what
would the answer be if, in addition to this, labour force growth is
also reduced by two percentage point?
(4.5+3)

3. (a) You are give the following information for an economy:

AD : Mt  Vt  Pt  Yt


AS : Yt  Yp   Pt  Pte 
Money supply rule : Mt   Yt 1   t

(All quantities are in natural logs and all terms have standard
interpretation,  t is a random variable such that E  t | It 1   0.)

(i) Derive an expression for the equilibrium values of price and

output assuming Rational Expectations. What is the policy
significance of these results?
(ii) Use AS- AD curves to show the above result diagrammatically.
(5+2.5)
(b) Suppose that the Phillips curve in an economy is given by the equation:
 t   te  0.18  3ut
where
 te    t 1
Further suppose that in period t  1 the unemployment rate is equal to
the natural rate and the inflation rate is zero:
(i) What is the natural rate of unemployment in this economy?
(ii) Suppose that beginning in period t the authorities bring the
unemployment rate down to 5% and keep it there indefinitely.
Determine the inflation rate in period t , t  1 and t  2 where
θ  0.

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 (iii) Repeat the same exercise for θ  1.
(iv) With the same information and θ  1, if half of the workers sign
indexed labour contracts. Calculate again the inflation rates in
period t , t  1 and t  2.

(v) Comparing answers in part ii  , iii  and iv  above, explain the
effect of θ and indexing on the impact of maintaining
unemployment rate below the natural rate.
(7.5)
(c) Use the wage setting and price setting (WS-PS) diagrams, to show how
the following factors impact unemployment rate and real wages:
(i) Labour reforms making unionization more difficult.
(ii) Rise in market power of firms following large scale Merger and
Acquisition activities.
(iii) An increase in the world production of oil.
Do your answers refer to the short-run or the medium run?
(2+2+2+1.5)
4. (a) Consider an economy where capital is perfectly mobile, prices are fixed
and exchange rate is flexible. The government decides to increase the
output by giving direct cash transfers to the public. Explain how such a
policy would impact the exchange rate, trade balance and output. Also,
explain what happens to the rate of interest and the composition of
output.
(b) Assume an economy where capital is not mobile, but prices are flexible
and exchange rate is fixed. Let there be an exogenous rise in exports.
Assuming that the economy was initially in internal and external
balance, how would the external and internal balance be affected by this
change? Suggest one policy which can correct both the imbalances
simultaneously. Explain any one reason why the policy suggested by you
may not be effective in restoring external balance.
(7.5)
(c) You are given the following information about an economy.
The Rupee-Dollar Exchange Rate (Rupees per Dollar) in the three months
forward market is 60.
(i) How can a speculator make gains if he/she expects the spot rate
to become 60.75 in three months?
(ii) How should he/she behave if the spot rate is expected to be
59.25?
(iii) What would happen if the speculator expected the rate to become
59.25 but in reality the spot rate turns out to be 60.75 in three
months?
(7.5)

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5. (a) (i) Assume perfect capital mobility, flexible exchange rate and fixed
prices. Let there be an exogenous increase in rate of interest
abroad. How would this impact output, exchange rate and trade
balance?
(ii) Under extended asset market approach to exchange rate how does
increased risk of foreign bonds impact the value of domestic
currency relative to foreign currency? (Consider only the initial
impact). How would this further impact the Expected Appreciation
of foreign currency (assuming that the expected exchange rate in
the spot market remains unchanged) and Risk Premium?
(4+3.5)
(b) Suppose that the rate of interest in India is 3%, that in USA is 6% (both
on annual basis) the exchange rate is Rs. 60/$ in the spot market and
Rs. 57/$ in the three months forward market.
(i) Calculate the value of Covered Interest Arbitrage Margin (CIAM)
and state the direction of capital flow. (You may ignore the
weighting factor on the interest differential).
(ii) Show the above diagrammatically using the relationship between
interest differential between two countries, and Forward Discount
or Forward Premium on the foreign currency. Explain how
arbitrage leads to elimination of this CIAM over time.
(4+3.5)
(c) Show that, following a monetary expansion, exchange rate, in the short-
run, overshoots its new medium run equilibrium value. Explain. Show
that the long-run behavior of nominal exchange rate is an extension of
neutrality of money to open economy?
(7.5)
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