ECON 3141/4141: International macro and finance
This is a 3000-words home assignment, i.e., to get a pass the number of words
cannot exceed 3000 (figures, equations, diagrams etc. do not count as words).
The home assignment will be marked and counts 40 % towards the overall mark in
this course. If a student believes that she or he has a good cause not to meet the
deadline (e.g. illness) she or he should discuss the matter with the course teacher
and seek a formal extension. Normally extension will only be granted when there
is a good reason backed by supporting evidence (e.g. medical certificate).
1. Consider the following dynamic macro model
(1)
(2)
Ct = β 0 + β 1 Yt + αCt−1
Yt = Ct + Jt
where Ct denotes private consumption (in period t), Jt denotes autonomous
expenditure and Yt symbolizes GDP. Assume that the initial conditions C0
and J0 are known, and that the parameters β 0 , β 1 , α also are known numbers.
(a) Explain the economic interpretation of the model in equation (1) and (2).
(b) Assume Jt = J0 , i.e., constant at the initial level J0 . Draw a graph that
illustrates the stable solution path for Yt in the case where Y0 is above
the long run steady state level of Y . Explain.
Replace (2) by
(3)
Yt = Ct + Jt + P CAt
where P CAt denotes the primary current account (or trade balance). Assume
the following function for P CAt :
(4)
P CAt = γ 0 + γ 11 σ t + γ 12 σ t−1 + γ 20 Yt
where σ t denotes the real exchange rate (as defined in the book by Burda
&Wyplosz).
(a) What do you regard to be reasonable signs of the derivative coefficients
(γ 11 , γ 12 , γ 20 ) in equation (4)? What about the sum γ 11 + γ 12 ?
(b) Discuss the condition(s) of stability of the system made up of (1), (3) and
(4).
(c) Choose a set of numbers for the derivative coefficients of the system (1),
(3) and (4) and (using that set of coefficients values), show how GDP is
affected by a permanent increase in the real exchange rate.
2. In small open economies, there is a lot of interest (and concern) about wage
formation, in particular in the sectors of the economy which face competition
from foreign firms, i.e., the exposed sector.
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(a) Why, according to your understanding, is wage formation so important
in the economic-policy debate?
A general wage equation is represented by
(5)
we,t = β 0 + β 11 mct + β 12 mct−1 + β 21 ut + β 22 ut−1 + αwe,t−1 .
where we is the log of hourly wage costs (wage costs per man-hour) in
the exposed sector, and ut is the rate of unemployment (or its log) in the
economy. mct represents the main-course variable of the Norwegian model
of inflation, hence mct = qe,t + ae,t where qe,t and ae,t denote the logs of
the e-sector product price and average labour productivity, respectively.
(b) Explain (briefly) under which theoretical assumptions mct can be viewed
as an exogenous variable in the wage equation.
(c) Show that the restriction 0 < α < 1 implies a dynamic wage equation in
equilibrium correction form (EC).
(d) Show that the following restrictions on (5): α = 1, β 11 + β 12 = 0, β 21 +
β 22 < 0, imply a dynamic wage equation in Phillips-curve form.
(e) Explain why both the Phillips curve and the EC versions of equation (5)
are consistent with a main hypothesis of the Norwegian model of inflation,
namely that in steady-state, wage growth ( ∆we,t ) is equal to the growth
in the main-course variable (∆mct ).
3. Figure 1 shows graphs of the Swedish nominal and real exchange rate. You
may want to down-load the data series from the web-page:
http://folk.uio.no/rnymoen/ECON3410_index.htm.
The name of the file is swefex.zip.
(a) In your view, has the Swedish governments of the past successfully used
devaluation to improving competitiveness?
(b) What does macroeconomic theory predict about the short- and long-run
effects of a devaluation on the real exchange rate?
(c) In late 1992, Sweden adopted a floating exchange rate regime. Try to investigate empirically, using the data set, whether the correlation between
the nominal and real exchange rate has been increased or reduced after
the change to a floating exchange rate regime.
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160
150
Nominal effective exchange rate (fall means devaluation/depreciation)
140
130
120
110
Real effective exchange rate (fall means improved competetiveness)
100
90
1980
1985
1990
1995
2000
Figure 1: Swedish effective (i.e., trade weighted) exchange indices (1995=100).
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