Econ 305: Intermediate Macroeconomics
Simon Fraser University
December 2000
David Andolfatto
Name
Instructions. Please limit your answer to the space provided below each question. To receive maximum
marks, write neatly and label diagrams clearly.
Small Open Economy (20 Marks)
Consider an economy populated by individuals who have preferences for time-dated consumption (c1 , c2 )
given by MRS = c2 /(βc1 ), where β > 0 is a parameter. Individuals begin with zero financial assets, but
are able to borrow or lend in a competitive financial market at a (gross) real interest rate equal to R > 0.
Individuals are endowed with an earnings stream (y1 , y2 ); for simplicity, assume a ‘representative’ individual.
There is also a government that levies taxes (τ 1 , τ 2 ) in order to finance an exogenous expenditure program
( g 1 , g2 ) .
1. Write down the conditions that characterize optimal household behaviour and solve for the first-period
consumption function cd1 . As well, write down the government’s intertemporal budget constraint and
explain what it means.
2. Suppose that we observe a ‘boom’ in current consumer spending c1 followed by a rise in future output
y2 . Would it be correct to say that the increase in consumer spending caused an increase in output?
Explain.
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3. Imagine that this economy is running a current account deficit in period 1. Explain all the possible
reasons for why the current account might be in a deficit position.
4. Suppose that the government wishes (for some reason) to reduce the current account deficit. In order
to so, it must increase desired national savings. One way to increase national savings is to increase
public sector savings (or reduce the public sector deficit). And so, the government decides to reduce
its deficit by increasing current taxes τ 1 (but leaving in place it’s expenditure program). Explain why
national savings (and hence the current account) is unlikely to be very sensitive to such a government
program.
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pment Facts (10 Marks)
Develo
In their article entitled “Changes in the Wealth of Nations,” Prescott and Parente report a number of
interesting “development facts” concerning the disparity in wealth and ‘poverty traps’. To the best of your
ability, summarize what you consider to be the most important and/or interesting features of the data on
economic development.
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Solow Growth Model (10 Marks)
In the data, it appears that countries with higher savings rates also tend to have higher real per capita
incomes. Use the reasoning provided by the basic Solow growth model to explain why this pattern might
make sense. Offer a critique of this explanation.
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Monetary Policy (10 Marks)
Standard economic theory predicts that countries with a history of ‘tight’ monetary policy should display low
inflation and low nominal interest rates relative to countries with a history of ‘loose’ monetary policy. Over
longer periods and in cross-sections, theory seems to be consistent with the data. Explain. In the ‘short-run’,
however, it appears that tightening monetary policy (reducing the rate of growth of base money) results in
an increase in nominal interest rate. Explain why this might be so and explain what the implications of this
are for a central bank interested in reducing inflation.
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