EE312 Final exam solutions (1/2022)
EE312 – Macroeconomic theories
Semester 1/2022
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True or False or Uncertain. Provide the intuitive reasons to your
answer. (30 points / 7.5 points for each)
1. With perfect capital mobility, monetary policy is highly effective under the fixed exchange rate regime.
Answer: False. It is highly ineffective. Explain the reasons in short few sentences.
2. In the consumption-saving model, equilibrium current consumption will proportionally increase with respect to the current income. (Hint: use the credit market diagram.)
Answer: False. Current consumption will increase by the fraction of the increase in income due to
preference for diversity and/or consumption smoothing behaviour. Savings will increase.
3. An increase in the real interest rate can reduce the current period labor supply.
Answer: It depends on whether IE or SE dominate. If SE dominate, then the labour supply will increase.
4. It is desirable to strictly ensure that society’s saving rate is equal to the golden-rule saving rate.
Answer: Not necessary. Output vs. consumption trade-off.
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IS-LM-BP model (40 points)
Consider a small open economy that can be explained by the Mundell-Fleming framework. Suppose that
the Federal reserve raises the Fed-fund rate. Discuss the impact of US macroeconomic policy on Thai
economy. What would happen to all key domestic aggregate variables? Discuss your results under the
following choices of exchange rate regimes.
1. (20 points) Fixed exchange rate
Answer: Exactly like the lecture. Exchange rate unchanged, BOP deficit. The CB needs to sell dollars,
using up its reserve. Money supply falls, reducing consumption, investment, national income, and level of
employment. Net exports remain the same. Real wage falls.
2. (20 points) Floating exchange rate
Answer: Exactly like the lecture. Thai baht will depreciate and net export will improve. IS shifts right,
therefore leading to higher level of equilibrium employment and national income. However, interest rate
will increase, reducing consumption and investment a little bit (crowding out effect). Overall, private consumption increase (higher income despite some crowding out effect), investment may increase or decrease
(depending on what you explicitly assume about the relationship between I and Y ).
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The real intertemporal model with investment (60 points)
Let’s consider our real intertemporal model with investment as we have discussed in class. (If you remember
the model structure, you can skip the paragraphs below.)
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Recap of Model structure:
The model is composed of a representative consumer, firm, and a government.
Consumer: Given the time endowment in both current (1st) and future (2nd) period (h), the consumer receives
utility from current and future consumption (C, C ′ ), as well as current and future leisure hours (L, L′ ). He then
maximizes his utility, u(C, C ′ , L, L′ ) subjected to:
C + wL +
1
1
w′ h + π ′ − T ′
C′ +
w′ L′ = wh + π − T +
1+r
1+r
1+r
We assume the consumer’s preferences satisfy the usual conditions (more is better, preference for diversity, all
goods are normal goods, substitution effects dominate income effects).
Firm: As for the firm, in the first period the firm owns capital K and employ labour N to produce output Y
using the given production function and current-period (1st-period) total factor productivity (z):
Y = zF (K, N )
The first-period profit is π = Y − wN − I where I is the firm’s investment. Investment will add to the future
stock of capital, while the current stock reduced at the rate of δ:
K ′ = (1 − δ)K + I
In the second period the firm produces output Y ′ , with the amount of 2nd-period capital stock K ′ (predetermined from the first period) and the given 2nd-period TFP (z ′ ):
Y ′ = z ′ F (K ′ , N ′ )
and make the second-period profit π ′ = Y ′ − w′ N ′ + (1 − δ)K ′ . The firm can choose labor demand (N, N ′ ), and
investment demand (I) to maximize its own life-time value:
V =π+
π′
1+r
Government: The government collect tax in each period (T, T ′ ) to finance an exogenous level of government
spending (G, G′ ). Note that the Ricardian equivalence applies.
Equilibrium: Assume that there is no international trade, and that in equilibrium,
Y = C + I + G,
Y ′ = C ′ + G′ ,
N = h − L,
and N ′ = h − L′ .
Suppose that it appears that new inventions will lead to major productivity improvements in the next few years.
We will model this as an increase in future-period (2nd-period) TFP (z ′ ). Answer the following questions
1. (30 points) Determine the equilibrium effect (up, down, or no change) of this belief on each of the following
1st-period variables {C, I, N, w, Y, r} and the amount of 2nd-period capital stock chosen in the first period
K ′.
Answer: See lecture notes. This is the case we discussed at length (z ′ increasing). Investment will increase
and therefore future capital stock will increase. There is no effect on first-period productivity (marginal
product of labour). C, I, N, Y, r will have increased. w the real wage will fall.
Now, we are all in the second period. There is no credit market in the second period, and hence the
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investment. The second-period equilibrium variable will only include {C ′ , N ′ , w′ , Y ′ }. Therefore, the
second-period equilibrium is a simple consumption-leisure model, with the 1st equilibrium
level of r and K ′ treated as the exogenous variable in the 2nd-period.
2. (20 points) Apparently, everyone was wrong: z ′ remains the same! Relative to what would happen if
both household and firm thought correctly that nothing will happen, what is the direction of change of
{C ′ , N ′ , w′ , Y ′ }? Show using two diagrams, namely output market and labor market.
Hint:
• Try to indicate the effect of changes in 1st-period equilibrium level of r and K ′ on the 2nd-period
curves, namely output demand, output supply, labor supply, and output supply. Notice that the
2nd-period price of the labor market is w′ while the 2nd-period price of the output market is 1/w′ .
• Assume that direct effect on productivity is larger than the indirect effect of real interest rate.
Answer: K ′ has increased. Therefore, labour demand has increased significantly due to higher productivity
(although would have increased by more if z ′ actually did increased). Labour supply falls (from first period
tradeoff), therefore real wage and employment will increase. Output supply will have increased by quite
a lot compared to everything doing nothing (believing correctly in the first period that there will be no
change in z ′ ). Price (1/w′ ) falls. Output demand increases a little (higher c′ ). Equilibrium Y increased
significantly.
3. (10 points) Has this incorrect belief of consumers made them better off (in terms of lifetime utility) or
worse off (compared to when they didn’t believe in anything at all)?
Answer: The consumers are worse off. They would either maximise lifetime utility in two cases: (i)
knowing z ′ will remain the same and therefore do nothing; and (ii) believing that z ′ will increase and z ′
actually increases.
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Long-term economic growth (50 points)
a) (30 points) Assume that suddenly there is a fall in saving rate from s1 to sG R where sG R is the golden-rule
savings rate. Assume the economy is initially in a steady state before the decrease in the saving rate.
Using the figures below, apply the corresponding changes and use the arrows to show how the capital
stock evolves over time. In the space next to the Solow diagram, draw another graph, with time on the
horizontal axis, and output per person on the vertical axis. Let the saving rate decrease at time t = T ,
and plot (i) output per person and (ii) consumption per person over time
Answer: Directly from lecture. k will fall, and therefore y will fall towards a new steady-state level. c
will increase (a sudden jump) and taper off towards a higher equilibrium level (maximised through the
golden-rule saving rates).
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b) (20 points) “As the Solow growth model predicts the convergence result, there is no aspect or implication
that can be drawn to link with the growth policies. The observed disparities of income-per-capita across
countries cannot be solved as it is considered a natural phenomenon.”
Comment on the statement. Do you agree or disagree, and why?
Answer: Directly from lecture. The Solow model does give very important insights but fail to internalise/endogenise the engines of growth.
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