Examiners’ commentaries 2023 (May)

Examiners’ commentaries 2023 (May)

EC2065 Macroeconomics

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2022–23. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2022).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

General remarks

Learning outcomes

At the end of the course and having completed the essential reading and activities, you should be
able to think about and give answers to key macroeconomic questions, for example:

What are the forces that drive long-term prosperity?

Is a growth slowdown in emerging economies inevitable?

Why are real interest rates so low?

What causes bubbles in financial markets?

Does the government have a budget constraint?

How does the labour market respond to structural change and shifting employment patterns?

What is the role of banks and why are they inherently fragile?

Is it a good idea for central banks to set up new digital currencies?

Why does economic activity fluctuate?

Can and should policymakers seek to ameliorate business cycles?

What options do central banks have when nominal interest rates fall to zero?

What are the causes of global imbalances?

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What the examiners are looking for

Although answers to Section A questions can and should be short, it is very important to present a
clear argument and explain your reasoning. Do not make your answers so terse that it is not possible
to follow your logic.

You need to ensure your answers remain focused and to the point of the question. Spend more time
initially thinking about the most relevant arguments before you actually start writing. A shorter but
well thought through answer is superior to a longer answer that does not address the question.

You need to be flexible in your ability to apply macroeconomic ideas and models in new or
unfamiliar contexts, particularly in the Section B questions. Merely memorising the exposition of a
model may not help you answer a question. Developing your ability to apply macroeconomic ideas
takes practice. Think about how you might apply the theories and models you learn in the course to
debates and discussions of macroeconomic issues you hear about. When learning a model, try to
understand the logic and workings of the model more deeply: which assumptions are crucial, and
what difference might it make if they were changed?

Examination revision strategy

Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.

We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.

The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sufficient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.

If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.

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 Examiners’ commentaries 2023 (May)

Examiners’ commentaries 2023 (May)

EC2065 Macroeconomics

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2022–23. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2022).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions – Zone A

Candidates should answer EIGHT of the following NINE questions: All FIVE from Section A (8
marks each) and any THREE from Section B (20 marks each). If more than EIGHT questions are
answered, only the first EIGHT questions attempted will be counted.

Section A

Answer ALL FIVE questions in this section (8 marks each).

Question 1

In the context of the Malthusian model, explain why technological progress does not
lead to a sustained rise in income per person.

Reading for this question

Subject guide, Chapter 1.

Approaching the question

Suppose better technology allows more output to be produced using the same amount of land
and labour. If this raised income and consumption per worker then the Malthusian model’s
assumptions about demographics would imply a faster growth rate of the population through
some combination of a lower death rate and a higher birth rate. Since land is in fixed supply and
the marginal product of labour is diminishing, a larger population means a smaller amount of
land per worker and hence a reduction in output per worker. This process continues until income
per worker has been pushed back to the level at which there would be no further growth in the
population. Better technology thus fails to raise income per person in the long run.

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Question 2

Consider the model of limited commitment where a household owns a house with
expected future value p0 that can provide collateral for a loan (e.g. home equity
withdrawal). Assume the collateral constraint is binding. If the central bank raises
the real interest rate r, show in a diagram how the set of feasible consumption plans
is affected. Is there an unambiguous prediction for the effect on current
consumption? Explain.

Reading for this question

Subject guide, Chapters 3 and 4.

Approaching the question

The increase in the real interest rate r makes the lifetime budget constraint steeper, pivoting it
around the endowment point. The collateral constraint is c ≤ y + p0 /(1 + r) (ignoring taxes t), so
the increase in r also reduces the maximum levels of borrowing and current consumption that
satisfy the constraint, so the point at which the lifetime budget constraint is truncated moves
further to the left.

Since the household was initially consuming the maximum amount in the current period
consistent with the collateral constraint, the higher interest rate r means that only lower values
of c are now attainable. There is an unambiguous reduction in current consumption c.

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 Examiners’ commentaries 2023 (May)

Question 3

Suppose firms are not able perfectly to monitor their workers, and thus the effort
e(w) exerted by workers depends on the wage w they are paid. Explain why firms
would want to choose wages that maximise e(w)/w and derive the first-order
condition for the optimal efficency wage w∗ . What happens if w∗ is greater than the
market-clearing real wage?

Reading for this question

Subject guide, Chapter 5.

Approaching the question

Given the total amount e(w)N of effective labour employed by firms at cost wN , it is in the
interests of firms to choose a wage that maximises effort relative to the wage, that is, maximise
the ratio e(w)/w. The first-order condition for maximising e(w)/w is:

∂(e(w)/w) we0 (w) − e(w)

= = 0.
∂w w2
This can be rearranged to deduce the condition for the optimal efficiency wage w∗ :

e(w∗ )
e0 (w∗ ) = .
w∗
If w∗ is greater than the real wage at which labour supply is equal to labour demand then firms
have no incentive to reduce real wages below w∗ even though enough labour would be willingly
supplied for less. There will be unemployment in equilibrium.

Question 4

Using the Diamond-Dybvig model of banks, explain why a system of

government-backed deposit insurance is a ‘free lunch’, that is, there are benefits and
no costs. What might be missing from the analysis that would suggest deposit
insurance should be limited?

Reading for this question

Subject guide, Chapter 7.

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EC2065 Macroeconomics

Approaching the question

If a credible system of deposit insurance is in place then there is no incentive for late types to run
to the bank because they obtain more by waiting and the government stands behind their
deposits. This eliminates the ‘bank run’ equilibrium from the model leaving only the good
equilibrium. Furthermore, since no bank runs now occur in equilibrium, the deposit insurance
will never be drawn upon because the banks only face an illiquidity problem, not an insolvency
problem. This means there are only benefits and no costs.

In practice, the presence of deposit insurance is likely to increase risk taking by banks, and thus
increase the risk of insolvency. This moral hazard problem suggests putting some limits on
deposit insurance.

Question 5

‘A country only gains from trade with the rest of the world if it is able to run a
current account surplus.’ Use the two-period consumption choice model for a small
open economy to explain whether this statement is true or false.

Reading for this question

Subject guide, Chapter 10.

Approaching the question

Consider a country where the domestic market-clearing real interest rate under autarky is higher
than the world real interest rate. The budget line with a gradient reflecting the autarky interest
rate is tangent to the indifference curve at the endowment point. The open-economy budget
constraint passes through the same endowment point, but has a lower gradient. This means the
representative household can reach a higher indifference curve by choosing a consumption plan to
the right of the endowment point, and is thus made better off through trade.

Since the new consumption plan is to the right of the endowment point, the country is borrowing
from the rest of the world, which means a current account deficit.

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Section B

Answer ANY THREE questions from this section (20 marks each).

Question 6

Consider two economies A and B with the same per-worker production function
y = f (k), where y denotes output per worker and k capital per worker. Total factor
productivity is assumed to be constant and the same in both economies, and is set
to z = 1. The production function is neoclassical, so the marginal product of capital
f 0 (k) is positive but diminishes as k increases. Capital per worker reaches a steady
state when the following equation holds:

i = (d + n)k

where i denotes investment per worker, d is the rate of depreciation of capital, and
n is the population growth rate.

Each economy saves a constant fraction of its income, but the saving rate sA is
higher in economy A and than that sB of economy B. The depreciation rate d and
the population growth rate n are the same in the two economies.

Assume initially that both A and B are closed economies, which means that
investment is equal to saving: i = sy = sf (k).

(a) Sketch a graph of both sides of the equation sf (k) = (d + n)k. Explain why
each economy has a steady state k∗ for capital per worker.
(5 marks)
(b) Given that sA > sB , which economy will have the larger steady-state capital per
worker k∗ ? Compare the long-run levels and growth rates of income per worker
in the two economies A and B.
(5 marks)

Assume both economies A and B have converged to their steady states for k.

(c) In which economy is the marginal product of capital M PK = f 0 (k) larger? If

both economies open up to foreign investment (and foreign investors are able to
earn a return equal to M PK ), which economy will attract investment from the
other?
(5 marks)

Consider the economy that attracts foreign investment and suppose this adds an
amount x to its initial capital stock k∗ . The economy’s GDP is now f (k∗ + x) and
its GNP (GDP minus foreign investors’ income) is f (k∗ + x) − f 0 (k∗ + x)x. The
owners of the domestic capital stock receive capital income f 0 (k∗ + x)k∗ , and
suppose this group of people receives no wages.

(d) Explain why both GDP and GNP will rise after the foreign investment. [Hint:
Differentiate with respect to x. You do not need to find the value of x.] What
happens to the capital income of owners of the domestic capital stock? Is
opening up the economy to foreign investment in their interests, or would they
have an incentive to oppose opening up even if it raises GDP and GNP? Briefly
explain.
(5 marks)

Reading for this question

Subject guide, Chapters 1, 2 and 10.

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EC2065 Macroeconomics

Approaching the question

(a) Since the function f (k) increases in k but at a diminishing rate, the saving line sf (k) is an
upward-sloping curve with a concave shape. The effective depreciation line (d + n)k is an
upward-sloping straight line passing through the origin. Since the gradient of the saving line
is high for low k and low for high k, while the gradient of the depreciation line is constant,
the two lines have a point of intersection, which is the steady state k ∗ .

(b) Since f (k) is the same in both economies, as sA > sB , the saving line of economy A is above
that of economy B. With all other parameters d and n being the same for the two
∗ ∗
economies, the steady-state capital per worker kA of economy A is greater than that kB of
economy B. Since income per worker is y = f (k) and f (k) is an increasing function of k,
economy A with a higher level of capital per worker has higher income per worker than
economy B in the long run. However, since both economies reach a steady state for k in the
long run, income per worker does not grow in the long run, so there is no difference in
long-run growth rates between the two economies.

(c) Since the marginal product of capital is diminishing, f 0 (k) is a decreasing function of k. As
economy A has higher capital per worker than economy B, economy A has a lower marginal
product of capital than B. If the economies open up to foreign investment then international
investors will invest in the economy with the higher marginal product of capital. This means
that capital will flow from the rich economy A to the poorer economy B.
(d) GDP f (k ∗ + x) is clearly increasing in foreign investment x because f (k) is an increasing
function of capital per worker. Differentiating GNP f (k ∗ + x) − f 0 (k ∗ + x)x with respect to
x:
∂GNP
= f 0 (k ∗ + x) − f 00 (k ∗ + x)x − f 0 (k ∗ + x) = −f 00 (k ∗ + x)x
∂x
which is positive because f 00 (k ∗ + x) is negative and x is positive. It follows that GNP is
also increasing in foreign investment x. However, the income of domestic owners of the
capital stock f 0 (k ∗ + x)k ∗ decreases because the diminishing marginal product implies
f 0 (k ∗ + x) goes down with x > 0. Since owners of capital are assumed to receive no wages in

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 Examiners’ commentaries 2023 (May)

this example (they are different people from the group of workers), they have an incentive to
oppose opening up the economy to international investment even though that would raise
both GDP and GNP.

Question 7

Consider the following two-period model of investment. The production function is

Y = zF (K, N ) in the current time period and Y 0 = z 0 F (K 0 , N 0 ) in the future.
Firms own the capital stock K and hire labour N at wage w. The future capital
stock K 0 = I + (1 − d)K is the sum of investment I and undepreciated capital
(1 − d)K. Suppose investment is financed from retained earnings. The dividends v
and v 0 paid to firms’ owners in the current and future time periods are:

v = Y − wN − I , and v 0 = Y 0 − w0 N 0 + (1 − d)K 0 .

(a) Use the production functions, capital stock equation, and equations for v and v 0
to write the present value of dividends V = v + v 0 /(1 + r) in terms of the firm’s
choices of K 0 , N , and N 0 . Show that choosing K 0 to maximise V implies
M PK 0 − d = r.
(5 marks)

Now suppose firms make insufficient profits to finance investment from retained
earnings, and are unable to issue new equity. Firms borrows an amount L from a
bank at real interest rate rl . Bank lending to firms is subject to a problem of
asymmetric information: good firms that will repay loans cannot be distinguished ex
ante from bad firms that will default, having done no investment. The proportion of
bad firms among all firms is t > 0. Banks take deposits from savers and must pay
the real interest rate r to depositors.

(b) Show that the interest rates rl and r are related as follows if competition among
banks drives bank profits to zero:

1+r
1 + rl = .
1−t

(5 marks)

If profits are insufficient to finance all investment from retained earnings then firms
pay no current dividends (v = 0). Borrowing L and future dividends v 0 are:

L = I + wN − Y , and v 0 = Y 0 − w0 N 0 + (1 − d)K 0 − (1 + rl )L.

(c) Use the production functions, capital stock equation, and equations for L, v 0 ,
and V = v 0 /(1 + r) to write the present value of dividends V in terms of the
firm’s choices of K 0 , N , and N 0 . Derive the optimal investment equation,
choosing K 0 to maximise V , and compare to part (a).
(5 marks)

Suppose there is a demand shock, for example, a reduction in government

expenditure, that leads GDP to decline and causes profits to fall to the point where
firms cannot finance all investment from retained earnings as in part (c).

(d) Explain how the presence of asymmetric information can magnify the effects of
the demand shock on GDP.
(5 marks)

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EC2065 Macroeconomics

Reading for this question

Subject guide, Chapters 3 and 4.

Approaching the question

(a) The equation for the future capital stock implies I = K 0 − (1 − d)K. Substituting this and
the production functions Y = zF (K, N ) and Y 0 = z 0 F (K 0 , N 0 ) into the expressions for
current and future dividends v and v 0 :

v = zF (K, N ) − wN − K 0 + (1 − d)K , and v 0 = z 0 F (K 0 , N 0 ) − w0 N 0 + (1 − d)K 0 .

The expression for V is therefore:

z 0 F (K 0 , N 0 ) − w0 N 0 + (1 − d)K 0
V = zF (K, N ) − wN − K 0 + (1 − d)K + .
1+r
The value of K 0 that maximises V is found using the first-order condition:
∂z 0 F (K 0 ,N 0 )
∂V ∂K 0 + (1 − d)
= −1 + = 0.
∂K 0 1+r
Rearranging and using M PK 0 = ∂z 0 F (K 0 , N 0 )/∂K 0 :

M PK 0 + 1 − d = 1 + r

which yields the answer M PK 0 − d = r.

(b) There is asymmetric information as individuals know their type, but banks cannot observe
the type of any individual borrower. This means that if bad borrowers mimic good
borrowers then both types are able to receive loans on the same terms. To lend an amount
L, the bank must take L in deposits. Since a fraction t goes to bad borrowers, the bank
receives repayment (1 − t)(1 + rl )L, and it must pay (1 + r)L to the deposits whose funds it
lent out. Bank profits are (1 − t)(1 + rl )L − (1 + r)L. If competition between banks drives
profits to zero then:
(1 − t)(1 + rl )L = (1 + r)L.
Dividing both sides by (1 − t)L yields the relationship 1 + rl = (1 + r)/(1 − t).
(c) The equation for the future capital stock implies I = K 0 − (1 − d)K, and by substituting
this and the production function Y = zF (K, N ) into the equation for borrowing L:

L = K 0 − (1 − d)K + wN − zF (K, N ).

Substituting the above and the future production function Y 0 = z 0 F (K 0 , N 0 ) into the
equation for future dividends v 0 :

v 0 = z 0 F (K 0 , N 0 ) − w0 N 0 + (1 − d)K 0 − (1 + rl )(K 0 − (1 − d)K + wN − zF (K, N ))

and hence the expression for V is the following (noting that v = 0 in this case):

z 0 F (K 0 , N 0 ) − w0 N 0 + (1 − d)K 0 − (1 + rl )(K 0 − (1 − d)K + wN − zF (K, N ))

V = .
1+r
The value of K 0 that maximises V is found using the first-order condition:
∂z 0 F (K 0 ,N 0 )
∂V ∂K 0 + (1 − d) − (1 + rl )
= = 0.
∂K 0 1+r
This immediately implies M PK 0 + 1 − d − 1 − rl = 0, and rearranging leads to the optimal
investment equation:
M PK 0 − d = rl .
This has the same form as the optimal investment equation in part (a) with the opportunity
cost of shareholder funds r replaced by the firm’s actual borrowing cost rl .

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 Examiners’ commentaries 2023 (May)

(d) Suppose the fall in output means that firms generate too little profits to finance all
investment from retained earnings. At v = 0, the investment demand equation switches from
M PK 0 − d = r to M PK 0 − d = rl . Since t > 0, the asymmetric information problem in part
(c) implies that rl > r. With a higher cost of investment for each value of r, investment falls
and the output demand curve shifts further to the left. The effects of the demand shock are
amplified by the need to draw on borrowed funds (subject to asymmetric information) to
finance investment.

Question 8

Consider the interbank market for loans of reserves. Answer the following questions
using a demand and supply diagram to represent the interbank market.

(a) Briefly explain the shapes of the reserve demand and reserve supply curves in
the market for interbank loans.
(4 marks)
(b) Suppose the central bank wants to raise the interest rate in the interbank
market. Explain how this can be achieved under the ‘traditional’, ‘corridor’,
and ‘floor’ systems of monetary policy implementation.
(6 marks)
(c) If a central bank wants to raise interest rates without reversing quantitative
easing that has previously led to a large increase in the supply of reserves,
explain which system(s) of monetary-policy implementation it is able to use
(assume it does not increase reserve requirements).
(4 marks)

Prior to 2003, the Federal Funds Rate in the US was typically above the Fed’s
discount rate (the interest rate for bank borrowing through the discount window).

(d) Explain this observation with reference to the ‘stigma’ of discount-window

borrowing.
(3 marks)

After the introduction of interest payments on reserves in 2008, the Federal Funds
Rate was typically below the interest rate paid on reserves.

(e) Noting that not all financial institutions with reserve accounts at the Fed are
eligible to receive interest on reserves, and that commercial banks face capital
regulations that limit borrowing, can you explain this observation?
(3 marks)

Reading for this question

Subject guide, Chapter 7.

Approaching the question

(a) The reserve supply curve is vertical (inelastic with respect to the interbank interest rate i)
because the quantity of reserves in the banking system is determined by the central bank’s
actions, which it can increase or decrease through open-market operations.
The reserve demand curve is downward sloping because a rise in the interest rate i for
interbank borrowing discourages banks from borrowing to hold reserves, and encourages
them to lend out reserves (taking as given the benefits they would expect to receive from
holding reserves in terms of fewer penalties from costly central-bank borrowing or receiving

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interest paid on reserves from the central bank). The reserve demand curve is bounded by
the corridor between the central bank’s standing-facility interest rates, the interest ir paid
on reserve holdings, and the interest rate ib charged on any (discount window) borrowing
from the central bank. The demand curve does not go outside this corridor because i < ir
implies an unlimited desire to borrow reserves at i and earn interest ir , while i > ib implies
no desire to borrow because using the central bank’s borrowing facility is cheaper (absent
any ‘stigma’).

(b) The equilibrium interbank interest rate i∗ is at the intersection of the reserve demand and
reserve supply curves. In the traditional system (with no interest paid on reserves, ir = 0),
the central bank implements an increase in i∗ through a contractionary open-market
operation, that is, a sale of assets held by the central bank, which reduces the amount of
reserves in the banking system. This shifts the reserve supply curve to the left and raises i∗ .

With a corridor system, the central bank can raise i∗ without requiring any open-market
operation that shifts the reserve supply curve. Instead, by raising both standing-facility
interest rates ir and ib by the same amount, the reserve demand curve has a parallel upward
shift also by the same amount that ir and ib are increased, which in turn raises i∗ by the
same amount. Intuitively, the demand for reserves compares i to ir and ib , so with no
change in the quantity of reserves supplied, an equal rise in ir and ib results in i∗ also rising
by the same amount in equilibrium.

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 Examiners’ commentaries 2023 (May)

When a floor system is used (where Rs is large enough that it intersects Rd where i is close
to the interest on reserves ir ), the interest rate i∗ can be increased by raising the interest
paid on reserves ir , which shifts the reserve demand curve upwards.

(c) It is not able to use the traditional system unless it also imposes substantially larger reserve
requirements. A large expansion of reserves from quantitative easing under the traditional
system pushes i∗ down to zero (because ir = 0). A small reduction in the supply of reserves
that leaves most of the QE expansion in place would not raise i∗ because Rs would continue
to intersect Rd on its flat section at ir = 0. A much larger reduction in Rs would eventually
raise i∗ , but this would require reversing QE.

The floor system does not require a shift of Rs to raise i∗ , which can be done by increasing
ir as seen in part (b), so the expansion of reserves that resulted from past QE can be left in
place. The floor system effectively separates the central bank’s decision about interest rates
from its decision about the quantity of reserves to supply (as long as these are sufficient to
reach the flat section of Rd at i = ir ). An increase in ir in the channel system also raises i∗ ,
but the central bank cannot target i∗ near the centre of the corridor unless it reduces Rs (or
imposes reserve requirements).

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EC2065 Macroeconomics

(d) When there ‘stigma’ attached to being seen to borrow from the central bank, a commercial
bank factors this in as a cost in addition to the direct cost ib . The reserve demand curve is
bounded within the corridor between ir (zero before 2008 in the US) and ib plus the cost of
the reputational damage. If the ‘stigma’ is sufficiently large, it is easy to see that it is
possible to have i∗ above ib in equilibrium as shown in the diagram below.

(e) When the Fed introduced interest on reserves, not all financial institutions were eligible to
receive this interest. That meant that some financial institutions had an incentive to lend
reserves even if i is less than ir , as long as i remained positive. While other banks eligible to
receive ir might appear to have an incentive to keep borrowing reserves at i < ir to earn
interest ir , in practice, this was limited by capital regulations on banks that made it difficult
for them to borrow large amounts. Hence, the reserve demand curve did not become
horizontal at i = ir . This allowed the Federal Funds market to be in equilibrium below ir as
shown below.

Question 9

Suppose that the government is planning a temporary increase in public spending

G. An economist would like to predict the effect on GDP Y . In what follows, use
the dynamic macroeconomic model and include wealth effects in your analysis where
appropriate. Unless otherwise stated, assume prices are flexible and markets are
perfectly competitive.

Initially assume that the extra public spending does not affect either the production
functions of firms or the utility functions of households.

(a) Explain why there will be ‘crowding out’ of private consumption and
investment, and thus GDP will rise by less than public spending.
(6 marks)

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 Examiners’ commentaries 2023 (May)

Now consider the case where the public spending is on new infrastructure projects.
Owing to the time taken to complete the work, assume that it raises future total
factor productivity, but not current TFP. Assume also that infrastructure projects
are only undertaken if the present discounted value of the extra income generated in
the future exceeds the current cost of the extra public spending.

(b) Will GDP now rise by more or less compared to the increase in public spending,
or is the answer ambiguous? Briefly explain.
(7 marks)

Now assume that prices are sticky, with firms having market power.

(c) Would your answer to part (b) change if (i) the central bank kept the nominal
(and real) interest rate constant; or (ii) the central bank adjusted the nominal
interest rate in line with the economy’s ‘natural rate of interest’ ?
(7 marks)

Reading for this question

Subject guide, Chapters 3, 4, 8 and 9.

Approaching the question

(a) Output demand shifts right overall because the reduction in consumption owing to the
negative wealth effect is smaller than the increase in public spending. Output supply shifts
to the right because of the negative wealth effect on leisure demand, and thus positive effect
on labour supply. Given consumption smoothing, the overall rightward shift of output
demand should be larger than the rightward shift of output supply, and thus the real
interest rate should rise. A higher real interest rate reduces consumption and investment
demand, with consumption also falling because of the negative wealth effect. Since both
consumption and investment unambiguously fall, there is crowding out and GDP rises by
less than the increase in public spending.

(b) The improvement in future TFP owing to the infrastructure shifts investment demand and
hence output demand to the right. Since the project pays off overall, the wealth effect is
positive: output supply shifts left and output demand rises because of higher consumption.
The overall rightward shift of output demand is now greater than the change in public
spending. However, whether GDP rises by more or less is ambiguous because of output
supply being upward sloping and shifting to the left. Crowding out can still occur through
higher interest rates.

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(c) When prices are sticky, output is determined by the output demand curve and monetary
policy. If the central bank fixes the interest rate then the M M line is horizontal. Since
output demand shifts to the right by more than G, the overall change in Y is larger than G
here. However, if the central bank set the nominal interest rate equal to the natural rate of
interest then the outcome would be exactly the same as in part (b).

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 Examiners’ commentaries 2023 (May)

Examiners’ commentaries 2023 (May)

EC2065 Macroeconomics

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2022–23. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2022).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions – Zone B

Candidates should answer EIGHT of the following NINE questions: All FIVE from Section A (8
marks each) and any THREE from Section B (20 marks each). If more than EIGHT questions are
answered, only the first EIGHT questions attempted will be counted.

Section A

Answer ALL FIVE questions in this section (8 marks each).

Question 1

Between 1980 and 2010, the wage premium earned by workers with a university
education increased significantly at the same time as a rise in the proportion of
university-educated workers. Explain one way it is possible to reconcile the rising
skill premium with the increased supply of skilled labour.

Reading for this question

Subject guide, Chapter 1.

Approaching the question

Skill-biased technological change is one explanation for how the skill premium can rise alongside
an increase in the relative supply of skilled labour. Skill-biased technological change is
improvements in technology that disproportionately boost the productivity of skilled workers
compared to unskilled workers. For example, advances in computing, telecommunications, data
science, and e-commerce may increase demand for high-skilled workers, but not unskilled

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workers. These changes can be represented by an increase in skill-augmenting productivity rather

than an increase in total factor productivity (TFP). Earlier technological progress that may have
been more uniform in its effects and can be represented by an increase in TFP. Skill-augmenting
productivity can raise the relative skilled wage even though there is an increase in the relative
supply of skilled workers.

Question 2

Suppose that a pay-as-you-go public pension system is introduced. At each point in

time, N old people receive benefits p paid for by N 0 young people, who each make
contributions t, hence pN = tN 0 . The population growth rate is n, hence
N 0 = (1 + n)N . Write down the life-time budget constraint of a young person after
the system is introduced and explain what is needed for all generations to benefit
from the pay-as-you-go pension system.

Reading for this question

Subject guide, Chapter 4.

Approaching the question

A young person pays t into the pension system while young and receives p when old. Current
disposable income is now y − t and future disposable income is y 0 + p. The life-time budget
constraint equates the present value of all consumption to the present value of current and future
disposable income:
c0 y0 + p
c+ =y−t+ .
1+r 1+r
Substituting the population growth formula N 0 = (1 + n)N into the pension system budget
constraint pN = tN 0 implies pN = t(1 + n)N . Cancelling N and solving for t:
p
t= .
1+n
This can be combined with the life-time budget constraint of a household:

c0 y0 y0
 
p p 1 1
c+ =y− + + =y+ + − p.
1+r 1+n 1+r 1+r 1+r 1+r 1+n

The life-time budget constraint can be written as:

c0 y0 (n − r)
c+ =y+ + p
1+r 1 + r (1 + n)(1 + r)

hence it follows that the young generation is better off if n > r. Since the initial old generation is
always better off by receiving p, all generations benefit if it always the case that n > r.

Question 3

Suppose that disruption from the Covid pandemic has increased mismatch between
job vacancies and people who became unemployed. Interpreting this as a
deterioration in matching efficiency in the equilibrium search model, analyse the
effects on wages, unemployment, and vacancies using the diagrams of the model.

Reading for this question

Subject guide, Chapter 5.

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 Examiners’ commentaries 2023 (May)

Approaching the question

A decrease in matching efficiency reduces the rate at which firms can fill vacancies for a given
level of market tightness, and thus increases expected hiring costs until a vacancy is filled. This
means there is less job creation unless wages fall to compensate, so the job-creation (JC) curve
shifts downwards. Moving along the wage curve (WC), the new equilibrium has lower wages w
and lower market tightness θ.

Lower matching efficiency also reduces the job finding rate for the unemployed at each level of
market tightness θ. That means a higher unemployment rate for a given number of vacancies, so
the Beveridge curve (BC) shifts to the right. With lower market tightness and an outward shift
of the Beveridge curve, unemployment is unambiguously higher. The effect on vacancies is
ambiguous, with the lower market tightness effect reducing vacancies while the outward shift of
the Beveridge curve increases vacancies all else equal.

Question 4

During 2022, the yield curve in the United States became ‘inverted’ (downward
sloping). Use the expectations theory of long-term interest rates to explain why an
inverted yield curve is often seen as a signal that a recession is imminent.

Reading for this question

Subject guide, Chapters 7 and 8.

Approaching the question

Under the expectations theory of interest rates, long-term interest rates are an average of current
and expected future short-term interest rates. According to this theory, current long-term rates
being below short-term rates implies future short-term interest rates are expected to be lower
than current interest rates. The short-term interest rate is controlled by the central bank and
might be set along the lines of the Taylor rule. If the short-term interest rate is expected to fall,
this could be due to expectations of a decline in real GDP or inflation that would lead the central
bank to lower rates.

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Question 5

Suppose there is a temporary increase in government expenditure G in a small open

economy. Using the international real dynamic model with flexible prices, find the
effects on GDP, Y , and the current account, CA. Explain whether the impact on
GDP is larger or smaller than in a closed economy with the same fiscal policy
change.

Reading for this question

Subject guide, Chapters 4 and 10.

Approaching the question

A temporary increase in government expenditure G shifts the output demand curve to the right,
not being fully offset by a reduction in consumption demand C d owing to the increased tax
burden. The negative wealth effect caused by the increased tax burden increases labour supply,
shifting the output supply curve to the right, but by less than output demand shifts because the
sum of the reduction in consumption demand and the increased earnings from supplying more
labour should not exceed the taxes required to pay for the increase in G itself.

Since Y d shifts to the right by more than Y s , the real interest rate r would rise in the absence of
any adjustment to balance-of-payments equilibrium. With perfect capital mobility, the real
interest rate in a small open economy cannot deviate from the world real interest rate r∗ if the
balance of payments is in equilibrium. At r = r∗ , before any adjustment on the current account,
there is an excess of demand for output over what is produced in the domestic economy. As
imports rise, net exports N X decline, shifting the output demand curve to the left. This
continues until it intersects Y s at r = r∗ , where both the goods market and the balance of
payments are in equilibrium.

The decline in N X means that the current account deficit increases (or the surplus declines).
Real GDP Y rises because the output supply curve shifts to the right, and the overall shift of Y d
must match this in equilibrium. In a closed economy, without the final leftward shift of the Y d
curve, the effect on real GDP would be larger.

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 Examiners’ commentaries 2023 (May)

Section B

Answer ANY THREE questions from this section (20 marks each).

Question 6

Consider the Solow model. The per-worker production function is y = zf (k), where
y denotes output per worker and k capital per worker. The function f (k) has the
neoclassical properties, so the marginal product of capital zf 0 (k) is positive but
diminishes as k increases. Total factor productivity z is constant. Investment is
equal to saving, which is given by a fraction s of income. Capital depreciates over
time at rate d, and the population growth rate is n. These assumptions imply that
the change over time in capital per worker k0 − k is:

szf (k) − (d + n)k

k0 − k =
1+n

(a) By sketching graphs of zf (k), szf (k), and (d + n)k, briefly explain why the
economy has steady states k∗ and y ∗ for capital and output per worker to which
it will converge in the long run.
(5 marks)

Suppose that climate change increases the frequency of flooding that causes damage
to the capital stock, or more generally, raises the maintenance cost of capital.
Interpret this as an increase in the depreciation rate d.

(b) Show the effect of higher d in your diagram from part (a). What happens to
output per worker y and its growth rate in the years after the rise in d and in
the long run? To avoid these effects on y, what would have to happen to the
economy’s saving rate s?
(5 marks)

The Golden Rule is the steady state for capital per worker where consumption per
worker c = (1 − s)y is maximised, which gives the highest sustainable level of
consumption per worker. The Golden-Rule level of capital per worker is found
where zf 0 (k) is equal to d + n. Assume the economy is initially at the Golden-Rule
steady state prior to the rise in d.

(c) What happens to the Golden-Rule k following the rise in d? Explain why this
means the direction of change in the saving rate from part (b) may not be
desirable.
(5 marks)

Assume the production function zf (k) is such that the Golden-Rule saving rate is
independent of d (which is true for a Cobb-Douglas production function). Continue
to assume the economy is initially at the Golden-Rule steady state.

(d) If the current generation is selfish they might choose a lower saving rate than
the Golden Rule. If the current generation wanted to make sacrifices to help
future generations, would it make sense for them to consume less, that is, have
s be higher than the Golden-Rule saving rate? Briefly explain your answer.
(5 marks)

Reading for this question

Subject guide, Chapters 1 and 2.

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EC2065 Macroeconomics

Approaching the question

(a) The per-worker production function zf (k) is an increasing and concave function. This is
also the shape of the saving line szf (k), which is a scaled-down version of zf (k). The
effective depreciation line (d + n) is an upward-sloping straight line.

The decreasing gradient of the saving line, together with the Inada conditions, ensures there
is one and only one positive level of capital per worker k at which the saving line intersects
the effective depreciation line. Using the given formula for k 0 − k, an intersection between
szf (k) and (d + n)k corresponds to a steady state for k, and also y because y = zf (k).
The economy converges to this steady state in the long run because the saving line is above
the depreciation line to the left of the steady state, and below it to the right. The formula
for k 0 − k confirms that k is rising over time when szf (k) is above (d + n)k.
(b) An increase in the depreciation rate from d1 to d2 > d1 owing to climate change increases
the gradient of the effective depreciation line (d + n)k and pivots it to the left. It now
intersects the saving line szf (k) at a lower level of capital per worker k2∗ , which is the new
steady state.

Starting from the initial steady state k1∗ and y1∗ , both capital per worker and output per
worker fall over time to approach the lower k2∗ and y2∗ in the long run. Growth in y becomes
negative but returns to zero in the long run.
The fall in y can only be avoided by raising the saving rate s sufficiently so that the saving
line shifts upwards to intersect the new effective depreciation line at the original steady
state k1∗ .

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 Examiners’ commentaries 2023 (May)

(c) The Golden-Rule level of capital per worker is the solution of the equation zf 0 (k) = d + n.
An increase in d raises the right-hand side. The left-hand side is decreasing in k because the
marginal product of capital zf 0 (k) is diminishing. The solution is therefore at a lower level of
k, so the Golden-Rule capital stock per worker declines when the depreciation rate is higher.
To obtain a steady state with lower k, it is necessary to reduce the saving rate all else equal,
though achieving a given steady state k requires higher saving when d rises. If it is desirable
to move to the new Golden-Rule level of k then because there are two conflicting effects on
the required saving rate, it may not move in the upward direction seen in part (b).
(d) Even if the current generation wants to help future generations and is willing to make
sacrifices, it does not make sense to have a higher saving rate than the Golden-Rule level.
First, the long-run level of consumption per worker must be lower because the saving rate is
different from what is required for the Golden Rule. Second, raising the saving rate leads to
an immediate fall in consumption per worker. Third, since capital and output per worker
monotonically approach the new steady state, the path of consumption per worker must
drop below what it would be with the Golden-Rule saving rate. Therefore, all generations
suffer lower consumption when the saving rate is above the Golden Rule.

Question 7

Consider the two-period model of consumption choice. A household receives income

y in the current time period and pays taxes t. In the future time period, income is
expected to be y 0 and taxes t0 . The real interest rate is r. The household chooses a
plan for current consumption c and future consumption c0 . Both current and future
consumption are normal goods and there is a diminishing marginal rate of
substitution between them. Assume that the household would like to be a borrower
at the prevailing interest rate r.

Government expenditure is G in the current time period and is planned to be G0 in

the future. The government can borrow at interest rate r and must satisfy its
present-value budget constraint. The tax burden is shared equally by all households.
In this question, G and G0 remain constant.

Suppose that a temporary recession occurs that reduces income y, but leaves
expectations of future income y 0 unchanged.

(a) Use a diagram to find the effects of the recession on c and c0 in the following
two cases: (i) the household faces no borrowing constraint, only the standard
present-value budget constraint; and (ii) the household cannot borrow
(c ≤ y − t). Does the household smooth consumption in response to the income
shock in these two cases?
(7 marks)

Suppose that the government cuts taxes t during the recession.

(b) Use a diagram to find the effects of the tax cut on c and c0 in the following two
cases: (i) no borrowing constraint; and (ii) the household cannot borrow. Does
‘Ricardian equivalence’ hold in these two cases?
(7 marks)
(c) With reference to the indifference curves of the household, explain why there is
a case for the government to cut taxes in a recession when households face
borrowing constraints. Is it possible through a sufficiently large tax cut to
ensure the household remains on the original indifference curve prior to the
recession? Explain.
(6 marks)

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Reading for this question

Subject guide, Chapters 3 and 4.

Approaching the question

(a) The recession moves the endowment point to the left, which shifts the life-time budget
constraint of the household to the left. In the absence of a borrowing constraint, the parallel
shift of the life-time budget constraint leads the household to choose a new consumption
plan with lower c and c0 , which implies that c falls by less than y.

When the household cannot borrow, the life-time budget constraint is truncated to the right
of current disposable income. This truncation point shifts to the left in the recession. Since
the household would like to borrow but cannot, the next best choice is to consume at the
endowment point. Thus, current consumption drops exactly in line with the fall in current
income, with no change in future consumption.

Without the borrowing constraint, the household smooths consumption in response to the
temporary income shock. However, consumption smoothing is not possible when there is a
binding borrowing constraint.

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 Examiners’ commentaries 2023 (May)

(b) With no borrowing constraint, the tax cut simply moves the endowment point down and
along the life-time budget constraint with taxes rising in the future. This is because the
government borrows at the same interest rate faced by the household, so the present value of
the tax burden faced by the household is unaffected by the tax cut. Consequently, the tax
cut has no effect on consumption.

However, with the borrowing constraint, the tax cut has a direct effect on the life-time
budget constraint because it is truncated at the endowment point, and the tax cut raises
current disposable income. This moves the truncation point to the right along the standard
life-time budget constraint. The household’s best response is to consume some or all of the
tax cut in the current time period. Ricardian equivalence holds when there is no borrowing
constraint, but breaks down when the household would like to borrow but cannot get access
to credit.

(c) With a borrowing constraint, the household obtains a higher utility level following the tax
cut in the recession compared to the case of no intervention. This is because the government
effectively borrows on behalf of the household. However, it is not possible in general to
restore the original level of utility prior to the recession. The best the government can do is
to give a large enough tax cut to allow the household to achieve the consumption plan with
no borrowing constraint, but that may still imply lower utility than before the recession
because government intervention cannot reverse the reduction in pre-tax income here.

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Question 8

Consider the Diamond-Dybvig model of banks. Each of a large number of

risk-averse households has a 50% chance of being an ‘early type’ who receives utility
only from consumption c1 in period 1, and a 50% chance of being a ‘late type’ who
receives utility from consumption c2 in period 2. All households start in period 0,
before they know their type, with one unit of goods. Per unit of goods invested in
period 0, investment projects have a payoff 1 + R if they reach fruition in period 2,
but a payoff of only one unit of goods if terminated in period 1. In the absence of
banks, households would obtain c1 = 1 and c2 = 1 + R.

Banks can offer a deposit contract (d1 , d2 ) to households, where d1 and d2 are the
amounts promised to those who withdraw in periods 1 and 2 respectively.
Depositors’ funds are placed in the investment projects, and banks earn zero profits
from a deposit contract if
d2
d1 + = 2.
1+R
(a) Show in a diagram how the equilibrium deposit contract is determined. Explain
why households might prefer it to investing directly.
(7 marks)
(b) Explain why there is a bank-run equilibrium where all depositors attempt to
withdraw in period 1.
(6 marks)

Suppose that to make banks less vulnerable to runs, bank regulators propose a cap
on the amount of interest banks can pay to short-term depositors who withdraw in
period 1.

(c) Explain what is the maximum period-1 payout d1 to depositors for which no
bank runs should occur. What would be a disadvantage of capping d1 at that
level?
(7 marks)

Reading for this question

Subject guide, Chapter 7.

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 Examiners’ commentaries 2023 (May)

Approaching the question

(a) The zero-profit line d1 + d2 /(1 + R) = 2 is a straight line with gradient −(1 + R) passing
through the point (1, 1 + R). Indifference curves are convex to the origin because of risk
aversion. The equilibrium deposit contract is where an indifference curve is tangent to the
zero-profit line. This gives the best deposit contract that banks would be willing to provide
from households’ perspective in period 0.

Risk aversion implies that households prefer a deposit contract not too far from the 45◦ line.
But since the indifference curves have gradient −1 on the 45◦ line (this tangent to the
indifference curves on the 45◦ line traces out points with the same expected level of
consumption), the zero-profit line is steeper, so the equilibrium features d2 > d1 . If the
return R on long-term investment is large then there is a substantial difference between the
c1 = 1 and c2 = 1 + R payoffs of early and late types in the absence of banks. Risk-averse
households will then prefer a deposit contract offered by banks with d1 > 1 and d2 < 1 + R
that provides some insurance against the risk of needing early access to wealth.

(b) A bank run is an equilibrium when all depositors find it rational to try to withdraw in
period 1, even the late types who are able to wait to consume. Since early types will always
want to withdraw in period 1, consider the withdrawal decision of a late type. If all other
late types are going to try to withdraw in period 1 then a total of N − 1 of the bank’s N
depositors will try to claim d1 in period 1. The maximum amount of funds the bank can
obtain in period 1 from liquidating its assets is N units of goods. But it needs to meet at
least N − 1 claims for c1 > 1. Since N is large and c1 > 1, this means (N − 1)d1 > N and it
follows that the bank will fail. Bank failure means that there will be nothing left for a late
type to claim in period 2, so attempting to withdraw in period 1 along with everyone else is
the individually rational course of action.

(c) Any payoff d1 greater than 1 leads to the possibility of a bank run equilibrium. This is
because the liquidation value in period 1 of the investment project is equal to one. Any d1
greater than this leads to bank failure if all (but one) depositors attempt to withdraw in
period 1, which means that running to the bank is the best response to the expectation
others will run to the bank. Hence the maximum value of d1 that avoids bank runs is d1 = 1.

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EC2065 Macroeconomics

If this cap on d1 is imposed, the equilibrium deposit contract would offer (1, 1 + R) rather
than the contract found in part (a), but this is the same as what could be obtained by direct
investment without the need for banks. A cap on d1 sufficient to eliminate bank runs would
therefore eliminate the gains from maturity transformation performed by banks.

Question 9

Consider the New Keynesian model with partial price adjustment. At any point in
time, some firms choose new prices for their goods while other firms continue to use
prices set in the past. Firms produce differentiated goods and are monopolistically
competitive. Assume wages are fully flexible.

(a) In this setting, briefly explain why it is inefficient for the economy to have an
inflation rate that differs from zero (either inflation or deflation).
(3 marks)

The ‘natural level of employment’ N ∗ is the employment level that would result if
all firms in the economy had fully flexible prices. Since firms are monopolistically
competitive, their demand for labour assuming flexible prices would be given by the
marginal revenue product of labour M RPN , which is decreasing in N and is below
the marginal product of labour M PN .

(b) With partial price adjustment, and assuming no inflation is expected in the
future, explain why those firms adjusting prices would increase their prices if
aggregate employment N is above N ∗ , and decrease prices if N is below N ∗ .
Hence explain why there is a positive Phillips-curve relationship between
inflation π and the output gap between real GDP Y and the natural level of
output Y ∗ , holding inflation expectations constant.
(5 marks)
(c) If the central bank credibly commits to ensure inflation is always zero, explain
why real GDP would be at its natural level Y ∗ .
(3 marks)

The natural level of output Y ∗ is inefficiently low because M PN > M RSl,C at

Y = Y ∗ , where M RSl,C is households’ marginal rate of substitution between leisure
and consumption. Assume that the government is willing to compromise on
inflation being at its optimal rate of π = 0 to try to raise GDP above Y ∗ .

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 Examiners’ commentaries 2023 (May)

(d) Without a commitment to zero inflation, what happens to inflation expectations

if the government acts in this way? How does the adjustment of inflation
expectations affect the difficulty of achieving the government’s goal for real
GDP?
(5 marks)

Suppose goods markets become less competitive so that the gap between M PN and
M RPN grows larger.

(e) Given the behaviour of the government in part (d), what are the implications of
less competitive markets for inflation?
(4 marks)

Reading for this question

Subject guide, Chapters 8 and 9.

Approaching the question

(a) The occurrence of inflation or deflation means that firms will have to incur costs in changing
their prices to keep up with changes in their costs. This is an unnecessary waste of resources.
Furthermore, since firms change their prices at different points in time, the occurrence of
inflation or deflation mechanically implies that firms are choosing different prices over time,
so there will be a distribution of prices even when there are no fundamental reasons in terms
differences in preferences or production functions to justify these price differences. This
price dispersion is inefficient because it leads to a misallocation of resources.
(b) If aggregate employment N is above N ∗ then a firm that does not change price faces a level
of demand that is met by employment where M RPN < w, implying the price of its good
relative to its costs (the firm’s profit margin) is lower than it would like, and a price increase
is desired. This is because M RPN = w at N = N ∗ , while higher N increases w moving
along the labour supply curve, and reduces M RPN because the marginal product of labour
is diminishing. The case of N < N ∗ is the opposite, and firms would want to decrease their
prices (assuming no inflation is expected in the future).

Since aggregate output Y moves in the same direction as aggregate employment N , inflation
is positive for Y > Y ∗ and negative for Y < Y ∗ , assuming no inflation is expected in the
future. This explains a positive Phillips curve relationship between inflation π and the
output gap Y − Y ∗ .
(c) A commitment to use monetary policy always to keep inflation at zero implies that expected
future inflation should be zero (π 0e = 0). In those circumstances, current inflation is only
equal to zero if firms have no incentive to raise or lower prices, which occurs when output is
at its natural level Y ∗ .

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(d) If the government aims for Y > Y ∗ then the Phillips curve implies inflation will be positive
even if no inflation were expected in the future. Since this incentive to aim for Y above Y ∗
applies at all times, expectations of future inflation should be positive. However, positive
expectations of future inflation increase the incentive for firms to raise prices pre-emptively.
This shifts the Phillips curve upwards, making it harder to achieve the government’s
objective for real GDP without raising inflation even further.

(e) Less competitive markets increase the gap between the marginal product of labour M PN
and the marginal revenue product M RPN . This makes the natural level of output Y ∗ even
more inefficiently low and increases the government’s incentive to try to raise real GDP. But
as seen in part (d), this leads to rising inflation and inflation expectations. Hence, when the
government acts in this way, markets being less competitive mean the outcome for inflation
will be worse.
Note that there is no automatic reason why less competitive markets increase inflation. If
the government were to act as in part (c), inflation would remain at zero.

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