A Concise Course Overview and past exam papers with outline answers 2023/24

This is a concise overview of the whole course, and at the end there are some past exam
papers with outline answers. The 2022 exam will differ in format from past exams as it will
be online, so read the instructions on you exam paper carefully, it may not have the same
number of questions to answer!

Here’s a quick reminder of what the course covered. More detail and insight would, of
course, increase marks awarded in the examination. Remember that correct diagrams can
greatly improve your explanations, so long as they are also properly explained! (Freehand
diagrams, fully labelled, are fine: clarity is needed rather than neatness). You must
demonstrate understanding
We discussed what is meant by ‘macro-economics’. Neo-classical economists tend to regard
macro simply as ‘Aggregate’ micro-economics, to be explained by a careful analysis of
individual decision-making which is then ‘aggregated’ (summed) to get macro results.
Keynes described this as a ‘Fallacy of Composition’. He believed that the macro economy is
more than the sum of its micro parts. For example, in the ‘paradox of thrift’. He argued that if
one person saves s/he will tend to have more savings, but if we all try to save our incomes
may fall because AD falls, and so we might end up with less savings! He also described how
prevailing moods (‘animal spirits’) may affect expectations and hence spending decisions
leading to destabilising fluctuations in aggregate demand. By contrast, neoclassical
economists argue that expectations adjustments tend to stabilise the economy.

Keynes had argued that falls in aggregate demand could result in ‘involuntary
unemployment’. That is, people looking for work at the prevailing level of wages but who
simply could not find jobs. Neoclassical economists had argued that if there were such
involuntarily unemployed persons then the excess supply of Labour would push wages down
until the labour market cleared at its equilibrium. At this natural equilibrium there would still
be people looking for work voluntarily, that is, people might be changing jobs, looking for
better jobs, or have just entered the labour market, But involuntary unemployment would
have would have been eliminated as overall labour demand would now match overall labour
supply.

We then looked at an overview of policy history since the Great Depression. In the Great
Depression countries had been locked in ‘beggar thy neighbour’ policies of exchange rate
depreciation and deflation. Keynes argued that although this might repair the finances of one
country if it did it alone, if all countries did it world output would fall because of lack of
demand and this would send countries into recession and hence exacerbate their financial
deficits. Keynes was one of the main architects of the Bretton Woods System which set fixed
exchange rates and afforded countries reprieve by providing loans to prevent them using
deflationary policies. Keynesian demand stimulus was then used to keep unemployment low
and control inflation, many Keynesians economists point to this as a ‘golden age’ of
Keynesian policy in which the rich world enjoyed one of its fastest and prolonged periods of
growth.
By the late 70’s ‘Stagflation’, high inflation combined with high unemployment, had allowed
a challenge to Keynesian economics. It seemed the old ‘Keynesian rules’ of spending more
when unemployment was high and spending less when inflation was high had broken down,
and so in 1979 Margaret Thatcher began the ‘Monetarist Experiment’. This did reduce
inflation, but at the cost of very high and prolonged unemployment, from which some areas
of Britain never fully recovered. Growth was better subsequently, though this might well
have been due to UK membership of the EU, but monetary targeting proved a failure as the
targets for monetary growth were seldom hit. Very high interest rates were used in an attempt
to control the money supply, and this, and the consequence of a high £ sterling exchange rate,
depressed aggregate demand and made UK manufacturing uncompetitive, resulting in very
high and subsequently chronically high (‘hysteresis’) unemployment.
Keynesians economists argued that Stagflation didn’t prove Keynes had been wrong. Some
cited the trebling of oil prices which caused a large negative supply-side shock. Others
emphasised that successive governments had tried to run the economy at too high a level of
growth, never advocated by Keynes, and had deregulated the finance sector too much, hence
allowing credit to rise beyond the capacity of the economy to match it with output hence
leading to inflation.

Given the failure of monetary targeting, the macroeconomic policy shifted from Monetary to
Exchange Rate targeting as a preparation for the UK joining the European Exchange Rate
Mechanism. A fixed, or at least pegged, exchange rate was supposed to impose ‘forced’
budgetary and inflation discipline on government and to provide stability of demand, to
anchor inflation expectations and reduce ‘discretionary’ budgetary changes, and to provide
‘safe’ environment for finance and FDI. Excessive demand, especially from government
policy, would put downward pressure, on the exchange rate e.g. as imports increased, and so
more ‘discipline’ in stemming overheating would be forced. But the ‘impossible trinity’ of
exchange rate and interest rate (and capital controls): It’s only possible to have two out of 1.
control of interest rate 2. Exchange rate control and 3. Free movement of capital. For
example, a high interest rate will tend to attract finance from other countries, that will cause
the £ to strengthen against other currencies, unless there are capital controls to prevent this ,
which have disadvantages, Equally, a low interest rate compared to other countries will tend
to cause an outflow of such ‘footloose finance’ and weaken the £, unless there are capital
controls, which can invite retaliation and limit consumption and investment opportunities.

Without capital controls, the ERM dictated an uncomfortably high interest rate regime to
allow the shadowing of the Deutschmark. Given Germany’s stronger productivity growth and
very inflation adverse stance this meant that the UK was persistently burdened by an
exchange rate that made it uncompetitive and an interest rate that had a depressing effect on
demand and investment. Once out of the ERM, as speculation forced an inevitable
devaluation, the shackles of too high interest rate producing negative output gap and slow
build of capacity (and innovation) and uncompetitive exchange rate were gone. Interest rates
and exchange rate fell, allowing a recovery and a switch to inflation targeting regime that
may have been a large contributor to the subsequent long ‘NICE’ period of Non-Inflationary
Continuous Expansion that lasted for the UK right to the financial crash that caused the Great
Recession from 2008.
The starting point for our macro theory development was the classical dichotomy and how
the quantity theory of money arose from this. Discussion centred around MV≡PQ . Where the
‘neutrality of money’ meant that increases in the, exogenous, money supply only increased
the nominal price level leaving real things, such as output and employment, unaltered. This
result came from a level of output (Q) set by the real equilibrium of the labour market (as the
capital stock is effectively constant in the short-run and so doesn’t alter the equilibrium by
changing much). A very stable demand for money also meant that the velocity of circulation
of money (V) is stable, as V is inverse to the demand for money. We saw that if money is
endogenous then the direction of causation might actually be the reverse: PQ rising might be
the cause of M rising! Keynes also showed how the demand for money (Md) might rise
sharply, e.g. in uncertain times there may be ‘retreats into liquidity’ as people hoard money
instead of risking it in an uncertain world, so if Md is unstable then V might be too. Keynes
also discussed how fluctuations in aggregate demand (AD) might affect Q, so decreases in
AD could lead to decreases in output and hence employment.
We went on from the basic Keynesian circular flow model and the multiplier (the ratio of the
change in Y to a change in injections, the crude formula being 1/(1-MPC) or I/MPL) on to
painstakingly develop the ‘Neo-classical synthesis’ with IS/LM combined with a neo-
classical theory of output (Q) that, through the labour market, set Q (or often we wrote Y to
indicate real income instead of Q). For overall equilibrium the neo-classical synthesis
required simultaneous equilibrium in the product markets (I=S), money market (I=M) and
labour market (Ld=Ls). The IS/LM framework was the determinant of AD, the labour market
still determined Q but there was now some doubt as to where Q would be at any time, as the
IS/LM side of the model might not coincide with the AS side! The neo-classical synthesis
seemed to allow for some Keynesian results. For example, if AD fell a long way it would
require very low interest rates in order to close the negative output gap i.e. get Aggregate
Demand back up to Aggregate Supply. Thus the economy could get stuck in a ‘ liquidity
trap’ or if the IS curve requires negative real interest rates then it should be remembered that
zero nominal interest rates have, usually, the Zero Lower Bound (ZLB) as an interest rate
floor as, usually, people will not lend money to receive less back then they lent in nominal
terms, as just keeping the money would be more profitable. This is why the Bank of England
resorted to special measures ‘Quantitative Easing’ which did in effect allow the Bank of
England to provide liquidity to banks at negative interest rates.

In long-run theory though, the neoclassical synthesis is driven by equilibrium in the Labour
market and so couldn’t produce permanent involuntary unemployment, without ‘fixing’ the
real wage too high for labour market clearing. Doing that is not really a revolution in
economics, as Keynes and his followers had argued for, as any neo-classical economist would
accept that fixing prices or wages can prevent the price mechanism working to clear markets!
Of course, even where there is overall enough jobs for workers there will still be frictional
and search unemployment, these are micro and largely voluntary as people search for jobs
they wish to accept or move between jobs.
So long as AD is less than AS, and prices are flexible, the long term adjustment of prices
would eventually lead to changes that might bring AD back to AS. For example, Pigou
argued that AD<AS led to prices falling and this would eventually have a ‘real balance’
effect. That is, money held idle in balances would increase in worth as prices fell and this
would lead to a ‘wealth effect’ as people began to spend these increased real holdings of
money. Hence AD would rise again to match AS. Keynes said this would take too long, and
that anyway, ‘In the long-run we are all dead’. But the issue of how to produce a permanent
equilibrium where there were people who wanted to work at prevailing wages who could not
find work, i.e. involuntarily unemployed, was never given rigorous micro-foundations by
Keynes.

If rational expectations are assumed then there will be no money illusion and hence the
labour market will not be affected by an increase in AD and prices, as the money wage will
‘instantly’ adjust to keep the real wage the same. If there is perfect competition then the
labour market will clear where supply meets demand and there is no excess supply of labour-
that is, no involuntary unemployment. There will of course still be frictional and search
unemployment due to ‘churn’ as people enter and leave the labour market, old jobs go and
new ones arise, and people quit and search for better jobs etc. In this very neoclassical
framework it is hard to provide any explanation for involuntary unemployment!
Much more recently New-Keynesians have used models of imperfect competition and
‘efficiency wages’ to produce credible micro-foundations for permanent involuntary
unemployment.
In passing we might note that in the IS/LM determination of AD, a lot depended on the slopes
of curves and whether prices, and wages, were fully flexible. For example, The IS curve
showed how AD responds to changes in the interest rate i.e. as r↓→Investment (I) ↑, the
multiplier then determines the slope of the IS curve where the higher the MPC the greater is
the multiplier. So the more sensitive investment is to the interest rate, and the higher is the
multiplier, the more powerful monetary policy will tend to be. The position of the IS curve
was affected by changes in injections: I (if the level of I for each level of r changed, G and X
(Exports). Another powerful influence on the IS curve was the exchange rate (ER) e.g. if
r↓→ER↓ (as capital/finance flows out of the UK) this would then cause X↑, M↓ and hence
AD↑. The low interest rate might also lead to some asset price inflation and perhaps financial
accelerator externalities, if out of control this can lead to financial bubbles that stimulate
demand but are destructive when they burst.
If the demand money is very interest inelastic, with an exogenous money supply, then the LM
curve is very steep and hence monetary policy becomes more powerful and fiscal policy less
powerful. Exogenous money sets a sort of ‘constraint’ on how much AD can change. If AD
expands the existing money supply has to be made to circulate faster by ‘squeezing back
money demand’ through higher interest rates. If Md is interest inelastic it won’t be squeezed
much and interest rates will have to rise much more leading to stronger crowding-out effects.
If this is the case then AD could be ‘anchored’ to a large extent by controlling the money
supply, if such money supply control were possible of course! In modern economies,
however, the money supply is probably almost wholly endogenous. That is, it expands to
meet demand, with commercial banks simply putting a mark-up on the Bank of England’s
policy (Repo) rate. The ‘LM curve’ thus in effect becomes flat, and in normal circumstances
is simply shifted up and down by changes in the Bank of England’s policy interest rate as set
by the Monetary Policy Committee. This led to the ‘TR curve’ (Taylor Rule) replacing the old
LM curves. The TR curve maps out, in interest rate and output space, how the Bank of
England alters the interest rate to ‘lean against the wind’ to stop the economy from falling
below the natural rate of output or racing ahead of the economy’s capacity- the deviation of
actual output from an estimate of what the non-accelerating inflation level of output is, is
called the ‘output-gap’ In the past this was linked closely to a ‘natural rate’ of unemployment,
so this level of output was taken as corresponding to an equilibrium rate of unemployment-
hence the NAIRU, that is, Non-Accelerating Rate of Unemployment . Unlike the LM curve
the TR curve is not showing equilibrium positions but rather the policy positions of the Bank
of England, that is, how it would set the interest rate in response to any level of output, or
more accurately, output gap .

A ‘flat LM curve’ through endogenous money, would mean that fiscal policy becomes more
powerful. That is, a rightward shift of the IS curve would not be offset by interest rates rising,
and hence investment falling, because of an upward sloping LM curve. Rising interest rates,
caused by fiscal expansion and at least partly endogenous money, would also lead to an
increased demand for £ sterling and hence an increase in the £ sterling exchange rate. This
would increase Imports (M) and decrease Exports (X), so again tending to decrease AD and
so offset the increased AD from increased government (fiscal) expenditure. So again, fiscal
policy is strengthened by endogenous money. If the LM curve is flat, then interest rates are
less likely to rise, and so then the predominant effect of fiscal expansion may simply be that
Imports rise (exports may also fall as it becomes easier to sell in the home market), this
would increase the supply of £ sterling to international currency markets and hence tend to
decrease the £ sterling. Such a weakening of the £ would in turn tend to reduce the leakages
caused by increased AD and so fiscal policy is again strengthened. With an increased interest
rate (upward sloping LM) the financial movements are bound to dominate and hence the
exchange rate increase (£ strengthen), with a flat LM curve the trade effect from increased
imports may decrease the exchange rate (£ weaken).

A higher Marginal Propensity to Consume (MPC) means a higher multiplier and hence fiscal
policy becomes more powerful, that is, unless the demand for money is very interest inelastic
and the money supply exogenous, in which case r will rise sharply with any increases in Y
and hence ‘crowd-out’ investment, and X, if the government attempts to increase demand
through fiscal policy (e.g. by G↑,T↓). Endogenous money would mean that the money supply
passively’ adjusts to higher AD without r↑, the LM curve becomes flat, and so there is no
crowding-out via the interest rate. But crowding –out of the private sector by an expanding
public sector will be also more likely when the capacity of the economy is neared.
Some very neo-classical economists argue that the multiplier is always very low, and hence
fiscal policy is impotent, a) because consumption is only affected by changes to permanent
income and b) consumers may ‘share’ the government’s budget constraint. That is, if the
government spends more consumers will then reason that taxes will rise in the future too, so
their permanent income is reduced and hence they cut back on consumption now, thereby off-
setting the rise in G. This process is known as ‘Ricardian Equivalence’ (although Ricardo
didn’t think much of it!).

We looked at how the neoclassical approach to macro came back into fashion leading to the
‘Monetarist Experiment’. Friedman led the revival- first a restatement of the Quantity Theory
in which he argued that Md is stable as it is a stable function, especially of wealth that
changes only slowly. He argued that consumption is also more stable than Keynes had
thought, as it depends on ‘permanent income’ rather than current income. Permanent income
involves the income from past wealth but also looking forward to expected future earnings
and hence future wealth. The looking though time is called ‘inter-temporal. Again, as wealth
changes more slowly than current income, the economy is generally thought to be more
stable if demand is a function of wealth rather than income, for example, money demand
would be more stable and so would income, as the multiplier would be low unless people
thought changes in income were permanent.
Friedman argued that ‘inflation is always and everywhere a monetary phenomenon’. So he
prescribed ‘Just control the money supply and announce tight monetary targets to anchor
expectations and the economy will then more or less look after itself- and there won’t be
accelerating inflation. In practice the pain of monetarism was much greater than this simple
prescription had promised, and it turned out that money is probably endogenous anyway.
Friedman had disputed the stability of the Phillips Curve. He argued that the Keynesian trade-
off between inflation and unemployment that it seemed to offer depended on assuming static
expectations of inflation. He argued that in practice people would learn from past inflation
and so adapt their expectations. Hence any ‘money illusion’ would be short lived. This meant
that there was no permanent trade-off available. There would be a series of ever higher short-
run Phillips curves as expectations followed the accelerating inflation, but when expectations
caught up with inflation then the economy would be back on a long-run vertical Phillips
Curve- although this was actually likely to be with higher unemployment as higher inflation
progressively eroded the effective working of the price mechanism.
The short-run Phillips Curve is a useful theoretical device for considering the effects of Bank
of England changes in the interest rate. The Bank 0f England has as its prime target inflation
but is charged also to consider unemployment effects resulting from changes in interest rates.
Reducing inflation rapidly through very high interest rates are likely to cause very large
increases in unemployment, as for example, the economy moves along a short-run Phillips
curve augmented by high inflation expectations. This describes well what happened in the
Monetarist Experiment. Nowadays, this would almost certainly, one hopes, lead to a lower
indifference curve between current inflation and unemployment for the policy maker. A more
gradual reduction of inflation through increased interest rates would better manage down
inflationary expectations without such high unemployment and so be preferred. In Keynesian
terms it is simply savage to use the mass misery of unemployment to bring down inflation by
sucking demand out of the economy. We can also note that since 2010 the Bank of England
has been very reluctant to increase interest rates for fear of sending the more slowly growing
UK economy back into recession. Again, with covid it did not respond immediately that
inflation went over it’s target.
Later than Friedman, Lucas argued that there wouldn’t be even a short-run trade-off if
economic agents had ‘rational expectations’: He asked why with adaptive expectations would
they be so slow to learn that they were being repeatedly fooled by inflation? So instead of
looking backwards at past inflation they might look forward and anticipate future inflation. If
they correctly anticipate inflation, then there would be no money illusion and the Phillips
curve, both short and long-run, becomes vertical i.e. with no inflation employment trade-off.
A difficulty for economists is that whereas adaptive expectations suggests people are a bit
dim and slow to learn, rational expectations implies that people are ultra-smart and better
informed than even most economists! In the ultra-smart world of rational expectations, even
if expansionary policy worked for a while, it is very likely to lose effect for all of the future.
This is the approach of modern neo-classical macroeconomics, ‘New Classical
Macroeconomics’, the underlying principle being that macroeconomics should be based on
rigorous microeconomic foundations using forward looking optimising agents with ‘model
consistent expectations’. The assumption of very forward agents also underlies theories such
as ‘Ricardian equivalence’ and ‘Real Business cycles’.
By the late 1990’s a ‘new macro consensus’ had been established. The IS curve was still
being used and combined with a Phillips Curve that allowed some short-run trade-off but not
a permanent trade-off. The IS curve was based on an intertemporal consumption function
(inter-temporal means through time), that is, it bases consumption spending not just on
current income but also on wealth and expected future earnings. This means that consumption
does not fluctuate so much with changes in income, and hence the marginal propensity to
consume is reduced by intertemporal considerations and hence the multiplier is smaller.
Fiscal will also then be less powerful than in older Keynesian models, although by then it was
generally accepted that trying to ‘fine-tune’ aggregate demand through fiscal policy is too
clumsy and with unpredictable lags.

It was more or less accepted today that the money supply is endogenous and so interest rates
in this ‘3-equation’ model are set ‘directly’ by the Bank of England, rather than the money
supply as in older IS/LM models. The task of the monetary authorities in endogenous models
such as the 3-equation or New Keynesian model, is to set the interest rate so as to maintain
the output of the economy at the NAIRU. If unemployment was above the NAIRU it might
be lowered by lowering interest rates to increase AD, but attempts to hold unemployment
below the NAIRU would lead to accelerating inflation. The New Keynesian micro-
foundations could now explain why there can be simultaneously both involuntary
unemployment and accelerating inflation i.e. the NAIRU equilibrium is at a level where some
permanent involuntary unemployment exists.

In New Keynesian micro-foundations ‘efficiency wages’ are paid. This means that the real
wages offered, by the ‘HR’ departments of firms, are set above that merely needed to entice
workers to supply their labour i.e. the Wage Setting (WS) curve is above the labour supply
curve (Ls). This might be done for various reasons such as to increase the pain of losing one’s
job so one works harder, to contain recruitment costs or to placate unions. The notion of
efficiency wage theory is thus that firms are pursuing a wage policy so as to recruit, motivate
and retain their workers.
The price setting curve (PS) is set by (imperfectly competitive) firms’ marketing departments.
The mark-up on costs to set a price determines what workers’ money wages are actually
worth in real terms. The higher the mark-up on the firms’ costs the higher prevailing prices
are, and so the lower is the real wage actually received by workers. The PS curve sets a mark-
up on wages (and other costs) so that the workers receive less than the real value of their
marginal product, even at the margin at the point of equilibrium. So the PS curve lies below
the neo-classical demand curve for labour that is marginal product (MP).
As WS is above the supply curve of labour, and PS is below the neoclassical demand curve
for labour, the WS and PS interest at a lower level of employment and output than would
occur in neo-classical perfect competition. This is an equilibrium and a Non-Accelerating
Inflation Rate of Unemployment (NAIRU). It is a NAIRU despite the existence of
involuntary unemployment as if AD is stimulated to take unemployment below (employment
above) this point then WS is above PS and so a ‘race’ between HR offering higher real wages
and Marketing setting higher mark-ups, that in effect set lower real wages again, begins.
Rounds of higher offering of real wages (that increases firms costs) and higher price mark-
ups (bringing real wages down again), leads to a wages price spiral and accelerating inflation.
The New Consensus regime, of holding inflation to a set target rate that roughly corresponded
to the NAIRU, seemed to work for a long-time, during the ‘Great Moderation’. In dynamic
portrayals of the model there were a serious of exogenous shocks which caused economic
agents to keep adjusting to the changed circumstances to try and reach equilibrium conditions
again, this causes the whole framework to ‘shake’ as unexpected outside factors repeatedly
hit it and cause fluctuations, but it is always trying to return to an equilibrium.

We did cover how in the in mid-2007 a financial crisis rocked the Western world’s economies
which was far from a mere fluctuation requiring equilibrium readjustments. Newspapers
often blamed ‘Labour’s overspending’ for the crisis and government debt. And it is true that
Labour had begun to run a budget deficit even when the economy was growing well, when it
might have been reducing national debt instead, but most economists accept that this deficit
was small compared to the scale of the subsequent recession, and it was the collapse of tax
revenues caused by the recession that, more than anything, led to the huge deficit. Before the
finance crisis unsustainable debt in the private-sector had been allowed to build-up, mainly
because of government deregulation of banks, and even encouragement of ‘reckless’ loans
such as in the huge USA sub-prime market. Loans had been given to people who would be
unlikely to be able to pay them back. But financial institutions had packaged high risk loans
as a bundle with lower risk (In CDO’s and other exotic new securitisations). When the
defaults, that is non-payment of debts, started to appear no-one could easily untangle bad
debts from good debts. Banks failed, and this then made the situation for other banks even
worse as they had been relying on the failed banks to pay them back too. In this situation of
fear banks looked at each other with suspicion, they stop lending to each other, they held
back on loans to preserve their capital, the supply of credit to the economy froze, people
stopped spending, and the financial crisis led to a deep economic recession.
To prevent a financial collapse and to boost aggregate demand again government around the
world returned to a more Keynesian approach and ran huge government deficits as the central
banks poured loads of money into the banks (called ‘Quantitative Easing’). QE was needed as
just lowering the Central Bank’s policy rate, e.g. the rate at which the Bank of England lends,
no longer worked to stimulate the economy: as fast as the Bank of England lowered its
(policy) lending rate the commercial banks raised their (commercial) interest rates (known as
‘spreads’), or banks simply refused to lend at all because they could not determine the level
of risk. The demand for investment loans also fell as expectations for future growth became
pessimistic.
For a while the fiscal and monetary stimulus to the world economy appeared to be working,
there was some recovery in the UK, but some observers were horrified by the mounting
government debts and with a new UK government and a hardening attitude in Europe, the
‘Austerians’ won back political power. Whereas the ‘Stimulards’ had favoured Keynesian
style stimulus to reverse falls in AD, the Austerians argued that increasing debt might lead to
higher interest rates and hence less private sector activity. Large debts could crowd-out
private sector recovery. George Osborne, the UK Chancellor, argued that in being seen to
tackle the UK deficit the world’s finance markets would have confidence in the UK’s ability
to repay her debts, and this would prevent the sort of high interest rates that follow from fear
of default that had been seen in some other countries such as Greece.
Keynesians argued that it is more important to deal with the short-tern consequences of a
recession, loss of output, employment, investment and taxes, and to then worry about debt
levels over the longer-term. They did not see imminent danger of default risk and hence high
interest rates as the financial world would not really worry that much about UK default, as
other countries were less safe havens for financiers money anyway and the UK had her own
central bank in any case, so she could always just print money if necessary. Britain has never
defaulted on her debt. About a third of UK debt is actually owned to the Bank of England, so
it could be just written off if needs be. Being outside of the Euro meant that, unlike, say,
Greece, the UK’s central bank, the Bank of England, can set UK interest rates. Fixed
exchange rates mean that monetary policy must be directed at preserving the exchange rate
rather than at regulating aggregate demand. With flexible exchange rates a lowering of
interest rates will tend to mean the exchange rate falls and this actually helps increase
aggregate demand, but with a fixed exchange rate the interest rate has to be held to more or
less match the interest rate set by other countries, in order to prevent the capital flows
between countries that drive exchange rates. A common currency is the ultimate fixed
exchange rate.
Keynesians also argued that ‘austerity’ e.g. cutting back on government expenditure might
make the debt problem worse! For example, less G might mean less T and more spent on
benefits (more G again). Also, if GDP fell, then the debt to GDP ratio, that is what really
matters, might not fall or could increase. When George Osborne became Chancellor the
economy did seem to be recovering, but many economists believe that his sharp reduction in
spending between 2010 and 2012 stalled the economy and prolonged the recession. Osborne
blamed poor growth in the rest of Europe (but perhaps that was because they were by then
also pursuing austerity measures) It did indeed appear that as the economy ‘flat-lined’ the
reduction in debt reduction stopped too. A lot depends on the size of the multiplier. If more G
leads to a lot more Y then the increase in Tax and reduction in welfare payments might more
than offset the extra G and actually reduce the deficit! Even if it only matched it, the ratio of
debt to GDP would have fallen. Keynes himself had argued against the Austerians of his time
by saying that ‘If you look after employment the deficit will look after itself’.
Beyond the compulsory elements of the course, we looked at the Real Business Cycle (RBC)
model, a model with rational expectations and everywhere perfect competition. Not
surprisingly, although this models assumes a flow of exogenous shocks that creates the
cycles, the re-optimisation by agents to the new circumstances predicts constant Pareto-
efficiency and the Quantity Theory of Money. The introduction of stochastic shocks through
time and re-optimisation makes the RBC a ‘Dynamic Stochastic General Equilibrium
Model’. In the RBC model there is no role for aggregate demand management, but if price
stickiness in introduced the model becomes a ‘New Keynesian DSGE’ model and there is
again a role for government to manage fluctuations for a more optimal dynamic path for the
economy.

PAST EXAM QUESTIONS AND OUTLINE ANSWERS (NB: No Guarantee they will
all be repeated- see revision lectures for emphasis this year)

2015 EXAM
1. What do we have to assume about M, V and Q for the quantity theory of money and
inflation to hold true?
Outline Answer: Exogenous Money, V stable because Md stable, Q determined by a clearing
labour market
2. Why was there always a lower bound for what could have been achieved through
demand management by lowering interest rates during the ‘Great Recession’?
Outline Answer: As AD fell a long way it would require very low interest rates in order to
close the negative output gap, this could hit a liquidity trap or if the IS curve requires
negative real interest rates then zero nominal interest rates have ZLB as an interest rate floor
as, usually, people would not lend money to receive less back in nominal terms, just keeping
the money would be preferable. This is why the Bank of England resorted to special measures
‘Quantitative Easing’ which did in effect allow the Bank of England to provide liquidity to
banks as negative interest rates.
3. Draw the shapes of the original Philips Curve, the adaptive expectations augmented
Philips curve and the Philips curve with rational expectations (assume flexible wages and
prices) and briefly explain what is being assumed about how people anticipate future inflation
Outline Answer: Original- permanent trade-off; adaptive-short-run trade-off; rational- no
systematic trade-off/vertical. Original-no learning/no anticipation of inflation; Adaptive-slow
learning using the past as a guide; Rational-ultra smart, using models with no systematic bias
to forecast inflation
4. Describe all the routes through which a rise in interest rates affects aggregate demand
in an open economy (i.e. one with international trade)
Outline Answer: Usual ones via lowering investment (-) and (perhaps) reduced consumption
(-), also mortgages and effective disposable income effects (-), maybe through asset prices
and wealth effects too (-) and reduction of financial externalities (-) ALSO interest rate up
attracts foreign monies to UK thereby increasing the strength of the pound, reduces X (-),
increases M (-) , reduces input prices and so may lead to expenditure switching to goods with
higher import content (-) and real income effects (+). Could mention income effects of AD
on volume of X and M
Section B
1. What was the rationale behind joining the European Exchange Rate Mechanism and
why did the UK’s economic performance improve after leaving it?
Outline Answer: Shifted from Monetary to Exchange Rate targeting, to impose ‘forced’
budgetary and inflation discipline on government and to provide stability, of demand, to
anchor inflation expectations and reduce ‘discretionary’ budgetary changes, and to provide
‘safe’ environment for finance and FDI. Excessive demand, especially from government
policy, would put downward pressure on the exchange rate and so more ‘discipline’ on
stemming overheating would be forced. But the ‘impossible trinity’ dictated an interest rate
regime to allow the shadowing of the Deutschmark, given Germany’s stronger productivity
growth and very inflation adverse stance this meant that the UK was persistently burdened by
an exchange rate that made it uncompetitive and an interest rate that had a depressing effect
on demand and investment. Once out of the ERM, as speculation forced an inevitable
devaluation, the shackles of too high interest rate producing negative output gap and slow
build of capacity (and innovation) and uncompetitive exchange rate were gone. Interest rates
and exchange rate fell, allowing a recovery and a switch to inflation targeting regime that
may have been a large contributor to NICE.

2. What is the three equations ‘new consensus’ macroeconomic model and how does
(did) it fit together?
Outline Answer: Equation 1: An intertemporal IS. Equation 2: Expectations augmented
Philips Curve. Equation 3: A Monetary response to inflation and unemployment- with
endogenous money and policy rate set by the Central Bank. The model revolves around a
NAIRU, either neo-classical or New Keynesian- or simply with some price/wage stickiness
and hence some temporary trade-offs, shocks take the economy from NAIRU leading to
accelerating inflation or decelerating inflation and negative output gaps. Central bank
responds according to its loss function/time preference by setting policy interest rate to move
along shifting augmented Phillips Curves back towards NAIRU and inflation target and back
on to the L/R vertical Phillips at the target inflation rate

3. Define NAIRU and explain how it differs in New Keynesian theory from the NAIRU
of neo (New)-classical theory.
Outline Answer: Non Accelerating Non-Inflationary Rate of Unemployment. If there is a
positive output gap so unemployment falls below the NAIRU this will lead to accelerating
inflation, policy that attempts to maintain this ‘over-employment’ will see ever increasing
inflationary expectations that become increasingly painful to reverse back to inflation target.
NAIRU in neo-classical reflects the output at any one time that is produced by the level of
employment at which the labour market fully clears with no, persistent, involuntary
unemployment i.e. where the disutility of work equals MP. In New Keynesian because of
efficiency wages/ insider versus outsider NAIRU is at a labour market equilibrium with the
real wage ‘stuck too high’ so there is persistent involuntary unemployment,

4. What are Pigou/Patinkin real balance/wealth effects and can we rely on them to solve
unemployment?
Outline answer: This is a rebuttal to Keyne’s liquidity trap or ZLB, but only if flexible prices/
wages are assumed. Lack of demand leads to price falls (or prices do keep up with monetary
trajectory) and so real money balances and bonds increase in real value creating positive
wealth effects for consumption or lift budget constraints allowing increased consumption. If
there are sticky wages. Employment may not rise to produce the output effects this depends
on, or the process maybe very slow. Particularly, assuming some degree of exogeneity of the
money supply, the effect may work in the long-run, but Keynes retorted ‘In the long-run we
are all dead’.

5. Did ‘austerity’ shorten the Great Recession and help pay down the Government’s
deficit? Explain your answer.

Outline answer: No.

6. Would the Bank of England nowadays apply monetary policy as harshly as Mrs
Thatcher’s government did? Explain your answer.
Outline answer: No. The B of E has as its prime target inflation but is charged also to
consider unemployment effects resulting from changes in interest rates. Reducing inflation
rapidly through very high interest rates are likely to cause very large increases in
unemployment, as for example, the economy moves along a short-run Phillips curve
augmented by high inflation expectations. This would almost certainly, one hopes, lead to a
lower indifference curve between current inflation and unemployment for the policy maker. A
more gradual reduction of inflation through increased interest rates would better manage
down inflationary expectations and so be preferred (lower value for the policy maker’s loss
function). In Keynesian terms it is simply savage to use the mass misery of unemployment to
bring down inflation by sucking demand out of the economy.

7. Describe the events that led to the 2008 financial crisis and why the Bank of England
had to resort to special monetary measures.
Outline answer: Read ‘It’s the Economy, Stupid’ by Pryce, Ross and Urwin

8. What is the ‘Lucas critique’ and what are its implications for macro-economic policy?
Outline answer: People learn during particular policy regimes and so start to anticipate and
adapt to the effects of policy including new policies. Historical data may thus be a misleading
guide as to future effects. For example, the past effects of policy may not be a good guide to
future effects as anticipatory behaviour, in particular rational expectations, may thwart the
intended effects of policy. In particular, even if expansionary policy worked for a while, it is
very likely to lose effect for all of the future. This is the approach of modern neo-classical
macroeconomics, ‘New Classical Macroeconomics’, the underlying principle being that
macroeconomics should be based on rigorous microeconomic foundations using forward
looking optimising agents with model consistent expectations.
The assumption of very forward agents also underlies theories such as ‘Ricardian
equivalence’ and ‘Real Business cycles’.

2016 EXAM
1. Briefly describe how Keynesian and Neo-classical economists disagree over the use
of the M.V= P.Q identity.
Outline Answer: Neo/ Classical: V is stable, possibly after adjustment as Md a stable function
of wealth/perm income Key: V unstable- linked to unstable Md
Neo/Classical: P roughly proportionate to M Key: P can be sticky, no set relation to M
Neo/Classica: Q stable (perhaps after adjustment)- related to supply equilibrium- in S/R
Labour market. Key: Q Fluctuates- related to AD in S/R
NC: Money Exogenous K: New K, may be endogenous

2. What are the main policy levers employed by the Bank of England to stimulate
aggregate demand? Briefly describe how they work.
Outline Answer: r, REPO, OMO, QE. Interest rate affects AD through C, I and Exchange
rate. QE, increase in base money to buy assets affects liquidity portfolio, and makes G debt
saleable, keeping r down. Also Expectations guidance.
(many others too but these will suffice)

3. ‘Stagflation’ in the 1970’s was used to discredit Keynesian policies, use aggregate
demand and supply analysis to suggest an alternative explanation.
Outline Answer: Supply-side shock- OPEC, Trade unions, less regulation on credit controls.
Correct AS/AD diagram- with negative supply shock. Critique- was this sufficient to settle
debate?
4. How does international trade affect the Keynesian multiplier?
Outline answer: Direct effect on effective MPC and the ‘dampening’ of IS shifts through
interest rate and exchange rate feedbacks. Bonus if they use a correct multiplier equation.

Section B
1. Describe the components of the standard neo-classical synthesis model and explain
how it self-equilibrates if all prices are flexible.
Outline answer: IS/LM ‘Keynesian’ derivation and combine with Neo-classical labour
market. Show shifting LM with exogenous money and ‘deflation’ to expand AD until it shifts
back to IS at Qe (Labour market equilibrium at same real wage).

2. Explain how a fall in ‘animal spirits’ might lead to a zero-lower- bound interest rate
and a ‘deflation trap’ for the economy?
Outline answer: Definition/description of animal spirits. Explanation of ZLB. Explanation of
deflation trap- explain value of money and deferred spend, plus rise in real debt so negative
wealth effects/deleverage on AD

3. George Osborne has recently said that ‘unexpectedly’ poor economic performance
might ‘necessitate’ greater than expected cuts in government spending, he went on to say that
the "whole purpose of our economic plan was to have a budget surplus". Explain how
different economists would endorse or condemn the Chancellor’s approach.
Outline Answer: Outline of Stimulard versus Austerian debate with particular reference to
related impacts on the budget balance. Some empirical/evidence knowledge useful.

4. What caused the 2007 financial crash and subsequent economic crises?
Outline answer: De-regulation, long build, proliferation of ‘exotic’ instruments, financial
accelerator cycle. Equity trap in sub-prime as trigger. Effects on finance, contagion spreads
etc, expecations links to AD

5. Answer question 5a or 5b:

a) What is ‘new-Keynesian’ economics?

or
b) Describe the three equations ‘new consensus’ macroeconomic model.

Outline answer: Inter-temporal IS- forward facing expectations, Phillips curve- expectations
augmented/adaptive expectations, monetary rule/ path. For New Key version: discussion of
efficiency wages, price setting and involuntary unemployment equilibrium. NAIRU and
consequences of movements from. Note asymmetric expectations assumptions.

6. Explain how different exchange rate regimes affect the potency of fiscal and monetary
policies.
Outline answer: Mundell-Fleming type interactions- IS/LM with an international sector and
rapid finance flows. Trace the transmission links. Fiscal policy stronger in fixed exchange
rate. Monetary policy stronger in flexible exchange rate. Bonus for discussion of interaction
with supply-side.

7. What is the difference between adaptive and rational expectations and what are the
implications for macro-economic policy?
Outline Answer: Definitions of adaptive and rational. Flaws with each approach. Implications
for policy-especially monetary. Lucas critique and policy impotency implication. Limitations
of policy impotence arguments.

8. Keynes famously said ‘In the long-run we are all dead’. Explain what he meant with
reference to his debate with Pigou.
Outline answer:
Liquidity trap/ZLB. IS does not meet LM even at r=0. Pigou’s view of market clearing and
the consequences of falling prices if AD<AD. Pigou/Patinkin wealth effects. Length of
equilibrating process- hence the quote. Policy feasibility.

2017 EXAM

SECTION A: Answer all the following questions

1. What assumptions are needed to produce the classical quantity theory of money
and inflation relationship?

Outline Answer: Irving Fisher identity. M exogenous and controllable. Q constant in short-
run- as clearing of Labour Market. V constant or stable invariant demand for money e.g.
wealth based. P is a dependent variable. Causation flows from M to P.

2. Explain why a larger Keynesian multiplier decreases the slope of the IS curve.
Outline Answer: Change in investment a function of real interest rate, but change in income
from a given change in investment is bigger the bigger the multiplier i.e. greater MPC. So
loci of equilibriums further along the income axis for any given level of interest- rate.
Diagrams would help. Acceptable in straight-maths too.

3. How does the assumption of endogenous money affect the LM curve and the
effectiveness of fiscal policy?

Outline Answer: Contrast endogenous with exogenous money. The greater the endogeneity
the flatter the curve. The flatter the LM the less crowding out of private investment from
increased fiscal stimulus, so the more potent fiscal policy- unless Ricardian etc.

4. What would you expect an expansionary fiscal stimulus to do to the foreign

exchange rate? Explain your reasoning.

Outline Answer:
Increased spending/deficit may raise the interest rate, upward sloping LM or increased yield
required on government debt, unless endogenous/monetary inflows without sterilisation.
Tends to raise exchange rate, as this increases inward speculative flows so increased demand
for sterling. But expansion of AD, non-Ricardian etc, may increase demand for imports and
increase domestic export absorption, so balance of trade deficit may then act to reduce
exchange rate. Overall, indeterminate, but speculative flows tend to dominate in the short-
run.

SECTION B: Answer three from the following eight questions

1. Explain why George Osborne found it so difficult to meet his targets for the
reduction of the Government’s budget deficit.

Outline Answer: Details of Osborne missing his successive targets. Finally abandoned by
May/Hammond. Austerity impacts from 2010- refer to the OBR’s own estimates of fiscal
impact. Distinction between AME and DEL so misleading commentaries on Austerity. Cut in
public sector investment 2010 and stronger multiplier at ZLB. Decreased or slower growth
GDP led to decreased/lower than estimated tax revenues. Slower world growth too- esp EU.
Expectations impact of ‘austerity’. Maybe mention Portes and Holland. Missing ‘confidence
fairy’ but there was a reduction in deficit ratio, maybe as growth picked-up after partly
delayed growth.

2. ‘Mrs Thatcher’s monetarist experiment was a success’. Critique this statement.

Outline Answer:
Explanation of the problems it was meant to tackle. Definition of monetarism. Intended
outcomes- especially unemployment and inflation. Failure to meet monetary aggregate targets
and Goodhart’s law. Evidence on actual outcomes. Expectations augmented Phillip’s Curve.
Alternative explanations of inflation falling. Hysterisis and ‘lost generation’. Excessive speed
of expected adjustment and soaring interest rate and exchange rate. The world –setting and
growth.

3. Explain how assuming flexible wages and prices ensure that the neo-classical
synthesis model eventually comes to rest at a point where there is no involuntary
unemployment.

Outline Answer: Explain the clearing of the labour market in terms of real wages and MP.
Tendency of natural employment below capacity to push output and increase demand, with
price adjustments acting on exogenous part of money supply to shift LM and lower exchange
rate. Unless ZLB/liquidity trap- AD can only be in equilibrium at ‘natural rate’ of output.
Unemployment only if sticky wages and prices. Indeterminacy if ZLB reached, but wealth
effects might eventually expand AD. Length of adjustment and vicious-circle dynamics
problems. Classical dichotomy.

4. What is the Lucas Critique? Does it make monetary policy pointless? Explain.

Outline Answer:
Explanation of the Lucas Critique- either econometric or intuitive. Role of expectations-
especially rational expectations. Agent adjustment to policy regimes, neutralising policy
effects. Vertical Phillips curve. Impotency of monetary policy with RE (perhaps with mention
of all flexible prices assumption). Logical and empirical objections to the ‘new-classical’
perspective and outcomes.

5. What did Keynes mean by a ‘fallacy of composition’ and why was it so important
to his critique of neo-classical economics?
Outline Answer:
Explanation and examples of fallacy of composition e.g. paradox of thrift. Micro-foundation
choices constrained by macro inter-dependency constraints. Scope for ‘animal spirits’ and
system complexity to affect real variables and dynamics. Self-fulfilling prophecies. Unstable
micro functions and risk distributions due to macro inter-dependence. Empirical support.
6. Explain how Friedman’s emphasis on wealth rather than income as a
determinant of behaviour suggests that the economy is more stable than Keynes had
portrayed it.
Outline Answer:
Explanation of concept of ‘wealth’. Consumption and the permanent income hypothesis
versus simple Keynesian consumption function. Consumer durables as investments.
Dampening of reactions to fluctuations so dampening consumption and hence reducing AD
fluctuations. Critique: behavioural and credit constraints. Similar with demand for money,
hence importance of a stable money supply, irrelevance if money endogenous.

7. Outline the operation of the ‘Three Equation New Consensus’ model in a closed
economy.
OR
Explain why trying to reduce unemployment below the NAIRU in a new-Keynesian
model is likely to be counter-productive.

Outline Answer:
Describe each of three equations. Importance of Phillips curve assumptions-can differ in each
model. New Keynesian NAIRU –explain price and wage setting curves. Accelerating
inflation above NAIRU with harmful consequences when inflation finally reversed. Discuss
Taylor rule and Central bank loss function/optimal central bank adjustment path.

8. What caused the 2007 ‘Great Financial Crisis’ and how successful were the
policy responses to it?
Outline Answer:
Long build-up- ‘NICE’. Financial Liberalisation. Short-termism and leverage. Derivatives
and CDOs. Large build-up of speculative debt. Reliance on efficient markets doctrine. Rating
agencies connivance with clients. Moral hazard. Systemic imperative for individuals and
organisations. Sub-prime trigger- Northern Rock and Lehmans, AiG etc. Macro-versus
micro-prudence- mark-to-market asset accounting etc.
Labour government fiscal response and central bank policy interest rate approaching lower
bound, so extra-ordinary open market operations (QE). VAT increase delayed – even car
scrappage scheme. Increased spreads thwarting intended effects of central bank reducing
Repo. Pushing on a string monetary (QE) problems. Darling’s fiscal stimulus. Nascent
recovery? Osborne’s ‘austerity’. Cuts in DEL increasing AME. The magnitude and length of
the Great recession. Now Fiscal shift to infrastructure- deficit elimination postponed-perhaps
should have been much earlier. Role of sovereign risk.

DATE OF EXAMINATION 2018

DURATION OF PAPER: 3 hours and fifteen minutes XXam – X.15pm (including 15
minutes reading time)
INSTRUCTIONS:
Answer ALL questions in section A and THREE questions from Section B.
Section A has 40 per cent of the marks.

SECTION A:

Answer ALL the following questions. Each question in this section carries ten marks

1. Briefly describe three main differences between Keynesian and Neo-classical

macroeconomics.

Outline Answer: Any three from:

Classical dichotomy versus Keynesian real effects- and/or monetary neutrality.
Price versus quantity adjustments.
Aggregate economics versus fallacy of composition.
Money demand instability versus stability.
Involuntary versus voluntary unemployment
Animal spirits and Knightian uncertainty versus risk and expectations adjustment.
Sticky wage and prices versus market clearing.
Pareto-efficiency versus Keynesian recession.
Shape of aggregate supply curves/Phillip’s Curves.
Equilibration versus ‘In the long-run we are all dead’.
Clearing versus jamming.
Discretionary demand stabilisation versus supply stability stabilising demand.

2. What is meant by the ‘Marginal Propensity to Consume’ and how does it

determine the size of the Keynesian multiplier in a simple Keynesian model?
Outline Answer: Definition of MPC, explanation of multiplier effect in Keynesian-cross type
model, link with spend on domestic production. Correct formula and directions of causation.
Psychological interpretation.

3. Why does a rise in the Bank of England’s policy interest rate tend to reduce
inflation?
Outline Answer: Explanation of domestic and also open economy monetary transmission via
the exchange rate following changes in MPC policy rate.

4. ‘The fall in growth expected after the BREXIT vote has been offset by better
than expected world growth’. Explain the economic analysis behind this statement.
Outline Answer: Explanation of the role of confidence and BREXIT and aggregate demand,
and why faster international economic growth could increase domestic growth e.g. through
exports and FDI links.

SECTION B:
Answer any THREE from the following eight questions. Each question in this section carries
20 marks

5. Draw a standard IS/LM diagram and

a) Explain what forces drive the model to equilibrium.
b) Outline the major missing elements compared to a real economy.
Outline Answer: Correct diagram of IS/LM. Explanation of why injection and leakages
imbalance, and/or Ms and Md imbalance, propels AD in an equilibrating direction.
Explanation of overall equilibrium.
Missing elements could include government, open economy and a supply-side. Lags, inter-
temporal consideration, inter-equilibrium dynamics, hysteresis, wider dynamics. Endogenous
money, risk spreads and policy rate setting.

6. What was the rationale behind the ‘Monetarist Experiment’ and was this
experiment a success?
Outline Answer: Explain what monetarism was, when it was attempted and what it promised.
Background on why it came to be favoured by Thatcher Government. An account of to what
extent it lived up to its promises- problems of endogeneity of money, Goodhart’s Law, failed
monetary targeting, sharp and then chronic impact on unemployment, hysteresis-‘lost
generation’, impact on inflation, discussion of whether inflation was brought down by
monetary policy or unemployment, or other global factors.

7. Explain how the labour market determines the existence or otherwise of

involuntary unemployment.
Outline Answer: Definitions of and distinction between voluntary and involuntary
unemployment. Description of Real wage and Marginal Product labour market equilibrium
and equilibration. Effect of sticky real wages. Explanation of some reasons why wages might
be sticky and above clearing level e.g. contracts, laws, unions, benefits. Keynesian market
jamming and quantity adjustment and constraints.

8. Why does the way expectations are formed have implications for macroeconomic
policy?
Outline Answer: Definition of expectations and account of constant, adaptive and rational
expectations formation. Relation to flat, curved and vertical Phillips Curve. Scope for
permanent, temporary or no policy volume impacts. Implications for control of inflation and
unemployment. Note on Keynesian/Knightian uncertainty. Advanced ‘perverse’ expectations
effects, game-theoretic complexity.

9. “We have not abandoned the intention to move to a surplus. What I have said is
we will not be targeting that at the end of this parliament”.
(Theresa May: July 2016)
What is meant by government ‘debt’ and ‘deficit’ and why has the priority to clear the
government deficit been downgraded?
Outline Answer:
Definitions and distinction between deficit and debt. Brief description of government and
national debt. Description of sequentially failed targets. Account of 2010 squeeze and 2012
slackening in face of slowed growth. Description of the Great Recession, longest ‘recovery’
on record. Description of slow recovery- GDP per capita, stagnation of disposable income.
Description of why the much-vaunted adverse consequences, such as sovereign default and
high interest rates, has not happened. Adverse consequences of austerity on deficit reduction,
automatic stablisers. Shift back to expansionary emphasis with National infrastructure plan
and need to offset BREXIT
10. Contrast the ‘permanent income hypothesis’ with the simple Keynesian
consumption function and explain why it matters for the success of aggregate demand
management.
Outline Answer: Description of simple Keynesian consumption function (with or without
intercept) and the permanent income hypothesis. Explanation of permanent income and inter-
temporal budget constraint and consumption smoothing. Explanation of why permanent
income is much less volatile than current disposable income, hence smaller multiplier
impacts and greater stability of aggregate demand/.

11. Outline and contrast the Neo-classical Synthesis and New Keynesian models of
the economy.
Outline Answer: Description of the synthesis and why it is called a synthesis. Perfect versus
imperfectly competitive supply-side. Description of a New Keynesian model: labour and
product market, inter-temporal IS curve (forward looking) , adaptive expectations (Backward
looking) Phillips/ wage and price setting curves. Adjustment to demand shocks. Note
asymmetry of expectations assumption. Efficiency wages versus clearing real wage. Pareto-
efficient NAIRU versus inefficient NAIRU. Institutional aspects.

12. Explain what is meant by ‘Crowding-out’ and ‘Ricardian equivalence’ and why
these effects might, but only might, reduce the impact of expansionary fiscal policy.
Outline Answer: Definitions of crowding-out and Ricardian equivalence. Explanation of why
there could be higher interest rates from fiscal expansion and impacts on investment.
Consequences for the overall multiplier. Explanation of consumer inter-temporal budget
constraint incorporating the government’s budget and so why an increase government in
spending might be off-set by a fall in consumption. A brief critique of the likelihood of these
effects and why they might not hold. For example, credit constrained consumers and
businesses, accelerator theory, expectations impact, policy-set interest rates, unknown future
government behaviours, lack of rational expectations, demographics.

2019
SECTION A:

• Briefly explain the assumptions behind the ‘Quantity Theory of Money’

prediction that a doubling of the money supply leads to a doubling of prices.

Outline Answer
Exogenous Money, Stable Velocity/Money demand function, price flexibility, supply-side
‘natural’ equilibrium (real wage = Marginal productivity) so Output constant.

• How does an ‘LM Curve’ differ from a ‘TR Curve’ in the IS/LM framework?

Outline Answer
LM iso-equilibrium curve Md=Ms, TR a ‘Taylor Rule’ Central Bank policy reaction
curve- ‘leaning against’ deviations from NAIRU/ + or – output gaps

• Describe the circumstances that might allow a government to borrow its way out of
debt.
 Outline Answer
Negative output gap/low inflation, strong multiplier (high MPC, credit constrained
consumers, endogenous money, hot-money off-sets), pump-primed expectations,
international coordination

• Why might having a single currency across different countries make the macro
stabilisation of each country harder?
Outline Answer
‘One size does not fit all’ problem. Loss of independent monetary and fiscal autonomy in the
face of asymmetric international shocks. Political prioritisations and power

SECTION B:
• What caused the Global Financial Crisis of 2007/8?

Outline Answer
Unsustainable build-up of private debt, risky and ‘exotic’ speculative instruments and
lending, misleading and corrupt securitisation packages and credit ratings, fiscal bias
and structural deficits, sub-prime trigger, freezing of wholesale money markets, fear
spreads, TARP issues, short-rates exceeding long-rates insolvency, mark-to-mark
asset collapse, need to restore capital reserves. Northern Rock and Lehmans.

• “We used to think that you could spend your way out of a recession and increase
employment by cutting taxes and boosting government spending…that option no
longer exists, and in so far as it ever did exist, it only worked on each occasion since
the war by injecting a bigger dose of inflation into the economy, followed by a higher
level of unemployment as the next step.”
Explain Milton Friedman’s theoretical underpinning for such statements.

Outline Answer
‘Monetarist’ theory of inflation. Short-run versus the original Phillips Curve- and the New-
classical long-run vertical Phillips Curve. Adaptive expectations and money illusion. NAIRU.
Neutrality of money but damage to price mechanism of high inflation.

• Does the level of ‘Government Debt’ really matter for fiscal stabilisation? Explain
your answer.

Outline Answer
Explanation of ‘National Debt’ and deficit. Short-run recession versus long-run debt
issues. ‘Future generations’ argument, sovereign default risk and interest rates,
Ricardian equivalence constraint and crowding -out. ‘Versus’ importance of central
bank, seigniorage, state immortality, government to government debt, redistribution.

• Explain how assuming economic agents base their decisions on wealth rather than
income predicts a more stable economy.

Outline Answer
Keynesian consumption function versus permanent income/ life-cycle hypotheses and
 implications for MPC and therefore the multiplier, relative magnitudes, response to
shocks. ‘Restatement of Quantity theory money demand’, Pigou/Patinkin real
balance/wealth effects

• Explain and contrast the role of uncertainty and expectations in Keynesian and
neoclassical macroeconomics.

Outline Answer
Knightian uncertainty versus risk. Individualistic probability versus group moods/
animal spirits and uncertainty. Micro-prudence versus macro-prudence. Self-fulfilling
prophecies and bounded rationality versus Lucas critique and neoclassical theoretic
consistency. Agent-based and group perspectives. Dynamic vicious and virtuous
circles versus adjustments and comparative statics.

10 Explain why three different equilibrium conditions are simultaneously necessary for
overall equilibrium in the Neoclassical synthesis

Outline Answer
Description of Goods, Money and Labour market equilibriums. Explanation of the forces
created in each market by disequilibrium. The supply-side driven dichotomy.

11. Describe ONE of the following ‘modern’ macro models:

a) New-Keynesian
b) New Consensus (3-equation)
c) Dynamic Stochastic General Equilibrium

Outline Answer
a) Description of and explanations for efficiency wages. Involuntary unemployment NAIRU.
The trades unions employers or HR versus marketing ‘race’ of accelerating inflation.
Imperfect competition. Non-Pareto properties.
b) Inter-temporal IS, forward looking Taylor Rules Reaction function, adaptive Phillips
curve. ‘Consignment Assignment’ consensus. Neutrality of money.
c) Why it’s GE, Dynamic and Stochastic. New Neoclassical Synthesis. Continuous demand
and supply shocks and impulse propagation. Basic ‘new classical’ versus Lags and frictions.
Production function with stochastic shocks-RBC. Budget constrained inter-temporal IS.
Classical dichotomy and Pareto properties.

12. What is the Zero Lower Bound (ZLB) and what problems arise when it is reached?

Outline Answer
Description of ZLB and why it exists. Real versus nominal interest rates. How it may be
reached in practice. Discussion of spreads and loss of policy levers. The problems it poses for
tackling recessions. The argument for ‘fiscal space’ and higher inflation target to tackle ZLB

2020 Exam

Section A – Answer ALL FOUR questions in this Section. This Section is worth 40% of the
marks. Each question is worth 10%.
 • When might an increase in the money supply not cause inflation? [10
Marks]

Md increases/liquidity trap, when Ms endogenous, when Q increases, when prices

were falling, when off-set by other changes.

• What is an ‘inter-temporal consumption function’? [10

Marks]

Consumer looks over time at income flow- permanent income/ wealth not just current
income. Use of discount rate.

• Why has the Bank of England been reluctant to raise interest rates since 2008
even when inflation has been above its target? [10
Marks]

Interest rates rise may further slow, tip into recession, an already fragile/slow growing
economy with low confidence levels by reducing I and C and increasing £ so X down and I
up. The inflation was deemed due to a one off negative supply shock of Brexit

• Describe, compare and contrast the ISLM model when (i) the Money Supply is
the primary policy instrument, and when (ii) an interest rate is the primary
policy instrument.
[10 Marks]

Exogenous money Upward sloping LM curve with crowding-out V’s endogenous money
flat one with no interest rate crowding-out
Section B – Answer ANY TWO out of the eight questions in this Section. This Section is
worth 60% of the marks. Each question is worth 30%. (error on exam said 20%)

• Explain the arguments for and against the claim that ‘Stagflation’ in the 1970s
revealed the failure of Keynesian economic policy.
[30 Marks]

High inflation and unemployment, so Phillips curve trade-off no-longer seemed

available so use of AD along a menu for policy choice no-longer seemed feasible.
Friedman money illusion so no long-run trade-off. But could’ve been oil or running
economy too long at too low a level of unemployment, or lax credit control eg CCC

• ‘The big economic mistake of the last Labour government was a failure to
regulate the banks properly, rather than to spend too much.’ Evaluate this claim,
explaining your reasoning.
[30 Marks]
 Labour had a Structural deficit, but small in relation to post-crisis deficit, Private debt
over-hang far bigger than public-sector- CDOs, derivatives and sub-prime, implosion,
credit freeze and increased spreads, ZLB approached, but global financial crisis not just
UK

• ‘Money is like a myth that requires only imagination for its creation, but faith
for its effectiveness’. Explain what is meant by this statement and evaluate its
importance for macroeconomic policy.
[30 Marks]

Money requires confidence it will be accepted by others for its existence as money.
Can be created by commercial banks if there is confidence in banks, generally
confidence in central banks so they can ‘print’ at will if they wanted to- subject to
currency confidence. Confidence in banks must be maintained to prevent sudden
massive loss of money and recession, can control price of money r but not volume.
Ms may expand with activity without increase in r, so no financial crowding out..all
makes fiscal multiplier bigger

• Explain the transformation and the significance of the original Phillips Curve
(wage inflation and unemployment) in the New Keynesian approach (price
inflation and the output gap).
[30 Marks]

Wage to prices, levels to gaps. Dynamic, gaps not set amounts. Permanent Inflation
unemployment Trade-off in original and no NAIRU versus no long-run trade-off in NK.
Adaptive S/R trade-off. And NAIRU even with involuntary unemployment.

• Answer both parts a) and b) of this question:

a) Distinguish between ‘voluntary’ and ‘involuntary’ unemployment. [15

Marks]

Willing and able to work at the equilibrium wage but can’t find a job v’s rejecting
below reservation wage, frictional and other search unemployment. Discouraged
precariat worker a grey area

b) What impacts might a harsher welfare support regime have on the

macroeconomy?
[15 Marks]

Ad impacts, could go either way but likely decrease in AD, whereas AS= Possible Increase
in employment and decrease in voluntary unemployment, fall in/ stagnant low paid wages,
stagnant productivity, more output, lower inflation. Higher level of employment at NAIRU.
Human capital may be affected..
2021 EXAM
Section A – Answer ALL FOUR questions in this Section. This Section is worth 40% of the
marks. Each question is worth 10%.

• Explain what John Maynard Keynes meant by his advice to Governments to:
“Look after the unemployment, and the Budget will look after itself.”

[10
Marks]
Outline Answer
Description of cyclical ‘Keynesian’ unemployment and the potential role of aggregate
demand management in relation to this. Link to automatic stabilisers, discretionary
spending, tax revenues and the government budget balance. Brief description of the role
of the government budget/public sector debt.

• Explain how a rise in the interest rate set by a central bank is likely to reduce
inflation.

[10 Marks]

Outline Answer
Brief description of how a central bank can raise market interest rates. Description of
the closed economy and open economy transmission mechanisms between interest rates
and inflation.

• Answer BOTH parts of this question

a) Draw a fully labelled demand and supply diagram showing equilibrium in the
aggregate labour market when there is perfect competition in all markets.

[5 Marks]
b) Discuss what this means for the level of unemployment.
[5 Marks]

Outline Answer
• Supply and demand showing Ls=Ld with W/P = MP b) Macro unemployment is zero
but there will be frictional, search and structural unemployment. Some registered
unemployment may not be ‘genuine’.

• ‘The Phillips Curve becomes more vertical as expectations become more rational’.
Explain and evaluate this statement.
[10 Marks]

Outline Answer
Knowledge of the Phillips-curve. Link between trade-offs and expectations. Money illusion
versus rational expectations.

Section B – Answer ANY THREE out of the eight questions in this Section. This Section is
worth 60% of the marks. Each question is worth 20%.

• Answer BOTH parts of this question:

a) Explain why the identities E≡Y and M.V≡P.Q are equivalent.

[10 Marks]

• Explain how one identity tends to emphasis the Keynesian approach and the
other the Neoclassical approach to macroeconomics.
[10
Marks]

Outline answer
a) Explanation of all terms. Interpretation of M.V as Expenditure and PQ as nominal
Income Y.
b) Autonomous expenditures v’s exogenous money stock and stable velocity. Y
expenditure led while Q supply led. Confidence impacts on E and Md

• ‘Trying to cure a recession through monetary policy can be like pushing on a

string’. Explain this statement with reference to ‘Quantitative Easing’.
[20 Marks]

Outline Answer
Explanation of QE process and its supposed monetary transmission mechanisms.
Portfolio adjustments impacts. Elastic Md. Zero-lower bound. Endogeneity. Confidence
and retreat into liquidity v’s real purchases and assets.

• What problems did the Bretton Woods agreement seek to solve and does its
approach still have any relevance for today?
[20 Marks]

Outline Answer
Beggar they neighbour nationalist policies- fallacy of composition/social dilemma
issues. Protectionism, struggling countries, retaliatory responses. High debt overhangs.
Role of giant trading blocs.

• Answer BOTH parts of this question:

a) Explain why the marginal propensity to consume might appear lower in

data from a cross-sectional study of household incomes and their consumption
than from a longitudinal study of aggregate consumption and aggregate
household income.
[10 Marks]

b) What, if anything, does this tell us about the likely reaction of consumers to an
 increase in government spending?

[10 Marks]

Outline answer
The effect of wealth being in the consumption function, differential impact of temporary
versus permanent increases in income. Temporary shocks balanced out in longitudinal
data. Smaller and/or lagged response to G. Ricardian equivalence ‘more likely’ with
forward looking intertemporal consumption function.

• Explain why the ‘Classical Dichotomy’ holds in the Neoclassical Synthesis model
with exogenous money and flexible prices and wages.
[20 Marks]

Outline answer
Independent real supply-side, aggregate production function, determination of Q.
Demand adjusts back to original after changes in nominal money supply, (shifting the
LM curve ) through excess supply or demand restoring the real value of the money
supply. So M and P are proportionately related.

• "Only when the economic tide goes out do you find out who is swimming naked”.
Explain the relevance of this statement to the financial crisis of 2007.
[20 Marks]

Outline Answer
Micro versus macro prudence. Mark to Mark accounting. Effect of falling asset values.
Role of CDO’s, toxic assets and rating agencies. Leverage on rising assets. Speculative
investments. Confidence, default and contagion. Liquidity and solvency of financial
institutions.

• Answer both part of this question:

a) What is the ‘NAIRU and is it the same as the ‘natural rate’ of

unemployment?
[10 Marks]

b) Explain in detail the process of inflation in the 3-equation model when

unemployment is below the NAIRU

[10 Marks]
• Non-accelerating rate of unemployment is not the same as the ‘natural rate’, as the
later is the outcome of long-run real supply-side under competitive conditions
whereas the former can be affected by imperfections, policies and institutions.
• Description of the price and wage setting curves and their interaction, with adaptive
expectations, that leads to accelerating inflation.
 12. Use the Neoclassical Synthesis model to explain the possible impacts of
BREXIT on the UK economy
[20 Marks]

Outline answer

Shifts in IS due to confidence, trade and exchange rate changes. Accommodating monetary
policy and LM curve. Supply-chain and productivity impacts on marginal productivity,
labour market clearing and Q, and consequent interactions with AD side. Candidates may
choose either positive or negative shocks to illustrate.

DATE OF EXAMINATION: 2022

Answer ALL questions in Section A and ANY THREE questions in Section B.

Section A is worth 40% of the marks. Each question in Section A is worth 10 Marks.

Section B is worth 60 % of the marks. Each question in Section B is worth 20 Marks.

Section A – Answer ALL FOUR questions in this Section. This Section is worth 40% of the
marks. Each question is worth 10%.

• ‘Macroeconomics is simply aggregated microeconomics’. Critically examine this

statement.
[10 Marks]
Outline Answer
Recognition that macro is about aggregates, with examples= output, employment/
unemployment, inflation, BoT/BoP. Explanation of the ‘Fallacy of Composition’ and
interdependence arguments, with examples- such as ‘paradox of thrift’, and/or
quantity constraints. Description of crowd/herding/animal spirits. Macro
complications from money and finance, in contrast with ‘Walrasian’ GE and Say’s
Law.

• Use the identity M.V≡P.Q to explain why it is misleading to say that too much
money is always the cause of inflation.
[10 Marks]

Outline Answer
Knowing what the letters mean, and why it is an identity. Explaining why Q and V
could change and the possibility of reverse causation or missing variable eg of AD on
both PQ and M. Endogenous money.

• Answer BOTH parts of this question:

 a) What is the fiscal multiplier?
[5 Marks]
AND

• Why might the size of the multiplier be affected by expectations of future

income?
[5 Marks]

Outline Answer
Definition of and
equation for the
fiscal multiplier,
and what it means.
The role for expectations of future income on the size of MPC e.g. intertemporal
consumption function or referring to permanent income hypothesis. Possibly
increased investment.

• Describe the circumstances in which an increase in government expenditure

could reduce the government’s budget deficit. [10
Marks]

Outline Answer
Knowing what the deficit is. Lack of capacity constraints. Large multiplier- high
MPC, small induced interest rate rise, low crowding-out and crowding-in, raised
expectations, small exchange rate impact, lack of Ricardian equivalence,. Tax base
expansion and fiscal drag. Reduced welfare payments.

Section B – Answer any THREE questions in this Section. This Section is worth 60% of the
marks. Each question is worth 20%.

• Using the Neoclassical Synthesis Model, explain how a pandemic (such as

Covid-19) is likely to affect the macroeconomy.
[20 Marks]

Outline Answer
Knowing what the Synthesis model is. Going through likely impacts on IS and LM
and supply and demand in Labour Market (MP of Labour). Adding policy response
effects- such as Furlough scheme of Labour ‘facilitated hoarding’ and supply.
Allowing for endogenous Ms and fiscal offsets. Reasons why recovery is quicker than
for ‘normal’ recessions.

• Does macroeconomic policy since the 1930’s suggest that the development of
 macroeconomic theory is driven by scientific method or by real world events?
Explain your answer with examples.

[20 Marks]

Outline Answer
Examples of how policy was ‘caught wanting’ (from any economy). The difficulties
with the scientific method in macro-Lack of control variables, ceteris paribus, a dearth
of counterfactuals and a surfeit of confounders. Macroeconomic policy responses-|
Great Depression- demand management, Stagflation-augmented Phillips Curve,
Monetarism- Goodhart and endogenous money, ERM- a foreseeable policy error ,
Inflation targeting- NICE and New Consensus, GFC-financial risk complacency,
integration of finance modelling and Covid- suspended animation ‘success’.
Macroeconomics as prior warnings to policy makers and as subsequent theoretical
responses.

• Answer BOTH parts of this question:

a) Why might a central bank hesitate to raise interest rates even if inflation
exceeds its target? [10
Marks]
AND

b) Explain why delaying such a rise in interest rates can be a risky strategy.
[10 Marks]

Outline Answer
a) Outline of Taylor Rule elements. Danger of a supply shock stalling the economy if
demand shock is added. Anticipations of only a temporary inflation spike. Already in
recession. Pound too high. Political pressures. Expectation of impending downturn.
b) Embedding higher inflation expectations. Augmented Phillips Curve- worsens
future trade-off between inflation and output/unemployment. Loss of Bank credibility
make inflation harder to keep down in future. Windfall redistributions from inflation.
Asset distortions and impacts.

• Answer BOTH parts of this question:

a) What is endogenous money and where does it come from? [10

Marks]

AND

b) How does endogenous money affect the LM curve? [10

Marks]
 Outline Answer
a) Correct definition – money not exogenous but created within the banking system,
including by QE/ BoE base deposits and commercial bank new loans. Also, by ‘too
big to fail’ and ready access to ‘reserve’ assets.
b) Some endogeneity – flatter LM curve. Wholly endogenous- flat ‘LM’ curve, but
with level set by the Bank of England- leading to replacement by a TR curve policy
function rather than loci of money market equilibriums.

• Did the Great Financial Crisis of 2007 prove that neoclassical economics is
wrong? Explain your answer in detail. [20
Marks]

Outline Answer
Yes- money not neutral. Real impacts and instability. Strong impacts of ‘animal
spirits’. Markets not efficient, risk not priced in. Regulation important. Very slow
recovery.

No- There was a recovery. Lack of prudence forced by policy interventions (e.g. sub-
prime). Incentives in Banks from moral hazard, from Agents’ incentives not aligned
with that of Principals, uncertainly spreads and asymmetric information outcomes- are
all consistent with individual maximisation.

• Explain why a common currency area, such as the eurozone, makes it more
difficult for individual member countries to manage their domestic aggregate
demand.
[20 Marks]

Outline Answer
Explanation of what a common currency area is. Explanation of why there is loss of
monetary policy sovereignty. Problems of convergence and ‘one size fits all’. Need to
place members’ fiscal sovereignty second to overall stability. Difficulty in stopping
weaker members using the currencies low risk for loans to exhaust credit worthiness.

• ‘Macroeconomics is good at explaining voluntary unemployment but poor at

explaining involuntary unemployment’. Explain the terms ‘voluntary’ and
‘involuntary’ and then discuss this statement.
[20 Marks]

Outline Answer
Explanations of voluntary (Search. Frictional. Unrealistic expectations. Spurious) and
involuntary (cannot find a job at the wage they can get in the labour market).
Friedman/Phelps augmented Phillips Curve based on money illusion causing
temporary withholding of labour. Rational expectations and flexible prices lead to
 market clearing. Involuntary unemployment from sticky wages- but then that’s just
micro. Efficiency wages. Quantity versus price adjustments- Clower/ Leijonhufvud
‘stuck’ circular flow. Modigliani sub-optimal equilibrium employment.

• Answer ONE of the following:

• ‘If a model assumes both perfect competition and rational expectations

then there is no role for Keynesian demand management policy in the
model’. Explain and discuss.
[20 Marks]
OR

• Describe and contrast the ‘3-equation Macro Consensus’ and the ‘Real Business
Cycle’ models. [20
Marks]

Outline Answer
• Explanation of why lack of price and wage setting rational expectations leads to only
non-systematic stochastic ‘errors’ and hence a distribution centred on full market
clearing aligned with real variables.

• Description and contrast of the two models and a contrast of their properties –RBC a
neoclassical market clearing RExpectations real side equilibrium model with labour
consumption choice optimisation – avoids the Lucas Critique. 3-equation has adaptive
expectations in the labour market and sticky wage setting with efficiency wages
leading to chronic involuntary unemployment even in equilibrium. Imperfect
competition. Fully intertemporal IS in RBC but not necessarily in 3-equation model.
Output gaps in 3-equation not in RBC.

2022 RESIT EXAMINATION

Section A – Answer ALL FOUR questions in this Section. This Section is worth 40% of the
marks. Each question is worth 10%.

• What does the ‘Fallacy of Composition’ describe in macroeconomics?

[10 Marks]

Outline Answer:
Macro deals with economic aggregates but for many economists what distinguishes
macro from micro is that the whole does not necessarily behave as the sum of the parts.
This is more than just the aggregation problem; it is that in a complex interrelated
system the intended behaviour of individual agents may collectively lead to unintended
outcomes overall. An obvious example is an audience standing to get a better view, but
 the classic example is Keynes’s ‘paradox of thrift’. It is also the case that micro cannot
account for the ‘animal spirits’ of crowd behaviour.

• How is the assumption that output is more or less constant in the short run
justified in the Quantity Theory of Money?
[10 Marks]
Outline Answer:
In the QT the Q (or T) in M.V=P.Q (T) is constant, so that with a constant V (as Md
stable) P is directly proportional to M (The exogenous money supply). This could be by
assumption of a steady-state, but in short-run is due to a fixed capital stock and
equilibrium in the labour market. In basic neo-classical theory, where the real wage =
MP of Labour, so changes in M affect only the nominal price level. The classical
dichotomy holds. In contrast, in Keynesian macro Q is likely to change with changes in
aggregate demand.

• Answer BOTH parts of this question:

a) What does ‘crowding-out’ mean in relation to the fiscal multiplier?

[5 Marks]
AND

• In what circumstances is crowding-out least likely to occur?

[5 Marks]

Outline Answer:
a) ‘Crowding-out’ refers to an expansion of government spending reducing private sector
spending and/or activity. If crowding-out occurs then the basic Keynesian multiplier is
reduced as the expansionary impact of increased G is offset by reduced C, I and X.
b) It is least likely if: there is excess capacity, Md is interest elastic, I is interest inelastic,
Ms is endogenous, the exchange rate is fixed, and consumption decisions are based on
current income.

• Why does a rise in interest rates tend to reduce inflation?

[10
Marks]
Outline Answer:
An increase in the real interest rate will tend to reduce C if there is a net impact of
borrowers over savers, reduces investment as borrowing/ opportunity cost of real
assets rise, and raises the exchange rate by causing inward speculative flows that
strengthen the £ thereby making imports, and imported inputs, cheaper and reducing
exports.

Section B – Answer any THREE questions in this Section. This Section is worth 60% of the
marks. Each question is worth 20%.
• What is the Neoclassical Synthesis Model and what does it suggest would be the
effect of a negative output shock on the macroeconomy?
[20 Marks]

Outline Answer:
Description of the Hicks/Hanson IS/LM model with a neoclassical labour market.
Tracing through what follows from AS < AD, via LM shifting and IS contraction, to a
higher price level and lower employment and output. Or, with endogenous Ms or lack
of TR response, on-going inflation.

• Some commentators have likened the current macroeconomic situation in the

UK to the ‘Stagflation’ of 1970’s. Evaluate if this is an accurate comparison.

[20 Marks]
Outline Answer:
Definition/ Description of ‘Stagflation’. Why might stagflation occur e.g., negative
supply shocks, cost-push and expansionary fiscal/ loose monetary conditions.
Description of 70’s negative shocks and cost-push, similar in effect to energy prices
and Ukraine war. Though less energy intensive. Policy dilemma, inflation versus risk
of stalling the already weakened economy, comparison of the stage of wage/price
expectations cycle- wages chasing or leading.

• Bank of England governor Andrew Bailey has warned that while a “moderation of
wage rises” would be “painful” for workers, pay curbs are needed to prevent inflation
becoming entrenched. Explain what he means by this with reference to the Phillips
Curve.
[20 Marks]
Outline Answer:
Description of ‘stagnant’ real wages (actually more a fall then a recovery) since GFC.
But inflation now likely to reduce real wages. If nominal wages rise in response, or in
places are pushed up by industrial action, then prices are likely to reflect this and a
wage-price spiral begins. As the expectation of inflation becomes embedded/
anticipated the Phillips Curve shifts, so worsening the trade-off between output/
employment and inflation, and allowing accelerating inflation means monetary
measures by Bank of England to eradicate it will need to be harsher, with stronger
deflationary measures that risk output, job and wage losses. Answers could also
usefully refer to WS and PS curves. Even if rational expectations hold, output is likely
to be constrained in the face of negative shocks as the ‘real-side’ has deteriorated,
making it harder for wages to rise, without substantial increases in productivity.

• Describe and explain the events that led to the Great Financial Crisis that began
in 2007.

Outline Answer:
 Description of the Great Financial Crash, that led to the Great Recession from 2008.
CCC, Big Bang, deregulation, more exotic financial instruments, Minsky cycle, short-
termism and lack of prudence, individual incentives v’s corporate sustainability, micro
and macro prudence, sub-prime, ‘weapons of mass financial destruction’, swaps
CDOs etc. Perverse incentives for rating agencies, ‘fish-stew’ problems for TARPs-
CDOs and Toxic assets, credit freezing and spreads increased leading to central bank
impotency and recession.
[20 Marks}

• What lessons did we learn from the ‘Monetarist Experiment’ of the 1980’s that
are still useful for today?

[20 Marks]
Outline Answer:
Description of the Monetarist Experiment. Restatement of the Quantity Theory.
Goodhart’s Law – leading to Lucas critique. Endogeneity of money, the ‘folly’ of
trying to achieve monetary targets. Dangers of: high interest rate ‘Dutch Disease’; of
placing too much trust in rational expectations and classical dichotomy; and the risk
of hysteresis. International influences on domestic inflation. Inflation may be reduced
but at a very high cost.

• What did the UK’s experience as a member of the European Exchange Rate
Mechanism suggest would be the problems faced if the UK ever joined the
EuroZone?
[20 Marks]
Outline Answer:
Description of the ERM and Eurozone. Similarities and differences. Relevance of the
‘Impossible trinity’ when exchange rate is pegged or is one-to-one as in common
currency. Danger of ‘one size does not fit all’ when monetary autonomy is reduced.
Problems caused by lack of convergence and not keeping up with productivity of
competitor nations. Need for fiscal rules, which further constrain aggregate demand
autonomy. A brief mention of the potential advantages of EuroZone for balance.

• Describe and explain the relationships assumed in the ‘3-equation Macro

Consensus Model’

[20 Marks]

Outline Answer:
Describe the 3 equations and what they assume: Intertemporal IS (forward looking) ,
Phillips-curve (Backward looking) and Monetary (TR) Rule (Forward looking). Show
how they interact in response to, say, a positive demand shock. Reference to WS and
PS curves and NAIRU/ ‘divine coincidence’
[20
Marks]
• Explain why aggregate demand management might be both unnecessary and
futile in a model that assumes perfect competition and rational expectations
[20 Marks]
 Outline Answer:
Description of the methods and intended purpose of aggregate demand management. Link
between perfect competition and market-clearing at Pareto-equilibria, and hence the lack
of the need for aggregate demand management. How rational expectations means policy
impacts will be anticipated and hence negated in effect by price adjustments and
intertemporal adjustments, to leave the real economy unchanged. Why there would be no
‘money-illusion’ and the classical dichotomy is assumed to hold in such conditions.

2023 Resit exam with outline answers

Answer ALL questions in Section A and ANY THREE questions in Section B.

Section A is worth 40% of the marks. Each question in Section A is worth 10 Marks.

Section B is worth 60 % of the marks. Each question in Section B is worth 20 Marks.

Section A – Answer ALL FOUR questions in this Section. This Section is worth 40%
of the marks. Each question is worth 10%.

• Using an example, explain how John Maynard Keynes distinguished

macroeconomics from microeconomics.
[10 Marks]

OUTLINE ANSWER
Macro is always about aggregates but need to explain what is meant by the ‘fallacy of
composition’ distinction: ‘The whole may not behave as the sum of parts’, the best
example being the ‘paradox of thrift’ but other examples are available. The
Crowd/’Animal Spirits’ argument and interdependence. The weakness of the ceteris
paribus assumption when using aggregates.

• Explain why E≡Y and M.V≡P.Q are equivalent to each other but can be used to
convey different impressions of how the macroeconomy works .
[10 Marks]

OUTLINE ANSWER

Describe the components of the two identities. Explain why MV is E and PQ is

(nominal) Y. Note the supply-side, Money supply and exogeneity assumptions for the
 Quantity Theory in the Fisher Equation of Exchange, whereas expenditure is linked
directly to income in Keynesian economics without reference to monetary or output
matters.

• What factors determine if an increase in government expenditure would add

significantly to aggregate demand?

[10 Marks]
OUTLINE ANSWER
Description of how MPC, and hence MPL (MPS , MPT and MPM) influence the
Keynesian multiplier. Possible Central Bank response, impact on exchange rate,
crowding-out: physical resource constraints and interest rate, expectations, capacity
constraints, Ricardian Equivalence.

• Why might it be expected that an increase in interest rates will tend to reduce
inflation?

[10 Marks]
OUTLINE ANSWER

Net impact on income and Consumption (saver v’s borrowers, disposable income).
Credit creation & financial flows sterilisation, investment, expectations, Central Bank
credibility, impact on exchange rates CPI and trade. Inflation can be ‘personal’.

Section B – Answer any THREE questions in this Section. This Section is worth 60% of the
marks. Each question is worth 20%.

• Compare and contrast how the UK macroeconomy and its policymakers

responded to sharp increases in the price of oil in the early 1970’s and 2022/3
[20 Marks]

OUTLINE ANSWER
Historical details of these negative supply shocks, and how they could later impinge on
demand. Identify ‘Stagflation’. A discussion on whether inflation was all cost push or
was combined with demand pull: Money supply, QE, forced saving and covid spending.
The dilemmas faced in responding to inflation when the economy is seen as weak. The
imperviousness of imported inflation. The hesitancy of the Central Bank in 2020’s and
harsher ‘Taylor Rule’ and fiscal response, e.g. raised taxation, of the 70’s, but higher
inflation in 70’s and lower unemployment of the 2020’s, with consideration of possible
underemployment- and health related withdrawal.

• If the UK were ever to re-join the European Union it might be required to adopt
 the Euro as its currency, explain why this might cause the aggregate demand
management problems the UK experienced when part of the European Exchange
Rate Mechanism

[20 Marks]

OUTLINE ANSWER
Description of Euro Zone and comparison with ERM. Explain ‘The ‘Impossible
Trinity’. Explain why ‘One size may not fit all’. Lack of convergence, description of
the UK’s experience in the ERM and what changed after leaving the ERM. Problem of
productivity differences and competitiveness, role of floating exchange in price versus
the quantity adjustments of fixed exchange rates. Brief attributes of an Optimal
currency area and possible supply-side benefits.

• Explain what is meant by the ‘Zero Lower Bound’ in relation to interest rates
and suggest how it might be avoided.
[20 Marks]

OUTLIN
E
ANSWER
Description of what the lower bound is, why it may arise and why it poses a problem.
Reference to IS curve and labour market/Aggregate Supply would be useful. ‘Filling
fiscal space’ to allow interest rates to rise. Encouraging Investment policy. Higher target
rate of inflation. Cashless economy option.

• ‘The LM curve shows points of equilibrium, but the TR curve shows policy
responses’ Explain in detail what this statement means.
[20 Marks]

OUTLIN
E
ANSWER

Description of how the ‘traditional’ LM curve is a locus of equilibrium points in

interest rate (r) and Income (Y) space between Ms and Md, using exogenous or semi-
exogenous Ms. Description of how endogenous money and the Taylor Rule have
replaced the LM curve in the neoclassical synthesis model. Description of the Taylor
rule notion and how the central bank will tend to ‘lean into the wind’ to help stabilise
the macroeconomy, in the face of fluctuations of the IS curve away from the target
inflation/output gap.

• Explain why inflation may tend to accelerate.

[20 Marks]
OUTLINE ANSWER
 Definition of inflation. Description of the role of expectations. Use of the Friedman/
Phelps Phillips Curve to show how adaptive expectations may shift the short-run
Phillips Curve and/or use of WS and PS curves to show response to an output gap
above NAIRU

• ‘Banks are inherently fragile’. Explain what this statement means and why such
fragility led to the 2007 financial crisis.
[20 Marks]

OUTLINE ANSWER
‘Borrow short but lend longer fragility’. Fractional reserve and liquidity. Profits and
solvency. Wholesale versus retail interest rates. Confidence and credibility
requirement. Securitisation and sub-prime. Misaligned incentives. CDOs and the
difficulty of TARP. Contagion, ‘fish-stew’ problem, spreads and credit freeze. Minsky
cycles. MPC lose of control on retail spreads.

• Explain what is meant by ‘involuntary unemployment’ and how economists from

different schools of thought might address it?
[20 Marks]

OUTLINE ANSWER
Define involuntary unemployment: not the same thing as simply looking for a job, or
same as underemployment. link to market wages and realistic expectations.
Neoclassical et al, remove frictions to adjustment of ‘too high’ real wages, that is,
supply—side policies for ‘flexible’ labour markets. Keynesian, remove
interdependency quantity constraints from being ‘stuck’, by boosting AD (fiscal or
monetary but ‘pushing on a string’ concerns) and/or inflate prices to reduce real wages
when downwardly sticky money wages . New Keynesian, pointless to reduce below
NAIRU, so address degree of monopoly and work on expectations. All, except ‘deep
greens’, pursue productivity enhancing policies.

• Detail the workings of ONE of the following models:

a) The ‘new consensus’ 3-equation model

OR
b) The Real Business Cycle Model
OR
c) The New Keynesian Dynamic Stochastic Equilibrium model
[20 Marks]

OUTLINE ANSWER

a) Describe the three equations: Intertemporal forward-looking IS curve; Phillips

curve with adaptive expectations; Monetary Policy ‘Taylor’ forward-looking
Response ‘Rule’. Detail adjustment process, WS and PS curves, and a NAIRU
outcome with involuntary unemployment. Possibilities for short-run stabilisation.

b) Describe assumptions of RBC- perfect competition, general equilibrium and

rational expectations. Describe welfare implications of Pareto-efficient equilibrium.
Note ‘classical dichotomy’. Describe Marco demand policy ‘futility’, Lucas Critique,
and the role of re-optimising agents to exogenous productivity/ ‘technical’ shocks and
consequences for employment and output, hence causing cycles through intertemporal
leisure v’s work/income optimal choices

c) Same ‘chassis’ as RBC, but with imperfect product markets. Leading to

underemployment and sticky prices. Calvo- pricing model and possible policy
response option by working on forward looking expectations of inflation. Importance
of central bank credibility.