Name Alexander Thomas

Student ID (from your campus card) 0 0 0 6 8 5 5 4 9

May/June 2020 Examination Code E C O N 2 0 1 1 - W E 0 1

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1a 1b 1c 1d 2 4

1a)

We begin with the Lucas surprise supply function 𝑦 = 𝑦̅ + 𝛼(𝜋 − 𝜋 𝑒 ) + 𝜀 and the Loss Function 𝐿 =
[𝑦 − (𝑦̅ + 𝑘)]2 + 2𝛽(𝜋 − 𝜋 ∗ )2

We substitute y into the Loss Function we get

L = [𝑦̅ + 𝛼(𝜋 − 𝜋 𝑒 ) + 𝜀 − (𝑦̅ + 𝑘)]2 + 2𝛽(𝜋 − 𝜋 ∗ )2

𝑦̅ cancel leaving

L = [𝛼(𝜋 − 𝜋 𝑒 ) + 𝜀 − 𝑘]2 + 2𝛽(𝜋 − 𝜋 ∗ )2

𝑑𝐿
= 2𝛼[𝛼(𝜋 − 𝜋 𝑒 ) + 𝜀 − 𝑘] + 4𝛽(𝜋 − 𝜋 ∗ ) = 0
𝑑𝜋

[𝛼 2 (𝜋 − 𝜋 𝑒 ) + 𝛼𝜀 − 𝛼𝑘] + 2𝛽(𝜋 − 𝜋 ∗ ) = 0

[𝛼 2 𝜋 − 𝛼 2 𝜋 𝑒 + 𝛼𝜀 − 𝛼𝑘] + 2𝛽𝜋 − 2𝛽𝜋 ∗ = 0

Re-arrange

𝛼 2 𝜋 + 2𝛽𝜋 = 𝛼 2 𝜋 𝑒 - 𝛼𝜀 + 𝛼𝑘 + 2𝛽𝜋 ∗

𝜋(𝛼 2 + 2𝛽) = 𝛼 2 𝜋 𝑒 - 𝛼𝜀 + 𝛼𝑘 + 2𝛽𝜋 ∗

𝛼 2 𝜋 𝑒 − 𝛼𝜀 + 𝛼𝑘 + 2𝛽𝜋 ∗
𝜋=
(𝛼 2 + 2𝛽)

We then take rational expectations where E(𝜀) = 0, 𝐸(𝜋) = 𝜋 𝑒 and E(𝛼, 𝜋 ∗ , 𝑘, 𝛽) = 𝛼, 𝜋 ∗ , 𝑘, 𝛽 respectively

𝛼 2 𝜋 𝑒 + 𝛼𝑘 + 2𝛽𝜋 ∗
𝜋𝑒 =
(𝛼 2 + 2𝛽)
 (𝛼 2 + 2𝛽)𝜋 𝑒 = 𝛼 2 𝜋 𝑒 + 𝛼𝑘 + 2𝛽𝜋 ∗

𝛼 2 𝜋 𝑒 + 2𝛽𝜋 𝑒 = 𝛼 2 𝜋 𝑒 + 𝛼𝑘 + 2𝛽𝜋 ∗

𝛼 2 𝜋 𝑒 cancel

2𝛽𝜋 𝑒 = 𝛼𝑘 + 2𝛽𝜋 ∗

Divide by 2𝛽

𝛼𝑘
𝜋𝑒 = + 𝜋∗
2𝛽

𝛼𝑘
Therefore, the expected rate of inflation does not equal the ideal rate of inflation as it differs by + .
2𝛽
1b)

Figure 1

The positive supply shock shifts the PS curve upwards from PS to PS’ which causes the ERU curve to shift
right to ERU1. At this new equilibrium B, there is an increase in output to ye’. To allow for this increased output,
the real exchange rate depreciates to 𝑞̅ ′. The AD curve remains unchanged at the point (r = r*) as the real
interest rate is restricted by the world interest rate. Thus, the exchange rate is forced to depreciate in response
to the supply shock.
1c)

We begin with the production function

𝛽 1−𝛽
𝑌𝑡 = 𝐴𝑡 𝐾𝑡 𝑁𝑡

Where Y is Output, N is Labour, K is Capital and A is the technological factor.

Taking Logs of the production function

𝛽 1−𝛽
log(𝑌𝑡 ) = log (𝐴𝑡 𝐾𝑡 𝑁𝑡 )

Applying log laws

𝛽 1−𝛽
log(𝑌𝑡 ) = log(𝐴𝑡 ) + log(𝐾𝑡 ) + log(𝑁𝑡 )

log(𝑌𝑡 ) = log(𝐴𝑡 ) + 𝛽log(𝐾𝑡 ) + (1 − 𝛽)log(𝑁𝑡 )

In order to calculate change we must take the differences between t and t+1

log(𝑌𝑡+1 ) = log(𝐴𝑡+1 ) + 𝛽log(𝐾𝑡+1 ) + (1 − 𝛽)log(𝑁𝑡+1 )

By subtracting t+1 and t and defining log(𝑌𝑡+1 ) − log(𝑌𝑡 ) as ∆log (𝑌𝑡 ) we obtain

∆log(𝑌𝑡 ) = ∆log(𝐴𝑡 ) + 𝛽∆log(𝐾𝑡 ) + (1 − 𝛽)∆log(𝑁𝑡 )

Re-arranging for 𝐴𝑡 we calculate the Solow Residual

∆log(𝐴𝑡 ) = ∆log(𝑌𝑡 ) − 𝛽∆log(𝐾𝑡 ) − (1 − 𝛽)∆log(𝑁𝑡 )

By assuming ∆log(𝐴𝑡 ) ≈ %∆ 𝐴𝑡

%∆ 𝐴𝑡 = %∆ 𝑌𝑡 − (1 − 𝛽) ∙ %∆ 𝑁𝑡 − 𝛽 ∙ %∆ 𝐾𝑡

This derivation shows the technology change is dependent on the observable factors Output (Y), Labour (N)
and Capital (K).
1d)

i)

Table mapping agent activity

Out In
t 𝑐𝑡 + 𝑠𝑡 𝑤𝑡
t+1 𝜌𝑐𝑡+1 𝑤𝑡+1 + (1 + 𝑟)𝑠𝑡

By equating we obtain

𝑐𝑡 + 𝑠𝑡 = 𝑤𝑡

𝜌𝑐𝑡+1 = 𝑤𝑡+1 + (1 + 𝑟)𝑠𝑡

By substituting in we obtain the lifetime budget equation of

𝑐𝑡+1 𝑤𝑡+1
𝑐𝑡 + = 𝑤𝑡 +
(1 + 𝑟) (1 + 𝑟)

We now face a maximisation problem for the agent of

max 𝑢(𝑐𝑡 ) + ρ max 𝑢(𝑐𝑡+1 )

We produce a Lagrangian of

𝑡+1 𝑤 𝑡+1 𝑐
𝐿 = 𝑢(𝑐𝑡 ) + 𝑢(𝑐𝑡+1 ) + 𝜆 (𝑤𝑡 + (1+𝑟) − 𝑐𝑡 − (1+𝑟) )

Taking First Order Conditions (FOC’s)

𝑑𝐿 𝑑𝐿 𝜆
= 𝑢′ (𝑐𝑡 ) − 𝜆, 𝑎𝑛𝑑 = 𝜌 𝑢′ (𝑐𝑡 ) −
𝑑𝑐𝑡 𝑑𝑐𝑡+1 (1 + 𝑟)

Combining FOC’s

𝑢′ (𝑐𝑡 ) 𝜆
=
𝜌 𝑢′ (𝑐𝑡 ) 𝜆
(1 + 𝑟)

Lambda’s cancel so our final Euler equation is

𝑢′ (𝑐𝑡 )
= (1 + 𝑟)
𝜌 𝑢′ (𝑐𝑡 )

ii) As seen in Figure 2 (below), as R decreases there is a substitution effect shown by the shift from A to B, as
there is now an increased opportunity cost of future consumption over current consumption. Furthermore,
there is a movement from B to C that reflects a negative wealth effect. When an agent saves, a fall in R will
make him worse off. In this example we assume the substitution effect outweighs the wealth effect.
Figure 2
2) a) Assuming an independent Central Bank we begin with the Government budget constraint of
𝑑𝐵
𝐺 + 𝑖𝐵 = 𝑇 +
𝑑𝑡
𝑑𝐵
Where G is Government expenditure, iB is the interest on debt, T is tax revenue and is the change in debt
𝑑𝑡
in terms of £.
By dividing through by ‘py’ and re-arranging, we obtain b – debt as a proportion of GDP
𝑑𝑏
= 𝑔 − 𝑡 + 𝑖𝑏
𝑑𝑡
By log-linearizing b and differentiating with respect to time, we obtain the dynamic budget constraint in terms
of debt to GDP.
𝑑𝑏
= (𝑔 − 𝑡) + (𝑟 − 𝛾)𝑏
𝑑𝑡
Where r is the real interest rate and 𝛾 is the growth rate of real GDP.
The stability of this equation is dependent on the relationship between 𝑟 and 𝛾. This relationship reflects the
cost of repayment versus the ability to repay and governs the slope of the ‘phase line’ – which shows the
growth of the debt ratio. If 𝑟 > 𝛾 then there is low growth in the economy, and it is in an unstable steady state
due to divergence as the debt ratio changes. Conversely, if 𝑟 < 𝛾 the high growth rate is self-correcting as it
sufficiently covers the cost of debt interest repayments. Therefore, at this higher growth rate there is a stable
steady state.
This is matter of concern, because if we consider figure 3 (below) we can compare the two examples of low
and high growth rates. Both economies hold a primary deficit for simplicity. In scenario 2, 𝑟 < 𝛾 and the
economy is in a stable dynamic as any increased cost of debt interest is covered due to the output growing at
a faster rate than the cost of debt. In scenario 1, the government debt is inherently unstable. If we begin at
point A and there is an increase in the debt ratio, this increases the burden of debt which increases the debt
ratio again. This cycle continues triggering an ever-increasing ratio of debt, which will eventually cause default.
b)
Prior to the Eurozone crisis it was inconceivable that a government would not honour its debt. Following this
crisis, a risk of default premium 𝜌 was introduced to the debt dynamic.
𝑑𝑏
= (𝑔 − 𝑡) + (𝑟 𝑟𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 + 𝜌 − 𝛾)𝑏
𝑑𝑡
To calculate the premium, we require the probability of default (w) which forms the equation 𝑤 = 𝑤𝑎 + 𝛽𝑖,
where 𝑤𝑎 is institutional factors that affect the probability of default and 𝛽 reflects the sensitivity of w to a
change in interest rates. W is unobservable so instead we use the ratings agency to calculate this probability,
𝑅
where 21 = 𝑤 = 𝑤𝑎 + 𝛽𝑖, so if R = 0 then there is a AAA rating. The rating agency therefore determine 𝜌 and
such influence the stability of the equation.

If the economy was initially at the point where (𝑟 𝑟𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 + 𝜌) < 𝛾 then the economy is in a stable dynamic
with relatively high rates of growth. If a debt downgrade occurs through 𝑤𝑎 decreasing, meaning there are less
debt reducing factors, this causes R to increase which also causes 𝜌 to increase. If this increase in 𝜌 is large
enough, then it can affect the stability of the debt dynamic. If the 𝑟 𝑟𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 + 𝜌 increases so that now
(𝑟 𝑟𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 + 𝜌) > 𝛾, this causes the economy to change from stable ‘Scenario 2’ to unstable ‘Scenario 1’. This
shows how the rating agencies may impact the stability of the equation. The rating downgrade forms a self-
fulfilling prophecy. An increase in probability of default results in an increasing premium required to be paid. If
there is no government response to this increased premium, then further downgrades are likely, which results
in increasing premiums followed by further downgrades until it eventually repeats enough to cause default. We
must note that had the rating agency not speculatively attacked the governments debt position, it would have
maintained its previously stable dynamic.
Figure 3
c)
The previous analysis has implied similarities of the government budget constraint to that of the household.
The government in our example faces a maximisation problem using an intertemporal budget constraint. This
is markedly similar to that of the Permanent Income Hypothesis (PIH) and as such the government and
household are comparable. This provides the insight of Ricardian equivalence into our analysis.
The idea of Ricardian equivalence stems from the idea that households consider the consequences of
government finance to their budget constraint (over an infinite time horizon). If the government reduces taxes
within the economy, households gain increased income in the current period, and usually this would imply an
increase in expenditure. However, Ricardian equivalence implies that this surplus is saved as the household
realises that this tax decrease must be financed and thus, they expect higher taxes in the future. The current
surplus is saved to finance this future tax increase.
This insight of Ricardian equivalence has implications for fiscal policy decisions. Temporary tax cuts have no
impact on aggregate demand as the tax cut is saved and such consumption, and therefore output, remains
unchanged. We will now consider the example where a government borrows to finance government spending.
The increased government spending increases aggregate demand as the offsetting fall in consumption, due to
Ricardian household mentality, is spread over future periods. The multiplier effect of government spending is
less than 1 as the reduction in consumption outweighs the initial benefit of increased government spending.
Thus, if governments are suffering from unstable debt dynamics, further borrowing to boost output is deemed
unwise due to Ricardian equivalence.
However, this concept of Ricardian equivalence is limited by its assumptions. It assumes that households and
governments borrow at the same rate when in reality credit markets are imperfect, and governments face
different borrowing rates. Furthermore, government and households differ as surpluses are not the only
method by which the government can repay debt. Governments can issue legal tender in times of emergency
through the central bank. This occurred in the 2008 Financial Crisis and 2020 Covid-19 pandemic where the
BoE provided the UK government with financial assistance. In addition, if we consider the assumptions of the
agent, another failing is that the agent is unlikely to know whether the tax reduction is permanent or temporary
and the model fails to account for households reproducing and assigning utility to their children.
4)
a)
The Real Business Cycle (RBC) model was developed to understand economic fluctuations in the economy. It
built upon the weaknesses of previous models which were vulnerable to the Lucas Critic (1976), therefore the
RBC model uses policy invariant parameters. A model of fluctuations must be dynamic, and as such it builds
upon the neoclassical framework of capital accumulation (Solow, 1956).
In so doing, the RBC is subject to the following assumptions:
- The economy is populated by many agents who are homogenous, and they are assumed to live
forever.
- These agents are assumed to allocate all their time between labour supply and leisure.
- These agents all have expectations that are rationally based.
- All of output is either invested or consumed, such that there is a totality of output.
- There is perfect competition and perfect information in the model.
- The economy is subjected to technology shocks that occur temporarily and randomly which drives
economic growth through the model - 𝑌𝑡 = 𝐴𝑡 ∙ 𝑓(𝐾𝑡 , 𝐿𝑡 )
- Capital changes over time and is subject to a rate of depreciation.

b)
An internally consistent theory is one that holds no irregular assumptions, whilst an external consistent theory
is one which is empirically supported.
If we consider the assumptions, as outlined above, we can see that the RBC theory is internally consistent.
The RBC extends the Walrasian paradigm and includes a simplistic and clear explanation for economic
fluctuations. However, the RBC model is externally inconsistent. The model requires periods of technological
decline in order for business cycles to be produced. Outside of wartime this is incredibly unlikely. Changes
were developed by Hansen and Prescott (1993) to incorporate changes in the stock of knowledge and
consider shocks of regulations that influence the conduct of business. This meant that the model no longer
solely considered temporary technological shocks that had little evidence. This appeared to improve its
external consistency, however Calomiris and Hanes (1995) countered denying its compatibility with long-run
empirical data. Furthermore, Hansen and Prescott admitted that the model adjusted much more quickly than
actual economies.
c)
Several economists consider the RBC model as having fundamental weaknesses and consider its explanation
for the observed cycles as implausible.
The first critic is from Mankiw (1989) who finds the assumption of intertemporal leisure implausible. The RBC
model considers the intertemporal substitution effect between labour supplied and leisure consumed. If we
consider the example where there is an increase in government spending, this is met by an increase in
demand for goods. For the equilibrium to be maintained, this increased demand is matched with an increase in
the real interest rate in order to restore the original rate of consumption and investment. This change in real
interest rate causes a change of an agent’s leisure/work preference. An increase in real interest rates
incentivises working today rather than working in the future, and therefore there is an increase in current
labour supply, causing output to rise. We therefore note that the RBC model does not allow for any involuntary
unemployment. For individuals to obey this observed pattern, they must be willing to re-allocate leisure over
time. This assumption is weak as empirical evidence finds that the intertemporal willingness to substitute
labour is small. It is not large enough to justify the predicted change that this model assumes. This reliance on
the willingness for the intertemporal substitution of labour and leisure is a significant weakness that some
economists find implausible.
A further assumption that economists find implausible surrounds the nature of the economic shocks
themselves. Firstly, Plosser (1989) found that the shocks were serially correlated and not entirely random as
initially presumed. Secondly, its reliance on large technological disturbances being the primary cause for the
economic fluctuations is a weakness as there is no empirical evidence regarding the source or nature of these
shocks. This is further evidenced as the propagation of the technological shock through the economy is
required to be exceptionally persistent. There is no empirical or economic justification for this assumption,
which is crucial for the model to produce dynamic results, as without it the model fails to fit the data. This final
assumption, and its lack of justification, is not economically grounded and as such many economists find the
RBC model implausible in explaining the observed cycles.