ECON6922-Macroeconomic Theory

Problem 1

1.State the expression for the change in the debt to GDP ratio (without money). 

a.Define the variables and explain what the expression means.

b.Show what happens to the debt to GDP ratio if interest rates are greater than real GDP growth rates.

c.Show what happens to the debt to GDP ratio if interest rates are less than real GDP growth rates.

d.If an economy is in the situation stated in b., and the debt ratio is positive, how can the economy stabilize the debt? What are the possible consequences of doing so?

2.Using the IS-LM model, show the effects of expansionary fiscal policy when:

a.The increase in government spending is bond financed.

b.The increase in government spending is money financed.

c.The increase in government spending is tax financed (ie balanced budget case)

3.What is meant by Ricardian equivalence? 

4.Suppose an economy has a debt to GDP ratio of 110%, a real growth rate of 2.5% and interest rates of 1%. Assuming their deficit is zero, should they be concerned with debt stability? What affect would fiscal consolidation have on growth rates?

5.What is the cyclically adjusted budget deficit? How can it be calculated?

Problem 2

1.Assume that households attempt to maximize lifetime utility subject to a budget constraint.  If households have perfect foresight and interest rates are zero, what will household consumption paths look like? Explain.

2.According to the Consumption CAPM, what should be the relationship between consumption growth and asset returns?  Do we see this in reality? Explain.

Problem 3

1.In our IS-PC-MR model what would happen if:

a.Profitability in the future is expected to be lower.

b.Real interest rates are expected to rise next quarter.

c.Credit constraints limit the ability of firms to borrow.

2.What is the difference between Q and q? Under what assumptions is investment solely a function of q?

3.According to empirical analysis, there appears to be a need for a scale term in investment functions. Suppose we use output, y, as a proxy for that scale affect, and our Investment equation becomes

Assuming a simple consumption function ,

a.What will happen to the slope of the IS curve? 

b.How will this affect the impact of a demand shock?

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