Mock Final Exam - 202223

ANSWER ANY TWO OUT OF THREE QUESTIONS
1. Suppose an independent Central Bank (CB, henceforth) chooses inflation

π to minimise the following social loss function:
1 1
L= (y − y∗ )2 + a (π − π ∗ )2 , a > 0,
2 2
where y∗ is the socially optimal level of output and π ∗ is the inflation
target. Furthermore, the CB is constrained by the following aggregate
supply curve:
y = yn + b (π − π e ) , b > 0,
where yn is the flexible price level/full employment level of output, π e is

the expected inflation rate and y∗ > yn . Answer the following:
(a) Explain the idea of time inconsistency. (15 marks)

(b) Why is there an inflationary bias (inflation above target) when mon-
etary policy has discretion? (25 marks)
(c) Why commitment to policy rules allows the monetary authority to
peg optimally inflation at the target? (10 marks)
Answer:
(a) Time inconsistency refers to the circumstance when an announcement

or a decision is dynamically inconsistent and thus not credible. As-
sume, the state sets the tax rate after firms invest. If the state could
commit credibly to a minimum tax rate before investors invest they
would invest. If the state cannot commit credibly the announcement
of this tax is not credible because investors know that the state will
deviate from his announcement after they invested and increase the
tax above the minimum level. Knowing this, the investors don’t have
any incentive to invest. The commitment of the government to an-
nounce a minimum tax rate for the next period (best plan) is not
optimal for the state anymore once the next period has arrived
(b) The reason is that the ability to choose inflation after expected infla-
tion is determined makes the policymaker worse off is that the policy
of announcing that inflation will be π ∗ , and then producing that in-
flation rate after expected inflation is determined, is not dynamically
consistent. If the policymaker announces that inflation will equal π ∗
and the public forms its expectations accordingly, the policymaker will
1
deviate from the policy once expectations are formed. The public’s
knowledge that the policymaker will do this causes it to expect infla-
tion greater than π ∗ . This expected inflation worsens the menu of
choices that the policymaker faces.
AN EXCELLENT ANSWER SHOULD SUPPLEMENT THE
PREVIOUS ARGUMENT WITH FORMAL AND DIAGRAM-
MATICAL ANALYSIS!
(c) In that case the policymaker determines inflation before the public
form their expectations and hence, any commitment to set inflation
at π, would imply π = π e (the policymaker shapes expectations of
the public in that case). The Phillips curve reduces to y = yn , and
hence the social loss function is minimised at π = π ∗ .
AN EXCELLENT ANSWER SHOULD SHOW, USING DI-
AGRAMMATICAL ANALYSIS, WHY TARGETING INFLA-
TION AT π ∗ IS NEVER OPTIMAL UNDER DISCRETION!
2. Consider the learning-by-doing model discussed in the lecture. Answer the

following:
(a) Compute the private marginal products of capital and labor of each
firm i. (10 marks)
(b) Compute the growth rate of consumption in equilibrium. (15 marks)
(c) Is the equilibrium growth rate socially optimal? (25 marks)
Answer:
(a) The production function of firm i is
Yi = F(Ki , KLi ). (1)
The private marginal productivity of capital in firm i:
∂Yi
= αB · (Ki )α−1 · (KLi )1−α . (2)
∂ Ki
The private marginal productivity of labor in firm i:
∂Yi
= (1 − α)B · (Ki )α · K 1−α Li−α . (3)
∂ Li
2
All firms i are identical and make the same choices → ki = k and
kL = K. Using this information, we obtain
∂Yi
= αB · (ki )α−1 · (K)1−α (4)
∂ Ki
∂Yi
= αB · (k)α−1 · (K)1−α (5)
∂ Ki
∂Yi
= αB · (k)α−1 · (kL)1−α (6)
∂ Ki
∂Yi
= αB · (L)1−α (7)
∂ Ki
Thus, the return to capital, r, is equal to

∂Yi
r= − δ = αB · L1−α − δ . (8)
∂ Ki
which is constant and not declining in K or Ki . Similarly, the wage
rate, w, is equal to
∂Yi
w= = (1 − α)BkL1−α . (9)
∂ Li
(b) The household side is similar to the Ramsey framework. The Euler
equation - Keynes-Ramsey rule - is
ċ 1
= (r − δ − ρ), (10)
c σ
which after substituting (16), reduces to
ċ 1
= (Ã − δ − ρ), (11)
c σ
ċ
with Ã = αB · (L)1−α and c > 0 for all times, if Ã > δ + ρ (which we
have assumed!)
(c) The above growth rate is suboptimally low
• firms consider their private marginal returns to capital
∂Yi
• ∂ Ki ignores the firm’s impact on the knowledge stock A = K
• a firm provides for free a positive externality to the rest of the
economy
3
• the market does not compensate the firm for this externality
→ investments are lower than socially desirable
Finally, a good answer should compute the social marginal
product of capital, compare it with the private one, and show
that the former always exceeds the latter, hence investment
is suboptimally low!
3. In the context of the lecture on labor markets and unemployment, answer

the following:
(a) Describe the labor market equilibrium under the frictionless bench-
mark. (15 marks)
(b) Explain which are the factors that affect the equilibrium rate of un-
employment. (10 marks)
(c) “It is preposterous to accuse trade unions of being responsible for
unemployment.” Comment. (25 marks)
Answer:
(a) A good answer should be centred around the following points:

i. Explain the labor supply side; diagrammatically, and discuss in-
come vs substitution effect
ii. Explain labor demand side; diagrammatically
iii. Putting supply and demand together;
iv. Discuss that there is no unemployment under frictionless bench-
mark; everybody can find employment at the current equilibrium
wage
v. Ideally: discuss the effect of minimum wage policies
(b) Equilibrium unemployment = frictional unemployment + struc-
tural unemployment.
Frictional unemployment:
• occurs because it takes time for a match to occur between work-
ers and a vacancy.
• depends on efficiency of labour market and its institutions.
• depends on economic conditions.
Structural unemployment:
• caused by inappropriate wage levels.
4
• because demand and supply are affected by regulations and in-
stitutions.
Importantly: provide examples to explain the notions of struc-
tural and frictional unemployment. For example, finding work
takes time, training, skill acquisition and so on, which justifies the ex-
istence of frictional unemployment. Trade unions and effective wage
considerations justify the existence of structural unemployment.
(c) A good answer should be centred around the following points:
i. Explain the main objectives of trade unions, for example, higher
wages and higher employment
ii. How is your answer of part (a) affected with the introduction of
trade unions, for example, higher wages and lower employment
iii. Insiders vs outsiders
iv. Claim that unions are responsible for unemployment not prepos-
terous
v. Can you think of examples where unions are a “good thing”?
Examples where unions are a “bad thing”?

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ANSWER ANY TWO OUT OF THREE QUESTIONS

1. Suppose an independent Central Bank (CB, henceforth) chooses inflation

where yn is the flexible price level/full employment level of output, π e is

(a) Explain the idea of time inconsistency. (15 marks)

(a) Time inconsistency refers to the circumstance when an announcement

2. Consider the learning-by-doing model discussed in the lecture. Answer the

(a) The production function of firm i is

Yi = F(Ki , KLi ). (1)

The private marginal productivity of capital in firm i:

Thus, the return to capital, r, is equal to

3. In the context of the lecture on labor markets and unemployment, answer

(a) A good answer should be centred around the following points:

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