L1032: MACROECONOMICS 2; Consider the Western Hemisphere which, for the purposes of this exercise, consists of three countries: the United States as the region’s economic hegemon as well as two other small open economies (called A and B) that are identical in every respect with one exception. Please read the instructions below before emailing me or the tutors with any questions.

You should answer all questions. The marks for each subpart of a question are indicated in

square brackets (e.g. [10]). There are 100 marks available in total. The mark achieved in

this coursework is worth 20% of the overall mark for Macroeconomics 2, and thus can

potentially make quite a difference.

Content. The assessed problem set for Macroeconomic 2 is based on the material presented

in Lectures 1-8 and the accompanying readings as described in the module handbook.

Please note that exact answers to these questions are not generally given in the textbook,

readings or lectures. You will have to work with the logic of the models and/or actual data

to develop your answers. Make sure that you explain the economic intuition that underpins

your answers. The use of diagrams, where appropriate, is essential and encouraged. Recall

that the Blanchard (2017) textbook offers an ‘Introduction to Econometrics’ in Appendix 3

as well as a ‘Maths Refresher’ in Appendix 2, respectively, which you might find useful.

Submission. E-submission online in the ‘Assignment’ tab of the module’s Canvas site.

See Canvas for the School guidelines on online submissions and more information.

Word Limit. There is a word limit of 1000 words. The following do not count towards the

limit: (i) the text of the questions; (ii) annotations of graphs; (iii) the contents of tables

(within reason); (iv) titles and your candidate number; (v) any bibliography (if needed).

When the word limit is exceeded, examiners will read up to an additional 500 words;

however, a penalty may be applied if they feel you have gained an unfair advantage over

other students in these additional 500 words.

Clarity. It is important that you render your answers clear and unambiguous. Markers will

not usually give the benefit of the doubt if there is more than one way to interpret your

answer, or if your answer is otherwise unclear. Including wrong material that is unrelated to

the question at hand will be penalised – stay relevant!

Plagiarism. This is not a group exercise but an individual assessment. You must work

independently and provide your own solutions. All submissions are passed through

plagiarism detection software.

MACROECONOMICS 2 (L1032) 2018/19

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Answer ALL THREE questions

All answers must be fully explained including diagrams, graphs or

regression output as and when appropriate

1. Consider the Western Hemisphere which, for the purposes of this exercise, consists of

three countries: the United States as the region’s economic hegemon as well as two

other small open economies (called A and B) that are identical in every respect with one

exception. Country A maintains a freely floating nominal exchange rate whereas

country B has pegged its currency to the US dollar. In either country, agents have fixed

exchange rate expectations. Suppose that the Fed—the US central bank—decides to

lower its policy interest rate by 1 percentage point.

a. Using an appropriate model, analyse the short run effect of this policy change on

country A in terms of its output, interest rate and exchange rate. [12 marks]

b. Using an appropriate model, analyse the short run effect of this policy change on

country B in terms of its output, interest rate and exchange rate. [12 marks]

c. Provide a concise summary and explanation of the similarities and differences of

this shock in countries A and B, respectively. [6 marks]

2. Produce and compare estimates of Okun’s Law for three major economies using recent

real-world data. Go to the World Bank’s “World Development Indicators”1 and make

the following selections within each of the dimensions of this DataBank:2

Country: Japan; United States; United Kingdom.

Series: “GDP growth (annual %)”; “Unemployment, total (% of total labor force)

(national estimate)”; and “Unemployment, total (% of total labor force) (modeled ILO

estimate)”

Time: 1980-2015

(Question continues on next page)

1 http://databank.worldbank.org/data/reports.aspx?source=world-development-indicators. 2 To verify whether you are looking at the correct data, make sure that the series you download have the

following codes: GDP growth: “NY.GDP.MKTP.KD.ZG”; total unemployment (ILO): “SL.UEM.TOTL.ZS”; total

unemployment (national): “SL.UEM.TOTL.NE.ZS”. When you download the data, it helps enormously for

further processing if you have the time dimension in rows, the series in columns, and the countries by page.

Go to the Layout tab, which is to the right of the Variables tab, where you can make these changes to the

preview. The download will then have the same format.

MACROECONOMICS 2 (L1032) 2018/19

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Note that some data series contain missing values for individual years. If you use Stata,

you have to remove the ‘double dots’ that populate cells when information is missing

before you can convert a variable to numeric format. Provide a small table of summary

statistics (number of observations, mean, standard deviation, minimum and maximum)

for the three variables, separately for each of the three countries. If some values strike

you as abnormally high or low, go back to the raw data and double check.

a. For Japan and the United States, provide a scatter plot of changes in the

unemployment rate against output growth (as in the Blanchard textbook p.200),

using the “national estimate” series for unemployment.

3 Include a regression line

(also called line of fitted values). Describe each graph and comment on how the

two countries compare. [10 marks]

b. Continue to use the “national estimate” series for Japan and the US and regress

changes in unemployment against GDP growth using 35 years’ worth of data.4

Report the regression output. Then use the estimated coefficients to write

Okun’s Law for each country in the form

𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑡𝑡−1 = −𝛼𝛼(𝑔𝑔𝑦𝑦,𝑡𝑡 − 𝜇𝜇) (1)

in which 𝑔𝑔𝑦𝑦,𝑡𝑡 denotes the growth rate of GDP. Insert the values that you have

estimated for 𝛼𝛼 and 𝜇𝜇. Give a short summary of how the estimated versions of

equation (1) compare across the US and Japan, respectively. [20 marks]

c. The national series of unemployment is missing for most years for the UK.

Therefore, now use the “ILO estimate” series of unemployment, which is available

from 1991 onwards, and re-do part (b) above for all three countries (Japan, US and

UK) using the “ILO estimate” series of unemployment. How do the empirical

country-specific versions of equation (1) look like in this case, and how do the UK

data fit Okun’s Law? [10 marks]

3 If you use Stata, the command for producing a scatter plot of two variables y and x is scatter y x if

country==”XXX”, where XXX stands for the country code or name. You may equally do this in Excel or any

other software such as EViews.

4 If you use Stata, the command for ordinary least squares (OLS) estimation is regress y x if

country==”XXX”, where XXX stands for the country code or name. Again you may equally well do this in Excel,

in which case the LINEST function (including a constant) will produce the desired result.

MACROECONOMICS 2 (L1032) 2018/19

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3. Use the Solow growth model to analyse an economy whose aggregate production

function is given by 𝑌𝑌 = 2K0.4N0.6. In terms of additional notation, let 𝛿𝛿 denote the

depreciation rate of capital, 𝑠𝑠 the savings rate, and employment 𝑁𝑁 is constant.

a. Verify whether this production function exhibits constant returns to scale.

Are there decreasing returns to labour? [5 marks]

b. For a given savings rate and depreciation rate, provide an expression for steady

state capital per worker. [5 marks]

c. Provide a stylised graph depicting steady state capital per worker in output per

worker and capital per worker space. Label all axes, curves and any important

points in that graph. [5 marks]

d. Solve for the steady state level of output per worker when the savings rate is 15%

and the depreciation rate is 7%, respectively. [5 marks]

e. Whilst the depreciation rate is 7% as before, suppose that the savings rate

increases permanently to 20%. What is the new steady state level of output per

worker? Use a stylised graph as in part (c) to visualise the qualitative change

entailed by this parameter change. [5 marks]

f. Does your result from the previous part (e) imply that countries such as China,

which are characterised by a high savings rate, exhibit a higher growth rate of

output than countries with low savings rates such as the United States? Could

differences in growth rates of output between both countries be attributed to

other features of the model? [5 marks]

End of problem set

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