1. Short question, 2014 Exam: Explain why the housing market collapse might have played a role in the 2008/09 U.S. recession through its e§ect on aggregate consumption.
2. Short question, 2009 Exam: Explain the following statement: "When wages are flexible, and there are no other frictions, unemployment is always zero in a full-information competitive labour market. It becomes positive when firms cannot observe their workers' e§ort."
3. Long question, based on 2015 Exam: Consider an economy where each generation lives for two time periods. Consumption of a particular generation when young and old is denoted by c and c0 respectively. Assume there is no population growth, so any time half of the population is young and half of the population is old. The young each receive labour income y (labour supply is inelastic). The old are retired and receive no labour income. There is a credit market where anyone can save and earn real interest rate r. The labour income of the young grows at rate g between generations (y0/y =1+ g).
Suppose the government levies a proportional income tax t on the incomes of the young. The government also pays out pensions to the old that are a fraction b of the current young's labour incomes (i.e. if the current young earn y, the current old receive by). Note that this says nothing about how these pensions are funded. The present value of a generation's lifetime after-tax income including pensions is:
we = (1-t)y + by01 + r
First suppose the government's pensions system is fully funded, meaning that the taxes collected from the young are invested and the proceeds are used to fund their future pensions when old.
(a) Assuming the government earns the same real return r as households do on their savings, write down an equation linking t and b. Show that this fully-funded pension system has no e§ect on households' consumption plans and explain what impact it has on the saving s = (1-t)y-c of the young.
(b) Explain why your findings in part (a) are an illustration of the ‘Ricardian equivalence' principle. Is it possible that your answers would be di§erent if households were unable to borrow?
Now suppose instead that the government has a ‘pay-as-you-go' pensions system, meaning that taxes collected from the young are used to pay the pensions of the current old.
(c) Write down an equation linking t and b under this pension system, and use this to find an expression for life-time wealth we in terms of y, t, r, and g only.
(d) Explain why the current old would gain from the introduction of the pay-as-you-go pension system, and find the condition for the current young generation to benefit from it as well. Assuming this condition is satisfied and the system is introduced, find the e§ects on the consumption and saving of the young. Explain why the ‘Ricardian equivalence' principle does not apply to this type of pension system.
(e Now suppose that the growth rate g falls, but the condition derived in part (d) continues to hold. Two options for reforming the pay-as-you-go pension system are: (i) maintaining contributions t and cutting benefits b; or (ii) increasing contributions t and maintaining benefits b. Compare the e§ects of these two reforms on the current old and young generations. Is it possible to say which reform is preferable?
4. Consider the dynamic macroeconomic model from the lectures. For each of the shocks below, find the effects on output, employment, the real interest rate, and the real wage (if an answer is ambiguous you should say so). Include wealth e§ects in your answers where appropriate.
(a) The government temporarily increases its expenditure G (assume government spending has no direct benefits in terms of production or utility).
(b) There is good news about future total factor productivity z0 (with no change to current total factor productivity z).
(c) The economy's production processes become less capital intensive (interpret this as raising the marginal product of labour MPN and reducing the marginal product of capital MP0 K, ignoring any direct e§ect on what output is produced using the initial supplies of capital and labour, and ignoring any wealth e§ects).