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Part 1. Short Questions

Enter your answer in the box provided.

1. (4 pts) Complete the following sentences with the most appropriate answers.

If domestic inflation is higher than foreign inflation, and if the domestic country has a fixed
exchange rate, the real exchange rate (i. increases / decreases / does not change / may
change in any direction). Assume that the Marshall-Lerner condition holds. Then, the trade
balance (ii. improves / deteriorates / does not change / may change in any direction).

i ii

increases
o deteriorates

2. (4 pts) Complete the following sentences with the most appropriate answers.

Suppose that there is an increase in foreign output and the domestic interest rate does not
change. Then, domestic output (i. increases / decreases / does not change / may change in
any direction). Net exports (ii. increase / decrease / do not change / may change in any
direction).

i ii

num
increases increases
3. (3 pts) Suppose the 1-year domestic interest rate is 1% and the 1-year foreign interest rate
is 2%. Also, there do not exist any capital control measures in both countries. By
approximately which rate is the domestic currency expected to appreciate during the
coming year?

a. -1%
b. 0%
c. 1%
d. 2%
e. Not enough information is given.

4. (10 pts) Consider two fictional economies, one called the domestic country and the other
the foreign country. Given the transactions listed in (1) through (7), construct the balance
of payments for the domestic country. If necessary, include a statistical discrepancy.
Report the values corresponding to (i)-(v) in the balance of payments.

(1) The domestic country purchased $100 in oil from the foreign country.
(2) Foreign tourists spent $25 on domestic ski slopes.
(3) Foreign investors were paid $15 in dividends from their holdings of domestic equities.
(4) Domestic residents gave $25 to foreign charities.
(5) Domestic businesses borrowed $65 from foreign banks.
(6) Foreign investors purchased $15 of domestic government bonds.
(7) Domestic investors sold $50 of their holdings of foreign government bonds.

Current Account Amount ($)

Exports (i) 25
*
Imports 100
&
Trade balance &
(ii) -75

Income received d
0

Income paid 15
i
Net income -15
&

Current account balance h

(iii) -90

Financial Account

Net capital transfers -25

·
 Increase in foreign holdings of domestic assets (iv) 65+15

Increase in domestic holdings of foreign assets -50

Financial account balance (v) 105

Statistical discrepancy: financial account + current account 15

i ii iii iv v

25 -75 -90 80 105

5. (5 pts) For this question, suppose that . Consider the following model of the goods market
in an open economy.
ca

The foreign GDP is assumed to be constant. Calculate the tax multiplier in this economy
(). If needed, round your answer to two decimal places (e.g., ).

a. 0.66
b. 1
c. 1.33
d. 2
e. 4

6. (10 pts) Determine whether each of the following statements is true or false.

i) Between 1960 and 2011, standards of living among non-OECD countries were
converging.
ii) Over the last hundred years in the developed countries, output has decreased in
 as many years as it has increased.
iii) Over the last hundred years in the developed countries, movements in output due
to recessions and expansions dominated the movement caused by long-run growth.
iv) Capital-to-output ratio in the US has been stable after WWII.
v) As more and more workers are better educated, the college wage premium
decreased in recent decades.

i ii iii iv v

false false false true false

7. (3 pts) Suppose that , , and . Compute the steady-state investment per worker. Be careful
about the unit. For example, being 5% implies that is 0.05 rather than 5.

a. 0.05
b. 0.1
c. 0.2
d. 1
e. 2

bc

8. (4 pts) Complete the following sentences with the most appropriate answers.

Consider the Solow model and an economy in its steady state. Suppose that the
depreciation rate increases permanently. Then, the growth rate of output-per-worker (i.
temporarily / permanently / does not) decrease(s). Also, output per worker (ii. temporarily /
permanently / does not) decrease(s).

i ii

temporarily permanently
9. (4 pts) Suppose that , , and . Given that , compute .

a. 0.95
b. 1
c. 1.1
d. 1.21
e. 1.26

10. (3 pts) Select a correct statement regarding the steady-state of the Solow model when and
.

a. GDP does not change.

b. Aggregate capital grows over time.
c. The growth rate of output per worker is .
d. Consumption per worker increases over time.
e. None of the above.

Part 2. Long Questions

Answer the questions in the space provided. Show your work unless instructed
otherwise. Please write legibly.
11. (25 pts) The Solow Model. We will concentrate on the long-run dynamics in this
question.
Consider an economy with and constant population (). At the beginning (year 0), the
economy is in its steady-state equilibrium.

(a) (8 pts) Draw graphs of output, savings, and depreciation against capital. All variables
should be expressed in terms of per-worker quantities. Denote the capital and output
per worker in the initial situation by and , respectively. The initial savings rate is
denoted by . When you draw a diagram, label all curves, lines, axes, and relevant
points clearly.

Income inequality has been increasing recently in many countries. That is, the rich are taking
more and more income than the poor. Furthermore, empirical evidence suggests that the rich
have higher saving rates than the poor (e.g., Dynan, Skinner, and Zeldes, "Do the rich save
more?" Journal of Political Economy 112(2), 2004: 397-444).

(b) (5 pts) Given the above information, determine the implications of increasing income
inequality on the aggregate savings rate . Explain your answer.

When income inequality increases, the aggregate savings rate may increase. As we
have more rich people who have high propensities to save than the poor, the
economy-wide saving rate increases.

(c) (7 pts) Suppose that income inequality suddenly increases in year 5 and stays at the
high level after that. In light of your answer in (b), explain what happens to capital,
output, and savings per worker in this economy in the long run. Illustrate changes in
the graphs on the previous page, if there are any.

After year 5, the saving rate increases from to . Given the new saving per worker
curve, clearly, the steady-state capital per worker increases from to . Then, in the long
run, capital, output, and savings per worker increase to , , and , respectively.

(d) (5 pts) In the space below, draw a graph of the capital-to-output ratio against time.
Briefly explain your answer.
 time

Note that . The economy stays at the initial steady-state until year 5. So, for . Starting
from year 5, as the economy approach the new steady-state, the capital-to-output ratio
increases and converges to the new steady-state value .
12. (25 pts) The IS-LM-IP Model. Consider the IS-LM-IP model for the Hong Kong
economy.

(a) (9 pts) Draw the IS and LM curves. When you draw a diagram, label all curves, lines,
axes, and relevant points clearly. Denote the current equilibrium by point A. Relate
the domestic interest to the variable(s) that we take as given. Explain why we do not
need to draw the IP curve in this case.
 From the UIP condition and the fact that (we are considering HK), .
Also, because we know already, we do not need to draw the IP curve which relates
with .

(b) (5 pts) Suppose the Hong Kong government decides to collect more taxes without
changing . Show the new equilibrium and label it as point B. Briefly describe any
changes in the curves, the equilibrium output, and the interest rate.

As increases, the IS curve shifts to the left. Then, to maintain the fixed exchange rate,
HKMA reduces money supply and shifts the LM curve to . Thus, at point B, output
decreases, and the interest rate does not change.

(c) (5 pts) Draw a money market diagram for points A and B below. If any curve shifts
between points, clearly illustrate that and briefly explain the underlying causes.
m
As decreases, the real money demand curve shifts to the left. Then, we know the
money supply should decrease accordingly to keep the interest rate unchanged.
Therefore, the money supply curve shifts to the left.

(d) (6 pts) Determine whether the following variables increase (), decrease (), do not
change (), or change in an uncertain direction (?) as the economy moves from point A
to B. State your answer without explanation.

= : : :

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