Question One: Stabilization Policy The macroeconomic stabilization policy assumes that it is desirable to stabilize the rate of output and inflation around target values as opposed to fluctuating values. Fluctuating values of inflation and output are sources of instability in the economy. a. Briefly explain why there is time lag in macroeconomic stabilization policy and why such lags reduce the ability of policy makers to stabilize the economy. b. The algebraic expression shows the average welfare loss from a given business cycle as defined in class notes: E[CUc]2y2+2(1)y2 Where 1mpmw and all symbols as defined in class. Explain how the welfare loss is captured by the equation and what should a consumer do to avoid the loss. c. Given the following expression: Y^e+(1)(Y^Y^e)(2(1)1+)(Y^Y^e)2d Explain how d2p2 contribute to consumer welfare loss whenever there are nominal price rigidities in the economy. d. Given that Ps and Pf represent sticky prices and flex prices respectively, while Pse=Ps, unanticipated inflation is given as e=(1)(Pf Ps) Describe how flex price firms determine unanticipated inflation and further derive the link between unanticipated inflation and consumer welfare. Question Two: RBC models a. Suppose the representative household maximises the expected value of period-t utility function, ut, is; u=t=0 eptu(ct,1lt) where u(:) is the instantaneous utility function for the representative member of the household, where each household has one member. Given that; ut=lnct+1(1lt)1,>0,>0 The household lives for 2 periods and the lifetime budget constraint are given by; ct+1+r1ct+1=wtlt+1+r 1wt+1lt+1 where ct is consumption per member, wt is the wage rate pr member, lt is leisure per member in period t and the discount rate is . Consider the dynamic case of the model and assume that the household has no initial wealth, and there is no uncertainty about the real interest rate (r) and the second period wage. i. Write out the Lagrange and solve for the first order conditions for the demand for leisure in periods t and t+1. ii. How would an increase in period t wage affect the relative demand for leisure in the two periods? iii. How does the relative demand for leisure in the two periods depend on the interest rate? b. Suppose the production function for firms in this model is given by Yt=Kt(AtLt)1where0<<1 and the stock of capital depreciates ate the rate in each period, explain how incomplete depreciation (depreciation less than 100% ) would affect the basic results of the RBC model (derivations are necessary for the explanation). c. Explain how the introduction of positive shocks to government purchases affect the household's labour supply decision (derivations are necessary for the explanation d. Models that account for the role of monetary changes often do so by including money in the utility functions. Explain the rational of adding money to the utility function and the benefit this adds to the model..

1. Question One: Stabilization Policy The macroeconomic stabilization policy assumes that it is
desirable to stabilize the rate of output and inflation around target values as opposed to fluctuating
values. Fluctuating values of inflation and output are sources of instability in the economy. a.
Briefly explain why there is time lag in macroeconomic stabilization policy and why such lags
reduce the ability of policy makers to stabilize the economy. b. The algebraic expression shows
the average welfare loss from a given business cycle as defined in class notes: E[CUc]2y2+2(1)y2
Where 1mpmw and all symbols as defined in class. Explain how the welfare loss is captured by
the equation and what should a consumer do to avoid the loss. c. Given the following expression:
Y^e+(1)(Y^Y^e)(2(1)1+)(Y^Y^e)2d Explain how d2p2 contribute to consumer welfare loss
whenever there are nominal price rigidities in the economy. d. Given that Ps and Pf represent
sticky prices and flex prices respectively, while Pse=Ps, unanticipated inflation is given as e=(1)(Pf
Ps) Describe how flex price firms determine unanticipated inflation and further derive the link
between unanticipated inflation and consumer welfare. Question Two: RBC models a. Suppose
the representative household maximises the expected value of period-t utility function, ut, is; u=t=0
eptu(ct,1lt) where u(:) is the instantaneous utility function for the representative member of the
household, where each household has one member. Given that; ut=lnct+1(1lt)1,>0,>0 The
household lives for 2 periods and the lifetime budget constraint are given by; ct+1+r1ct+1=wtlt+1+r
1wt+1lt+1 where ct is consumption per member, wt is the wage rate pr member, lt is leisure per
member in period t and the discount rate is . Consider the dynamic case of the model and assume
that the household has no initial wealth, and there is no uncertainty about the real interest rate (r)
and the second period wage. i. Write out the Lagrange and solve for the first order conditions for
the demand for leisure in periods t and t+1. ii. How would an increase in period t wage affect the
relative demand for leisure in the two periods? iii. How does the relative demand for leisure in the
two periods depend on the interest rate? b. Suppose the production function for firms in this model
is given by Yt=Kt(AtLt)1where0<<1 and the stock of capital depreciates ate the rate in each
period, explain how incomplete depreciation (depreciation less than 100% ) would affect the basic
results of the RBC model (derivations are necessary for the explanation). c. Explain how the
introduction of positive shocks to government purchases affect the household's labour supply
decision (derivations are necessary for the explanation d. Models that account for the role of
monetary changes often do so by including money in the utility functions. Explain the rational of
adding money to the utility function and the benefit this adds to the model.