Foundations of ModernMacroeconomics

Second Edition

Exercise and Solutions Manual

BEN J. HEIJDRALAURIE S. M. REIJNDERS

andWARD E. ROMP

OXPORDUNIVERSITY PRESS

Contents

Preface ix

1 Who is who in macroeconomics? 11 Short questions 12 The Cobb-Douglas production function 13 The AS-AD model 24 Consumption tax 35 Tax incidence 36 The Keynesian cross model 47 The import leakage 58 The liquidity trap 59 The IS-LM-AS model with inflation 6

2 Dynamics in aggregate demand and supply 251 Short questions 252 The Keynesian cross model (continued) 253 The IS-LM model with capital accumulation 264 Stability of the IS-LM model 265 The Blinder-Solow model 276 Ricardian equivalence in the Blinder-Solow model 277 The Blinder-Solow model with capital accumulation 288 Adaptive expectations in a monetarist model 299 More on adaptive expectations 2910 Optimization and computation 3011 The multiplier-accelerator model 31

3 Rational expectations and economic policy 651 Short questions 652 Stabilization of demand shocks 653 Overlapping wage contracts and the REH 664 A variation on the Muth model 675 Expectational difference equations 686 The Cagan model 687 Fiscal policy under rational expectations 698 The labour market 699 Liquidity trap 7010 PIP meets the Pigou effect 7111 PIP and the output gap 72

VI

12 Contemporaneous information 7213 Sticky prices 7314 Automatic stabilizer 73

4 Anticipation effects and economic policy 1091 Short questions 1092 The IS-LM model with sticky prices 1103 Leaning against the wind I l l4 The term structure of interest rates I l l5 Fiscal policy with fixed nominal wages and

perfect foresight 112

5 The government budget deficit 1431 Short questions 1432 Tax smoothing 1433 The two-period model with tax smoothing 1444 Ricardian equivalence 1455 Ricardian equivalence in the two-period model 145

6 A closer look at the labour market 1571 Short questions 1572 Two-sector model with a skill-biased productivity shock 1573 Progressive taxation 1584 Indivisible labour 1595 Efficiency wages 159

7 Trade unions and the labour market 1731 Short questions 1732 Smalltalk 1733 The Blanchard-Summers model 1744 Variable unemployment benefits 1745 The two-sector labour market model 174

8 Search in the labour market 1811 Short questions 1812 Search unemployment 1813 A CES matching function 1824 Downward real wage rigidity 1835 Dynamics of unemployment and vacancies 183

9 Macroeconomic policy, credibility, and politics 1991 Short questions 1992 Capital taxation and income inequality 1993 Choice of policy instrument 2004 Rules versus discretion 2015 Political business cycles 202

Vll

10 The open economy 2171 Short questions 2172 The Mundell-Fleming model 2173 The Dornbusch model 2184 The Buiter-Miller model 2195 Dynamics of foreign reserves 2206 Price flexibility in the Mundell-Fleming model 221

11 Money 2531 Short questions 2532 Optimal money growth 2533 Monetary superneutrality 2554 Cash-in-advance constraint in continuous time 2565 Cash-in-advance with labour supply 257

12 New Keynesian economics 2791 Short questions 2792 Cost function for a Dixit-Stiglitz technology 2793 The multiplier when taxes are distortionary 2804 Consumers in the New Keynesian model 2805 Producers in the New Keynesian model 2816 Monetary policy in the New Keynesian model 283

13 Exogenous economic growth 3051 Short questions 3052 The Harrod-Domar model 3063 The production function 3064 The wage-rental ratio 3075 The Solow-Swan model 3076 The Pasinetti model 3087 The Solow-Swan model with population growth 3088 Some mathematics 3099 Optimal investment 30910 Welfare of future generations 31011 The savings function 31012 The savings ratio in the Ramsey model 31113 Technological change 31114 Constant marginal utility 31215 Intertemporal substitution 313

14 Endogenous economic growth 3491 Short questions 3492 Endogenous growth 3493 Minimum consumption and endogenous growth 3504 Asymptotic endogenous growth 3515 External effect and endogenous growth 3516 Asymptotic capital fundamentalist model 352

vm

15 Real business cycles 3691 Short questions 3692 Small open economy model 3693 The non-market sector 3704 A general RBC model . . . . ^ 3725 Government spending shocks in the unit-elastic model 3736 No wealth effect in labour supply 373

16 Overlapping generations in continuous time 3951 Short questions 3952 The Buiter model 3953 Endogenous growth 3964 The Blanchard - Yaari model without insurance 3975 Technological change 3976 Mandatory retirement 3997 Public infrastructure 400

17 Overlapping generations in discrete time 4311 Short questions 4312 Capital fundamentalism in an OLG model 4313 Welfare effects of debt 4324 Lifetime uncertainty in a two-period model 4335 Pensions in the Diamond-Samuelson model 4346 Consumption taxation and redistribution 434

Bibliography 457