Microeconomic Analysis and macroeconomic homework
Tutorial 5 questions ECON203 Microeconomic Analysis (Session 2, 2018) Tutorial 5 N.B This is economics – diagrams are always your friend 1. Three friends - James, Himari and Izad – are approached with offers to buy income insurance (i.e. insurance to protect income in the case of injury or disability. Their characteristics are as follows: James – income: 100000 ; income if injured: 20000 ; probability of injury: 0.05 ; utility function: ? = √? Himari – income: 110000 ; income if injured: 30000 ; probability of injury: 0.025 ; utility function: ? = ? Izad – income: 120000 ; income if injured: 15000 ; probability of injury: 0.1 ; utility function: ? = ?2 a) Describe the prospects for each individual, noting the expected value and variance in each case. b) How would you describe the attitude to risk of each friend? c) What is each friend’s willingness to pay for full income insurance (i.e. insurance which guarantees their income regardless of the state of nature)? d) If the person selling insurance offers them each full income insurance that is actuarially fair relative to their circumstances, which of them would purchase it? Explain with reference to the cost of this insurance and their willingness to pay. e) How would their circumstances have to be different (in terms of probability and size of loss of income) for them to make a different decision about whether to buy the insurance at the price originally quoted? Untitled ECON204 MACROECONOMIC ANALYSIS SESSION 2, 2018 WEEK 6 Country tutorial assessment task: - Collect data on inflation and unemployment for your country for the last 20 years. Draw the Phillip’s curve by first finding the change in the inflation rate between periods (if possible, quarters). Then use a software program like Excel (or any econometrics/stats program) to draw a scatter graph of the changes in the inflation rate (on the y-axis) against unemployment rates (on the x-axis). Finally, find the equation for the line of best fit. Question 1 The Phillips curve, supply shocks and wage flexibility Suppose that the Phillips curve is given by ?? = ??? − ?(?? − ??) (1) where the natural rate of unemployment, ?? = ?+? ? . [Recall that this Phillips curve was derived under price-setting and wage-setting: ?? = (1 + ?) ?? (2) ?? = ???(1 − ??? + ?) (3) where m is the mark up over marginal cost, which is just the wage rate Wt when output is assumed to simply equal employment: ?? = ?? We can think of ? as a measure of wage flexibility---the higher is ?, the greater is the response of the wage to a change in the unemployment rate, ?? . z represents other factors affecting wage bargains.] a. Explain how you obtain (1) from (2) and (3). b. Suppose m = 0.2 and z = 0.04. What is the natural rate of unemployment if ? = 0.3? If ? = 0.4? What is the relation between ? and the natural rate of unemployment? c. In most rich countries recently, the unemployment rate has been falling, but wages have not been rising. Looking at equation (1), what might be possible causes of such a ‘puzzling’ outcome? Question 2 Monetary policy, low natural interest rates and the (revised) AS-AD model Use the AS-AD model (in output-inflation space) where the central bank uses an interest rate rule with an inflation target,??. ?? = ?? + ?(?? − ??) Assume that the economy begins in the medium run equilibrium. Suppose households’ saving increases permanently due to the need to save more for the future because of persistent uncertain economic conditions, and firms’ investment decreases permanently due to persistent uncertain economic conditions. a. Explain what would immediately happen to the IS and AD curves in response to these 2 shocks. What will happen to the interest rate, inflation and output in the short run? Use the IS-LM and AS- AD models to illustrate your answer. b. Now consider the medium-run goods market equilibrium. Given the persistent savings and investment shocks, what will happen to the natural rate of interest, in. (Explain carefully the natural rate of interest concept, and how it is determined by medium-run goods market equilibrium.) c. Explain why you think an ageing population that lives longer may lead to a permanent positive savings shock resulting in in being lower in most countries. d. Suppose the tariff wars persist, so that all countries raise tariffs on all imports. Explain why this may lead to a permanent reduction in firms’ real investments everywhere, and how it may contribute to keeping in low. e. If the economy reached a point where the central bank lowered the nominal interest rate so far as to enter a liquidity trap, could conventional monetary policy still be effective?