Problem Set 2 Mock Exam Questions (Please answer all questions) Question 1 (Macroeconomics: Inter-temporal consumption) An individual inherited wealth of $150 and he has a current income in period one of $350. The future income in period two is $270 and he leaves a bequest of $50 to his children. It saves $100 in period one. The interest rate is 10%. a) Derive the equation of the individual’s inter-temporal budget constraint. (5 marks) b) Find his consumption in period one and in period two. (5 marks) c) Graph the individual’s budget line and show his equilibrium point. (5 marks) d) Consider the original case of an interest rate at 10%. Discuss and show graphically what the equilibrium could be if the individual had received a higher inheritance. (10 marks) e) Consider the original case of an interest rate at 10%. Discuss and show graphically now what the equilibrium of this individual could have been if the he had NOT received any inheritance but had borrowed $50 during the first period, and had received a future income of $435, still leaving a bequest of $50. Link your finding to the predictions of the Permanent Income Hypothesis theory. (10 marks) f) Suppose the economy is hit by a financial crisis and that, as a result of it, it experiences a credit crunch similar to one faced in the years 2007/2008. Discuss and illustrate the effect of a borrowing constraint when the individual is a borrower and contrast it with the case of when he is a lender. (5 marks) Total 40 marks Question 2 (Microeconomics: Consumer theory) Let us consider a price increase for a normal good, a good whose demand increases as income increases, Initial position, price of both goods X and Y are $1 and money income is $100. (a) Draw a diagram and find show the utility maximisation where quantity of good is 43 (this is utility maximisation/optimum utility). (5 marks) (b) If price of good X increases from £1 to £2, show the new budget line, and utility maximisation where consumer is consuming 18 units of good X. (5 Marks) (c) Find the substitution and income effects on this diagram – assuming that consumer consumes 29 units of good X (10 marks) (d) Derive your compensated budget line (BL³) (10 marks) (e) Show Compensated Variations (CV) and Equivalent Variations of income in your diagrams. (10 marks) Total 40 marks Question 3 - (Microeconomics – Firms and industries) A monopolist can produce at a constant average (and marginal) cost of AC = MC = 5. It faces a market demand curve given by Q = 53 - P. Where AC is total average cost, MC is marginal cost, Q is output and P is the price of the firm. a) Calculate the profit-maximizing price and quantity for this monopolist. Also calculate its profits. (5 marks) b) Suppose a second firm enters the market. Let Q1 be the output of the first firm and Q2 be the output of the second. (5 marks) c) Suppose (as in the Cournot model) that each firm chooses its profit-maximizing level of output on the assumption that its competitor’s output is fixed. Find each firm’s “reaction curve” (i.e., the rule that gives its desired output in terms of its competitor’s output). (5 marks) d) Calculate the Cournot equilibrium (i.e., the values of Q1 and Q2 for which both firms are doing as well as they can given their competitors’ output). What are the resulting market price and profits of each firm? (5 marks) e) Suppose there are Suppose Firm 1 is the Stackelberg leader (i.e., makes its output decisions before Firm 2). Find the reaction curves that tell each firm how much to produce in terms of the output of its competitor. (10 marks) Total 30 marks Question 4-(Macroeconomics: AD/AS model & immigration policy) Use the Aggregate Demand / Aggregate Supply model (AD/AS) of an open economy. a) Explain the effects of more restrictive versus less restrictive immigration policies. (10 marks) b) Evaluate how legislation about composition and levels of immigration flows can affect output. (10 marks) c) Discuss, from an economic point of view, why immigration policy is a controversial topic. (10 marks) Total 30 marks Question 5- (Macroeconomics: IS/TR/CM & AD/AS models & trade) Consider a country with flexible exchange rate and perfect capital mobility. Use the IS/TR/CM model TOGETHER with the AD/AS model to evaluate the effects of a government subsidy to exporting firms on: a) (i) the level of the domestic final output; (5 marks) (ii) the level of the domestic real interest rate and of the domestic inflation; 5 marks (iii) the level of the nominal exchange rate. b) Evaluate the short run and long run sustainability of this policy. (5 marks) (15 marks) Total 30 marks