178.300 Macroeconomics Policy and Applications Assignment 2 Questions Semester 2, 2025

178.300 Question 1 (20 Marks) Open Economy Model

Assume you are in a small open economy with flexible exchange rates. The economy experiences a permanent positive demand shock.

1. Draw the PC −MR, the IS −RX and the ERU −AD graphs to help you explain the path back to medium run equilibrium.
2. Draw a graph of the real exchange rate over time and give a brief explanation of its path.
3. How does the medium run equilibrium vary from that in the closed economy? 

Question 2 (20 Marks) Supply-Side Shock

Oil prices fell dramatically in 1986. Use the WS−PS and ERU diagrams to explain the effect of this supply-side shock on a small open economy. At the initial real exchange rate, what has happened to real wages and the level of employment? 

Question 3 (20 Marks) Demand-Side Shock

Consult Chapter 11 and use the mathematics from Section 11.4.1 of the Appendix to derive the RX curve after a negative demand shock in bloc B. 

Question 4 (20 Marks) The Loss Function

A central bank has the following loss function:

L = − (yt − ye) + β(πt − πT )2   (13.1)

Consult Chapter 13 to answer the following questions:

1. What can we interpret about the central bank’s preferences from this loss function (Equation 13.1)?
2. Briefly explain how this loss function compares to the standard loss function and a loss function with yT > ye.
3. Find the inflation bias for a central bank with this loss function (Equation

13.1). [Hint: see Section 4.6 in Chapter 4].

Question 5 (20 Marks) Financial Crisis

Assume an economy with lump-sum taxes is hit by a large negative demand shock (e.g. financial crisis). In response, the government introduces a large fiscal stimulus package to try and boost economic activity and help stabilize the economy. Assess whether the policy will be successful in each of the following cases:                                                                                    

1. In the 3-equation model, when stimulus is financed through borrowing
2. In the 3-equation model, when the stimulus is financed by raising taxes (i.e. a balanced budget expansion)
3. In the RE − PIH model, when the stimulus is financed through