School of Accountancy, Economics and Finance

DUE DATE: Friday 10 October 2025

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.

(a) Draw the PC −MR, the IS −RX and the ERU −AD graphs to help you explain the path back to medium run equilibrium.

(b) Draw a graph of the real exchange rate over time and give a brief explanation of its path.

(c) 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 = − (y_t − y_e) + β(π_t − π^T )²                                                         (13.1)

Consult Chapter 13 to answer the following questions:

(a) What can we interpret about the central bank’s preferences from this loss function (Equation 13.1)?

(b) Briefly explain how this loss function compares to the standard loss function and a loss function with y^T > y_e.

(c) 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:                                                                                    

(a) In the 3-equation model, when stimulus is financed through borrowing

(b) In the 3-equation model, when the stimulus is financed by raising taxes (i.e. a balanced budget expansion)

(c) In the RE − PIH model, when the stimulus is financed through

In which case will output expand the most? Justify your answer.