Macroeconomics Exam: Solow, Growth, Policy, Cycles
Macroeconomics Exam — Answer 3 of 10 Questions
Please answer 3 of the 10 questions attached below.
Solow Model: Steady-State Conclusions
1. Conclusion of the Solow Growth Model – The steady-state level
The Solow growth model shows that an economy moves toward a steady state in the long run. In this steady state, capital per worker and output per worker are constant. Investment is just enough to cover depreciation and population growth. Long-run growth of income per worker depends only on technological progress, which is external to the model. A higher saving rate increases the level of output but not the long-run growth rate. Poorer countries can grow faster and catch up if they have similar institutions and technology. Without technological progress, economic growth will stop.
Endogenous Growth Theory: Technical Progress
2. How does Endogenous Growth Theory explain technical progress?
Endogenous growth theory explains technical progress as something created inside the economy. Technology improves because firms and individuals invest in education, human capital, innovation, and research and development. Knowledge can spill over to other firms and create positive externalities for the whole economy. Unlike the Solow model, growth can continue indefinitely. Government policies can support growth through education and R&D spending. Therefore, economic growth depends on decisions made by firms, workers, and governments. Technical progress is not automatic but is the result of deliberate investment.
Endogenous Growth Theory: Technical Progress
2. How does Endogenous Growth Theory explain technical progress?
Endogenous growth theory explains technical progress as something created within the economy. Technology improves because firms invest in education, human capital, innovation, and research. Knowledge spreads to other firms and creates positive effects for the whole economy. Unlike the Solow model, growth can continue forever. Government policies can support growth through education and R&D spending. Therefore, economic growth depends on decisions made by firms, workers, and governments. Technical progress is not automatic but is the result of investment.
IS-LM Effects of Expansionary Policies
3. Effect of expansive fiscal and monetary policy in the IS-LM model
An expansionary fiscal policy means higher government spending or lower taxes. This shifts the IS curve to the right and increases output. Because income increases, the demand for money rises and the interest rate usually goes up. Expansionary monetary policy increases the money supply and shifts the LM curve downward (or to the right on money-market presentations). This lowers the interest rate and increases investment and output. When both policies are used together, output increases more and interest rates change less. The IS-LM model explains these effects in the short run.
Fiscal vs. Monetary Policy: Pros and Cons
4. Fiscal policy vs monetary policy – pros and cons
Fiscal policy affects aggregate demand through government spending and taxes. Its main advantage is that it can strongly increase output during a recession. However, it often works slowly because of political decisions and implementation delays. Monetary policy, managed by the central bank, is faster and can quickly change interest rates to influence investment and consumption. However, it is less effective when nominal interest rates are already very low (the liquidity trap).
- Fiscal policy — advantages: Powerful demand stimulus; direct support to sectors or households.
- Fiscal policy — disadvantages: Political delays, potential long-term debt, crowding out if financed by borrowing.
- Monetary policy — advantages: Rapid implementation, flexible tools (rates, open-market operations, forward guidance).
- Monetary policy — disadvantages: Less effective at the zero lower bound; distributional limits; limited direct support to specific sectors.
Because both policies have strengths and weaknesses, they are often combined for a balanced macroeconomic response.
Lucas’s Imperfect Information and Policy
5. Conclusions of Lucas’ imperfect information theory for monetary policy
Lucas’s imperfect information theory argues that people do not always have perfect information about aggregate versus relative price changes. They can confuse general inflation with changes in relative prices. Because of this, unexpected monetary policy can increase output in the short run by inducing misperceptions among producers and workers. Over time, agents learn and adjust their expectations, so monetary policy loses its real effects in the long run. There is no long-run trade-off between inflation and unemployment. Central banks should therefore favor stable, predictable policies to avoid surprise-driven distortions.
Current Business Cycle: Theoretical Characteristics
6. Characteristics of the current business cycle – theoretical view
Contemporary business cycles are usually less extreme than in the past. Output, employment, and investment move together during expansions and recessions; consumption is typically more stable than output. Shocks often originate from technological innovations, financial market disturbances, or global events. Expectations of firms and households play a central role. Governments and central banks attempt to mitigate severe recessions through fiscal and monetary tools. Business cycles are a regular feature of market economies.
Real Business Cycle: Sources of Fluctuations
7. Sources of business fluctuations in Real Business Cycle theory
Real Business Cycle (RBC) theory explains economic fluctuations using real (non-monetary) factors. The primary source is changes in technology and productivity. These technology shocks affect output, employment, and investment directly. Workers adjust labor supply in response to productivity changes. Prices and wages are assumed to be flexible and markets clear. In the RBC view, government intervention is unnecessary because cycles represent efficient responses to real shocks.
Reasons for Unemployment
8. What are the reasons for unemployment?
There are several reasons for unemployment:
- Frictional unemployment: Short-term unemployment as workers move between jobs or search for the right match.
- Structural unemployment: When workers’ skills or locations do not match job requirements, often due to technological change or sectoral shifts.
- Cyclical unemployment: Caused by downturns in aggregate demand during recessions.
- Institutional factors: Labor market rules, minimum wages, or regulations can affect hiring and unemployment durations.
- Efficiency wage effects: Firms may pay wages above market-clearing levels to increase productivity, which can reduce hiring.
Unemployment is partly unavoidable in modern economies, though policies can reduce its duration and severity.
Inflation: Positive and Negative Implications
9. Positive and negative implications of inflation
Low and stable inflation can help the economy function smoothly by allowing relative prices and wages to adjust. Moderate inflation can reduce real wages and potentially increase employment when wages are downwardly rigid. However, high inflation erodes purchasing power, creates uncertainty, and harms saving and investment. People on fixed incomes are particularly hurt. For these reasons, central banks aim to keep inflation low and stable.
Deglobalization: Causes and Consequences
10. Deglobalisation in the current world – reasons and consequences
Deglobalization refers to a reduction in global trade and economic integration. Causes include trade conflicts, geopolitical tensions, and global crises. Countries may protect domestic industries and shorten supply chains to reduce risk. Firms shift production closer to home, which can raise production costs and consumer prices. Developing countries may lose access to global markets and suffer lower growth. Deglobalization can therefore reshape the structure of the world economy and affect long-term productivity.