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Part I: True, False, or Uncertain (20 credits) Say whether the following statements are true, false or uncertain. Justify your answer in a couple of paragraphs. Credit is given for the quality of the justiﬁcation, so answering “true” without explanation does not give points even if “true” is correct. “Uncertain” is the same as “it depends”, and you should explain what the answer depends upon. If appropriate, you can support your argument through relevant graphs. 1. If a small economy is initially open but then it is cut oﬀ from the international credit market, then both consumption and investment in this economy will decrease. Your answer with justiﬁcation (including graphs if applicable):

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2. Shocks to government spending cannot be an important cause of business cycles, since they induce the wrong comovement between employment and output. Your answer with justiﬁcation (including graphs if applicable):

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3. Once a central bank has reduced the nominal interest rate to zero, there is nothing else it can do to reduce the real interest rate. Your answer with justiﬁcation (including graphs if applicable):

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4. The problem of poor economic performance due to coordination failures can be corrected easily through appropriate government policy: all that the government needs to do is to spread optimism. Your answer with justiﬁcation (including graphs if applicable):

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Part II: Short Problems (30 Credits) Increasing Returns and Growth, 15 Credits Consider the following modiﬁcation of the Diamond growth model. The production function is Yt = Kt2 Ntd . ¯ As usual only the young work and their exogenous labor supply is N = 1. There is no exogenous technological progress. The economy is controlled by a planner. The planner decides to save a fraction s ∈ (0, 1) of total output every period. Thus capital accumulates according to the equation Kt+1 = sKt2 . 1. Add a plot of Kt+1 as a function of Kt to the graph below. Compute the unique strictly positive level of the capital stock for which this plot intersects the 45◦ -line. Your graph and computations: Kt+1 45◦

Kt The graph is shown above. Intersections with the 45◦ -line are steady-state levels and obtained by solving the equation K = sK 2 . One level satisfying this equation is K = 0, but here we are looking for a strictly positive level. Dividing both sides by sK yields K = 1 . s

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2. Use your graph from part 1 to trace out graphically how the capital stock evolves over time if it starts out at K0 < 1 . Discuss what happens to the capital stock in s the long run. Your discussion: The red lines trace out the path of capital if it starts at K0 < 1 . In the long run s the capital stock converges to zero.

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3. Use your graph from part 1 to trace...