UNIVERSITY OF OSLO
DEPARTMENT OF ECONOMICS
Term paper in: ECON4330 – Open Economy Macroeconomics
Published: Wednesday, March 12, 2008
To be delivered by: Monday, April 7, 2008
between 10.00 a.m. and 12.00 noon
Place of delivery: Next to SV-info-center, ground floor
Further instructions:
 This term paper is compulsory. Candidates who have passed the compulsory term paper
in a previous semester, does not have the right to hand in the term paper again. This is so,
even if the candidate did not pass the exam.
 You must use a printed front page, which will be found at
http://www.oekonomi.uio.no/info/EMNER/Forside_obl_eng.doc
 Note: The students can feel free to discuss with each other how to solve the problems, but
each student is supposed to formulate her/his own answers. Only single-authored papers
are accepted, and papers that for all practical purposes are identical will not be approved.
 It is of importance that the term paper is delivered by the deadline (see above). Term
papers delivered after the deadline, will not be corrected.*)
 All term papers must be delivered to the place given above. You must not deliver your
term paper to the course teacher or send it by e-mail. If you want to hand in your term
paper before the deadline, please contact the department office on 12th floor.
 If the term paper is not accepted, you will be given a new attempt. If you still not
succeed, you will not be permitted to take the exam in this course. You will then be
withdrawn from the exam, so that this will not be an attempt.
*) If a student believes that she or he has a good cause not to meet the deadline (e.g. illness) she or he should
discuss the matter with the course teacher and seek a formal extension. Normally extension will only be granted
when there is a good reason backed by supporting evidence (e.g. medical certificate).
Part A
We look an infinite horizon model of savings and the current account in a small open
economy. The time path for output is given exogenously (“endowment economy”). There is
no investment
1) A representative consumer maximizes utility
where is consumption in period s and
budget constraint is
is a subjective discount factor. The
where r is the real rate of interest, is net foreign assets at the beginning of period t,
is GDP and is government expenditure in period s.
Explain briefly the reasoning that is behind the inclusion of in the budget equation
for the consumer.
2) The maximization problem in 1) leads to the first-order condition (Euler equation)
Interpret this condition.
3) Robert Hall’s theory of aggregate consumption states that
Interpret this equation and explain the assumptions that are needed to get from (3) to
(4).
4) Define total wealth as
If equation (3) holds true, it follows that
State in words what this means. Discuss briefly whether it is likely to be a good
description of aggregate consumption.
5) Suppose consumption demand is given by (6). Derive an equation for the current
account surplus of the country in period t. Explain briefly how permanent and
transitory income shocks will affect the current account.
Part B
For four years in a row a country has had a substantial current account deficit. As an
economist you are asked for an explanation. In preparing your answer, what information on
the country would you be looking for? Write a short memo on this.
Part C
1) Explain what is meant by perfect capital mobility between currencies. Discuss briefly
under what conditions one can expect capital mobility to be close to perfect.
2) Explain with a graph how the equilibrium exchange rate is determined according to
the simple monetary theory of exchange rate determination with flexible prices and
perfect capital mobility. (The equations for a long-linearized version of the model are
enclosed).
3) Suppose we look at an agricultural economy. Due to a severe drought output is
expected to be below normal until after the next rainy season. Then it is expected to
return to normal. The money supply is assumed to be constant. Sketch in a graph the
time path for the exchange rate from before the drought started until after the next
rainy season as it would follow from the monetary model. The graph should have time
on the horizontal axis. Explain briefly the reasoning behind it. (If it helps your
reasoning, you may derive the mathematical solution for the time path, but this is not
required).
4) Now, leave the agricultural economy and the monetary model behind, but retain the
assumption of perfect capital mobility. A recession has just started in country A. It is
expected to last for three years. The recession is not expected to affect economic
activity in country B. In normal conditions the nominal interest rate in both countries
is 6 per cent per year. If a country is in recession, the central bank in that country is
expected to lower its interest rate to 2 per cent per year. How would you expect the
exchange rate between the two currencies to evolve from before the recession until it
is over. Sketch the time path in a graph. You can assume that after the recession is
over the exchange rate returns to where it started.
5) Suppose instead that the recession is expected to spread to country B a year from now
and then last for three years there too. Sketch the expected time path of the exchange
rate from before the start of the recession in country A until after the end of the
recession in country B. You can again assume that after the recessions are over the
exchange rate returns to where it started.
The monetary model
Equations:
Symbols (in logs except for interest rates):
money supply
domestic price level
foreign price level
exchange rate
output
domestic interest rate
foreign interest rate
Exogenous: , , ,