ECON0024: ECONOMIC POLICY ANALYSIS

ECON0024 TURN OVER
SUMMER TERM 2024
DEPARTMENTALLY MANAGED REMOTE ONLINE EXAMINATION
ECON0024: ECONOMIC POLICY ANALYSIS

Assessment Component: 75% Remote Online Controlled Condition Examination
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QUESTIONS

Answer FOUR questions from Part A, ONE question from Part B and ONE question from
Part C.
Questions in Part A carry 10 per cent of the total mark each, and questions in Parts B and
C carry 30 per cent of the total mark each.

PART A
Answer FOUR questions from this section.
A1. A small competitive economy produces two internationally traded outputs, wheat and
cloth, using two inputs, labour and capital, according to constant-returns-to-scale production
technologies. Output prices, fixed on world markets, are pA for wheat and pB for cloth. Input
prices are w for labour and r for capital. The two factors are free to move between sectors so
factor prices are the same in the two industries. Aggregate capital stock is fixed at K and
capital stocks employed in the two sectors are KA and KB. Aggregate labour force L is the
sum of native labour N and immigrant labour M, the two being equally productive and perfect
substitutes, and is split into LA and LB employed in the two sectors. Factor market
equilibrium involves
gA(KA/LA) = gB(KB/LB) = w/r
cA(w,r) = pA cB(w,r) = pB
LA+LB = N+M KA+KB = K
where gA and gB are the (absolute values of the) marginal rates of technical substitution
between the two inputs in the two sectors and cA and cB are unit cost functions in the two
sectors. Suppose production of cloth is more capital-intensive.
How does a small inflow of immigrant labour affect factor returns and factor use in the two
sectors?
Suppose the immigrant inflow is large enough that production shifts entirely to the wheat
sector. What happens to factor returns in this case?

A2. Answer all items.
a) Suppose a central bank targets an overnight interbank rate as its policy instrument.
The yield on a 10-year corporate bond is generally substantially higher. What are the
two main factors that determine the size of this wedge? Explain.
b) Suppose the 10-year government bond yield falls lower than the 1-year government
bond yield. What is this called? What may it indicate? Why?
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c) Describe two types of unconventional monetary policy.

A3. Are the following statements True, False or Uncertain? Explain each answer.
a) Health inequalities are only present in countries without universal health insurance.
b) In the context of the Grossman (1972) model, people demand medical care because
they enjoy going to the doctor.
c) Health spending as a share of GDP has declined in the United Kingdom since the
mid 1950s, which is the main reason underlying the worsening health of the
population.

A4. Are the following statements True, False or Uncertain? Explain each answer.
1) The main motivation for introducing minimum wage policies was always poverty reduction.
2) Minimum wages have an unambiguously negative effect on employment in the
neoclassical (perfectly competitive) framework. This highlights the idea that this policy can
do more harm than good.
3) The current state of the art evidence on the employment effects of the minimum wage
suggests that employment increases at lower levels of the minimum wage, but once the
minimum wage to median wage ratio goes above 45%, employment starts to decline.

A5. Financial Times, November 2022:   UK chancellor Hunt considers tax hit on dividends
  Hunt has asked officials to look at raising the dividend taxation rate  . Sir Keir Starmer, the
Labour leader, has said   Some people obviously earn their income through a wage, other
people earn it through stocks and shares and dividends and we are looking at what is a fair
way to tax all income wherever it comes from    
What arguments might be used by a government to tax interest income from saving accounts
differently from income from employment? How would your argument differ if the capital
income was from dividend payments rather than from interest on saving accounts?

A6. Choose two sources of labour market frictions in developing countries. Discuss their
potential effects on labour market outcomes, and which groups of workers are likely to be more
affected. Do so considering the evidence discussed in class, emphasizing at least one piece of
causal evidence available.

A7. Discuss the following statement: It is better to pay teachers based on an absolute measure
of performance than on a relative measure of performance that ranks a teacher against a set
of her peers. This is especially true when the measure of performance is value added.
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PART B
Answer ONE question from this section.
B1. Consider the following news item.

Over 20 percent of taxi drivers in Chicago are from South Asia, the highest figure for all
metro areas in the US.
There are also more doctors, engineers, scientists, accountants and economists driving
taxis in Chicago than in any other US city, with the exception of Washington DC, a survey
has found.
"These are highly qualified people but the qualifications are different," said Jack Nichols,
manager of Flash Cab Company that operates 560 cabs.
"If they are doctors back in Pakistan, they are not necessarily licensed to be a doctor here. If
they are an accountant (in their native country), accounting practices here are different."
  
Many immigrants turn to taxi driving when faced with difficulty in getting their degrees
recognised in the US, and in some cases because of the language barrier, said Richard Kaye,
a labour economist with the Illinois Department of Employment Security.
Among them is Vijay Kalhon, who has a master's degree from Delhi University.
He drives a cab owned by an Indian American but plans eventually to get teacher
certification.
  
"No one comes in and says, 'I am going to do this permanently," said [Mohammed Khan,
another Indian American cab driver], "but the freedom of being by yourself catches hold of
you."
Nichols of Flash Cab agreed. "Everybody gets into this as a temporary thing and most end up
staying."

Osman Chowdhury,   Over 20 percent of Chicago cab drivers from South Asia  ,
NRIinternet.com

a) Explain what features of the labour markets in the two countries you would expect to
encourage highly qualified South Asians to migrate to the United States.
b) Explain why South Asians arriving in the US labour market would not typically be
initially remunerated for their skills similarly to native-born Americans but why this
effect might diminish over time.
c) Suppose you want to estimate the rate at which South Asian immigrants assimilate to
the US labour market. Assume you have a single year  s cross-sectional labour survey
with data on South Asian-born and American-born workers in the Chicago labour
market covering earnings, age, other characteristics and (in the case of immigrants)
years since arrival in the country. Explain how you could estimate the rate of
assimilation, problems you would face and assumptions which you would need to make.
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d) Suppose that you are now given access to several years of this survey. How would this
change what you would do and the assumptions which you would need to make?

B2. Family Hubs are at the heart of the new policy of the British government for the Early
Years, led by Rt Hon Dame Andrea Leadsom DBE MP. They are baby-centred services,
designed to give every baby the best start for life, by integrating within them a host of services
to help parents and children. The Family Hubs Network states   Family Hubs provide the
opportunity for an enhanced role for health visitors. Their placement at the heart of
communities would expand current, community-based service provision and facilitate a greater
degree of integration of services to maximise efficiency and coordination of professionals and
voluntary sector providers. Hubs can also coordinate services currently delivered through The
Family Nurse Partnership programme. This will ensure that every new parent will come
through the door providing early access to public and community-based services and networks
for all, including those who are typically harder to reach. Where Family Nurse Partnerships are
based in Hubs they can draw on skills beyond their health visitor competency for example from
Jobcentre Plus to help young parents with a job search.  
a) The Universal Health Visiting Programme have faced repeated challenges in the last few
years. Briefly discuss the nature and content of this programme and the challenges it has
faced.
b) The results of the RCT evaluation of the Family Nurse Partnership (Robling et al., 2016)
have clearly shown the lack of effectiveness of the programme in improving maternal and
child outcomes. Discuss.
c) Discuss the challenges in conducting cost-benefits analyses of early interventions, with
particular reference to the programmes in (a) and (b).

B3. Answer all questions:
a) What are the key components in an analysis of the revenue generated from an increase
in the top rate of income tax?
b) Considering the taxation of incomes below the top tax bracket, how does a Mirrlees
optimal tax analysis differ from the choice of revenue maximising top rate in part (a)?
c) Under what circumstances can an optimal marginal income tax rate be negative? Give
a practical example of the importance of an optimal negative marginal tax rate.

B4. This question discusses the causes of firm informality, focusing only on the extensive
margin of informality. Consider a model where:
? Entrepreneurs are characterised by their productivity   ; they observe    when
choosing to operate in the formal or informal sectors.
? Formal firms pay revenue and payroll taxes, ty and tw respectively; they also pay a
per-period fixed cost of operation, cf .
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? The production function F (k, ?) is the same in both sectors, increasing and
concave in ? and k (labour and capital respectively).
? Informal firms face a "cost of informality" that is increasing and convex in firm  s
output: p(y(  )).
? Wages and cost of capital are different across sectors.
Answer the following questions:
a) With the above set up in mind, write the profit functions in the formal and
informal sectors and characterise the decision to be formal.
b) Explain the intuition behind the different costs and benefits of formality/informality
that are captured in these profit functions.
c) Given this framework, discuss the potential policy interventions available to
policy makers.
d) Write the regression that one could use to estimate the effect of these different
policies on firm formalization. Discuss the potential problems to get at causal
estimates and how the literature has addressed these challenges.

PART C
Answer ONE question from this section.

C1. For this question, consider a bivariate SVAR in = ? ?, with three lags,
= 1?1 + 2?2 + 3?3 + ,
where are the structural shocks. Assume a   named shock   normalisation; that is, the first
shock is the monetary policy shock.
a) What parameter measures the contemporaneous impact (0-horizon IRF) of inflation to
a monetary policy shock?
b) Write out the formula for the impulse response of to the monetary policy shock at
the third horizon. Show your working and all terms explicitly.
c) Suppose an analyst suggested identifying the monetary policy shock in this model
using a recursive/Cholesky scheme. What restriction does this impose on the model?
Answer both mathematically and in words. What does this imply about how monetary
policy reacts to economic conditions?
d) This may seem like an unrealistic assumption, but why might it be a fair description
of how a central bank sets interest rates?
e) Suppose you intended to estimate the SVAR in the question using data from the
United States. Do you think the bivariate model is misspecified?
f) Describe an approach to identifying the monetary policy shock in a SVAR other than
recursive identification.

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C2. Imagine you work at the Congressional Budget Office, and you are asked to evaluate the
impact of raising the federal minimum wage to $15.
1) Suppose you have access to county level wage and employment data from the restaurant
sector from the last 30 years. Your supervisor suggests that you should analyse past state-level
minimum wages by exploiting a border discontinuity design. Can you explain how you would
implement this method?
2) How is this method related to the seminal paper of Card and Kruger (1994), which studies
the 1992 increase in Minimum Wages in New Jersey?
3) Besides documenting the impact of the policy, your boss also asked you to study the impact
of the policy before and after the policy change. Can you explain how to do that (write down
the regression equation estimating it)? What could we potentially learn from this exercise?
4) Your supervisor highlights that someone could also rely on state-level variation and estimate
the impact of the minimum using a standard TWFE estimation technique. Can you explain the
differences between this and the border discontinuity design?
5) Once you implement a proper literature review, you recognize that Dube, Lester, Reich
(2010) had implemented the TWFE and the border discontinuity approach examining state-
level variation in the minimum wages in the USA. Please explain their findings on employment
and wages. Which one leads to more credible estimates if you look at the before and after
changes in employment?

C3. Imagine a setting where a single student is taught by a single teacher. The human capital
of the student, h, is a function of M types of teacher effort, 1  : ? =    =1 + , where
1    are the productivity of each type of effort, and e is a shock which is mean zero and
independent of teacher effort. The teacher  s effort is costly, and the cost function is:
(1    ) =    12 ()2=1 .
a) Suppose there is a social planner with the following social welfare function, which
depends on student human capital and teacher effort: = (?) ? (1 ? )(1    ) where
is a constant, and (?) is the expected value of h. The social planner chooses 1   in order
to maximize . What are the optimum choices of 1  ? How do they depend on and
1    ? Discuss.
b) Suppose now the social planner cannot observe 1  , nor ?. Instead, the planner only
observes the performance of the student in exams: 1   . Assume that = + ,
= 1    , where 1    are constants, and 1    are mean zero random variables
independent of teacher effort. The planner can offer teachers compensation contracts of the
following form: = +    =1 , where X is total teacher compensation, s is a base salary,
and 1    are performance bonuses. The planner chooses s, 1    , to maximize welfare.
Teachers choose 1   in order to maximize their expected utility, which is equal to expected
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total compensation net of cost: () ? (1    ). In addition, their expected utility needs to
exceed the utility on their outside option, 0, otherwise they do not become teachers. Solve the
problem of the planner. What are the optimum choices of 1    ? How do they differ from
the answer in a)? Discuss.
c) Suppose now that the planner is further constrained in the compensation contracts she
can write, and is required to pay the same bonus for all tests: = , = 1   . How is this
different from paying a bonus based on the average test? What are the optimum choices of
1    in this case? How do they differ from the answers in a) and b)? What happens if =
, = 1   , and = , = 1   ? Discuss.
d) Go back to b), but consider now the more complex case where =    =1 + ,
= 1    , where 1    are constants, and 1    are mean zero random variables
independent of teacher effort. Describe how you would work out the answer to b) in this case
(you do not need to present the full solution to the problem). Discuss.