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1 Exam Number Section MACROECONOMICS IN THE GLOBAL ECONOMY Core Course ANSWER KEY Final Exam March 1, 2010 Note: These are only suggested answers. You may have received partial or full credit for your answers that differ from ones suggested below as long as you have been able to rationalize your answer and as long as it is consistent with macroeconomic theory. Thus, the answers below are not exhaustive. Instructions: Space to answer the questions is limited. DO NOT WRITE IN THE BACK SIDE OF ANY PAGE (unless you have made a mistake in the space provided to answer the questions in that case you need to cross out the mistake and you are allowed to use the same amount of space in the back side of that page). You have three hours for the exam. The exam is open book. Make your assumptions and diagrams clear, reasonable, and explicit. If you are using graphs you must provide also an explanation and interpretation of the changes implied by your graphical presentation. Please read all questions before you start answering them! There are 70 points in the exam. After each question you can find the maximum number of points for the question. Good luck! Page 1

2 1. True/false/uncertain. (Total: 15 points). Explain whether each of the following statements is true, false, or could go either way depending on the circumstances. Explanation determines grade. Start your answer by selecting one of the three statements True, False, or Uncertain and then provide arguments to justify your selection. You can use graphs wherever appropriate to support your answers. a) As you might know, Greece is a member of the Euro area and as such it does not have its own currency. The Greek government is under pressure to improve its fiscal discipline as its large government debt has raised concerns about the possibility of default. Greece cannot devalue its currency anymore to get out of this situation, but here is an alternative: Greece could produce very high inflation, which is not technically default, but it will reduce the real value of its debt and will ease the pressure on the government to cut its spending or increase taxes. (5 points) FALSE Greece cannot create inflation, since it is a member of the euro area and is unable to conduct independent monetary policy. Inflation only helps, if it is instrumental in raising a country s revenues (tax) relative to the value of its debt. Future revenues are linked to future income of the country which cannot be raised in any way (unless Greece becomes more productive). The only way for Greece to create inflation would be to leave the euro area, and then employ expansionary monetary policy to inflate. b) Historically in developed economies stagflation has been associated with oil price shocks. If the central bank tightens monetary policy in the face of an oil price shock, then it is possible that stagflation will be only a stagnation or recession without a significant rise in inflation. (5 points) CORRECT/UNCERTAIN: Why CORRECT? Strict monetary policy can keep inflation under control as Germany showed in the 70s. [Remember the discussion we had in class: In 1973 and 1979 the price of oil grew by about 60% and put upward pressure on prices in countries that were dependent on oil as a source of energy. Although, all countries faced the same increase in the price of oil, inflation behaved very differently depending on the response of monetary policy. The differences in the response of monetary policy did not result in significant differences in GDP growth rates. Some of the countries that employed accommodative monetary policies had to deal with deeper recessions when inflation had to be brought back to normal levels (as in the case of the United Kingdom). Germany employed a more conservative monetary policy stance and was able to escape with a lower inflation (relative to the United Kingdom) and a smaller decline in GDP growth]. Page 2

3 Why UNCERTAIN? One can argue that the Central Bank s job is not easy if a sharp increase in the price of oil translates into a higher inflation rate in an oil dependent economy. One can also claim that a conservative monetary policy stance can lead to an unnecessarily deeper recession. c) On February 23, 2010, Bloomberg reported that the consumer confidence index in the US unexpectedly dropped from 56.5 to 46 (the consensus forecast predicted a decline to 55). This sharp decline in consumer confidence must have led to rallies both on the bond market and the stock market. (5 points) UNCERTAIN/CORRECT/FALSE (depending on the arguments). CORRECT for bond markets as interest rates are likely to be lower (because of lower real and expected inflation). Not clear for stocks depending on how the magnitude of this effect compares with the potential negative impact of a longer recession and lower dividends. More generally, lower interest rates imply lower discount rate, hence all future streams of payments will be more valuable. Given that for bonds these streams are fixed, bond prices will go up. For stocks there are additional effects lower confidence leads to lower sales and revenues, hence lower profits. This implies that future payments for stocks will go down. However, it is UNCERTAIN which way the overall effect will go 2. Yield Curve. (Total: 15 points). Below is a picture of the yield curve for the US economy (from February 23, 2010). The yield curve displays interest rates at different maturities (from 3 months to 30 years). a) Describe the likely evolution of the yield curve in the United States over the coming years. Be very clear about what type of economic scenario you have in mind to support your answer. (8 points) Many answers are possible, however, the important message is that short-term interest rates are likely to go up as the Fed starts tightening monetary policy in the coming months. However, the speed of the change is uncertain. Page 3

4 The long-term rates could remain stable but they could move up, if there is a sense that inflation is not under control (e.g. if the Fed does not raise rates faster and inflation expectations pick up). The long-term rates could go down if news about the economy signal a weaker recovery (suggesting a prolonged period of low rates and low inflation). b) Long- term interest rates have been low by historical standards during the past years. Can you think of a possible scenario where they can get even lower in the coming months/years? (7 points) The idea is that the yield curve represents market expectations of future short term rates. Possible answers: (1) the economy slips into a recession so lower interest rates for a longer period of time; (2) inflation expectations go down, or there is a possibility of deflation. Other optional answers may include: It is possible also to make arguments about liquidity and regulation, i.e. if pension funds are required to match their liabilities to the maturity of their assets, then the demand for year bonds may increase. If world saving increases further, then the whole yield curve may drop further. 3. Growth and Foreign Assets. (Total 10 points) The 4Is framework we saw in class stated that a country like China needs to reform its institutions (i.e. improve their quality) to be able to reach the level of income of the richest countries. In the case of China, there is something special though: China has been running current account surpluses for many years and, as a result, it has accumulated a large amount of foreign assets. China s net foreign asset position (foreign assets foreign liabilities) is about 2 trillion dollars and this represents more than 40% of its annual GDP (GDP is around 4.8 trillion USD measured at market exchange rates in 2009). Given the large size of its foreign asset position, could China use them to improve its growth prospects over the coming decades? Can they be an extra source of funds to invest in new technologies? Will they be able to buy themselves some extra time before they need to reform institutions in order to catch up with the income level of the richest countries? (When discussing the role of foreign assets you can either focus on the foreign reserves held at the central bank or on the broader notion of net foreign asset position which includes all foreign assets accumulated by the country minus all foreign liabilities). The main point here is that in the long-run growth is determined by the quality of institutions, productivity, capital accumulation and skills. The accumulation of assets and their subsequent spending may help in countries where there are financial constraints or where the government cannot issue bonds to finance its (possibly) productivity-enhancing projects. However, even in this case, the spending of assets can generate only a temporary boost to economic growth. There are many variations on this answer, however: 1. Foreign reserves mean assets that can be converted into either future consumption or investment, so this is good news for China. It can also be a good way to provide credibility in Page 4

5 terms of attracting foreign investment in the future (as it can be seen as an indication of less vulnerability to shocks). All these factors augur well for the growth prospects of China. 2. However, without good institutions in place, having large reserves alone is simply not enough. Note that the size of China s reserves is relatively small compared with the resources that it needs to foster growth in the coming decades. What they need is a much larger fraction of their GDP allocated for growth enhancing investment projects and institutional improvements to accelerate economic growth for the coming decades. 3. A subtle angle is the analysis of changes in the Central Bank s balance sheet and how these changes relate to the long-term dynamics of growth and public balances. Foreign reserves are only a part of the net foreign asset position and they sit on the balance sheet of the central bank. Whatever they do with the reserves, they have to figure out how to balance the balance sheet. For example, if the government wants to spend the reserves on consumption, they must give an asset to the central bank in exchange for the reserves. This could be a bond. However, if the government issues a bond, then this consumption is actually financed by a government bond, not by reserves. The problem arises from the fact that the central bank has already issued an asset (for the public) in exchange for the foreign reserves. 4. Fiscal Policy During Recessions. (Total: 15 points) One of the distinctive features of the current crisis was its global nature. The Euro area has suffered from this recession as much as many other advanced economies. All countries have adopted a combination of expansionary fiscal and monetary policies to try to fight the recession. a) What is the impact for the Euro economy of expansionary fiscal policy employed by the US government? Does the implementation such an expansionary policy by the US help the Euro- area recovery? In your answer, be very specific about the channels through which US policy can influence the Euro area and keep in mind that the Euro area has a flexible exchange rate regime. (5 points) The expansionary fiscal policy employed by the United States is expected to increase US output. This will increase imports from the Euro area so this is good news for the euro area. Some may refer to this as an increase in foreign output increases net exports (NX) and hence domestic output. There is also a second channel: the US is a large economy and it is quite likely that the world interest rates will rise (or not fall as much) in response to the expansionary fiscal policy in the US. Faced with higher interest rates, capital will flow to the US and this will lead to a depreciation of the euro, which will further help the exports of the euro area. So there are two channels through foreign output and through depreciation, which both help improve the euro area exports and its output. b) If many countries engage in expansionary fiscal policy at the same time, what is the likely effect on global interest rates? (5 points) Page 5

6 If many countries simultaneously employ expansionary fiscal policy, this means public saving will go down. Global interest rates are expected to go up as this represents a decrease in total world saving. c) Think about a small open economy with a fixed exchange rate that decides to balance the budget and not to implement expansionary fiscal policy to fight the recession. Based on your answer to b), how will the evolution of the global interest rates affect recovery in that country? What is the effect of expansionary fiscal policy in other countries for this small open economy beyond the effect through interest rates? (5 points) Again there are two channels: higher output abroad generates more NX, but higher interest rates lead to outflow of capital. The former effect implies an increase in domestic output. However, the outflow of capital reduces liquidity and slows down growth. The overall effect is unclear positive news from NX, but negative from outflows and higher rates. Output in this economy may either go up or down. 5. Monetary Policy in an Open Economy. (Total: 15 points). News from Reuters Feb 11, Mexico said it will offer a 10-year syndicated peso bond equivalent to at least $1 billion before the end of February and these local bonds could be included in Citigroup's World Government Bond Index (WGBI) during the first quarter. Inclusion in the index could draw more foreign investors into the domestic debt market. "The index is crucial because an impressive amount of capital flow will come from abroad and the final consequence of this is, clearly, the exchange rate will benefit," said Luis Flores, an economist at brokerage IXE in Mexico City. Analysts said last month's announcement that the central bank could move to accumulate dollars was designed to limit potential appreciation of the peso, which would make Mexico's exports less competitive during recovery from a deep slump. "There is appetite to enter the Mexican market, and this will help the exchange rate. This is why the central bank said it will start accumulating reserves, because this could generate important flows," said Rafael Camarena, an economist at Santander in Mexico City. a) How does the expectation of Mexico being able to issue syndicated bonds that are included in an index leads to a surge in capital inflows? (Hint: the fact that the bonds issued by the Mexican government will be included in the WGBI index helps providing credibility to the Mexican government, you can think about it as a reduction in the risk premium). (5 points Page 6

7 A decrease in the risk premium means that as long as interest rates do not change in Mexico (and there is no reason for them to change given that they are determined by the state of the economy), Mexico will be able to attract more capital from other countries. b) How do capital inflows affect the exchange rate? Remember that Mexico today has a flexible exchange rate system. (5 points) Capital inflows will tend to appreciate the currency as foreigners need to buy Peso and sell foreign currency in return. c) Why is the central bank accumulating dollars? How does it affect the money supply? Can these changes in the balance sheet of the central bank lead to any concerns for the Mexican economy going forward? (5 points) Because they do not want the Peso to appreciate excessively (they can use dollars to buy Pesos). It will increase the money supply. Yes, these changes can lead to concerns. They might lead to inflation, which might force the central bank to raise rates and end up with attracting more capital (unless investors start getting worried about a future depreciation). DO NOT WRITE BELOW THIS LINE Page 7