Understanding the World Economy Final Exam Indicative answers

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1 Nicolas Coeurdacier Master Economics & Business Spring 2017 Understanding the World Economy Final Exam Indicative answers I. Multiple choice [50 points = 2 per question] It is a multiple choice questionnaire. You have to select at LEAST one answer from the four proposed answers. You have to select ALL the correct answers, AND ONLY the correct answers to get the maximum number of points. 1. An economy produces apples and oranges. In year 0, 2 apples and 2 oranges are produced and sold at the price of $2 per apple and $2 per orange. In year 1, 3 apples and 1 orange are produced and sold at the price of $2 per apple and $1 per orange. Thus: A) Using year 0 prices, real GDP has increased B) Using year 1 prices, real GDP has increased C) Nominal GDP has increased. D) The consumption price index has decreased. 2. The same economy now produces apples, oranges and invents the fruit salad (a fruit salad is made with mixing 1 apple and 1 orange, cut in small pieces). The apple producer sells 2 apples to final consumers and 2 to the Fruit salad company at the price of 1$. The orange producer sells 2 oranges to final consumers and 2 to the Fruit Salad company at the price of 1$. Hence, the Fruit salad company produces 2 fruit salads, sold at a price of 3$ to final consumers. A) the value added of the fruit salad company is equal to 2$ B) the overall (nominal) GDP of the economy is equal to 6$ C) the overall (nominal) GDP of the economy is equal to 10$ D) the overall (nominal) GDP of the economy is equal to 14$. 3. If a country runs a current account deficit, this means that A) aggregate savings exceed domestic investment B) aggregate savings are below domestic investment C) the government is running a primary deficit. D) the government is running a primary surplus. 4. The participation rate is defined as: A) B)!"#$%& C) '()*+ (), ", D) The total number of participants in the labour market 5. In the Solow Growth model: A) Economies which reach their steady state start to have negative growth B) Investment equals depreciation of capital in the steady state C) TFP (Total Factor Productivity) growth is always smaller than total output growth D) The steady state is mostly a function of the size of the country.

2 6. In the Solow growth model, the following factors contribute to a higher steady state level of output per worker A) a higher investment rate B) a higher consumption to GDP ratio C) a higher level of TFP (Total Factor Productivity) D) a higher rate of inflation 7. In the Solow Growth Model, without technological change, A) The output per worker of countries converge to a steady state due to decreasing returns to capital. B) The output per worker of countries keeps on growing if the population is growing C) A poorer country grows faster than a richer one if it shares the same steady-state. D) A poorer country grows faster than a richer one if it is converging towards a higher steady-state of output per worker in the long-term. 8. The Okun s Law is typically defined as the negative relationship between: A) The unemployment rate and the output per worker B) The unemployment rate and the participation rate C) The unemployment rate and the output gap D) The unemployment rate and the rate of inflation 9. In the long-run, an improvement in TFP (Total Factor Productivity) in a country: A) usually increases the real wage of workers B) usually increases the demand for labor C) usually increases employment if the labor supply is downward sloping with respect to the real wage D) usually increases the output per worker 10. A higher real wage rate will A) increase the opportunity cost of leisure B) increase the ability of workers to consume leisure C) always increase the number of hours worked D) increase the number of hours worked if the substitution effect dominates 11. The natural rate of unemployment can increase because: A) The minimum wage increases above the marginal productivity of some low skilled workers B) Competition in the product market increases C) Labour becomes more mobile within the country and workers have to compete with a larger population of unemployed D) Unions are very uncoordinated in their wage demands 12. The government of your country decides to increase the firing costs for firms. As a consequence, we should observe A) Less flows into unemployment B) More flows out of unemployment C) An increasing level of long-term unemployed D) That people are changing jobs less often.

3 13. According to the quantity theory, in the long run an increase in the money supply will A) increase the rate of inflation in the economy B) increase the level of GDP in the economy C) increase the amount of investment in the economy D) none of the above 14. Higher expected inflation is costly because: A) it transfers resources from lenders to borrowers B) it requires more frequent adjustments in costs and prices C) nominal interest rate is also higher which reduces investment D) nominal interest rate is lower which reduces incentives to save 15. The Laffer curve A) is a downward sloping curve: the higher the tax rate, the lower the tax revenues B) suggests that it is possible to decrease the tax rate and to increase tax revenues C) has an inverted U shape: a certain level of public spending maximizes the growth rate D) has a U shape: taxes must be low or high to generate significant tax revenues 16. Can a government run fiscal deficits without finding its debt running out of control (exploding with respect to GDP)? A) No, in no circumstances B) Yes, if the inflation rate is very low. C) Yes, if real GDP growth is higher than the real interest rate D) Yes, if the real interest rate is higher than real GDP growth 17. If a government lowers taxes on its wealthy residents, A) After-tax income inequalities within the country tend to fall. B) Fiscal revenues always falls. C) aggregate demand and output usually improves but less so than a tax cut on poorer residents. D) Private savings tend to increase if wealthy tax payers are forward-looking. 18. In the US data, A) Investment is more volatile than consumption. B) Government spending is very procyclical. C) Employment is very procyclical. D) Inflation is very countercyclical. 19. In the Aggregate demand-aggregate supply model, a rise in oil prices should lead to E) a fall in both output and prices. F) a fall in output and an increase in prices. G) an increase in output and a fall in prices. H) an increase in both output and prices. 20. In the Aggregate demand-aggregate supply model, an increase in government spending should lead to A) lower output and lower inflation. B) higher output and higher inflation. C) higher output and lower inflation. D) none of the above

4 21. Which of the following statements about inflation and monetary policy are true: A) In the long-run, there is always a tradeoff between the inflation rate and the unemployment rate B) A higher rate of inflation lowers unemployment when not expected. C) A higher expected inflation increases inflation. D) When unemployment is above its natural rate due to low aggregate demand, inflation tends to increase. 22. According to Purchasing Power Parity: A) we should observe a convergence of the output per worker across countries. B) the nominal exchange rate of country should be constant. C) countries with higher domestic inflation than the US should see a depreciation of their currency with respect to the US dollar. D) countries with lower nominal interest rates than the US should see a depreciation of their currency with respect to the US dollar. 23. Suppose that yearly nominal interest rates for Treasury bills in Bigland and in Smalland are equal. This can mean that: A) The currency of Smalland is expected to depreciate against the currency of Bigland in the following year. B) The currency of Smalland is expected to appreciate against the currency of Bigland in the following year. C) Expected inflation is the same in both countries and markets form their exchange rate expectations over a year based on purchasing power parity. D) Smalland has credibly fixed its exchange rate to the currency of Bigland. 24. What are the three components of the impossible trinity of Mundell that cannot hold together at the same time? A) Floating exchange rate, free capital movements and independent monetary policy B) Fixed exchange rate, constrained capital movements and independent fiscal policy C) Fixed exchange rate, free capital movements and independent monetary policy D) Floating exchange rate, constrained capital movements and independent fiscal policy 25. Suppose France has a negative shock to aggregate demand but the rest of the Eurozone does not: A) the ECB should raise interest rates to cushion the shock. B) the ECB should lower interest rates to cushion the shock. C) the shock would be partially cushioned by a higher rate of inflation in France. D) the shock would be partially cushioned by a depreciation of the euro. II. Short questions & essays [50 points] a. Debt sustainability in Southland [10 points --- (i)=3pts, (ii)=3pts, (iii)=4pts] Southland was facing the following fiscal situation in 2007: Public Debt-to-GDP ratio = 50%; Primary fiscal surplus over GDP = -1%; Real interest rate = 3%; Real growth rate of GDP = 1%.

5 (i) What is the size of the fiscal adjustment that Southland needs to implement to stabilize the debt to GDP ratio to 50%? r-g=2%. Fiscal surplus necessary to stabilize the debt over GDP = 2%*50%=1%. Currently, fiscal deficit = -1%. Southlands needs a 2% fiscal adjustment. As Southland did not adjust its fiscal stance over ten years, the debt to GDP ratio increased to 100% while the primary fiscal surplus fell to -2% of GDP in (ii) In 2017, what is the size of the fiscal adjustment needed to stabilize the debt over GDP to 100% --- assuming that the real interest rate and the real growth rate remained the same over the period ? Similary: r-g=2%. Fiscal surplus necessary to stabilize the debt over GDP = 100%*2%=2%. Needs a primary surplus of 2% and a 4% fiscal adjustment. iii) In 2017, as investors starts to anticipate a default in Southland, real interest rates increase to 10% while the real growth rate decreases to zero. What is now the size of the necessary fiscal adjustment to stabilize the debt to GDP ratio to 100%? Comment. r-g=10%. Fiscal surplus necessary to stabilize the debt over GDP = 10%*100%=10%. Needs a primary surplus of 10%! And a much higher fiscal adjustment of 12%. Very large effect of changes in r-g on the stability of public debt. The doubling of public debt and of the fiscal deficit over 10 years had a small effect on the necessary adjustment but movements in r-g have a huge effect in this example. Explain why some countries can be very quickly on an unsustainable fiscal path once risk of default materializes: as investors anticipate default and ask for higher rates, default becomes more likely as debt is quickly unsustainable (self-fulfilling outcome). b. Inflation and unemployment [15 points] In the post-world war II US data, depending on the time period or the horizon considered, the correlation between the inflation rate and the unemployment rate is negative, positive or roughly zero. Comment. [Hint: Describe the possible relationships between inflation and unemployment in theory] (please be concise, limit your answer to 350 words) Answers: see mostly lectures 6 and 8 (a bit lecture 5 for money neutrality). Phillips curve and movements along the curve due to shocks to aggregate demand: higher aggregate demand lowers unemployment and increases inflation: negative correlation between inflation and unemployment. Think of most recessions in developed countries since the 90s Shifts upwards of the Phillips curve due to negative aggregate supply shocks: negative supply shocks (rising oil prices for instance) increase inflation and reduce output, increasing unemployment. Negative supply shocks generate a positive correlation between inflation and unemployment. Think of oil shocks in the 70s. This is the conventional view of business cycles driven by demand or supply shock, keeping inflation expectations given. At longer horizon, the level of inflation change inflation expectations: no trade-off between inflation and unemployment in the long-run. The Phillips curve is vertical = zero correlation at longer horizons. c. Housing prices, household debt and consumption [25 points, Q1=10 pts, Q2= 15 pts] Panel A shows, across developed countries, the link between the % change in household leverage over the period (x-axis) and the change in housing prices over the same period (y-axis). Panel B shows for the same countries the link between the % change in household leverage over (xaxis) and the subsequent fall in consumption (in %) at the heart of the Great Recession (2008Q2-2009Q1) (y-axis).

6 1) How is the relationship between the % change in household leverage over the period and the change in housing prices (Panel A)? Explain this relationship. [10 points] (please be concise, limit your answer to 250 words) 2) How is the relationship between the % change in household leverage over the period and the subsequent decline in consumption (Panel B)? Explain this relationship. What are the implications for your understanding of the severity of the Great Recession across countries [15 points] (please be concise, limit your answer to 300 words) Panel A: Household leverage and the run-up in housing prices Panel B: Household leverage and subsequent decline in consumption Source: Glick and Lansing (2010), Federal Reserve San Francisco

7 1) Panel A positive relationship between the two variables. Causality runs both ways: higher housing prices triggers more borrowing through collateral channel: higher housing prices increase the value of collateral making it easier to borrow and increasing household leverage. As borrowing rises, demand for housing rises, which triggers higher housing prices. Circular mechanism on the boom illustrated below (left panel). Other potential channels: Financial innovation/deregulation. Financial innovation (think securitization) increases credit supply which triggers higher borrowing for mortgages (households previously excluded have better access to credit, at better rates). This in turn fuels housing prices. Low world interest rates (high world supply of savings = savings glut) also might have contributed to increasing household debt and increasing housing prices. (Too) optimistic expectations about future housing prices are self-fulfilling: higher expected prices lead to higher demand for housing (and higher leverage), validating ex-post the expectations (housing bubble). The collateral channel 2)Panel B: countries with higher increase of leverage on the booming period saw a sharper decline in aggregate consumption on the burst. [ This can be tied to the collateral channel playing on the burst when housing prices are falling. Falling collateral value reduces the ability to borrow for households, both for housing goods but also other consumption goods (mechanism illustrated above on the right panel). This falls in borrowing (deleveraging) reinforces the fall in housing prices and so on and so forth. Fall in consumption triggers by the deleveraging of households. Deleveraging can be further amplified due to the necessity of banks to deleverage, which reduces further the supply of credit on the burst (credit crunch). Alternative channel: wealth effect. Falling housing wealth triggers falling consumption as households consume partly out of their wealth. In the short/medium-run with rigid prices, the fall in aggregate consumption translates in to a fall in aggregate demand, generating a recession. The recession should been more severe in the countries experiencing a higher rise of leverage on the booming period --- even though this depends on the fiscal and monetary responses in these countries.