Period 3 MBA Program January February MACROECONOMICS IN THE GLOBAL ECONOMY Core Course. Professor Ilian Mihov

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1 Period 3 MBA Program January February 2008 MACROECONOMICS IN THE GLOBAL ECONOMY Core Course Professor SOLUTIONS Final Exam February 25, 2008 Time: 09:00 12:00 Note: These are only suggested solutions. You may have received partial or full credit for 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. For each question (except question 1) you can use a maximum of one side of one page in the answer book. You have 5 questions and you can use 6 single-sided pages in the book (for question 1 you can use two single-sided pages). If you make a mistake and you want to start on a new page, then cross out the whole page with the mistake. 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 75 points in the exam. After each question you can find the maximum number of points for the question. Good luck!

2 Page 2 1. True/false/uncertain. (Total: 20 points; 2 single-sided pages in the booklet). Explain whether each of the following statements is true, false, or could go either way depending on the circumstances. You can use graphs where appropriate to support your answers. Explanation determines grade. Start your answer by selecting one of the three statements True, False, or Uncertain and then justify your selection. a. In June 2005 the US Bureau of Labor Statistics announced that the US economy had created fewer jobs than expected. This announcement should lead to a drop in the stock market. (5 points) ANSWER: Uncertain. The effect of the employment report on the stock market is uncertain: On the one hand, the weaker employment report signals that monetary policy will be looser in the future (i.e. they will go down or they will not increase as fast as previously expected). This implies that the rate at which future dividends are discounted will go down, and therefore stock prices will increase. On the other hand, weak employment reports signal that the economy is not moving fast enough and it may imply that the economy is falling below potential. If this is the case, then firms on average move further away from profitability (potential supply) and therefore future dividends will be lower. This will depress stock prices. It is unclear which one of the two effects will dominate and therefore it is difficult to predict in general whether stock prices will increase or decrease. b. A country that grows to catch up to the technological frontier should expect to see an appreciation of its real exchange rate. (5 points) ANSWER: True. There is empirical evidence that shows that as countries grow their price levels converge to the price level in advanced economies (and this is the definition of the real exchange rate appreciation). Theoretically we can explain the convergence with the Balassa-Samuelson effect. As productivity in manufacturing increases, wages increase. With higher wages throughout the economy, prices in the non-tradable goods have to increase (to keep some margin between costs and revenues). This process of rising of non-tradable prices is the real exchange rate appreciation.

3 Page 3 c. In 2007 the Bank of Japan raised interest rates to 0.5%. This interest rates increase should appreciate the Yen. (5 points) ANSWER: Uncertain. Only surprises matter. An unexpected increase in the interest rate will appreciate the currency, but if the increase was already expected, then they might be no change as the markets would have already adjusted to this expected increase. d. Technological progress makes some work obsolete, hence unemployment in the aggregate economy should increase when the pace of technological progress accelerates. (5 points) ANSWER: FALSE. An increase in productivity, which is usually associated with technological progress is associated with higher wages, reduction in unemployment and increased employment. There are several possible ways to explain the statement: (1) It is possible that certain firms fire workers if productivity increases if the demand for their goods is fixed (to produce the same amount firms need fewer workers); but even in this case, higher productivity implies higher surplus in the aggregate economy, which translates in more demand for other goods. (2) Empirically we know that productivity has increased rapidly in the last 130 years and at the same time employment has increased and real wages have gone up; (3) In a cross-section of countries, the most productive countries are the ones with the highest wages; (4) theoretically even at industry level higher productivity usually leads to higher wages and more employment if demand is not fixed. Example: computer industry, which started with almost no employment 20 years ago and today there are millions of people working in this industry and their wages have increased.

4 2. The effect of China on the global economy. (Total: 10 points; 1 single-sided page in the booklet). For the past decade China has been growing at rates close to 10%. This growth was a result of investment and improvements in productivity, which allowed the country to become one of the leading exporters in the world. a. What is the effect of output growth in China on world savings and the world real interest rate? (5 points) Page 4 ANSWER: Increase in income in general leads to increase in total savings. As savings in China increase, world savings will rise as a result. The world interest rate will fall with higher savings. b. The size of Chinese economy is about 5% of world GDP at market exchange rates, which makes it one of the largest economies in the world. If productivity in China rises rapidly, what will happen to the world price level? In answering this question, state clearly your assumptions about world demand and world money supply. (5 points) ANSWER: Assuming that there is no change in world demand and world money supply, faster productivity growth will lead to falling prices (or falling inflation). There could be a picture like the one below. Depending on how much the IS curve and LM curves shift, we may see deflation (falling inflation), no change, or inflation (increasing inflation). Real interest rate Long-run aggregate supply 1. Increase in Productivity IS Equilibrium interest rate LM Y LR New Y LR Output

5 3. Inflation stabilization in Argentina. (Total: 15 points; 1 single-sided page in the booklet). In 1991 Argentina adopted a currency board arrangement in order to control inflation (through an arrangement called The Convertibility Plan). During the previous few years Argentina had experienced very high inflation, which at some point reached 10000%. While inflation was increasing in the years from 1987 to 1990, output was contracting with growth rates of between -2% and -7% per year. a. Why was the economy contracting in the years when there was inflation? (7 points) Page 5 ANSWER. Usually we see inflation increasing in periods of overheating, i.e. fast growth. In most cases, this is a result of a surprisingly low interest rates and unexpectedly high money supply growth. During hyperinflations it is difficult for the bank to surprise the public, as most people already anticipate not only high inflation, but also acceleration of inflation. With these expectations, everyone who receives local currency tries to buy something very quickly and thus prices increase much faster than money growth. But if inflation is higher than money growth, it means that the liquidity in the economy or real balances (M/P) decline. If liquidity shrinks quickly, then the real interest rate increases and the economy may go into a recession (This is the LM curve explanation of the recession in Argentina). There could be also an explanation based on confidence. In this case the argument is that in a period of high inflation, firms do not want to invest because high inflation is also variable inflation and hence planning production and calculating the future real rate of return is very difficult. b. Right after the introduction of the currency board in April 1991, the economy started growing at rates greater than 10% per year. At the same time inflation dropped immediately reaching virtually 0% in We have seen that the disinflation in the US in the early 1980s generated a sharp increase in unemployment and a recession. How is it possible that Argentina managed to achieve the reduction from inflation of over 10000% to 0% without any loss of output? (8 points). ANSWER. The key answer here is credibility. In order to reduce the rate of inflation, the central bank has to convince the public that in the future they will not print so much money. A currency board (or a fixed exchange rate in general) is a credible way of tying down the hands of the central bank.

6 Page 6 4. Eastern Europe. (Total: 15 points; 1 single-sided page in the booklet). On January 28, 2008 Financial Time published an article entitled: Eastern Europe to feel credit squeeze. The article describes how and why countries from Central and Eastern Europe might be affected by the financial turmoil in the US and Western Europe. The article also reports a striking set of facts all of the new EU members from the region have high inflation and large current account deficits, while at the same time growing at rates between 4% and 8% (with the exception of Hungary). The table below reports data on the current account and inflation for selected new members of the EU. Country Current account (%of GDP) CPI inflation (%) Bulgaria Czech republic Hungary Latvia Poland Romania a. Some of these countries have fixed exchange rate regimes. For example, in Latvia -- the country with the highest inflation rate -- the Bank of Latvia explicitly states that they have fixed their national currency (Lat) against the euro. Given that their hands are tied by the exchange rate and they cannot print money at their discretion, why do we observe such a high level of inflation in Latvia? (6 points) ANSWER: In fixed exchange rate regimes, capital flows (or current account surpluses) will determine money supply. As most of these countries have experienced a large increase in the inflows due to improved growth prospects after they joined the EU, the growth rate of money supply in these countries has increased very rapidly. As usual, high money supply growth has translated into inflation.

7 Page 7 b. The new EU members have to join the euro area at some point and eliminate their national currencies. One of the requirements for joining the euro area is that these countries have to maintain a stable exchange rate vis-à-vis the euro. It is wellknown that countries cannot run current account deficits forever, so there should be some adjustment at some point. But how will these countries balance their trade if they cannot devalue their currencies? In your answer make sure to discuss whether this current inflation rate holds back the adjustment of the current account, helps this adjustment or has no effect. (9 points) ANSWER: The starting point is that the current account is equal to saving minus investment. From here there are several possible explanations: (1) If the CA is driven by high investment, then at some point these countries will start producing more goods with there new productive capacity, this will generate more income and hence saving will increase. (2) The CA deficit is in part run because of decline in savings. The reason for this decline is because households have been selling their wealth (real estate) to foreigners and thus they have been consuming a lot (hence the CA deficit) out of their wealth. The adjustment will come at some point if capital inflows dry up and then saving will increase as consumption cannot be financed by running down wealth forever. (5 points for either one of the two explanations). The current high level of inflation are either hurting the adjustment as they make domestic goods more expensive abroad and foreign goods cheaper at home (contributing to the increase in the trade imbalance). It is possible to argue that the high inflation rates are due to the catching up hypothesis (question 1b above) and hence they are mostly in the non-tradable sector. In this case the inflation rate has no effect on the current account. One needs more data to determine which one of the two hypotheses is correct.

8 5. Financial turmoil in the US. Yield curve and monetary policy. (Total: 15 points; 1 single-sided page in the booklet). Page 8 Over the past few months official reports indicate that the rate of unemployment in the US is about 4.9% to 5% (which is close to most estimates of the natural rate of unemployment). At the same time we have seen sharp deterioration of financial markets conditions due to the sub-prime crisis and the implosion of the house price bubble. a. Since September 2007, the Fed has lowered interest rates by 225 basis points. How can you justify these actions in light of the information about unemployment and overall market conditions? (5 points) ANSWER: If unemployment is close to the natural rate, then it means that the economy is close to potential. If the economy is close to potential, then interest rates should not be changed. However, central banks are forward-looking and the decline in interest rates is a reaction not to the current state but to what may happen to the economy in the future. The Fed expects that the decline in house prices and the turmoil in financial markets will reduce consumer and business confidence and lower overall demand. Hence the Fed is acting preemptively to prevent a recession. Real interest rate 2 Long-run aggregate supply LM 1 r 1 r IS Y LR Output b. Between 2002 and 2007 the USD depreciated against the euro and other major currencies by about 40%. At the same time the US trade deficit increased from $423 billion to $758 billion. This is somewhat puzzling because we expect that when a currency depreciates, the trade deficit should shrink. In your view, why did the fall in the US dollar not lead to the expected improvement in the current account? (5 points) ANSWER: This is similar to Q4,b. The current account is saving minus investment. We know however that investment in the US did not increase a lot, so the current account deficit is due entirely to a fall in the saving rates. Savings had declined because of the house price bubble as consumers saw the prices of their houses rising, they increased borrowing and this increase in borrowing increased consumption. Hence the current account deficit. The exchange rate did move to reverse the current account deficit (dollar depreciation should lead to more US exports), but the wealth effect completely dominated the dynamics and prevented the current account from balancing.

9 Page 9 c. The current Fed funds rate is at 3%. Below is the yield curve for US government securities (February 19, 2008). What do you think markets expect about short term interest rates in the next 6 months? (5 points) ANSWER: Since the yields on bonds for up to 2-years are lower than the short term rate, this implies that markets expect lower short term interest rates in the future. In other words, the expectations are that the Fed will lower interest rates further.