FINAL EXAM (Two Hours) DECEMBER 21, 2016 SECTION #

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1 COURSE MACROECONOMICS FINAL EXAM (Two Hours) DECEMBER 21, 2016 NAME TA Part I (20 points) SECTION # 1 POINT EACH QUESTION 1. China s GDP appears to be roughly 55% of U.S. GDP, if we use what currency conversion in comparing GDP levels? Market Exchange Rate 2. The U.S. unemployment rate has fallen sharply over the past 5 years, despite soft real GDP growth. What other statistic largely explains this phenomenon? Labor Force Participation Rate (LFPR) declining (LFPR GETS FULL CREDIT) 3. Name and write the equation that relates real interest rates to nominal interest rates. Fisher Equation: i = r + π (½ POINT FOR NAME, ½ POINT FOR EQUATION) 4. What slope does the corporate demand curve for loanable funds exhibit, and why does it have such a slope? Downward (negative) slope. Because firms are sensitive to borrowing price (interest rate), so higher interest rates imply less funds demanded (or vice versa) 5. What is the biggest difference between the mandates of the U.S. Federal Reserve and the ECB? Fed has dual mandate, keep inflation and unemployment low and stable, whereas ECB has single mandate, keep inflation low and stable. 1

2 6. Name two key drivers of labor productivity a. Capital deepening or more capital per worker b. Technological innovation or level of technology c. Education or training (ANY TWO OF THESE GETS FULL CREDIT) 7. Suppose you only had data on the U.S. unemployment rate, and someone asked you to venture an opinion on real GDP growth. Name and write down the formula you would use to answer the question. Okun s Law: % Y = LTSG 2 U 8. Describe the slope of the long run aggregate supply curve, in AD/AS space. Vertical slope (½ POINT FOR NAME, ½ POINT FOR EQUATION) 9. Milton Friedman advocated a monetary policy rule in the 1960s. What equation summarizes the rule and what key assumption must you make to depend upon this equation to conduct monetary policy? Quantity Equation (not necessary to specify name): M V = P Y or % M + % V = % P + % Y, (% P = π) The key assumption is that V is constant or % V = 0 2 (½ POINT FOR EQUATION, ½ POINT FOR ASSUMPTION) 10. Suppose U.S. unemployment leaps, and hits 10%. Suppose further that inflation falls to zero. What problem will a monetary policy maker have, if they traditionally depend upon the Taylor Rule to set policy? Be specific. Taylor Rule would set a negative nominal interest rate which can t be done. This is known as the zero lower bound. (½ POINT FOR NEGATIVE RATE, ½ FOR ZLB)

3 11. If both the real and nominal exchange rates between the US and Japan remain unchanged while Japan experiences 0.5% deflation, what, if anything, can we say about inflation in the US? There will also be a 0.5% deflation in the US (½ POINT FOR DEFLATION, ½ POINT FOR DEFLATION = 0.5%) 12. The yield on a 1-year GBP bond is 2%. A US investor believes the pound sterling will appreciate by 1% versus the dollar over the next year and that inflation in the US will be 1.5%. What does she expect her real return will be if she invests in the 1-year GBP bond? 2% + 1% 1.5% = 1.5% Yield + Pound Appreciation Inflation = Real Return 13. Name and write the equation relating unemployment to inflation. Phillips Curve: π t = π e + α(u U t ) (½ POINT FOR NAME, ½ POINT FOR EQUATION) 14. Which of the three types of unemployment cannot explain the fact that unemployment in France has been significantly higher than in the US for many decades? Cyclical unemployment 15. In Germany the government pays the entire cost of university education. True or False: This means in Germany a university education is a public good, while in the US it is not. False (education is rivalrous and excludable, even if it is not rivalrous within a classroom it is always excludable.) 3

4 16. Does Germany currently have a current account deficit or surplus? According to the EU s Macroeconomic Imbalances Procedure, is it too high, too low, or about right? A surplus, and according to Macroeconomic Imbalances Procedure it is too high. (½ FOR SURPLUS, ½ POINT FOR SURPLUS IS TOO HIGH, DEFICIT TOO HIGH EARNS ZERO CREDIT) 17. Economic Growth from 3 million years ago to the beginning of the industrial revolution in 1800 was approximately: a) %, b) 0.5%, c) 1% or d) 2.5%? 18. The U.S. Federal Reserve, at their meeting on 12/14/16, a. Left their fed funds rate target unchanged b. Raised their fed funds rate target by 25 basis points. c. Raised their fed funds rate target by 50 basis points. 19. In Value and Capital, Hicks gives two reasons why the interest rates on two loans created on the same day may differ. What are they? Duration of the loan and risk of default (½ POINT EACH) 20. Who was the leader of China from who is generally accredited for reforms that have allowed for rapid economic growth? Deng Xiaoping (or any near approximation) 4

5 Part II (22 points) Here is some data for the US at the beginning of 2017 (simplified for calculations). Debt/GDP ratio: 50% Nominal GDP: $20 trillion Expected government Deficit in 2017: $500 bn Average US government nominal borrowing rate: 2% Expected inflation: 3% Expected growth: 2% Show your workings a) What percentage of GDP will the US government expect to spend on interest payments in 2017? Debt = 20 tr 0.5 = 10 tr Interest payments = 10 tr 0.02 = 0.2 tr Interest Payments GDP = 0.2 tr 20 tr 20 tr = 100 = 1% 20 tr b) What is the Debt/GDP ratio expected to be at the beginning of 2018? (2 POINTS FORMULATION) (1 POINT FOR MATH) GDP Nominal 2018 = 20 tr 1.05 = 21 tr Debt 2018 = 10 tr tr = 10.5 tr = 10 tr 1.05 Debt 10.5 tr = GDP 21 tr 10 tr = 100 = 50% 20 tr 1.05 (2 POINTS FORMULATION) (1 POINT FOR MATH) Trump assumes office in January 2017 and dramatically changes expectations about government spending. His tax cuts and spending plans are estimated to increase the deficit by an additional $1.05 trillion per year. c) Assuming GDP growth does not change, what is the Debt/GDP ratio now expected to be at the beginning of 2018? New Debt 2018 = 10 tr tr = 11 tr 1.05 = tr Debt tr = GDP 21 tr 11 tr = 100 = 55% 20 tr 1.05 (2 POINTS FORMULATION) (1 POINT FOR MATH) 5

6 Trump s team of economists argue that this does not accurately represent the expected Debt/GDP ratio because it ignores the expected boom in GDP growth. They accept the budget deficit will grow by $1.05 trillion, but believe GDP growth will be 5% and inflation will remain at 3%. They calculate a forecast of the Debt/GDP ratio using dynamic scoring with these updated growth numbers. d) What is Trump s economists expected Debt/GDP ratio? A numeric formula will get full credit here. New GDP Nominal 2018 = 20 tr 1.08 = 21.6 tr New Debt 2018 = 11 tr 1.05 = tr Debt tr = GDP 21.6 tr 11 tr = 100 = 53.47% 20 tr 1.08 (2 POINTS) You are asked your opinion on whether you think the 5% growth rate estimated by Trump s economists is sustainable. Here are some facts about the economy as 2017 begins, coupled with your assumptions, on how the economy would work, without the Trump plan: labor force, january m unemployment rate, january % NAIRU estimate, January % labor force growth (w/o Trump plan) 1% labor productivity growth (w/o Trump plan) 1% Δ labor force participation rate zero e) What does NAIRU stand for? Non-Accelerating Inflation Rate of Unemployment (1 POINT) f) If Trump fails to get any of his plans enacted, what do your assumptions tell you about the long term sustainable pace for U.S. real GDP growth? Be specific. LTSG = LPG + LFG = 1% + 1% = 2% (1 POINT) g) Trump s Treasury Secretary, is confident his plan will be enacted, and is confident that it will lift the sustainable growth rate to 5%. What two inputs could grow faster than you expected, in reaction to the Trump plan? LPG (labor productivity growth) and LFG (labor force growth) (1 POINT EACH) 6

7 h) Suppose labor productivity, in reaction, to the Trump plan, accelerates to 3%. What else needs to accelerate, to allow the Trump plan to work? How might this happen? LFG needs to increase from 1% to 2% (LTSG = LPG + LFG 5% = 3% + LFG LFG = 2%) For this to happen: (1 POINT) The number of immigrants coming to the U.S. need to increase. Discouraged workers (not included in the labor force) start seeking work again (i.e. they will be included in the labor force again). (ANY OF THESE TWO EARNS 2 POINTS) i) Suppose the Trump plan is enacted, real GDP does accelerate to 5%/year, labor productivity accelerates to 2%/year, but nothing else changes. Roughly, what will the unemployment rate, be, one year later? Correct Answer: GDP grows 5%, Labor productivity grows 2% => employment grows 3% Labor force growth grows 1% => unemployment must go down 2% Therefore unemployment must be 5-2 = 3% Also accepted: LTSG = LPG + LFG LTSG = 2% + 1% = 3% Okun s law: % Y = LTSG 2 U 5% = 3% 2 U U = 1% U = U 2018 U 2017 = U % = 1% U 2018 = 4% (1 POINT FOR OKUN S LAW) (1 POINT FOR MATH) j) Again, if the Trump plan results in real GDP acceleration to 5%/year, labor productivity accelerates to 2%/year, but nothing else changes, do you conclude that this growth is sustainable? What do you think will happen if this growth continues for a few years? This growth rate is not sustainable since the economy will be growing at 5% while the LTSG (long-term sustainable growth) rate is 3%, thus the unemployment rate will continue decreasing. This will cause an increase in inflation (because of the Phillips curve). (1 POINT FOR NOT SUSTAINABLE) (1 POINT FOR HIGH INFLATION) 7

8 Part III (22 points) Japan has been suffering from slow growth and low inflation since Since he arrived on the job in 2013, the governor of the central bank, Haruhiko Kuroda, has been making a determined effort to increase inflation. Given that when he arrived the short term interest rate was already at zero, he has not been able to lower interest rates in the usual way. One thing he has tried is Quantitative Easing. a) Name one other way that Kuroda might be able to influence longer term rates. Forward Guidance (2) b) All these efforts mean that the long term Japanese government bond yield is now close to zero. However, corporate bond yields remain above zero. Why does Kuroda not care that much about government bond yields directly? The economy responds to the corporate rate, not the government rate OR The Government demand curve is inelastic (2) In order to lower the corporate interest rate, recently Kuroda announced that the Japanese central bank will buy corporate bonds directly. c) On the graph below label the axes of the corporate bond market. Here is some data on the Japanese corporate bond market before QE is implemented: Currently corporations borrow 8 trillion Yen at a 2% real interest rate. It is estimated that if the real corporate interest rate were actually 3%, then corporations would want to borrow only 4 trillion Yen, but households would want to lend 10 trillion Yen. It is also assumed that the supply and demand curve in the corporate bond market are straight lines. d) Add these lines to your graph. Label the axes and the supply and demand curves for the Japanese corporate bond market. 8

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11 Part IV (8 Points) For part II, use the following U.S. Bureau of Economic Analysis estimates, BILLIONS OF NOMINAL DOLLARS YEAR: U.S. EXPORTS $ $ U.S. IMPORTS $ $ U.S. OIL IMPORTS $ $80.00 U.S. IMPORTS (China) $ $ U.S. TRADE BALANCE Oil Price per bbl $100 $67 Import price index China Export price index The BEA data tells us that in 2013 the U.S. ran a trade deficit of a) $75 billion real b) $75 billion nominal c) $100 billion real d) $100 billion nominal $465 - $565 = - $100 billion nominal (option D) (1 POINT) 2. BEA estimates that in 2015 the U.S. bought $600 billion of foreign goods and services and sold $500 billion worth of goods and services. Which of the statements below is likely to be true, given this BLS data? (2 POINTS) a) The U.S. Federal Reserve also bought $100 billion of bonds, to balance accounts b) Foreigners bought a total of $100 billion of U.S. assets to balance accounts. c) The U.S. bought foreign assets. Foreigners bought U.S. assets. And foreign purchases of U.S. assets exceeded U.S. purchases of foreign assets by $100 billion. d) The BEA statistics are wrong. The total amount of goods and services purchases by the U.S. must equal the total goods and services purchased by foreigners. 3. By what percent did the volume of oil imports change? Volume = Nominal Imports/ Oil Price 2013: 120/100 = 1.2 BN 2015: 80/67 = BN (2 POINTS FOR Change = ( )/1.2 = -0.5 % NUMERIC FORMULA) 4. Did the change in real imports and real exports raise, lower, or leave unchanged, the level of real GDP? Explain briefly Export price index unchanged, Chinese imports prices unchanged, oil prices fall nominal trade deficit is the same ($100 bn), price index falls as oil prices fall real trade deficit rises and real GDP fall (2 POINTS FOR ANSWER, 1 POINT FOR EXPLANATION) 11

12 Part V (18 points) Euro Area Labor force growth 1% Labor productivity trend 1.5% Real GDP growth (4 th /4 th ) 2% Unemployment 8% NAIRU 6% Inflation 1.5% π* 2% r* 1% a) You are elected head of the European Central Bank and the members of Euro vote to switch the ECB to a dual mandate. Using the data above and the Taylor rule, what would you recommend as the target rate for the Euro area? ff = r + π (π π ) + (u u) = ( 0.5) + (6 8) = 0.25 % (1 POINT FOR FORMULA) (1 POINT FOR MATH) b) The finance ministers from each of Germany and Italy are not happy with your decision and come to speak to you. They each give you data on their country, but you mix it up. Which country is Germany and which is Italy? Country A (ITALY) Country B (GERMANY) Labor force growth 1% 1% Labor productivity trend 1% 2% Real GDP growth (4 th /4 th ) 1% 3% Unemployment 12% 4% NAIRU 8% 5% Inflation 1% 2% π*???? (2 POINTS) r* 0% 2% c) Which of the following do you think are the most likely values for π*? Country A Country B i) 1% 3% ii) 2% 2% iii) 3% 1% π* in both countries should be the same = 2 % (2 POINTS) 12

13 d) If country A had control of its own monetary policy, what would the Taylor rule say about the target interest rate? Is there a problem? ff = (1 2) + (8 12) = 3.5%, Zero Lower Bound Problem (2 POINTS FOR MATH, 1 POINT FOR ZLB) e) What would be considered a neutral target rate for Country A? Does the Taylor rule say monetary policy should be tight, neutral or easy? Neutral rate for country A should be r +π = (2 2) + (8 8) = 2 %. Taylor rule says monetary policy should be easy. (1 POINT FOR EACH PART) f) If country B had control of its own monetary policy, what would the Taylor rule say about the target interest rate? Is there a problem? ff = (2 2) + (5 4) = 5 % There is no zero lower bound problem here. U < U*, so raise rates. If they mention other problems, such as the fact that this is very different to the desired rate in Italy, that is fine. (2 POINTS FOR MATH) (1 POINT FOR ANSWER ABOUT PROBLEM) g) You refuse to listen to the advice of the Italian finance minister who ends up having a referendum and taking Italy out of the Euro area. Inflation in Italy compared to Germany following this change will be i) Higher ii) The same iii) Lower It will be higher because rates are cut (2 POINTS) h) Net exports in Italy will likely i) Increase ii) Stay the same iii) Decrease Rates are cut, so currency should depreciate and boost exports, make imports expensive, net exports should increase (2 POITNS) 13

14 Part VI (10 points) a) On June 23 rd 2016 the UK voted to do what? To leave the European Union or Brexit (2 points) b) Between June 23 and June 27 Sterling depreciated by 10% against the US dollar. By approximately how much do you think the price index moved in each country in these 4 days? UK CPI change US CPI change i) 0% 0% ii) 1% 1% iii) -1% 0% iv) 10% 0% v) -10% 10% 2 points c) Based on your answer to part b, how much did the real exchange rate move in these 4 days? 10% 2 points d) Again based on your answer to part b, how much did the PPP exchange rate move? 0% 2 points e) If the Bank of England were to follow a policy of a fixed nominal exchange rate between Sterling and the dollar, compared to now would the resulting real exchange rate likely be: i) More volatile ii) Less volatile iii) About as volatile 2 points 14