Exam Number Section MACROECONOMICS IN THE GLOBAL ECONOMY Core Course Professor Antonio Fatás Final Exam February 24, 2011 9:00-12:00 Instructions: (PLEASE READ) SUGGESTED ANSWERS 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
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. a) You are comparing data from two countries over the last ten years and you see that one of them has had a significantly higher nominal interest rate every year during that period. You should conclude that the risk premium in that country (the one with higher nominal interest rates) must be the only reason why nominal interest rates are high. (5 points) FALSE or UNCERTAIN. False because this is not the normal reason why nominal interest rates are different across countries. The main reason is that their inflation rates are different. And inflation rates are determined by central bank policies. You can say uncertain if you make the point that it is theoretically possible to think about two countries with the same inflation but different nominal interest rates because of country risk, but I cannot think of an example of this type. b) The rise in food prices across the world is the outcome of expansionary monetary policies in advanced economies (the US in particular). Large countries can export inflation to other countries if they have expansionary monetary policy. (5 points) FALSE or UNCERTAIN. False because domestic inflation is cause by domestic monetary policy. A country can decide to run more restrictive monetary policy than the US. This will lead to an appreciation of their currency and a lower inflation (so food prices in their currency will not be increasing that much). You can say uncertain if you talk about countries with fixed exchange rates to the US dollar. In that case you are obliged to follow US monetary policy. c) The ECB (European Central Bank) interest rate today is 1%, compared to the interest rate set by the US Federal Reserve, which is close to 0%. From this difference you learn that the ECB must be a tougher central bank when it comes to inflation (By tougher I mean that they raise interest rates by a larger amount when they see a threat of inflation.). (5 points) FALSE or UNCERTAIN. There are two potential reasons why the interest rate is higher in Europe. It is either because the economic climate is different (higher inflation or higher growth) or because the central bank is tougher. Strictly speaking it is not true that you learn that the ECB must be tougher because you cannot tell the two hypothesis apart. But if you explain clear that this is uncertain because both are possible, this is fine. Page 2
2. Growth. (Total: 10 points). Brazil has been growing fast over the last years and there are expectations that it will continue to grow fast. Below is a set of factors regarding the potential growth of Brazil. Comment on each of them giving your views on how each of these factors might affect the potential growth rate of the economy over the next two decades. The private consumption to GDP ratio in Brazil is relatively high (close to 65%). Some see this as a positive factor because it creates a large internal market for companies. At the same time, the share of investment in physical capital in GDP is less than 20%. Given this information, what is your forecast for GDP per capita growth? What are the other factors that are key to understand growth prospects in Brazil? (Justify your answer, the justification is more important than the actual forecast) For a country to grow it needs to invest. An investment rate of less than 20% is not high for Brazil. With that investment rate we expect a growth rate of about 2 or 2.5% in GDP per capita. To invest more Brazil needs to find more resources to fund the investment projects. It can fund those projects by saving more but this means consuming less, so in that sense the high consumption rate is not good news, it is bad news if it cannot go down. There is a second way to fund the investment without reducing consumption: by attracting foreign investment, which implies running a current account deficit or capital account surplus (Saving < Investment). This is fine temporarily. At some point Brazil will need to save some resources to pay back for the capital they borrowed from abroad. Regarding other factors: not only investment in physical capital is important but also investment in human capital and technology, innovation and knowledge. In addition, to ensure that investment happens we need to provide an institutional environment (legal system, absence of corruption and red tape) that favors investment. In class we saw that institutions are the main determinant of investment and growth. And in the case of Brazil we saw that there was the need for significant improvements in these institutions. 3. Interest rates. (Total: 15 points) During the last decade we have witnessed world real interest rates at levels that were very low by historical standards. a) Offer two explanations that could justify low real interest rates in the world during these years. (5 points) Real interes rates are determined by the intersection of saving and investment. Low real interest rates are the result of increased saving or decreased investment. We saw in class that there had been an increase in saving coming from China and also other emerging markets (such as oil producing countries). We also talked briefly about investment rates being weaker than in previous decades. Any explanation is fine as long as it is consistent with the savinginvestment equilibrium. Page 3
b) If real interest rates were so low, how can it be that we have not seen inflation increasing? (5 points) Low real interest rates were the result of the equilibrium of saving and investment rates. This has no effect on inflation. Inflation can arise if the central bank lowers short term interest rates and increases liquidity but this is not what we are seeing here. As long as central banks keep liquidity in line with money demand, inflation will remain under control. c) Many governments around the world have today a high level of debt. In the next years they will make an effort to reduce these levels of government debt. If they are successful (i.e. if they implement policies to actually reduce the level of government debt), how will this affect real interest rates in the world? (When answering just consider the effect of this change, do not take into account other possible changes that might be happening at the same time in the world economy). (5 points) To reduce government debt government will have to turn large deficits into surpluses or at least smaller deficits through increasing in taxes or decreases in government spending. This means an increase in government saving (or a decrease in government borrowing). This should send interest rates down. 4. Fiscal Policy. (Total: 15 points) During the last recession not all countries were affected in the same way. Think about Germany or Greece as countries that suffered a deep recession and about Australia as a country that managed to avoid a recession and had higher growth rates than Germany or Greece. Answer the three questions below using the following assumptions: First, answer as if these are the only three countries in the world, ignore other countries. Second, assume that there is perfect capital mobility. Third, consider Germany as a large economy that can affect the world interest rate (i.e. think about Germany as setting the world interest rate). a) What is the impact for Greece of expansionary fiscal policy employed by the German government during the recession? (Remember that Greece and Germany share a currency) (5 points) If we just talk about fiscal policy, expansionary fiscal policy in Germany will lead to higher interest rates. Higher interest rates could have a negative consequence on Greece unless the government of Greece implements the same type of policy. So as long as there is coordination in fiscal policy we are likely to see similar outcomes in both countries. But if only Germany moves there could be some contractionary effects on the Greek economy. There is also a direct positive effect that runs through exports: if Germany grows faster because of fiscal policy, it will buy more goods from other countries including Greece. Page 4
b) What is the impact on Australia of expansionary fiscal policy employed by the German government? What was the likely response of the exchange rate? (Remember that the exchange rate between the Australian Dollar and the Euro is floating) (5 points) Some effects are similar: faster growth in Germany will increase exports of Australia. The big difference is that in the case of Australia it is unlikely that the government will be using aggressive discretionary fiscal policy. This means that Germany will be pushing interest rates higher than in Australia. As a result there will be a capital flow towards Germany that will lead to an appreciation of the Euro relative to the Australian Dollar. This will increase exports in Australia and make the economy grow faster which might not be what the government or central bank want. c) Does your answer to b) change depending on whether the ECB (European Central Bank) implements expansionary monetary policy at the same time? In which way? (5 points) Yes, it does. If the ECB is running expansionary monetary policy then interest in Germany do not go up. In fact, they could even go down if monetary policy is very aggressive (as it has been). In this case the capital will flow in the opposite direction leading to an appreciation of the Australian dollar relative to the Euro. (this matches more what we have seen in the data). 5. Monetary Policy. (Total: 15 points). During the Fall of 2010, the US Federal Reserve announced new measures of monetary policy to stimulate the economy. These measures are known as the second round of Quantitative Easing QE2. The Fed has committed to buy about $600 Billion of long- term government bonds from commercial banks. a) Why do we call the purchase of government bonds monetary policy? Isn t this fiscal policy? How does it affect the money supply? (5 points) This is standard monetary policy. The purchase and sell of securities by central banks is what we call open market operations and it is the main way monetary policy is conducted in advanced economies. When the central bank buys government securities from commercial banks it pays them by crediting their accounts at the central bank (what we call reserves). This increases the liquidity of commercial banks it is also an increase in the monetary base (currency + reserves). The total money supply is equal to the monetary base times the money multiplier. An increase in the monetary base generally leads to an automatic increase in the money supply. However, we can have the case (as we have seen in the last two years) that the increase in the reserves does not lead to a significant increase in the money supply because the money multiplier is decreasing. And this is a sign that the commercial banks hold to that liquidity and they do not pass it to the private sector in the form of loans. Page 5
b) The Fed has justified the purchase of long- term government bonds (as opposed to simply increasing short- term lending to commercial banks) by arguing that given the current levels of short- term interest rates, the only thing they can do is make the yield curve flatter by bringing down long- term rates. Justify this logic. (5 points) Short-term nominal interest rates are zero they cannot go down anymore. One way to stimulate the economy is to influence long-term rates which are a reference for the loans that corporations get (they borrow long term not short term). You can also think about the central banks sending a message that the short term rates are going to be low for a long period of time (this is what low long-term rates indicate in the yield curve). In addition, providing liquidity at longer horizons is a commitment to keeping inflation higher than today (and closer to the target). c) Since they started this plan, nominal long- term interest rates have slightly increased. The Fed argues that this is not a sign of failure of their policy. Give two arguments why despite the fact that long- term nominal interest rates are increasing the Fed s action might still be helping the economy. (5 points) The central bank wants to keep real interest rates constant. What we might be witnessing is that inflation expectations are increasing and this is what nominal interest rates are higher. What matters to the Fed is the difference between the two. Even if nominal interest rates are higher, real interest rates might be decreasing. In addition, the central bank is trying to raise inflation expectation to avoid a deflation trap. If they are successful, this will at some point stimulate the economy. If the economy starts doing better then interest rates are likely to increase (both real and nominal). There is no failure here, this is the outcome that the Fed is looking for. You want to ensure that the economy does well and once it does, interest rates will increase and this will be a sign of strength. Page 6
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