Exam Number Section MACROECONOMICS IN THE GLOBAL ECONOMY Professor Antonio Fatás Final Exam February 23, 2015 Instructions: (PLEASE READ) 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 clear, reasonable, and explicit. The logic you use in your answers is what matters (you do not need to get the facts right). There are 70 points in the exam. After each question you can find the maximum number of points for the question. In case of doubt on an exam question, participants will state their assumptions on the exam paper. Professors are not allowed to answer questions from the amphitheaters. Good luck! 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) The Real Exchange Rate for countries that are net exporters (exports are larger than imports) is likely to be lower than one. (5 points) FALSE. There is no connection between the real exchange rate being below one and net exports. Real exchange rates are lower for countries with low GDP per capita. b) A country that runs a current account surplus can have either a private capital inflow or a private capital outflow. (5 points) TRUE. Both are possible. A capital surplus means a pool of saving that can either result in a private capital outflow or an accumulation of foreign reserves. China has a current account surplus + a private capital inflow (so they accumulate high volume of reserves). c) The monetary base and the money supply always move in the same direction. (5 points) FALSE. They do NOT have to always move in the same direction. During the Great Depression the monetary base increased while the money supply collapsed because of the collapse in the money multiplier. 2. Monetary Policy in the UK. (Total: 10 Points). In the Financial Times, (February 12) Mark Carney the governor of the Bank of England talks about how recent data on inflation, lower than expected, is likely to push further the date when the first interest rate increase will happen. a) If this was news to the market, how do you expect the position and shape of the Yield Curve to change when Carney spoke? (5 points) This should lower the level of all interest rates so that the Yield Curve shifts downward across all maturities. Regarding the shape, not much to say except that given that shortterm interest rates are zero, it must be that the curve becomes less steep as long-term interest rates go down. 2
b) Imagine that the interpretation that the market is doing is different. They believe that deflation is not a problem, that the economy is growing at a healthy rate and that inflation will soon come back. When they hear Mark Carney speak they learn that the governor of the Bank of England is getting his analysis wrong. He is too worried about deflation when it is now time to worry about inflation. How would the yield curve react to the speech in this case? (5 points) In this case the market expects higher inflation so long-term interest rates will increase for sure. Very-short-term rates will not move (because Carney does not realize that he needs to raise rates). But other short-term rates (one to two years) might go up as the market believes that inflation is around the corner and Carney will have to change his mind and then raise interest rates very fast soon. So yield curve shifting up. Becoming steeper especially in the very-short to short-term rates. 3. Swiss National Bank, Nigerian Central Bank and Exchange Rate policy. (Total 15 Points). After having set a ceiling for the value of the Swiss Francs at about 0.83 Euros per Swiss Franc (or 1.20 Swiss Francs per Euro), recently the Swiss National Bank (SNB) abandoned this policy and let the Swiss Franc appreciate to about 0.95 Euros per Swiss Franc. In a recent article, Professors Eichengreen and Weder write: It is hard to explain what the SNB was thinking when it decided to change its policy. The sharp appreciation of the franc threatens to plunge the Swiss economy into deflation and recession. The risk of balance-sheet losses for the SNB, with its euro-heavy portfolio, may be greater now that the ECB has embarked on quantitative easing. But this is no justification for abandoning its mandate to pursue price and financial stability. a) What do they mean when they say that the risk of balance-sheet losses was high now because of its euro-heavy portfolio? Why was the SNB balance euroheavy? (5 points) For the SNB to defend its previous policy they had to buy Euros to avoid an appreciation of the Swiss Francs. For this reason their balance sheet was packed with Eurodenominated assets. The risk is that at some point, when they abandoned the policy, the Swiss Franc appreciated and the Euro assets lost value (as measured in Swiss Francs), therefore imposing losses on the SNB. 3
b) Why is the change of policy a threat towards deflation and recession? (5 points) The policy means that the SNB is not willing to follow the expansionary policies of the ECB and in that sense is a contractionary policy, as they stop increasing the money supply in Swiss Francs. Another way to think about it is that the appreciation of the currency will: - reduce exports and demand and GDP - reduce prices of imported goods therefore putting downward pressure on inflation (i.e. generating more deflation). c) A different central bank (Nigeria) is also struggling with the value of its exchange rate. From Reuters (January 30): Nigeria's foreign exchange reserves fell to $34.38 billion by Jan. 28, down 20.3 percent from $43.16 billion a year earlier, owing to drawdowns by the central bank to defend the local currency, the naira. The naira has remained under pressure, trading outside the central bank's target band of 160-176 to the dollar as oil prices plunge. How can you explain the difference in the behavior of foreign reserves and the balance sheet of the central bank of Nigeria (relative to the Swiss Central Bank), when both were defending their commitment to an exchange rate? (5 points) They both have a fixed exchange rate but they are fighting a market that is pointing in opposite directions. The SNB is trying to avoid an appreciation of the Franc. The Nigerian central bank is trying to avoid a depreciation of the Naira. To do that you need to sell your foreign reserves and buy your own currency (the opposite than the SNB). 4. Nominal and Real Exchange Rates in India. (Total: 10 Points). In the last 10 years the real exchange rate of India has appreciated by about 10%. At the same time the nominal exchange rate has changed from about 40 Indian Rupee per US dollar to about 62 Indian Rupee per US dollar. a) How can you explain the behavior of the real and nominal exchange rates? (5 Points) India is a country with low GDP per capita. We expect its real exchange rate to be low (its price level to be low). As it converges we expect the real exchange rate to appreciate. The nominal exchange rate could move in any direction and it all depends on inflation. If 4
inflation is high (as in India), this is already appreciating the real exchange rate in fact, it is appreciating it too much relative to equilibrium. As a result, the nominal exchange rate depreciates to ensure that the real exchange rate appreciates by the right amount. b) Can you give a scenario for the next 10 years in which the nominal exchange rate of the Indian Rupee appreciates relative to the US dollar? Be specific about your predictions for the evolution of the real exchange rate as well. (5 points) Continue convergence relative to advanced economies so that the real exchange rate needs to appreciate. But have the central bank in India bringing inflation down to the levels of the advanced economies (2-3%). In this scenario the nominal exchange rate has to appreciate. 5. Current Account and Exchange Rates. (Total 10 Points). From Reuters, January 31, 2015. South Africa's currency, the rand, was under pressure despite the news of a current account surplus. South Africa's rand weakened against the dollar on Friday, despite a larger than expected current account surplus for December. a) Provide a scenario under which a better-than-expected current account surplus leads to a depreciation of the currency. (5 points) The simplest is one where lower than expected demand (from consumption and investment) is reducing imports and creating a current account surplus. This can be seen as a shift to the left of the IS curve, lower interest rates, a capital outflow and a depreciation of the currency. b) In that scenario, what should the central bank do if they want to stop the depreciation of the currency? Would there be any negative effects of that policy? (5 points) In this scenario, to stop the depreciation of the currency the central bank needs to raise interest rates (shift the LM to the left). But this would reduce growth even further. There will be political pressures to avoid this (in fact the pressure will be to do the opposite and therefore force the currency to depreciate even further). 6. Fiscal Policy in the Euro area. (Total: 10 Points). The chart below from The Economist contains data on government debt (as % of GDP) as well as interest spending (as % of GDP) for 6 countries [Note: Interest spending refers to the value of interest paid on debt as a ratio to the GDP of that country]. 5
a) Given the information in the chart, and if you compare the following 4 countries: Greece, Portugal, Spain and Italy, which country is required to make a larger effort to keep their current debt-to-gdp ratio constant? Where by effort we mean the size of the primary surplus measured as a % of GDP that stabilizes debt around current levels. Important: Assume for your answer that the expected nominal growth of GDP for all these countries is identical and equal to 4%. (5 points) The size of the primary surplus required to keep the debt to GDP ratio constant is equal to (interest rate GDP growth rate) * Debt/GDP which can be rewritten as interest rate*debt/gdp GDP growth rate * Debt/GDP The first term in the expression above is the interest spending from the Figure above. The second terms is the GDP growth rate (assumed to be equal to 4% for all of them) * the Debt/GDP ratio (which is also in the Figure above). Greece is the country that clearly has to do the smallest effort going forward. Because they interest spending is lower than anyone else (first term is smaller) + their Debt/GDP ratio is the highest so the second term is larger but it comes with a negative sign. b) In what way is this effort (primary surplus) related to the level of debt (as % of GDP) for these four countries? (5 points) 6
Typically the effort is proportional to the Debt/GDP ratio if we assume that the difference (interest rate growth rate) is similar for all countries. But in this case, because Greece has a much better deal on interest rates than the other countries, their interest spending is lower (as opposed to higher!) and it turns out that the country with the highest debt has to make the smallest effort and also because of the second term that is inversely related to the level of Debt to GDP. **** Calculations are not needed in the answer, but just for clarity: Greece needs a primary surplus which is equal to (debt to GDP is about 175) 2.6 4*(175) = -4.4% Portugal (debt to GDP is about 125) 5.0 4*(125) = 0% Italy (debt to GDP ratio is about 125) 4.7 4*(125) = -0.3% So Greece can keep its debt to GDP ratio constant with a deficit (not even a surplus) while Portugal needs a balanced budget, similar to Italy. DO NOT WRITE BELOW THIS LINE 7