Social Analysis 10 May 2004 Final Part II: Essay Questions Answers Bluebook I: You’re In Control!! (28 minutes/56 points) 1. (7 minutes/14 points)

(a) (1 minute/2 points) In this problem, the positive cyclical unemployment indicates that actual GDP is

less than potential GDP. Thus the short run equilibrium of the economy must be to the left of the LRAS curve, as shown in the diagram below.

LRASP SRAS

(b) (1 minute/2 points) With no further government action, in the long run SRAS will shift to the right as

wages and input prices decline in response to the recessionary gap, and more and more firms are able to lower prices. Over the long run, Y will increase to the potential GDP or LRAS level. Unemployment will decline, and reach the natural rate. The price level will fall. This is illustrated in the diagram below:

Recessionary Gap

ESR PSR

YSR YLR Y

AD

LRASP SRAS0

(c) (3 minutes/6 points) Either expansionary fiscal or monetary policy could be used. Expansionary monetary policy could take three forms:

• Open market operations in which the Fed buys bonds, thus increasing reserves in the banking system, and expanding the money supply through the money multiplier process;

• Lowering reserve requirements, thus allowing banks to lend out more, which

increases the money supply;

• Lowering the discount rate—the rate at which banks borrow reserves from the Fed at the “discount window.” This, in theory, allows banks to borrow more in reserves, lend out more, and thus increases the money supply.

In all three cases, as the money supply increases, i decreases, and r decreases (if we

assume no change in inflationary expectations). As r declines, C, I and NX increase. Hence, AD increases, and the AD curve shifts to the right.

Expansionary fiscal policy would involve an increase in government spending (G)

or a decrease in taxes (T). Government spending directly increases AD, since G is a component of AD. Lower taxes mean higher disposable income, which stimulates consumption. Hence, AD increases.

Recessionary Gap

E0 P0

EFinal PFinal

YSR YLR Y

AD

SRASFinal

(d) (2 minutes/4 points) The advisor is wrong. Declining oil prices may affect the quantity produced by individual oil-supplying

firms, but that is not the issue here. With cheaper oil in the macroeconomy, a major input in production has become much less expensive.

When the price of oil declines, most every firm in the economy benefits from lower

input prices. Consequently, this is manifested in a rightward shift of SRAS—every level of aggregate supply is now associated with a lower price level. A rightward shift of SRAS would be a positive supply shock, causing increased Y and decreased P and unemployment. Thus it is inapplicable to the current situation.

If your advisor is (partially) correct that a shift of SRAS caused the current

recessionary gap, SRAS must have shifted left, reflecting a negative supply shock.

2. (7 minutes/14 points)

(a) (5 minutes/10 points)

Increases in the money supply decrease the real interest rate in the short run and cause increases in C, I, and NX. However, during the transition to the long run, money demand increases, causing i to increase back to its original level; and assuming no change in inflationary expectations, r increases back to its original level as well. Thus in the long run, monetary policy does not affect real macroeconomic variables such as Y, C, I, G, and NX. Only the price level, P, is affected. A one time permanent increase in G directly increases G, and in the short run, increases Y as well. In the long run, Y returns to its long-run, potential level. The increase in G is permanent so G is higher. The higher G comes at the expense of primarily lower I, because fiscal policy, unlike monetary policy, leads to a sustained increase in i and r. Thus I is crowded out. Similarly, NX is crowded out over the medium to long run. A higher r also crowds out some consumption spending as well, but since the interest elasticity of consumption is typically fairly low, this effect is not large. A decrease in taxes has no effect on G and no long run effect on Y. Lower taxes mean higher disposable income, which stimulates C; hence, C rises in the long run. As with an increase in G, lower taxes result in a rise in the price level, which results in turn in an increase in money demand. Hence, the money demand curve shifts to the right, raising the equilibrium interest rate. This crowds out some consumption (although not enough to negate the stimulatory effect of higher disposable income), investment and net exports.

The long-run effects of the various policies are summarized in the table below:

Action Effect on Y Effect on C Effect on I Effect on G Effect on NX

Any monetary policy action

None None None None None

Increased G None ↓ (a little) ↓ (a lot) ↑ (direct) ↓ Decreased T None ↑ ↓ None ↓

(b) (2 minutes/4 points) There is no meaningful distinction between the long run and the very long run when

it comes to monetary policy, since only the price level changes. However, there is a distinction between the long run and very long run when it

comes to the effects of fiscal policy. The difference lies in the effects of higher interest rates (see the answers to part a) on net exports, NX. In the long run, a higher r leads to an increased demand for dollar denominated assets, which, in turn, leads to an increased demand for dollars. The “price” of a dollar, which is just the nominal exchange rate, E, increases as a result. This increase in E results in an increase in the real exchange rate, e. The increase in e means that domestic goods are more expensive for foreigners to buy, so exports decline. Conversely, a higher e means that foreign goods are cheaper for domestic consumers; hence, imports rise. Since exports go down, and imports go up, NX must decline in the long run.

In the very long run, however, the situation is different. Research by Feldstein and

Horioka using data from very long periods of time demonstrated a close correlation between domestic saving and domestic investment. Turning to the loanable funds equation:

S(r) + (T – G) = I(r) + NCO

and recalling that the left-hand side represents “national saving,” a close correlation

between national saving and I over very long periods indicates that NCO ceases to be a factor at some point. That is, NCO must go to zero in the very long run. The explanation for this usually involves the concept of “home bias”—the propensity of investors to return their capital to their own countries eventually.

In any event, over very long periods of time, NCO, and therefore NX, is not

affected by fiscal policy.

3. (7 minutes/14 points)

(a) (3 minutes/6 points)

+6%

+4%

+2%

(b) (3 minutes/6 points)

i. (.5 minute/1 point) See the “star” above on the graph. ii. (2.5 minutes/5 points) Unemployment declined by 2 percentage points. Now we can correlate this

change in unemployment with a change in GDP using Okun’s Law. Okun’s Law states that whenever unemployment declines by 1 percentage point, potential GDP grew (approximately) 2.5 percentage points faster than actual GDP. Here a decline in unemployment of 2 percentage points would be associated with growth in actual GDP which is 5 percentage points more than the corresponding growth in actual GDP.

(c) (1 minute/2 points) The tradeoff this economy faces shows that when unemployment is 3%, the change

in inflation annually is 6 percentage points. By keeping unemployment at 3% for five years, inflation will increase by 6 percentage points for each of the next 5 years. Hence, the total change in inflation will be 5 years times 6%, or 30%.

3% Unemployment 6% NAIRU

8%5%

−4%

7%

0

−2%

4%

Change in Inflation

4. (7 minutes/14 points) (a) (1 minute/2 points) Stagflation is characterized by high inflation and high unemployment. Therefore,

the short-run aggregate supply curve meets the aggregate demand curve to the left of potential GDP. From the diagram, we can see that the price level is higher and output is lower than their potential levels.

Stagflation

LRASP SRAS1

(b) (1.5 minutes/3 points) On option for the Central Bank is to “accommodate” the supply shock through

expansionary monetary policy. This would shift the aggregate demand curve to the right and eliminate the recessionary gap. Unfortunately, the new price level would be even higher. Alternatively, the Central Bank could choose to fight inflation by conducting contractionary monetary policy. Thus would shift the aggregate demand curve to the left, bringing the price level down. But that would increase unemployment and decrease output even further, deepening the recession.

(c) (1.5 minutes/3 points) Selling bonds is an example of contractionary monetary policy. The aggregate

demand curve would shift to the left, decreasing output and the price level, as on the graph below. If the Central Bank undertakes sufficiently contractionary policy, the price level will decline from P1 to P0, but GDP will decrease from Y1 to Y2.

Recessionary Gap

ESR PSR P0 E0

YSR YLR Y

AD

SRAS0

LRASP SRAS1

(d) (3 minutes/6 points)

i. (1.5 minutes/3 points) As reserves are extracted from the banking system as people exchange their

money for bonds, the money supply will decrease. This shifts the money supply curve to the left, causing the nominal interest rate to increase.

M1S

i0

i

M

i1

M0 M1

MD

M0S

E2

AD1

E1 P1 P0 E0

Y2 Y1 YLR Y

AD0

SRAS0

ii. (1.5 minutes/3 points)

Nominal GDP is a determinant of money demand. We know that in GDP has

om

decreased in response to the Central Bank’s open market operation. This decrease in nominal GDP will shift the money demand curve to the left, frM0

D to M1D. The leftward shift in the money demand curve will exactly offset

the previous shift in the money supply curve. The nominal interest rate will return to its initial level.

M1D

M1S

i0

i

M

i1

M0 M1

M0D

M0S

Bluebook II: Need a Little Loan(able Funds)? (19.5 minutes/39 points) 1. (13.5 minutes/27 points)

(a) (1 minute/2 points) The loanable funds equation, in long run equilibrium, is:

S(r) + (T – G) = I(r) + NCO. S, or private savings, and (T – G) or public savings, comprise the supply of loanable

funds. Investment and net capital outflow (NCO) comprise the uses of, and thus the

demand for, loanable funds. (b) (4 minutes/8 points)

r Supply = S + (T – G)

r*

Qty. of Loanable Funds

Demand = I + NCO

The supply of loanable funds curve slopes upward because of the interest rate effect

on S, private savings. When r increases, the “price,” or opportunity cost of consuming now increases. This triggers competing income and substitution effects: as long as the substitution effect, which leads to more saving, outweighs the income effect, which leads to less saving (for consumers who are net savers; for net borrowers, the effects work in the same direction), savings will increase when the interest rate increases. Empirically, people do seem to save more as r increases; hence, the supply of loanable funds curve slopes up.

Because of the effect of r on the NPV of investment projects, firms are sensitive to r in determining when to invest. Higher r means fewer proposed projects have a positive NPV; hence, as r goes up, investment goes down. This contributes to a downward slope for the demand for loanable funds curve.

NCO is also a negative function of the interest rate. As the real interest rate in a

nation rises, capital flows into that nation as its assets become more attractive, relative to foreign assets. Hence, net capital inflow (or the capital account) increases, which means that net capital outflow (NCO) decreases. Thus, like I, NCO is a negative function of r, which is also consistent with a downward-sloping demand for loanable funds curve.

(c) (4 minutes/8 points)

i. (2 minutes/4 points) A permanent increase in government spending decreases public saving (T – G),

and shifts the supply of loanable funds curve to the left, as in the graph below. At every interest rate, there is a smaller quantity of loanable funds supplied. A higher equilibrium interest rate is necessary to bring the loanable funds market back into equilibrium; the equilibrium interest rate increases from r* to r**.

Supply1

r Supply0

r**

r*

Qty. of Loanable Funds

Demand

ii. (2 minutes/4 points) An investment tax credit for firms raises the quantity of investment, and hence

the demand for loanable funds, at every real interest rate. Thus the demand for loanable funds curve shifts to the right. A higher equilibrium interest rate is necessary to bring the loanable funds market back to equilibrium.

r Supply

r**

r*

Demand1

Qty. of Loanable Funds

Demand0

(d) (2.5 minutes/5 points)

i. (.5 minute/1 point) The capital account can be viewed as “net capital inflow”—capital coming into

a country from foreign savers minus capital leaving the country as domestic savers invest their money abroad. Hence, an influx of funds into Cashstrapped would increase Cashstrapped’s capital account.

ii. (2 minutes/4 points) It may seem somewhat counterintuitive, but the influx of foreign funds relates to

the demand curve, since this reflects net capital outflow (which is just the negative of net capital inflow). As funds flow in, net capital outflow (≈ NX, or the current account) declines; there is a smaller quantity of loanable funds demanded at each interest rate. This represents a leftward shift in the demand for loanable funds curve, as shown below:

r Supply

r*

r**

Demand0

Qty. of Loanable Funds

Demand1

(e) (2 minutes/4 points)

(i) (.5 minute/1 point) A continued inflow implies that Cashstrapped’s real interest rate is higher than

the rate in other countries. This is also consistent with the increase in Cashstrapped’s capital account, noted in part (d) (i), and a decrease in the country’s current account.

(ii) (.5 minute/1 point) As noted above, Cashstrapped’s current account, or NCO, will decline. (iii)(1 minute/2 points) Cashstrapped’s currency is likely to appreciate relative to other currencies.

Foreign investors want to buy Cashstrapped’s assets, so they need Cashstrapped’s currency. Hence, the demand on the foreign exchange market for the country’s currency increases. When the demand for any commodity increases, including a currency, its price increases. The price of a currency is just the nominal exchange rate, E.

Note also that the appreciation of Cashstrapped’s currency is consistent with the

decline in the country’s current account, or NCO, noted above.

2. (6 minutes/12 points)

(a) (2 minutes/4 points) Contractionary monetary policy carried out by the New Yorkland Central Bank will

increase nominal and real interest rates (holding expected inflation constant) in New Yorkland. An increase in New Yorkland interest rates will lead to capital flowing into New Yorkland and out of Bostonia. Since yank-denominated assets will become more attractive relative to sock-denominated assets, investors will demand more yank denominated assets, and hence demand more yanks to buy those assets. This will cause an appreciation of the yank, and a depreciation of the sock.

An appreciation of the yank means that the yank/sock nominal exchange rate will

decline—it will take fewer yanks to buy one sock, i.e., one sock is worth fewer yanks.

(b) (1 minute/2 points) An appreciation of the yank relative to the sock will lead to a fall in net export

demand for New Yorkland. Bostonia goods become more attractive to New Yorkland consumers as the purchasing power of the yank abroad increases (increasing imports), while New Yorkland goods become less attractive to Bostonia consumers (the purchasing power of the sock decreases). Therefore, the current account balance of New Yorkland, which represents international trade in goods and services, will decrease.

(c) (1 minute/2 points) A decrease in New Yorkland’s current account implies an increase in the current

account of its trading partner. Since the current account equals the negative of the capital account, an increase in Bostonia’s current account means a decrease in its capital account.

(d) (2 minutes/4 points)

Yes, the economist could be correct. Income abroad is a determinant of net exports. When New Yorkland’s GDP decreases, citizens of New Yorkland will have less money to spend on goods, including imports from Bostonia. Since net exports are a component of Bostonia’s aggregate demand, when GDP in New Yorkland decreases, aggregate demand in Bostonia is likely to decrease as well. In the short-run, this would be reflected in a leftward shift of Bostonia’s AD curve, resulting in lower short-run equilibrium GDP.

Bluebook III: Tales of Countries Far and Farther (32 minutes/64 points) 1. (6 minutes/12 points)

(a) (1.5 minutes/3 points)

i MS

i*

MD

M

The money supply curve in Discretia will be upward-sloping. An upward-sloping

supply curve means that as the nominal interest rate, i, increases, so does the stock of money, M. As i increases, the opportunity cost of holding excess reserves increases—the bank forgoes more in interest that it could have been making. Hence, it is likely to decrease its excess reserves by lending out some of them. This triggers the money multiplier effect, which results ultimately in a higher quantity of money.

(b) (1.5 minutes/3 points) Since banks in Fixedland always hold 2% in excess reserves, the amount of reserves

in the economy, and the quantity of money supplied, does not depend on the interest rate. Thus, the money supply curve is a vertical line.

MS

i

i*

M M

MD

(c) (3 minutes/6 points)

An expansionary OMO of equal magnitude will have a greater effect in Fixedland.

In the graph above, MD is the money demand curve common to both countries. We start the analysis with a common equilibrium at i*, where MD intersects M0

SF, the money supply curve for Fixedland, and M0

SD, the money supply curve for Discretia. An equal horizontal shift to the right in both curves, shown in the graph, results in a

smaller decline in the equilibrium interest rate in Discretia, from i* to iD, than in Fixedland, where the rate goes from i* to iF.

iF

iD

MD

M0SD

M1SF

i*

i

M M

M0SF

M1SD

minutes/24 points) 2. (12

(a) (2 minutes/4 points)

ase in taxes will shift AD to the left lowering output (Y) and prices (P). se the Money Demand curve to shift to

the left. Since the Money Supply curve does not move, the leftward shift in money s

∆Y ∆r Net Effect in the short run

The incre

The decrease in nominal GDP (PY) will cau

demand decreases the nominal interest rate and, assuming inflationary expectationremain unchanged, decreases the real interest rate. The decrease in the nominal interest rate is shown on the graph below:

(b) (4 minutes/8 points)

Consumption DOWN UP DOWN Investment DOWN UP DOWN Government NONE NONE Spending

NONE

Net Exports UP UP UP C, I, and NX are the only components of AE to be affected in the short run.

pending not change. The reduction in income caused by the tax crease will cause C and I to go down. The decrease in the interest rate, however,

asticity

Government s willinwill cause C and I to go UP. What will the net effect be? Since the income elof consumption and investment is high a small decrease in income will lead to a large decrease in both consumption and investment. Since the interest rate elasticityof consumption and investment is low, it would take a very large decrease in the interest rate to create such a large increase in consumption and investment. The

i**

M1D

M0D

i*

i

M M

MS

effects of a decrease in income will therefore outweigh the effects of an decrease in the interest rate, and the net effect on both consumption and investment will be todecrease. A decrease in income will cause NX to increase, since NX = Exports – Imports, ana decrease

d in income will lower imports. The decrease in the interest rate relative to

e foreign interest rate will reduce the demand for dollar denominated assets. This

(c)

In the long run, GDP will return to its potential level, so Y is unchanged. However, ve fallen, leading to a decrease in nominal GDP, PY. This, in

turn, will mean that money demand is permanently lower than at the initial long-run

consumption, since we know that C is more sensitive to changes in income than to

These effects are summarized below:

Net Effect of ng

run

thwill reduce the demand for dollars, reducing the nominal exchange rate. The reduction in the nominal exchange rate leads to a reduction in the real exchange rate, increasing exports and decreasing imports, causing NX to go up.

(3 minutes/6 points)

the price level will ha

equilibrium, which means that the interest rate is permanently lower.

Even though Y has returned to its long-run level, taxes are permanently higher, meaning that disposable income is permanently lower. This will reduce

changes in the interest rate.

So, the only changes in I and NX will come by virtue of the lower r.

lower r in the lo

Consumption DOWN Investment UP Government E Spending

NON

Net Exports UP (d) 6 points)

If the government had engaged in contractionary monetary policy, the only thing to n would be price levels. In the long run, monetary policy has

no impact on interest rates, and therefore no effect on the composition of Aggregate

(3 minutes/

change in the long ru

Expenditures. Contractionary monetary policy raises real interest rates in the short run, which causes AD to shift to the left, and prices and income to fall. Over the long run, SRAS shifts to the right, restoring long-run equilibrium at potential GDP, but at a lower price level.

vels they were at before the monetary policy was

conducted.

that ices.

3. 4

(a) (5 minutes/10 points)

All the probabilities have to sum up to 100%; hence 30% + 50% + x% = 100%, 20%, or .20.

Calculate value of consol with each interest rate:

Interest rate .10 .20 i

This decrease in prices will cause the Money Demand curve to shift left until interest rates return to the le

Monetary policy doesn’t change anything real in the long run – the only thingchanges is pr

(1 minutes/28 points)

which implies that x = Now, set up table to find i if the premium is 200.

Probability .30 .50 .20 Market value

100/0.1= 1000 100/0.2=500 100/i

of consolGain from call – 100/i

at $1000 0 0 1000

If th he ca s $200, then the expected gains from buying the call are

200. This means that:

i = 0.05, or 5%.

) min es/6 p

Pc = .5(100/0.02) + .5(100/0.25) = .5(5000) + .5(400) = 2500 + 200 = $2700

) (4 minutes/8 points)

Expected Value of put = .5(0) + .5(2000 – 400) = 800. profit, then, is $1000 – $800 = $200.

)

he price of an option varies directly with the volatility of the price of the more volatile future asset prices are the higher is the possible

from buying an option on that asset and correspondingly the higher is the premium on the option.

e Premium on t ll i

(0.2)(100/i – 1000) = 200, which implies that

(b (3 ut oints) (c The trader’s expected

(d (2 minutes/4 points)

Tunderlying asset. Thegain

This higher potential gain is due to the fact that volatility increases an option’s upside potential, without any increase in downside risk. The most an option bucan lose is the premium he

yer

or she paid for the option.

Bluebook IV: Back to the Future (18.5 minutes/37 points) 1. (4 minutes/8 points)

(a) (1 minute/2 points) According to the growth accounting formula: %∆ (Y/L)= % ∆A + α % ∆ (K/L) Using the information for China, where α=1/6 %∆ (Y/L) = .5 + (1/6) ×18 = 3.5 Hence, productivity growth in China is 3.5% (b) (3 minutes/6 points) Given population growth rates, and the fact that there has been no change in labor

force participation rates in either countries, it must be that labor force has grown at the same rate as population. Therefore, labor force has grown at 2% in China and 1% in the US.

Using this information, we can calculate the growth rate of the capital stock by

using the formula: %∆ (K/L) = %∆K - %∆L, where %∆K is the growth rate of the capital stock. Plugging in the numbers for the US and China into the formula: US: 3 = %∆K – 1, implies that %∆K = 4. China: 18 = %∆K – 2, implies that %∆K = 20.

2. (8.5 minutes/17 points) (a) (1 minute/2 points)

To compare living standards, we would look at per capita consumption. C/pop = (1-s) (Y/L) (L/pop) Since the only difference between the two countries is the consumption rate,

Partyland must now have a lower savings rate, s. This means that (1-s) is higher, which, at least for now, implies higher per capita consumption.

(b) (3 minutes/6 points) The higher consumption per person in Partyland today was facilitated by a lower

savings rate and therefore, reduced investment in capital stock. In Sayvland, on the other hand, a higher savings rate provides more funds for investment in capital stock.

The investment in capital stock affects the amount of capital available per unit labor

in the future and therefore, affects productivity. Productivity in turn, affects living standards by affecting C/pop.

With lower investment today, Partyland is likely to have lower productivity in the

future and therefore, lower living standards in comparison to Sayvland. (c) (1 minute/2 points) Using the Rule of 70, it will take approximately 70/2 = 35 years for Badland to

double its per capita GDP. (d) (3.5 minutes/7 points) First, note that Growland’s GDP is double that of Badland’s, but is only growing at

half the rate of Badland.

Applying rule of 70, Growland will double per capita GDP in 70/1 = 70 years. Therefore, in 70 years, Growland’s per capita GDP will be $4000.

In part (c) above, we calculated that it will take Badland 70/2 = 35 years to double

its per capita GDP to $2000. Assuming the same rate of growth, it will take another 35 years to double its per capita GDP to $4000.

Therefore, in 70 years, Badland will be able to catch up to Growland at a per capita

GDP of $4000

3. (6 minutes/12 points)

(a) (3 minutes/6 points) 1. Poorer countries are likely to have less capital per person (lower K/L ratios).

Given diminishing marginal productivity of capital, this means that the lower K/L ratio is associated with higher returns to capital. High returns to capital encourage domestic savings and attract foreign investment. The higher investment rates will cause the country to grow faster. Further, for any given level of investment, higher marginal productivity of capital means faster output growth.

2. Poor countries are able to ‘free ride’ off the technology of richer countries. They

are able to adopt technology that has already been developed, rather than engage in

the time consuming process of developing their own technology. This enables them to achieve a faster rate of TFP growth and therefore, output growth.

(b) (3 minutes/6 points) One of the factors that leads us to expect convergence is that capital will flow freely

to poorer countries that offer higher rates of return on investment, due to scarcity of capital.

Home bias refers to the fact that most of the saving done in a country will remain

within a country (i.e. invested domestically) over the very long run. The increasing prevalence of home bias would suggest that capital flows from richer countries to poorer countries would be reduced. This would reduce investment rates and in turn, growth rates in poor countries.

Therefore, increasing prevalence of home bias will reduce the rate of convergence

and poor countries will take longer to catch up to richer countries.

Bluebook V: Almost Home Free (22 minutes/44 points) 1. (3 minutes/6 points) The Fed focused on nominal interest rates rather than real interest rates, not recognizing

that an increase in nominal interest rates will actually decrease real interest rates if the increase in nominal rates is less than inflation. The Fed raised short term interest rates as inflation rose, but the nominal interest rate rose less than inflation, which caused the real interest rate to fall. The fall in the real interest rate stimulated demand, thereby increasing inflation. Since i = r + expected inflation, if the nominal interest rate increases by less than inflation, real interest rates must fall for the equation to hold.

2. (4 minutes/8 points) Professor Feldstein said that in the short run controlling the money supply is not a

reliable tool because: 1) It is difficult for the Federal Reserve to control money supply in the short run. This

is because the reserve requirement applies only to a very narrow part of the money supply, namely checking deposits.

2) Velocity varies substantially in the short run. Although one of the assumptions of

the quantity theory of money put forth in section is that velocity is constant in the long run (or at least that it is determined by things other than the money supply), remember that this is an assumption about the long run, not the short run. When the Fed conducts monetary policy, they are trying to manage demand in the short run.

3. (2 minutes/4 points) Because a current account deficit in some countries (countries who are net borrowers)

should be exactly offset by current account surpluses in other countries (countries who are net lenders).

4. (3 minutes/6 points) Professor Feldstein said that budget deficits are bad because: 1) Budget deficits crowd out private investment. The funds that the government has

borrowed to finance the deficit are no longer available for private investment. In the long run, deficits lower growth by reducing private investment.

2) The national debt eventually has to be repaid, or interest has to be paid permanently on that national debt. In order for the government to pay the interest and principle they must collect more in taxes. So, the deficit means that future taxes will have to be higher.

The higher future taxes mean additional deadweight loss, which Professor Feldstein talked about earlier in the lecture.

3) They cause current account deficits. We know that in the very long run, countries cannot run current account deficits. So, at some point the current account will have to move towards balance, and the transition period could be very difficult. This goes very much to the lecture by Rogoff on the dollar.

5. (3 minutes/6 points) Currency depreciations decreased trade imbalances because a depreciated currency will

reduce imports and increase exports. There are four reasons why this may no longer be as effective as the textbooks might indicate.

1) In an increasingly integrated global economy companies’ pricing power has been

eroded around the world. Low inflation has made price increases more obvious, so it is harder for firms to pass on cost increases of any sort, whether rising input prices or higher wages. Thus, it will be harder for a European car company to raise its prices in the US in response to a stronger Euro.

2) Foreign firms may hold prices and accept lower margins, especially if they think the

currency will weaken again or if they are determined to maintain market share 3) Manufacturing operations that are spread across countries make it easier for firms to

match their dollar sales with dollar costs, reducing the effects of currency movements. 4) There is often a long delay, perhaps of more than a year, before consumers and

producers adjust to changes in prices. 6. (3 minutes/6 points) The vulnerability of Asia’s financial systems had much to do with “domestic defects.”

Banks throughout the region had mountains of bad debt, which official figures grossly underestimated or hid. Lax supervision, weak management, woefully poor control of risk, and a habit of lending to connected firms or at government behest were chiefly to blame.

These defects persisted for so long mainly because the financial system was shielded

from outside competition. Entry of foreign-owned banks was restricted. The competition provided from these foreign banks would presumably have exposed Asia’s problems by bringing down costs and importing better standards.

7. (4 minutes/8 points) Market forces can defuse a worrisome buildup in a nation’s current account deficit

through adjustments in: 1) product prices 2) equity prices 3) interest rates

4) exchange rates