Download Understanding the World Economy Final Exam – Indicative answers

Nicolas Coeurdacier
Master Economics & Business – Spring 2015
Understanding the World Economy
Final Exam – Indicative answers
I. Multiple choice [50 points = 2 per question]
It is a multiple choice questionnaire. You have to select at LEAST one answer from the four proposed answers.
You have to select ALL the correct answers, AND ONLY the correct answers to get the maximum number of
points.
1. An economy produces pineapples and mangoes. In year 0, 2 pineapples and 5 mangoes are produced
and sold at the price of $1 per mango and $1 per pineapple. In year 1, 5 mangoes and 2 pineapples are
produced and sold at the price of $2 per mango and $1 per pineapple. Thus:
A) Nominal GDP has risen from $7 to $12.
B) The economy had inflation between year 0 and year 1.
C) The price index has decreased.
D) Real GDP is unaffected.
2. If Gross Domestic Product (GDP) exceeds Gross National Income (GNI), we know with certainty
that …
A) a trade deficit exists
B) production in the country relies a lot on immigration.
C) receipts of factor income from the rest of the world exceed payments of factor income to the
rest of the world.
D) receipts of factor income from the rest of the world are less than payments of factor
income to the rest of the world.
3. In the neoclassical (Solow) growth model, …
A) rich economies grow quicker if they are close to their steady state.
B) rich economies grow quicker if they are far from their steady state.
C) rich economies do not grow.
D) rich economies grow as long as investment is larger than depreciation.
4. in the neoclassical (Solow) growth model, an increase in TFP should lead to…
A) an increase in the stock of capital.
B) an increase in real wages.
C) an increase in output.
D) an increase in inflation.
5. The labour supply is upward sloping when:
A) the substitution effect of a higher wage dominates the income effect.
B) the income effect of a higher wage dominates the substitution effect.
C) people are willing to work more when wages are higher.
D) there are lot of immigration workers in the economy.
6. The natural rate of unemployment can be positive because
A) in recession, people lose their jobs.
B) old above 65 and young under 15 people do not work.
C) there are always some people looking for a job and firms looking for new hires.
D) wage rigidities such as the minimum wage prevent the labour market from clearing.
7. In Smalland, firms set prices (P) at a mark-up of 10% over costs. Costs are all in the form of wages
(W) so that P = (1.1) W.
Labour unions enter into bargains with firms on wages. The higher is unemployment the less powerful
are unions and the lower is the real wage they can achieve in negotiations. The real wage that gets
negotiated is: W/P = 1 - 2u, where u is the fraction of the workforce unemployed.
Then, the natural rate of unemployment in Smalland is approximately:
A) 4.5%
B) 9%
C) 10%
D) 14.5%
8. In Bigland, on average 2% of the employed people lose their job each month and the probability
that an unemployed finds a job within a month is 30%. According to the job flow model, the steadystate unemployment rate in Bigland is:
A) 2.00%
B) 6.25%
C) 6.67%
D) 30%
9. Seigniorage is…
A) the fact that fiscal policy is under the control of the government.
B) the revenues that the government obtains from printing money.
C) always increasing with the rate of growth of the money supply.
D) equal to the inflation tax when inflation equals the rate of growth of the money supply.
10. A necessary condition for hyperinflations to stop is that:
A) inflation reaches 100% per month. Above that, no one pays attention to prices.
B) the central bank stops printing money.
C) the government stabilizes the budget.
D) a new currency is introduced.
11. Which of the following statements are true:
A) Countries with high growth rate are likely to see their debt to GDP ratio increasing very fast as
the economy overheats
B) A country for which the real interest rate is equal to the growth rate of GDP can
stabilize its debt to GDP ratio by keeping the primary fiscal deficit equal to zero.
C) Debt sustainability is independent of the growth rate of the economy.
D) A higher real interest rate makes it more difficult for a country to have a sustainable
level of debt.
12. According to the quantity theory of money:
A) when the money supply increases, velocity falls in the long run.
B) when the money supply increases, output increases in the long run.
C) when the money supply increases, the price level increases in the long run.
D) everything else equal, the rate of inflation is equal to the rate of money growth.
13. If a society experiences deflationary pressures,
A) the real interest rate increases.
B) the real interest rate is unaffected.
C) the real interest rate decreases.
D) the real interest rate turns negative.
14. If a government increase taxes on his residents, …
A) the fiscal deficit usually increases.
B) the current account deficit usually worsens.
C) aggregate demand and output usually falls.
D) private savings usually fall but aggregate savings usually still increase.
15. Suppose Spain and Portugal have a negative shock to aggregate demand but the rest of the
Eurozone does not: …
A) the ECB should raise interest rates to cushion the shock.
B) the shock would be partially cushioned because of low fiscal transfers in the euro area.
C) the shock would be partially cushioned by a depreciation of the euro.
D) the recession would be harsher if prices and wages are very rigid in Spain and Portugal.
16. In the ‘Aggregate Demand-Aggregate Supply’ model…
A) An increase in the supply of money leads to both increase in prices and output in the
short-run.
B) An increase in the supply of money leads to both increase in prices and output in the long-run.
C) An increase in the supply of money leads to both increase in prices and nominal wages
in the long-run.
D) An increase in government spending leads to both an increase in prices and output in
the short-run.
17. In the ‘Aggregate demand-Aggregate supply’ model, an increase in oil prices leads to (in the short
run)
A) a fall in both output and prices.
B) a fall in output and an increase in prices.
C) an increase in output and a fall in prices.
D) an increase in both output and prices.
18. Which of the following statements about monetary policy are true:
A) In the short-run, an increase in the rate of growth of money can be used to increase inflation
and reduce aggregate demand.
B) In the short-run, an increase in the policy rate can be used to lower inflation and
aggregate demand.
C) Monetary policy can be reasonably well approximated by a Taylor rule in the US over
the last 30 years.
D) Stabilizing inflation simply requires increasing the policy rate when inflation is above targeted
inflation.
19. Through quantitative easing, the Federal Reserve…
A) has limited the amount of credit in the US economy.
B) has expanded its own balance-sheet.
C) has lent directly to firms and financial institutions.
D) has lowered inflation in the US economy.
20. According to Purchasing Power Parity:
A) the rate of change in the nominal exchange rate equals the inflation differential
between two countries.
B) the nominal exchange rate is constant.
C) countries with low domestic inflation have a high rate of depreciation of their currency.
D) countries with identical nominal interest rates should have a stable nominal exchange rate
21. Big Mac Prices and (spot) nominal exchange rates with respect to the US dollar and GDP per
capita in USD (in 2007) are presented in the table below for 4 countries (source: The Economist). We
focus on Purchasing Power Parity (PPP) based on Big Mac prices.
Country
Big Mac Price in local Spot nominal exchange rate
currency
(mid-quotes) with respect to
the USD.
(Foreign currency units/USD)
USA
3.22 USD
United Kingdom 1.99 GBP
0.51
South Korea
2900 KRW
942
China
11 CHY
7.77
Nominal GDP per
capita in USD
(2007, source IMF)
45,845
34,312
19,751
2,461
In 2007,
A) According to PPP, the Korean Won is overvalued with respect to the US dollar.
B) According to PPP, the British Pound is overvalued with respect to the US dollar.
C) PPP would be verified if a Big Mac in China would cost approximately 25 Yuans.
D) PPP almost holds between China and Korea.
22. According to the data of the previous table,
A) Big Macs are cheaper in China mainly because tomatoes and onions are cheaper in China.
B) Big Macs are more expensive in richer countries such as UK and US mainly because in
rich countries workers are more productive in other sectors, such as manufacturing.
C) Big Mac are cheaper in China mainly because workers in Big Mac restaurants are more
productive in in China than in richer countries.
D) Big Macs are cheaper in China mainly because wages are lower in China.
23. Suppose that yearly nominal interest rates for Treasury bills in the UK and in Germany are 3% and
1% respectively. This could mean that:
A) The Pound is expected to depreciate by 2% against the euro in the following year.
B) The Pound is expected to appreciate by 2% against the euro in the following year.
C) Inflation in Germany is 2% higher than in the UK.
D) There is a higher perceived risk of default on UK treasuries.
24. An appreciation of the US real exchange rate …
A) necessarily means that the US has a higher inflation than the rest of the world
B) necessarily corresponds to an appreciation of the nominal US dollar exchange rate.
C) indicates a loss of competitiveness of US produced goods vis-à-vis the rest of the world.
D) should lead to an increase of the trade deficit of the US, at least in the medium run.
25. Countries’ governments have incentives to reimburse their sovereign debt
A) when debt and interest rates are high.
B) because otherwise the country can get excluded from international financial markets.
C) because foreign creditors can make large losses when the government defaults.
D) because domestic residents and national banks can make large losses when the
government defaults.
II. Short questions & essays [50 points]
a. Debt sustainability in the Union of the South [5 points = 2.5 per question]
The Union of the South was facing the following fiscal situation 5 years ago:
Public Debt-to-GDP ratio = 100%; Primary fiscal surplus over GDP = -1%;
Real interest rate = 3%; Real growth rate = 1%.
i) What is the size of the fiscal adjustment necessary in the Union of the South to stabilize the debt to
GDP ratio to 100%?
r-g=2%. Fiscal surplus necessary to stabilize the debt over GDP = 2%*100%=2%. Currently, fiscal
deficit = -1%. Union of the South needs a 3% fiscal adjustment.
Due to a slow adjustment of the fiscal stance in the Union of the South over the last five years, the
debt to GDP ratio increased to 150%.
Recently, as investors started to anticipate a default in the Union of the South, real interest rates
increased to 10% and the real growth rate decreased to zero.
ii) What is now the size of the fiscal surplus that the country needs to run to stabilize its debt over
GDP?
Similary: r-g=10%. Fiscal surplus necessary to stabilize the debt over GDP = 10%*150%=15%. Needs
a primary surplus of 15%! And a much higher fiscal adjustment.
b. R&D and economic growth [15 points]
In any given year, countries with a higher level of GDP per capita tend to spend a larger fraction of
their GDP in Research and Development (R&D). Explain this phenomenon and discuss the
implications for the convergence of poor countries with respect to rich countries.
(please be concise, limit your answer to 300 words)
Indicative Answer:
Decreasing marginal product of capital implies that once reached the steady state level of capital,
countries can no longer grow through capital accumulation. To keep growing after this level, they need
to find ways to improve efficiency in the economy in the form of better institutions and/or better
technologies. Hence, as they have less scope to grow through capital accumulation, rich countries have
more incentives to pursue R&D to keep growing [here you can take the example of South Korea along
its development path or China more recently]. While in the long-run, R&D expenditure is an important
factor behind economic growth, in the short-run rich countries will be the ones investing in
technological progress most. However, this does not imply that poor countries cannot grow through
technological progress as they can always resort to Foreign Direct Investment/Trade in capital goods
to do that through technology transfers [see slides on technological transfers].
b. Fiscal multipliers over the business cycle [30 points = 15 for (i) + 15 for (ii)]
Figure 1 shows the estimated value of the fiscal multiplier in the US over the period 1947-2010 as
measured by A.J. Auerbach and Y. Gorodnichenko (“Measuring the Output Responses to Fiscal
Policy”, mimeo UC Berkeley, 2010).
Recessions as dated by the NBER correspond to the shaded regions.
Figure 1: Fiscal multipliers over the business cycle.
Note for Fig. 1: shaded regions are recessions defined by the NBER. The solid black line is the (cumulative) fiscal
, where time index h is in quarters. Blue dashed lines are 90% confidence
multiplier computed as
interval. The multiplier incorporates the feedback from G shock to a measure of the business cycle conditions. In each
instance, the shock is one % increase in government spending.
i) Define the ‘fiscal multiplier’. Looking at Figure 1, is the fiscal multiplier on average positive? How
does it change over the business cycle?
What are the mechanisms limiting the impact of fiscal policy on aggregate output? How can you
interpret the cyclicality of the fiscal multiplier?
(please be concise, limit your answer to max. 500 words)
ii. What are the key implications of the cyclicality of the multiplier for the use of fiscal policy as a
stabilization tool? What are the key implications for countries running austerity measures today?
(please be concise, limit your answer to max. 500 words)
Indicative Answers:
Key elements [see lectures 9-11]
i/
- Define fiscal multiplier as % increase in output for 1% increase in public spending (‘spending
multiplier; potentially different of multiplier for tax cuts). Here cumulative multiplier over 20
quarters (5 years) = cumulative response of output over 5 years divided by cumulative change
in spending over the same 5 years with an initial 1% increase in public spending.
-
-
Multiplier below unity on average but positive (see Fig 1). Multiplier appears countercyclical: low
in expansions and high in recessions. Looking at Fig. 1, multiplier is between 0 and 0.5 in
expansions and between 1 and 1.5 in recessions.
Discuss the limits to the effectiveness of fiscal policy as a stabilization tool (see class slides) =
limits of the use of fiscal policy to stimulate output. Key word is crowding out: of consumption
= Ricardian equivalence, crowding out of investment and net exports. Provide intuition.
Why are fiscal multipliers countercyclical?
Different possible stories:
1/ At very low interest rates, fiscal multiplier higher as less of an impact of fiscal policy on
interest rates. This implies less crowding of investment/consumption due to very
accommodative monetary policy. Think that at zero lower bound, interest rate tied to zero.
2/ People more credit constrained in bad times: failure of Ricardian equivalence. Stimulating
aggregate demand through fiscal spending becomes more efficient.
3/ At full capacity, in expansion, increase in aggregate demand have less of an impact on
output (and more on prices), as there is less slack in the economy. Difficult to increase further
output when at full capacity and unemployment very low.
ii/
- Implications for the use of fiscal policy as stabilization tool: overall good news. Fiscal policy
used mostly in bad times to smooth negative shocks to aggregate demand. Fiscal policy
typically used in long lasting recessions (delays of implementation). These are exactly when it is
the most efficient to stabilize output! And typically it can substitute monetary policy which, for
long lasting recessions, can run its curse like in the last recession (zero lower bound).
-
Implications today in periods of austerity: large increase in public debt means necessary fiscal
adjustment in the future = fiscal austerity. Happening in most developed economies to some
extent. Of course, austerity is much stronger in Southern Europe countries these days. If
multiplier much larger in bad times, austerity will slowdown growth further in these countries.
Vicious circle: as fiscal spending falls and tax increases, lowers GDP significantly, which lowers
tax receipts and makes it harder to stabilize debt. Sovereign risk raises and investors ask for
higher interest rates, which worsen further the fiscal situation.
Higher multipliers in bad times = one of the main argument to postpone austerity measures
and debt stabilization.
Note however, that the US might be slightly special: very low multiplier in very open
economies not the case of the U.S. [large internal demand]. Smaller more open economies tend
to have lower multipliers, which might reduce the adverse effects on output of fiscal
consolidation in many countries (not so much for Greece though as fairly closed economy and
fixed exchange rate regime, e.g. currency union).