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Simulated Test Question 1
(US and European Economies, 2011)
1. How has the US (West) continued to misallocate the key ingredients necessary for long-term
sustainable economic success and growth to its detriment?
Answer: 1) Misallocation of capital - Lying at the heart of capital misallocation is the issue of debt –
its excess, its consumption, its perverse hold on the way Westerners today conduct their lives and
their economies. At the core of capital misallocation is the breakdown of the relationship between
debt and equity holders. The biggest failure in the long term financial and economic policies has its
roots in the inability and failure of debt holders to manage the freewheeling and risk-loving exploits
of equity holders. 2) Misallocation of labor - Pension plans led to a widespread mispricing of labor
contracts that has made the cost of labor look cheaper than it actually is. The postponement of these
hidden pension costs to the future is coming to haunt the West. The broad social shift to favor the
service sector over the productive industry has created an exodus driven by bad labor-pricing signals.
Laws governing the global migration of labor are becoming even more stringent, and more restrictive
to America’s detriment. 3) Loss of technological superiority - To a large extent, the West’s preeminence has been all about its inventions and its TFP brought about by efficiency harnessed to
invention. But the scientific and technological monopoly the West once enjoyed has now been well
and truly breached.
2. During the 1980s, the United States experienced “twin deficits” in the current account and
government budget. Since 1998, the U.S. current account deficit has grown steadily, along with rising
government budget deficits. Do government budget deficits lead to current account deficits? Identify
other possible sources of the current account deficits. Do current account deficits necessarily indicate
problems in the economy?
Answer: “Twin deficits” are possible, but there are other factors that influence the current account.
Since 1998, the decline in the current account has been associated with movements in investment and
national savings. Note the following expression from the textbook:
CA = SP + SG - I
It is not clear that budget deficits cause current account deficits. There are two possibilities
besides a budget deficit (SG < 0):
1) Private savings (SP) may change when the government changes taxes (e.g., tax rates). Suppose tax
rates decrease, causing a decrease in government saving. According to Ricardian equivalence,
households will respond to a tax cut today by increasing savings in anticipation of a future tax
increase needed to finance the current budget deficit. This implies private savings will increase,
possibly offsetting the effect on national saving.
2) The current account may move independently of saving, namely because of changes in investment
(I). An increase in domestic investment opportunities could lead to current account deficits.
3. In 2001, President George W. Bush and Federal Reserve Chairman Alan Greenspan were both
concerned about a sluggish U.S. economy. They also were concerned about the large U.S. current
account deficit. To help stimulate the economy, President Bush proposed a tax cut, whereas the Fed
had been increasing U.S. money supply. Compare the effects of these two policies in terms of their
implications for the current account. If policy makers are concerned about the current account deficit,
discuss whether stimulatory fiscal policy or monetary policy makes more sense in this case. Then,
reconsider similar issues for 2009–2010, when the economy was in a deep slump, the Fed had taken
interest rates to zero, and the Obama administration was arguing for larger fiscal stimulus.
Answer: From the model, we know that fiscal expansion leads to crowding out of investment and
external demand because it leads to an appreciation in the home currency. In contrast, a monetary
expansion leads to a decrease in the interest rate and a depreciation in the currency, causing an
improvement in the current account. Therefore, if policy makers are concerned about reducing the
current account deficit and want to expand output, they should use monetary policy.
The situation in 2009–2010 was very different. The Fed had exhausted its monetary toolkit. Keeping
their interest rate target at zero meant the economy was at the zero lower bound (in a liquidity trap).
Under these circumstances, the job of reviving the economy falls to fiscal policy. As of mid-December,
2010, a tax bill was being considered by Congress. If the current version of the bill is passed, there will
be some additional stimulus from the two-percentage-point reduction in the payroll tax for a year, the
two-year extension of the Bush tax cuts, and an extension of unemployment compensation benefits.
However, these are all temporary measures. We should not expect this bill to have the same punch as
permanent changes in taxes. And, because of the deep recession, the U.S. current account deficit for
2009 was about half its 2005 level. Under these circumstances, the United States (and most other
countries) did not pay much attention to the current account. They were properly concerned with
reviving their domestic economies.
4. Several elements had contributed to the creation of a bubble in the United States: inequality, the
absence of a strong social safety net in the US combined with excessive risk taking initiated by its
financial sector, and export-led development strategy adopted by foreign countries. How can it be
said that both the US and the emerging economies with export-led growth strategy are responsible for
the current financial crisis? Discuss.
Answer: The exporters did not believe that the crisis in the late 1990s indicated any problems in the
broader strategy of export-led growth. Instead, the crises reinforced their beliefs that generating trade
surpluses was even better than simply being export oriented, for it allowed the country to build
foreign exchange reserves. Yet these exporters’ attempt to achieve safety has increased the rest of the
world’s vulnerability. The supercharged export-led growth strategy not only increases the burden on
the rest of the world to create demand for their goods, but it also accentuates the domestic distortions
the strategy previously created. The export-led growth strategy also led to an enormous buildup of
the exporters’ foreign-exchange reserves, which went looking for a home around the world.
On the other hand, the US was willing to spend much more than its own producers could supply,
and it has a strong financial system capable of attracting the inflows and reassuring the exporters that
their savings would be safe, safer than the developing countries had been. The United States, with
growing inequality making the political environment favorable to more debt-financed consumption,
was a prime candidate to be the new demander of last resort.
The jobless nature of the recovery and the weak U.S. safety net had also caused the United States to
infuse substantial fiscal and monetary stimulus in response to downturn. The ensuing fiscal stimulus
pushed a government budget that was temporarily surplus into large fiscal deficits. At the same time,
the Fed kept giving all sorts of assurances to the markets on its willingness to maintain easy monetary
conditions and to step in to provide liquidity in case the financial markets had problems. These
assurances had led to an explosion of lending, which unfortunately continued expanding and
deteriorating in quality even after the Fed started tightening. For an unsustainable while, the United
States provided the demand the rest of the world needed.
Meanwhile, foreign central banks were confronted with vast dollar inflows as exports to the United
States expanded, and as U.S. investors looked abroad to escape from low U.S. interest rates. As the
central banks bought dollar assets in an attempt to keep the domestic exchange rate from appreciating,
they looked for a little extra return. The money pushed out to developing countries by the Fed’s lowinterest policy came back to help expand the agencies’ purchase of subprime mortgage backed
securities. Knowing that the agencies enjoyed the implicit guarantee of the government, the foreign
central banks really did not care about the risks the agencies took. Equally problematic were private
foreign investors, who trusted the ratings on mortgage-backed securities and, together with Fannie
and Freddie, bid up the prices for these securities, making them far more attractive to create than they
should have been.
Somehow the private financial sector contrived to convert its edge into an instrument of selfdestruction, for the commercial and investment banks that packed together and sold mortgagebacked securities ended up holding large quantities of them. More than anything else, this
phenomenon is what transformed what would otherwise have been a contained U.S. housing bust
into a devastating global financial crisis.
5. Since 1976, US trade deficits collectively add up to over $7 trillion. More than 70 percent of that has
been added since 2000. Yet surveys report that Americans owe only about $3.5 trillion more to
foreigners than foreigners owe to Americans. How do you resolve this puzzle?
Answer: For the past three decades, the financial account of the US has been almost always in surplus,
reflecting a net export of assets to the rest of the world to pay for chronic current account deficits. If
there were no valuation effects, the change in the level of external wealth between two dates should
equal the cumulative net import of assets (minus the financial account) over the intervening period.
But valuation effects or capital gains from 1988 to 2009 have reduced U.S. net external indebtedness in
2009 by more than half compared with the level that financial flows alone would have predicted. The
United States has since the 1980s been a net debtor with W = A − L < 0. Negative external wealth
would lead to a deficit on net factor income from abroad with r*W= r* (A − L) < 0. Yet U.S. net factor
income from abroad has been positive throughout this period. The only way a net debtor can earn
positive net interest income is by receiving a higher rate of interest on its assets than it pays on its
liabilities. The United States has “exorbitant privilege” of being able to borrow cheaply while earning
higher returns on U.S. external assets. In addition, the United States has long enjoyed positive capital
gains, KG, on its external wealth. These large capital gains on external assets and the smaller capital
losses on external liabilities are not the result of price or exchange rate effects. They are gains that
cannot be otherwise obtained. These capital gains are sarcastically called as “statistical manna from
heaven.” Without these two offsetting effects, the declines in U.S. external wealth would have been
much bigger.
6. Why does currency mismatch not matter for the United States?
Answer: Large-scale currency mismatch – debts in a foreign currency and assets and revenues in the
national currency – is a precondition for foreign debt to cause a major crisis. Yet analogies between
the position of the United States as debtor economy now and these other earlier debtor economies do
not hold. Because the role of the dollar as the key currency of the international monetary system
creates a large demand to hold dollars as reserve stores of wealth, the US has the “exorbitant
privilege.” The United States’ debts are denominated in its own currency unlike Mexico, East Asia,
and Argentina. It can always create more dollars, and its value is everyone’s problem because other
countries lose a fortune when the dollar falls.
7. Recently, there has been substantial pressure on China from the U.S. government to allow the value
of the yuan to decrease relative to the U.S. dollar. Why might the U.S. government want this change in
the value of the yuan? How would such a change affect the relative price of Chinese goods versus U.S.
goods? How would it affect the value of U.S. liabilities owned by Chinese residents?
Answer: A decrease in the yuan–dollar exchange rate would lead to an increase in the relative price of
Chinese goods. This would make Chinese goods exported to the United States relatively less
attractive for Americans. At the same time, it would make U.S. imports into China more attractive for
Chinese consumers. The decrease in the yuan–dollar exchange rate would lead to a decrease in the
value of U.S. liabilities owned by Chinese residents. When Chinese residents convert their dollardenominated liabilities back into yuan, they will receive fewer yuan after the yuan–dollar exchange
rate decreases because each dollar is now worth fewer yuan.
8. Define the national income identity, the current account identity, and the balance of payment
Answer: Refer to slides 7, 8, and 25