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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 identity. Answer: Refer to slides 7, 8, and 25