L1059 Advanced Macroeconomics Exam 2019 with answers PDF

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L1059

THE UNIVERSITY OF SUSSEX BA AND BSc SECOND AND FINAL YEAR EXAMINATION ECONOMICS GRADUATE DIPLOMA EXAMINATION May/June 2019 (A2)

ADVANCED MACROECONOMICS Assessment period: May/June 2019 (A2)

DO NOT TURN OVER UNTIL INSTRUCTED TO BY THE CHIEF INVIGILATOR Candidates must attempt Sections A and B The use of approved calculators, if needed, is permitted Duration: 2 Hours

/Turn over

L1059 Advanced Macroeconomics ___________________________________________________________________

SECTION A Attempt THREE questions for a maximum of 20 marks each (60 marks in total) 1.

During the period between the discovery of oil in the North Sea and its extraction, the UK current account moved sharply into deficit. Can you link these two events using the UK exchange rate? Ans: A discovery news shock would raise expectations of economic growth which will translate into actual growth in the short run. Therefore the market would expect BoE to raise rates in the short run to curb inflationary tendencies in the economy. This would lead to UK exchange rate appreciation through the IP condition (more demand for UK sterling denominated assets). That would hurt non-oil exports and overall exports would decline given that UK has a bigger share of non-oil exports to total exports. Imports would also become cheaper and hence would increase with the strong pound sterling.

2.

Consider an increase of x% in the rate of nominal money growth. Assume that it causes a rise in expected inflation of y%, where y% < x%. What would be the effect on output and nominal interest rate in the short and medium run? Ans: Starting with prices P0 and output Yn, •

An increase in M at given prices P0 lowers i (LM curve shifts down.)

•

With constant initial inflation, this lowers r.

•

Through the IS curve, this pushes demand and output (via investment, perhaps consumption) above Yn and unemployment below the NAIRU.

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L1059 Advanced Macroeconomics ___________________________________________________________________ • • • • • • •

Through the Phillips curve, this leads to rising inflation. As inflation increases, it eventually overtakes money growth. Moreover, inflation expectations adjust up, raising IS. With P rising faster than M, real money balances decline so LM curve shifts back up. ⇒ i rises, which at given inflation increases r. As the LM curve rises, r rises, and we move back up the IS curve. We return to equilibrium once Y = Yn, and r = rn, with a new higher price level P1. Since IS has risen, LM has to end up higher than it started:

LM2

IS2

LM0 IS0 i1=rn+π1

LM1

i0=rn+π0

Yn

3

Output

L1059 Advanced Macroeconomics ___________________________________________________________________

3.

a) Derive the Uncovered Interest Parity (UIP) condition and explain the economics behind it. [14 marks] b) Using the UIP identify the conditions under which a local currency can depreciate in response to a local interest rate rise. Use diagrams wherever possible. [6 marks] Ans: a) UIP derivation as in lecture 1. b) Local currency depreciation could happen if there is an upward shift of the UIP line. This is either because of increase in i* or expected depreciation of E(t+1). Potential channel, high i → low AD → weak economic outlook and weak growth expectations → expected selling off of local currency denominated assets → expected depreciation.

4.

Bank of England February 2019 Inflation Report presents the following outlook for the UK economy: i) growth has slowed, ii) inflation has fallen back to the 2% target, and iii) future nominal interest rate rises should be gradual and limited. Using standard models, discuss the effect of these announcements on the yield curve, oil price, equity market, and GDP. Clearly state your modelling assumptions and use diagrams wherever possible. Ans: BoE is using forward guidance to signal that there would be no further rate rise during this year unless the economic outlook becomes positive. Therefore market could expect rate remaining stable or a rate cut. A slightly downward sloping yield curve. No effect on oil price (UK price taker). Equity market volatility to reduce and experience moderate growth. Moderate increase in GDP to Yn. Use the standard ISLM diagram in the short and medium run. SECTION B Attempt ONE question (40 marks in total) 5.

(a) Consider a coin toss experiment and the following assets. Asset A gives £200 if the first is heads, £50 for tails. Asset B gives £200 if the second is heads and £50 for tails. Asset C is half of A plus half of B. Assets A and B are independent. Show that the expected value of each asset is the same and C reduces risk. Explain why C reduces risk? [30 marks] (b) Define seignorage. What is the relationship between money growth and seignorage? [10 marks]

Ans: a) E(A)=E(B)=E(C)=125 σA= σB = 75 and σC = 75/√2. C is a convex combination of A & B (two independent assets), therefore a diversified portfolio. Portfolio diversification using independent assets reduces risk. b) Seignorage The revenue gained by the government through printing money is called seignorage. It’s best to think in terms of months, since things change rapidly under hyperinflation.

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L1059 Advanced Macroeconomics ___________________________________________________________________ If the change in the money supply is ∆฀฀, then the real revenue received by the government is ฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀ = ฀ ฀ =. ฀ ฀

∆฀฀

We can rewrite this as ∆฀฀ ฀฀ ฀฀= . ฀ ฀ ฀฀ We now have two equations to put together: the value of seignorage, and money demand: ∆฀฀ ฀฀ ฀฀ =�฀฀ ฀฀(฀฀ + ฀฀ ฀฀ ). ฀฀= , and ฀ ฀ ฀ ฀฀ ฀ Substituting the second into the first, ฀฀=

∆฀฀ �฀฀฀฀(฀฀ + ฀฀ ฀฀ ) ฀ ฀

where L, and hence S, is declining in ฀฀ ฀฀ . The case of constant nominal money growth Consider constant money growth

∆฀฀

฀฀

.

∆฀฀

Over time, ฀฀ ฀ ฀ = ฀ ฀ = so we substitute for ฀฀ ฀฀ : ฀฀ ฀฀= But now S is rising in money demand.

∆฀฀

฀฀

∆฀฀ ∆฀฀ �฀฀ ฀฀ �฀฀ + �. ฀ ฀ ฀฀

directly, and falling in

∆฀฀

฀฀

indirectly via inflation expectations and

The indirect, negative effect starts small and gets big quite fast—eventually outweighing the direct effect.

L1059 Advanced Macroeconomics ___________________________________________________________________

With low money growth, an increase will increase seignorage. But there is a limit to the maximum seignorage that can be raised: at a certain point, money demand declines too rapidly. 6.

(a) What is the difference between GDP and GNP?

[5 marks] Ans: Instead of using GDP we will consider GNP, which includes investment income flows in and out of the country: • •

Domestic investments in foreign countries provide returns to us, adding to GNP. Foreign investments domestically provide returns to foreigners, subtracting from GNP.

Let ฀฀฀฀฀฀฀฀ be the country’s net foreign assets. So if the country is a net debtor then ฀฀฀฀฀฀฀ ฀ < 0. • NB: This is the net foreign asset position of the country, public and private sector together, so it is different from public sector (government) debt B. Foreign assets include bonds issued by foreigners (governments or firms); equity (shares) in foreign firms; equity in physical capital or resources in foreign countries. Foreign debts include bonds issued by the domestic government or by domestic firms that are held by foreigners; equity that foreigners hold in domestic firms or capital. We will assume that all assets receive the same effective real return r: foreigners receive r on their assets in our country (our debts), we receive r on our assets abroad. Now we have ฀฀฀฀฀฀ = �฀฀ ฀ ฀ = ฀฀฀ ฀ + ฀฀฀ ฀ + ฀฀฀ ฀ + ฀฀฀฀฀ ฀ + ฀฀฀฀฀฀฀฀฀฀ . That is, GNP is equal to GDP plus the real return on our NFA. If NFA < 0 then we have net debts, and the net effect is that we are paying foreigners for their investments here. (b) Define ‘current account’. Show that the financial balances of the private, public and foreign sectors add up to zero. [15 marks] Ans: Net exports plus the return on ฀฀฀฀฀฀ is what we call the current account: (1) ฀฀฀฀฀ ฀ = ฀฀฀฀฀ ฀ + ฀฀฀฀฀฀฀฀฀฀ . That is, the current account is net payments from abroad due to your trade balance (net exports), plus net payments from abroad due to ownership of foreign assets. Of course, both NX and ฀฀฀฀฀฀ can be negative. This is the first of three different but equivalent definitions of the current account.

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L1059 Advanced Macroeconomics ___________________________________________________________________ If CA > 0, foreigners are making net payments to us: we are exporting more than we are importing, and/or we have positive ฀฀฀฀฀฀ that pay us a return. What happens to the money? • It is foreign currency. • By definition we are not spending it on imports. ⇒ We as a country must be saving it. Saving means acquiring assets, so this implies that we must be adding to our ฀฀฀฀฀฀: ฀฀฀฀฀฀ are growing. NB: Assets can be bonds, equity etc., or just foreign currency held as currency reserves. Conversely, suppose CA < 0. • We are importing more than we are exporting and/or we have net foreign debts and are paying returns to foreigners. • But this implies we must be borrowing, or spending down our existing assets, to cover the payments. This implies a fundamental equation: it means that the current account is also the change in net foreign assets: (2) ฀฀฀฀฀ ฀ = ฀฀฀฀฀฀฀ ฀ − ฀฀฀฀฀฀฀฀−1 . Recall the discussion of fiscal policy: the fiscal deficit/surplus is a flow where the total government debt is the stock. Likewise, the CA is the flow where ฀฀฀฀฀฀ is the stock. Now return to GNP: ฀฀฀฀฀฀ = �฀฀ ฀ ฀ = ฀฀฀ ฀ + ฀฀฀ ฀ + ฀฀฀ ฀ + ฀฀฀฀฀฀ Remember that private saving ฀฀฀฀ ฀฀ is defined as ฀ ฀ ฀฀฀฀ = �฀฀ ฀ ฀ − ฀฀฀ ฀ − ฀฀฀฀ � where T is taxes (note that now we use ฀฀฀฀ , which is income). Substitute into the GNP equation to get ฀ ฀ ฀฀฀฀ = −฀฀฀ ฀ + ฀฀฀ ฀ + ฀฀฀ ฀ + ฀฀฀฀฀฀ . But public or government saving is ฀฀฀฀฀฀ = ฀฀฀ ฀ − ฀฀฀฀ , i.e. the fiscal surplus, so rearrange to get total national saving: ฀฀ ฀฀ ฀ ฀ ฀฀฀ ฀ = ฀฀฀฀+ (฀฀฀ ฀ − ฀฀฀฀ ) = ฀฀+฀฀ ฀฀฀฀ = ฀฀฀ ฀ + ฀฀฀฀฀฀ . This is a key finding: total national saving is equal to investment plus the current account. So: (3) ฀฀฀฀฀ ฀ = ฀฀฀ ฀ − ฀฀฀฀ . Why? In a closed economy, national saving equals investment: spending must equal production, so if the economy as a whole wants to save for the future, this saving must be spent on capital via investment. Saving doesn’t mean buying nothing! • What if person A saves by lending to person B in the same country, and person B consumes all he has borrowed? • Then there is no investment. But there is also no net saving: between A and B, all income has been consumed. In an open economy, if saving is not equal to investment then the difference can go abroad:

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L1059 Advanced Macroeconomics ___________________________________________________________________ • •

If S > I then excess saving can be saved abroad by increasing (buying) foreign assets. If S < I then saving is too low to finance domestic investment, so the country borrows from abroad.

So for the country to save, it must either invest domestically, or increase foreign assets.

Sectoral financial balances We have effectively broken down the economy into three “sectors”: • the private sector (households and corporate/firms) • the public sector (government) • the “foreign sector”, i.e. the rest of the world.

If any “sector” earns more than it spends, then it must be increasing its financial assets: e.g. buying bonds. • •

If a sector earns less than it spends, its financial assets decline as it has to borrow, i.e. issue/sell bonds. If it earns more than it spends, its financial assets rise as it buys bonds (saves).

But a financial asset (bond) is a claim on someone else: they must pay you in the future. So, since these are the only agents in the economy, any sale of a financial asset (borrowing) by one sector must be matched by the purchase of the asset (saving) by another sector. • The first sector has reduced its financial assets. • The second sector has increased its financial assets. This is another way to interpret the above equation:

฀฀ �฀฀฀฀฀฀ − ฀฀฀฀ � + ฀฀฀฀− ฀฀฀฀฀ ฀ = 0.

Consider the first term, ฀฀฀฀฀฀ − ฀฀฀฀ . It is private sector saving over and above investment spending. So it is income not spent on consumption or investment. Hence instead it must be spent on financial assets like bonds. • So we call it the financial balance of the private sector. Similarly, ฀฀฀฀ ฀฀ is the financial balance of the government: ฀ ฀ • if ฀฀฀฀ > 0, i.e. a fiscal surplus, then the government can buy back its debts, so government debt is decreasing. • if ฀฀฀฀฀฀ < 0, i.e. a deficit, then the government is borrowing, i.e. issuing more debt (government bonds). Finally, ฀฀฀฀฀฀ is the financial balance of the foreign sector or the rest of the world, because it is the change in ฀฀฀฀฀฀: • If ฀฀฀฀฀ ฀ > 0 then we are increasing our NFA so the rest of the world is reducing its financial assets. • If ฀฀฀฀฀ ฀ < 0 then we are borrowing from abroad so the rest of the world is increasing its financial assets. 8

L1059 Advanced Macroeconomics ___________________________________________________________________ One final recap:

�฀฀฀฀฀฀ − ฀฀฀฀ � +฀฀฀฀ ฀฀− ฀฀฀฀฀ ฀ = 0.

The equation says that the financial balances of the private sector, public sector, and foreign sector add to zero. Financial balances are changes or flows in financial assets of each sector. ⇒ A new claim is a claim on someone else, so a plus for one sector is a minus for another sector. (c) Using a two-country model explain how expansionary monetary policy in one country could trigger ‘global imbalance’. [20 marks] Consider a world with two countries, A and B. Suppose country A wants to stimulate its economy. It can do so by lowering its exchange rate: this makes its goods cheaper to country B, and leads to high net exports. Assume it starts off with no foreign debt or assets. Then: • High net exports ⇒ ฀฀฀฀฀ ฀ > 0 ⇒ rising foreign assets. So the country is saving abroad. But “saving abroad” means it is lending to country B. With only two countries in the world, ฀฀฀฀ ฀ ฀ = −฀฀฀฀฀฀ so ฀฀฀฀฀ ฀ < 0. That is, country B must be borrowing from A. Put another way: capital is flowing from A to B. •

But this is essentially the same thing as a monetary expansion in country A with floating exchange rates, which we can illustrate with the familiar IS-LM diagram:

Interest rate

Interest rate

Monetary expansion in country A

LM IS LM'

i i'

i i'

Yn

• •

UIP

Y'

Output

Monetary expansion in A raises YA and reduces iA. This reduces E, so NX increases along IS.

9

E'

E

Exchange rate

L1059 Advanced Macroeconomics ___________________________________________________________________

Interest rate

Interest rate

For country B, the decline in iA shifts UIP and IS down:* LM'

IS

LM

IS'

UIP

i

i

Y'

E

Output

Yn

E'

Exchange rate

If they keep iB constant they must have a monetary contraction, reducing YB: it is contractionary for country B.

* See week 2 exercises! IS shifts down because with decline in iA, NX is lower for any given iB.

Interest rate

Interest rate

How should country B react if it wants to maintain full employment? By imitating A’s monetary expansion:

LM' IS'

UIP

LM''

i

i

i'

i'

Y'

Yn

Output

E

E'

Exchange rate

If they do it enough then E stays where it is, iB falls to the same as iA, and Y returns to Yn. In this case we then have to go back to re-do country A’s diagram, because the decline in iB shifts A’s UIP curve down... In this 2-country world, a monetary expansion in one country is contractionary for the other. So you can ‘export unemployment’: boosting your economy makes the other economy worse off. This also implies that when country A has a monetary expansion, it creates pressure for country B to reduce its interest rate too. Putting the above together:

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L1059 Advanced Macroeconomics ___________________________________________________________________ • • • • •

A monetary expansion in country A, i.e. reduction in iA, is equivalent to choosing a low (competitive) exchange rate. This is contractionary for country B, so it creates pressure for B to also lower iB. As long as B is not fully counteracting A’s expansion (iB > iA), A has a current account surplus with B. Hence A is increasing its ฀฀฀฀฀฀, i.e. bonds issued by B, so B is building up debt with A. That is, capital flows from low-i A to high-i B as net exports flow from A to B: essentially, B buys the extra imports with debt.

To summarize, the decline in iA causes: Output: YA rises, YB declines. Current accounts (flows of financial capital): • A has a surplus, so B has a deficit: 0 < ฀฀฀฀ ฀ ฀ = −฀฀฀฀฀฀ . Net foreign assets (stocks of financial capital): • A’s net holdings of foreign assets rises • So B’s net holdings of foreign assets falls. And finally: if B wants to reduce or prevent all of this, it has to lower its interest rate iB.

END OF PAPER

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