Tutorials and Quiz Qs

Question 1

What is the difference between inflation and core inflation?

Answer 1

• Core inflation excludes certain items that face volatile price movements.
• These products are taken out of the calculation because they often have temporary price shocks which diverge from the overall trend of inflation, giving a false impression on actual changes in price levels. These products often include energy and foodstuffs.

Question 2

Consider the following two events: (i) share prices decrease 30 percent, (ii) prices of real estate (houses) decrease 30 percent. Which of these events is most likely to cause a financial crisis? Why?

Answer 2

• Real estate price decline (-30%) is more likely to trigger a financial crisis than a stock market crash.

o Debt financing: Real estate purchases are usually highly leveraged (i.e., bought with mortgages), meaning a fall in prices leads to widespread losses for banks and financial institutions.

o Loan defaults: If borrowers owe more than their home is worth (negative equity), they may default, causing stress on the banking system.

o Systemic risk: The 2008 financial crisis was largely due to subprime mortgage defaults, which spread through the banking sector and led to a credit crunch.

• Stock market decline (-30%) is less likely to cause a financial crisis:
  o Equities are less debt-financed than real estate.
  o Investors bear most of the losses directly rather than banks.
  o While it reduces wealth and confidence, it does not immediately threaten financial institutions in the same way as a housing crash.

Question 3

What alternative economic policy measures could be used if the authorities are worried that a house price bubble is developing?

Answer 3

• If policymakers worry about excessive house price growth, they can use targeted financial regulations rather than interest rates:
  o Macroprudential Regulation
   Loan-to-value (LTV) limits: Restricting how much buyers can borrow relative to home prices.
   Debt-to-income (DTI) limits: Ensuring borrowers do not take on excessive debt relative to their income.
   Higher bank capital requirements: Forcing banks to hold more reserves against mortgage loans, reducing risk.
  o Tax Measures
   Property taxes: Discourage speculation and overheating in the housing market.
   Stamp duties on property transactions: Reduce speculative buying and flipping of homes.
• Other Financial Regulations
  o Leverage caps for financial institutions: Prevent banks from overextending mortgage lending.
  o Taxes on risky financial assets: Discourage banks from holding mortgage-backed securities that could amplify risks.

Question 4

Explain the difference between debt and equity finance. What are the advantages and disadvantages of each?

Answer 4

• Debt finance involves borrowing to invest, and equity finance is the selling of shares to finance investment.
  o Advantages:
   Maintains full ownership and control of the company.
   Interest payments are often tax-deductible.
   Predictable repayment structure.
  o Disadvantages:
   Increases financial risk and bankruptcy risk.
   Fixed repayment obligations regardless of business performance.
   Can limit future borrowing capacity.
• Equity Finance
  o Definition: Selling ownership stakes (shares) to raise funds.
  o Advantages:
   No obligation to repay funds—reduces financial risk.
   Attracts investors who may offer expertise and networks.
   Can improve long-term stability.
  o Disadvantages:
   Loss of control—new shareholders have voting rights.
   Profits must be shared through dividends or capital gains.
   Can be costly (e.g., issuing shares, legal fees).

Question 5

Q1. [E] What two issues hinder household lending directly to firms? How do banks remedy these problems?

Answer 5

1. Information Asymmetry & Trust Issues
   * Problem:
   o Individual households struggle to determine which firms will repay loans and which won’t.
   o Lack of access to credit history and financial records makes risk assessment difficult.
   o Trust issues arise since lenders don’t have repeated interactions with borrowers.
   * How Banks Solve This:
   o Banks establish long-term relationships with borrowers, allowing them to track financial behavior.
   o They share borrower information via credit rating agencies, which help assess risk.
   o By screening and monitoring, banks can sort good credit risks from bad, reducing uncertainty.
2. Maturity Mismatch
   * Problem:
   o Households typically want short-term access to their money (e.g., bank deposits).
   o Firms often need long-term loans (e.g., to fund expansion, purchase equipment).
   o If households were to lend directly, they might not be willing to wait decades to be repaid.
   * How Banks Solve This:
   o Banks pool deposits from many households and lend long-term, ensuring liquidity.
   o They rely on the fact that not all depositors withdraw at once, allowing them to provide long-term loans while maintaining enough cash for withdrawals.
   o This works similarly to insurance companies, which manage unpredictable risks using stable averages across large populations.

Question 6

Explain the dynamics of a bank run. What role does the liquidity mismatch between assets and liabilities have to play?

Answer 6

• How a Bank Run Happens:
  o Loss of Confidence – Depositors fear that the bank might fail and start withdrawing their money.
  o Contagion Effect – Seeing others withdraw, more depositors panic and rush to take out their deposits.
  o Liquidity Crisis – Banks only hold a fraction of deposits as cash; most are tied up in illiquid assets (e.g., mortgages, long-term loans).
  o Forced Asset Sales – To meet withdrawals, banks may have to sell assets quickly, often at discounted prices, worsening their financial position.
  o Bank Collapse – If withdrawals continue, the bank may run out of cash, leading to failure—even if it was fundamentally solvent.
• Role of Liquidity Mismatch:
  o Banks rely on short-term deposits to fund long-term loans.
  o This maturity mismatch means they cannot immediately convert assets into cash without heavy losses.
  o Even solvent banks can fail if too many depositors demand their money at once.
  o Bank runs occur in retail markets (customer withdrawals) and wholesale markets (when other banks refuse to lend to a struggling bank).

Question 7

Most central banks require banks and other regulated financial institutions to hold sufficient financial reserves and undergo regular “stress testing”. In what way could such reviews help to prevent a bank run?

Answer 7

• What Are Stress Tests?
  o Stress tests are simulations conducted by central banks and regulators to assess how banks would cope with severe economic or financial shocks.
  o They help determine whether a bank has sufficient capital and liquidity to withstand crises without failing.
• How Do Stress Tests Work?
  o Regulators use economic models to simulate extreme but plausible scenarios, such as:
   A severe recession (e.g., a sharp drop in GDP).
   A housing market crash (falling house prices and mortgage defaults).
   A stock market collapse (sudden loss of asset value).
   A liquidity crisis (sudden withdrawal of deposits).
   A spike in interest rates (affecting loan repayments).
  o Banks must estimate their potential losses under these scenarios and show they have enough capital to absorb shocks.
• Why Are Stress Tests Important?
  o Prevents systemic crises – Identifies weak banks before they collapse.
  o Restores confidence – Assures depositors, investors, and markets that banks are stable.
  o Improves risk management – Helps banks adjust their lending and investment strategies.
  o Guides regulation – Central banks use results to enforce capital requirements or require struggling banks to raise more funds.
• Regular stress tests ensure that banks hold enough liquid assets to handle unexpected withdrawals.
• Increases transparency, reassuring depositors and financial institutions about a bank’s stability.
• Distinguishes between fundamentally strong and weak banks, preventing unnecessary panic.
• Regulatory requirements (e.g., capital reserves, liquidity ratios) reduce the likelihood of insolvency.
• Central banks (like the Bank of England) act as a lender of last resort, providing emergency liquidity to prevent collapse.

Question 8

A computer system that costs £27,000 will yield returns of £8,000 at the end of each of the next 2 years, at which time it will be sold as scrap for £12,000.
a) If the interest rate facing a firm is 4 per cent, should it purchase this system? Why?

Answer 8

The present value of the stream of income from the purchase of the system is:
PV=8,000/1.04+8,000/〖1.04〗^2 +12,000/〖1.04〗^2 =26,183.43
This is less than the cost of the system, so it is a bad investment, and the firm should not purchase it.

Question 9

Outline some mechanisms through which the rise (fall) in stock prices in a boom (recession) amplifies the impact of the business cycle on investment. Be careful to give the explicit economic arguments behind these mechanisms you have identified.

Answer 9

1. The Accelerator Principle (Bernanke’s Moral Hazard Argument)
   * Core Idea: When stock prices rise, firms have higher equity values, reducing moral hazard in lending. This increases investment and amplifies booms. In recessions, the reverse occurs.
   * Mechanism:
   o Banks lend at a fixed interest rate, meaning they lose everything if a firm defaults but only gain limited upside if the firm succeeds.
   o Firms, however, capture the full upside of investment returns but bear downside risks.
   o Equity as a buffer:
    When stock prices rise, firms’ equity value increases.
    Higher equity means firms have more “skin in the game”, making them less likely to take on excessive risk.
    Banks are more willing to lend, leading to more investment.
    In a recession, falling stock prices shrink equity, making banks more reluctant to lend, reducing investment further.
2. Tobin’s Q Theory
   * Core Idea: If the market value of firms (stock prices) is higher than the replacement cost of physical capital, firms have an incentive to invest.
   * Mechanism:
   o Tobin’s Q = Market Value of Firm / Replacement Cost of Capital
   o If Q > 1, firms can issue new shares to finance investment in capital, as the cost of acquiring new capital is less than the market value of the firm.
   o Investment is constrained by adjustment costs (e.g., time to build new capital).
   o When stock prices rise in a boom, Q increases, encouraging firms to invest more.
   o When stock prices fall in a recession, Q decreases, discouraging investment.
3. Myers-Majluf Problem (Asymmetric Information and Adverse Selection)
   * Core Idea: Firms with genuine investment opportunities may struggle to raise capital due to investor fears of overvaluation.
   * Mechanism:
   o When firms issue new shares, investors worry they might be overvalued, leading to an adverse selection problem.
   o Investors demand a discount on new shares, making it costlier for firms to raise capital.
   o In booms, stock prices are high, meaning even with a discount, firms can still raise sufficient capital for investment.
   o In recessions, stock prices are low, making capital raising too expensive, reducing investment.

Question 10

A company has bank debt, including promised interest payments, equal to £5 million. The company can use the existing resources of the firm for one of two alternative investment projects:
- Project A gives £6.5 million with certainty.
- Project B gives £10 million with 40 percent probability and £4 million with 60 percent probability.
There are no real costs of bankruptcy so the bank gets the whole return in case of bankruptcy. How much larger is expected gross return to the bank from project A than from project B?

Answer 10

Under project A, the bank definitely gets the £5 million it is owed. Under project B, with 40% probability it gets back the £5million, but with 60% probability it only gets £4 million. Therefore, its expected gross return is 0.45 + 0.64 = £4.4 million. The difference is 5 - 4.4 = £0.6 million.

Question 11

Consider the following statements:
In order to handle unexpected withdrawals of deposits, a bank needs to have a buffer of liquid assets
‘Fire sales’ of assets is one method by which losses at one bank can increase the likelihood of bankruptcy at another bank
The failure of one bank spreading to others is called a bank run

Answer 11

TRUE
TRUE
FALSE
See p.505-506 in Gottfries. III describes contagion rather than a bank run.

Question 12

Consider the following statements:
If technology shocks drive business cycle fluctuations, we would expect to see consumption and investment increase with production
If technology shocks drive business cycle fluctuations, we would expect to see real wages and real interest rates increase with production
If ‘animal spirits’ drive business cycle fluctuations, changes in expected demand are partly self-fulfilling

Answer 12

TRUE
TRUE
TRUE

🧾 Statement 1:
If technology shocks drive business cycle fluctuations, we would expect to see consumption and investment increase with production.
✅ True

In Real Business Cycle (RBC) theory, positive technology shocks increase productivity → higher output.
This leads to:
↑ Income → ↑ Consumption
↑ Return on capital → ↑ Investment
So: Consumption, investment, and output move together — they’re procyclical.
🧾 Statement 2:
If technology shocks drive business cycle fluctuations, we would expect to see real wages and real interest rates increase with production.
✅ True

A positive tech shock → higher marginal product of labour and capital
This results in:
↑ Real wages (labour is more productive)
↑ Real interest rates (capital is more productive)
Both are procyclical in RBC models
🧾 Statement 3:
If ‘animal spirits’ drive business cycle fluctuations, changes in expected demand are partly self-fulfilling.
✅ True

In Keynesian models, ‘animal spirits’ (irrational or emotional expectations) can influence investment and consumption decisions.
If firms expect demand to rise, they:
Invest more
Hire more workers
This creates actual increases in demand, making the expectation self-fulfilling

Question 13

The real value of all firms in the economy is is the existing capital stock, and is the share of investment financed by borrowing.
What is the expression for Tobin’s under perfect competition and the assumption that firms finance all their investment by issuing shares?

Answer 13

q = S/K

Question 14

Consider whether any of the following statements about real business cycle (RBC) theory are true.
RBC theory tries to explain business cycles as resulting from ‘technology shocks’ (which can be positive or negative – so recessions are caused by a worsening in technology).
RBC theory assumes that production is always on the natural level, so the output gap is always zero.
RBC theory does a good job explaining some features of business cycles, including the fact that consumption and investment tend to move together, with consumption varying less over the business cycle than investment.

Answer 14

TRUE
TRUE
TRUE

Question 15

One of the main issues hindering households lending directly to firms is a lack of trust and information. Which of the following is NOT a reason why banks can more easily overcome this issue?

Banks hold an equity capital buffer to cover unexpectedly large defaults on their loans.

Due to the law of large numbers, the average withdrawal of a bank deposit is small, as some customers of the bank withdraw their funds while others make new deposits.

Due to the law of large numbers, banks can take average default rates into account and do not need to ensure that every single loan is repaid.

Banks can assess the credit worthiness of potential borrowers more accurately.

Long-term lending relationships imply that banks may have access to firm-specific information.

Banks have developed expertise in contracts and their enforcement.

None of A) to F) are reasons why banks can more easily overcome this.
Incorrect:
All of A) to F) are reasons why banks can more easily overcome this.

Answer 15

Due to the law of large numbers, the average withdrawal of a bank deposit is small, as some customers of the bank withdraw their funds while others make new deposits.

Question 16

The return on an investment is known to be either +10 percent with 0.75 probability or - 20 percent with 0.25 probability respectively. Outside lenders lend at 10% interest rate but they refuse to take risk. Owners try to finance as large a share as possible of the project by debt and the rest is financed with equity. How large a share of the investment can be financed by loans? Round to the closest 2%

if the firm finances 50% of the project with a loan, what is the expected return to the equity holders?

what is the most amount of money the equity holders can borrow without making an expected loss?

Answer 16

Answer: B
In the bad case only 80% of the money is recovered which can be used as collateral. Therefore 0.8=X*1.10 must hold if the equity holders borrow as much as possible. Solving for X we get X=0.7272

72%

Borrowing 50% at 10% interest rate we have to repay 55% of the return. Therefore the expected return is R=0.75*(110-55)+0.25(80-55)=47.5 and because the equity holders have to invest 50% of their own money they make a 5% loss.

Borrowing at 10% interest rate we have to repay D1.1 of the return. Therefore the expected profit is 0.75(110-1.1D)+0.25(80-1.1*D) – (100-D). Here 100-D is the amount invested by the equity holders. Setting this equal to zero and solving for D we get: D=25%.

Question 17

Suppose that the latest data shows that inflation, as measured by the consumer price index, is above the inflation target, but core inflation and expectations of inflation seem to be in line with the target. Discuss how the central bank might interpret and react to this information.

Answer 17

• Headline Inflation (CPI Inflation):
  o This includes all goods and services in the consumer basket, including volatile items like energy and food prices.
  o If CPI inflation is above target, it suggests a general increase in prices, but we need to determine whether it’s temporary or persistent.
• Core Inflation:
  o This excludes volatile items like food and energy to provide a clearer picture of underlying price trends.
  o Since core inflation is still on target, it indicates that the long-term inflation trend is stable and not driven by broad price increases.
• Inflation Expectations:
  o If businesses and consumers expect higher inflation in the future, this can lead to self-fulfilling inflation (e.g., wage-price spirals).
  o Since expectations are still in line with the target, there is no immediate concern about persistent inflationary pressures.
  How the Central Bank Might Interpret This
• If CPI inflation is above target but core inflation is stable:
  o The deviation is likely due to temporary factors like:
   A rise in energy prices (e.g., oil shocks, supply disruptions).
   Changes in indirect taxes (e.g., VAT increases or import tariffs).
  o The central bank may not react immediately if it believes these are short-term effects that will fade.
• If the central bank worries about long-term inflation expectations:
  o Even if the current inflation spike is due to temporary factors, the central bank must consider whether people expect inflation to stay high.
  o If inflation expectations rise, businesses may increase prices, and workers may demand higher wages, creating a cycle of persistent inflation.
  o In this case, the central bank may increase interest rates to prevent inflation from becoming entrenched.
  Possible Policy Reactions
• If the inflation increase is seen as temporary:
  o The central bank might wait and monitor before adjusting policy.
  o No immediate interest rate hike is needed.
• If inflation expectations start to rise:
  o The central bank may increase interest rates to control inflation expectations and prevent further price increases.
  o Higher rates discourage borrowing and spending, slowing down demand-driven inflation.
  Conclusion
• The central bank’s reaction depends on whether inflation is temporary or likely to persist.
• If the rise in CPI inflation is due to energy prices or tax changes and expectations remain stable, they may wait it out.
• If inflation expectations start rising, they may raise interest rates to prevent long-term inflation.

Question 18

What is the repo rate?

Answer 18

• The repo rate is the interest rate implicit in a repurchase agreement (repo).
• A repo is a short-term borrowing mechanism where:
  o One party sells securities (e.g., government bonds) with an agreement to repurchase them later at a higher price.
  o The difference between the selling price and the repurchase price represents the interest on the loan (i.e., the repo rate).
• A higher repo rate makes borrowing more expensive, reducing liquidity.
• A lower repo rate makes borrowing cheaper, increasing liquidity.
• Example:
  o Alice sells Bob a Treasury bond for $100 today.
  o Alice agrees to buy back the same bond in one month for $101.
  o The effective interest rate on this short-term loan is 1% per month.

Question 19

What is the interbank rate?

Answer 19

1. Definition of the Interbank Rate
   * The interbank rate is the interest rate at which commercial banks lend to each other in the interbank market.
   * This rate fluctuates daily based on supply and demand for reserves.
2. Key Features
   * Short-term loans:
   o Loans in the interbank market are usually for one week or less.
   o Most interbank loans are overnight (borrowed today, repaid the next day).
   * No collateral required:
   o Unlike the repo market, banks do not pledge assets as security.
   o Loans are based on trust and creditworthiness between banks.
3. Why Do Banks Use the Interbank Market?
   * To manage liquidity:
   o Banks with excess reserves can lend to banks facing short-term shortages.
   o This allows banks to meet daily funding needs without holding too much idle cash.
   * To meet regulatory reserve requirements:
   o Central banks require commercial banks to hold a minimum level of reserves.
   o If a bank falls short, it can borrow from another bank at the interbank rate.
4. How Is the Interbank Rate Determined?
   * Supply and demand: If banks have excess reserves, the interbank rate falls. If reserves are scarce, the rate rises.
   * Central bank influence:
   o Central banks set a target range for the interbank rate (e.g., the Federal Funds Rate in the U.S.).
   o They influence it by adjusting the repo rate, reserve requirements, or open market operations.

Question 20

The overnight interbank rate is typically very close to the repo rate. Why is this?

Answer 20

• Substitutes for borrowing:
  o Banks can choose between borrowing in the repo market or the interbank market.
  o If one market offers significantly lower interest rates, banks will shift their borrowing to that market.
• Market forces drive convergence:
  o If the repo rate is lower than the interbank rate, more banks will borrow in the repo market.
  o This increases demand for repo borrowing, pushing repo rates up.
  o Simultaneously, lower borrowing demand in the interbank market pushes interbank rates down.
  o The two rates converge due to competition between lenders and borrowers.

Question 21

What could cause the interbank rate to differ from the repo rate?

Answer 21

Collateral vs. No Collateral:
* Repo loans require collateral, while interbank loans do not.
o This means repo loans are less risky for the lender.
o In normal conditions, the interbank rate is slightly higher to compensate for this extra risk.
Financial Uncertainty and Default Risk:
* If lenders lose confidence in borrowing banks, they may demand higher interest rates in the interbank market.
* This happens in financial crises when banks are worried about default risk.
* Example: 2008 Financial Crisis → The interbank rate spiked above the repo rate due to fear of defaults.
Central Bank Influence:
* The central bank can actively adjust repo rates to influence liquidity and monetary policy.
* If the central bank provides more liquidity in the repo market, the repo rate may fall below the interbank rate.

Question 22

The overnight interbank rate is typically very close to the interest rate on short term government debt. Why might this be?

Answer 22

• Banks have two close alternatives for lending money:
• Lend to another bank in the interbank market.
• Buy short-term government debt (e.g., Treasury bills).
• Market forces drive convergence:
• If the interbank rate is higher, banks will prefer lending to other banks → More lending in the interbank market lowers its rate.
• If the government debt rate is higher, banks will buy short-term government debt → Increased demand lowers government debt rates.
• This process continues until the two rates converge.

Question 23

What could cause the interbank rate to differ significantly from the rate on short-term government debt?

Answer 23

• Perceived risk of default:
• If markets believe banks are more likely to default than the government, banks must offer a higher interbank rate to attract lenders.
• Example: Financial crises (e.g., 2008) → Interbank rates spiked as lenders feared some banks would fail.
• If the opposite happens (e.g., people fear a government default), government debt rates will rise above interbank rates.
• Liquidity and central bank intervention:
• If the central bank provides liquidity to banks (e.g., through repo operations), the interbank rate may stay lowwhile government debt rates rise.
• Conversely, if the government issues a lot of short-term debt, the supply increase might push debt rates higherthan interbank rates.

Question 24

Does the central bank directly control the interest rates that are important for consumers and investors? How does the central bank influence the interest rates?

Answer 24

• Does the central bank directly control consumer and investor interest rates?
  o No, the central bank does not directly set the interest rates that consumers and businesses face.
• It only controls:
  o The rate at which it lends to commercial banks (sometimes called the discount rate).
  o The rate at which commercial banks can deposit their excess reserves at the central bank (often overnight).
• How does the central bank influence other interest rates?
  o Interbank rate channel:
  o The interbank rate (the rate at which banks lend to each other) typically lies between the lending and deposit rates set by the central bank.
  o This rate influences the rates that banks offer to consumers and businesses.
• Open market operations (OMO):
  o The central bank buys or sells government bonds to control the supply of money in the banking system.
  o Buying bonds → More money in banks → Lower interest rates.
  o Selling bonds → Less money in banks → Higher interest rates.
• Repo agreements:
  o The central bank enters repurchase agreements (repos) with banks, lending them money in exchange for securities.
  o This affects short-term interest rates, influencing borrowing costs in the economy.
• Reserve requirements:
  o The central bank sets minimum reserves that banks must hold.
  o Higher reserve requirements → Less lending → Higher interest rates.
  o Lower reserve requirements → More lending → Lower interest rates.
• How does this affect consumers and investors?
  o Since banks adjust their lending rates based on the interbank rate, changes in central bank policy influence:
  o Mortgage rates (home loans).
  o Business loan rates (cost of investment).
  o Consumer loan rates (credit cards, auto loans, etc.).
  o Bond yields (important for investment decision

Question 25

Suppose that financial uncertainty leads to an increase in spread between the repo rate and the interbank rate. What should the central bank do?

Answer 25

* The interbank rate determines the cost of funds for banks and thereby the bank lending rates and other interest rates which affect consumption and investment (e.g. home mortgage rates). * Thus, an increase in the margin will raise the level of all interest rates in the economy (including mortgages). * Assuming that interest rates were where the central bank wanted them to be before the increase in financial uncertainty, then if the margin increases, the central bank should reduce its repo rate so as to compensate for the increase in the margin. * If it does not, interest rates throughout the economy will rise, and there will be lower demand and production.

Question 26

What is the difference between repurchase agreements and outright market operations where the central bank buys long-term government bonds? Consider specifically the risk that the bonds lose value because interest rates increase or increased risk of government default.

Answer 26

1. What Are Repurchase Agreements (Repos)? * A repo agreement is a short-term collateralized loan where: o The central bank buys a government bond from a financial institution. o The institution agrees to repurchase it at a specified price and date. * Key feature: The resale price is fixed, so the central bank does not bear the risk of bond price fluctuations due to interest rate changes or default risk. 2. What Are Outright Market Operations? * In an outright market operation, the central bank permanently buys long-term government bonds. * Key difference: o The central bank holds the bond indefinitely. o If interest rates rise, bond prices fall → The central bank suffers a loss. o If the government defaults or is at higher risk of default, the bond’s value drops → Loss for the central bank. 4. Why Did Central Banks Shift to Outright Purchases During Quantitative Easing (QE)? * Before 2008, central banks mostly used repo agreements to manage short-term liquidity. * After the 2008-09 financial crisis, central banks: o Bought long-term government bonds outright to lower long-term interest rates. o Took on default and interest rate risk to support financial markets. o Increased money supply permanently rather than just temporarily injecting liquidity.

Question 27

Explain the mechanism through which lower real interest rates lead to higher inflation in the short run.

Answer 27

Definition of the Short Run * The short run is the period in which the capital stock is fixed, meaning firms cannot immediately increase their production capacity by adding new machinery or factories. * However, firms can increase investment, which affects labor demand and resource allocation. Summary: The Inflationary Chain Reaction 1. Lower real interest rates → Firms borrow and invest more. 2. Higher investment → Increased demand for labor and materials. 3. Lower unemployment → Firms compete for workers, leading to higher wages. 4. Higher wage growth → Firms increase prices to cover rising labor costs. 5. Higher inflation in the short run.

Question 28

Consider the following statements: According to the Taylor principle, when the expected inflation increases above the target level, the policymakers should react by increasing the interest rate one for one with inflation. The rate at which banks can deposit money overnight at the central bank is a ceiling for the interbank rate, whereas the rate at which banks can borrow overnight from the central bank is a floor for the interbank rate. Although according to the macroeconomic theory presented in the textbook monetary policy cannot permanently raise the level of production, stabilisation of output remains a reasonable objective for policymakers.

Answer 28

FALSE FALSE TRUE Statement I is false. According to the Taylor principle the interest rate should be increased by more than one for one with inflation (see question 11 and sections 10.2 and 10.4 of the textbook). Statement II is false. It is the other way around. See section 10.7 of the textbook and questions 4, 5 and 6 in the tutorial sheet. Statement III is true. See section 10.1 of the textbook. Attempts to maintain the levels of output and employment above their natural levels are likely to come at a high long-run cost offsetting short-run gains, but keeping production close to its natural level is typically one of the objectives of monetary policy.

Question 29

Consider the following statements about central banks’ (CBs) use of repos and outright market operations (OMOs), noting which (if any) of the statements are true: Other things being equal, repos are riskier than OMOs because CBs might be forced to repossess distressed assets. Since the 2008 financial crisis, repos have increased in popularity relative to OMOs. Both repos and OMOs are used by CBs to influence market interest rates.

Answer 29

FALSE FALSE TRUE Explanation: I. is deeply false – repo isn’t short for “repossess” but “repurchase”. As the solution guide says: “When the central bank buys a bond in a repo agreement, the contract specifies the price at which it will resell the bond, so it will not lose money if the bond loses value because of default, because of increased risk of default, or because interest rates increase. In an outright purchase, the central bank takes the risk of losses if the value of the bond goes down. A shift from repo agreements to outright purchases was a central element in the so-called “quantitative easing” after the financial crisis in 2008-2009.” (So II is also false.) Statement III is true – both are tools of monetary policy.

Question 30

The discount rate is the rate at which the US Federal Reserve lends money to commercial banks. Commercial banks may also earn the interest rate on excess reserves (IOER). The federal funds rate is the interest rate in the interbank market, where commercial banks borrow and lend to one another. Which of the following statements is/are true? 1. The IOER constitutes a theoretical lower bound for the federal funds rate. 2. The discount rate constitutes a lower bound for the federal funds rate. 3. The discount rate is set above the IOER.

Answer 30

only statements 1 and 3

Question 31

Consider the closed economy of country ABC. Suppose that citizens of Country ABC suddenly become very pessimistic about the future and, if no action is taken, a negative output gap of $600 million will arise. Suppose further that the central bankers have just met to set the nominal interest rate and it will remain fixed in response to this shock. If the multiplier associated with government spending is 1.2 and the overall tax rate is 25%, by how much will the government debt increase if the government decides to close the negative output gap with a fiscal stimulus (i.e. increased government spending) compared to if they did nothing?

Answer 31

$350 million In order to generate additional income of $600 million, the government needs to increase spending by $600m/1.2 = 500 million. If they had done nothing, the fall in tax revenue is equal to 0.25*$600m = 150 million, and so the government debt will increase by $500m – $150m = 350 million relative to doing nothing.

Question 32

How could inflation bias be removed from monetary policy? Name several methods, as well as their drawbacks.

Answer 32

1. Passing a law that requires the central bank to keep inflation at some low level/ fixed norm for inflation. However, such a strict rule means that the central bank’s ability to stabilize output may be severely curtailed. It is also important to note that the central bank does not have complete control over inflation, so there would have to be rules for when inflation fell out width a certain range. 2. Monetary Policy Rule. Central bank has to follow a specific rule for any given circumstance. Firstly it is hard to make a rule for every situation facing central bankers, and making an incomplete one can again limit flexibility. 3. Long term contracts. Employ monetary policy committee members for a long enough time to ensure they are thinking about the long term consequences of their decisions. 4. A contract for the central bank. Delegate all policy making decisions to an independent body and set up incentives for that body to keep inflation low.

Question 33

Explain the three different responses to a fiscal crisis. What are costs of each one?

Answer 33

1. Reduce the primary deficit. This is often politically painful. There are also problems associated with the time required to increase taxes and reduce government expenditure. Countries with unemployment insurance systems will also often find that cutting public sector jobs when there are little private sector ones on offer only serves to increase the welfare bill. 2. Debt monetization. Where the central bank buys government bonds financed by an increase in the monetary base. Given that most bonds have their repayments fixed in nominal terms unexpectedly high inflation reduces their value in real terms. This response is why countries with their own currencies will never default on debt denominated in domestic currency. The issue with this method is that expansion of the monetary base often results in increased inflation and may increase future cost of borrowing. 3. Default. By stopping payment of interest and repaying bonds that mature the government’s debt burden immediately vanishes. The issue with this is that it becomes very difficult for the government to borrow on the market again, and if it is able to do so at all then it is only at a significantly higher rate (many countries – from Argentina to Zambia – have experienced this problem at various times).

Question 34

Why might myopic governments underinvest in public infrastructure?

Answer 34

* If the government is myopic, it will care more about expenditure that has an immediate payoff than that which has a payoff in the future. * This means that investment in public infrastructure such as transport systems and schools, which operate over a long time period, will be lower than is optimal.

Question 35

How could deficit bias be removed from fiscal policy? Explain at least two different methods.

Answer 35

1. Debt targets and ceilings. By setting relatively permanent commitments on debt should act as a constraint to day to day policy restrictions. 2. Budgetary procedures. By making sure that the effects of fiscal policy are fully considered before any measures are passed and sufficient time is given for due consideration then policy may be more constrained. 3. Delegation. Fiscal policy could be delegated to some independent body, similar to the central bank. The issue with this is that such a body might lack democratic accountability, as well as the fact that the aims of distributional consequences, making fiscal policy inherently political. 4. Fiscal Policy Councils. Similar to the above method, this would involve the setting up of an independent committee to evaluate and give advice on fiscal policy.

Question 36

What are some reasons for deficit bias in fiscal policy?

Answer 36

1. Myopia. A deficit allows for government to raise expenditure and lower taxes today, with the associated costs only coming later. These sort of policies will help a government win votes and remain in power if the associated costs are uncertain or if voters are oblivious to them. Alternatively voters may be myopic and credit constrained, so rationally vote for a government that borrows on their behalf. 2. Political fragmentation. In political systems where there are many political parties who are required to cooperate, they all may push for their own specific interests without taking responsibility for the country as a whole. Another issue with division of power is that compromise may be difficult to reach. For example even if parties agreed on deficit reduction, conservatives may argue for reduced expenditure whilst labour argue for tax hikes. Lack of agreement could lead to no action, despite the fact everyone agrees the current course is unsustainable. 3. Strategic Deficits. If the party in power today thinks that a future government will waste the resources of government, it may spend money today in order to reduce the scope of future policy.

Question 37

The textbook notes that the model presented in the current chapter contains two relative prices that affect demand. What are they?

Answer 37

* The real interest rate (the intertemporal relative price), which affects choice between consumption today and consumption in future periods, and * the real exchange rate (the international relative price) which affects the choice between goods produced at home and abroad.

Question 38

Q4*. [T] Assume that the quantities exported and imported are determined by the following functions: X=(a-bε) Y^* and IM=mYε What is the equation for net exports when expressed in units of the domestically produced good? What factors affect net exports and why?

Question 39

Describe the different effects of an increase in ε on NX

Answer 39

There are two opposing types of effects: volume effects and valuation effects. Volume effects affect the quantity of goods moving across borders. As ε increases for the home country, domestic goods become more expensive relative to foreign goods, so foreign consumers buy more of their own goods and fewer of the home country’s goods, so exports decrease. Similarly, an increase in ε makes imports relatively more attractive than domestically produced goods for home consumers, so imports increase. So the volume effects of an increase in the real exchange rate tend to both decrease exports and increase imports; both of these volume effects will decrease net exports. Valuation effects point in the opposite direction. As ε increases, the “price” of imports (measured in units of domestic good) falls, which increases net exports.

Question 40

What determines the overall effect on net exports?

Answer 40

For a given increase in ε, the volume effects tend to decrease net exports while the valuation effects tend to increase them. So the total effect will depend on the relative size of the two opposing effects. Since the valuation effect has a fixed effect on net exports (because a 1% increase in ε will always make the value of a given import fall by 1%), the total effect will depend on whether the price elasticities of demand for imports and exports are more or less than the fixed valuation effect. If the price elasticities of imports and exports are zero, for example, then the valuation effect will be the only effect and a rise in ε will cause NX to rise. On the other hand, if the price elasticities are very large, so that imports and exports change a lot even in response to a small change in ε, then a rise in ε will cause net exports to fall.

Question 41

Do you think the Marshall-Lerner condition is more likely to hold in the short run or the long run? Why? [Hint: it is easier to answer this question if you think about the J-curve, use Google to find some information about it]

Answer 41

* The Marshall-Lerner (ML) condition is more likely to hold in the long-run, and may not hold at all in the short run. Recall that the ML condition requires that exports and imports are sufficiently elastic (i.e. responsive to price changes as a result of changes in the real exchange rate). Conversely, if the physical quantities of exports and imports do not respond sufficiently to changes in the exchange rate, then the ML condition will not hold. Since consumers and firms tend to respond to price changes more in the long run than in the short run, the ML condition may not hold in the short run, but it is much more likely to hold in the long run. * The idea that following a depreciation, trade balances might get worse before they get better is known as the J-curve (since net exports follow a J-shaped curve, as shown in the graph below).

Question 42

How might multinational banks, pension funds and manufacturers and contribute to the integration of financial markets between countries?

Answer 42

* Banks o may contribute to the integration of financial markets between countries because they have knowledge about credit markets in different countries and can help investors to invest or channel funds to foreign markets. o By seeking to borrow in countries with low real interest rates and lend in countries with high real interest rates, banks can help to bring about the convergence of global real interest rates. * Pension funds o perform a role which is analogous to banks, but they are more likely to take an ownership stake (e.g. purchase shares) in countries with high real returns, rather than making loans there. o In recent years, for instance, Canadian pension funds “have bought outright or own stakes in some of the UK's most prized infrastructure. That includes High Speed One, the railway line that connects London to the Channel Tunnel; Scotia, Scotland's biggest gas network; the ports of Southampton and Grimsby; Birmingham and Bristol airports and Camelot, the operator of the national lottery .” * Multinational manufacturers o will attempt to make their “property, plant and equipment” investments in countries where they get the highest real return, and to gradually reduce their holdings where the returns are lowest. o By doing so, they contribute towards convergence in real rates of return and financial integration. o For instance, many manufacturers who invested heavily in Chinese production in 1990s and early 2000s (when Chinese wages were relatively low and the marginal product of capital correspondingly high) are – now that Chinese wages have risen sharply – shifting some of their investments into South and Southeast Asia where wages are still comparatively low .

Question 43

Consider the following statements: The main objective of Fiscal policy councils, introduced in a number of countries including Denmark and Sweden, is to eliminate deficit bias by making independent fiscal policy decisions which must be accepted by the government A country with an average nominal deficit over the cycle equal to 5% of GDP, inflation of 3% and the real growth rate of 2% will have the long-run debt-to-GDP ratio of 100% In a world with less than full Ricardian equivalence, a deficit will redistribute income from current to future generations

Answer 43

FALSE TRUE FALSE

Question 44

Assume a country is running a trade deficit, current account deficit and budget deficit this year. Which of the following statements is/are true? An increase in the trade deficit will, all else equal, lead to an increase in the current account deficit Unless full Ricardian equivalence holds, an increase in the budget deficit will, all else equal, lead to an increase in the current account deficit The current account deficit measures the net amount of additional foreign borrowing this year

Answer 44

TRUE TRUE TRUE

Question 45

Consider the following statements: In a small open economy with a fixed exchange rate, allowing free movement of capital is compatible with having autonomous monetary policy. In a small open economy with free movement of capital, if the currency is expected to depreciate, the nominal interest rate must be greater than the rate in the rest of the world In a small open economy with a fixed exchange rate, an increase in government spending would imply the central bank should increase the money supply

Answer 45

FALSE TRUE TRUE I describes the impossible trinity (or policy trilemma) except that a fixed exchange rate and free movement of capital is incompatible with autonomous monetary policy. II describes the uncovered interest parity condition. III is true because increased government spending would increase money demand and put upward pressure on the interest rate. In order to keep it, and the exchange rate, fixed, the central bank must increase the money supply.

Question 46

Consider the following statements: Given a fixed nominal exchange rate, the domestic real exchange rate will appreciate if domestic inflation is higher than foreign inflation In the analysis presented in the course, the term small open economy is used to refer to countries whose imports do not exceed exports According to the interest parity condition, if the currency of a small open economy is expected to depreciate, the nominal interest rate in the small open economy has to be higher than the foreign interest rate

Answer 46

TRUE FALSE TRUE This question is based on the material from chapter 12 of Gottfries and relevant tutorial sheets and lectures. Statement I is true. The real exchange rate is given by , therefore if is fixed a faster growth of relative to will lead to appreciation in real terms. Statement II is false. By small open economies we mean economies small enough that shocks and policy decisions which happen in the economy do not affect the rest of the world. If statement II was true, we would limit ourselves to analysing countries with negative (or at least not positive) net exports only, which is not the case. Statement III is true. The interest parity is given by . The interest rate in the small open economy has to be higher to compensate for the expected depreciation (decrease in ). For more details see Gottfries chapter 12.

Question 47

A country has a floating exchange rate and the interest parity condition holds. The expected exchange rate next year is 10 units of foreign currency per unit of domestic currency and the foreign interest rate is 5%. What is the expected percentage change in the exchange rate if the domestic interest rate and domestic inflation are 2% and 1% respectively? Round your answer to the nearest percent.

Answer 47

Appreciation of 3%

Question 48

Consider a country which has a floating exchange rate and assume the interest parity condition holds. The expected exchange rate next year is 25 units of foreign currency to one unit of domestic currency, the domestic interest rate is 10%, the foreign interest rate is 25%. What is the current nominal exchange rate? Round your answer to the nearest integer.

Answer 48

22

Question 49

In general, what sorts of circumstances might cause you predict that the nominal and real exchange rate between two countries might move in the same direction? In opposite directions?

Answer 49

🔷When do nominal and real exchange rates move in the same direction? ✅ Circumstances: * No major inflation differences between the two countries * The real change is driven by trade competitiveness or capital flows * For example: If the UK becomes more competitive (e.g. better productivity), demand for the pound increases → real and nominal appreciation 💡 Intuition: If prices are stable in both countries, any change in real exchange rate must be caused by a change in the nominal rate. 📌 Example: * UK real exchange rate appreciates → £ becomes more valuable * If inflation is similar in the UK and US → nominal rate must rise too (pound appreciates in nominal terms) 🔷 When do nominal and real exchange rates move in opposite directions? ✅ Circumstances: o Inflation rates differ significantly * Suppose real appreciation is happening, but your country has much higher inflation o This pushes down the nominal exchange rate 💡 Example: * Country A (UK) has real appreciation vs Country B (US) * But UK inflation is 4% and US inflation is 1% * Then even though UK goods are becoming more valuable (real appreciation), the high inflation weakens the pound → nominal depreciation ✅ Whether nominal and real move in the same or opposite directions depends on the relative size of: 1. The real exchange rate change 2. The inflation gap 🔷 Key Takeaway: Real exchange rate change=Nominal exchange rate change+Inflation differential So: * If inflation differential is small → real and nominal tend to move together * If inflation differential is large → they might move oppositely

Question 50

Q4. [E] “An enormous, 9.0-magnitude earthquake rocked Japan on March 11, 2011, unleashing a tsunami that swamped the Japanese coast, killing more than 15,000 people and causing hundreds of billions of dollars of property damage.” a) What does theory suggest would happen to the value of the Japanese Yen in the days after the disaster? b) What does theory suggest would happen to Japanese net exports?

Answer 50

* Output ↓ (due to destruction) * Domestic demand ↓ but less than output * Net exports ↓ * BUT: Capital inflows (repatriation) ↑ → yen appreciates - Again for the reasons given in the earlier question about whisky, we would expect domestic production in Japan to fall as a result of the disaster, and we would expect imports to fall by less (or even to rise), thus causing net exports to deteriorate. - In fact, the 2011 Tohoku earthquake led to Japan’s first trade deficit since 1980 (see graphs below).

Question 51

What factors may cause differences between countries in… a) ...savings ratios?

Answer 51

o Pension systems o If the state provides generous pensions, people don’t need to save as much privately o Example: Iceland o Low savings – 2% GDP o Natural resource wealth o Countries with large resource revenues eg. oil often save government surpluses in soverign wealth funds o Example: Norway  savings of 40% of GDP – are saving resource rents from oil extraction. o Access to credit o In countries with easy to access credit people can borrow to smooth consumption (reducing the need to save) o Cultural and social norms o Some societies place more value on thrift, long term planning or providing for future generations

Question 52

What factors may cause differences between countries in… b) ...investment ratios?

Answer 52

(Hint: Go back to Chapters 3-4.) * Access to credit and functioning financial markets o Well developed financial systems means its easier for firms to borrow and invest o Poorly functioning markets or high borrowing costs = less investment * Political risk and property rights o Firms are less willing to invest in countries where businesses fear expropriation (government taking assets) o Or where laws are unstable * Returns to capital o In theory, with integrated global markets, return on capital should equalise across countries o So investment differences are not huge across developed countries o But slight differences remain due to:  Local tax policies  Business environment  Infrastructure * Demographics and growth expectations o Countries expecting faster growth or population  May invest more to build homes, infrastructure etc.

Question 53

Financial markets are neither perfectly integrated internationally nor are they completely separated. Which factors may limit international financial integration (lending between countries)?

Answer 53

* Information asymmetries * Foreign investors often lack detailed info about domestic borrowers * Hard to assess creditworthiness or risk in unfamiliar markets * Lack of trust / institutional quality * Investors fear corruption, weak rule of law, or unreliable courts * Hard to enforce contracts in countries with poor governance * Fear of expropriation / political risk * Foreign investors may worry a government will seize assets or change rules arbitrarily * Legal and regulatory differences * Different bankruptcy laws, property rights, and tax systems add complexity and risk * Capital controls * Some governments restrict foreign borrowing/lending to limit exchange rate volatility or control inflation * Currency risk * If returns are in a different currency, exchange rate volatility can deter cross-border lending * Home bias * Investors often prefer to hold domestic assets, even when foreign returns are higher

Question 54

How might multinational banks, pension funds and manufacturers and contribute to the integration of financial markets between countries?

Answer 54

* Banks o may contribute to the integration of financial markets between countries because they have knowledge about credit markets in different countries and can help investors to invest or channel funds to foreign markets. o By seeking to borrow in countries with low real interest rates and lend in countries with high real interest rates, banks can help to bring about the convergence of global real interest rates. * Pension funds o perform a role which is analogous to banks, but they are more likely to take an ownership stake (e.g. purchase shares) in countries with high real returns, rather than making loans there. o In recent years, for instance, Canadian pension funds “have bought outright or own stakes in some of the UK's most prized infrastructure. That includes High Speed One, the railway line that connects London to the Channel Tunnel; Scotia, Scotland's biggest gas network; the ports of Southampton and Grimsby; Birmingham and Bristol airports and Camelot, the operator of the national lottery .” * Multinational manufacturers o will attempt to make their “property, plant and equipment” investments in countries where they get the highest real return, and to gradually reduce their holdings where the returns are lowest. o By doing so, they contribute towards convergence in real rates of return and financial integration. o For instance, many manufacturers who invested heavily in Chinese production in 1990s and early 2000s (when Chinese wages were relatively low and the marginal product of capital correspondingly high) are – now that Chinese wages have risen sharply – shifting some of their investments into South and Southeast Asia where wages are still comparatively low .

Question 55

Does the openness of the economy make it impossible to use capital taxes to redistribute income in the open economy?

Answer 55

o No. With perfectly integrated financial markets, capital must earn the same return in all countries but you can still tax individuals in the country where they live. In theory, one can make individuals pay tax on capital income independent of whether this income comes from the home country or from abroad. o Two important limitations are that individuals may hide capital income in tax havens and that rich individuals may move to countries with low capital taxes

Question 56

Is it possible for one country to have a different expected real interest rate than the rest of the world?

Answer 56

o If a government tightly restricts international capital flows (international borrowing and lending) then the country could, in theory, have a different expected rate of return on capital. o Of course actual (as opposed to expected) real rates may differ substantially across the world if there are surprise inflations/deflations or sudden currency appreciations/depreciations.

Question 57

Assume that consumers become more optimistic and expect higher future income but production remains on the natural level. What is the effect on private lending, government net lending, and the current account?

Answer 57

* Consumers expect higher future income → They increase consumption today, even though current income hasn’t changed → C increases * Since Y and G are constant, higher C means: * Private saving falls (because consumers are spending more) * Private net lending ↓ * Government net lending remains unchanged * No change in taxes or spending * National net lending = private + government * So total national lending ↓ * Current account = net national saving – investment * If investment is unchanged (no productivity or interest rate shock), then: * ↓ National saving ⇒ current account worsens (deficit ↑ or surplus ↓)

Question 58

The three equations below describe the Mundell-Fleming model. [IS] Y=C(Y-T,Y^e-T^e,i-π^e,A)+I(i-π^e,Y^e,K)+G+NX(eP/P^* ,Y^*,Y) [LM] M/P=Y/V(i) [IP] 1+i^*=(1+i) e^e/e [Philips curve] …. 4 eq -> 4 end-variables With three equations we must also have three endogenous variables. Which variables should best be treated as endogenous if: The country has a fixed exchange rate? b) The country has a floating exchange rate and the central bank is assumed to set the money supply exogenously? c) The country has a floating exchange rate and the central bank is assumed to set the interest rate exogenously? Explain in economic terms.

Answer 58

With a fixed exchange rate, Y, M and i are endogenous in the three equation system. Production is determined by aggregate demand. The interest rate is determined by the interest parity condition. (The IP condition implies that if the fixed exchange rate is credible the interest rate must be the same as abroad – the central bank has no control over it.) Money supply is determined endogenously so that the LM equation is satisfied for a given interest rate. * In this case Y, i and e are endogenous. * Production is determined by aggregate demand, * the interest rate is determined by supply and demand for money, * and the exchange rate is determined by the interest parity condition. * In this case Y, M and e are endogenous. * Production is determined by aggregate demand, * the central bank must adjust the money supply so as to achieve the desired interest rate, * and the exchange rate is determined by the interest parity condition. * Notice that the endogenous/exogenous distinction relates to what you are solving for with the equations, and thus what you are modelling. * The distinction has nothing to do with a variable being controlled or not controlled by the central bank. Contrasting parts (b) and (c) for instance – in both cases the central bank could in principle control either the interest rate or the money supply, but since they’re jointly determined, you can’t freely choose both at once. You can freely choose one, and then the other is set.

Question 59

"Expansionary fiscal policy is useless because an increase in government expenditure will just crowd out private demand." Under what conditions will this be true?

Answer 59

 Crowding out = when gov spending causes private consumption or investment to fall, cancelling out the stimulus o Can happen via:  Interest rate rises – discourages private investment  Exchange rate appreciation – NX falls  Forward looking consumers expecting higher future taxes so they reduce consumption  Fixed Exchange rate = FALSE o Central bank does not set the interest rate freely — it must adjust money supply to keep the exchange rate fixed o So: fiscal policy can have a stronger effect, because monetary policy accommodates it o When Gov spending increases:  AD ↑ → output Y ↑  No rise in interest rate (because the central bank keeps it steady to maintain the peg)  No exchange rate appreciation (because the exchange rate is fixed)  Possibly some Ricardian crowding out: * Consumers might expect future tax increases → C falls slightly * But this effect is usually partial unless all consumers are fully Ricardian (which is unrealistic)  Floating exchange rate with inflation targetting central bank = TRUE o With a floating exchange rate and an inflation target, the extent of crowding out depends on the reaction of the central bank  If government expenditure increases, the central bank will, most likely, set a higher interest rate than it would otherwise have set, and this * will reduce investments and lead to an appreciation of the exchange rate which has a negative effect on exports.  If the central bank was doing its job properly, then in the period just before the fiscal intervention, the interest rate should have been set to put aggregate demand at the level where the central bank wanted it to be. * Thus any changes in AD resulting from the fiscal intervention should be offset to bring AD back to the target level. * So the increase in government spending will be offset by an equal decrease in private expenditure. * Thus in this case, the statement is true.

Question 60

"Fiscal policy is less powerful in the open economy compared to the closed economy." Under what conditions will this be true?

Answer 60

 In general, this is true: the impact of fiscal policy is reduced in the open economy because some demand is directed towards goods produced abroad and this “leakage” reduces the multiplier effect.  Very small, very open economies like Hong Kong & Luxembourg will find that any fiscal stimulus they attempt will mainly leak away in the form of higher demand for imports.  But larger economies like the USA, China, or Japan will have much lower leakage rates because more of domestic demand is satisfied with domestic production.  And the exchange rate system matters too. o With a fixed exchange rate, the interest rate and exchange rate will be unchanged and this means that there is no crowding out of investments and net exports. o With a floating rate, there is crowding out. Moreover, this crowding out effect is larger in an open economy, because it affects both investment and net exports.

Question 61

How does the long-run impact of monetary policy on production depend on whether there is a fixed or a floating exchange rate regime?

Answer 61

o NO o Output is unaffected by the monetary policy in the long run, and that is the case under both exchange rate regimes. o This is because MP only affects demand but natural output is determined by supply side factors eg. tech, labour, capital etc. o There a short run differences but no long run effects

Question 62

Q7. [T] A country has a floating exchange rate and a target rate of inflation. Suppose that inflation is initially equal to the target. Then there is a large discovery of oil in the country. This will increase future incomes in the country and investments need to be made in order extract the resource. Compare the following policy responses: a) An increase in taxes b) A reduction in government expenditure c) An increase in interest rates Which in your view, is the best way to deal with the shock if the objective of the policymaker is to prevent excessive inflation?

Answer 62

* The country has: * A floating exchange rate * An inflation target * Inflation is on target initially * Then: * A large oil discovery is made * This increases expected future income * There’s also an immediate rise in investment demand to exploit the oil So: * Consumption ↑ (because people expect to be richer in the future) * Investment ↑ (to develop oil infrastructure) * → Aggregate Demand ↑ * → Pressure on output ↑ → inflation ↑ 🔷 Policy Option A: Increase taxes 🔸 Mechanism: * Higher taxes reduce disposable income → consumption falls * If consumers are non-Ricardian (realistically, most are), this works to dampen demand * If consumers were fully Ricardian, they’d save more instead of consuming less, knowing taxes will be refunded later — but this is rarely the case in practice ✅ Pros: * Directly targets the consumption boom * Avoids raising interest rates (so doesn’t hurt investment or net exports much) ❌ Cons: * Politically unpopular * You're taxing a population that's actually becoming richer 🔷 Policy Option B: Cut government spending 🔸 Mechanism: * Lower G → IS curve shifts left * Reduces overall AD → lowers inflationary pressure ✅ Pros: * Like taxes, reduces AD without interfering with interest rates or exchange rates * Possibly more politically acceptable than raising taxes ❌ Cons: * May reduce public investment at the very time when infrastructure is needed to support oil development * Also, the country is richer — cutting public spending might not be the best use of new wealth 🔷 Policy Option C: Raise interest rates 🔸 Mechanism: * Central bank raises the nominal interest rate * → Consumption and investment become more expensive → C and I ↓ * → Capital inflows increase → currency appreciates * → Net exports fall → reduces AD * Also helps anchor inflation expectations ✅ Pros: * Uses exchange rate appreciation to reduce demand for domestic goods * Avoids cutting spending or raising taxes in a newly richer country * Frees up domestic resources (labour, capital) to support higher investment in oil sector ❌ Cons: * Can hurt investment (which is also rising due to the oil shock) * May overkill if interest rates are raised too much Best option: Increase interest rates Why? * Raising interest rates achieves the objective with the least sacrifice of consumption or investment * It reduces net exports, shifting demand away from domestic producers toward foreign goods — which is what you want in this case * Since the country is getting richer, it makes sense for the currency to appreciate and for intertemporal prices to adjust

Question 63

Outline three desirable goals of monetary policy in an open economy.

Answer 63

(1) Exchange rate stability (to facilitate trade) (2) Autonomy of monetary policy (to stabilize domestic fluctuations) (3) Free movement of capital (for efficient allocation of resources)

Question 64

In international economics, there is an idea variously known as ’the impossible trinity’ or ’the trilemma’ which implies that the three things one might desire from monetary policy in an open economy cannot all be had at the same time. Why might the goals outlined above be incompatible? (Hint: use the interest partiy conditon.)

Answer 64

Goal (1) requires ∆e⁄e=0, goal (2) requires i≠i^* and goal (3) requires that the interest parity condition holds (i-i^*≈-∆e/e). The object here is to show that one can’t have all three of these goods at the same time. Let’s start by supposing that the central bank opts for: (1) a stable exchange rate, and (3) capital mobility. Substituting the condition for (1) into (3) yields i-i^*=0⇒i=i^*, which is inconsistent with the second goal of an autonomous monetary policy. What if the central bank opts for (1) a stable exchange rate and (2) monetary autonomy? This can only be achieved through the failure of (3) the interest parity condition to hold, i.e. forgoing capital mobility. A similar logic applies to governments who opt for (2) and (3), which is in fact the arrangement chosen by most of the world’s advanced economies. With free movement of capital and autonomous monetary policy then i≠i^*⇒i-i^*≠0⇒∆e/e≠0

Question 65

Q1. [E] One way firms can avoid exchange rate uncertainty is by buying currency in the forward market. That is, signing a contract that involves buying foreign currency in one years’ time at some predetermined exchange rate. a) Consider a bank operating with the UK. If the bank were to lend £1 domestically, what return would it have after one year? b) The bank is willing to sell currency on the forward exchange market. The bank offers to sell £1 for Australian dollars at the rate ft,t+1¬.To hedge its risk it buys Australian dollars today at rate e¬t and lends it at rate i*. After one year it sells the dollars at the forward rate. What is the return of this transaction in pounds? c) Why, in terms of risk, are these two transactions equal? How does this contrast with uncovered interest parity? d) Show that the forward exchange rate is equal to the expected future exchange rate. Given that UK interest rates are 0.5%, Australian rates are 2% and the current exchange rate is 2.14 dollars per pound, what is the expected future exchange rate of dollars to pounds?

Answer 65

After one year the bank would receive 1+i. i.e. £1 x (1 + i) no exchange rate risk as everything done in pounds The bank initially buys e_t dollars and lends them at the Australian interest rate i^*.\ Et x (1 + i*) AUD After one year it sells the dollars at the price 1/f_(t,t+1) . This is known as the forward rate Thus the total return is e_t (1+i^* ) 1/f_(t,t+1) In the second strategy, you also earn: et( 1 + i*)/ ft,t+1 = 1 = i This equality is called Covered Interest Parity (CIP) and it holds when: Capital can move freely Investors can use forward contracts There’s no risk or transaction cost Both of these transactions are riskless. * Because the forward rate is locked in, the bank knows exactly the rate of return it will receive in one years’ time. o Essence of CIP * Uncovered interest parity however does involve risk, as the expected future exchange rate is a random variable. Covered interest parity shows that 1+i_t=e_t (1+i_t^* ) 1/f_(t,t+1) ⇒f_(t,t+1)=(1+i_t^*)/(1+i_t ) e_t Rearranging uncovered interest parity 1+i_t^*=(1+i_t ) (e_(t+1)^e)/e_t ⇒e_(t+1)^e=(1+i_t^*)/(1+i_t ) e_t=f_(t,t+1) Given the information in the question f_(t,t+1)=(1+0.02)/(1+0.05) 2.14=2.17 dollars per pound.

Question 66

Q3. [T] Within a monetary union, member countries are unable, following a shock, to stabilise the economy using monetary policy, as the interest rate and the nominal exchange rate are fixed. Name some alternative adjustment mechanisms. What may limit their effectiveness?

Answer 66

SUMMARY real exchange rate via inflation ✅improves competitiveness ❌too slow without wage cuts fiscal policy ✅ stimulates AD directly ❌may be restricted by debt, rules or politics labour mobility ✅reduces regional unemployment ❌ barriers to movement (language, legal, cultural) wage flexibility ✅boosts exports via lower costs ❌ politically unpopular ❌causes deflation risk Real exchange rate adjustment o Even though the nominal exchange rate is fixed, the real exchange rate may change over time if there are differences in inflation across member countries. o For example, during an economic downturn a country will experience low levels of inflation, which leads to real depreciation and raises net exports. o However, this process can be very slow, unless the adjustment happens through reduction of nominal wages (which would be very unpopular, of course). 2. Fiscal policy o In theory, fiscal policy might compensate for the lack of autonomous monetary policy. However, there are several limits and obstacles to this, which the recent crisis in Greece illustrates. First, a country experiencing an economic downturn may well be in a poor fiscal condition already, which severely limits the scope of fiscal stimulus or even enforces cutbacks. Second, any fiscal policy adjustments are only implemented after a prolonged decision-making process, which is only more difficult during times of economic uncertainty. 3. Labour mobility/migration Another mechanism is migration. One reason that the currency unions within a big country like the US can work is that people will move from depressed areas (the rustbelt) to rapidly growing areas (e.g. Texas). In Europe, this happens less because of barriers of language and culture. In addition, there may be legal restrictions on immigration

Question 67

Q5. [T] In theory, monetary policy is very powerful when you have a floating exchange rate. a) Explain why this is so.

Answer 67

o If demand is strong, a central bank that targets inflation will raise the interest rate and this will lead to an appreciation of the exchange rate (increase in value of the currency). o In this way, investment, consumption, and exports are all affected by monetary policy. ✅ 1. Interest rate channel * If demand is rising and inflation is above target: o Central bank raises interest rate ii o → Borrowing becomes more expensive → Investment ↓ o → Households may save more and consume less → Consumption ✅ 2. Exchange rate channel * Higher interest rate → capital inflows → currency appreciates * Appreciation = real exchange rate ↑ * → Exports ↓, imports ↑ → net exports ↓ * Helps cool down demand (or stimulate it in the opposite case) ✅ 3. Expectations channel * Credible monetary policy affects expectations of future inflation * This influences wage-setting, price-setting, and long-term borrowing 📌 Together, these effects mean the central bank can stabilise output and inflation, even in the face of external shocks — precisely because the exchange rate adjusts. This is in contrast to a fixed exchange rate regime, where monetary policy loses its autonomy.

Question 68

Q7. [E] The textbook explains that “when judging whether exchange rate uncertainty is good or bad for investment and trade, a crucial question is why the exchange rate varies in the first place.” Explain what is meant by this.

Answer 68

o Exchange rate fluctuations would be a bad thing if they are due to irrational speculation, and it would be a worthwhile endeavour to eliminate them. o However if exchange rate fluctuations act as they do in the Mundell-Fleming model and stabilize demand then this is not the case. o Indeed, exchange rate fluctuations may actually reduce uncertainty about total demand for firm’s products.

Question 69

Q8. [E] In the context of a monetary union, why is the difference between a symmetric and an asymmetric shock important?

Answer 69

o If a shock is symmetric (i.e. effects all countries in the same way), then a common monetary policy suits everybody’s needs. In this sense the central bank would act in a similar way to what a national central bank would have done anyway. o If a shock is asymmetric (effects different countries in different ways) then optimal monetary policy may be different in one part of the union to another.

Question 70

Q9. [T] ’Exports and imports have increased continuously relative to GDP. If this process continues, the case for joining the euro will become stronger’. Do you agree? Explain your answer.

Answer 70

o As exports and imports increase relative to GDP, trade links between countries become stronger. This strengthens the case for joining the European Monetary Union for several reasons. o Lower transaction costs o More trade → more foreign exchange transactions o Joining the euro removes these costs entirely o Reduced exchange rate risk o With high trade openness, firms are more exposed to currency fluctuations o A common currency eliminates this uncertainty o More synchronised business cycles o If countries are strongly linked through trade, shocks in one country affect others o This makes a single monetary policy more appropriate for all members o The more trade → the more likely this synchronisation becomes o So, other things being equal, a rise in the trade share makes a currency union more attractive.

Question 71

. [T] Few advanced economies have a fixed exchange rate today. One example is Denmark. a) What are the advantages and disadvantages of a fixed exchange rate compared to a floating exchange rate? b) What are the advantages and disadvantages of a fixed exchange rate compared to membership of a monetary union?

Answer 71

The advantages and disadvantages are similar to those of being a member of a monetary union compared to floating (see Section 15.3). o In short, there are: o efficiency gains from reduced transaction costs o reduced exchange rate uncertainty o increased gains from trade. o However, there are increased risks of macroeconomic instability due to the fact that monetary policy is limited (there is no monetary policy except the possibility to change the target level of the exchange rate). o A credibly fixed exchange rate is almost like being member of a monetary union. o You stabilize the nominal exchange rate but you will not have an independent monetary policy. o One difference is that you still have to exchange currencies so you don’t save transaction costs. o Another is that it is much easier to leave the fixed exchange rate and move to a floating rate than to leave a monetary union. o This also means that there may be speculation that the currency will devalue, forcing the country to set a higher interest rate (or the other way around for revaluation).

Question 72

When a set of countries have credibly fixed exchange rates between them, the interest rates on safe assets will be the same in all those countries. But who sets that common interest rate? Compare the classic gold standard, the Bretton Woods system, EMS, and the EMU.

Answer 72

o If two countries have a credibly fixed exchange rate the interest rates in the two countries cannot differ very much because this would create arbitrage opportunities. o Investors will gain by borrowing in the country with a low interest rate and lend in the country with a high interest rate. In actual fixed exchange rate systems, it may be one country who has to adjust or it may be a mutual responsibility. o ✅ 1. The Classic Gold Standard (late 1800s – WWI) o Currencies were fixed to gold at a set price o Exchange rates were effectively fixed through convertibility into gold o 🟡 Who set interest rates? o The dominant country: Britain, via the Bank of England  Other countries had to adjust their interest rates to maintain gold parity with the British pound o 🔍 Why Britain? o It was the global financial centre and had a strong, stable economy o Other countries needed to follow its lead to maintain their peg o ✅ Interest rate leader: Britain o o ✅ 2. The Bretton Woods System (1945–1971) o All currencies were pegged to the US dollar o The dollar was pegged to gold at $35/oz o Countries kept their exchange rates stable by intervening in currency markets o 🟡 Who set interest rates? o The US Federal Reserve set US interest rates for domestic reasons o Other countries (like France, Japan, West Germany) had to adjust their interest rates to maintain their peg to the dollar o 📌 Effectively: The US had monetary autonomy, others didn’t o ✅ Interest rate leader: United States o o ✅ 3. The European Monetary System (EMS / ERM, 1979–1990s) o European currencies were tied to each other within narrow bands o In theory, it was a joint system, but in practice one country dominated o 🟡 Who set interest rates? o Germany (via the Bundesbank) became the de facto leader: o Germany had low inflation and a credible anti-inflation reputation o Other countries had to raise or lower their interest rates to maintain parity with the Deutsche Mark o 📌 When speculative attacks happened (e.g. UK in 1992), weaker currencies were forced to raise rates or exit the system o ✅ Interest rate leader: Germany o o ✅ 4. European Monetary Union (EMU, from 1999 onward) o Countries gave up national currencies and adopted the euro o A single central bank — the European Central Bank (ECB) — sets interest rates for the entire eurozone o 🟡 Who sets interest rates? o The ECB, based in Frankfurt, with input from all eurozone members via the Governing Council o 📌 All countries use the same interest rate — no more national discretion o ✅ Interest rate leader: ECB (collective, rule-based) o In all fixed exchange rate systems with capital mobility, only one country (or institution) truly sets interest rates — the others have to follow to maintain the peg. The only way to regain monetary autonomy is to have your own currency and a floating exchange rate

Question 73

The government of Protectoland, a small open economy, decided to increase import tariffs on cheese. Suppose that the Marshall-Lerner condition holds. In the long run, what is the effect of the policy on the value of net exports, , and the level of natural real exchange rate,

Answer 73

NX stays unchanged; natural real exchange rate increases

Question 74

Consider the following scenario: A report of a world-class consultancy company states that there is compelling evidence of capital overaccumulation in the rest of the world. Following this publication, the world real interest rate decreases. What effect will this have on the value of net exports, , and the real exchange rate, , of a small open economy in the long run? Suppose the Marshall-Lerner condition holds

Answer 74

NX decreases;  natural real exchange rate increases decrease in the world interest rate decreases domestic interest rate stimulating consumption and investment and thus domestic demand. (The report mentioned capital overaccumulation in the rest of the world and therefore did not lead to a decrease in investment in the SOE). For production to be on the natural level, net exports must decrease. A decrease in net exports requires real appreciation (note that the net export function is unaffected).

Question 75

Consider country S, a small open economy, and country L, a large open economy. Initially both countries have no outstanding foreign borrowing or lending (F=0). Which of the following statements is/are true? (Consider the countries separately). Following an increase in domestic government spending, country S would necessarily become an international borrower An increase in domestic government spending would not lead to crowding out of domestic consumption and investment in country L An increase in domestic government spending would lead to a decrease in net exports for country S, and an increase in net exports for country L

Answer 75

none of them his question is based on the lecture about the large open economy. Statement I is false. Initially F=0 and increment F equals N X. We are not given any information about the initial value of net exports. An increase in government spending in country S would not affect the real interest rate. Investment and consumption would stay at the same level (no crowding out) and NX would decrease. However, whether the country becomes an international borrower (increment F equals 0 ) depends on the initial value of net exports and the size of the increase in government spending. (In the example on Mike’s slides a small open economy would become an international borrower, but that was a specific example that helped to contrast a small and a large open economies). Statement II is false. Unlike in small open economy, an increase in government spending in country L would lead to an increase in the interest rate reducing consumption and investment. Like a closed economy, country L would experience crowding out. Statement III is false. NX would decrease in either case, just to a different extent.

Question 76

Suppose that a small open economy has a floating exchange rate and things are generally as described in the standard textbook Mundell-Fleming model. In addition, the expected nominal exchange rate is given by the current nominal exchange rate (e to the power of e equals e). If there is a negative demand shock (such as an exogenous fall in domestic consumption), what will happen to the nominal exchange rate, e and output, Y in the short run?

Answer 76

e depreciates, Y stays unchanged Answer: D There is no change in output. There is an immediate decrease in such that net exports increase by the same amount as consumption falls. In this model, the IS* curve is horizontal and output is determined by the LM curve (which has not moved). For the derivation of the fact that the IS* curve is horizontal see Mike’s slides on endogeneous expected exchange rate. For a less detailed discussion see p 393 of Gottfries.

Question 77

Citizens of Ainolatac are considering organising an independence referendum. If they become independent, they will be a small open economy which can be described by the standard textbook Mundell-Fleming model and the Marshall-Lerner condition would hold. Most prominent economists of the region are worried that the independence result might generate a significant amount of uncertainty which would depress investment. They are having a meeting to decide whether they would be better off with a floating or fixed exchange rate. Which of the following is/are generally true? A floating exchange rate would allow the country to stabilise output faster than a fixed exchange rate Neither a floating nor a fixed exchange rate would allow the country to maintain a constant nominal interest rate under any circumstances Domestic fluctuations in output would be smaller under a fixed exchange rate

Answer 77

true false false his question is based on the tutorial sheet for chapter 14. Statement I is true. A decrease in investment associated with the referendum outcome would shift the IS curve to the left. Under the floating exchange rate, the central bank can use monetary policy. By increasing the money supply, they would be able to shift the LM curve to the right stabilising output at the natural level. When the exchange rate is fixed, the interest rate is determined by the rest of the world. The central bank would have to generate a leftward shift in LM to defend the exchange rate. Only over time, lower inflation would contribute to depreciation of real exchange rate and push output back to its natural level. Statement II is false. If the CB has enough reserves to defend the fixed exchange rate, the nominal interest rate will stay unchanged (the same as abroad). If a floating exchange rate is adopted, the interest rate will vary. Statement III is false. With a floating exchange rate, the output would fall but then it could be pushed back to its natural level by monetary policy. With a fixed exchange rate, as discussed above, the CB would have to shift the LM curve to the left which would depress output even further (compared to the effect of the shock itself). Output fluctuates more when the exchange rate is fixed.

Question 78

Coabana is a small open economy with its own a free-floating currency (the Coabanian peso). The Coabanans only export cigars, and their only import is beans. International financial markets are perfectly integrated, the Marshall-Lerner condition holds, and we make all the standard assumptions about the long-run equilibrium discussed in the lectures, problem sets and textbook. Consider the following statements about Coabana in the long run: The real interest rate in Coabana is determined by the real interest rate in the world financial markets. An increase in the world interest rate will cause the Coabana’s net exports to decrease. An increase in the world interest rate will cause depreciation of the peso in real terms.

Answer 78

true false true Statement I is true. With perfectly integrated financial markets the domestic real interest rate is tied to the real interest rate in the world financial market. Statement II is false. An increase in the world interest rate raises the Coabana’s real interest rate and reduces investment & consumption and thus domestic demand in Coabana. For production to be on the natural level net exports must increase. Statement III is true. An increase in the world interest rate will be accompanied by an increase in net exports which requires real depreciation.

Question 79

Consider a small open economy with a floating exchange rate which can be described by the standard Mundell-Fleming model and for which the Marshall-Lerner condition holds. Two events happen simultaneously: The US Fed raises the interest rate. The main importer of the country’s goods enters a recession. What type of pressure on the nominal exchange rate does each of these events create?

Answer 79

i creates downward pressure, ii creates downward pressure. Both these events create downward pressure on the exchange rate. The US is a large open economy, the decision of the Fed is likely to affect the world interest rate (or can even be considered to be the world interest rate). A higher world interest rate shifts the IP curve to the right and contributes to depreciation of domestic currency. A recession in the economy of the main trade partner shifts the IS curve to the left which also contributes to depreciation of domestic currency.

Question 80

Consider two small open economies which both can be described by the standard textbook Mundell-Fleming, for which the Marshall-Lerner condition holds and inflation expectations are anchored at the central banks’ target levels. Country A has a fixed exchange rate and decides to stimulate its economy by devaluing its currency by five percent. Country B has a floating exchange rate and decides to stimulate its economy by increasing the inflation target by one percentage point. Assess each of these three statements: The long-run effect of the chosen monetary policy on output will be stronger in country A. County’s A Phillips curve is more likely to be affected by the chosen monetary policy than country’s B Phillips curve. Both policies are likely to results in a short-run increase in output.

Answer 80

false false true Statement I is false. In the long run monetary policy is neutral. Irrespective of the exchange rate regime output will return to its natural level. Statement II is false. It’s the other way around. There is nothing in A’s monetary policy which is likely to affect the Phillips curve. County B on the other hand changes its inflation target, which will lead to an increase in expected inflation and push the Phillips curve up. Statement III is true. Both policies are likely to stimulate export and shift the IS curve to the right.