Period 3

MBA Program May – June 2008

MACROECONOMICS IN THE GLOBAL ECONOMY

Core Course

Professor Antonio Fatás

Final Exam
June 26, 2008
9:00-12:00

Space to answer the questions is limited. DO NOT WRITE IN THE BACK SIDE OF
ANY PAGE (unless you have made a mistake in the space provided to answer the
questions – in that case you need to cross out the mistake and you are allowed to
use the same amount of space in the back side of that page).

You have three hours for the exam.

The exam is open book.

Make your assumptions and diagrams clear, reasonable, and explicit.

If you are using graphs you must provide also an explanation and interpretation of the
changes implied by your graphical presentation.

Please read all questions before you start answering them!

There are 70 points in the exam. After each question you can find the maximum number
of points for the question.

Good luck!

Note: These are suggested answers to the questions in the final exam. They are to
be used as guidelines and not as the perfect answer to the questions. They are
short and concise; some of the arguments can be elaborated further. Also, there
might be other solutions to some of the questions that might be as good as the
ones we suggest here.

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1. True/false/uncertain. (Total: 15 points).

Explain whether each of the following statements is true, false, or could go either way
depending on the circumstances. You can use graphs where appropriate to support your
answers. Explanation determines grade. Start your answer by selecting one of the
three statements – “True”, “False”, or “Uncertain” and then justify your selection.

a. Over the past 20 years GDP in the US has increased by about 3.03% per year (at
PPP). Over the same period of time, GDP in the countries from the euro area
increased by 2.34% (at PPP). This implies that living standards in the US have
increased faster than in these European countries (5 points).

ANSWER: FALSE/UNCERTAIN. Living standards are measured by income per

capita. Even though the US had a higher total GDP growth, its income per capita
growth might have been lower if population has been growing rapidly.

b. If the interest rate controlled by the central bank declines to 0%, then the central
bank cannot increase money supply further because they cannot lower interest
rates below 0%. (5 points)

ANSWER: FALSE. Even if the interest rate is 0%, the central bank can still increase
money supply by buying securities, foreign currency or any other asset. The
purchase of assets injects automatically money in the economy and money supply
increases irrespective of the interest rate.

c. In order to reduce inflation, a central bank inevitably has to generate a recession.

(5 points)

ANSWER: FALSE/UNCERTAIN. A central bank which has high credibility can

reduce inflation by simply promising that money supply will increase slower (if at all)
in the future. However, most central banks do not have this level of credibility, but it
is still possible to gain it by adopting a credible fixed exchange rate regime, which
does not allow the central bank to print money. One example is the currency board in
Argentina. As soon as the fixed exchange rate was introduced, inflation dropped from
10,000% to single-digit numbers.

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2. Exchange Rates. (Total: 10 points).

Below is a graph of the exchange rate between the Malaysian Ringgit and the US dollar.
The dashed line presents the actual exchange rate, while the solid line is a calculation of
the equilibrium rate based on purchasing power parity. The exchange rate is reported in
terms of how many ringgits one can buy with one US dollar. From September 1998 until
July 2005 the ringgit was fixed against the dollar at 3.80 ringgits/$. In recent years the
actual exchange rate has been between 3.1 and 3.8 ringgits/$, while the PPP-based
exchange rate suggests that it should have been at less than 1.75 ringgits/$. (Note that
the exchange rate is quoted as ringgits/$. When this rate goes up, the ringgit depreciates
and the dollar appreciates).
Malaysia (Ringgit/US$)
4.0

3.0

2.0

1.0

0.0
1980 1985 1990 1995 2000 2005

a. Can you explain why the actual exchange rate has been consistently above the
exchange rate based on purchasing power parity? Under what conditions do you
expect to see that the two exchange rates will converge? (5 points).

ANSWER: The main explanation for the discrepancy is the presence of non-tradables.
The solid line is the equilibrium rate (using PPP) which implies that at this exchange rate
prices are the same in Malaysia and the US. Indeed arbitrage in goods will make these
prices equal and will lead to the necessary adjustment in the exchange rate. However, a
large amount of goods and services are non-tradable and their prices can deviate from
the world level. The low prices in Malaysia are explained by low level of productivity. As
we saw in class, countries with low income per capita have lower prices (“lower real
exchange rates”)

As Malaysia grows and the productivity gap with the advanced economies is closing,
wages in Malaysia will increase. With higher wages, prices will have to increase also and
the overall price level will rise. If non-tradables have the same prices in the US and
Malaysia, then the actual exchange rate will move closer towards the equilibrium rate
and eventually the two rates will converge.

b. During the Asian crisis in 1997-98 Mahathir Mohamad, Malaysia’s former prime
minister, imposed capital controls in order to stop any further depreciation of the
ringgit. As the pressure on the Asian currencies subsided in the subsequent few
years, the government started to remove regulations associated with capital
controls and the regime for withdrawing investments from Malaysia became much
more liberal. What do you think will be the immediate effect of complete removal
of all capital controls on the ringgit? What will determine the direction in which
the ringgit moves in the long run if there are no capital controls? (5 points).

ANSWER: The removal of capital controls has uncertain effect on the exchange rate
depending on whether capital outflows or inflows dominate. This will depend on the
initial level of the exchange rate relative to fundamentals. If the capital controls have
been in place to keep the exchange rate fixed at a level which is not consistent with

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fundamentals, once they are removed the exchange rate will move towards equilibrium.
In the long-run we know that the only variable that explains exchange rates is inflation.
Hence whether the ringgit will appreciate or depreciate will depend on the level of
inflation in Malaysia relative to the rest of the world.

3. Growth and Natural Resources (10 points).

In November 2007, Brazil’s state-controlled oil company Petrobras announced that they
have discovered new and significant oil reserves in the Tupi oilfield off the coast of Brazil.
Given current estimates, Brazil could join the world's “top 10” oil producers. At the time
of the discovery, Petrobras President Sergio Gabrielli said that these discoveries would
give Brazil the world's eighth-largest oil and gas reserves. “Brazil's reserves will lie
somewhere between those of Nigeria and those of Venezuela,” Gabrielli said at a news
conference. Assume that the reserves are indeed “extractable” and the estimates are
right. This sudden increase in nation’s wealth will now allow Brazil to grow fast and
become a rich country. Evaluate this statement and provide evidence to support your
argument. Are there arguments in the opposite direction?

ANSWER: It is not necessarily true that Brazil will start growing faster as a result of the oil
discovery. On the one hand natural resources can be a blessing as they allow countries to
relax certain budget constraints and use the funds to improve infrastructure, institutions
and the level of education. On the other hand, natural resources have been more of a
curse in many countries as they generate corruption, political instability and sometimes
even wars.

There are examples in both directions – Botswana has managed to use its resources to
deliver stellar growth rates over the past 40 years, while Venezuela, Sierra Leone and
many others have stagnated as a result of political instability as well as social and ethnic
conflicts.

In order for Brazil to grow faster and become a rich country, the institutional setup in the
country has to improve.

4. Capital Inflows, Monetary Policy and the Yield Curve (Total: 14 Points).

In recent months, capital inflows to Brazil have appreciated its currency. Capital is
attracted by high interest rates (the Central Bank interest rate is 12.25%). These capital
inflows increase the foreign reserves of the central bank as the foreign currency is
exchanged by the local currency (Real). So far inflation has been contained but there is a
risk that it will go up, even more because of what they see in other countries. Therefore,
the central bank of Brazil is worried about increases in inflation. The president of the
central bank of Brazil Henrique Meirelles said in a recent interview in Sao Paolo:

“The biggest concern over the next 12 months for Brazil and the rest of the world is
inflation. The risk is that prices for food and raw materials will continue to rise. If every
central banker decides that this is a problem for other countries, nobody will do anything
and there will be [faster] worldwide inflation.”

a. How do these capital flows that Brazil is experiencing influence the ability of the
central bank to run monetary policy? Is the appreciation of the currency consistent
with their interest rates? (7 points)

ANSWER: Capital inflows make monetary policy management more difficult as the
inflows generate an increase in money supply (foreign investors exchange their

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currencies for Reals). This increase in money supply is likely to lead to inflation. The
central bank will try to sterilize these inflows by raising interest rate, which might induce
even larger capital inflows.

If increases in interest rates were not anticipated by the market, one should expect an
appreciation (which is what we observe). This is also consistent with the idea of capital
inflows (foreigners need to buy the local currency).

Once higher interest rates are incorporated into the value of the currency, interest parity
tells us that we should observe a depreciation of the currency at a rate which is equal to
the difference between interest rates in Brazil and other countries.

b. What are the expectations of financial markets according to the yield curve below.
(The top panel displays interest rates at different maturities, from 3 months to 9
years. The bottom panel displays the change in those interest rates on June 19th. )
(7 points)

ANSWER: Markets expect that interest rates will go up over the next two years. In other
words, inflation will remain an issue and we are likely to see as high or even higher
interest rates set by the central bank going forward. In the medium term, there is a sense
that inflationary pressures will come down and the central bank will be able to reduce
interest rates (the yield curve has a negative slope between 3 years and 9 years). Having
said that, interest rates are likely to remain very high for many years as reflected by the
still high levels of interest rates at longer horizons. Credibility remains an issue for the
Brazilian central bank.

It is possible also to argue that the upward sloping yield curve signals expansion in Brazil
(partial credit can be given if this is the only explanation offered). But given the
information in the first question, it is more likely that the market anticipates higher
inflation rather than faster expansion.

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5. Oil price shocks and global inflation. (21 points).

a. Can oil price shocks (increases in the price of oil) lead to a persistent increase in
inflation? What are the effects on output and inflation? What is the role of monetary
policy? (7 points)

ANSWER: In principle, oil price increases only affect inflation temporarily (as long as the
price of oil does not increase by the same rate every year, something that is unlikely).
However, if monetary policy accommodates this high oil prices, i.e. the central bank
prints more money so that households and firms have enough money to buy oil at its
higher prices, then inflation will become persistent. In this case expectations of inflation
will be revised upwards and we might end up with higher inflation in other goods and
services. Again, the key issue here is whether monetary policy accommodates the
change in prices.

One can also address the question by saying that oil price shocks are negative
productivity shocks as higher oil prices make some of our physical capital obsolete (i.e. it
is inefficient to use this capital at this level of oil prices). This is a shift of the LRAS curve. If
the central bank reacts and reduces money supply since potential output in the economy
has gone down, then there will be no inflation. If the central bank keeps interest rates
constant, then the economy will be in the overheating zone and inflation will increase.
The key thing is that there is an imbalance between money supply that is needed at the
new level of potential output and the actual money supply.

One can represent this graphically:

New LRAS LRAS

Real
interest
rate
oil shocks
2 LM

Equilibrium
real interest rate
1

IS

Output
YLR
b. A Financial Times article last week talked about the increase in inflation we observe
today in many countries around the world “The result is unexpectedly big increases

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in overall inflation: the consensus for world consumer price inflation in 2008 has
jumped from the 2.4 per cent forecast in February 2007 to the 4.3 per cent forecast in
June 2008. These jumps are modest, but not that modest. Nor is the forecast level. If
people get used to the idea that inflation can jump like this, the notion may well
become embedded in expectations, with dire consequences.”

Take the perspective of an individual country that sees global inflation going up. This
means that the prices of goods that they import from other countries are going up (i.e.
goods are more expensive). And given that it seems that this is not just a one-time
increase (i.e. inflation will stay higher in the world for a few years) this cannot be
ignored. The central bank of that country cannot control inflation in the rest of the
world; therefore, there is little they can do. The central bank has no role to play to
control this imported inflation. Is that true? Would standard monetary policies to
reduce inflation not work in this environment? Would it make a difference whether
the country has a fixed exchange rate or a flexible one? (7 points)

ANSWER: This is not right. Inflation is determined by central bank policies. The increase
in price of oil can make the life of a central bank more difficult, but a central bank can
always reduce the growth rate of the money supply (i.e. raise interest rates) until inflation
stays constant or even goes down. It might be painful (it might cause a recession) but it
can do it. Prices will grow slowly, even gas prices, because their currency will
appreciate. So even if in dollars the price of oil keeps going up, it will not go up that
much (or even down if you take this to an extreme) in their local currency. Of course, this
is only possible if you have a flexible exchange rates and independent monetary policy.
With a fixed exchange rate, monetary policy has to follow the policies of the country to
which the currency is pegged.

c. An article in Bloomberg on June 19th, summarized the press conference of Mervin

King, Governor of the Bank of England that day. Mervyn King said that British living
standards will slip (go down) and economic growth needs to weaken as policy
makers refuse to flinch (refuse to give up) in their fight against accelerating inflation.
``It will not be an easy time, and I know that some families will find it particularly
difficult,'' King said yesterday in London. ``These changes to our spending power and
to the housing market are real shifts that, although not easy to accept, we cannot side-
step.''
Can you explain what he means by this statement? What if he tries to fight against the
decline in living standards that the families are experiencing? How would he do it?
What would be the consequences? (7 points)

ANSWER: He means that an increase in the price of oil combined with the (negative)
wealth effect of decreasing housing prices represents a real shock to the economy and
the economy needs to adjust to that. The living standards are coming down because of
the increase in the price of oil represents a decrease in income per capita (you could see
this as a shift to the left of potential output as in part a). In addition, wealth (at least
perceived wealth) is coming down which requires an adjustment in spending patterns.
The central bank cannot go against these real changes in income. If the central bank tries
to fight against a shift to the left of potential output they will be generating inflation which
might produce some short-lived benefits at the cost of a future recession.

One could also say that before this adjustment the economy went into the overheating
zone because of high spending. Spending was high because of the wealth effect
generated from high house prices. As house prices adjust now, households have to
retract back their spending and this might be painful.

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