14.02 Problem Set 7 - Solutions

Part I: True/False (5 points each, 50 points total)

1. True. Rather than being truly 'miraculous', countries like Singapore and Taiwan were able to grow at very high rates for many years because they invested a tremendous amount of their income each year, and were able to adopt pre-existing technology rather than re-inventing everything themselves.

2. False. The Asian crisis was characterized by a sharp depreciation of Asian currencies. If firms' debt was in domestic currency and revenue was in foreign currency, this would increase revenue relative to debt, helping the firms. In fact, many firms had borrowed in foreign currency (foreign lenders would rather not face any currency risk), but had revenue in domestic currency. When the domestic currency depreciated, they became unable to pay off their debt and were forced into bankruptcy.

3. True. See lecture slides (Fiscal Policy in the 1990's).

4. True. See lecture slides (Fiscal Policy in the 1990's).

5. False. Investors care about the real return they receive and usually wish to consume in domestic currency, so they must also consider the expected inflation and exchange rates. Additionally, investors are risk averse, and must worry about the risk of sovereign default: the foreign government may refuse to pay bondholders.

6. False. Because the risk of holding a bond rises with time, we would expect the yield curve to be upward sloping even in the absence of any expected interest rate changes. Thus a yield curve that is only slightly upward sloping is consistent with no expected changes in the interest rate, or possibly an expected future decrease in short-term interest rates.

7. False. If investors did not anticipate an interest rate cut, they set stock prices too low, thus the stock market should rise when the Fed acts. Conversely, if investors were expecting interest rates to be lower than they actually turned out to be, stock prices will be too high. Thus the immediate effects of both announcements could not have been the same - the effect on stock prices should be in opposite directions. (See page 298 of the text.)

8. True or False. The statement is true since consumers can act to undo the future monetary and fiscal policy, for example by decreasing their private savings when the government raises its savings. (Perhaps even more clearly, when the Fed increases the money supply firms could raise prices immediately, keeping the real money supply, and thus output, constant). However, the statement is false to the extent that completely rational consumers are not able to predict future policy. If the government announces that it will balance its budget next year, but then doesn't, the consumers may not immediately observe the change in policy or be able to change their behavior immediately to undo the change.

9. False. This may not be the BEST advice to give President Bush. There are other ways that the federal government could increase current spending to boost output that would also have additional positive long-run effects, like investment tax credits or spending on education.

10. False. American, Japanese, and German stocks and bonds are substitutes for one another. A change in the return on American financial assets will affect the investment decisions of all investors and will result in changes in foreign asset markets.

Part II: Big Mac Question (10 points)

Price of BIG MAC in US: 2.54.

Price of BIG MAC in Chile: 1260 pesos.

Exchange rate should be 1260/2.54 = 496 pesos/dollar.

Part III: Expansionary Monetary Policy and the Yield Curve (8 points each, 16 points total)

NOTE: This question was updated via email. Here is the answer to the updated version (changes are in red/underlined).

In quiz 2, we examined the effect of a monetary contraction (section 3, part 3).

1. Draw the path of the nominal interest rate following the money supply contraction under the assumption of a fixed price level no further change in nominal money supply.

2. Suppose that the highest point in the interest rate path is reached after one year immediately and the long run value is reached after three years. Draw the yield curve, just after the reduction in the money supply, one year later, and three years later.

Answer:

Two effects are in motion that determine the slope of the yield curve. First, the financial market requires a risk premium for bonds of higher maturity, therefore, the yield curve tends to be upward sloping. Second, when interest rates are expected to decrease, then the yield curve tends to be flatter and maybe even downward sloping for some maturities (as shown above). See also Blanchard, page 292.

In the above graphs, I assumed that the second effect dominates for the first curve (which does not need to be the case, but the curve must at least be flatter than the original and long run curve). After one year, I assumed that the second effect dominates, while in the long run, only the first effect is at work.

Part IV: Budget Deficits (8 points each, 24 total)

1. Here are three classical reasons why budget deficits are bad:

i. They increase the level of government debt, adding to interest rate payments in the future.

ii. They keep interest rates high, and therefore decrease investment.

iii. Usually they are accompanied by a current account deficit (twin deficits), with an associated loss of competitiveness.

Note that other possible answers are acceptable here, as longs as they are reasonable and refer to the economic (rather than ideological) costs of a deficit.

2. In the short run, getting rid of the deficit means a decrease in output (contractionary fiscal policy). In the long run, it will imply higher growth rate if we assume that higher investment brings along higher productivity.

3. The budget deficit achieved was eventually negative (a surplus!!), thanks to the extra taxes collected from the booming stock market.