Economics-Q58

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Part A. Multiple Choice Questions:Choose only one, most satisfactory answer for each question (6points each).
 

1. In general, treating other macro variables as given, as the aggregate real income of an economy rises temporarily in the short run,
 
a) real net exports rise by more than the income increase.
b) real net exports rise by the same amount as the income increase.
c) real consumption demand rises by less than the income increase.
d) real consumption demand rises by more than the income increase.
e) real consumption demand rises by the same amount as the income increase.
 
2. Suppose i, P, P*, Y, Y*, , R, T, and G are exogenously given and the interest parity condition holds. Then, if the economic circumstances in future years are expected to remain unchanged, aggregate preferred expenditure, D, rises when
 
a) net taxes collected by the government rises.
b) the domestic aggregate price level rises.
c) the foreign aggregate price level rises.
d) the nominal interest rate rises.
e) all of the above.
 
3. In the short run, when prices are sticky and the goods market is in equilibrium, income rises as the interest rate declines because
 
a) exports rise.
b) imports decline.
c) investment expenditure rises.
d) all of the above.
e) none of the above.
 
4. During 2005, the U.S. aggregate real income, Y, increased sharply. We want to figure out what factors may have contributed to that income increase. Suppose that we know that the LM curve did not shift during that year and that the markets for money and for goods and services were both in equilibrium at all times. Which one of the following factors could have caused the increase in income in this situation?
 
a) A temporary decrease in the domestic nominal interest rate.
b) An increase in the expected return on investment.
c) A temporary increase in the domestic price level.
d) A temporary increase in net taxes.
e) All of the above.
 
5. ITS, Inc., has established a subsidiary in Indonesia and is contemplating an expansion of its operations there, but the company is concerned about the macroeconomic conditions in the country. The managers learn that a couple of Indonesian banks with influential owners are facing cash flow problems and the Central Bank of Indonesia has decided to lower the discount rate temporarily and help out those banks. In the short-run when prices are sticky but the exchange rate is allowed to vary in a flexible way, this policy will
 
a) cause a depreciation of the nominal exchange rate in Indonesia.
b) raise the equilibrium aggregate real income in Indonesia.
c) cause a decline in the interest rates in Indonesia.
d) all of the above.
e) only a and c.
 
6. Latin America is a major export market for the US. Following the 2015-2016 economic crisis in Brazil, the real incomes of Latin American countries temporarily declined. What impact this event must have had on the IS curve of the US economy?
 
a) The IS curve must have shifted to the left.
b) The IS curve could not have been affected.
c) The IS curve must have shifted to the right.
d) The impact on the IS curve cannot be predicted.
 
7. In 2009, the U.S. aggregate real income, Y, dropped sharply. We want to figure out what factors may have caused the decline. Assume that the markets for money and for goods and services were both in equilibrium at all times. We know that the LM curve shifted downward due to a large increase in money supply. Which one of the following factors could have caused the decrease in income in that situation?
 
a) A temporary decrease in net taxes.
b) An increase in the expected return on investment.
c) A temporary decrease in the domestic price level.
d) A temporary increase in the domestic nominal interest rate.
e) A temporary decline in private consumption due to the decline in real wealth.
 
8. The government of Korea wants to raise the value of the country’s currency and increase domestic income of the economy in the short run. Which combination of the following short-term policies can definitely yield the desired result?
 
a) Increase money supply and keep government expenditure unchanged.
b) Increase government expenditure and keep money supply unchanged.
c) Increase money supply and reduce government expenditure.
d) Increase both money supply and government expenditure.
e) Reduce both money supply and government expenditure.
 

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Part B. Short-Answer and Algebraic Questions
 
1. This question is based on the article, “Sweden’s economy is thriving, so why is monetary policy so loose?”, published by The Economist on June 1, 2017. (The article is copied at the end of this document.) The article points out that in early 2017, the Swedish economy was booming and its inflation rate was on target, yet the Riksbank, Sweden’s central bank, “decided not only to maintain the main policy rate at -0.50%, where it has been since February 2016, but to increase the amount of asset purchases under quantitative easing (QE) by a further SKr15bn ($1.7bn) during the second half of 2017.”
 
(a) One explanation offered by the article for this decision of Riksbank is that “the inflation figure is deceptive … some of the increase [in inflation] was driven by one-off factors, such as rises in air fares and energy prices.” Assume that the inflation rate was indeed expected to decline and nominal interest rate and nominal exchange rate were expected to remain unchanged. If Riksbank had decided not to engaged in QE in the second half of 2017, which components of GDP would have been directly affected by the expectation of reduced inflation? How and in which direction? [4] Which components would have been indirectly affected due to the induced changes in income? [4] Which components would not have been affected directly or indirectly? [3]

 
(b) According to the article, Riksbank is constrained by the policies of the European Central Bank (ECB). What would happen to the Swedish economy if its exchange rate is floating and the Riksbank switches to tighter monetary policy before the ECB does? Why? [5] Does the article’s analysis of this issue assume that the interest parity (IP) condition hold true or does it assume that the IP is violated? [3]
 
(c) Given Riksbank’s decision to engage in QE in the second half of 2017, what would happen to its balance sheet (i.e., holding of financial assets) in that period? Why? [5]

 
(d) The article points out that Riksbank’s QE may cause property prices to continue to rise. If that happens and few people take on new mortgages, what is likely to happen to aggregate private consumption in Sweden? [5] In that case, is the article correct to conjecture that “rising mortgage payments might lead to a drop in overall demand”? [3]

 

2. This question is based on the article, “Another paradox of thrift,” published by The Economist on September 16, 2010. For your convenience, the article is copied at the end of this document.
(a) Based on the arguments in the article, how do low interest rates influence savings through pension systems? [7]

 
(b) The article argues that if in response to lower interest rates pensions systems cut benefits rather than arranging for additional savings, private household savings will rise. Why could this be the case? [6]
 

(c) Central banks lower interest rates to stimulate the economy. Could this policy have the opposite effect? Under what conditions this may happen? [7]
 

Full blast
Sweden’s economy is thriving, so why is monetary policy so loose?
 
Like other countries on the euro area’s periphery, it is in thrall to the European Central Bank
Print edition | Finance and economics

ON A recent balmy day, people thronged the parks and promenades of central Stockholm. Swedes have much to feel sunny about. Real economic growth, at a heady 3.2% in 2016, has averaged 2.8% annually since 2009, compared with the euro area’s 1.1% per year. In April, Swedish inflation was close to the target of 2% aimed at by the Riksbank, Sweden’s central bank. Yet it decided not only to maintain the main policy rate at -0.50%, where it has been since February 2016, but to increase the amount of asset purchases under quantitative easing (QE) by a further SKr15bn ($1.7bn) during the second half of 2017.
 
One explanation for keeping policy so loose is that the inflation figure is deceptive. Johan Javeus of SEB, a bank, points out that some of the increase was driven by one-off factors, such as rises in air fares and energy prices. After raising rates prematurely in 2010 and 2011, the Riksbank is loth to do so again.
But also, it is hemmed in by the European Central Bank (ECB). The Riksbank fears that tightening before the ECB would lead to a strong appreciation of the krona, hurting exports while making imports cheaper and dragging inflation down. Other small European economies outside the euro area have the same problem more acutely. Denmark, with its peg to the euro, is forced to shadow the ECB. The Swiss central bank has seen its balance-sheet swell to over 100% of GDP as it has sought to dampen upward pressure on the Swiss franc, traditionally seen as a safe haven. Even the Czech central bank was forced in early April to abandon a cap on the koruna.
 
In Sweden QE itself prompts worries, notably about property prices, which rose by 8% in 2016 and 10.8% in 2015. A financial crash is unlikely: banks learnt from Sweden’s severe banking crisis in the early 1990s, and the assets of Swedish households easily exceed their debts. But rising mortgage payments might lead to a drop in overall demand. The Riksbank, for its part, has decided to focus only on inflation, leaving the property market to Sweden’s financial regulator.
 
More broadly, perhaps the greatest cause for worry is the employment gap between high-skilled locals (with an unemployment rate of 3%) and low-skilled migrants (at 33%). In that, the Riksbank is powerless. As Sweden has struggled since 2013 to absorb more than 300,000 asylum-seekers, the politics of immigration and employment make monetary policy look easy.

 

Another paradox of thrift
 
Why low interest rates could also encourage saving?
 
“JOHN BULL can stand many things but he cannot stand two per cent.” That aphorism, quoted by Walter Bagehot, a 19th-century editor of The Economist, expressed savers’ traditional distaste for very low interest rates.
For the first three centuries of the Bank of England’s existence, 2% was indeed as low as the central bank was willing to let interest rates fall. Not even the Depression, nor the long Victorian period of stable prices, induced the bank to go any further. Some minimum return on capital was deemed to be required.
 
All that changed with the credit crunch of 2007-08. Interest rates are at 1% or below in most rich countries, and there seems to be little prospect of their rising soon. The futures market believes that American rates will still be below 1% in July 2012.
 
Investors seem to have two reactions to the prospect of a prolonged period of low rates. For the bulls, it is a sign that investors will eventually decide to reject the safety of cash in favour of the higher returns available from riskier assets. The net effect will be familiar: central banks will have underwritten the markets as they have so often in the past 25 years. Rates were cut in response to market wobbles in 1987, 1998 and 2001.
For the bears, low rates are a sign of the desperation of central bankers, and an indication that economic growth will be subdued for some time to come. They predict Japanese-style stagnation.
 
Not everyone accepts the Japanese parallel. But there is a reasonably broad consensus that growth will be more sluggish than it might have been, thanks to the lingering effects of the financial crisis and to deteriorating demography, particularly in western Europe.
 
A long period of low rates has profound consequences for savers. Take pensions. Whether pension schemes are funded by the public or private sector, or are structured as defined-benefit (final-salary) or defined-contribution plans, the fundamental principle is the same. Schemes try to build up a capital pot, which is used to buy an income in retirement, for example in the form of an annuity.
 
Low rates increase the liabilities of pension schemes. Or, put another way, you need a much larger capital pot to buy a given level of income. According to Nick Horsfall of Towers Watson, a consultant actuary, British liabilities have risen by 15% over the past three years, thanks to lower nominal government-bond yields.
 
In addition, deflation is a hidden risk for pension schemes. If it occurs, it will cut the nominal incomes of those (companies, public-sector bodies) that have to fund future pensions, creating another potential gap between assets and liabilities. It is possible for pension funds to insure themselves against deflation in the derivatives market. But the cost of this has risen sharply in recent years, as deflation has become more likely.
However pensions are funded, the consequences are clear. More money will have to be put aside to pay for them. In other words, savings will have to go up.
 
Some will argue that pension schemes will simply cut benefits instead. But that would still leave the individual with an expected pension shortfall, to which the rational response would be to save more.
The effects of low interest rates do not stop there. Rates are low in real as well as in nominal terms, which makes it harder to accumulate a given capital sum. Since less of the work is performed by investment returns, more of the work has to be done by the saver.
 
Here again, Japan may provide the template. Its investors have been so eager to save that they have been willing to buy government bonds even with nominal yields of just 1-2%.
 
Indeed, the rich world may be due for a cultural shift. If the motto of the past 25 years was “borrow now, pay later”, then “save now, rather than starve later” might soon be the more appropriate philosophy. Many people are unprepared for retirement. A staggering 47% of British women of working age do not have a pension plan, according to a survey by Baring Asset Management, and 22% of all adults aged between 55 and 64 are in the same position. If they think they will have a comfortable retirement on state benefits, they are in for a nasty surprise.
Interest-rate cuts hurt savers’ incomes even as they make borrowers better off. If this income effect were to become powerful enough, it would be a nice irony. Low interest rates, which have the main aim of encouraging spending, could have the perverse effect of encouraging saving.
 
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