Problem set 6

The 1980s was a period of expansionary fiscal policy for the U.S. Consider the following information about the U.S. economy:

Year	Real exchange rate (1973=100.0)	Current account balance ($billion)
1980	84.9	+2.3
1985	132.5	-125.4
1987	90.9	-167.1

Suppose that 1985 represented the consequences of the expansionary fiscal policy in the short run, while 1987 represented the long run. Draw a foreign-sector diagram for the U.S. which includes a short-run NX line and a long-run NX line (NXLR) and which shows the shift in NFI resulting from the expansionary fiscal policy. Use your diagram to label each of the numerical values in the table above.

Indicate where exchange rate overshooting shows up in your diagram.

The George W. Bush administration pursued an expansionary fiscal policy when it took office at the start of 2001. Consider the following information about the U.S. economy from 2000-2002:

Year	Real exchange rate (R) (2000=100.0)	Net exports (NX) ($billion)
2000	100.0	-340
2001	109.5	-323
2002	108.8	-398

Note: In answering the questions below, be sure to use these exact values from the table to label your diagram.

Depict the initial situation for the US in year 2000 in a foreign sector NX-NFI diagram. For now, just draw NXLR and NFI; do not add NXSR yet. Label the equilibrium point LR1.

Now consider the foreign-sector consequences of expansionary fiscal policy.

(1)

Which direction would you predict each of the following would change in the long-run as a result of the policy: the U.S. real exchange rate (R) and its net exports (NX)? Explain briefly the reasoning that underlies your predictions.

(2)

Suppose that year 2002 represents the new long-run equilibrium. Depict the new equilibrium in your diagram. Use a subscript "b" to label any new curves you draw, and label the equilibrium point LR2. Did R and NX each move in the direction you predicted? (No explanation necessary.)

Suppose that year 2001 represented the short-run equilibrium in the transition between LR1 in 2000 and LR2 in 2002.

(1)

Add a curve for NXSR to your diagram that is consistent with the actual change in R and NX from 2000 to 2001. Label the short-run equilibrium point SR1.

(2)

Does NXSR have the slope that we usually expect to see? If so, explain why. If not, explain what could account for its slope.

Indicate in your diagram the portion of the short-run change in the value of the dollar that illustrates exchange rate overshooting as a result of the expansionary fiscal policy.

5.	(No diagrams are required to receive full credit for this problem.) The following passages come from past issues of the Los Angeles Times:
	a.	"Strong Dollar Bodes Well for U.S. Market," April 23, 2000:
			"The demand for dollar assets from around the world has been phenomenal," says economist Stephen Roach of Morgan Stanley....What's going on? In simplest terms, the rest of the world is making a living by selling goods to the United States, which is paying them in dollars. But then, the nations receiving those dollars are investing them back in U.S. government bonds and notes and in the stocks and bonds of private companies.
		What is the impact of the activity described here on each of the following for the U.S.: (1) net foreign investment (NFI), (2) real exchange rate, and (3) current-account balance (net exports)? Discuss the reasoning behind your answers.
	b.	"Strong Dollar Bodes Well for U.S. Market," April 23, 2000:
			[I]f ... the Federal Reserve slam[s] the brakes on the U.S. economy, ... the resulting slowdown would reduce imports and the international flow of investments.
		What sort of monetary policy is this passage describing? Do you agree that such a monetary policy would likely "reduce imports and the international flow of investments"? Why or why not?
	c.	"Dollar Tumbles to New Multiyear Lows," May 7, 2005:
			If the dollar's weakness snowballs, it could cause foreigners to pull out of U.S. assets rather than risk further devaluation of their holdings. That is already happening on some scale. Foreigners pulled a net $418 million out of U.S. stocks in the week ended May 2, according to UBS Warburg. That's the fourth week in five that outflows rose.
		Do you think the drop in the value of the dollar is better understood as the cause or the effect of the "outflows" described in the passage? Explain briefly.

6.	The questions below concern the online reading, "Emerging Nations Reject Capital Plan," from the April 18, 2011, issue of The Wall Street Journal. You can earn full credit for the questions in this problem without drawing any diagrams. If you do draw diagrams, be sure to also provide explanations.
	a.	Consider Passage A from the article. How is it that domestic exporters get "hurt" by "surging capital inflows"?
	b.	Consider Passage B regarding "other tools" that the IMF wanted emerging markets to try in order to "curb surging inflows"?
		(1)	What "policies on interest rates" do you think the IMF had in mind?
		(2)	What "policies on ... government budgets" do you think the IMF had in mind?
		(3)	Describe how those policies would have worked to achieve the goal of reducing capital inflows.
	c.	Consider Passage C. Do you agree with the logic of the argument raised by the developing countries who "blame the U.S. Federal Reserve" for contributing to the "surging capital inflows" that they are experiencing? Why or why not?
	d.	Consider Passage D.
		(1)	What do you think the term "precautionary levels" of foreign exchange reserves for countries with fixed exchange rates refers to?
		(2)	If a country stopped "accumulating excess reserves well beyond precautionary levels," what would you expect to happen to the country's (a) exchange rate and (b) current account balance? Explain briefly.
		(3)	What reasoning do you think U.S. Treasury Secretary Tim Geithner had in mind by asserting that a country that is "accumulating excess reserves ... magnifies capital flows into [other] emerging markets with open capital accounts"?
		(4)	What reasoning do you think Tim Geithner had in mind by asserting that these inflows end up "fueling inflation in economies" with fixed exchange rates?

1.	a.	Draw a basic foreign sector (NFI-NX) diagram to depict an initial long-run situation in which a country has balanced trade. Be sure to label your axes and your curves.
	b.	(1) Why does NXLR slope down? (2) Why does NFI slope up?

2.	a.	State the fundamental open-economy relationship.
	b.	Write out the full expression for a country's net production (which is also its net foreign investment (NFI)), and use it to show the four ways a country can increase the amount it has available for net foreign investment.