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WOFFORD ECO 302 - Study Guide

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Eco 302 Name_______________________________ Final Exam 18 May 2011 Please write answers in ink. You may use a pencil to draw your graphs. Good luck. 120 points. 15 points each. Allocate your time efficiently. 1. In March 2009 the nominal exchange rate between the U.S. dollar and the Brazilian real was around 2.3 real per dollar. By March 2009 it was quite clear that the Brazilian economy was not as affected by the world financial crisis as the U.S. economy. In March 2010, the exchange rate was 1.8 real per dollar. a. Graph the foreign exchange market in March 2009 from the U.S. perspective. b. Using the graph, explain how expectations about the relative future performance of the U.S. and Brazil affected the demand for U.S. dollar-denominated assets. Expectations of a slow recovery and low interest rates in the United States decreased the relative expected return of the domestic asset. Therefore, the alternative asset (i.e., Brazilian Real-denominated assets) increased its relative expected return. This resulted in a shift to the left in the demand for the domestic asset and in a depreciation of the U.S. dollar, as noted in the graph below.2. On November 2007 Brazil announced the discovery of huge oil reserves that could poten-tially transform the country into a big exporter of oil. a. What would be the effect of the increase in revenues from oil exports on Brazil's exchange rate? An increase in Brazilian net exports will result in an inflow of foreign currency. If the central bank of Brazil does not want to accumulate foreign assets, it will sell them and get Brazilian reals in exchange. This reduces Brazil’s money supply and increases domestic interest rates. Alternatively, the inflow of foreign currency can create inflation and increase the real exchange rate. These are just two reasons as to why Brazil’s exchange rate will increase. b. How would this affect other Brazilian exports? Is this a desirable outcome for the country as a whole? Even if the oil exporting industry thrives in Brazil, it can potentially have negative consequences for other exporting industries if the Brazilian currency becomes more expensive (i.e., if the exchange rate increases). The more expensive currency makes exports more expensive, and other industries are severely affected. This effect is often referred to as the “Dutch disease,” based on the experience of the Netherlands’ discovery of natural gas reserves in the 1960s. As this is clearly not a good prospect for the Brazilian economy, monetary authorities probably will try to minimize the effect of the foreign currency inflow on Brazil’s exchange rate. 3. Assume that Social Security taxes remain constant, but that the number of employed people in the United States declines over time. a. Explain the effect of such a scenario on the size of contributions for social insurance and the government deficit in the United States. A decrease in the number of employed people results (holding Social Security tax rates constant) in a decrease in contributions for social insurance. This decreases tax revenue and therefore increases the size of the government deficit. This effect often takes place during contractions, when unemployment increases. b. Assume now that employment remains constant, but there is an increase in unemployment insurance benefits. How would your answer to (a) change? Even if employment remains constant, an increase in unemployment insurance benefits (e.g., more people applied for unemployment insurance, or the time period for unemployment insurance is extended) increases government transfer payments and therefore adds to the government deficit.4. On March 26, 2010, the Wall Street Journal reported the following: "A sudden drop-off in investor demand for U.S. Treasury notes is raising questions about whether interest rates will finally begin a march higher [...]. [...] there are signs the spotlight is turning to the ability of the U.S. to finance its own budget deficit." a. Explain the effect of higher Treasury note interest rates on the government deficit. An increase in Treasury note interest rates represents an increase in net interest payments for the U.S. government and therefore increases the deficit. b. What would be the long run effect of distrust in the U.S. government's ability to finance its own deficit? Although it is not plausible to happen in the near future, there could be some trouble ahead for the U.S. government to sell its debt. This decrease in the demand for U.S. Treasuries should be considered, as the WSJ article suggests, as a wake-up call. Investors are taking into consideration the size and persistence of the U.S. deficit, and are not as willing as they were a few years ago to buy U.S. debt. Trust in the U.S. government’s ability to repay its debt is still high, but maintaining such big deficits and for such a long time might create some problems in the future, especially if investors decide to buy fewer U.S. Treasuries. If that ever happens, the United States will have to choose between two options: immediate contractionary fiscal policy to reduce the deficit, or increase the monetary base to pay for its deficit—not a nice trade off. 5. Assume that the expenditure and tax multipliers can be estimated to be 0.75 and 0.5 respectively. a. Would you recommend expansionary fiscal policy based on tax cuts or increased government expenditures? According to the estimates of the expenditure and tax multipliers, one should recommend conducting expansionary fiscal policy by increasing government expenditures, as this will have a bigger effect on aggregate demand. In this case, government expenditures should be wisely directed to productive uses, with the potential to improve infrastructure and increase productivity in the long run. b. Suppose now that there is substantial evidence that supports the hypothesis of a crowding out effect in this economy. How would your answer to (b) change?If there is a crowding-out effect, the original increase in government expenditure (or investment) will be realized at the expense of some private investment. A priori, there is no reason to believe that the government allocates resources (i.e., allocates funds to the most productive investment) more efficiently than the private sector. It is not clear that expansionary fiscal policy based on increased government spending will be a

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