1) (20 points) Explain, in five sentences or less, exactly why the trade deficit in the US increased from 1995 to 2000. There are two specific reasons. Make sure you explain clearly (the intuition) why each reason would add to our trade deficit.
2) (40 points total)
a. (10 points) Suppose that you received your college degree from Penn State and nailed a great job over in Europe in the summer of 2001. Given that your family remains in the US, you make sure that you visit the family every November by traveling from Europe to the US. We are going to compare the cost of this vacation, in terms of euros, during two different periods: November 2002 and November 2012. We assume that the cost of the trip, in terms of $ US, remains the same at $1,000 in both periods. Using the link below and rounding down to two decimals, compare the euro cost of the trip in November 2002 vs. the euro cost of the trip in November 2012.
See the St. Louis Federal Reserve site for $ per euro exchange rate (to get actual data click on “view data” on left hand side of page)
b. (30 points – 15 points for explanation and 15 points for correct and completely labeled diagram) Using the same link above, we are now going to use our supply/demand framework for US $ to model the movement in the euro per $ exchange rate between December 2007 (the very beginning of the Great Recession) and November 2008 (pretty much the height of the global financial crisis).
Note that the data is in $ per euro so you need to convert it into euro per dollar before proceeding. For example, $ 1.2 per euro is converted by 1/1.2 = .833 meaning that $1 = .83 euro (this is the vertical axis on your graph, i.e., euro per $).
Rounding down again to two decimals, draw a supply and demand diagram like we did numerous times in the lectures labeling the vertical axis as euro per $ and the initial supply and demand curves labeled with 12/07, Label this initial point as point A.
Now explain what happened to each curve and WHY between 12/07 and 11/08. Label this new point (11/08) as point B with your supply and demand curves labeled accordingly
(Hint: the two obvious facts during this period is that the 1) US was in a deep recession and 2) we were at the height of the (global) financial crisis (in 11/08). Assume all else is constant.
True/ False (40 points total – 2 points each)
1) In a closed economy, savings = investment is the same as the closed economy goods market equilibrium condition we know as Y = C + I + G.
2) If income exceeds absorption, then the economy is ‘consuming beyond its means.’
3) In the open economy goods market equilibrium with two large countries, the sum of the absorptions must equal the sum of the incomes produced by the two countries.
4) Goods market equilibrium in an open economy requires that savings equals investment plus the current account.
5) If savings exceeds investment then the country is running a trade deficit where NX < 0.
6) If NX is positive then the country is consuming beyond their means and must borrow from the rest of the world.
7) During the mid 2000s, the current account deficit in the US exceeded 10% of GDP.
8) We argued that when the economic growth in the US is greater than the (economic) growth rates of our trading partners, the trade deficit in the US should get larger, all else constant.
9) A country that intervenes in the foreign exchange market to keep their currency weak is consistent with the country being export oriented.
10) We argued that when the US economy grew briskly during the new economy, the supply of US dollars in exchange for other currencies rose since along with economic growth, our appetite for imports grows as well. This effect, all else constant, would weaken the value of the $.
11) We argued that the E. Asian and Russian crises would map to our foreign exchange market analysis as a decrease in the supply of dollars resulting in a stronger US dollar.
12) During the Reagan Administration, the current account became a major economic issue. In particular, the US began running a large current account surplus where US exports were much larger than US imports.
13) Export oriented countries prefer a weaker currency relative to a stronger currency.
14) If there is pressure for the Chinese yuan to appreciate against the US dollar, then China can ‘fight’ this appreciation by buying $ with their yuan.
15) We argued that one reason that interest rates are low on government securities is due to China’s exchange rate regime.
16) Monetary policy is thought to be stronger in an open economy relative to a closed economy since if the Fed, for example, wanted to prevent the economy from overheating, they would raise interest rates. Along with the normal closed economy impact on consumption and investment, we also would have a stronger dollar which would lower net exports, adding to the power of monetary policy.
17) One reason fiscal policy is thought to be stronger in an open economy relative to a closed economy is due to the fact that in an open economy setting, the change in the interest rate effects the exchange rate and thus, adds power to fiscal policy through this exchange rate channel.
18) A rush to the safe haven of $ US during a financial crisis is depicted in the supply / demand model in the $ US market as an increase in the demand to exchange foreign currencies in for $. The end result should be $ US appreciation, all else constant.
19) We argued that the $ US was appreciating in the early years of the Reagan Administration due to the expansionary fiscal policy during this time.
20) When people refer to the twin deficits in the US they are most likely referring to the new economy years since this was the time twin deficits occurred in the US economy..
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