1. This question is based on the article, "Lean on me," published by The Economist in its March 31, 2016 print edition. In answering the following questions, note that when a country grows slowly, its demand for investment is relatively low. Also, keep in mind that all countries in the Eurozone use the same currency (the euro) and trade freely among themselves.

(a)According to the article, on the eve of the global financial crisis, Germany and some other rich northern European countries were running large surpluses in their trade with peripheral European countries. Based on the discussions in the article, what is the key underlying cause of these trade imbalances? [11]

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(b)Some politicians have claimed that when a country runs large trade surpluses, it must be practicing protectionism (trade restrictions) and currency manipulation (depreciating the value of the domestic currency). To what extent these types of policies could have contributed to trade imbalances in Europe? [6]

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(c)The fundamental macroeconomic identity implies that the sum of private, public, and foreign savings always equals aggregate investment (this is known as the savings-investment identity; for more detail, see Module 2 Background Notes, pp. 7-10). Before the global financial crisis, peripheral European countries were receiving significant amounts of foreign savings from Northern European countries.

According to the article, how did (1) investment, (2) private savings, and (3) public savings, in peripheral countries respond to those transfers? Was this consistent with the savings-investment identity, and why or why not? [12]

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(d)Extra Points Question: The article points out that in the past, the Eurozone had been too dependent on net exports for economic growth. What policy changes does the article recommend for perking up economic growth in the zone? Since growth through exports does not seem feasible, how should such policies affect other GDP components (investment and public and private consumption) to help raise growth? Does the article recommend that European governments increase or decrease their savings? [10]

Answer:

[Article]

EUROPE is hardly bursting with optimism. Threats of different kinds, from coping with refugees to the prospect of "Brexit", weigh on continental minds. For the first time in years, however, the euro zone's economy is not foremost among the worries. It grew in 2015, for a second consecutive year; unemployment rates around the periphery are falling; and "Grexit" has again been averted. Yet some caution is in order. The euro-zone economy remains heavily dependent on exports for its growth. That is both an indicator of the incomplete nature of Europe's recovery and a dangerous vulnerability.

Europe's economic crisis was a stew with many ingredients, from spendthrift governments to inadequate safeguards in the banking system. The stock in which it all simmered, however, consisted of big imbalances in trade and capital flows. Economic integration encouraged high-saving households in slow-growing northern economies to ship their money to the periphery, where potential returns were higher. The flipside of that lending was a parallel imbalance in trade, as peripheral economies consumed more goods and services than they could produce themselves. On the eve of the global financial crisis, Germany was running a trade surplus of 2% of euro-area GDP, while Spain was running a deficit of 1% of euro-area GDP.

Such imbalances are not inherently bad: it makes sense for savings-rich countries to fund investment in poorer ones. Such investment, if sensibly used, should boost growth in the long run, making it easier to repay the debts. But in the euro area too much of the borrowed money paid for consumption or investment in bubbly property. When northern Europeans began pulling money out in the aftermath of the global financial crisis, the periphery had to make an abrupt adjustment. Jobs that had relied on construction and booming domestic consumption evaporated. Investment collapsed amid financial panic and the wobbling of the euro-area banking system. Government spending also faced a squeeze, thanks to pressure from bond markets and austerity-minded politicians in other parts of the euro area. The best hope for peripheral economies was exports, to provide jobs for the jobless and to earn money to repay lenders.

Outside currency unions, rebalancing toward exports is made easier by exchange-rate movements: capital-flow reversals lead to depreciations that make exports cheaper in foreign markets. Yet within the euro area, depreciation was not an option, and no peripheral economy was willing to risk the financial chaos that would have resulted from dropping out of the single currency. Even so, rebalancing could have been made easier if northern Europe, and especially Germany, had shared in the adjustment.

Faster growth in wages might have boosted German consumption and investment while limiting how much wages in peripheral economies needed to fall to make export industries there more competitive. Yet German labour unions asked for only modest pay rises, despite low unemployment. By the same token, had the periphery been able to export more to the core, it would not have needed to slash imports so viciously. But from 2011 to 2015, German imports grew only slightly faster than those of the rest of the euro area, by 10% compared with 7%. Meanwhile, German exports rose faster still, by 17%.

In other words, stronger northern countries did not pick up much of the slack. Poor policy choices contributed to the feebleness of German domestic demand. In 2012 and 2013 German officials lobbied against looser monetary policy; while other big central banks launched asset-purchase programmes, the European Central Bank (ECB) dithered. The German government joined the continent's fiscal austerity drive, closing the country's budget gap even as Germany briefly sank back into recession. Instead, Germany relied on exports as the source of growth.

The rebalancing that has occurred within the euro area is therefore of an odd sort. The periphery has indeed leaned heavily on exports since the onset of the crisisalbeit more to the rest of the world than to other parts of the euro zone. That is because consumption has only grown relatively modestly, and investment scarcely at all, in Germany and the rest of the core. Instead, core and periphery alike have relied on international demand for their exports (see chart). Between 2011 and 2015 the euro area's trade surplus rose from just 0.1% of euro-zone GDP to 3.7%. Even last year, as emerging economies slowed and as Germany enjoyed its lowest unemployment rate in decades, German net exports contributed about as much to the rise in euro-area GDP as German household spending did.

When you're not strong

It may seem churlish to moan about how the beleaguered euro zone found its way, at last, back to growth. But the dependence on foreign demand carries risks. It places a dangerous drag on recoveries elsewhere. America's trade deficit grew in 2015 despite a spectacular fall in its imports of petroleum; trade subtracted 0.6 percentage points from American GDP growth last year. And Europe's addiction to exports leaves it vulnerable to any deceleration in global growth. Were China's economy to slow more sharply, or America's to return to recession, Europe, too, would see growth wane.

Most importantly, exports' starring role in European growth reveals the pitiful weakness of other elements of the euro zone's economy. Take away the growth, of nearly a percentage point, attributable to trade, and Europe's nominal GDP rose by just 2% last year. The ECB's frantic easing has been sufficient to push down the euro, and thus to boost exports, but not enough to perk up wages or inflation. It is no wonder, then, that consumption is not pulling its weight. Government spending and investment could boost domestic demand directly, but governments in the euro zone remain committed to a course of austerity, despite extraordinarily low government-bond yields. The euro area's weak and distorted recovery is a danger. It is not too late for the fiscal and monetary boost needed to get a real boom going.

2. Early in 2008, economists predicted that in the absence of any change in fiscal and monetary policies, the declines in house and other asset prices would reduce private consumer spending by about $230 billion in that year. The Bush administration implemented a $150 billion tax rebate to counter the drop in private spending. Assume that for every dollar of increase in their disposable income (earnings net of taxes), American households spend $0.80 more on goods and services and save the rest. (Note: each dollar of tax rebate increases disposable income by $1.) Also, assume that for every dollar of spending, the US imports $0.20 worth of goods and services and the rest, $0.80, is spent on U.S. products.

(a) What was the direct impact of the 2008 tax rebate on total private spending?[3]

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(b) What was the direct impact of the 2008 tax rebate on total private spending on U.S. products?[3]

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(c) What was the direct impact of the 2008 tax rebate on the private spending of imported products (increase in imports)?[3]

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(d) The increased amount of spending on U.S. products that you calculated in part (b) had a second-round effect. It became income for the households in the country. If the average tax rate is 25 percent, what must have been the increase in household disposable income (i.e., after-tax income) in that 2^nd round? [3]

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(e) The increase in disposable income in the 2^nd round led to additional spending. The part of this additional spending that fell on domestic products in that round generated further income for domestic firms and entailed a 3^rd round of effects, causing increased disposable income, spending, imports, etc. Similarly, there were fourth, fifth, ... rounds of income and spending increase. The following table provides a method of organizing the information about these rounds, up to round 14 when the marginal increases became negligible compared to the initial stimulus.

Assume that in each round, the spending, import, and tax shares remained the same as described above. Calculate the increases in the variables listed in the last 4 columns of Table 1 for each listed round. Note: You may want to complete these calculations in spreadsheet software (such as Microsoft Excel) and transfer them back to this document. Please do not submit a separate document for your calculations. [10]

Table 1. The Effects of Tax Rebate on Spending and Income (Billions of dollars) Increase in Increase Increase in Total Disposable in Increase Spending on Initial Tax Private Private in Domestic Goods Rounds Rebate Income Spending Imports and Services 150.00 N 0.00 3 0.00 0.00 5 0.00 6 0.00 7 0.00 8 0.00 9 0.00 10 0.00 11 0.00 12 0.00 13 0.00 14 0.00 Total 150.00