Task06.

The Economist Apr 6th 2005 -

America has been warned many times in recent years that its profligate spending is dangerous, for itself and for the world economy. So far, however, Americans have ignored such doom-mongering, gleefully driving their current-account and budget deficits to record levels. Now the World Bank and the International Monetary Fund (IMF) seem to be trying to stage an intervention. This week, both have come out with reports on the global financial situation and both reports give warning that America's fiscal irresponsibility poses serious risks to the world economy.

Neither organisation issues the kind of scathing indictment that might offend its most powerful constituent. Nonetheless, both make it pointedly clear that America's copious spending is a real, and growing, problem for the rest of the world. America's 12-month current account deficit now stands at $665.9 billion, or 5.7% of GDP. Since a negative balance in the current account must be complemented by a positive balance in the capital account, this means that foreign funds are streaming in. America is mortgaging its future to pay for current spending.

Part of the reason this spending is so hard to get a grip on is that it is happening on multiple levels. With interest rates low, consumers have been tapping into their home equity and taking on credit card debt, the latest figures from America's Bureau of Economic Analysis show individuals' savings were just 0.6% of their income in February. Meanwhile, even after massive tax cuts, the Bush administration has forged ahead with ambitious spending programmes. Thus, in 2004 the federal government's budget deficit hit $412 billion, a worrying 3.6% of GDP. It is projected to fall only to $365 billion, or 3% of GDP, in 2005.

The gap between income and spending has been financed by foreigners, especially central banks; more than half of all publicly available Treasury bonds are now held abroad. But the central banks that are buying up all this paper, particularly Asian ones, are trapped in something of a vicious circle.

The natural adjustment mechanism for America's rapidly growing foreign liabilities would be a declining dollar, which would lower demand for imports and make America's exports more attractive on foreign markets. But the Asian central banks are stalling this process because they want to keep their currencies from appreciating against the dollar and thus becoming less competitive and buying sackloads of dollars and then dumping them into US Treasuries achieves just that. This simply enables America to borrow more, making the inevitable adjustment sharper when it comes. That risk, of course, makes dollar denominated assets less attractive, meaning that the Asian central banks have to go to ever-greater lengths to keep their currencies from appreciating.

The World Bank estimates that roughly 70% of global foreign reserves are now in dollars. That growing portfolio of dollar assets is vulnerable to currency correction. This is not such a problem if the dollar declines gently, but an abrupt change in its value could spell trouble, as central banks find themselves with gaping holes in their portfolios.

Central banks have another problem: many are reaching the limits of their ability to "sterilise" their currency transactions. In order to keep their exchange rate operations from causing inflation at home (the natural result of keeping one's currency undervalued), central banks sell bonds on the domestic market in order to mop up excess money supply. However, this is expensive, since in many cases the interest rates on domestic bonds are significantly higher than on the Treasuries the central banks are buying. The World Bank estimates that this differential costs emerging market central banks $250m a year for every $10 billion they hold in reserves.

There are further, institutional, limitations. The Reserve Bank of India, which is forbidden to issue debt or sell rupee assets on international markets, is running down its inventory of securities to sell. Last autumn, South Korea's central bank bumped up against the annual limits on the sale of government debt. And China, a huge consumer of American debt, has been stuffing securities into its state owned banks at below-market rates. This has made its already fragile financial sector even weaker, and cannot go on indefinitely.

But as the IMF notes (and the World Bank agrees), dollar depreciation cannot be the only mechanism of adjustment for current global imbalances. They want developing countries with artificially cheap currencies to make their exchange rates more flexible. Europe and Japan are urged to stimulate domestic demand, taking the pressure off America to be the world's customer, though this seems a little unfair to Japan, which has been energetic, if ineffective, in pursuit of consumer stimulus. And America, the Bank and Fund make clear, must get its fiscal house in order, cutting its budget deficit and encouraging consumers to save.

Unfortunately, like much good advice, these recommendations seem to have little hope of being implemented any time soon. The political pressure in Asia to subsidise exports with low exchange rates is intense. Interest rates in Japan have been near zero for four years, giving the central bank little room for additional action; meanwhile, the European Central Bank seems to be preparing for a rise in interest rates this autumn, to keep inflation near its target of just below 2%, which will hardly do much for demand. And in America, the political will to reduce deficits seems to be all but extinct.

Given all these reasons to worry, it might seem surprising that both the IMF and the World Bank are broadly optimistic about the world economy. But as they point out, growth in 2004 was robust, and the world is currently enjoying high levels of macroeconomic stability. Alan Greenspan is expected to deliver steady increases in interest rates, slowing American demand, and forcing its consumers to rebuild shaky savings; it is hoped that this will help bring about an orderly adjustment in the dollar's value. This will not be pain-free for the rest of the world, developing countries that have got sweet debt deals from investors fleeing low American interest rates will find their borrowing less easy to finance. But the resulting decline in imports should allow central banks to cut back on the breakneck pace of growth in reserves. And who knows? Perhaps once ordinary Americans are forced to live within their means, they will start demanding the same from their government.

1. Japan, if anything, is more "fiscally irresponsible" than the U.S. since its government deficit, as a percent of GNP, is twice as big in 2005. Yet Japan has a very big current account surplus. What must be true of Japanese private savings and investments?

2. Why would the " natural adjustment mechanism for America's rapidly growing foreign liabilities" (paragraph 5) be a decline in the dollar? Alternatively said: what are the effects of U.S. Treasury issuance?

3. Presumably, the currency of a central bank (such as China's) that is buying lots of dollars would appreciate if the central bank stopped intervening. In that case, if there is a chance the fixed exchange rate will be abandoned, what does UIP tell us about the relative interest rates on domestic and foreign currency debt?

4. Why might the IMF and World Bank see any connection between America's "fiscal irresponsibility" (paragraph 1) and its current account deficit?

5. Why is it "expensive" (paragraph 7) for a central bank to sterilize increases in foreign exchange holdings when the interest rate on domestic debt is higher than that on foreign reserves and the exchange rate is fixed?

Task08.

Chepa's utility function is given by U (x, y) = ln x + 4 ln y. Assume that Chepa has endowments (10, 10) and that Py = 10 throughout the problem.

I need help with questions G) and H) only please.

a) (Note: this part of the question is intended to reduce your workload for parts (b) to (e). If you prefer not to work with a general demand function but calculate the demand separately for each of the cases, you can do the part after part (f).) Given Py = 10, solve for the optimal bundle for Chepa as a function of Px and money income M.

(b) Suppose Px = 10. Calculate Chepa's endowment income. How much of each good will Chepa consume? Call this bundle A.

(c) Now suppose Px drops to 5. Calculate Chepa's new endowment income. Find Chepa's new consumption bundle. Call this bundle B.

(d) What is the income required such that Chepa can just afford bundle A under the new prices? Find Chepa's consumption bundle if she has this income and is facing the new prices. Call this bundle H1.

(e) Find Chepa's consumption bundle if she has her original endowment income and is facing the new prices. Call this bundle H2.

(f) Using your answers from (b) to (e), calculate the substitution effect, ordinary income effect, endowment income effect and the price effect associated with the change in Px.

(g) Express Chepa's endowment income as a function of Px. Using this expression and your answer to (a), find the range of values of Px such that Chepa will be a net seller of good x.

(h) This part of the question is to investigate Chepa's welfare under different prices. We will do it step by step.

(i) By substituting out the M with the expression of Chepa's endowment income (see part (g)), obtain Chepa's gross demands as functions of Px.

(ii) Plug your answer to (i) into Chepa's utility function (that is, replacing the general x and y in her utility function by the optimal x and y given Px) to obtain an expression of the maximal utility achieved by Chepa as a function of Px.

(iii) Find the value of Px that gives Chepa the lowest utility. (Hint: Take the answer to (ii), differentiate it with respect to Px, set the derivative to zero and solve for Px in that equation. It is a good practice to check the second order condition to make sure you are getting a minimum but if you feel uninterested or that this is too hard, you can trust that I am giving you a "nicely behaved" minimisation problem and skip checking the SOC.)

(iv) Explain the economic meaning of your result in (iii).