ECON 100 Tutorial: Week 24

www.lancaster.ac.uk/postgrad/alia10/a.ali11@lancaster.ac.uk

office hours: 2:00PM to 3:00PM tuesdays LUMS C85

Question 1

From the national income identity, what association might exist between a fiscal deficit and a trade deficit?

First, we know the national income identity is: Y = C + I + G + X – M

A fiscal deficit occurs when government spending is greater than tax revenues.

Using the same notation as in the national income identity, we could show a fiscal deficit as:

G – T > 0 or G > T A trade deficit occurs when

exports are less than imports; net exports is negative.Using the same notation as in the national income identity, we could show a trade deficit by writing:

X – M < 0 or X < M

Question 1From the national income identity, what association might exist between a fiscal deficit and a trade deficit?

Let’s substitute (Yp + T) for Y, where Yp is permanent income and T is taxes:(Yp + T) = C + I + G + X - M

We can re-arrange: (Yp – C) = I + G – T + X – M Note: Yp – C = S

Therefore: S = I + G – T + X – M(S – I) = (G - T) + (X – M)

We’ve seen this equation before. If, for simplicity, S = I, then S – I = 0 and then we can re-write our equation as: 0 = (G – T) + (X – M)This equation tells us that: If savings equals investment (S = I) and we have a fiscal deficit (G – T > 0), then we will have a precisely equal trade deficit (X – M < 0).In other words: If S = I, then – (G – T) = (X – M).

This illustrates the twin deficit hypothesis. If the fiscal deficit increases, and S = I, then the trade deficit will have to increase as well. In effect, the economy is borrowing from foreigners in exchange for foreign-made goods. Theoretically, if this trend continues, then the double deficits will lead to currency devaluation (Question 3 looks at this idea again)

Question 2

Merchants (not countries) trade; so why is the state (in recent history) so concerned with the balance of international trade and its associated capital movements?

When the UK has a trade balance, the value of foreign currency the UK holds is equal to the value of domestic currency held by other states abroad. If the value of £’s held by other states > the value of foreign currency the UK holds, that means that there is a trade deficit, X < M, and vice versa.

If other states hold a lot of £’s then the demand for our £’s will be lower. This will push down the value of the £ in exchange markets. This makes deficit spending more expensive for the UK and reduces the effectiveness of anti-recessionary policies.

So, in short, governments care about the balance of international trade because it has an effect on the effectiveness of government policies.

Here is an example: https://www.youtube.com/watch?v=Njp8bKpi-vgProf. Steele’s solution is on the next slide – please review it.

Question 3

Of what relevance to international trade are the data below:

Prof. Steele’s solution:Chronic US trade deficits increase debt held overseas. Without willingness to hold US debt, the value of the US$ would fall (and holders of US debt would take a haircut as real as that received recently by holders of Greek government bonds). Note: this is the same scenario as in Question 2.

Question 3Relative to the previous slide, it is relevant to note that most holders of US debt are actually not foreign investors.Why does that matter:In a crisis, domestic debt-holders might be more willing to live with a reduction in interest rate and less likely to require austerity measures.The key concern however, is the amount debt.

Question 4

Is the balance of international payments an accountancy principle or an economic concept? Or is it both?

Prof. Steele’s solution:It is an accountancy principle whereby categories of international financial flows are defined such that international payments are necessarily ‘balanced’. The structure of that balance is a matter for interpretation. The economic issue is whether payments flows are sustainable; e.g., for how long will China accumulate US Bonds? (China held $1.1 trillion in Dec 2011.)

In the Balance of International Payments Accounts, the ‘basic balance’ refers to the current account plus net long-term capital movements. It gives the amount that must be absorbed by official foreign exchange reserves in order to stabilize the international value of sterling.

Question 5

Without trade statistics, how might an international payments problem be noticed?

Prof. Steele’s solution:By falling international values of the domestic currency. More domestic currency is being used to pay for foreign goods, than foreigners are acquiring in order to purchase domestic goods.As is generally the case, when supply exceeds demand, the value of the item tends to fall

Question 6

Which words fit the gaps in the following passage: The means by which the state manipulates interest rates derives from the sheer volume of its indebtedness. The implication is that variations in yields on _______________have special relevance to interest rates generally. The relevance is that, if the state wishes to raise interest rates, debt instruments must be offered to the market at ______ prices, so raising _______ to new creditors. In competing for savings, other institutions are then forced to match those ________ rates. In reverse, where the state initiates the repurchase of existing debt, bond prices _____ and yields ______. Other institutions are then able to arrange their own borrowing requirements at _______ rates. By such actions - which alter the composition of the ____________ in terms of __________ and ___________________ - the state manipulates interest rates. Typically, this technique is applied at the short end of the market. Less frequently, it is applied at the long end, with dealing in gilts, when it has become known as ‘______________’.

government debt

reducedyields

higher

rise fall

lower

national debt

currency interest-bearing securities

quantitative easing

What is quantitative easing?• Expansionary monetary policy usually involves the central bank

buying short-term government bonds in order to lower short-term market interest rates. If they keep doing this, it will eventually stop working – that is when the economy is falls into a liquidity trap.

• A liquidity trap can occur when short-term interest rates are either at, or close to, zero, so that normal monetary policy can no longer lower interest rates.

(Zero is the lower bound on interest rates – meaning they can’t be

lower than zero – meaning bonds have to give at least a zero return.) • This is when central banks use quantitative easing.• Quantitative easing is when central banks purchase long-term

assets (including bonds, gilts, real estate) in an attempt to lower the long-term interest rate and increase money supply.

Question 7

What are ‘exchange risk’ and ‘default risk’ and what is their respective relevance for state borrowing within the European Union?

Exchange risk is the risk of the foreign currency value of a debt instrument falling, as the domestic exchange rate appreciates in relation to that foreign currency. For example, if you are a resident of the UK and you invest in some EU stock in euros, even if the value of your investment appreciates, you could still lose money if the euro depreciates in relation to GBP. Exchange risk is possible for all investments made in foreign currency.

Default risk: if the state debt is denominated in (say) euros, but the state has no euros to redeem maturing debt and no capacity to borrow from the ECB.In other words, we could say that:

Default Risk is when the state is unable to make the required payments on their debt obligations. Default Risk is possible for all investments.

Both Exchange Risk and Default Risk exist for investment in foreign bonds.The higher these risks are, the higher individual’s discount rates will be.

Question 9

Today the pound was devalued, we withdrew from the Exchange Rate Mechanism, the pound fell, interest rates were raised first of all by 2 per cent then by another 3 per cent and they took the 3 per cent off and the speculators have made about £10 billion at the expense of the British tax payers.’ (Tony Benn, 2002)

Examine the view that the profit made by currency speculators on ‘Black’ Wednesday, Sept 16, 1992 was ‘at the expense of the British tax payers.’

The following slides and the first 10 minutes of this BBC documentary outline what occurred on Black Wednesday:

https://www.youtube.com/watch?v=K_oET45GzMI

Q9 Background Info about Sept. 16, 1992• In 1990, in an effort to control inflation and

maintain a stable economy, the Chancellor of the Exchequer (and later in the year Prime Minister) John Major convinced Prime Minister Margaret Thatcher to join the European Exchange Rate Mechanism (ERM).– This meant that the pound would be pegged to

the Deutsch Mark.– This required the UK match interest rates with the

Germans in order to maintain the fixed exchange rate between the pound and the mark.

Q9 Background Info ctd.• Over the following 2 years, a slow economy in the UK

meant that monetary policy makers wanted to lower interest rates.

• But in 1992, inflationary concerns in Germany led to the German central bank raising interest rates in Germany.

• Housing trouble in the UK made raising interest rates in the UK a bad political move (because doing so would cause mortgage payments to rise and individuals who couldn’t pay their mortgages ended up selling their homes for less than they had initially bought them.)– So, the UK gov’t initially did not match interest rates, but had

to instead find another way to maintain the fixed exchange rate between the pound and the mark.

Q9 Background Info ctd.

What would happen if the UK didn’t match the German interest rate?– Having different interest rates and a fixed exchange rate meant

that it was profitable to convert pounds into marks and then buy German bonds, which decreased demand for the pound relative to the mark.• Decreasing demand for the pound should have lowered the relative value

of the pound, breaking the fixed exchange between the currencies.

So how did the UK keep the fixed exchange rate without matching interest rates?– To avoid a lowering of the value of the pound, the UK central bank

started buying pounds on the foreign exchange market.• To do this, it used its foreign currency reserves and gold reserves.• Political effort was put into reconciling German and UK interest rates.

Early on 16 September 1992, it became clear that Germany and the UK were not coming to an agreement on interest rates, and currency speculators began short-selling pounds

– This put heavy downward pressure on the value of the pound.

Short Selling: In this scenario, the short seller borrows pounds and immediately sells them on the exchange market for another currency. The short seller then waits, hoping for the value of the pound to decrease; if it does, then the short seller can profit by purchasing the pounds to return to the lender.

Q9 Background Info ctd.

Question 9So, Question 4 is asking about what is essentially the British Central Banks’ response to the short-selling of the pound:

Today the pound was devalued, we withdrew from the Exchange Rate Mechanism, the pound fell, interest rates were raised first of all by 2 per cent then by another 3 per cent and they took the 3 per cent off and the speculators have made about £10 billion at the expense of the British tax payers.’ (Tony Benn, 2002)

Examine the view that the profit made by currency speculators on ‘Black’ Wednesday, Sept 16, 1992 was ‘at the expense of the British tax payers.’

Question 9What happened on Sept. 16, 1992?• The UK government sold about £27 billion of reserves in an effort to

prop up the value of the pound. • Because the value of the £ at the end of the day dropped by a little

over 10%, the total drop in value of their currency portfolio was about £3.3 billion.

This means that the value of the reserves was lower, but that does not necessarily represent a £3.3 billion cost to the taxpayers. Why not?

– 1) 1/3 of the 10 billion that speculators have made, came from the UK central bank (about 3.3 billion). The other 2/3 of this came from other foreign currency speculators.

– 2) Of the 3.3 billion, some was not replenished; Of that which was replenished, some of it came from the fluctuation of the pound against other currencies and some was replenished by the sale of central bank assets and some was replenished via inflation and seignorage.

– 3) The central bank doesn’t have the ability to tax citizens or to procure tax revenues.

Prof. Steele’s solution is on the next slide; essentially quite similar to my answer.

Exam 4 on FridayDon’t forget to bring to the exam:

- Student ID number- Pencil & Eraser- Calculator

Good luck!

Note: Next week’s tutorial will be some sort of review of past exams in preparation for the final.

Practice Past Exam Questions

Please Note: Solutions are not given to tutors for these questions. The solutions here are suggestions only – I can’t guarantee they are correct.

For the 2013 past exam, I have additional slides here.

The hypothesis of rational expectations contends that individuals:

a) do not make systematic errors b) anticipate future prices accuratelyc) adapt slowly to the rate of inflationd) only make rational errors

2010 Exam Q34

By the ‘Lucas critique’, economic forecasts are:

(a) always unreliable (b) most reliable when economic policy is stable (c) most unreliable when a change in economic policy is implemented (d) most unreliable when inflation is accelerating

2012 Exam Q39

UK National Debt comprises:

(a) the sum of trade deficits over past years (b) sterling currency notes and coins in circulation, plus commercial bank deposits (c) outstanding loans to the state, excluding sterling currency notes and coins in circulation (d) outstanding loans to the state, including sterling currency notes and coins in circulation

2012 Exam Q32

Suppose that an economy, initially in equilibrium, experiences a shock owing to a decrease in autonomous consumption. Assume a fixed exchange rate and price inflexibility. What will be the short-run effect on the current and financial accounts of the balance of payments?

a) both accounts will move into surplusb) both accounts will move into deficitc) there will be a deficit on the current account

and a surplus on the financial accountd) there will be a surplus on the current account

and a deficit on the financial account 2010 Exam Q37

  

The general structure:

BoP ≡ X - M + IOU (loan/credit) ≡ 0

BoP ≡ current account + capital account ≡ 0

income-expenditure ∆wealth ≡ 0

(deficit) (wealth falls) - + (exporting assets or writing an IOU)

(surplus) (wealth rises) + - (importing assets or receiving an IOU)

Balance of International Payments Accounts

NB: the current account surplus is matched by a a ‘capital outflow’

If a UK resident citizen buys a BMW car from Germany and the car exporter uses the payment to buy UK government bonds, which of the following statements would be true?

(a) UK net exports fall and net capital exports fall (b) UK net exports rise and net capital exports rise (c) UK net exports fall and net capital exports rise (d) UK net exports rise and net capital exports fall

2012 Exam Q34

Quantitative easing is a process whereby a central bank:

a) sells long-term government bonds b) purchases long-term government bonds c) sells short-term government bonds d) purchases short-term government bonds

2011 Exam Q35

When the Bank of England undertakes quantitative easing:

(a) long-term government bonds (gilts) are bought using newly created money (b) the composition of the national debt is altered (c) the volume of the national debt remains constant (d) all of the above

2012 Exam Q40

Lecture 56: Question 5What is quantitative easing?• Expansionary monetary policy usually involves the

central bank buying short-term government bonds in order to lower short-term market interest rates.

• However, when short-term interest rates are either at, or close to, zero, normal monetary policy can no longer lower interest rates.

• That’s where quantitative easing comes in. • Quantitative easing involves purchasing long-term

bonds (gilts) in an attempt to lower the long-term interest rate and increase money supply

For UK international payments, the ‘balance for official financing’ is the value of:

a) net exports including ‘invisibles’ b) foreign exchange reserves c) net UK borrowing from foreign central banks d) foreign exchange bought/sold to maintain the exchange value of sterling

2011 Exam Q38

The balance of international payments is: a) a corollary of the government’s overseas borrowing b) a measure of an economy’s indebtedness c) the overseas aid budget of a nation state d) an accountancy identity

2013 Exam Q34

In the context of the balance of international payments, a residual for ‘official financing’ indicates the extent to which the monetary authority:

a) sells domestic currency to increase holdings of foreign exchange reserves b) sells foreign exchange reserves to support the value of the domestic currency c) allows the international value of its currency to be determined by market forces d) is taking advantage of a trade surplus to build its foreign exchange reserves

2013 Exam Q39

  

The general structure:

BoP ≡ X - M + IOU (loan/credit) ≡ 0

BoP ≡ current account + capital account ≡ 0

BoP ≡ X - M + ‘invisibles’ + DLT + DST + Dforex ≡ 0

BoP ≡ { balance for official financing } + Dforex ≡ 0

Balance of International Payments Accounts (Lecture 61 Slide 35)

balance for official financing: the amount taken from (or absorbed by) official forex reserves in order to stabilise the international value of domestic currency

(exports of gold and/or forex to

support £)

Which of the following is not a function of the Bank of England?

a) lender of last resortb) supplier of moneyc) acting as a store of valued) determining the official interest rate

2010 Exam Q40

A nation with a fixed exchange rate cannot insulate itself from world inflation because, if initially its domestic inflation rate is lower than elsewhere:

a) economic recession forces domestic prices up b) domestic goods become less competitive and cost-push inflation raises domestic prices c) domestic goods become more competitive which tends to increase money in domestic circulation d) none of the above 2011 Exam Q39

Under a fixed exchange rate

• Low domestic inflation will cause the price of goods to rise more slowly than in other countries

• So other countries will seek to buy goods from the low inflation country

• This will increase the amount of capital in the low inflation country

• This will put upward pressure on the low inflation country’s currency

By the Heckscher-Ohlin theorem a country specializes in the production and export of goods that uses:

a) its most abundant factor most intensively b) its least abundant factor most intensively c) factors that are most demand elastic d) factors that are most supply elastic

2011 Exam Q40