Macroeconomics

U6301: Macroeconomics for International and Public Affairs
Sample Application – Suggested Answers
Instructions: Please read each question carefully. Don’t cheat. Use words, math, and/or graphs
to support your answers. Unsupported answers will receive little or no credit. Optimize your time:
Be precise and to the point. Make sure that all of your diagrams are clearly drawn and labeled.
Submission: Submit your answers to the corresponding questions in the Quiz and then at the
end upload your graphical illustrations by uploading pictures. You can use a web camera or your
smart phone to take pictures of your work on paper, send if necessary the pictures to yourself by
email, and then upload them to the Quiz questions on CourseWorks.
GOOD LUCK!
U6301: Macroeconomics for International and Public Affairs Spring 2020
2
SAMPLE APPLICATION.
Nigeria experienced in the second half of 2014 a massive decline in the international price of oil that
was perceived to be temporary. Nigeria is an oil exporting country and you can assume that it is
a small open economy in the international funds market. Further, Nigeria had for years a current
account surplus, CANG > 0.
a) Explain the effects of the decline in the price of oil on current employment, current output,
and future output.
We have A1 ↓ and A¯
2 and therefore:
1. a decrease in current employment, N∗
1
↓;
2. a decrease in current output, Y
∗
1
↓;
3. no change in future output, Y¯
2.
b) Illustrate the S − I-diagram for Nigeria’s funds market.
r
S, I
S(.)
I(.)
r
w
Remember CANG > 0.
I S
CA = S − I > 0
c) Illustrate the effect of a current temporary drop in the price of oil on Nigeria’s funds market.
(If you indicate it in your diagram from b), then label the change clearly.)
r
S, I
S(.)
I(.)
r
w
Remember CANG > 0.
I S
S(Y1 ↓)
S
0
CA0 = S
0 − I
U6301: Macroeconomics for International and Public Affairs Spring 2020
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d) What are the effects on Nigeria’s i) domestic saving, S, ii) domestic investment, I, and iii)
current account balance, CA?
We have S(.) ↓ and I(.) unaffected and therefore:
1. a decrease in domestic saving, S ↓;
2. no change in domestic investment, ¯I;
3. a decrease in the current account, CA ↓= S ↓ −¯I.
e) Could one argue that Nigeria’s current account deficit following the decline, CANG
2015 < 0, was caused by the decline in the oil price? Briefly explain. Yes, a significant drop in current income and domestic saving can reduce the current account such that the initial current account surplus turns into a current account deficit. Previous part not necessary. Nigeria’s government is concerned about its dependence on the domestic oil sector and engages in efforts to diversify the economy away from oil. To finance public programs, G ↑, the federal government borrowed $1.5 billion in the international bond market. f) Illustrate the effect of public spending, G, on Nigeria’s current funds market. (Keep the assumptions of small open economy and CANG > 0.)
r
S, I
S(.)
I(.)
r
w
I S
S(G ↑)
S
0
CA0 = S
0 − I
g) What are the effects on Nigeria’s domestic saving, S, domestic investment, I, and current
account balance, CA?
We have again S(.) ↓ and I(.) unaffected and therefore:
1. a decrease in domestic saving, S ↓;
2. no change in domestic investment, ¯I;
3. a decrease in the current account, CA ↓= S ↓ −¯I.
U6301: Macroeconomics for International and Public Affairs Spring 2020
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h) Would you expect larger or smaller changes in domestic saving, S, domestic investment, I,
and the current account balance, CA, if the private sector is a) myopic or b) forward-looking?
Briefly explain.
In neither scenario we have a change in investment, ¯I.
If households are myopic, then they would not anticipate any tax burden in the future and
have no incentive to change their consumption and increase saving: C¯ and S¯
pvt.
If households are forward-looking, then they may anticipate a tax burden in the future and
have an incentive to reduce their consumption and increase saving to prepare themselves: C ↓
and Spvt ↑.
Hence, the contraction in saving would be greater if households are myopic and the contraction
in the current account as well:
S
myopic ⇓= GNDI − C¯ − G ⇑ < GNDI − C ↓ −G ⇑= S f orward ↓; (1) CAmyopic ⇓= S myopic ⇓ −¯I < Sf orward ↓ −¯I = CAf orward ↓ . (2) i) What are the effects on Nigeria’s current consumption, C, domestic investment, I, and net exports, NX, if the private sector is forward-looking? Briefly explain. If households are forward-looking, they are expecting a greater future tax burden because of the increased borrowing. Hence, they will reduce current consumption. Domestic investment remains unaffected and the net exports are falling because of the drop in the current account and the government’s greater demand for goods and services: Y¯ ∗ = C ↓ +¯I + G ⇑ +NX ↓ . (3) Note that long-run GDP follows from the product approach: Y ast = AKαN∗1−α. Hence, the change in government spending affects expenditures (right-hand demand side) but not output (left-hand supply side) as it depends on TFP, current capital, or current employment. j) If the increase in government spending is used for public infrastructure programs, could one argue that this would have positive effects on long-run future output and future tax revenues? Briefly explain. Yes, if the public infrastructure programs increase the future capital stock, Kt+1 ↑, and/or future factor productivity, At+1 ↑, then following the product approach we can experience an increase in future output: Yt+1 ↑= At+1 ↑ Kα t+1 ↑ | {z } G↑? N 1−α t+1 The future increase in economic activity – and holding tax rates constant over time – will result in greater tax revenues in the future: Yt+1 ↑ → Tt+1 ↑= tQ¯ t+1 ↑. U6301: Macroeconomics for International and Public Affairs Spring 2020 5 Previous part not necessary. The Economist Intelligence Unit comments on Nigeria’s expansionary government borrowing: “The increase in external borrowing fits with our existing forecast, and we maintain our view that medium-term debt sustainability will be challenged by sub-optimal economic policy.” k) If international investors share this perspective, would you expect a decrease or increase in Nigeria’s risk premium, RP, and effective interest rate, r 0 , for future bonds? Briefly explain. If investors share this skepticism, then they expect a greater risk of default and expect to be compensated for the increased risk. Hence, the risk premium would increase, RP ↑, which would increase the effective interest rate, r 0 ↑= r w + RP ↑, as the international risk-free interest rate itself does not change. l) What would be the effects of increased skepticism on Nigeria’s domestic saving, S, and private domestic investment, I? The increase in risk would not encourage domestic saving and remain –adjusted for risk– the same. However, the increase in the effective real interest rate makes borrowing more expensive and decreases investment. S(.) I(.) S I r S, I r w r w + RP I 0 RP ↑ Note that the reduction in investment is independent of CA > 0 (initially) or CA < 0 (2015