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Question 1
2
1.
In November 2023, the German Supreme Court ruled to end a COVID-era exception to the country’s debt ceiling, which limits deficits to 0.35% of
GDP annually. As a result, the government will now be required to eliminate around $USD 60 billion of planned spending – approximately 1.4% of
German GDP. At risk of being cut, for example, are billions of euros in subsidies offered to U.S. chipmaker Intel for planned plants in Germany considered key for the country’s transition to a carbon neutral economy. Prior to this ruling, the IMF forecasted German GDP growth to be 0.8% in
2024 (resulting in a -0.9% output gap), and inflation to be 3.1%. This compares to a projected 1.3% GDP growth and 3.5% inflation for Europe as a
whole.
a)
Using an aggregate demand and aggregate supply (AS/AD) chart, show where Germany was projected to be in 2024, prior to the ruling. Label this point “B”. Then,
model the impact of the ruling, labeling the new point “C”. (5 marks)
b)
The European Central Bank (ECB), which controls monetary policy for all of Europe including Germany, maintains a 2% inflation target for the Euro area and has a
reputation for being relatively “hawkish” (tough on inflation). Assuming the ECB lives up to its reputation, what is the impact of the ECB’s most likely interest rate
move on Germany in 2024? Show such a move on your chart, labelling the new point “D”. (5 marks)
c)
If the ECB rate move that you envision was not fully anticipated by market participants (e.g., bond traders) beforehand, what is the likely impact of the move on the
Euro area yield curve? Answer this question by first drawing a “typical” yield curve (solid line) and then drawing on the same chart a new yield curve (dotted line)
after the ECB rate move. Also, what is the likely impact on the value of the Euro, given that it is one of the most heavily traded currencies in the world? Specifically,
if the Euro were trading at 1 Euro = 1.0800 USD before the rate move, what is a reasonable (directionally correct) estimate of the exchange rate after the move? (2.5
marks for yield curve + 2.5 marks for Euro:USD = 5 marks total)
d)
In response to the ruling, DWBG Chief Economist Toto Foxx argued for reform of the debt brake law, saying “The debt brake was implemented when Europe had a
debt sustainability problem and Germany wanted to lead by example. Now, Germany has a growth and competitiveness problem.” Foxx shares the view of many
economists that Germany has already suffered years of chronic under-investment in infrastructure such as roads, rail and broadband networks, contributing to its
current stagnation. On your chart (or a new one if it is easier), depict what you believe Toto Foxx would like to see as the equilibrium outcome for Germany. (5
marks)
e)
At a conference to announce Foxx’s proposal, renowned investor Michael Lessi criticized Foxx’s policy recommendation, arguing that lifting the debt brake would lead
to (i) an upward spike in German inflation; and (ii) an even larger mountain of government debt. Foxx responded: “No, no, no, Michael that is so not right! Your
model is completely wrong. Lifting the debt brake would SOLVE both the inflation problem and the debt problem!”. Briefly explain what Foxx is likely thinking with
regard to both of Lessi’s two concerns. Again, reference your model as part of your explanation. (7 marks)
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Q1, part a)
Using an aggregate demand and aggregate supply (AS/AD) chart, show where Germany was projected to be in 2024,
prior to the ruling. Label this point “B”. Then, model the impact of the ruling, labeling the new point “C”. (5 marks)
Graders: be tolerant of different views of the magnitudes here, e.g., of the
output gap @ B. The key in this question is to get the DIRECTIONALITY of the
curve shifts correct.
LRAS
AS
Price
level
•
•
B
C
•
A
•
AD’ AD
Real GDP
•
The graph should look something like this. Prior to the ruling, there
was a negative output gap and prices were rising quickly, which
implies that AS must be shifted inward relative to the long run
equilibrium (shown here as point A; it’s okay if they don’t show this
on their graphs). Showing B correctly is worth 2.5 marks.
The ruling will lead to a decline in G, which shifts AD to the left.
Students should also reference that the decline in G will lead to
declines in C and I, through the multiplier effect. There is also a direct
effect on I, since the subsidies to Intel will result in lower investment.
The result is lower GDP, a lower price level, and higher
unemployment relative to B. Showing C correctly is worth 2.5 marks,
of which the explanation is 1.5 marks.
Some students may put the inflation rate on the y-axis instead of the
price level; this is fine, so long as they specify that they expect a
reduction in inflation (disinflation) rather than prices falling outright
relative to B.
Some students may also shift the AS curve inward, since the question
references subsidies to Intel. This is incorrect, since the subsidies
were for investment (a component of AD), not for production. If they
do this along with an AD shift, but explain both shifts in a reasonable
way, they should receive 1.5/2.5 on the “C” component.
If they shift LRAS instead, making an argument that the Intel subsidies
would have led to higher productivity in the long run, that is fine.
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Q1, part b)
The European Central Bank (ECB), which controls monetary policy for all of Europe including Germany, maintains a 2% inflation target for the Euro
area and has a reputation for being relatively “hawkish” (tough on inflation). Assuming the ECB lives up to its reputation, what is the impact of the
ECB’s most likely interest rate move on Germany in 2024? Show such a move on your chart, labelling the new point “D”. (5 marks)
LRAS
•
AS
Price
level
•
•
B
C
D
A
AD’ AD
AD’’
Real GDP
The ECB sets interest rates based on the entire Euro area, which
should still have an inflation forecast > 2%. As a result, the ECB is
likely to raise interest rates. Telling this story correctly is worth 1
mark.
Higher interest rates will lead to lower AD, through all components,
leading to a point like D (1 mark).
Each component of AD will fall. The explanation for why is worth 3
marks. For C (consumption), students should reference higher
borrowing costs, incentives to save, and/or wealth effects through
stock prices and housing. For I (investment) and G (government
spending), students should reference borrowing costs and/or the net
present value of projects falling. For NX, the students should note
that the value of the Euro will increase as interest rates rise and
investors attempt to buy Euro area bonds; this makes exports more
expensive for the rest of the world, and imports cheaper.
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Q1, part c)
If the ECB rate move that you envision was not fully anticipated by market participants (e.g., bond traders) beforehand, what is the likely impact of
the move on the Euro area yield curve? Answer this question by first drawing a “typical” yield curve (solid line) and then drawing on the same
chart a new yield curve (dotted line) after the ECB rate move. Also, what is the likely impact on the value of the Euro, given that it is one of the
most heavily traded currencies in the world? Specifically, if the Euro were trading at 1 Euro = 1.0800 USD before the rate move, what is a
reasonable (directionally correct) estimate of the exchange rate after the move? (2.5 marks for yield curve + 2.5 marks for Euro:USD = 5 marks total)
•
Interest
rate
Graders: Don’t worry much about the long end
of the yield curve, except if they do something
that is crazy (inverted U or exponential). The
new long end could be somewhat above the
old long end rather than asymptotically
converging to the old curve as is shown here
•
•
Maturity
The original yield curve should be upward sloping, and slightly concave. If
they draw it as a straight, upward sloping line, that is fine too. For full
marks, they should mention that the yield curve slopes upward because
there is a term premium and risk premium built into longer maturities. 1
mark for the original + explanation.
The most leftward point on the yield curve should bump up as a result of
the ECB’s move, and the yield curve should be higher for the short-medium
term. They could then either draw the curve converging to the original at
longer maturities (like in the black dotted line), or crossing the original at
some point and going lower for a bit (red dotted line) if they are specific
about the fact that bond traders may assign a higher probability to a
recession happening in the future as a result of the rate move. The most
important thing is that the curve flattens, relative to the original. 1.5 marks
for this part.
When the ECB raises interest rates, bond traders will find Euro area bonds
more attractive, and will buy Euros as a result. The Euro will appreciate as a
result. 1 Euro will now buy more USD, so the exchange rate should move to
something like 1.10. 2.5 marks.
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Q1, part e)
In response to the ruling, DWBG Chief Economist Toto Foxx argued for reform of the debt brake law, saying “The debt brake was implemented when
Europe had a debt sustainability problem and Germany wanted to lead by example. Now, Germany has a growth and competitiveness problem.”
Foxx shares the view of many economists that Germany has already suffered years of chronic under-investment in infrastructure such as roads, rail
and broadband networks, contributing to its current stagnation. On your chart (or a new one if it is easier), depict what you believe Toto Foxx would
like to see as the equilibrium outcome for Germany. (5 marks)
LRAS
Price
level
LRAS’
•
F
•
F’’
•
E
•
D
F’
Real GDP
Foxx wants stimulus – specifically in infrastructure – to stimulate both
short term growth and longer term competitiveness.
The short term growth can be modeled as a move to a point like E,
showing an upward shift in AD through government investment in
infrastructure. 1 mark
The other dimension to Foxx’s argument is that LRAS would shift right
as a result of the infrastructure investment – which would increase
productivity. 2.5 marks for the LRAS move.
The equilibrium move could take place through one or more of three
possible moves:
• This could either be through a rightward AD shift (likely
through more government stimulus, since monetary policy isn’t
an option specifically for Germany (ECB decides) and there
doesn’t seem to be a lot of “pent up demand” in this case).
That’s the move to F.
• Or through a rightward AS shift (caused by falling wages, as a
result of high unemployment), that’s F’.
• Or through a more realistic assumption, which is that it is
MOSTLY an AD stimulus and a little bit of wage cram down.
That is F’’.
• The adjustment story is worth 1.5 marks and you can be
flexible in whether that is modeled as F, F’ or F’’.
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Q1, part f)
At a conference to announce Foxx’s proposal, renowned investor Michael Lessi criticized Foxx’s policy recommendation, arguing that lifting the debt
brake would lead to (i) an upward spike in German inflation; and (ii) an even larger mountain of government debt. Foxx responded: “No, no, no,
Michael that is so not right! Your model is completely wrong. Lifting the debt brake would SOLVE both the inflation problem and the debt
problem!”. Briefly explain what Foxx is likely thinking with regard to both of Lessi’s two concerns. Again, reference your model as part of your
explanation. (7 marks)
•
LRAS’
LRAS
Price
level
AS
E
•
G
D
AD’’’
AD’’
Real GDP
The key point with respect to inflation is that, while the initial boost
in G may be inflationary (i.e., moving from D to E), the rightward shift
in LRAS will put downward pressure on prices in the longer run (i.e.
moving from E to G). The reason AS shifts could be due to wages
given the sizeable output gap (but, yeah, sticky wages) or due to
lower firm costs if the infrastructure investment improves efficiency,
reduces bottlenecks - in short helps firms derive productivity gains
3.5 marks for this story.
With respect to debt, the economy’s debt-to-GDP ratio will fall if the
rate of GDP growth (which is now substantially higher) is larger than
the interest it pays on its debt. While the absolute value of debt may
rise, the economy’s ability to support that debt has increased as a
result of the policy, i.e., the debt/GDP might improve. This isn’t
entirely believable based on experience, but that’s the argument and
how you make it (and model it). 3.5 marks for this story.
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Question 2
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3.
The Bank of Canada’s (BOC) website prominently features Canada’s “Inflation-control strategy”, the centerpiece of which is the inflation target of
2%, defined as “the midpoint of the 1% - 3% control range”. Now consider the chart showing actual inflation in Canada from the start point of the
BOC’s inflation-control strategy in 1991 to just prior to the start of the pandemic in early 2020. The 2% target line is highlighted in red. Some
analysts have used such a chart to support the hypothesis that the BOC’s inflation target is “not symmetric” – meaning that the BOC does not have
equal tolerance for over- and under-shooting around the stated inflation target of 2%. More specifically, these analysts claim that the BOC’s 2%
target is more akin to a ceiling.
a)
The BOC denies the “not symmetric” hypothesis, but there are many believers in it. Some of these believers have tried to speculate as to the economic rationale
(versus the political rationale) for the BOC not having a symmetric inflation target. What might this economic rationale be? Generate a compelling hypothesis for
why the BOC might be consciously (and using sound economic logic) acting to keep inflation most of the time BELOW target rather than letting it fluctuate above and
below symmetrically around a mean of 2%. (5 marks)
b)
Jim Stanford, a noted left-wing economist and “friend of the working man”, believes the asymmetric hypothesis is true and he believes it is bad not only for the
overall economy, but particularly for Canadian lower and middle income workers. Briefly explain what you think his argument might be about why the asymmetry is
bad for the Canadian working class. (5 marks)
c)
Now consider the chart showing the BOC’s target overnight rate (official policy rate). If the BOC is, as it states, equally concerned about inflation rising above or
falling below the 2% target, provide a brief explanation for why the bank so badly undershot its 2% inflation target, especially during the 10+ year period following
the GFC, i.e., 2009-2019 when interest rates operated in a range from 0.25% (the “effective lower bound”) to 1.75%. (5 marks)
d)
Note: Not yet covered this material in class. Is there anything more the BOC could have done to achieve the 2% inflation target, particularly in the 2010 to 2017
period when inflation was chronically below target except for a small (and brief) spell above 2% in 2012? Be specific (and concise) about what actions the BOC might
have taken to solve this problem. (5 marks)
e)
Now that Jim Stanford has (finally) got what he wanted – inflation running above target – what would he apparently expect to see in terms of outcomes for lower and
middle income workers? You can bolster your argument by asking for 2 (only 2) data points that you would like to check to verify if Stanford’s belief has come true.
What 2 do you choose and why? (5 marks)
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Canada: Annual inflation rate, 1991-2020
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Bank of Canada, Official Policy Rate, 1991-2020
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a)
The BOC denies the “not symmetric” hypothesis, but there are many believers in it. Some of these believers have tried to speculate as to the
economic rationale (versus the political rationale) for the BOC not having a symmetric inflation target. What might this economic rationale be?
Generate a compelling hypothesis for why the BOC might be consciously (and using sound economic logic) acting to keep inflation most of the
time BELOW target rather than letting it fluctuate above and below symmetrically around a mean of 2%. (5 marks)
–
There are several economically-defensible explanations for why the BOC might want to keep interest rate most of the time BELOW target. The primary answer is #1
below, that’s enough to give 5 marks. Any of the points below, solidly argued, would be sufficient for 5 marks.
•
Wages are Quick to Rise, Slow to Fall: This is something we stressed in class. This means that inflation could plausibly spike up quickly when the economy gets
toward full employment and labor starts to become scarce. Knowing this, the BOC tries to keep the economy “a little bit on the cool side” at all times to
prevent wages from driving a wage-price spiral. Formally, the answer relies on an assumption that the AS curve is very steep once we get at or above LRAS.
•
Preventing Inflation Expectations from Becoming Unanchored: One of the primary concerns for central banks is the anchoring of inflation expectations. If the
public starts to believe that inflation will consistently be higher than the target, this can lead to a self-fulfilling prophecy where higher inflation becomes
entrenched. By treating the 2% target as a ceiling, the BOC might aim to firmly anchor expectations around this level, thereby preventing a possible upward
drift.
•
Asymmetric Costs of Over- and Under-Shooting the Target: The economic costs of inflation exceeding the target might be perceived as higher than the costs of
falling short. For example, high inflation can erode savings and fixed incomes, whereas moderately low inflation (still positive but below the target) might not
have as immediate or severe negative impacts.
•
Global Economic Considerations: In an increasingly interconnected global economy, higher U.S. inflation can have broader implications, including affecting
exchange rates and international trade balances. Keeping inflation tightly controlled near the lower end of the target might be seen as a strategy to maintain
global economic stability.
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Jim Stanford, a noted left-wing economist and “friend of the working man”, believes the asymmetric hypothesis is true and he believes it is bad
not only for the overall economy, but particularly for Canadian lower and middle income workers. Briefly explain what you think his argument
might be about why the asymmetry is bad for the Canadian working class. (5 marks)
b)
– Below are some specific arguments for why an asymmetric inflation target might be harmful for lower and middle income workers. The ”meta” here is how asymmetry
impacts labour market outcomes in ways that negatively impact lower and middle income workers in a disproportionate way. A 4/5 answer would need to make this
‘meta’ point and back it up with the point below about employment effects. To get 5 out of 5, at least one of the additional mechanisms – most likely the
wage/bargaining power argument – would need to be made.
–
1.
Employment Effects: A central bank that aggressively prevents inflation from going above a certain target may keep monetary policy tighter than it otherwise
would be, which can lead to higher unemployment levels. Krugman has often emphasized the human cost of high unemployment, especially on the working class,
who are usually the first to lose their jobs and the last to experience the benefits of economic recovery. (2.5 marks for getting this)
2.
Weaker Bargaining Power of Labor: When inflation is consistently low, or when central banks react more aggressively to inflation spikes than to dips, employers
may be less likely to increase wages. Simply put, workers have less bargaining power over wages. Lower and middle-income workers, whose wages are less flexible
and who often rely on annual cost-of-living adjustments to maintain their purchasing power, could find their real incomes stagnating or even decreasing over time.
Other, less obvious possibilities for Stanford’s viewpoint:
•
Debt Burdens: If inflation is kept very low, the real value of debt does not erode as quickly, which can be particularly burdensome for lower and middle-income
individuals who may have higher debt relative to their incomes. Thus, they might struggle more with repayments in a low inflation environment.
•
Economic Growth and Investment: A focus on maintaining inflation at or below a certain threshold might lead to underinvestment in the economy. Lower
economic growth can disproportionately affect lower-income workers who rely more heavily on the availability of jobs and government services that are often
funded through growth-driven tax revenues.
•
Social Safety Nets and Government Programs: Inflation below target levels can be symptomatic of an economy not running at full capacity, which might lead to
reduced tax revenues and, consequently, less funding for social programs. These programs disproportionately benefit lower and middle-income workers, who
would suffer from cuts in services or support.
•
Inequality: Persistently low inflation, which may signal a sluggish economy, can exacerbate income and wealth inequality. Asset prices, such as stocks and real
estate, often continue to rise even when inflation is low, benefiting the wealthy who own these assets, while wages for the working class do not keep pace
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c)
Now consider the chart showing the BOC’s target overnight rate (official policy rate). If the BOC is, as it states, equally concerned about inflation
rising above or falling below the 2% target, provide a brief explanation for why the bank so badly undershot its 2% inflation target, especially
during the 10+ year period following the GFC, i.e., 2009-2019 when interest rates operated in a range from 0.25% (the “effective lower bound”) to
1.75%. (5 marks)
–
In the aftermath of the GFC, the BOC faced several challenges in hitting its 2% inflation target, particularly when interest rates were close to the effective lower
bound (ZLB). The ‘meta’ in this answer is chronically weak demand combined with monetary policy ineffectiveness at or near the effective lower bounds. Below are
some specific reasons for this. As with (b) we are looking for an understanding of the ‘meta’ and a point or two in terms of specifics.
1.
Weak Demand: The Great Recession caused a significant drop in aggregate demand due to high unemployment, wealth effects, and reduced consumer
confidence. When demand is weak, companies have less ability to raise prices, which suppresses inflation. Relatedly, and specific to Canada, the Great
Recession was a global phenomenon and Canada is very much exposed to these forces, especially through trade and commodity prices. Lower commodity
prices contributed to disinflationary pressures, which the BOC’s policies could not easily counteract.
2.
Monetary Policy Ineffectiveness: At the ELB, the conventional monetary policy tool of lowering short-term interest rates becomes ineffective. Even with nearzero interest rates, investment and consumption may not increase sufficiently to boost the economy and raise inflation.
Other less obvious points:
•
Deflationary Expectations: Inflation expectations can become self-fulfilling. If businesses and consumers expect low inflation or deflation, they may delay
spending, which can further reduce inflation. The trauma of the financial crisis likely dampened inflation expectations, making it harder for the BOC to push
inflation up to the target.
•
Credit Constraints: The financial crisis resulted in a tightening of credit conditions. Banks became reluctant to lend, and creditworthy borrowers were harder to
find. This credit crunch limited the effectiveness of monetary policy, as businesses and consumers were unable to access the credit needed to spend and invest.
•
Fiscal Policy Constraints: The effectiveness of monetary policy is often enhanced by supportive fiscal policy. However, during the Great Recession, there was
significant concern about the level of public debt and deficits, which led to fiscal policy that was less expansionary than might have been needed to support
achieving the inflation target.
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d)
Is there anything more the BOC could have done to achieve the 2% inflation target, particularly in the 2010 to 2017 period when inflation was
chronically below target except for a small (and brief) spell above 2% in 2012? Be specific (and concise) about what actions the BOC might have
taken to solve this problem. (5 marks)
–
The answer here is quite simple: YES. The BOC could have engaged in unconventional monetary policy. That, again, the meta. This needs to be clearly stated along
with at least 1 of the following specific tools that the BOC has in its unconventional policy arsenal.
•
Forward guidance and commitments – “open mouth operations”: Forward guidance & commitments by central bank authorities to keep rates low until “x
happens”. This can “talk down” longer-term rates, such as mortgage rates, which are typically more important to consumers, businesses, and investors
•
Quantitative Easing (QE): Purchases of assets (typically longer-term assets such as T-bills) for the central bank’s portfolio, financed by the creation of reserves
in the banking system.
•
Yield curve control: Direct intervention by the central bank: purchasing bonds of a specific duration to “control” that piece of the yield curve. Buying bonds at a
specific duration raises their price = lowering their yield
•
Helicopter money or direct funding of fiscal policy. The BOC buys bonds being issued by the government so the government can more aggressively fund fiscal
spending to boost the economy.
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e)
Now that Jim Stanford has (finally) got what he wanted – inflation running above target – what would he apparently expect to see in terms of
outcomes for lower and middle income workers? You can bolster your argument by asking for 2 (only 2) data points that you would like to check
to verify if Stanford’s belief has come true. What 2 do you choose and why? (5 marks)
–
–
Stanford would expect to see positive outcomes along the two outcomes he cares about most for lower and middle income workers. 2.5 for each one.
1.
Full employment: Stanford would like a labour market that has lots of jobs with employers actively courting workers, who are in scarce supply. A simple
indicator here would be the unemployment rate. Other more sophisticated metrics could also be asked for as well, e.g., the output gap, number of job
openings, net new jobs, labor force participation rate, employment-population ratio, initial jobless claims.
2.
Rising real wages: With the economy running hot, Stanford’s hope is that nominal wage growth will outstrip inflation. This is risky – it may not happen – but
there is no doubt that a hot labour market gives workers more bargaining power, so it is at least possible. Here, students should simply ask for data on real
wages, such as real wage growth.
Other less likely arguments:
1.
Decreased Real Debt Burdens: If inflation is running hot, the real value of debt is eroded more quickly, which can might help lower and middle-income
individuals who may have higher debt relative to their incomes. Thus, they might benefit more with repayments in a higher inflation environment. This is, of
course, offset by potentially higher interest rates on debt to the extent that rates are not locked in, i.e., floating rate mortgages.