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
1
From 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 antirecessionary 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-vg
Prof. 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 3
Relative 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
government debt
in yields on _______________have
special relevance to interest rates
generally. The relevance is that, if the state wishes to raise interest
reduced
rates, debt instruments must be offered to the market at ______
yields to new creditors. In competing for savings,
prices, so raising _______
higher
other institutions are then forced to match those ________
rates. In
reverse, where the state initiates the repurchase of existing debt,
rise and yields ______.
fall
bond prices _____
Other institutions are then able
lower rates. By
to arrange their own borrowing requirements at _______
national debt in
such actions - which alter the composition of the ____________
interest-bearing securities
currency
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,
quantitative easing
with dealing in gilts, when it has become known as ‘______________’.
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.
Q9 Background Info ctd.
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.
Question 9
So, 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 9
What 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 Friday
Don’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)
b)
c)
d)
do not make systematic errors
anticipate future prices accurately
adapt slowly to the rate of inflation
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 surplus
b) both accounts will move into deficit
c) there will be a deficit on the current account
and a surplus on the financial account
d) there will be a surplus on the current account
and a deficit on the financial account
2010 Exam Q37
Balance of International Payments Accounts
The general structure:
BoP
≡
X-M
BoP
≡ current account
income-expenditure
(deficit)
(surplus)
+
NB:
+ IOU (loan/credit)
≡0
+ capital account
≡0
∆wealth
≡0
(wealth falls)
+ (exporting assets or writing an IOU)
(wealth rises)
- (importing assets or receiving an IOU)
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 5
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.
• 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
Balance of International Payments Accounts (Lecture 61 Slide 35)
The general structure:
BoP
≡ X - M + IOU (loan/credit)
≡0
BoP
≡ current account + capital account ≡ 0
BoP
≡ X - M + ‘invisibles’
BoP
≡ { balance for official financing } + Dforex
+ DLT + DST + Dforex
≡0
≡0
(exports of gold
and/or forex to
support £)
balance for official financing: the amount taken from (or absorbed
by) official forex reserves in order to stabilise the international value
of domestic currency
Which of the following is not a function
of the Bank of England?
a)
b)
c)
d)
lender of last resort
supplier of money
acting as a store of value
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