606Finex Prac Answers(F23)

PPS606: Answers to Final Exam Practice Problems Professor Krupp Fall 2023 1) Explain the difference between inflation targeting and interest rate targeting as monetary policy tools. What practical implications does choosing one vs. the other have for how policy is conducted? Answer: Inflation targeting refers to the use of the inflation rate as the nominal anchor that drives monetary policy decision-making. The central bank announces a desired (targeted) inflation rate it intends to achieve, and then it uses open market operations and other tools to try to achieve the rate. In contrast, interest rate targeting uses the base interest rate as the nominal anchor, and it conducts monetary policy to keep the rate at the targeted level. The only practical difference between these two monetary policies is the nominal anchor on which inflation expectations are tied. They are extremely similar and require the same tools to achieve. Given that inflation is influenced by the prices of traded goods and services, however, it may be a bit more difficult to achieve a targeted inflation rate than a targeted nominal interest rate (since the central bank has monopoly power over bank reserves and can pay interest in bank reserves to achieve the targeted interest rate.) Inflation is harder to control directly. 2) Agree or disagree, and explain: According to the impossible trinity, a country cannot simultaneously address internal and external balance problems with an open capital market. Answer: Disagree. A country with a fixed exchange rate and an open capital market cannot use monetary policy to address internal balance problems, but it can use fiscal policy successfully. Having an open capital market means that the country cannot keep its interest rate lower or higher than the world rate for any length of time, but it doesn’t mean both internal and external balance aren’t achievable. If the country has floating exchange rates, it can pursue internal balance issues using monetary policy because fiscal policy is ineffective. 3) Define the following terms: a) Portfolio securities: debt instruments (e.g., bonds) and equity assets (e.g., share of stock amounting to less than 10% of the capitalized value of the firm) b) International reserves: central bank and/or government holdings of foreign currencies c) Marginal propensity to import: Additional spending on imports out of an increase in income; leakage. d) Deleveraging: the act of paying down debt. e) Financial liberalization: this refers to when a country opens its capital market, both to foreign inflows {purchases of domestic financial assets, access to bank accounts, etc.) and to domestic outflows (domestic purchases of foreign assets, access to foreign banks, loans, etc.) It may also include deregulation of interest rates, allowing the entry of foreign banks to compete with domestic banks, removal of capital controls, etc. f) Steady state level of capital per worker: Level of K per person where the rate of investment = rate of K usage (depreciation + population growth rate); in other words, it is where capital accumulation = capital depletion, so the capital stock stops growing and economic growth stops. g) Currency devaluation vs. depreciation: A devaluation occurs when a country chooses to lower the fixed exchange value of its currency against another currency

(or basket of currencies), while a depreciation is a market-driven decrease in the exchange value of one country’s currency against another (floating ERs). 4) How is TFP measured? What is growth accounting, and how is it used to assess the factors that explain real GDP growth? Answer: Total factor productivity (TFP) refers to the increase in real GDP that is due to the combined factor inputs and their overall increased productivity. It is measured as a residual in growth accounting since it cannot be measured directly at the aggregate level (productivity is measured as Aoutput/A(combined inputs), and output is measured in different units for different production (goods and services.) The percentage growth in real GDP equals the % growth in factors used (K, L, etc.) plus the % growth due to increases in multifactor productivity (or TFP). Since we can measure labor hours and capital services (sort of), we can derive TFP = %AReal GDP - %AFactors. 5) According to Eisfeldt, et. al “Human Capitalists” paper, the authors make the case that the apparent decline in measures of the labor share of income are misleading. What is their argument, and how do they analyze what has changed as a result of labor market polarization and technology change? The authors assert that labor market polarization has led to a wider gulf between those with lower skills and education and those who have more education and higher cognitive abilities. The first group of workers tend to have jobs with more routine tasks that are being displaced by technology and automation, so their employment rates are falling (these are the workers in the shrinking middle of the labor market.) In contrast, those workers with more education and high- tech skills face increasing demand for their ability to utilize computers, Al, and other new types of technology to increase their productivity. This group of workers is referred to as “human capitalists,” and they are receiving an increasing share of their compensation in the form of equity (e.g., stock options, reserved shares, etc.) In the national income and product accounts, the labor share of income usually reflects wage compensation and fringe benefits, and the capital share reflects equity compensation to owners. Given that there is an increasing number of human capitalists whose labor compensation includes equity shares, this is not being counted as part of the total payments to labor in the statistics, so it understates the labor share of national income. The authors find that that the equity share of compensation to human capitalists is highest in the sectors where the price of investment goods has declined the most, namely the high-tech sector and healthcare. Since these workers’ skills are complements to physical and intellectual capital, the falling price of capital increases the demand and compensation for these workers and reduces demand for production workers who are substitutes for capital. 6) Assume the economy is operating below full employment. Use the Mundell-Fleming model (IS-MP-BP) to show how the following policies affect GDP and the real interest rate in the short run (assume perfect capital mobility): a) The government devalues the home currency (surprise, one-shot) (fixed ER system) Answer: Under fixed ERs and perfect capital mobility, a one-shot, permanent devaluation can be effective in achieving full employment. The devaluation makes exports relatively cheap and imports relatively more expensive, boosting exports and shifting the IS curve rightward (IS’). At

Interest rate MP fu % BOP <IN\ / d) The government increases the money supply (fixed exchange rate) Answer: Monetary policy is completely ineffective for domestic internal balance when the exchange rate is fixed and capital is perfectly mobile. An increase in the money supply will lower the interest rate and cause net capital outflows, requiring the Central Bank to buy the excess supply of domestic currency and sell out of its reserves to restore external balance. Thus, the MPcurve shifts out and back almost immediately and there is no net change in output at all. Interest rate MP MP’ M ‘\,/ BOP / IS Y 7) Inthe Erel, et. al (2023) paper, what do they find about the behavior of online banks compared to traditional brick and mortar banks when the Fed raised the federal funds rate to reduce inflation? What are the implications for monetary policy transmission? Answer: In this paper, the authors analyze how purely online banks and traditional brick and mortar banks adjusted the interest rates they pay on deposits and on loan rates in response to the Fed raising the federal funds rate in 2021-2022. They found that online banks raised their deposit rates significantly more than traditional banks, and that this pass-through led to an outflow of deposits from traditional banks and an inflow to online banks. Online banks also raised their mortgage and auto loan rates, but by less than did traditional banks, indicating that they priced their loans closer to the marginal cost of funds. Monetary policy transmission is improved if there is a greater pass-through response to deposit rates and loans when the central bank changes the base interest rate in the economy, so the proliferation of online banking has helped increase monetary policy transmission, at least according to their research. 8) Agree or disagree, and explain: The Beveridge curve will shift leftward if there is an improvement in labor market matching efficiency.

Answer: Agree. The Beveridge curve shows the empirical relationship between the number of job vacancies and the unemployment rate, which is affected by the matching efficiency between those seeking jobs (the unemployed) and the jobs that are currently seeking employees. It is typically a downward-sloping curve since job vacancies and unemployment tend to be negatively correlated. If the curve shifts leftward (closer to the origin), this indicates a higher match efficiency between job seekers and vacancies---the unemployment rate is lower for a given vacancy rate. 9) According to the Taylor Rule, how should monetary policy be adjusted if the target inflation rate is 2%, actual inflation is 4%, the desired real interest rate is 2%, and there is a 3% output gap? Compare the policy recommendations under two scenarios: when the weights on inflation and the output gap are 50/50, and when they are 70/30. Answer: The equation for the Taylor Rule is: Nominal FFR =1+ r* + a(im - m*) - b(Output gap), where 11 refers to actual inflation, m* is desired inflation, r* is the desired real interest rate, and a and b are the weights on the inflation gap and the output gap. If the weights are 50/50, then the nominal FFR should be: FFR =4+ 2+ .5(2) - .5(3) = 5.5%. If the weights are 70/30, then: FFR =4+2+.7(2)-.3(3) = 6.5%. 10) Agree or disagree and explain: According to the Yared (2019) paper, most of the increase in government debt/GDP ratios over the past 40 + years is due to a fall in global savings. Answer: Disagree. In the Yared paper, he finds that political economy reasons are likely a major contributing factor to rising debt/GDP ratios in many developed countries over the past 20+ years. While aging populations raise the government pension and health care expenditures and likely lower tax collection as more of the population stops working and paying taxes, there also has been a tendency for government officials to engage in time inconsistent behavior. They increase expenditures and keep tax rates lower in order to get elected in the short run (with support from older voters who benefit more), hoping that future officials will address the deficit and growing debt problems that their predecessors “gifted” to them. Increased political polarization and frequent shifts in the parties in power also contribute to short-term policies that shift the long-term burdens onto future generations. Global savings have actually risen as more countries have moved from least developed and developing into middle and upper middle income status, but most of Yared’s focus is on developed countries.