Master Economics & Business Understanding the World Economy. Sample Essays and Exercices

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1 Master Economics & Business Understanding the World Economy Sample Essays and Exercices Examples of short exercises 1. Decreasing Marginal Product of Capital and Depreciation Consider two sectors using the same type of capital to produce two different goods. Production in sector 1 is characterized by a low depreciation rate whereas production in sector 2 is characterized by a high depreciation rate. Both sectors share the same initial level of capital stock. Using a diagrammatic example, discuss which sector will grow/shrink faster in the short-run and how your answer depends on the exact location of the initial level of capital stock. (please be concise, limit your answer to one graph and 150 words) Answer Output if K starts here, both sectors will grow but low depreciation sector will grow faster as further away from steady state if K starts here, low depreciation sector will expand and the other one will shrink if K starts here, both sectors will shrink but high depreciation sector will shrink faster as further away from steady state Output in both sectors High Depreciation Low Depreciation Savings in both sectors Steady State K high depreciation sector Steady State K Low depreciation sector Capital Stock Different depreciation rates imply that the sector with a higher depreciation rate is characterized by a lower steady state level of capital than the sector with low depreciation rate. If both sectors start at a level of capital stock below the steady state of the high depreciation sector, then the low depreciation sector will grow faster because of the higher net investment. If the initial level of capital is above the steady state of the low depreciation sector, then the high depreciation sector will shrink faster than the low depreciation sector. For levels of initial capital between the two steady states, the low depreciation sector will grow whereas the high depreciation sector will shrink. The pace of these changes will depend from the relative distance from their respective steady states.

2 2. Financial crisis and the UK labour market UK unemployment has been increasing for a sustained period of time. March 2010 figures reveal that it is now at 16-year high. Meanwhile employment and real wages have both declined. Using a diagrammatic analysis, show the channel through which a financial crisis is likely to affect the level of employment as well as real wages. Discuss how your answer depends on the factors affecting the slope of the labour supply and/or rigidities in the labour market. (please be concise, limit your answer to 150 words) Answer: The financial crisis can be viewed as a negative shock which has downward shifted labour demand. If the labour supply is completely inelastic (i.e. substitution effect exactly offsets income effect) and assuming skills are uniformly distributed across workers, then real wages will fall with no change in the level of unemployment. In UK data, however, employment and real wages have both fallen suggesting that the substitution effect is significantly stronger than the income effect (case 1 on the graph). Other possibility is some downward rigidities on wages: a fall in labour demand does not lead to a large enough fall in wages (when the supply curve is vertical) and some workers have to be sacked to keep firm profitable (case 2 on the graph). Real Wage Case 1: Flexible wages but Upward Supply Curve: Substitution Effect Dominates Income Effect Real Wage Case 2: Downward wage rigidity leading to a Short- Run Upward Supply Curve Labour Demand Upward Sloping Supply Curve: Substitution Effect dominates Long-Run Supply Curve (1) w 1 (1) Short-Run Supply Curve due to wage rigidity w 1 (2) (2) w 2 w 2 Financial crisis w 3 (3) Financial crisis L 2 L 1 Employment L 2 L 1 =L 3 Employment Financial crisis moves equilibrium on the labour market from (1) to (2) along the upward sloping curve. Labour market equilibrium moves to (2) in the short-run due to real wage rigidities. Then equilibrium moves to (3) in the long-run after wages fully adjust.

3 3. Uncovered interest parity Assume that the current (annual) UK interest rate is 10% and that of the USA is 5%. Investors expect the exchange rate to be $1 per 1 in a year time. a) What is uncovered interest parity (UIP)? b) The current spot rate is 0.5 per 1$. Should you buy or sell sterling? c) At what expected exchange rate (for a year from now) are you indifferent between investing in USA and UK bonds given the current spot rate of 0.5 per 1$? d) Inflation numbers have just been released which indicate that this afternoon s meeting of the Bank of England will see an increase in interest rates to 20%. How does your answer to b) change? Answers: a) Uncovered interest parity states : r = r* + %e where %e is the expected depreciation of the domestic currency vis-a-vis the foreign currency, r (resp. r*) is the nominal interest rate in the domestic economy (resp. the foreign economy). b) Call r UK rate and r* US rate. Expected depreciation of sterling is (1-1/2)/(1/2)=100%. Differential r-r*is only 10-5=5%<100%. Hence sell sterling. c) Indifferent if 5%=(x-1/2)/(1/2) so x=2.5%+50%= So indifferent if sterling per $1 expected in one year (or $1/0.525 per 1) d) 20%-5%=15%=(x-1/2)/(1/2) so x=57.5% So indifferent if sterling per $1 expected in one year. (or $1/0.575 per 1)

4 Example of short essays 1) It s all about capital! Figure 1 plots the output per worker as a function of physical capital per worker in USD for selected countries. According to the concepts seen in class, discuss the following interpretation of the graph: "If we want to rise the living standards of poor countries to the level of rich countries, we just have to send them large quantities of capital". [Please do not use more than 800 words] Figure 1: Output per worker as a function of physical capital per worker in 1996 for selected countries. Correction It s all about capital! Some hints: The graph shows that countries with higher capital stock per worker have higher output per worker. But this should not be interpreted as a causal relationship: it does not mean that giving the stock of capital per worker of the US to Zambia would effectively raise income in Zambia to the level of the US. Indeed, capital is also more productive in the US, which allows the US to sustain a large level of capital in the steady-state. This is important because differences in capital per worker between Zambia and the US on this graph can have two potential sources: 1. There is indeed some lack of capital in Zambia (due for instance to low level of private savings) and Zambia is far away from its steady-state (implied by the Solow growth model). In that case, sending capital to Zambia can substitute the low level of local savings and can be efficient to raise output per capita; this would accelerate the convergence of the country towards its steadystate. Note that foreigners would be willing to lend capital as returns to capital are high

5 (because the country is far away from its steady-state + decreasing MPK). In other words, sending capital to poor countries can be an effective policy in countries far-away from their steady-state; in that case, growth can be achieved by increasing production inputs (here you could potentially refer to East Asia). 2. but one can interpret the graph very differently: Zambia has very little capital because returns to capital are very low in Zambia; in other words, Zambia is close to its "bad" steady-state and cannot grow much more through capital accumulation. Sending more capital would not help much in that case! At this point, you could discuss why some poor countries have a "bad" steady-state (institutions, technology, or more boadly TFP and human capital). 2) The Lucas Paradox Using the graphs showing Average Net Capital Inflows per Capita (over the period ) as a function of GDP per capita in 1970 for two different samples of countries ( 45 emerging and developed countries and OECD countries only ) and using the concepts seen in class, explain and discuss the following paradox raised by Nobel Prize R.E Lucas: "Why doesn't Capital Flow from Rich to Poor Countries?" [Please do not use more than 1000 words] Average Net Foreign Capital Inflows per Capita Sample of 45 emerging and developed countries ISR GRC ARG IND URU US JAP NOR GDP per capita in 1970

6 Average Net Foreign Capital Inflows per Capita Sample of OECD Countries ISR PRT GRC SPA US UK GER GDP per capita in 1970 Note: GDP per Capita in 1970 denotes GDP per Capita in USD adjusted for PPP in Average Net Foreign Capital Inflows per Capita denotes Net Capital Inflows per Head in USD averaged over the period Example: 1603 USD for Argentina means that on average over the period , 1803 USD (per head) were lent. A negative number means that on average the country was lending capital abroad (e.g Japan). Correction The Lucas Paradox: 1) Data description I expect student to explain that there is no clear pattern overall on the previous graph: we do not observe capital flowing to the poorer countries in 1970 in a systematic way. More precisely, it seems that the poorest countries do not seem to receive large inflows but above a certain level of income per capita (roughly 5000 USD) we do observe a tendency of capital flowing from the rich to the poor (see graph). The US being somehow an outlier: richest country but borrowing to the rest of the world on average over the period (best answers should try to explain why: quality/liquidity of financial assets provided by the US seems a right way to go). 2) Explaining the Lucas paradox: Assuming decreasing marginal productivity of capital as in the neoclassical growth model, poorer countries with low level of capital stocks should have higher marginal productivity of capital, provide higher returns to foreign investors and attract capital flows: we should observe a negative relationship on the previous graph. 3) Solving the paradox Explain that differences in return to capital are not only driven by differences in capital stock but also by differences in human capital and TFP (institutions, technology differences ). Capital should flow towards poor countries everything else equal. An explanation of the following graph provides a good answer:

7 Marginal Productivity of Capital Poor Countries with Low TFP/Low levels of Human capital Richer Countries with High TFP/High levels of Human capital Required rate of return Country 1 Country 2 Country 3 Capital Stock On the graph, country 1 has a low TFP (due to poor institutions for instance) and/or a low level of human capital: as a consequence for any capital stock, country 1 has a lower MPK than country 2 (and 3) which are on the blue schedule. If country 1 is at the point of the graph, the MPK of country 1 equalizes the world required rate of return and we should not expect the country to receive capital inflows, and thus despite that country 1 is poorer than country 2 and 3. To the opposite, country 2 has also a lower level of capital stock than country 3 but has a high MPK due to high TFP/High level of human capital: we should expect capital to flow towards country 2 since the MPK is higher than the required rate of return. Other valuable points: - Higher risks (expropriation risk, sovereign risk, volatile sectors as primary commodities ) in poorer countries: this shifts upwards the required rate of return for these countries once we adjust for risk. - Poorer countries tend to have more restrictions on capital inflows/more financial repression/capital markets imperfections - Non-decreasing MPK: at low level of income, MPK is increasing Poverty Traps 4) Controlling for TFP/Human capital Best answers should try to put similar countries in a bin to control for TFP/Human capital and see if the Lucas paradox disappears for these countries. One way is to look at OECD countries (as suggested in the spreadsheet), assuming that variations in TFP levels and human capital are not too large between these countries. The following graph seems to confirm that (US being an outlier). This confirms that conditionally on TFP levels/human capital, capital flows towards countries where it is scarce. Similar to the concept of conditional convergence as seen in class.

8 Average Net Foreign Capital Inflows per Capita Sample of OECD Countries ISR PRT GRC SPA US UK GER ) Fiscal policy GDP per capita in Under which conditions fiscal expansions have a large impact on aggregate demand and output? Discuss the implications for a country like Greece running a large austerity plan. [please no more than 700 words] Key elements [see lectures 9-11] - Discuss the Keynesian multipliers and the limits to the effectiveness of fiscal policy as a stabilization tool (Ricardian equivalence, crowding out of investment and net exports) - Implications: fiscal austerity less costly when country more open and with flexible exchange rate regime (as fiscal multiplier is smaller). Greece typically is a country not very open and with fixed exchange rate. Makes adjustment more costly. - Can also add a discussion regarding the crowding in of investment if austerity plan. Depends on the response of real interest rates to the austerity plan. Potentially ambiguous depending on the recessionary effect of the plan. 4) Financial crisis in Iceland What was the impact of the sharp depreciation of the Icelandic Krona in October 2008 on the external debt of Iceland (see fig. 1 and 2)? How did the structure external debt affect investors decisions before the crisis? [600 words maximum] You were expected to talk about the currency composition of external assets and liabilities for Iceland, investigate the capital losses on the external position associated to a devaluation of the Krona with respect to other currencies and discuss how this aggravates external debt of Iceland ex-post. Ex-ante, investors can expect Iceland to be harshly hit in case of a Krona depreciation (financial fragility) which leaves room for multiple equilibria, one where Iceland is hit by a self-fulfilling currency crash (see class notes, lecture 12).

9 Fig. 1: Currency crash in Iceland in October 2008 (nominal exchange rate: Icelandic Krona/Euro) 800% Foreign currency liabilities of banks and CB forex reserves september % 600% 750% GDP 500% 400% 300% 200% CB forex reserves: 21% GDP CB swaps and credit lines: 14% GDP 100% 0% Foreign currency liabilities of the banks CB forex liquidity Fig. 2 : Forex exposure of banks liabilities in Iceland before the crash.