Part A

1.According to the 3-equation model studied in the module, foreign exchange market and bond
traders take account of the nominal but not the real UIP condition in making their trading decisions.

False.

In the 3-equation model, foreign exchange market and bond traders have rational expectations and
are forward-looking which take all available information into account when making trading
decisions.

The nominal UIP condition states that the differences between interest rates between countries is
equal to the expected change in the exchange rate. It is an arbitrage condition and assumes that the
expected exchange rate is unchanged. The real UIP condition considered the differences in
inflations and reflect the relationship between interest rate and real exchange rate. The real
exchange rate involves transition costs between countries and is more practical.

Therefore, foreign exchange market and bond traders, as forward-looking behavior, will consider
the real exchange rate, which relies on the real UIP condition.

2. In the 3-equation model, in the absence of a lagged effect of monetary policy on aggregate
demand, both supply and demand shocks can be offset without any consequences for employment.
(page 323- 330, 374)

False.

The ERU curve is defined as the combination of the real exchange rate and output in which the
wage-setting real wage is equal to the price-setting real wage.

A positive supply shock (Figure A) shifts the price-setting curve upwards due to the decrease in
output costs, resulting in a rightward shift of ERU with a higher unemployment rate. The new
unemployment rate is determined by the new ERU curve, and monetary policy, as a demand-side
policy, cannot offset the change in the unemployment rate.

A positive demand shock (Figure B) shifts the aggregate demand rightwards, and the absence of
Lagged effect improves monetary policy’s effectiveness because it will not suffer from the
interaction with trade unions, therefore no time effects affect, remaining the ERU unchanged, and
leading to no consequence for the unemployment rate.

3. Compare a closed with an open economy, each of which is initially in medium-run equilibrium
and has an inflation-targeting central bank. Assume that both are modelled by the 3-equation model
and wage-setters use the producer rather than the consumer price index. Statement: The response of
output and inflation to a decision by the central bank to raise the inflation target is identical in
closed and open economies.

False.

ERU curve is vertical when wage-setters use the producer rather than the consumer price index,
and is downwards-slopping only when the wage-setting behavior is defined by real wage.

A rise in inflation target means that central bank can accept higher inflation and output in the short
run which means the MR curve, representing the combination of inflation and output gap, shifts
rightwards.

In a closed economy, central bank adjusts interest rates along the IS curve, which is the combination
of interest rate and output, to return to equilibrium (from B to A).In an open economy, since the
foreign exchange market is involved and has impacts on the interest rate, the central bank adjusts
alone the RX curve (from B’ to A’), which is a flatter than IS curve because exchange channel is
involved, reflecting a smaller effects in output when adjust interest rate.
4.
If a climate change-related shock wipes out a domestic tradeables industry (e.g. through drought)
and is modelled as a permanent negative trade shock for the home economy, the long-run real
exchange rate is depreciated. (page 374,401)

Uncertain. The climate change-related shock is regarded as a permanent negative trade shock and has
impacts on both the demand and supply side.

In the medium run, the aggregate demand curve shifts to the left due to the decrease in net exports caused by
the disruption of the availability of goods in this destroyed industry. BT curve, representing the trade
balance, also moves to the left due to the larger trade surplus caused by the decrease in aggregate demand.
While on the supply side, this shock leads the ERU curve to move leftwards due to the effect of higher prices
of certain goods or manufacturers in this destroyed industry, pushing the price-setting curve downwards.

In the medium run, the leftwards shift of both aggregate demand and ERU leads to a new equilibrium at
point B (B’) where there is constant inflation. In the long run, the equilibrium is defined as the situation in
which the economy is at constant inflation and trade balance, which means the aggregate demand might be
further changed to obtain long-run equilibrium where three lines intersect. Under this situation, the long-run
equilibrium can be either appreciation or depreciation, depending on how negatively the supply-side effect
has on the ERU curve.
5.Economic theory and experience during the pandemic suggest that countries whose governments
borrow in a currency they do not issue are susceptible to a sovereign debt crisis in a time of fiscal
stress. (page 455,457,458)

True.

A sovereign debt crisis refers to the inability of the government to honor the repayment of bonds it
has issued. When there is a pandemic, it leads to a large negative demand shock due to consumers’
uncertainty about the future, causing the economy to be in recession. Countries with fiscal stress are
not able to motivate consumption by applying expansionary fiscal policy because their government
debt is higher than their revenues. Also, when the governments borrow in a currency they do not
issue, it refers that these countries are in a common currency area and do not have central banks,
leading to no monetary policy that can be applied to avoid the recession.

Without a central bank for a country, there is no lender of last resort for the government and
commercial banks, and a sovereign debt crisis will increase the fear for bonds holders of these
countries and decrease the illiquidity of these governments, further causing the insolvency of
commercial banks due to the panic investors.

Therefore, bank failures, together with the inability to recover from recession, will lead to
increasing national public debt which explains why countries in a common currency area but
without central banks are vulnerable to a sovereign debt crisis.
6.Assume that the cause of a recession is a fall in autonomous consumption or investment. The
government financial balance (also referred to as the government budget balance) and the external
financial balance move inversely with the private sector financial balance. Refer to Figure A6 in
your answer.

False.

When the country’s output gap is negative, it refers to a recession in its economy, and according to
Figure A6, periods of recession for China are from 1995 to 2004, 2010 to 2016, and 2019 to 2021.
On the graph, it is obvious that the government financial balance and current account balance move
inversely with the private sector financial balance during these recession periods.

The current account balance consists of the trade balance (which is the external financial balance)
plus the net interest and profits receipts. When the recession is caused due to a fall in autonomous
consumption or investment, it means that private sectors prefer to save relative to investing, which
causes a decrease in net receipts from abroad.

Therefore, when the private sector balance increases during the recession, the external financial
balance also increases in order to have an increase current account balance, while when the private
sector decreases during the recession, with a decrease in net receipts, it is not enough to determine
the trend of external financial balance singly based on a decrease in current account balance.
Part B
B1
(a)
A “budget for growth” is regarded as the government’s plan for achieving economic growth, and
normally involves increasing government spending on infrastructures, healthcare, education, and
other industries that can promote higher levels of economic activities.

Fiscal policy is a demand-side policy controlled by the government in order to stabilize the
economy or target a different equilibrium output, and the IS curve, representing the aggregate
demand in a closed economy has the function:

A loosening of fiscal policy includes an increase in government expenditure and a decrease in tax
revenue which can stimulate consumption and investment and shift the IS curve rightwards, leading
to a positive output gap.

When a government combines the budget for growth and a loosening of fiscal policy, it reveals that
the government actually finances the government spending by borrowing because the tax revenue
received is decreased under a loosening fiscal policy, and under this situation, both the amount of
debt and the GDP is expected to increase.

Debt-to-GDP measures the ratios of a country’s total public

debt to its GDP, and a falling path of the ratio means that there is a decrease in this proportion,
resulting in a decrease in debt burden for the government. Theoretically, if a government wants to
achieve a fallen debt-to-GDP ratio, it has to either decrease the amount of debt by decreasing its
borrowing or increase the GDP by promoting economic activities.

However, this leads to the trade-off between a budget for growth and a loosened fiscal policy in the
persuasion of a fallen debt-to-GDP ratio which is the economic basis of the OBR’s statement.

The OBR’s statement, concerning the above relationship between a budget for growth and a
loosening fiscal policy

The percentage increase in debt is much higher than the GDP growth rate, leading to an increase to
the debt-to-ratio GDP.

A loosening of fascial policy might not be that effective in the medium run due to the constant
household intertemporal budget constraint under the Ricardian equivalence. The Ricardian
equivalence suggests that households anticipate future taxes to finance government spending. When
there is a temporary rise in government spending financed by borrowing, households can recognize
higher future taxes to repay the government debt, thus saving more for the future. In this case, the
multiplier of the government’s increasing expenditure on households is very small that households
might not increase their consumption as the government expected, which is a negative effect
towards the loosening fiscal policy, causing a relatively lower GDP growth.

Therefore, an increasing debt due to the increased borrowing for financing economic growth and a
relatively low increase in GDP stimulated by a loosening of fiscal policy due to the Ricardian
equivalence in the medium term together make the country more difficult to deliver a fallen debt-to-
GDP ratio.

This problem might be more straightforward when applying real-life data that from 2010 to 2023,
the debt is 23.5% of GDP higher

2010, the GDP of the UK was about 2.49 trillion dollars, and its debt-to-GDP ratio was about 70%,
and, while this ratio shows an increasing path, and in 2018, this ratio is already above 80%.
(b)

The results from the last question should depend on household inflation forecasts and monetary
policy because both might affect the effectiveness of the budget for growth and a loosening of fiscal
policy.

Household inflation forecasts:

We assume that households are under the permanent income hypothesis (PHI) that they prefer a
smooth path of consumption independent of their current income, and their consumption is
determined by allocating their resources across their lifetimes. There are three different
characteristics related to households’ decision-making, which are static, adaptive, and rational.

Most of the time, households are regarded as having adaptive expectations that they set aside their
forecast of inflation last period and take last period’s outcome as their best prediction of inflation
for this period.

If households are static, it means that households remain largely unchanged by external factors, and
when they recognize inflation to happen in the future, they will not change their consumption
behavior because they have poor adaptability and can only maintain their established routine of
consumption. However, in reality, households are unlikely to remain completely static over time
because they are always affected by various economic decisions and factors.

If households are adaptive, it means that they are capable of adjusting to external changes but might
focus more on the short-term adjustments to accommodate the policy released. Therefore, these
households, when recognize an inflation in the future, are likely to increase their savings and reduce
consumption which leads to a negative effect on the expansionary fiscal policy, causing more
difficulties for the government to reduce the debt-to-GDP ratio.

If a household’s inflation forecasts are under rational consideration, it means that they
Monetary policy:
When there is a loosening of fiscal policy, apart from a positive output gap, it can also lead to
inflation risk, and this is when monetary policy needs to be involved. In order to avoid the inflation
risk, the central bank might apply a contractional monetary policy including an increase in interest
rate to decrease investment which shifts the IS curve leftwards. The application of monetary policy,
as a result, might decrease the positive output gap delivered through a loosening of fiscal policy
which is not favorable by the government in the persuasion of a fallen path debt-to-GDP ratio.

B2
(a)
Country V has a fixed exchange rate
Country X’s performance: there is a sharp decrease from an ideal stable 2% to -1%
and a gradual recovery. Both the nominal and the real interest rates have decreased,
followed by a gradual increase to its initial level, with the real interest rate declined to
a smaller extent.

Country V’s performance: while its inflation, GDP and GDP growth trend/
performance are exactly the same as country X’s, it has a constant unchanged
nominal exchange rate and nominal interest rate. The real interest rate of V
experienced a dramatic increase followed by a gradual return to its initial level at 3%.
The country also experienced a slight increase and then decrease to original level in
the trade balance/GDP ratio. On the contrary to X, V’s primary budget/GDP ratio has
dropped significantly to a negative 6.5% with a slow return.

and country X has a flexible exchange rate