International Economics Environment

Final Exam
2018
Question 1 (15 points): Business Cycle Measurement
a) How are business cycle dates determined in the U.S.?

The business cycle, also known as the economic cycle or trade cycle, is the downward and upward movement of gross domestic
product (GDP) around its long-term growth trend. The length of a business cycle is the period of time containing a single boom and
contraction in sequence.
The reference dates of the United States' business cycles are determined by the Business Cycle Dating Committee of the National
Bureau of Economic Research (NBER), which looks at various coincident indicators such as real GDP, real personal income,
employment, and sales to make informative judgments on when to set the historical dates of the peaks and troughs of past business
cycles, with emphasis in industrial production, employment, real income, and wholesale-trade. The duration is also lasting for more
than a few months.
b) A popular concept—used in many other countries—is that two or more consecutive quarters of negative real GDP growth marks a recession.
Would recession dates in the U.S. over the last 20 years be any different if this popular concept had been used instead?

The two-quarter-recession theory doesn’t identify depressions but recessions within the cycles of peaks and troughs of economic
activity. It notes only that the term depression is often used to refer to a particularly severe period of economic weakness.
For instance, If an economy grows by 3% in one quarter and then contracts by 0.5% in each of the next two quarters, it is deemed
to be in recession. However, if GDP contracts by 3% in one quarter, rises by 1% in the next, then falls by 3% in the third, it escapes
being classified as recession.
On the other hand, the NBER interprets the term recession in a slight different manner compared to the rest of the world. It
identifies months and quarters of turning points without designating a date within the period that turning points occurred, that
said, from the Peak through the Trough period is identified as “recession”.
The two major recessions in the US happened in 2001 and 2007. If the two-quarter-recession theory is applied, the 2001
recession doesn’t not fall into the criteria as the negative growth of GDP did not last for two consecutive quarters.
Therefore, the US in the past 20 years would definitely be largely different if the two-quarter-recession rule is applied to the US,
as the world perceives ‘recession’ entirely different compared to the US.
c) Whatever concept one uses to determine recession dates, it is misleading to think that individuals are getting richer over time as long as we
are not in a recession. Why is that the case? [Hint: as an example, would individuals in the U.S., on average, get richer if real GDP grew at
0.01% per year for several years?]

In general, individuals do not get richer even we are not in a recession. Quantitative easing and low interest rates make the economy grow –
but most individuals don’t benefit. The GDP is a composition of aggregated expenditure of consumption, investment, government spending
and net exports.
There is a difference between GDP and wealth creation. It is the latter that ultimately determines a national prosperity. We create wealth
when we turn an individual’s idea into a good or a service for someone else to buy.
For example - Consider the Keynesian idea of burying $10 notes in bottles in mineshafts and having the private sector dig them up, or
Krugman’s proposal to stage a fake alien invasion to boost anti-alien defense spending. Both would boost GDP, but neither would add to
worthwhile economic activity. In summary, there are many number of factors that can affect the growth of GDP and it’s not an ideal indicator
for individual’s wealth.
Question 2 (25 points): The Bathtub Model
• This question relates to the bathtub model of the labor market discussed in class last week, which you will apply to a particular country. To
do so, pick a country whose first letter starts with the same letter as your first name. (If you can’t find any, use your last name. If you still
can’t find any, email me.) Below I refer to this country as ‘your country.’ The bathtub model of the labor market states that the
unemployment rate depends on two key parameters: the job finding probability (f), and the job separation probability (s).

a) Find a good measure of the average job finding probability for your country over the last few decades (take the average if you have many
years of data). Describe how you constructed that measure.

Country chosen: Luxembourg (1980 until 2018)

Average number of unemployed person: 7028
On average, approximately 1,827 people is looking for a job per month
The probability of job finding (f) = 0.26 or 26%

The probability of job finding (f) is constructed by averaging the number of unemployed person throughout the period specified. Then, find out
the average differences between these periods, we will be able to get (f).
b) Find a good measure of the average job separation probability for your country over the last few decades (take the average if you have many
years of data). Describe how you constructed that measure.

Country chosen: Luxembourg from 1980 until 2018

Average number of employed person: 321,754
On average, approximately 3,217 people is looking for job separation per month
The probability of job separation (s) = 0.01 or 1%

The probability of job separation (s) is constructed by averaging the number of employed person throughout the period specified. Then, find
out the average differences between these periods, we will be able to get (s).
c) Compare the unemployment rate from the model to the actual unemployment rate (averaged over the same years): what do you conclude?

The actual average unemployment rate from 1982-2018 is 3.7%

Compare to Bathtub model:
U* = s / (s + f)
U* = 0.01 / (0.26 + 0.01)
U* = 0.01 / 0.27
U* = 0.0370 or 3.7%

The actual unemployment rate suggested by FRED and Tradingeconomics.com that the average between 1982-2018 is 3.7%.
The result from the Bathtub model suggests an unemployment rate of 3.7% which is perfectly spot on compared to the actual unemployment
rate of 3.7%.
Question 3 (10 points): Monetary Policy
• The next FOMC meeting will take place next week (March 20—21). Of course, no one knows what will transpire at that meeting yet. Nevertheless, in less than 10
lines, describe
a) How you think the interest rate policy (higher/lower/unchanged) should affect the exchange rate between the U.S. dollar and the Euro (assuming the ECB policy
remains constant)? [note: this may not actually happen, as many other things are at play to determine exchange rates on any given day.]

Simply put, changes in domestic interest rates in one of the countries affect the foreign exchange rate as the demand for the currency that has had a change of interest
rate will change.
Increase in interest rate – The FOMC meeting has announced an increase from 1.5% to 1.75%
• The U.S interest rates is 1.5% and European interest rates is 0%. An increase in U.S official interest rates by 0.25 basis points would take the official rate to 1.75%.
Assume that European interest rates, and hence the demand for the Euro, remain constant. The increase in the U.S rate would entice some people to move their
investments (e.g. shares, property or other currency holdings) to hold U.S currency, because they would get paid a higher interest rate following the change. Even
though U.S interest rates are relatively low in the example above, the marginal change in consumer behavior will cause an increase in demand for the USD and
hence and increase in the USD/EURO foreign exchange rate.
• Clearly an increase in the US official rate, holding all other interest rates constant, would not only affect the USD/EURO rate. In fact, all foreign exchange rates
where the USD is listed first (USD/x) should increase.
Decrease in interest rates
• It should be clear from the above real-life example that if the opposite were to happen, interest rates in the U.S reduced by 0.25 basis points to 1.25%, then the
demand for the USD would decrease as investors move out of holding USD and into other investments (shares, property or other currencies). This decrease in the
demand for holding the USD will lead to a fall in all foreign exchange rates where the USD is listed first. However, since European interest rate is 0%, the US interest
rate is still more attractive regardless of the decrease.

*The General Rule of Thumb

• An increase in a domestic interest rate, holding all else constant, will increase demand for that country’s currency causing an appreciation of any exchange rates
where the currency that has had the increase in demand is listed first.
• A decrease in a domestic interest rate, holding all else constant, will decrease demand for that country’s currency causing a depreciation of any exchange rates
where the currency that has had the decrease in demand is listed first.
• b) How will the interest rate policy (higher/lower/unchanged) be implemented in terms of open market operation? In other words, will the
NY Fed traders need to sell or buy treasuries (bonds) on the market to hit the target Fed Funds rate just announced?

Interest rates are indirectly affected by open market operations (OMOs). OMOs are a tool in monetary policy allowing a central bank to control
the money supply in an economy.
Under contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation.
Expansionary monetary policy entails the purchase of securities and an increase in money supply. Changes to the money supply affect the rates
at which banks borrow reserves from one another due to the law of supply and demand.
Therefore, the NY Fed traders will need to sell the government bonds to the public. This sale will then reduces the price of bonds, thus raising
the interest rate on these bonds to hit the target Fed Funds rate.