This assignment is designed to give you a clear objective as you read articles on current developments in the business press and a feel for the uncertainty surrounding current and future economic conditions.

Provide forecasts for each of the following variables with a detailed explanation following each number which explains how and why you chose the number. At the end, summarize how your forecast on growth and inflation relates to your forecast on Fed policy, long-term interest rates, the stock market and the US $ exchange rates.

1. Real GDP growth for 2009 Quarters III and IV - SAAR (Seasonally Adjusted Annual Rate).

2. The inflation rate measured as the growth rate in the implicit GDP price deflator (the GDP Price Index) for 2009 Quarters III and IV - SAAR.

The advance data for 2008 Quarter III (IV) will be announced at the end of October 2009 (January 2010).  The latest estimates for the 2009 Quarter II were -1.0% for GDP growth and 0.0% for the growth rate in the implicit GDP price deflator (the GDP Price Index is in table 4 of the BEA GDP Report).

3. a) Will the Fed change the Federal Funds target rate at the FOMC meeting on November 3-4th 2009 and by how much ? b) Will the Fed change the Federal Funds target rate at the following FOMC meeting on December 15-16th 2009 and by how much ?  c) What will the target Fed Funds rate be on December 17th 2009? d) Will the Fed change its language in the November or December FOMC meetings to suggests a shift in its overal monetary policy stance and how?

4. The 10-year Treasury bond yield reported in the New York Times on  December 21st, 2009.

5. The S&P500 index of the stock market reported in the Wall Street Journal on December 21st, 2009.

6. The exchange rate for the Japanese Yen (Yen per US Dollar) and the Euro (US Dollar per Euro) reported in the Wall Street Journal on December 21st, 2009.

7. The exchange rate for the Chinese Yuan (Yuan per US Dollar) reported in the Wall Street Journal on December 21st, 2009.

8. The year-over-year percentage change in US National Home Prices in Q3 2009 (relative to Q3 2008) as measured by the the S&P/Case-Shiller Index. This Q3 2009 figure will be available in late December 2009.

While searching for background information for your forecasts you might find useful to look into the large amount of economic information and data available on the Internet. All the official GDP data are in the Bureau of Economic Analysis web page at: http://www.bea.gov/national/index.htm. A starting place for online analysis is Roubini Global Economics (RGE) Monitor web site  and the course homepage on Business Cycle Indicators.  See also references to WEB data, analysis and information in the course home pages on Macro Data. One good WEB resource is "Economic Trends" by the Research Department at Federal Reserve Bank of Cleveland. This is a regular source for analysis and charts of US business cycle conditions. Another good source is the Dallas Fed's Slide Show for the US Economy (updated every Tuesday). See also the page on the Global Business Information Resources at Stern. Many online data and resources for NYU students are at the NYU's Virtual Business Library.
 

1. To defend or not defend?  Exchange rate dilemmas in emerging markets
Consider the uncovered interest parity condition modified for the case of a country risk premium (in the case when investors are risk-averse):

i_t  = i_t^f + (E(S_t+1) - S_t)/S_t + RP_t

where i is the domestic interest rate (the interest rate in emerging market country Emergia), i^f is the foreign interest rate (the US interest rate), s_t is the current spot exchange rate (Emergos per US Dollars) and  E_t(s_t+1) is the expectation at time t of the value of the exchange rate a period ahead (say one year). Solving  the expression above for the current spot rate, we can rewrite the expression as:

S_t = [E(S_t+1)] / [ i_t  - i_t^f + 1 - RP_t]

(a) Suppose that initially:  s_t = E_t(s_t+1) = 1 so that both the spot and expected future exchange rate are equal to 1; domestic and foreign interest rates are equal to 5% so that  i = 0.05 and i^f = 0.05; and there is no risk premium on domestic assets so that RP=0. Would the spot exchange rate change over time if nothing else changes? What would be the value of  the forward exchange rate at time t?

(b) Starting from the initial equilibrium, suppose that at time t investors change their expectation of the future exchange rate and now believe that the currency will be depreciated by 10% a year from now so that: E_t(s_t+1) = 1.10. Suppose that the country is in a regime of flexible exchange rates. By how much will  the current spot exchange rate (s_t) change following this change in expectations? Explain also why.
Also,  how will the forward exchange rate change following the change in the expectation about the future exchange rate? (to answer this last part of the question use the covered interest parity condition).

(c) Now suppose that the country is committed to maintain the spot exchange rate fixed to the initial parity (s_t  = 1). Following the change in expectation about the future exchange rate (described above in point (b)), by how much should the domestic interest rate be changed by the domestic central bank in order to prevent a devaluation of the domestic currency, i.e. maintain the fixed parity? Explain why.
Also, how will the forward exchange rate change following the change in the expectation about the future exchange rate and the interest rate reaction of the central bank? (to answer this last part of the question use the covered interest parity condition).

(d) Now suppose that you start again from the initial equilibrium (described in (a) above). Suppose that investors change their view of the riskiness of the domestic asset. They now start to believe that the domestic asset is more risky than the foreign asset, maybe because of a risk of default of domestic assets. Specifically suppose that the risk premium on domestic assets goes from zero to 7% so that now  RP_t = 0.07. Suppose that the country is in a regime of flexible exchange rates. By how much will  the current spot exchange rate (s_t) change following this change in expectations? Explain why.

(e) Now suppose that the country is committed to maintain the spot exchange rate fixed to the initial parity (s_t  = 1). Following the change in the risk premium (described above in point (d)), by how much should the domestic interest rate be changed by the domestic central bank in order to prevent a devaluation of the domestic currency? Explain why.

(f) Explain why the central bank may or may not be willing to change the interest rate following the exogenous changes in expected future exchange rate and/or risk premium described in points (b) and (d) above. First, suppose that the central bank does not change interest rates and lets the spot exchange rate be flexible and react to the shock to expectations (or risk premium);  what would be the effect of the movement of the exchange rate on the level of economic activity (aggregate demand, trade balance, output and unemployment rate) and inflation rate of the country?  Suppose alternatively that the central bank defends the fixed parity by changing interest rate: what would the the consequences of this change in interest rates on the level of economic activity (aggregate demand, trade balance, output and unemployment rate) and inflation rate of the country?  Which tradeoff is the central bank facing in deciding whether to let the currency float or defend instead the fixed parity?  How is this central bank dilemma (tradeoff) affected if the country has a very large stock of foreign currency denominated external liabilities (i.e. a large foreign debt in US $)?  Why will the effect on output of letting the exchange float be very different in the presence of a large stock of foreign debt?

(g) Finally, consider the current yield curve (either in local currency or in foreign currency) in an emerging market economy (in the fall of 2008). Find the data and draw the yield curve for a country of your choice (look in Bloomberg). Explain the reasons for the shape of the yield curve and what the slope of the curve says about future levels of inflation and economic activity in the country.
 

2. Current Account and Foreign Debt Accumulation in Asia
Chapter 3 of the lectures notes presented a detailed example of balance of payments accounts for Korea in 1996. Use the page for Thailand (provided  in the hard copy of the assignments distributed during the first lecture of the course) from the International Financial Statistics of the International Monetary Fund to compute the balance of payments accounts for Thailand for 1996. Use the exact scheme found in Chapter 3 for Korea to do the same exercize for Thailand (for comparison I also attach the equivalent page for Korea in the hard copy of the assignments provided during the first lecture of the course).
   
Two caveats should be kept in mind while doing this exercise. First, the Errors and Omissions item should be included among capital inflows if it is positive or among the capital outflows if it is negative. Second, usually assets items in the capital/financial account have a negative sign since they represent an increase in foreign assets (a capital outflow that, by BP accounting practice, takes a negative sign). However, if a particular Asset item has a positive sign, this means that the country reduced its stock of foreign assets of that type during the year. In this case, the item should be put in the capital inflows section of the accounts with a positive sign rather than in the capital outflows section. In fact, a reduction in the gross stock of foreign assets is equivalent to the repatriation of previous capital outflows, i.e. it is formally a capital inflow.
 

3. Are the US current account deficit and external debt sustainable?
(a). Make a chart of the U.S. current account deficit, both in absolute $ value and as a share of GDP from 1990 to 2008. Find also the most recent estimate of the U.S. current account deficit for 2009 (Q1 and Q2).

(b). For the same sampe period (1990-2008), chart the evolution of the net foreign assets of the U.S. (NIIP) and decompose the total NIPP in the part that is the net stock of foreign direct investment from the part that is the rest (portfolio, banks, other forms of debt).

(c). Discuss the evolution of the U.S current account deficit and net foreign assets: how much of the evolution of the deficit (as a share of GDP) is due to changes in private savings, public savings (fiscal deficits) and investment rate (all as a share of GDP).

(d). Based on this analysis, are the U.S. current account and external debt sustainable? Does the U.S. differ or not from emerging market or not?

(e). How likely are the risks of a hard landing (a crash of the U.S. dollar triggered by foreign investors reduced willingness to lend to the U.S. and accumulate U.S. assets)?

(f). Will the U.S. dollar strengthen or weaken in the next 2 years and why?

Data for the U.S. current account, GDP and components of GDP are available from the statistical tables in the Appendix of the 2009 Economic Report of the President (http://www.gpoaccess.gov/eop/index.html). This web link also includes a link to the statistical tables from the Appendix as spreadsheet files (1997-forward): 
To get exactly CA = S - I (apart from the statistical discrepancy), use the two sheets of table B32 from this source.
where the Current Account is the Net Lending or Net Borrowing column.

There has been a wide debate on the causes of the Mexican Peso crisis of 1994-95. There are at least three competing (but not necessarily incompatible) views of the causes of the crisis:

1. The "Unsustainable External Position" View.

According to this view an stabilization program under a regime of fixed exchange rate and capital mobility leads a real exchange rate appreciation and a worsening of the current account that becomes eventually unsustainable. The real appreciation is caused by a number of factors: first, domestic price and wage inflation is sluggish (subject to inertia) so that inflation falls slower than the controlled rate of depreciation of the currency (or fixed exchange rate if the crawl rate is close to zero). Second, an exchange rate based stabilization leads to a fall in the real interest rate (r = i - dP/P) (as the nominal interest rate - i.e. i  - falls faster than inflation - i.e. dP/P - once the currency is pegged); this fall in the real interest rat in turn leads to an expansion in aggregate demand and imports that causes protracted current account deficits and a real exchange rate appreciation. Even though they are driven by private sector behavior (a fall in private savings), rather than an inadequate fiscal position, the current account deficit and the real appreciation can eventually become unsustainable. Therefore, at some point a big real exchange rate depreciation is needed to restore the initial level of competitiveness and current account equilibrium.

2. The "Adverse Shock" View.

According to this view Mexico was subject to a large number of exogenous domestic political and external economic shocks during 1994. It has been argued that it was very difficult for the Mexican authorities to gauge the size or anticipate the recurrent nature of these shocks. The Mexican authorities reaction to the March events appeared to have restored a relative calm in the foreign exchange and financial market until November. Therefore, it may well have appeared reasonable to continue with the 1994 policy of sterilizing the monetary impact of international reserve losses to offset the effects of what were perceived to be temporary political and external shocks.

3. The "Policy Slippages" View.

According to this view the large number of adverse shocks that hit Mexico in 1994, added to the potential vulnerability stemming from weakness in the external accounts, called for a much tighter monetary policy than the one followed, and probably also for an early widening of the exchange rate intervention band, so as to assure the markets that the authorities were fully committed to sustaining the exchange rate regime. The failure to tighten monetary policy and raise interest rate enough during 1994 seriously hurt the credibility of the authorities' commitment to defend the exchange rate.

Discuss in detail the specific evidence in favor and against each of these three views; in each case, provide data and reasoning supporting or criticizing the alternative views. The "Factors Behind the Financial Crisis in Mexico," and "Evolution of the Mexican Peso Crisis," in your case package are a good source of background information, but you may want to add to it.
Good Internet resources on Mexico can be found at :
http://www.rgemonitor.com/423/
  

Different authors have provided different explanations of the causes of the Argentina's financial crisis of 2001-2002. Some argue that fiscal deficits and eventually unsustainable public debt accumulation was the primary cause. Some argue that the country was unlucky and hit by a number of external shocks that were not under its control. Some blame the "sudden stop" of capital flows to emerging markets after the Asian and Russian crisis. Some argue that the exchange rate regime and external accounts were unsustainable. Some argue that structural rigidities in the economy prevented the country from responding to external shocks.

(a) Which are in your assessment the most important factors that explain the crisis?

(b) Was it appropriate for the IMF to provide a large support package in December 2000 (the Blindaje plan) and another one ($8 billion) in August 2001? When was the right time for the IMF to pull the plug on Argentina?

(c) What could have been a reasonable Plan B to resolve the crisis if the IMF and Argentina had come earlier to the conclusion that the currency regime and public debt were not sustainable and thus Plan A (the IMF rescue loan) was not likely to be succesful?

(d) Why did Argentina have a joint financial crisis (currency collapse, banking crisis, financial crisis, domestic and external debt default, capital controls and bank deposit freeze) at the end of 2001? Was any of these crises avoidable?

(e) Should have Argentina dollarized instead of moving to a float?  What were the pros and cons of each option?

(f) Was the 2005 restructuring of the external debt of Argentina a fair and sustainable debt restructuring deal that satisfied the country's need to have a sustainable debt and did not burden creditors with excessive losses?

(g) What are the economic problems faced by Argentina today and in the near future? How did the global financial crisis affect Argentina?

Basic Readings for this assignment:

Report on the Evaluation of the Role of the IMF in Argentina 1991-2001 Independent Evaluation Office, IMF, June 30, 2004.
Michael Mussa "Argentina and the Fund: From Triumph to Tragedy, 2002 (available online as read-only PDF files at http://bookstore.petersoninstitute.org/book-store/343.html)
Other materials on Argentina from the RGE Argentina page.