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 (chained-weighted) GDP growth for 2005 Quarter III - SAAR (Seasonally Adjusted Annual Rate).

2. The inflation rate measured as the growth rate in the implicit GDP price deflator (the Chain-Weighted GDP Price Index) for 2005 Quarter III - SAAR.

The advance data for 2005 Quarter III will be announced at the end of October 2005.  The latest estimates for the 2005 Quarter II were 3.3% for GDP growth and 2.4% for the growth rate in the implicit GDP price deflator (the Chain-Weighted GDP Price Index).

3. a) Will the Fed change the Federal Funds rate at the FOMC meeting on November 1st, 2005 and by how much ? b) Will the Fed change the Federal Funds rate at the following FOMC meeting on December 13th 2005 and by how much ? c) What will the target Fed Funds rate be on December 14th 2005?

4. The 10-year Treasury bond yield reported in the New York Times on  December 16th, 2005.

5. The S&P500 index of the stock market reported in the Wall Street Journal on December 16th, 2005.

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 16th, 2005.

7. The exchange rate for the Chinese Yuan (Yuan per US Dollar) reported in the Wall Street Journal on December 16th, 2005.

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 in an emerging market economy (in September 2004). 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 attached page for Thailand 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).
    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 2004. Find also the most recent estimate of the U.S. current account deficit for 2004 and 2005 (Q1 and Q2).

(b). For the same sampe period (1990-2004), 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 2005 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:
http://a257.g.akamaitech.net/7/257/2422/17feb20051700/www.gpoaccess.gov/eop/tables05.html
where the Current Account is the Net Lending or Net Borrowing column.

Not only do countries grow at much different rates, they often grow for different reasons. Consider three countries that have been popular recently with emerging-market investors: Brazil, Mexico and Singapore. Some relevant statistics (which you should take with a grain or two of salt) include:

       Growth Rate  Brazil  Mexico  Singapore

       Output        3.6     4.9       8.4
       Population    2.4     2.7       6.4
       Capital       3.0     3.2      11.3

(a) Use the data to decompose output growth in each country into components due to capital, labor (which we are approximating with the population), and productivity growth.

(b) Use your numbers, and any other factors you think are relevant, to comment on the growth experience of these three countries. In particular, comment on the Krugman controversial view that the Asian economic "miracle" was not due to total factor productivity (TFP) growth but rather to intensive use of inputs. In this regard read the articles in The Economist "The miracle of the sausage makers" and "The Asian Miracle: Is It Over?"  (in your reading packet). Do you agree or not with Krugman's view, and why ?
 

2. The debate on the New Economy, the surge in  U.S. productivity growth  and European versus American productivity: large permanent increase or modest pick-up?
A debate has been raging for a while on whether productivity growth has been increasing in the 1990s relative to its dismal performance in the 1970s and 1980s and whether we are now in a New Economy where sustained higher growth without inflation is possible. The debate started with a debate on the role of computers and service sectors in productivity, on whether productivity is underestimated, whether sustained productivity growth is possible in the US economy today and whether we are now in a "New Economy" where a "New Paradigm" of high long-run growth and low inflation holds.
 Until 1995, productivity growth in the U.S. was mediocre (1.4% in 1990-95 and 1.3% in the 1980s) and close to levels observed in past decades. Since the labor supply was growing at about 1% per year, this implied that the maximum long-run growth rate of the economy was a modest 2.4%, the historic average for 1980-95.  Then, something changed: in 1996 productivity growth (in the non-farm business sector) started to pick up and averaged over 2.5% per year in 1996-2000. The slowdown in economic activity in late 2000 did not lead to a slowdown of productivity growth; during the 2001 recession, productivity still  averaged 2.5%.  In 2002-2003, in spite of a lukewarm jobless economic recovery, productivity growth was surprisingly high, averaging 3.9%. Since then,
productivity growth has somewhat slowed down. In 2004, productivity growth was 3.4% while in Q1:2005 it was 3.2%. In Q2:2005, productivity growth sharply slowed down to 1.8%, a possible sign that the high productivity growth of the last few years may have come to an end.
  There is a broad debate on these data and trends. Some are very optimistic and argue that the investments in Information Technology (IT) and the New Economy have led to a sharp increase in the long-run rate of productivity growth, close to a 3.5% or more. Since labor supply is growing by about 1% per year this would imply a sustainable long run growth rate of the economy of 4.5% or above, well above the recent historic average of 2.4.%.  Others are more cautious and skeptical and argue that, while the long run growth rate of productivity is now higher than the average in the 1980s and 1990-95 period (1.4%) because of the New Economy, it may not be greater than 2.5%% per year as the figures for 1996-2000 are biased by the excessive investment in IT and the excessive growth rate of the economy in that period and that the 2001-2003 figures are biased by the jobless recovery where output grew fast without job growth; i.e. while the New Economy is for real, it has been excessively hyped up and the bust of the IT sector after 2001 and the 2004-2005 slowdown in productivity (once job growth recovered) proves that.  They thus argue that the maximum sustainable rate of growth of the economy has gone up from 2.4% to a figure close to 3.5% (2.5% productivity growth and 1% labor supply growth), well below the 4.5% suggested by the optimist camp.
 At the same time, a debate has been raging on the differences between the growth rates of Europe and US. Some argue that productivity levels and their growth rates in Europe are not much lower than the US and that the slower growth in Europe depends on a smaller share of individuals being in the labor force and working and the smaller number of hours worked in Europe relative to the U.S. Others argue that productivity growth, not just the level, is lower in Europe than in the U.S.
  Discuss the evidence in favor and against the alternative views presented in these debates on the New Economy and productivity growth and present your opinions on these issues.
1. What is your estimate of the long run growth of productivity and of GDP growth? How much did the 2002-2003 productivity performance depend on a jobless recovery? Thus, if the 2002-2003 spurt sustainable? Is the recent productivity slowdown in 2004-2005 transitory or permanent?
2. What is the evidence that the long run productivity growth is now closer to 3.5% than 2.5% and/or equal to your estimate?
3. In which camp are you in this debate between optimists and skeptics? Why?
4. Compare U.S. and European productivity levels and growth, explain their differences and why such differences exist.
  In presenting your views rely on materials in the following RGE home page:  New Economy and Productivity Growth  Latest data on U.S. productivity growth are in the BLS Productivity home page . Also, the Morgan Stanley Dean Witter Global Economic Forum provides a daily analysis of the developments in the U.S. and global economy. The 2002 Economic Report of the President is another useful source.
Articles on Europe versus US include, among others:
http://www.economist.com/displaystory.cfm?story_id=1450033
http://www.economist.com/displaystory.cfm?story_id=2765877
http://www.economist.com/displaystory.cfm?story_id=2051755
http://imf.org/external/pubs/cat/longres.cfm?sk=17757.0
http://www.morganstanley.com/GEFdata/digests/20040917-fri.html#anchor0
http://www.morganstanley.com/GEFdata/digests/20041015-fri.html#anchor0
http://www.iie.com/publications/papers/baily1003.pdf
 
 

3. The Singapore Case
There has been a lot of interest in the economies in Asia, including Hong Kong, Taiwan, South Korea and Singapore.  For several years these economies experienced rapid growth, although things changed dramatically beginning in 1997. Other developing countries have looked to these nations as models for the development of their own economies.  The more advanced industrialized countries have looked to these countries as competitors as well as business opportunities.  In addition, there was for a while much speculation that these countries have discovered a `new' recipe for successful capitalist development that stresses state directed, export oriented, industrial policies.  The purpose of this case is to gain a better understanding of the growth process in these countries; what they achieved, how they did it, whether or not it  is sustainable, and what other countries can learn from their success and recent problems.

Deliverable for the Singapore case: A five to seven page report.

Background Readings (not required):

Krugman, Paul, "The Myth of Asia's Miracle," Foreign Affairs, Vol. 73, November/December 1994, pp. 62-78.  This controversial article is the essential background reading you need.  It is a non-technical summary of the Alwyn Young paper listed below.

Young, Alwyn, "A Tale of Two Cities: Factor Accumulation and Technical Change in Hong Kong and Singapore," NBER Macroeconomics Annual 1992, MIT Press, pp. 13-63.

Sarel, Michael “Growth and Producitivity in ASEAN Countries” IMF Working paper WP/97/97.    You might find it useful to at least glance at this (although it is not essential).

IMF's Home page on Singapore

Case for Discussion (required reading):
"Singapore," Harvard Business School case no. 9-793-096 (rev. 4/95).
"Singapore, Supplement" Harvard Business School, Case 700-050.

For more than 25 years, Singapore achieved virtually unprecedented levels of real economic growth.  Governed closely by its leader, Lee Kuan Yew, Singapore benefited from an unusual mix of macroeconomic and microeconomic policies.  In the 1990s, though, the island nation was faced with apparent diminishing returns to its previous strategy, with new competitive pressures, changing social issues, and new leadership.
 

Questions  (These are intended to stimulate your discussion, not to completely define what you do in your written report):

· How do you explain the rapid economic growth in Singapore since 1965?  How does it compare to most other developing countries?  How is its experience similar to or different from the other rapidly growing economies of Taiwan, South Korea and Hong Kong?

· What is the role of savings and investment in Singapore's development?  What has happened to the volume and quality of other inputs such as labor?  What has happened to productivity growth?  How does it compare to productivity growth in other countries?

· What are the choices facing the Singaporean government in 2002?  Can the economy sustain the economic "miracle?"  If so, how?  If not, why not?

· How did Singapore fare compared to the other Asian "Tigers" in the recent financial crisis of 1997-1998?

· What, if any, lessons are there from Singapore's experience for the U.S. and other mature industrialized nations?

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 (as nominal interest rates fall faster than inflation once the currency is pegged); this is turn leads to an expansion in aggregate demand that cause 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.