PSU
Winter 2017
Hiro Ito
ECON441/541
Homework Assignment #6
Answer Keys
Question 1:
Explain how a country with a fixed exchange rate arrangement which is experiencing a recession and
running current account deficit could face a “catch-22” situation.
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Look at Fig. 3 in Ch. 8 19
You could achieve either internal or external balance, but not both simultaneously.
If you try to achieve internal balance by implementing expansionary policy, you’d end up
exacerbating external imbalance.
If you try to achieve external balance by implementing contractionary policy, you’d end up
exacerbating internal imbalance, i.e., recession.
Question 2:
Why was the U.S. experiencing speculative attacks on the dollar in the late 1960s and early 1970s?
Why did West Germany and Japan want to leave the Bretton Woods system by the late 1960s? How
could a country “export inflation”?
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The U.S. was expansionary in both fiscal and monetary policies during the 1960s (e.g., the
Vietnam War, Great Society Program), creating inflationary pressure.
The higher expected rate of inflation led to a perception that the US dollar is overvalued.
W. Germany and Japan on the other hand were experiencing real appreciation due to greater
demand for their goods (they are both big exporters). Expectations of US dollar overvaluation
also meant a perception that their currencies, i.e., German Deutsch Mark and Japanese Yen,
are undervalued.
To maintain the peg with the US dollar, the central banks of these countries needed to
intervene in the foreign exchange market, increasing their holdings of US dollars.
An increase in foreign reserves means that much liquidity is being provided in the markets,
raising the expectations of higher inflation. The central banks could intervene and sterilize the
increase in foreign reserves, but the extent of overvaluation of US dollar and that of
undervaluation of Deutsch Mark and Japanese Yen were so high that these two countries
essentially had to import inflation from the US.
The mounting inflation pressure became too high to bear for W. Germany and Japan, leading
the two countries to start thinking the benefits of leaving the Bretton Woods system outweigh
the costs. Keep in mind that these two countries had experienced either hyper- or very high
inflation in the past, which led to political social devastations (including WWII), so central
bankers tended to dislike high inflation expectations.
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Question 3:
Why do economists argue German reunification is a remote cause of the EMS crisis in 1992?
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German reunification in 1991 required high fiscal expenditure in unified Germany.
Fiscal expansion led to higher inflation expectations, leading Bundesbank to consider raising
its policy interest rate.
In 1991, the U.S. and other industrialized economies started experiencing a recession, that
spread to other European economies.
Although Bundesbank raised its policy rate to fight inflation, other European countries, which
pegged their currencies to the Deutsch Mark, did not want to raise the interest rate to sustain
the peg, because they feared that raising interest rates would exacerbate the recessionary
situation. Bundesbank refused to lower its policy interest rate.
As the economic situations in other European economies continued to worsen, investors
started speculative attacks on some of the currencies, esp. British pound and Italian Lila.
Investors thought that these countries could not adjust their interest rates to Germany’s, and
therefore that the peg would not be sustainable.
In the fall of 1992, the U.K. and Italy left the EMS.
Question 4:
Some argue that it is China that caused the housing bubble that preceded the current crisis. Refer to the
country’s efforts to prevent sharp appreciation of the currency, i.e., maintain a quasi-fixed exchange
rate system and argue theoretically (using a graph if necessary) how China’s current policy could lead
to asset bubbles in the U.S. Discuss also why China does not want to adopt (freely) flexible exchange
rate system.
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China has been increasing its holding of international reserves for the last decade or so.
A large portion of the reserves are held in the form of U.S. Treasuries.
Some argue that because China holds such a large amount of Treasuries, it (= capital inflows
from China) helps U.S. government yields and other interest rates to be sustained at lower
levels, helping lower the cost of long-term debt, esp. mortgage debt.
From their perspective, Chinese money contributes to lowering the price of credit in the U.S.
and sows seeds for the housing bubbles.
Many argue that the reason why China holds so much of international reserves is because its
currency is set at an undervalued value. That gives trade competitiveness and makes it easier
for the country to run trade surplus and current account surplus. With largely closed financial
account, current account surplus means balance of payments surplus, which leads to an
accumulation of international reserves.
Those who argue that China caused the housing bubble contend that China should stop
manipulating the currency value and other trade practices that lead the country to persistently
run current account surplus.
Question 5:
How could some countries in the Euro area benefit from joining the Euro? Why did those countries
that appeared to have benefited from the joining the Euro experience the debt crisis?
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The Euro member countries can import the credibility of Germany as the inflation fighter,
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lowering inflation expectations.
A fall in the inflation expectations also means a fall in the risk premium.
Basically, other Euro member countries can enjoy the same level of risk premium as
Germany’s, which allows them to borrow at the same, lower, interest rate.
However, if some Euro member countries continue to have high expected inflation (due to lax
fiscal management), they can end up having low or even negative real interest rates, which can
allow them to borrow from the international financial markets (or at least from other Euro
creditor countries, i.e., northern European countries) at cheaper costs. This is how these
countries started running current account deficit persistently and also the government and the
private sectors started becoming profligate and later experiencing bubbles.
Then, the bubble bust, leaving both the public and private sectors heavily indebted.
Initially, in the immediate aftermath of the global financial crisis of 2008, the Euro
governments tried to jumpstart the economies by implementing expansionary fiscal policies.
But expansionary fiscal policies and a fall in tax revenues due to the recession ended up
exacerbating the public sector debt.
Higher debt also led to a series of downgrading for their sovereignty bonds, which contributed
to raising the cost of borrowing from the markets and repaying the debt. Consequently, the
debt size increased, leading to a vicious cycle.
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