Assignment 1: Macro Forecasting
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 2015 Quarters III and IV - SAAR (Seasonally Adjusted Annual Rate). Provide also your forecast for real GDP growth in 2015 and 2016 (year over year growth rate) and explain the reasons behind your forecast and for the difference in growth in 2016 versus 2015.
2. The inflation rate measured as the growth rate in the implicit GDP price deflator (the GDP Price Index) for 2015 Quarters III and IV - SAAR.
The advance data for 2015 Quarter III (IV) will be announced at the end of October 2015 (January 2016). The latest estimates for the 2015 Quarter II were 3.7% for GDP growth and 2.1% 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) When will the Fed favorite measure of inflation (Core PCE inflation) reach persistently the Fed target of 2%? b) When will the unemployment rate reach its NAIRU level and what is your best estimate of NAIRU? c) How much slack is left in the labor market today?
4. a) When will the Fed start normalizing the policy rate (Fed Funds rate) above 0%? In 2015 or in 2016, or even later? In which month of which year? b) In which year and quarter will the Fed finish normalizing the Fed Funds rate to its neutral level and what will that neutral level be? c) When will the Fed will start to run down its balance sheet by not reinvesting the maturing Treasuries and RMBS that it has purchased during the various rounds of quantitative easing?
5. The 10-year Treasury bond yield reported in the New York Times on December 16th, 2015.
6. The S&P500 index of the stock market reported in the Wall Street Journal on December 16th, 2015.
7. 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, 2015.
8. The exchange rate for the Chinese Yuan (Yuan per US Dollar) reported in the Wall Street Journal on December 16th, 2015.
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://bea.gov/national/index.htm#gdp.
A starting place for online analysis is Roubini
Global Economics (RGE) web site (especially its U.S. page https://www.roubini.com/economies/region/united-states
). Another good source is the Dallas Fed's Slide
Show for the US Economy (updated regularly). You can also use the Stern
page on Macroeconomics
Resources for Students. Many online data and resources for NYU students are
at the NYU's Virtual Business
Assignment 2: International Indicators
1. To defend or not defend? Exchange rate dilemmas in emerging
Consider the uncovered interest parity condition modified for the case of a country risk premium (in the case when investors are risk-averse):
it = itf + (E(St+1) - St)/St + RPt
where i is the domestic interest rate (the interest rate in emerging market country Emergia), if is the foreign interest rate (the US interest rate), st is the current spot exchange rate (Emergos per US Dollars) and Et(st+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:
St = [E(St+1)] / [ it - itf + 1 - RPt]
(a) Suppose that initially: st = Et(st+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 if = 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: Et(st+1)
= 1.10. Suppose that the country is in a regime of flexible exchange rates. By
how much will the current spot exchange rate (st) 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 (st = 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?
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 RPt = 0.07. Suppose that the country is in a regime of flexible exchange rates. By how much will the current spot exchange rate (st) 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 (st = 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 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 of your choice (in the fall
of 2015). 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, expectations
about exchange rates, sovereign risk and economic activity in the country.
2. Emerging Markets Slowdown and Financial Pressures in 2015: Risk of Another Crisis?
In 2013-15 emerging market economies have experienced a significant growth slowdown and downward financial pressures on their equity markets, currencies and bonds (in local and foreign currency). This started in 2013 with the Taper Tantrum in the US and the beginning of the slowdown of China. And after a period of greater calm in 2014 concerns about emerging markets have resurfaced in 2015 especially during the summer when worries about a Chinese hard landing and concerns about the Chinese stock market and its currency have peaked.
(a) Discuss in detail the role played in this slowdown and financial pressures by: the Fed likely exit from zero policy rate; the slowdown of China; the end of the commodity super-cycle; the loosening of monetary, credit and fiscal policy in the boom years; the move away from market oriented reforms and towards state capitalism; the middle income trap; the lack of second generation reforms; rising political risks in many emerging markets.
(b) Which emerging market economies are most at risk and why? Which are the stronger ones? Consider current account balances and their financing (via debt versus equity, short versus longer term liabilities, foreign versus domestic currency liabilities), fiscal balances and public debt, credit creation, savings and investment, growth, inflation, social and political stability, upcoming elections.
(c) Will some emerging market experience again the kind of crises observed in the 1994-2003 period (currency crises, balance of payments/external debt crises, sovereign debt crises, banking crises, household and corporate debt crises)? Why or why not? Present both sets of arguments.
(d) Which fragile emerging market economies have done since 2013 macro policy adjustments (monetary, fiscal, credit) and structural reforms to address their vulnerabilities and which have not done so and are now more vulnerable?
In answering these questions use materials and readings from sections I.1 and I.2 in the course reading list including the collection of readings on Submerging Markets? found at Project Syndicate: http://www.project-syndicate.org/focal-points/emerging-market-meltdown . Readings on emerging market economies found at Roubini Global Economics (http://www.roubini.com/region/emerging-markets) are also useful; for example; https://www.roubini.com/analysis/despite-depreciation-dismal-outlook-for-em-fx ; https://www.roubini.com/outlook/article/emerging-markets-outlook-navigating-the-doldrums ; https://www.roubini.com/analysis/the-imbalances-behind-the-2013-em-mini-crisis; https://www.roubini.com/markets/emerging-markets.
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 2014. Find also the most recent estimate of the U.S. current account deficit for 2015 (Q1 and Q2).
(b). For the same sample period (1990-2014), 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) and how much has the role of different factors changed over time?
(d). Based on this analysis, are the U.S. current account and external debt sustainable? Does the U.S. differ or not from emerging markets or not and why?
(e). How likely are the risks of a sharp fall of the U.S. dollar and rise in U.S. long term interest rates triggered by foreign investors reduced willingness to lend to the U.S. and accumulate U.S. assets? Will the fall in the FX reserves of many emerging market lead to a weakening of the U.S. dollar and rising U.S. bond yields as they purchase less U.S. Treasury Bonds? Or will the glut of global savings (as many countries still run large current account surpluses) together with easy liquidity conditions in the Eurozone and Japan keep the dollar strong and U.S. bond yields low? How will Fed policy affect the value of the dollar over time?
(f). Will the U.S. dollar strengthen or weaken in the next 2 years and relative to which currencies and why?
Data on Savings, Investment and Current Account (on a
quarterly and annual basis including Q1 and Q2 2014) are available from the
Bureau of Economic Analysis; see:
Data on nominal GDP - to take ratios of savings, investment
and current account as a share of GDP - are also available from the BEA.
Note that the way BEA presents the data on the current account is slightly confusing; instead of referring to the current account, it refers to Net Lending or Net Borrowing (implicitly from/to the rest of the world). So, the item representing such Net Lending or Net Borrowing is our definition current account.
For example in BEA Table 5.1 under the tab Savings and Investment by Sector http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&903=137
the Row 1 gives you gross savings. Row 21 gives you gross investment. Row 35 gives you the current account deficit, where the current account deficit is the item that is defined (as I explained above) as Net Lending or Net Borrowing (Row 35). Row 42 gives you the statistical discrepancy that should be added to Saving to have an item that is Savings (net of the statistical discrepancy).
So, for example in 2011 Q1:
CA = S - I
-489 = (2316.8 - 44.1) - (2761.7)
where 2761.7 is the sum of gross domestic investment (2761.1) and the item called "capital account transactions" (0.6), i.e. I or Investment is the sum of lines 21 and 28 (Gross Domestic Investment plus Capital Transactions). What I called in class the Capital Account is now called by BEA as the Financial Account.
Data on the net foreign assets of the United States can be obtained from the table on the (Net) International Investment Position (NIIP) of the United States published in the Survey of Current Business, Bureau of Economic Analysis, U.S. Department of Commerce. A recent online version of the table for 2014 is available at: http://www.bea.gov/international/index.htm#iip under "International Investment Position".
Assignment 3: The Mexican Peso Crisis of 1994-95
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 a 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 syllabus package are a good source of background
information, but you may want to add to it.