Choose 1 question from Micro section (block a). Choose 1 question from Macro section (block b). Upto 900 words per question. Define all concepts and key terms Harvard Referencing Give titles to sections of the essays to give clear structure. Use diagrams

SOAS University of London 2020-2021 Department of Economics Introduction to Economic Analysis, Term 2, 153400003 Tutorial 7

Solutions

1) What are “global imbalances”, and what are the underlying causes? a) Which countries have recorded the largest imbalances? You may want to have

a look at the CFR Global Imbalances Tracker (https://www.cfr.org/report/global-

imbalances-tracker)

CA imbalances:

• Surplus: China, Eurozone/Europe, East Asia, MENA (2005-2015)

• Deficits: Anglophone Countries, Eurozone (until 2012)

b) What is the role of domestic savings and investment in driving macroeconomic

imbalances?

• CA = S – I or I = S – CA [See the discussion of “National Income Accounting for an

Open Economy” and especially slides 19-21 in the slides for Lecture 7 on “Exchange

Rates and the Balance of Payments”.]

o Not just private savings but also corporate and government savings.

o Crucial role of Savings and Investments in defining the structural CA balance, and

thus should be the focus of any policy aiming at decreasing a CA deficit (instead

of tariff-related trade policies).

• China vs. US

o Distribution of income affects the savings of an economy.

o Other cultural or institutional factors (need for precautionary savings, social safety

nets, healthcare, pension, …).

o Availability of credit and the role of debt (US debt-driven consumption).

2) Is the Big Mac index a useful tool to analyse exchange rates? Why should we care about undervaluation or overvaluation of the exchange rate?

• Big Mac Index is based on PPP: useful tool to understand the theory, but limited in terms of

empirical validation.

• PPP signals where XR should be heading in LR, but it says little of today’s Equilibrium.

• Even over the long run, adjustment towards PPP need not come from a shift in exchange rates;

relative prices can change instead.

• Criticisms:

o Big Macs are non-tradable goods, and should serve the local market.

o Price of food at McDonald’s may differ from prices at local restaurants.

o Prices vary with local costs (non-tradable), such as rents and wages, which are lower

in poor countries, as well as with the price of ingredients that trade across borders. For

this reason, PPP is a more reliable comparison for the currencies of economies with

similar levels of income.

o Trade barriers, transport costs and differences in taxes drive a wedge between prices

in different countries.

• An overvaluation of the exchange rate may have an adverse effect on exports and the current

account. An undervalued exchange rate makes imports more expensive and could fuel

inflation (“imported inflation”). While an undervalued exchange rate may help to promote

exports, it reduces pressure on firms to innovate to stay competitive.

3) What are arguments for countries to adopt a fixed or a floating exchange rate?

See next week.