Fiscal Policy — MCQs

A country has debt of LCU 300 billion and nominal GDP of LCU 500 billion. With a LCU 20 billion deficit and 4% nominal GDP growth, the next-period debt-to-GDP ratio is closest to:

Carden Global Markets advises multinational companies on foreign-exchange exposures. An analyst is reviewing transactions involving the US dollar, euro, and British pound. Carden quotes exchange rates as units of the price currency per one unit of the base currency. Thus, a USD/EUR quote is the number of US dollars per euro, and an EUR/GBP quote is the number of euros per British pound. Bid–ask spreads, taxes, transaction costs, and counterparty risk are ignored for all calculations. A UK client plans to convert GBP 5 million into USD immediately. Because no direct USD/GBP quote is displayed, the analyst must derive a cross-rate from the two spot quotations in Exhibit 1. The conversion is executed at the implied cross-rate without a dealer spread. Carden also assesses whether the observed one-year forward rate is consistent with no-arbitrage. The relevant USD and EUR interest rates are annual risk-free rates, and both borrowing and lending can occur at those rates. Interest is compounded annually, and the forward contract matures exactly one year from today. The analyst applies covered interest rate parity using the USD/EUR quotation convention. For an unhedged strategic forecast, the analyst uses relative purchasing power parity. Expected inflation over the next year is 5.00% in the United States and 2.00% in the euro area. The forecast is expressed as USD per EUR, and the exact gross-inflation-rate relationship is used rather than the linear approximation. Finally, the economics team reviews the euro area's external accounts. It reports a current account surplus and net private capital outflows of equal size. Official reserve assets do not change. For this question, net capital outflows are represented as a financial-account deficit. The team must identify how these entries reconcile in the balance-of-payments framework. All spot rates, interest rates, inflation rates, and analyst statements needed for the six independent assessments are included in Exhibits 1 and 2.

Elena Park, an economist at an asset-management firm, assesses the economy of Ardell, which has a floating exchange rate and an inflation-targeting central bank. Exhibit 1 presents the indicators used in her cyclical assessment. Household survey data also show declining confidence and postponement of discretionary purchases. Corporate analysts report rising inventories and reduced new orders, although no widespread liquidation of productive capacity has occurred. The government has not enacted any new tax or spending legislation during the current year. Nevertheless, income-tax receipts have declined as employment and corporate profits have weakened. Payments under existing unemployment-benefit programs have increased. As a result, the budget deficit has risen from 2.0% to 3.4% of GDP. A government adviser characterizes the larger deficit as an expansionary response to current economic conditions. The central bank reduces its policy rate from 3.0% to 2.5%. Inflation expectations are expected to remain unchanged over the next several quarters, and foreign policy rates are assumed to remain constant. Bank balance sheets are sufficiently strong to permit additional lending, and the exchange rate is allowed to adjust freely. Park expects the policy action to affect market interest rates and the currency before it has its full effect on output and employment. Park also examines two Ardell industries. Solara Consumer Brands operates in an industry with many sellers, low barriers to entry, and differentiated products. Each firm faces a downward-sloping demand curve. Solara currently earns positive economic profit, but rival firms can introduce competing brands without significant legal or capital barriers. Park expects entry to continue until Solara reaches its long-run equilibrium. At the profit-maximizing quantity, Solara sets output where marginal revenue equals marginal cost. Titan Water Network is the sole supplier in its region because duplicating the distribution network would be prohibitively expensive. Regulation does not require Titan to set price equal to marginal cost. Titan also chooses output where marginal revenue equals marginal cost, subject to its market demand curve. Park notes that Titan's market structure differs from Solara's, but both firms face downward-sloping demand and therefore have marginal revenue below price.

An international investment team is assessing Estara, an economy whose currency floats freely and whose capital account is open. Estaran pension funds have recently increased purchases of foreign bonds, while foreign corporations have expanded direct investment in Estara's technology sector. The portfolio flows create demand for foreign currencies when Estaran investors acquire overseas assets, whereas inward direct investment creates demand for the Estaran currency when foreign investors fund domestic projects. The team treats these as separate transactions and does not assume that one necessarily offsets the other. A currency analyst is asked to calculate a cross-rate and a one-year forward rate using Exhibit 1. All interest rates are effective annual rates, transaction costs are zero, and the forward contract is priced to prevent covered interest arbitrage. The USD is the price currency in both reported spot quotations. The analyst must preserve this convention when eliminating the common currency. A colleague incorrectly proposes multiplying the two spot quotations to obtain GBP per EUR and argues that the forward rate must equal the spot rate because no exchange-rate forecast has been supplied. The team notes that covered interest parity is a no-arbitrage condition rather than an exchange-rate forecast. The team also evaluates Estara's equilibrium real exchange rate. Productivity in Estara's traded-goods industries is expected to increase faster than productivity in its non-traded sector and faster than traded-sector productivity among its principal commercial partners. Labor is mobile between Estara's domestic sectors, so higher traded-sector productivity is expected to place upward pressure on economy-wide real wages. The analysts assume that this wage adjustment raises the relative price of Estaran non-traded goods. Finally, the team prepares a long-run growth estimate using a constant-returns production function. Exhibit 2 provides the relevant assumptions. Population and total employment are expected to grow at the same rate, so the calculation of output per worker does not require a separate employment-growth adjustment. The stated capital share is the elasticity applied to growth in capital per worker. The productivity growth rate enters the calculation directly. Each question can therefore be answered independently using the information in the relevant exhibit and paragraph.

Meridian Global Strategy advises institutional investors with assets and liabilities denominated in several currencies. Its economics team is reviewing exchange-rate quotations, cross-border capital flows, relative purchasing power parity, and a proposed trade restriction. Unless otherwise indicated, currencies float freely, transaction costs are negligible, and exchange rates can adjust immediately. The team's current market observations appear in Exhibit 1. An analyst must calculate the USD price of one GBP using the two spot quotations. The quotation convention is important: USD/EUR expresses the number of US dollars required to purchase one euro, while EUR/GBP expresses the number of euros required to purchase one British pound. The cross-rate calculation must cancel the intermediate EUR units. The team also studies Norland, a financially open economy with a floating exchange rate. International investors unexpectedly revise upward their assessment of Norland's sovereign credit quality and purchase a substantial amount of its local-currency government bonds. The purchases are not offset by sales of other Norland assets, and Norland's central bank does not intervene in the foreign-exchange market. Investors must obtain Norland's currency before settling their bond purchases. No simultaneous change in expected inflation or domestic productivity occurs. For its one-year currency forecast, Meridian assumes relative purchasing power parity is the only relevant equilibrium condition. Expected inflation is 4.0% in the United States and 2.0% in the euro area. The team uses the standard approximation that the expected percentage change in the quoted exchange rate equals the price-currency inflation rate minus the base-currency inflation rate. It also recognizes that the higher-inflation currency should lose purchasing power relative to the lower-inflation currency. Finally, Norland's government proposes a tariff on an imported industrial input. Norland is too small to influence the world price, and foreign exporters do not reduce their pre-tariff price. The tariff would raise the domestic price, increase domestic production of the input, reduce domestic consumption, and generate government revenue. There is no learning-by-doing externality, national-security rationale, or other domestic market failure. Meridian's analyst must evaluate national welfare rather than the welfare of a particular producer, consumer, or government agency.