MBA 2011 Coursework Submission Cover Sheet

Student ID Number/Study Group Number: 6123M Assignment No: ME2 Name of Course: Macroeconomics Lecturer for this Coursework: Michael Kitson

Hand-in date: 25 May 2012

Word Count: 2,470

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The Cambridge MBA 2011/12

Chosen Country: United States of America 1. Discuss the long-term strengths and weaknesses of the macroeconomy of the country. The US is usually ranked in the top five of the World Banks Doing Business Indicators and the World 2 Economic Forums Global Competitiveness Index , and remains the largest economy in the world. Its high per capita income reflects high productivity. Despite only having 5% of the worlds population, the United 3 States accounted for 30% of global patent applications in 2007 and 85 of the worlds top 400 4 universities . It helps that the US is a large country. In a sample of 101 countries, the advantage shows up as an 5 estimated difference in income per capita of 54% . The advantage is larger if there are no internal barriers to trade. The United States since its inception has always been fortunate to have free trade internally, as only the federal government can regulate trade among the 50 states. Other large countries such as Canada, China, and Russia have many internal barriers obstructing goods and services from crossing between provinces. Free movement of goods and services within a country promotes economic performance. A large internal market allows vast economies of scale and a larger area is likely to have a good variety of natural resources. In addition, labour and capital can move among regions of a country. Migration within a country can be a major source of long-run growth, as well as a shock-absorber in the short run. Many of the most important factors in explaining US economic performance stretch back over two decades or more, and will continue to remain relevant in the future. The two main ones are deregulation and globalisation. The US economy has generally been less regulated than most European economies, but the last quarter century has seen further deregulation. In the 1980s, deregulation was extended to the telecommunications sector. More recently, there has been electricity deregulation as well. Some of these efforts have faced problems, particularly banking and electricity, but nevertheless, the overall effect has been to make the US economy more efficient in the long run. The ratio of trade to GDP has more than tripled since the 1950s and now stands at 20% . The increase in exports over 1993-2000, even including the period of the East Asia crisis, constituted 20% of the growth in US GDP over this period. Imports increased rapidly as well, but were also beneficial. The increase in imports and in the trade deficit, though politically unpopular, acted as a safety valve during the strongest phase of the US expansion. They released pressure from fast-growing domestic demand, pressure that would otherwise have caused high inflation and interest rates. Still, the United States is also faced with a number of weaknesses. Health care is expensive and 7 inefficient: health spending is 50% higher per capita than that of the next highest OECD country , but their infant mortality rate (5.98 deaths per 1000 births) is higher than in all OECD countries except Mexico and 8 Turkey. Health care costs, which already account for about 17% of GDP , are expected to rise rapidly as the population ages. Despite its high productivity and competitiveness, the cumulative current account deficit over the last thirty years is $8.5 trillion, a reflection of extremely low household savings rates and government deficits. In addition, the USs largest trading partner, as a single economy, is the EU with $367.8 billion worth of EU goods going to the US and $268.6 billion of US goods going to the EU as of 2011, totalling 9 approximately $636.4 billion in total trade. Over the long-term, this dependency on the EU may have catastrophic consequences to the US economy if the EU disintegrates.
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2. Analyse the trade position of the country and discuss the countrys comparative advantage. In March, the US trade deficit widened to a larger-than-expected $51.8 billion, up from $45.4 billion in February. The economy posted record exports of $186.8 billion in March, but imports also hit a new 10 monthly high of $238.6 billion. Unlike in recent months, the increase in the deficit was not because of higher oil imports. Rather, a rise in purchases of capital goods from overseas and consumer products accounted for a large proportion of the imbalance. Rising imports are not necessarily a bad thing as they reflect growing domestic demand; American consumers have been spending more recently and many imports are high-tech goods designed in the US but assembled overseas with domestically produced parts. On the other hand, most of the US economys exports were from the services sector and electronic components. In simple terms, a countrys comparative advantage is in those products that it exports more than it imports. These advantages may result from protectionism or simply because of more production efficiencies. The United States comparative advantage today lies increasingly in services (especially financial), and high-tech manufacturing. In 2008, despite a trade deficit of $882 billion, food, technology and services accounted for a positive $300 billion figure. The U.S service sector also has a global comparative advantage. In the last two decades, the share of services in 11 US GDP has risen from about 60 per cent to 72 per cent ,- a trend that is still continuing. As trade partners develop and grow, their demand for services will rise thereby ensuring that US export levels and benefit the international recipients as well.

Source: WTO

In addition to a positive services balance sheet, the US has a clear comparative advantage in financial assets. In 2009, the value of the inflow of foreign-owned financial assets (US exports) into the US was $306 billion; the value of the outflow of US-owned financial assets abroad (US imports) was $140 billion. This is low compared to 2006 and 2007, when foreigners were bought than $2 trillion in US financial assets, but still is very favourable and maintains a clear comparative advantage for a US.

3. Evaluate the possible impact on the macroeconomy of the country if there is a sustained fall in the real exchange rate. The exchange rate of the US dollar is predominantly determined by supply and demand on the open market associated with buying and selling of US dollar denominated goods and services. Since 2002, there has been a trend of depreciation of the US dollar:

Price-adjusted Broad Dollar Index - Monthly Index

115 110 105 100

Rate

95 90 85 80 75

Source: Board of Governors of the Federal Reserve (Accessed 21/5/2012)

This trend has raised some concerns that the decline is a symptom of broader economic problems such as slow economic recovery and rising debt. A depreciating currency can have a number of effects on economic performance: a decrease in purchasing power for US residents, increasing commodity prices, rising interest rates and an increase in exports. If this trend is sustained, then the US may have a reduction in external debt or even face a situation where the dollar does not remain a reserve currency. A depreciating dollar makes US goods more attractive to foreign buyers, while making imports into the US more expensive. As a result, this should reduce the US trade deficit. This in turn is likely to have two positive effects: it will subtract less from demand and help increase employment, and it will reduce the growth rate of US debt to foreign lenders. As imports become more expensive, the purchasing power of US consumers will be reduced. For the 26% dollar depreciation which began in 2002, the US terms of trade for this period decreased by 12 approximately 13% . This is less than the total depreciation of the dollar, reflecting the fact that some importers do not always pass through costs to consumers, and that the US economy is less dependent on imports in GDP (only 16%). However, on a command-basis GNP calculation, it is estimated that there was a $300 billion loss in international purchasing power due to the 26% depreciation from 2002-2008. In addition, US net external debt may be reduced. This is caused by favourable valuation effects as US foreign liabilities are denominated in US dollars, while US foreign assets are denominated in external currencies. Most countries are unable to borrow in their own currencies and this was a problem that plagued countries caught in the 1997 Asian financial crisis. Fortunately, this is not a problem for the US. Because international commodity prices are priced in dollars, prices in the US are not directly affected by movements in an exchange rate, however an IMF analysis argues that the dollar does have an impact on

commodity prices : depreciation makes commodities less expensive in non-dollar countries; it reduces yield on dollar denominated foreign assets making commodities a more attractive investment, thereby driving demand and raising prices; and finally, it may cause countries to use monetary policy to reduce interest rates and stimulate foreign demand, including that for commodities. All of this will result in rising global commodity prices, including those in the US. The IMF study indicates that if the dollar had not depreciated, gold prices might have been $250 per ounce lower, oil would be $25 per barrel lower, and general commodity prices would be 12% lower.

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4. Discuss the impact of the recent financial crisis and world economic slowdown on the economy of the country.

According to numerous indicators, the 2007-2009 recession was the most severe economic contraction since the 1930s. The slowdown of economic activity was moderate through the first half of 2008, but this was the point the economy was hit by the financial crisis which would then worsen the economic weakness and accelerate the decline. By the second half of 2009, real GDP had contracted by approximately 5.1%, or by about $680 billion. At 14 this point the output gap widened to 6.2% . This was much larger than that of previous recessions, in which the real GDP falls averaged 2.0% and the output gap increased to near 4.0%. However, the most recent fall was still well short of that during the Great Depression, when real GDP decreased by 30%. As output decreased, the unemployment rate increased, rising from 4.6% in 2007 to a peak of 10.0% in 15 October 2009 , and remaining only slightly below that level into 2011. The US unemployment rate had not been at that level since the aftermath of the 1981 recession when it reached 10.8%. This rise in the unemployment rate resulted in about 7 million people being put out of work during the recession. Another 8.5 million workers had been pushed involuntarily into part-time employment. The recession was coupled with a major financial crisis that amplified the negative effects on the economy. Falling stock and house prices led to a large decline in household wealth which fell by over $12 trillion (about 20%) through 2009. In addition, the financial panic caused a vast increase in risk premiums that limited the availability of credit to the economy, affecting credit supported spending by consumers such as for automobiles, as well as business capital expenditure. The negative shocks the economy received were more severe than what occurred in 1929. However, unlike in 1929, the recession did not turn into a depression, largely because policy responses by the government helped to support and stabilise the financial system. Monetary Policy: To stimulate the economy, during 2008 and 2009 the Federal Reserve aggressively used monetary policy as a stimulus by lowering the federal funds rate to almost zero and expanding its role as a lender of last resort by forming lending programs to create liquidity to the financial system and improve lender confidence. Between September and November 2008, the Feds balance sheet more than doubled because of this lending, increasing from under $1 trillion to more than $2 trillion. Fiscal Policy: Congress enacted the Economic Stimulus Act of 2008. This act was a $120 billion package that provided tax rebates to households and accelerated depreciation rules for business. The Obama administration then passed the American Recovery and Reinvestment Act of 2009. This was a $787 billion package with $286 billion of tax cuts and $501 billion of spending increases that, relative to expectations without this act, is estimated to have raised real GDP between 1.5% and 4.2% in 2010. However, this is expected to be much lower for 2012.

5. Outline some plans which you believe will improve the long-term growth performance of the macroeconomy. The long-run growth potential of the US economy should not be materially affected by the crisis and the recession. However, for this to be the case, the US government should implement a number of policies to ensure the outcome. First of all, the Federal Reserve should promote longer-term performance of the economy through the use of expansionary monetary policy. The Fed can both create money and buy US government bonds at low rates, thereby monetising the fiscal deficit. Doing so significantly expands money supply, pushes down interest rates, and helps stimulate the economy. The Fed can also control the federal funds rate- keeping it low will ensure that inflation remains stable over time and contributes to long-run macroeconomic and financial stability. Low inflation improves the functioning of markets, making them more effective at allocating resources; and it allows households and businesses to plan for the future without having to be unduly concerned with unpredictable prices. To achieve economic and financial stability, US fiscal policy should be sustainable and debt relative to national income should remain stable or, ideally, decline over time. The increasing fiscal burden caused by an aging population and the on-going rise in healthcare costs make addressing the issue more critical. Fiscal policymakers can promote stronger economic performance through the design of tax policies and spending programs. However, the two goals of achieving fiscal sustainability and avoiding the creation of headwinds limiting current recovery are not incompatible. Putting into place a plan to reduce long-term fiscal deficits, while bearing in mind the implications for the recovery in the near term, can help serve both objectives. Fiscal policies that promote a stronger short-term recovery can serve longer-term objectives as well. In the short term, reducing unemployment by promoting, for example, government infrastructure projects can ensure that the economy is producing at its full potential rather than leaving productive resources underutilised. In the longer term, minimizing the duration of frictional and cyclical unemployment supports the economy by avoiding the erosion of skills. Housing is a particularly pressing issue: over the medium term, housing activity should stabilise and begin to grow again, if for no other reason than population growth will contribute to demand. Fiscally sound housing policies should be put into place that helps speed that process. Compared to other OECD countries, housing supply in the US is the most responsive to changes in price. A responsive supply helps to avoid excessive increases and volatility in prices, and this can be improved further by improving land-use and planning regulations and tax incentives for developers. In addition, the US should, at least temporarily, eliminate tax policies that favour housing over other investments. These lower borrowing costs and encourage excessive investment, speculation and price volatility. Tax breaks are capitalized in house prices, preventing some lower-income households from home ownership. Property taxes should better reflect market values. To the fullest extent possible, tax and spending policies should increase incentives to work and to save (lower taxes for low-income bands or an increase in the tax-free threshold on savings, similar to ISA policies in the UK), encourage investments in the skills of the workforce (subsidised university degrees or employee training programs) and promote research and development. An economy cannot freely grow its way out of fiscal imbalance, but a more productive economy will ease the trade-offs faced.

References 1. World Bank Doing Business Indicators http://www.doingbusiness.org/rankings 2. WEF Global Competitiveness Index http://reports.weforum.org/global-competitiveness-2011-2012/ 3. http://www.conferenceboard.ca/hcp/details/innovation/share-of-world-patents.aspx 4. US News Global University Rankings 2011 http://www.usnews.com/education/worlds-best-universities-rankings/articles/2011/10/18/worldsbest-universities-about-the-rankings-2011 5. Footnote 24 in Frankel and Rose, An Estimate of the Effect of Common Currencies on Trade and Income, Centre for Economic Policy Research Working Paper No. 2631; and KSG Working Paper, April 10, 2001 6. European Commission Figures, http://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_113465.pdf 7. OECD Figures, document downloaded from http://www.oecd.org/document/60/0,3746,en_2649_33929_2085200_1_1_1_1,00.html 8. OECD Figures, document downloaded from http://www.oecd.org/document/60/0,3746,en_2649_33929_2085200_1_1_1_1,00.html 9. United States Census Bureau http://www.census.gov/foreign-trade/balance/c0003.html#2011 10. United States Bureau of Economic Analysis http://www.bea.gov/newsreleases/international/trade/tradnewsrelease.htm 11. United States Bureau of Economic Analysis, Document downloaded from http://www.bea.gov/industry/gdpbyind_data.htm 12. United Nations Statistics Division, documents downloaded from http://unstats.un.org/unsd/trade/imts/analyticaltradetables.htm 13. Commodities Boom Riding A Wave, Helbling, Mercer-Blackman, Finance & Development, March 2008 http://www.imf.org/external/pubs/ft/fandd/2008/03/pdf/helbling.pdf 14. 'How Big Is the Output Gap?', FRBFS Economic Letter, Number 2009-19, June 12, 2009 http://www.frbsf.org/publications/economics/letter/2009/el2009-19.pdf 15. US Department of Labor Statistics http://data.bls.gov/timeseries/LNS14000000