ECONOMICS 2310A

Assignment #2

Due date: July 31st, 2010 before noon

Question I: Impacts of an Exchange Rate Adjustment

Assume the US Current Account Deficit experiences a hard-landing. Along with this
hard-landing, the US Dollar experiences a major real and nominal depreciation. Given
this scenario, you are to discuss how 4 export-driven African economies will be impacted
by this dollar depreciation and how they should respond.

You should identify the key export and import items for each of these countries as well as
their patter of trade. At least one of the countries of your choice should operate under
floating (flexible) exchange rates system and one under fixed exchange rates system.
Furthermore, at least one of these countries should be oil exporting.
(Suggested length: 2 double-spaced pages- NO diagram is desired.) Your best up todate
source is IMF.

Question II: International Transmission of National Economic Shocks

The recent financial crisis is remarkable in many ways, but one aspect is of special
interest for international economists. International economists have been interested in
interdependence for a very long time – arguably too interested. Global interdependence is
one of those topics people love to talk about because it sounds sophisticated. But the
interdependence this time has been real – and it seems to be operating through channels
that are not yet part of standard international macro analysis. Much thinking about
international linkages still relies on some version of the traditional foreign trade
multiplier: country A’s GDP affects its level of imports, which are country B’s exports,
so demand shocks get transmitted through international trade.

(a) Using the National Income Identity in a two country framework, show how the
deficit in the current account of a country (say US) is linked to the surplus in
another country’s (the rest of the world) current account.
(b) Then using the same identity show how the national income in one country is
linked to that in another country (you need to employ the so called “foreign
trade multiplier” expression.) In this context, illustrate how a drop in demand
for imports (say due to a downturn) in one country will drive the GDP in both
economies lower.
(c) The fact however is that in spite of globalization, trade flows don’t seem large
enough to produce all that much interdependence. For instance, U.S. imports of
goods and services as a percentage of rest-of-world GDP since 1980 has roughly
doubled, but it’s still fairly small. One way to think about this is to ask what it
would take for a U.S. recession to impose a one percent of GDP negative demand
shock on the rest of the world. For this to happen, U.S. imports would have to
decline from 6 to 5 – a 17% decline. Given that the typical estimate of the income
demand for imports is around 2; this would require a decline of more than 8% in
U.S. GDP. So it would take an extremely severe recession in the United States to
produce even a moderate-sized negative demand shock abroad. In light of this, we
need to look elsewhere to explain the observed interdependencies of the late.
Discuss what in your opinion should replace the old international trade- multiplier
model to explain the current international linkages. Support your answer.
(Suggested length: 3 double-spaced pages including a diagram for part c. NO
diagram is needed for a and b.)