Selected Questions From Tyler Cowen’s 2005 Macro Final

Note: I’m working through Tyler’s 2005 Macro final. 

3. How will the aging baby boom generation affect the following and why? Savings rates, interest rates (real, nominal, short and long term), Fed policy, inflation, and investment.

We’re going to become (ARE!) a savings-driven society. That means zero tolerance for inflation with all the painful adjustments implicit in changing inflation regimes. And don’t expect the fed to push extra-hard against this political force to keep its 2% implicit target. Ouch.

Increasing dependency ratios are going to drag the economy a bit, which means a lower demand for loans to complement the increased supply.  I’m sure that the elderly will limit consumption to conserve savings even further than we might expect them to.

Demand is a big problem in an old society.  Nice little throwaway comment there, but what does it mean? It means that the marginal consumer wants to spend less than last year but also does not want to invest the savings of others in novel or innovative productive activities. Leisure is good for your own kids, but not for every one else’s kids. Steve Jobs’ kids knew their old man less than he would have liked but we’re all better off for it.

More downward pressure on inflation. Who wants to invest in this environment? Trick question: more people than ever (savings are up and S = I!). But they want to keep their savings at home, not spread them around the world looking for opportunities!

Selected Questions From Tyler Cowen’s 2005 Macro Final

Note: I’m working through Tyler’s 2005 Macro final. You’d be out of your mind to take a formal economics class in this blogosphere.

2. What is the difference between covered and uncovered interest parity? Which are assumed by the traditional Dornbusch model of exchange rate overshooting? None, just one, or both? How do the observed failures of the expectations theory of the term structure affect the Dornbusch model?

Covered parity means you have a forward contract guaranteeing you your money back. Uncovered parity means you’re exposed to exchange rate fluctuations not offset by interest rate changes.

I had to look up Dornbusch, but I remember his ideas from the CFA exams. The point here is that the economy adjusts to shocks in a lumpy way as information is processed by affected sectors and knock-on effects are realized.

Anyway, the point is that interest rates change based on local equilibria which themselves might be based on asset prices that adjust only slowly to shocks. Think about how long it takes house prices to adjust to changes in interest rates. The full expression of the shock might take a longer and more meandering path than we expect.

Not sure what failures in the term structure Tyler’s talking about here but a wonky term structure would mean that different rates within asset classes will react in different ways.  This just seems to make rates even less predictable. I wouldn’t want to be in charge of that model.

And when the changes, when they come, come fast. Consider how this affects the information transmission of price systems. Tyler himself recently quoted James Hamilton that the market will change its view quickly (on Italian debt, for instance) when perception switches to ruin.

Selected Questions From Tyler Cowen’s 2005 Macro Final

Note: I’m blogging through Tyler’s 2005 Macro final. I’m not really imagining that these answers are ‘right’ in the exam sense, but rather just an excuse to think about 2005 questions in 2011.

1. The pessimists commonly argue that the large U.S. trade and budget deficits eventually will require a big fall in the dollar, higher real interest rates, and a general loss of confidence in dollar-denominated assets. We all know that g > r would stop this problem in its tracks. But let us say that g is not big enough relative to r. What other non-pessimistic scenarios can you outline? How valid are they?

I think that g and r are growth interest rates.

I’ll take the question generally as asking for non-pessimistic scenarios on trade and budget deficits in the future.

Not sure if its non-pessimistic, but the twin deficits persist to this day, mostly because investors are terrified of any investment other than treasuries. Flight to safety preserves the purchasing power of the currency of account.

Less pessimistically, of course, trade deficits due to investment can persist for as long as there are investment booms elsewhere.

And let’s not forget that those trade deficits are nice while we have them. I like the way Russ Roberts thinks of the extremis scenario of exchange rate ‘over/under-valuation. He says that if some foreign country wants to give us a bunch of free cars (be it from exchange rate ‘misalignment’ or enormous foreign productivity matters not), they’re going to of course undermine our domestic auto industry. But (now think carefully about this for a sec) we’re getting free friggen cars!

But to the degree that these foreign investment booms prove illusory, we get a debt overhang and disinflationary recession. But there I go being pessimistic again. Michael Pettis has convinced me that the end-game in China is going to be an abrupt and far-too-late end to their government sponsored investment boom. Ew.

There are also some insights in Tyler’s question, which actually isn’t so pessimistic. What we wouldn’t give for a bit of inflation, depreciation and the ensuing loss of confidence today!