1. Policy Clash?

Former Senator Sarbanes (D, MD), when in office, famously liked to browbeat Fed officials during Senate hearings for running a tight monetary policy which, according to the Senator, kept interest rates too high. Sarbanes claimed he wanted an easier monetary policy that would promote investment. 

In his congressional testimony, then Fed Chairman Alan Greenspan replied to Sarbanes that easier monetary policy often results in higher, not lower interest rates, and so an easier monetary policy would not have positive impact on investment over the long run. 

Drawing on (a) the effects of easier monetary policy in the short-run IS-LM model, (b) the Fisher interest rate equation and (c) the long-run quantity theory of inflation model, sort out exactly why these two men disagree on the interest-rate effects of monetary policy.  Is one of these men right and the other one wrong in their analysis? Note: to get credit your answer must draw on tools (a), (b) and (c ) above in developing your answer.

Should you hedge your receivables?

U.S. Company Solarwind LLC has a contract with the South African government to install a large solar panel farm that will generate 1MW of electricity for the Northern South African electric grid. The project is scheduled to be completed in one year at which time the final payment of the contract, 500M South African Rand (SAR), will be made to Solarwind. At the current exchange rate of $.35 per SAR, the USD value of the receivable is $175M. The problem is that the 500M SARs will be received one year in the future. Solarwind risk management is concerned that the SAR may depreciate relative to the USD over this time. Therefore Solarwind is considering a money market hedge (MMH) and tasks you with (a) working out the MMH setup and (b) calculating how much Solarwind can expect to receive through the hedge.  The one-year SAR and USD risk-free interbank borrowing and lending rates available to Solarwind are:

i(SAR) = 3%

i(USD) = 3%. 

Explain how you would set up a MMH for this SAR-denominated receivable and show how much (in USDs) the MMH would yield in one year.  Assume there are no transactions costs.

2. Trade Deficits - Caused by a Savings Glut?

The U.S. trade deficit is often linked by the popular press (and by politicians of all stripes) to declining U.S. competiveness or unfair trade practices.  However most economists (please read the article by Ben Bernanke "The Global Saving Glut and the U.S. Current Account Deficit" in the Readings folder) actually attribute the U.S. trade deficit to two well-established empirical facts: 

(1) The savings "glut" in less-developed countries that has caused a perverse reversal of the traditional flow of international capital.  Capital normally flows out of capital-rich countries and into capital-poor countries, but instead, excess savings are flowing from capital-poor to capital-rich countries.

(2) The persistent attractiveness of the U.S. economy as a place for foreign residents to invest in.

Use the small open economy model below to explain the logic of why these to empirical facts can cause a U.S. trade deficit. Assume that the worldwide risk-free real interest rate is fixed at r* and does not move.  Use words to explain your equations.

The subscript US refers to the U.S.A. and the subscript ROW refers the Rest of the World.

Developed Countries:

YD ≡ CUS+IUS+GUS+NXUS

SD ≡ YUS - CUS - GUS

Rest of World:

YROW ≡ CROW+IROW+GROW+NXROW

SROW ≡ YROW- CROW- GROW

World:

YW ≡ YUS + YROW ≡ (CUS+ CROW ) + (IUS+ IROW ) + (GUS+ GROW ) = CW+IW+GW

SW ≡ YW- CW- GW