GMM Practice Questions

Intersession 2021
1. Katrina
In early September 2005, Hurricane Katrina ripped through the U.S. southeast and devastated the city of
New Orleans. Over 1800 people died in the storm and hundreds of thousands of people were displaced
from their homes. Many left the city permanently, in part because of the risk of future storms as well as
the growing difficulty and cost of obtaining homeowners insurance. It is well established that Katrina
disproportionately affected minorities and the disadvantaged in New Orleans.

a. First, model what you see as the main effects of Hurricane Katrina on the city of New Orleans,
assuming the economy is at close to full employment when Katrina strikes. Do not show the
adjustment path following the shock.
b. After the storm, the Bush Administration sought $105 billion for repairs and reconstruction in the
region. Add this to your model in (a). Again, do not model the adjustment back to equilibrium.
c. In addition to its devastation of New Orleans, Katrina has other effects in the region: it destroys a
significant amount of the Gulf Coast’s highway infrastructure; it damages or destroys 30 oil
platforms and causes the closure of nine oil refineries; and it destroys 1.3 million acres of forest
lands in the region. With this additional information, now model what you see as the likely impact
of Katrina on the whole US economy, assuming a starting point of NRU. Based on your analysis,
what would you have done at the time if you had been Alan Greenspan, the Chairman of the Federal
Reserve. Why? (Briefly explain). Model your rate move, but do not model any remaining
adjustments back to equilibrium.

2. Canada and the USA

a. In the first quarter of 2010, Canada’s economy expanded at 6.1% on an annualized quarterly
basis, the fastest pace in a decade. This followed a 4.9% increase in the fourth quarter of 2009.
One prominent analyst called these levels of growth “unsustainably fast”. Briefly explain what
the analyst is likely to be thinking (3-4 sentences)? What do you think he is most worried about
when he uses the term “unsustainable” (1-2 sentences)?
b. Two much discussed differences between Canada and the US relate to (1) immigration and (2)
productivity. There are about 3.5 new immigrants to the United States for every 1,000 people in
the country. In Canada, the corresponding number is 6.2. Canada emphasizes education and
skill in selecting immigrants; the US much less so. Canadian business-sector productivity is
approximately 75 per cent of the United States. Very briefly, explain how these data might be
related (immigration levels and the productivity gap). Please ignore the issue of illegal
immigration in formulating your answer.
3. US Economy, 2001-2012
Consider the slide “US Economy, 2001-2012” taken from a presentation by TD Economist, Martin
Schwerdtfeger at Ivey on March 21, 2011.

a. Using our standard AS/AD framework, establish a starting point (label it “A”) for the economy at
the end of 2007. Now model the economy at the start of 2009 (“B”). Finally, model the
economy in 2011 (“C”). Be sure to consider how we get, simultaneously, output that is pre-crisis
level and below potential. (5 marks)
b. Riding a wave of popular concern about spiraling government debt, the Tea Party becomes a
dominant force in US politics, winning the November 2012 presidential election and capturing
majorities in both houses of Congress. The first act of the newly elected government is to
implement its promised plan of “austerity”, cutting government spending by 15%. On your
same chart, model the main impact of this policy and label that point “D”. (2.5 marks)
c. List 2 reasons why the budget deficit might actually get worse under this policy (consider only 1a
and 1b when answering this question; not the remaining question). (5 marks)
d. The same day the government’s new policy is passed, the new Chairman of the Federal Reserve,
Paul Krugman (appointed to a four year term as a last pre-election move by the outgoing Obama
administration), announces a new program called “QE BOOM” whereby the Fed will purchase $1
trillion worth of treasury notes with maturations of 5-10 years. The official interest rate (Federal
Funds Rate) at the time of QE BOOM is zero. Unemployment is still over 9%, well above
consensus NRU, and the core CPI remains at historically low levels, even dipping periodically into
negative territory. You do not need to model the impact of this policy on your chart. Rather,
list, and briefly explain, 2 mechanisms through which QE BOOM might plausibly help the
economic situation in the US. Be specific, but brief (max 25 words per mechanism). (5 marks)

US Economy, 2001-2012

U.S. Real GDP, $Billions

15,000 Forecast

14,500 Potential*

14,000 Actual & TD Forecast

13,500

13,000

12,500

12,000

11,500

11,000
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

*Congressional Budget Office. Forecast by TD Economics as at March 2011

Source: CBO, BEA, TD Economics
4. Potash
In 2020, the Canadian potash marketing cartel known as Canpotex collapses as a result of the actions of
a new entrant into the sector, the Australian company BHP-Billiton. BHP is running its Saskatchewan
mine – the world’s largest and lowest cost – “full out” and, as a result, global potash prices plunge from
$600 per metric tonne to $120. A survey of potash market experts suggests the price of potash is likely
to remain at around this level for the foreseeable future.

a. What is the impact in Belarus, which is the world’s second largest supplier of potash with
approximately 15 percent global market share. Assume the Belarus economy is close to its full
capacity at the time of the price change. Carry your analysis through to equilibrium assuming no
intervention by monetary or government authorities. Be sure to specify mechanisms (e.g., C, I
and G). (7.5 marks)
b. What is the impact in Malaysia, which is a large net importer of potash? Assume the Malaysian
economy is operating at close to full capacity at the time of the price change. Carry your
analysis through to equilibrium assuming no intervention by monetary or government
authorities. Again, specify mechanisms. (7.5 marks)

5. Australia
In its 14th straight year of expanding growth, Australia added 57,800 jobs in March 2006. This was
higher than had been forecast. Despite the increase in jobs, the unemployment rate stayed the same at
5.1%. This occurred even as the labour force participation rate fell to 64.5%.

a. Model where you think the Australian economy is at in March 2006.

b. If you were a currency trader specializing in the Australian dollar and you had correctly
predicted the robust job numbers ahead of the announcement, what action would you have
taken? Briefly explain.
c. Finally, provide a unified explanation for the three labour market indicators (jobs,
unemployment and labour force participation rate). In other words, how would you explain this
particular combination of outcomes?
6. Emerging Markets
Consider the chart below taken from a 2010 article on emerging markets in The Economist:

a. First, what is this main take away from this chart, i.e., what do you conclude from it? Second,
offer a brief explanation for what is going on, i.e., what are the key causal factors at work here?
b. The Economist goes on to make the following claim: “During the past five years virtually all
emerging economies boomed. Now their fortunes will diverge much more.” Choose 3 factors
that you think will importantly determine which emerging economies do well or badly in the
context of the economic crisis and its immediate aftermath. For example, one factor (that you
are not allowed to choose) might be “Countries that relied heavily on exports to the US will do
relatively poorly going forward”. Offer a brief explanation for your choice: e.g., “Exports to the
US are likely to remain muted because of the likely desire by US consumers to repair their
balance sheets (i.e., to save /deleverage) in the aftermath of the crisis and, less certainly,
because the US dollar is likely to depreciate (making imports more costly) given the growing
concerns being raised about the US fiscal position and the Federal Reserve’s unconventional
monetary moves”.
7. Venezuela
Consider the economic data below for the country of Venezuela, one of the world’s top 10 oil producers
and exporters. The oil sector accounts for roughly 25% of Venezuelan GDP, 90% of export earnings, and
more than half of the central government's ordinary revenues. The country’s oil industry is controlled
by the government through is sole ownership of PDVSA, by far the largest oil company in Venezuela.

2004 2005 2006 2007 2008

Real GDP growth (%) 18.3 10.3 10.3 8.4 4.8

Unemployment (av; %) 15.1 12.2 10 8.5 7.4
Public-sector balance (% of GDP) -1.9 1.6 0 3 -1.1
Consumer prices (av; %) 21.7 16 13.7 18.7 30.4
Current-account balance (US$ m) 15,519 25,110 27,149 20,001 39,202

a. Since its peak in 2008, the price of oil has plunged approximately 45 percent. Model where you
think the Venezuelan economy is at in 2008 prior to the oil price collapse (Point A), and then
again after the oil price collapse (Point B).
b. Now consider the following measures announced in 2009 by Venezuela’s President, Hugo
Chavez in response to the crisis: (i) an increase in the value-added tax by three percentage
points and a cut in this year’s budget by 6.7%; (ii) maintenance of the currency peg, currently
fixed at 2.15 bolívar fuertes to 1.00 US$; and (iii) a hike in the minimum wage of 20%. For each
of these policies, please provide one reason why it might be positive for the overall economy
and one reason why it might be negative for the overall economy. Be specific, but brief.
c. Based on the data provided and your analysis in (a) and (b) above, provide a “ball park” forecast
number for each of the economic variables listed in the data table above (Real GDP,
Unemployment, etc) and a VERY BRIEF explanation for each number. I am primarily interested
in your explanation of the direction (up or down) and secondarily interested in magnitude (large
vs. small increase/decrease).
d. Most recently, the government has announced that it plans to issue a significant amount of new
debt to shore up its fiscal position. Prior to this, the government (yes, the government)
announced a loosening of monetary policy, cutting the reserve requirement and interest rates.
Why would the government loosen monetary policy prior to a debt issuance? Does this raise
any macroeconomic concerns for you? Would this information cause you to revise any of your
forecasts in (c)?
e. Finally, given that Venezuela operates under a fixed exchange rate regime, is it really able to
conduct monetary policy independently as suggested in (d)? If so, how?
8. Canada and Europe in 2008
Below is a summary of highlights from the April 2008 Bank of Canada Monetary Policy Report:

a. Based on this information, model what you think is a plausible description of the Canadian
economy currently and through to 2010. Be sure to indicate what you believe are the main
causes of any deviations from long run equilibrium as well as the main causes of any moves back
toward equilibrium.
b. For this question, adopt the perspective that government’s primary role is to be a steward (good
manager) of the economy. Examine the chart below, which shows a comparison of G7
countries’ fiscal balances. Given your assessment of where the economy is at in (a), is current
fiscal policy in Canada appropriate in your opinion? Provide a brief supporting rationale for your
answer.

c. If you again assume that government’s role is to be a steward of the economy, model what you
think is a plausible scenario for the Euro area economy as it stood in 1990. What is the main
danger of the fiscal policy stance adopted by Euro area governments in 1990? Briefly explain
your answer.
9. US Housing Market
Examine the chart below showing recent data on the US housing market.

U.S. EXISTING HOME PRICES & HOME SUPPLY*

Y/Y % Change Supply of existing homes*
20 11

10
15
Price (left scale) 9
10
8

5 7

6
0
5
-5
4
Supply (right scale)
-10 3
Jan.00 Jan.01 Jan.02 Jan.03 Jan.04 Jan.05 Jan.06 Jan.07 Jan.08
*Single-family homes, months supply; Last plotted: Mar. 2008.
Source: Bloomberg, National Association of Realtors / Haver Analytics.

a. Briefly explain why this kind of housing market information is important to understanding a
country’s macroeconomic environment. Be specific.
b. If you were the chairman of the Federal Reserve (US Central Bank) and could ask for any
additional data on the US economy to inform your next interest rate decision, what would be
your top 3 choices for the data items you would like to have. Very briefly explain your priorities.
c. If you worked as a trader of Canadian bonds and you had correctly forecast the drop in U.S.
housing prices ahead of actual events, what action would you have taken? Provide a very brief
explanation for your answer.
10. New Zealand
Consider the following data for New Zealand, published in October 2008 by the Economist Intelligence
Unit (EIU):

2007a 2008b

Real GDP growth 3.2 0.4

Unemployment rate (av) 3.6 3.9
Consumer price inflation (year-end) 3.2 4.4
Government balance (% of GDP) +3.9 +0.3
Exports of goods fob (US$ bn) 27.3 30.8
Imports of goods fob (US$ bn) 29.1 32.5
Current-account balance (US$ bn) -10.2 -9.5
Current-account balance (% of GDP) -8.0 -7.1

After raising the overnight cash rate (OCR) on four occasions in 2007 to 8.25%, the Reserve Bank of New
Zealand (RBNZ) made its first rate cut in the current cycle in July 2008, lowering the OCR by 25 basis
points to 8%, and its second in September, cutting rates to 7.5%. The RBNZ’s medium-term inflation
target is 1-3%.

a. Using the above information, model where you think the New Zealand economy is at in 2007
and again in 2008. Be sure to clearly label your data points.
b. What is the most likely cause of the change in position between 2007 and 2008? Be specific.
c. The RBNZ has a regular review of its official cash rate on October 23, 2008. What would YOU do
to the OCR if you were the RBNZ? Briefly explain your rationale and model the impact of your
move on the same chart.
d. Now list the main risk (choose ONE) you see with your rate move. Provide sufficient explanation
for your logic to be clear (but do NOT write an essay!)
e. Finally, consider the following information as a new fact, i.e., one that you did not know until
just now: the New Zealand dollar has been one of the world’s most popular among “carry
traders”, who borrow cheaply in low-yielding currencies such as the Japanese yen and invest in
countries such as New Zealand, where interest rates are much higher. In the context of the
present global crisis, what is likely to happen to the carry trade going forward and what might
this mean for the following economic outcomes in New Zealand: (i) value of the Kiwi dollar; (ii)
current account balance; (iii) inflation. Briefly explain. For simplicity, please ignore possible
policy responses by the RBNZ to changes in the volume of the carry trade.
11. The Fiscal Multiplier
The “fiscal multiplier” can be defined as the extent to which overall output (GDP) rises in response to a
unit increase in government spending. For example, if an increase in government spending of $1 million
leads eventually to an increase of $1.5 million in GDP, the fiscal multiplier would be 1.5. This is the
number claimed by the Obama administration. Currently, the magnitude of the fiscal multiplier is a
subject of active and at times nasty debate among policymakers and economists. In a recent Wall Street
Journal op-ed piece, Harvard economist Robert Barro argued against Obama’s estimate, claiming
instead: “A much more plausible starting point is a multiplier of zero”.

a. How could the fiscal multiplier possibly be zero? (Provide a maximum 3 sentence explanation)
b. For each of the following country comparisons, provide (a) your prediction for where the fiscal
multiplier is likely to be greater; and (b) the economic rationale underpinning your prediction
(maximum 3 sentences each):
i. High income countries versus developing countries
ii. Fixed exchange rate countries versus flexible exchange rate countries
iii. Countries where trade (X+M) is a large portion of GDP versus countries where it is not
iv. Countries with large fiscal debts versus countries with low fiscal debts

12. Trilemma
This question is about the “macroeconomic trilemma”.

a. List Canada’s set of current policy choices (i.e., what we have decided upon) with respect to the
macroeconomic trilemma. (2.5 marks)
b. Now consider the alternatives. What would you consider to be the “next best” set of choices for
Canada? Simply list these choices. Briefly explain why you rejected the third set of policy
choices, i.e., what are the main problems or shortcomings with it? (5 marks)
c. Now draw on your knowledge of recent macroeconomic history, particularly the event known as
the “Great Recession” and its aftermath (i.e., 2008-2011), and make an argument for why the
status quo (i.e., Canada’s current trilemma choices) is either affirmed as the right choice, or
undermined. In other words, would Canada have been better or worse off under a different
trilemma regime? Use bullet points and be as context-specific (Canada, 2008-2011) as possible.
Maximum 100 words. (7.5 marks)