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UNIVERSITY OF CALIFORNIA, BERKELEY FALL 2007 ECON 182 Suggested Solutions to Problem Set 2 Problem 1: Metzler Diagram and Saving Glut a. Bernanke (2005, reading from the syllabus) argues that, "over the past decade . .. a global saving glut . .. helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today." According to Bernanke, what are the sources of saving glut in developing and rich countries respectively? Developing countries: East Asian countries built up large quantities of foreign-exchange reserves in response to instability of capital flows and the exchange rate. Additionally, re- serves were accumulated in the context of foreign exchange interventions intended to pro- mote export-let growth by preventing exchange-rate appreciation. Another factor is the sharp rise in oil prices. The current account surpluses of oil exporters, notably in the Middle East but also in countries such as Russia, Nigeria, and Venezuela, have risen as oil revenues have surged. Rich countries: The rich countries with aging populations must make provision for an im- pending sharp increase in the number of retirees relative to the number of workers. b. Draw the two-country Metzler diagram excluding developing countries (i.e. with the US and other rich countries). Explain how the saving glut of rich countries contributes to the "global imbalances"? The initial diagram can be taken from the lecture 5 slides 5-6 (both countries have zero cur- rent account). One country is the US and the other country represents the rich countries with saving glut. The saving glut of rich countries can be depicted as a right shift of the sav- ings curve, which means under all interest rates the savings increase. In the equilibrium, the world interest rate goes down. The US runs a current account deficit and the rich countries with saving glut runs a same amount of current account surplus. c. Is the real interest rate endogenous or exogenous in the Metzler diagram analysis? Do you think that either “country” is able to manipulate the interest rate? Why? The real interest rate is endogenous in the sense that it is pinned down by equalizing the (dis)savings of two countries in the equilibrium. The Metzler diagram is used to analyze two BIG countries, whose investment/savings can affect the world interest rate. On the other hand, we assume the world interest rate doesn’t change according to the savings of a SMALL open economy. Although the world interest rate is not predetermined, we usually assume the private investors take the interest rate as given since they are small relative to their country and the whole world. It is equivalent to assume that the change of the savings from one private investor doesn’t change the aggregate savings. This is the standard setup of a general equilibrium model with representative agents. LAST MODIFIED 1:59PM, 09/20/2007
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This note was uploaded on 10/21/2008 for the course ECON 182 taught by Professor Kasa during the Fall '08 term at Berkeley.

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