Question 1: (i) Briefly, what is the issue? What impact does it have on different regions' GDP, prices, exchange rates and Interest rates? The issue is an unprecedented level of world surplus savings (especially in the Asian economies) that faced with weak investment opportunities serve to fund a growing US current account deficit which creates dangerous world imbalances. The Euro-zone and Japan have slow GDP growth and their savings increase due to a lack of confidence in both financial and social security systems as well as the inability of the private sector to find investments. Also we see increasing fiscal deficits, very low real interest rates and low inflation. The Euro appreciated vs.

USD, creating loss of export competitiveness that added up to a weak demand. The yen has been down in real terms (to avoid deflation). Therefore, most of the countries (specially Asia and specifically China) are using this surplus to lend money to the US, thus making the US both borrower and spender of last resort (to finance mainly US consumption, its current account deficit and to some extent its fiscal deficit). Furthermore, any FD Is from Europe and the US into developing Asian economies are recycled (although the Asian countries keep the technology) into Asian Central Banks' purchase of US Treasuries. The banks also use this as a mechanism to maintain export competitiveness by fixing their currency against the USD, which increases their foreign reserve accumulations. Tight monetary and fiscal policies as well as direct interventions in credit markets have helped to sustain this high domestic savings.

China's economic growth rate is 9%, due to: increasing exports & spending in capital goods and construction; very low interest rates; increasing (but still low) inflation and real exchange rate depreciation. (ii) Why does it put the world economy at high risk? What is the worst possible outcome? The US current account deficit has increased to 6. 5% of GDP, because of low and falling savings as well as private spending rising faster than disposable income. The US net external liabilities have also increased to levels that had never been seen before. Thus, in order to achieve a growth of output in line with full employment, US domestic demand needs to grow more than GDP (since imports grow also 6% more than exports).

Therefore the US has increased its current account deficit to adjust the current account surplus of the rest of the world. The alternative would have been not to dispose of all those savings causing a global slump. But how long will both the US current account deficit and Asian countries exchange rate + saving & lending policies, be sustainable? Not long, because: o In the US: "What can't go on, won't"o It is impossible to bridge the current account deficit through the growth of exports over imports, because at current real exchange rate, imports grow twice as fast as exports do as % GDP and also because to maintain the current trade balance as % GDP, exports must grow more than 10% per year (current growth is 5. 5%). o To eliminate the current account deficit the US will need, at least, a 90% USD real depreciation. o US' Net liabilities forecast for 2015 (with current trade balance trend) will be 120% of GDP o Increasing protectionism in the US & Europe.

o In Asia: o The economies of the poor Asian countries will eventually find investment opportunities at home (or even in Europe) rather than the US. o The rates of return of US Treasuries are negative in USD and local currency denominated terms (if an appreciation of Asian currencies occur). o It is difficult to sterilize the monetary impact of their enormous reserve accumulations (cheap lending & bad debt through the economy & real state boom) o But, sustaining the dollar means to maintain the competitiveness of the exports and to give an anchor currency to the Asian monetary system. The worst outcome would be a "hard landing" of the USD, with a sharp depreciation. In the US this would cause inflation and a rise in interest rates which would start a recession that would affect the world's economy. A 2 nd consequence would be that it would create a weak USD maybe causing Asian currencies change to peg to another currency (GBP? Euro? ) (iii) How can this problem be resolved with the lowest cost? What policy actions (in USA, Europe and China) would you recommend? The main messages are: "the longer the delay the bigger the adjustment" and "the agreement has to be as global as possible" (include the US, Asia and Europe) Several measures are suggested (all taken together and agreed between the countries): 1.

Depreciation of the dollar: necessary but not sufficient. 2. Decrease US fiscal deficit: i. e. increasing taxes and decreasing government expenditure.

Increase in domestic savings (for instance by increasing interest rates) is paramount. Increase exports would also be of help. 3. Expansionary policies in Asia: decrease their excess savings and stimulate domestic spending (through structural reforms in financial system) and favor internal lending.

4. Allow a real exchange rate appreciation of Asian currencies: a new competitiveness policy would have to be based in productivity than current exchange rate intervention. 5. Euro-zone should create new investment opportunities: structural reforms like social security, labor legislation, tax system, public sector services and enterprises, should allow the creation of new investment opportunities in Europe.

Also EUR would appreciate vs USD, causing exports to US to reduce; but a depreciation against Asian currencies could be a gain in competitiveness for export oriented countries such as Germany.