Midterm Exam

UNIVERSITY OF MARYLAND—BALTIMORE COUNTY
Department of Economics
ECON 482: International Finance
Professor McIntyre
Fall 2004
Midterm Exam
Name:
Score:
/100
Instructions: You have 90 minutes to complete this evaluation exercise. Do all parts and answer
all questions; there are 100 possible points. Show all of your work, please take this exam in pencil,
and BE NEAT. When appropriate, carefully label or otherwise distinguish your answers. Use the
other side of the paper if you need additional space. This exam is five pages long including this
title page; make sure you have them all. Are you reading this? May the Force be with you.
1
Definitions & Short Answer
Answer the following questions with a sentence or two. 5 pts. apiece; 30 pts. total.
1. Write down the equation for the real exchange rate, s, as a function of the nominal domestic/foreign spot rate, S ,
the domestic price level, P , and the foreign price level, P ∗ . What does the real exchange rate tell us, generally
speaking? That is, what does s measure, or give us information about?
2. True, False, or Uncertain, and MOST IMPORTANT, Explain: ‘‘According to the elasticities/trade approach to
exchange rates and the balance of payments, an equilibrium in the currency markets is equivalent to a balance of
payments equilibrium.’’
3. Define the term ‘‘forward premium.’’
4. If covered interest parity holds and the forward premium is equal to zero, what is the relationship between
foreign and domestic interest rates? Explain.
5. Define the term ‘‘sterilization,’’ as it pertains to central banks and foreign currency markets.
6. Write down the balance of payments accounting identity. Be sure to define/explain any terms you introduce.
2
Interest Rate Parity Redux
20 pts.
OK, let’s try this one more time...
(5 pts.)
(15 pts.)
1. Suppose
Explain.
F −S
S
+ R∗ > R. Is it more profitable to engage in financial investment domestically or abroad?
2. Based on your answer to (1), illustrate on the charts below how the international financial system re-equilibrates
itself, that is, how it returns to a situation in which covered interest rate parity holds (all notation/markets are as
explained in class). In the space to the right, carefully explain each step in this process.
S
F
SFX
SFX
DFX
DFX
QFX
QFX
R*
R
SL
SL
DL
DL
QL
QL
(F-S)/S
o
45
R-R*
3
The Monetary Approach to the Balance of Payments
25 pts.
Suppose aggregate money demand in the United Kingdom is given by the standard Cambridge-k function MUd K =
kU K PU K yU K , where all notation is as discussed in class and the subscript U Ks denote British quantities. Assume
that the U.K.’s money market always clears, that is, money supply equals money demand or MU K = MUd K . We know
that the U.K. does business with Japan, which has similar preferences regarding money demand. In particular, money
demand in Japan is given by MJd = kJ PJ yJ , where the subscript Js denote Japanese quantities. Furthermore, Japan’s
money market always clears.
(10 pts.)
1. Assuming purchasing power parity (PPP) holds between the U.K. and Japan, use the information given above to
derive an expression for the £/B spot rate, S, as a function of relative incomes and relative money supplies.
(5 pts.)
2. Suppose that Japanese GDP increases. All else being equal and assuming that S floats, what does your model
predict with respect to the value of the yen vis-á-vis the pound? Explain. Is this consistent with the ‘‘strong
economy, strong currency’’ cliché?
(5 pts.)
3. Suppose that the Bank of England takes steps to increase the British money supply by increasing its holdings of
domestic credit. All else being equal and again assuming a floating exchange rate, what does your model predict
with respect to the value of the pound vis-á-vis the yen? Explain.
(5 pts.)
4. Regarding your answer to part (3), how does the Bank of England’s policy affect the U.K.’s balance of payments?
Is the U.K. experiencing a balance of payments surplus, deficit, or equilibrium? Explain.
4
The Monetary Base, the Money Supply, the Spot Rate, and the J-curve
25 pts.
(4 pts.)
1. From class, you know there are two ways to define a nation’s monetary base. One of then is based on central
bank assets, the other is based on central bank liabilities. In the space below, write down these two definitions in
equation form, taking care to define any notation you introduce.
(3 pts.)
2. Hence write down the equation linking a nation’s monetary base, M B, to its money supply, M . Again, take care
to define any notation you introduce.
(3 pts.)
3. Describe the impact on this nation’s monetary base and money supply if its central bank decreases its holdings of
foreign currency reserves.
(6 pts.)
4. How does this impact the value of this nation’s currency? Explain.
(4 pts.)
5. Based on your answer to part (4), describe the impact on this nation’s current account balance, assuming its
import demand and export supply schedules are perfectly inelastic in the short run.
(5 pts.)
6. On the graph below, illustrate the dynamic behavior of this nation’s current account as imports/exports adjust to
the new spot rate. Is this an example of a J-curve effect? Explain to the right of your chart.
Current Account Balance
0
time
UNIVERSITY OF MARYLAND—BALTIMORE COUNTY
Department of Economics
ECON 482: International Finance
Professor McIntyre
Fall 2004
Key to Midterm Exam
1
Definitions & Short Answer
Answer the following questions with a sentence or two. 5 pts. apiece; 30 pts. total.
1. Write down the equation for the real exchange rate, s, as a function of the nominal domestic/foreign spot rate, S ,
the domestic price level, P , and the foreign price level, P ∗ . What does the real exchange rate tell us, generally
speaking? That is, what does s measure, or give us information about?
s = SP ∗ /P. The real exchange rate measures the purchasing power of the dollar–or other currency–abroad.
2. True, False, or Uncertain, and MOST IMPORTANT, Explain: ‘‘According to the elasticities/trade approach to
exchange rates and the balance of payments, an equilibrium in the currency markets is equivalent to a balance of
payments equilibrium.’’
TRUE. Under the elasticities approach, the supply of foreign exchange is equal to import demand, and the
demand for foreign exchange in equal to export supply. Thus if the spot market clears, i.e. FX demand =
FX supply, the current account balance will be equal to zero. Since the elasticities approach only assumes
trade in goods and services, a current account balance is equivalent to a balance of payments equilibrium.
3. Define the term ‘‘forward premium.’’
A forward premium is a positive spread between the forward and spot rates, i.e. when F > S.
4. If covered interest parity holds and the forward premium is equal to zero, what is the relationship between
foreign and domestic interest rates? Explain.
Recall the covered interest parity condition: F −S
= R − R∗ . If the forward premium equals zero, i.e. if
S
F = S, then the interest parity condition becomes 0 = R − R∗ . Thus, foreign and domestic yields will be
equal, R = R∗ .
5. Define the term ‘‘sterilization,’’ as it pertains to central banks and foreign currency markets.
Sterilization refers to a situation in which a central bank does not let a FX market intervention (a change in
its holding of FX reserves) aﬀect the monetary base and hence money supply. Suppose, for example, that
a central bank is selling FX reserves. All else being equal this will decrease that nation’s monetary base
and money supply. This central bank could sterilize this intervention by purchasing an equivalent amount
of domestic securities.
6. Write down the balance of payments accounting identity. Be sure to define/explain any terms you introduce.
Current account balance + capital account balance + oﬃcial settlements balance + statistical discrepancy
= 0.
2
Interest Rate Parity Redux
20 pts.
OK, let’s try this one more time...
(5 pts.)
1. Suppose
Explain.
F −S
S
+ R∗ > R. Is it more profitable to engage in financial investment domestically or abroad?
It is more profitable to engage in financial investment abroad. The LHS of the inequality is the return to
foreign financial investment; it is the sum of the interest return to a foreign asset plus the return associated
with holding and converting foreign currency. The RHS is the return to domestic investment.
(15 pts.)
2. Based on your answer to (1), illustrate on the charts below how the international financial system re-equilibrates
itself, that is, how it returns to a situation in which covered interest rate parity holds (all notation/markets are as
explained in class). In the space to the right, carefully explain each step in this process.
S
F
SFX
DFX
DFX
QFX
QFX
R*
R
SL
DL
QL
SFX
SL
DL
QL
Since it advantageous to invest abroad, individuals will substitute some of their foreign investments for
domestic ones. The process is as follows:
–Investors will pull funds out of domestic financial markets. This will decrease SL domestically and raise
domestic yields.
–Investors will require foreign exchange to purchase foreign securities. This represents and increase in
DF X, weakening the dollar.
–Investors will place these funds in foreign markets. This will increase SL abroad, decreasing foreign yields.
–The the future, foreign investors will need to repatriate their funds (and domestic investors will want to
move some funds back overseas). This increases the future supply of F X and causes an decrease in the
forward rate.
3
The Monetary Approach to the Balance of Payments
25 pts.
Suppose aggregate money demand in the United Kingdom is given by the standard Cambridge-k function MUd K =
kU K PU K yU K , where all notation is as discussed in class and the subscript U Ks denote British quantities. Assume
that the U.K.’s money market always clears, that is, money supply equals money demand or MU K = MUd K . We know
that the U.K. does business with Japan, which has similar preferences regarding money demand. In particular, money
demand in Japan is given by MJd = kJ PJ yJ , where the subscript Js denote Japanese quantities. Furthermore, Japan’s
money market always clears.
(10 pts.)
1. Assuming purchasing power parity (PPP) holds between the U.K. and Japan, use the information given above to
derive an expression for the £/B spot rate, S, as a function of relative incomes and relative money supplies.
Since the money market clears in both the U.K. and Japan, MU K = kU K PU K yU K and MJ = kJ PJ yJ . Since
PPP holds, SPJ = PU K . Plug this into the U.K.’s money market clearing condition: MU K = kU K SPJ yU K .
Take the ratio of MU K to MJ and do some algebra:
kU K SPJ yU K
kU K SyU K
MUK
=
=
.
MJ
kJ PJ yJ
kJ yJ
MU K
kJ yJ
yJ
kJ
MU K
=
.
=⇒ S =
MJ
kU K yUK
MJ
yU K kU K
(5 pts.)
2. Suppose that Japanese GDP increases. All else being equal and assuming that S floats, what does your model
predict with respect to the value of the yen vis-á-vis the pound? Explain. Is this consistent with the ‘‘strong
economy, strong currency’’ cliché?
Recall that S is in /B terms. An increase in yJ will increase S. This is a pound depreciation/yen appreciation.
Since Japan’s economy has gotten better and its currency stronger, this is consistent with the supplied cliche.
(5 pts.)
3. Suppose that the Bank of England takes steps to increase the British money supply by increasing its holdings of
domestic credit. All else being equal and again assuming a floating exchange rate, what does your model predict
with respect to the value of the pound vis-á-vis the yen? Explain.
An increase in MU K will increase S. This is a pound depreciation.
(5 pts.)
4. Regarding your answer to part (3), how does the Bank of England’s policy affect the U.K.’s balance of payments?
Is the U.K. experiencing a balance of payments surplus, deficit, or equilibrium? Explain.
Since the U.K. is allowing the spot rate to float, pressure on the pound to weaken will not aﬀect the Bank of
England’s stock of foreign currency reserves. As such, the U.K.’s balance of payments is still in equilibrium.
4
The Monetary Base, the Money Supply, the Spot Rate, and the J-curve
25 pts.
(4 pts.)
1. From class, you know there are two ways to define a nation’s monetary base. One of then is based on central
bank assets, the other is based on central bank liabilities. In the space below, write down these two definitions in
equation form, taking care to define any notation you introduce.
M B = Domestic Credit + Foreign Exchange Reserves.
M B = Currency + Reserves.
(3 pts.)
2. Hence write down the equation linking a nation’s monetary base, M B, to its money supply, M . Again, take care
to define any notation you introduce.
M = mM B, where m is the money multiplier.
(3 pts.)
3. Describe the impact on this nation’s monetary base and money supply if its central bank decreases its holdings of
foreign currency reserves.
If the central bank’s holdings of foreign exchange decreases, the monetary base will decrease and thus the
money supply will decrease.
(6 pts.)
4. How does this impact the value of this nation’s currency? Explain.
From part (3) the previous question, you know that a decrease in a nation’s money supply causes a currency
appreciation.
(4 pts.)
5. Based on your answer to part (4), describe the impact on this nation’s current account balance, assuming its
import demand and export supply schedules are perfectly inelastic in the short run.
From the elasticities approach, you know that SF X = DIM P ORT S , and DF X = SEXP ORT S . If there is
pressure on this nation’s currency to appreciate, it must be the case that SF X > DF X, which implies
DIMP ORT S > SEXP ORT S . Since the import demand and export supply schedules are perfectly inelastic,
this currency appreciation will lead to a current account deficit in the short run.
(5 pts.)
6. On the graph below, illustrate the dynamic behavior of this nation’s current account as imports/exports adjust to
the new spot rate. Is this an example of a J-curve effect? Explain to the right of your chart.
Current Account Balance
0
time
As imports/exports adjust over time, the current account deficit will alleviate itself. This is consistent with
“J-curve behavior.”

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