HE206

NANYANG TECHNOLOGICAL UNIVERSITY

SEMESTER 2 EXAMINATION 2007-2008


HE206 International Monetary Economics


April/May 2008 Time Allowed: 2 hours

INSTRUCTIONS

1 This paper contains SIX(6) questions and comprises FOUR(4) pages.

2 Answer FOUR(4) questions only:-
Section A - any THREE(3) questions
Section B - any ONE(1) question

3 The number of marks allocated is shown at the end of each question.

4 Begin your answer to each question on a separate page of the answer book.

5 Answers will be graded for content and appropriate presentation.


SECTION A

Answer any THREE(3) questions from this section.

Question 1

Consider a small open economy with free capital mobility that is best described by the
following DDAA framework, where the AA curve represents asset market equilibrium and
the DD curve represents goods market equilibrium. Suppose the economys export also
depends positively on world output (Y
*
) so that the DD curve for the goods market is also a
function of Y
*
as shown:

AA curve: M/P =L (R
*
+E
e
/E-1, Y) with L
1
<0 and L
2
>0
DD curve: Y =Y (EP
*
/P, A
0
, Y
*
) with Y
1
>0, Y
2
>0 and Y
3
>0

where M is domestic money supply, P is domestic price level, R
*
is foreign interest rate, E
is the exchange rate (i.e., domestic currency per unit of foreign currency), E
e
the expected
value of E, Y is domestic output, L(.) is the domestic real money demand function, L
1
and L
2

are the first and second derivatives of the L(.) function, P
*
is foreign price level, A
0
is the
term containing all autonomous expenditures, Y(.) is a function related to aggregate demand,
and Y
1
, Y
2
and Y
3
are the first, second and third derivatives of the Y(.) function.

Note: Question No. 1 continues on page 2
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HE206

Question 1 (continued)


(a) Suppose there is a temporary reduction in world output due to, say, a global recession.

(i) What will happen to the output of this economy if she is adopting a flexible
exchange rate system?
(5 marks)

(ii) What will happen to the output of this economy if she is adopting a fixed
exchange rate system?
(6 marks)

(iii) Which exchange rate system provided a better insulation against the
fluctuation in world output demand?
(2 marks)

(b) Now suppose there is a temporary rise in domestic real money demand. Use the DD
and AA curves to show which exchange rate system would better insulate the
domestic output against the fluctuation in domestic real money demand?
(12 marks)

(TOTAL: 25 marks)




Question 2

(a) Consider a small open economy that is best described by the DDAA framework
discussed in the textbook or question 1 above. Suppose the economy is adopting a
flexible exchange rate system, and there is a permanent once-and-for-all rise in
domestic real money demand. Discuss the short run and long run effects of this rise in
money demand on domestic exchange rate, output, price and interest rate? [Hint: For
the effects on interest rate, your may also need to use the diagrams on the money
market and the foreign exchange market.]
(17 marks)


(b) Briefly explain the concept of exchange rate pass through. What assumption has the
above DD-AA framework made on the exchange rate pass through? What will happen
to the short run output if this assumption is relaxed?
(8 marks)

(TOTAL: 25 marks)


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HE206

Question 3

(a) Consider an economy that is best described by the Swan Diagram. Suppose the
economy is adopting a fixed exchange rate system, and is experiencing a severe
current account deficit and a moderate recession.

(i) What will happen to her internal balance if her government tightens the fiscal
policy until the current account deficit disappears?
(6 marks)

(ii) Would the government be able to use just devaluation to achieve both internal
and external balance? Explain.
(7 marks)

(b) Consider an Asian economy adopting a fixed exchange rate system amid the Asian
exchange rate crisis in 1997-98. Use diagram(s) to explain why market participants
worry of a devaluation of the currency could itself cause a collapse of the fixed
exchange rate system. Even if the economy managed to keep the fixed exchange rate
such as the case of Hong Kong, what will happen to her interest rate? Is this outcome
necessarily better than those economies with a collapse in their exchange rate?
(12 marks)

(TOTAL: 25 marks)




Question 4

(a) Do you think the Monetary Authority of Singapore is able to influence the current
nominal effective exchange rate of Singapore? Explain. How would this be affected
by Singapores ageing population twenty to thirty years from now? What policies
could change the outcome?
(9 marks)

(b) What is the difference between a monitoring band system and a crawling band
system? Use Singapores experience during the Asian Financial Crisis to highlight the
importance of the difference.
(8 marks)

(c) List three major differences between Singapores monitoring band system and
Williamsons monitoring band system. Which difference could lead to very different
result during extreme adversity such as the Asian Financial Crisis in 1997-98 or the
severe recession in 1985-86.
(8 marks)

(TOTAL: 25 marks)

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HE206

SECTION B

Answer any ONE(1) question from this section.

Question 5

Is the European Union an Optimum Currency Area? What are the challenges that EU faces
and what is its future? Do you think that East Asia satisfies the OCA criteria?

(TOTAL: 25 marks)




Question 6

Although to some extent it fits both the Generation 1 and Generation 2 types of financial
crisis, the Asian financial crisis was essentially a Generation 3 type of crisis. Discuss. Also
explain some of the policy mistakes made by the IMF in managing the Asian Financial
Crisis.


(TOTAL: 25 marks)


- END OF PAPER -
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