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Economics 103 Spring 2006 International Monetary Relations

Second Midterm Exam

May 23, 2006

Time: Total score:

70 minutes 70 points

Internal and External Balance with a Currency Board: 10 minutes

Hong Kong has a currency board that credibly xes its exchange rate to the U.S. dollar and does not deviate. Suppose there is a temporary drop in Hong Kongs real income. What is the immediate response in Hong Kongs domestic money market? State in one sentence what action the currency board takes. What is the expected depreciation rate? Use a diagram showing the nominal exchange rate and output to analyze the output eect of the currency boards intervention. How does the output eect compare to a oating exchange rate regime? In your diagram, depict the current account target schedule and suppose the target was met before Hong Kongs drop in real income. Does the monetary intervention by the currency board bring the currant account balance closer to target than a oating exchange rate regime?

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Internal and External Balance under the Gold Standard: 10 minutes

A country under the gold standard suers a temporary drop in consumption and investment because economic prospects make residents and companies reluctant to spend. Suppose prices are completely exible, even in the short term, whereas the nominal exchange rate is xed by gold parity. Also suppose that the long-term output level is consistent with the countrys long-term target level of the current account of zero. Finally, suppose the central bank does not play by the rules of the game and waits until markets adjust and absorb the shock through changes in the domestic price level. Use a diagram showing the nominal exchange rate and output to derive answers to the following questions. Does the current account balance rise above or fall below target immediately after the autonomous drop in consumption and investment? Depict the new position of the DD curve immediately after the temporary drop in consumption and investment. Under the price-specie-ow mechanism, what does the new current account balance imply for gold ows from or to the home country? What is the implied change to the domestic price level? What does less domestic output and income for a given quantity of gold (money) in circulation imply for changes to the domestic price level? [Hint: Your answer does not change from the previous one.] What does the change in the price level imply for the directions of the shifts in the AA, DD and XX schedules? Suppose the price-specie-ow mechanism successfully restores external balance and depict a consistent new equilibrium level of output. [Hint: All three curves change positions.]

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Escaping a Liquidity Trap: 10 minutes

State the Uncovered Interest Parity condition and suppose the home country is in a liquidity trap with R = 0. Show that, in a liquidity trap, the upper bound on the nominal exchange rate E is a function of exchange rate expectations and the foreign interest rate. Explain why a domestic monetary expansion is ineective in a liquidity trap unless it credibly changes exchange rate expectations. Use a diagram showing the nominal exchange rate and output to explain how pegging the exchange rate to a foreign currency basket, combined with a devaluation, might allow a country to escape the liquidity trap.

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Current-account Responses in Large Economies: 10 minutes

U.S. residents and companies spend a smaller fraction of national income on imports than residents and companies in smaller countries do. As a consequence, the U.S. import volume is less responsive to real exchange rate movements than in smaller countries. Does this imply that the DD-curve for the U.S. commodity market is atter or steeper than the DD-curve for a smaller country? Provide an explanation and depict your answer in a nominal exchange rate-output diagram. [Hint: You may provide a verbal explanation or derive the slope of the DD-curve, in comparison to a small country, using a Keynesian cross.] Would a temporary monetary expansion in the U.S. have a stronger or weaker eect on output than the same policy change in a small country? Why?

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Sterilized Forward-market Intervention: 10 minutes

The central bank enters contracts to buy foreign currency at the forward exchange rate F (selling domestic currency) in three months from today, and publicly announces its new forward position. You are asked to show that this is a successful sterilized intervention under a oating exchange rate. Suppose the initial forward exchange rate is the same as the current spot exchange rate F = E. How does F change with the central banks intervention? Use the Covered Interest Parity condition to show how the forward premium changes, all else equal. Exchange rate expectations E e for three months from today are rational. Use the Uncovered Interest Parity condition to show how the expected depreciation rate changes, all else equal. If there is no commodity market eect of the monetary intervention, how does the nominal interest rate change? Use a diagram showing the nominal exchange rate and output to derive the output response of the sterilized intervention. Does the nominal exchange rate change as much, less, or more than in the absence of a commodity market response? How does the nominal interest rate change?

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Facts and Fallacies: 10 minutes

If a countrys tradeable goods sector grows more productive at a faster rate than its nontraded goods sector, the countrys real exchange rate appreciates irrespective of productivity change among its trading partners. A failure of the Law of One Price implies a failure of Relative PPP. The Marshall-Lerner condition holds i the value eect dominates the volume eect.

State whether the following statements are true or false. Provide a brief explanation.

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Empirics of Purchasing Power Parity: 10 minutes

Below is a plot of the ARG/USD (australes-dollar) nominal exchange rate and the ratio of the Argentine and the U.S. CPI for January 1960 to March 2006. Does absolute or relative PPP hold during the 1960s? Why? Does absolute or relative PPP hold during the inationary period of 1975-1983? Why? Give two reasons why PPP can break down.