# Midterm 2 Empirical Test Solutions

```EC 1550-S01 International Finance
Spring 2017
Brown University
Department of Economics
MIDTERM 2 - EMPIRICAL
You have 50 MINUTES to finish the exam. Please show all your work in the designated blank pages
provided. Good luck! BOOKS AND NOTES ARE STRICTLY PROHIBITED.
Problem 1 (16 points): To Peg or not to Peg.
Benedikt Johannesson, the finance minister of Iceland, described the status quo of floating exchange rate
for the kroner (ISK) as “untenable” in an interview over the weekend. He is worried that abrupt
fluctuations of the kroner relative to other major currencies will have a negative effect in the robust
recovery of foreign investments and the improvement in the current account. He also said that Iceland is
thinking to peg its currency to one of the major currencies in the world and most probably the EUR.
If the country does decide to peg its currency to the EUR answer the following questions.
Assume that the home country is Iceland
1. What must be true for the interest rates. Explain. [4 points]
2. What type of foreign reserves must the Central bank have to sustain the peg? [4 points]
3. If the country’s trade share with the EUR based countries is only 25%, is the peg to the Euro a good idea?
Why/Why not? [4 points]
4. If the risk premium (ρ) for Iceland’s bonds (domestic assets) increases, how can Iceland’s central bank
defend the peg? Use the assets market graph and briefly explain with words. [4 points]
Problem 2 (18 points): The Big Mac and Balassa-Samuelson
The January 2017, Big Mac index that is calculated by The Economist shows that 1 Big Mac costs 3.09
British Pounds in UK, but it costs EUR 3.88 in Euro area. The nominal exchange rate is E£/€ = 0.85.
Assume that the home country is Euro area.
1. What would be the hypothetical (nominal) euro-pound (E£/€hypoth.) exchange rate that would make PPP
hold? [4 points]
2. Is the Euro over- or under- valued compared to the pound? Explain. [4 points]
3. You are told that in a two-country, two-goods model with tradable and non-tradable goods the real
exchange rate is less than one (q€/£ < 1) if and only if
𝑎∗𝑇
𝑎∗𝑁
<
𝑎𝑇
𝑎𝑁
, where
𝑎∗𝑇
𝑎∗𝑁
,
𝑎𝑇
𝑎𝑁
are the relative
productivities of tradable to non-tradable goods in the foreign country (the UK in this exercise), and the
domestic country (EUR area) respectively.
Compute the real exchange rate q€/£. What must the UK economy do for the real exchange rate to go to to
1? Assume non-tradable goods productivity in UK remains constant. [4 points]
4. If you know that wages are given by: W = PT*αT (assume that the price of tradable goods is determined
from global markets), what do you expect to happen on wages in the UK if the real exchange rate goes to
1. [4 points]
5. Do you think that after Brexit happens from the EU, the scenario above (i.e. real exchange rate increasing
to 1) is more, or less probable and why? [2 points]
1
Problem 3 (6 POINTS). INTERNAL EXTERNALITIES.
You are an economic adviser to the government of China in 2008. The country has a current account
surplus and is facing “gathering” (i.e. increasing) inflationary pressures.
1. Show the location of the Chinese economy on an II-XX diagram (Exchange rate – Domestic spending
diagram). Explain. [2 points]
2. What would be your advice on how the authorities should move the renminbi’s exchange rate? [2 points]
3. What would be your advice about fiscal policy? In that regard, you have three pieces of data: First, the
current account surplus is big, in excess of 9 percent of GDP. Second, China currently provides a rather
low level of government services to its people. Third, China’s government would like to attract workers
from the rural coun- tryside into manufacturing employment, so Chinese officials would prefer to soften
any negative impact of their policy package on urban employment. [2 points]
2
Solutions
Problem 1 (16 points): To Peg or not to Peg.
1. R* = R, as follows from UIP with a fixed exchange rate.
2. European assets, to be able to intervene in the foreign exchange market selling them (decreasing the
money supply) as needed to protect the peg.
3. By pegging to the Euro, the fluctuations between ISK and EUR will be sease, and with them the
fluctuations on trade flows between Iceland and the Euro will be mitigated. However, this will be taking
care only of 25% of the problem (i.e. current account and iip fluctuations). 75% of trade (and financial)
flows is with other currencies, and for that part Iceland will be «inheriting» the fluctuation of the Euro
with the other main currencies (e.g. the USD). If we add to the above the fact that Iceland is giving away
its monetary policy in order to maintain the peg, there seem to be sufficienty good reasons why Iceland
might not want to peg to the Euro after all.
4. The domestic return curve in the assets market diagram is pushed outward. The central bank contracts
money supply, selling foreign (european) assets to maintain the peg (Assumption: direct intervention in
the Forex market).
3
Problem 2 (18 points): The Big Mac and Balassa-Samuelson
1. E£/€hypoth = 3.09/3.88 = 0.7964
2. The euro is over-valued.
Explanation: euro is buying more pounds (0.85) than what PPP would imply (0.7964).
Alternative explanation: at given exchange rate, price of “Euro price of big mac” > “UK price of big
mac”, when expressed in same currency (i.e. European “basket of goods” more expensive compared to
UK goods): 3.88 > 3.09*(1/0.85)
3. q€/£ = 3.09 * (1/0.85) / 3.88 = 0.94 < 1.
UK should increase the productivity of the tradable sector to equalize the relative productivity between
4. From part 3, the real exchange rate will go to 1, if the tradable sector productivity increases. This will
imply a higher wage, as implied by the equation W = PT*αT.
5. (Open ended. Can be discussed in class)
One idea: Brexit à Less trade between EU-UK à Less innovative products flowing from rest of Europe
to the UK à Lower tradable productivity in UK (𝑎∗𝑇 ) à Further decrease in q£/€
Problem 3 (6 POINTS). INTERNAL EXTERNALITIES.
1. We know that China has a large current-account surplus, placing them high above the XX line. They also
have moderate inflationary pressures (described as “gathering” in the question, implying they are not yet
very strong). This suggests that China is above the II line but not too far above it. It would be placed in
zone 1 (see below).
2. China needs to appreciate the exchange rate to move down on the graph toward the balance. (Shown on
the graph with the dashed line down.)
3. China would need to expand government spending to move to the right and hit the overall balance point.
Such a policy would help cushion the negative aggregate demand pressure that the appreciation might
generate.
4
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