Student Name ________________________________________
International Finance 423
Spring 2012- Midterm Test II
Instructions
There are 4 sections on this test. You are required to answer 4 questions in total, a
maximum of one question from each section. In sections where you have a choice of
questions, you are required to circle the question you are answering. Marks for each
section are in parentheses.
SECTION I: True, False, Uncertain. Explain.
Answer only one questions (5)
Explain why the following statement is True, False, or Uncertain based on economic theories.
Answers that lack any explanation will not receive any points.
Q.1
In an open economy DD-AA model, with flexible exchange rates, a permanent increase in domestic
government purchases leads to an increase in domestic equilibrium interest rate and output, and
results in an appreciation of domestic currency against foreign currency in the short run.
[Diagrams required]
False: A permanent increase in G, shifts DD curve to the right but because this increase
is permanent, exchange rate expectations causes a sharper currency appreciation
which shifts the AA curve downward. The short-run intersection of both curves is at the
point where E has appreciated but output and interest rates remains the same
Figure 16
Q.2
Both the temporary and permanent expansionary fiscal policy under flexible exchange rates
lowers the current account balance. [Diagrams required]
True
Both the temporary and permanent expansionary fiscal policy leads to a fall in the
current account balance. Increase in G or decrease in T, leads to an appreciation of the
currency which leads to deterioration of the CA
See Figure 17
Q.3
Devaluation must be accompanied by the sale of domestic assets by the central bank. [Diagrams
required]
False. Must be accompanied by the purchase of foreign assets.
See pages 472-473 and Figure 17-4 of Krugman’s text (8th ed.) for an explanation
SECTION IIShorter Answers (8 points)
ANSWER ONLY ONE QUESTION: Circle the question you are answering.
Q.1
If the central bank does not purchase foreign assets when output increases but instead holds the
money constant, can it still keep the exchange rate fixed at Eo? Explain with the aid of a diagram.
No, the rise in output leads to an excess demand for money. If the central bank does not increase
supply to meet this demand, the domestic interest rate would rise above the foreign rate, R*. This
higher rate of return (and given expectations in the foreign exchange market) would cause the
exchange rate to fall below Eo
Q.2
Imagine the economy is at a point on the AA-DD diagram which is below both the DD schedule and
the AA schedule operating at a level below the equilibrium output. Explain what will happen next
under flexible exchange rates to return the economy to equilibrium. Show on a diagram and tell
your story
If the economy has an exchange rate and output combination which is below the DD
schedule, then the country’s output market in not in equilibrium; in particular there is
excess supply in the output market. If the economy has an exchange rate and output
combination which is below the AA schedule, then the country’s asset market is not in
equilibrium; in particular, the exchange rate is “too low” so the returns on the foreign
asset are above the returns on the home asset and there is excess supply of the
domestic currency in the foreign exchange market. The excess supply of the domestic
currency leads to an immediate depreciation of the home currency and, thus, a rise in
the nominal exchange rate. This serves to equalize the expected returns on the home
and foreign assets and moves the economy vertically to the AA curve. (From A to A’)
If the economy began at a level of output below the equilibrium level of output, (point A
in Figure B1) then the output market is still out of equilibrium but is characterized by
excess demand. Firms then increase production, and this increases the demand for real
balances, raises the interest rate, and lowers the nominal exchange rate. This is
depicted in Figure B1 as a movement from point A’ to E along the AA curve
Q.3
Suppose your country’s central bank wants to decrease the value of the Japanese yen against your
currency. How might your central bank intervene in the foreign exchange market to accomplish
this? If your central bank wants to leave your country’s money supply unchanged by the foreign
exchange market intervention, how will it conduct this intervention?
Sell Japanese assets. Sterilized intervention, buy domestic assets.
SECTION III (12) FINANCIAL CRISES IN HISTORY
You are required to answer this question
For wary Argentines, the crops were the cash in the early 2000s due to the collapse of the peso.
Explain this sentence in the context of the Argentina peso crisis and Leslie Moore’s article on the
issue. Make sure to detail the causes, effects, contagion, winners and losers during this period and
how the crisis was dealt with
SECTION IV (20) ANALYTICAL QUESTION
You are required to answer this question.
Consider the model of output and exchange rate determination (the AA-DD-XX model) we have
studied in class. Suppose the economy begins at a short run equilibrium point where exchange
rate is at a level E0 and Output equal Y0.
Compare and contrast the short-run effects of the temporary policies (listed below) by the home
government on home output, the home current account, and the nominal exchange rate under a
floating exchange rate regime to the effects on these variables under a fixed exchange rate regime.
(Clearly explain and show the effects on two different graphs, one for flexible rates and the
other for fixed rates under each temporary policy)
i.
a decrease in money supply
A decrease in the home money supply leads to excess demand in the money market
and a rise in the home interest rate to clear the home money market. This increases the
return on home assets and leads to a decrease in the nominal exchange rate to satisfy
UIRP (uncovered interest rate parity condition). This is depicted as a leftward shift in AA
curve from AA to AA’.
Under floating rates, the decrease in the nominal exchange rate leads to a decrease in
the real exchange rate which causes a decrease in the current account. This is depicted
with the original equilibrium at 1 and the new equilibrium at 2, which lies below the XX
curve.
Under fixed rates, the home central bank cannot allow the nominal exchange rate to fall.
So, they must reverse the decrease in the money supply through an expansion of the
money supply. Thus, the exchange rate does not change, nor does the current account,
nor does output. This is shown in Figure B1 where the new equilibrium is the same as
the original equilibrium.
In comparing the effects under the two exchange rate regimes, we see that under
floating rates an decrease in the home money supply is effective in decreasing all three
variables while it has no effect on any variables under fixed rates.
ii.
an increase in taxes
An increase in the home taxes decreases the home disposable income which lowers
home demand for home goods and lower home demand for foreign goods. The first
effect decreases home aggregate demand but the second effect (which increases the
current account) increases home aggregate demand. In the model, we assume the first
effect dominates. So, a decrease in taxes lowers aggregate demand and the DD curve
shifts to the left. The fall in aggregate demand leads to a decrease in output, a decrease
in the demand for real balances, a decrease in the home interest rate, and a rise in the
nominal exchange rate.
Under floating rates, the rise in the nominal exchange rate leads to a rise in the real
exchange rate which increases the current account. Overall, output decreases because
the decrease in output due to the fall in aggregate demand is larger than the rise in
output due to the higher current account. This is depicted with the original equilibrium
at 1 and the new equilibrium at 2, which lies above the XX curve.
Under fixed rates, the central bank must contract the home money supply to prevent the
exchange rate from rising. This is depicted as a shift in the AA curve to the right to AA’
decreasing output even further. Output decreases because of the fall in aggregate
demand and the reduction of money supply. The current
account rises because of two reasons: 1) the fall in imports induced by the fall in
disposable income and 2) the fall in imports induced by the fall in equilibrium
output. This is depicted on the point which lies above the XX curve.
So comparing we see that the nominal exchange rate rise under floating rates but not
under fixed rates. Output decreases by less under floating than under fixed rates. The
current account increases both under floating and fixed rates.