Final Examination
International Finance – ECON 4740
Fall 2005, A. Alexander
 Provide your answers to the following in your Blue Book.
 Make certain that you answer every part of each question. There are 150 total points
possible on this exam.
 You have 2 hours to complete this exam.
 Suggested time allocation –10-15 minutes on questions 1; around 20 minutes on
question 2, and 20-25 minutes each on questions 3, 4, and 5.
1. Answer concisely each of the following questions. (20 points)
(a) Russia has attracted a great deal of Foreign Direct Investment (FDI) in the past
decade. Making specific reference to what developing countries especially need
to do to facilitate and attract FDI, to what can we attribute the boost in FDI to
Russia?
7 points
They should to make reference to fall of communism here. If they do
that, they get +2. If they obviously have no idea why Russia may be in
this position, give them +1.
They should also allude to some of the following and hopefully point
out that Russia has done some of them:
i.
Developed a policy framework for FDI
ii.
Developed a strong economic framework
iii. Developed a range of business facilitation measures
iv.
Has strengthened national innovation systems
v.
Has encouraged spread of technology
vi.
Has so far ensured private property rights
If cite 2 or more of these, or other good solid thing that Russia may
have done to facilitate FDI not listed, +5
If cite only one, or have other reason not terribly well thought-out +34
If struggling, +1-2
(b) Recently, Russian President Vladimir Putin has moved to consolidate power to his
office, yielding fears in the international community that Russia is moving toward
a more authoritarian government. Explain what the likely effect on FDI of this
movement might be on Russia.
5 points
Here, I am looking for them to explain that this might signal political
instability, a threat to property rights, or something to this effect. If
they get that across somehow, give +3. If they don’t convey that, give
half credit.
They also need to explain likely effect is that FDI will flow out/capital
flight. If they convey that, +2. If they don’t say it, they get no credit.
(c) Advise President Putin on steps he can take to avoid any detrimental effects on
FDI from his recent actions consolidating his power. Be specific in your advice.
8 points
President Putin needs to signal that private property rights will be
respected no matter how much he concentrates power. He should also
convey that there will be political stability as well as economic
stability.
If they give an answer that yields solid advice to Putin (like above, or
something creative that’s valid), +8
If not, but gave a good yet shaky try, +5-7
If just making it up, +1-4
2. Consider a country with a small, open economy. International financial markets are
characterized by perfect asset substitutability. (25 points)
(a) Suppose the economy is under a flexible exchange rate regime. Say that
we observe an increase in the foreign inflation rate. Using language that
someone with limited background in international finance would
understand, explain the reaction of the exchange rate (remember, this is
the domestic price of foreign currency; and don’t forget to assume that
FER will not change).
6 points
Here, all they need to say is something to the effect of:
With an increase in the foreign inflation rate, and assuming the lawof-one-price or purchasing power parity, the exchange rate (domestic
price of foreign currency) will fall OR your domestic currency
appreciates.
If they get it right, +6.
If they get things backwards but gave it a good effort, +4.
If they get impacts backwards and did so because they were not
paying attention to fact this is opposite case from what we talked
about in class, +3
If they are clearly not getting it or making it up, +2
(b) Suppose now that this government wants to reduce the impact of the
situation in part (a) by intervening in the foreign currency market – say
they feel the change in the exchange rate is too large. What could the
government do? What impact would this have on the country’s money
supply?
6 points
What to do - If the gov’t does not want its currency to appreciate, it
needs to intervene to reduce it. It could pursue any action that will
reduce the demand for its own currency OR increase the supply of its
own currency OR increase demand for the foreign currency OR
reduce the supply of the foreign currency. However they say the gov’t
goes about this is fine as long as they explain how that action stops the
domestic currency from appreciating.
Effect on money supply – country’s money supply will rise as a result
of above action, whatever it might be.
If they discuss each point I asked for and convey a general strong
understanding in easily-understood language, give full credit +6.
If they are consistent in error from above, but answer correctly given
their error, +5.
If they get things backwards but gave it a good effort, +3-4.
If they get impacts backwards and did so because they were not
paying attention to fact this is opposite case from what we talked
about in class, +3
If they are clearly not getting it or making it up, +2
(c) Suppose the government wishes to sterilize the impact of its actions in part
(b). What would it aim to do? How would it do this, say, using bonds?
How effective will this action be?
6 points
Since money supply has risen, sterilizing implies that gov’t will reduce
money supply somehow. It could sell bonds, or could say gov’t
performs some money market activities (eg open market operations to
influence discount rate) that reduces money supply
In this context, the action will be effective. Since the source of the
need to sterilize was not money market disequilibrium, no offsetting
changes will happen in response to the sterilization.
If they discuss each point I asked for and convey a general strong
understanding in easily-understood language, give full credit +6.
If they are consistent in error from above, but answer correctly given
their error, +5.
If they get things backwards but gave it a good effort, +3-4.
If they get impacts backwards and did so because they were not
paying attention to fact this is opposite case from what we talked
about in class, +3
If they are clearly not getting it or making it up, +2
(d) Explain in easily understood terms why the situation you describe in parts
(a) – (c) would be different if the economy had a fixed exchange rate –
that is, describe how the MAER in (a) – (c) differs in its outcomes from
the MABP (the fixed exchange rate model)
7 points
Main difference – mechanism is change in FER rather than exchange
rates. Thus, diseq’m could be persistent, since source is money
market disequilibrium that will continue so long as growth in money
demand and money supply are different.
Sterilization will not be effective because of this.
If summarize simply the differences, full credit
If struggle, half credit.
3. Discuss, in easily understood terms, the following: (35 points)
(a) For any given economy, what are the signs of vulnerability to a financial
crisis?
10 points





Export growth deceleration
Overvalued currency
Current account deficit
CA deficit financed heavily with short term debt.
Weak financial institutions
(b) When a currency is attacked, what are the most common defenses a
government might pursue? What is the goal of these defenses?
5 points
Increase in interest rate to try an convince investors to stay
Increase in monetary base to offset capital flight
Goal – to try and calm capital flight.
(c) Countries with liberalized capital accounts are all prone to financial crisis.
Does this mean that we should all just reinstate all of our capital controls
globally? If not, why not? What are the policy implications for capital
account liberalization, given that we continue with it, that we can learn
from financial crises (use the Asian financial crisis to illustrate.)
20 points
Policy implications - should address each of the following – do not
need to elaborate a great deal, but should indicate that each must be
addressed.
 Capital account liberalization is a bad idea if a country has
o thin markets (ie very few participants),
o nontransparent financial institutions (risk-taking will be
unacceptably high when financial decision-making process
not transparent), and
o low technical capacity (eg inability to enforce financial
regulations.)
If these conditions exist, capital account liberalization will lead
to a crisis – financial risk-taking will be unacceptably high.
 Sequencing of liberalization is extremely important. All types of
investment should not be liberalized at once. The timing should
be:
o First, domestic financial markets should be liberalized
o Foreign direct investment should be liberalized next (may
say not as unstable, very locally beneficial, does not rely on
local banking system and crowd out home country lending)
o Stock and bond markets should come next (may say
generates local equity)
o Finally, liberalize access to offshore bank borrowing.
If cover both points fully, +25 points
If leave out one or two subpoints on each point, +20 – 23.
If do not cover one of the two main points, +10-15.
4. Discuss the current U.S. external imbalance, giving special attention the differences
we see between the 1990’s and the present in structure of the U.S.’s current account
deficit and how it is financed. Are there implications from this situation for the U.S.
in the long term? (30 points)
Discussion = 15 points total
Discussion - Should convey somehow that
 Current account deficit is much bigger in raw dollars (eg , -$136
billion in 1997 versus -$688 billion in 2004) and also in other
measures (net debt asa % of GDP in 1997 was 5%, and now is
around 25%.; Net int’l investment position was -$360 billion in
1997, and is now -$2.5 trillion). Don’t need to use numbers – these
are just examples
 Structure is different in that in 1990’s, the US had high public
savings, a net savings rate of 3-4%, and strong private investment;
now, US has public dissavings borrowed abroad, a net savings
rate of around 1%, and weak private investment.
 Now, debt is owed primarily to East Asian central banks, who
have used these dollar reserves they’ve accumulated to keep their
currencies pegged/managed.
Cover all points – full credit
Cover most points, +9-12.
Do not cover sufficiently to convey they understand major differences
between now, 1990’s, +5-8.
Implications = 15 points total
Implications - Here, I’m looking for a strong argument – no specific
answer or magic words, but an answer that shows that they’ve
synthesized the important concepts in this area. They can discuss it
however they wish – as long as it shows they’re applying what they
learned!
If they do that, then give full credit.
If they make a half-hearted attempt to do that, +8 points.
5. You have been nominated to replace the Deputy Secretary of Treasury. Both the
current Federal Reserve Chairman Alan Greenspan and your boss Treasury Secretary
John Snow have indicated that depreciating the dollar might reduce our balance of
payments imbalances. You have been asked to provide a briefing to President Bush
discussing the sustainability of this situation. You are free to disagree with Secretary
Snow and Chairman Greenspan.
Write a briefing for the president, using concise and easily-understood language, on
the impacts that depreciating the dollar could have on the BoP situation. In your
briefing, include reference to the importance of (1) the types of goods the U.S.
exports and imports, (2) elasticities of demand for U.S. exports, (3) domestic U.S.
demand for imports, (4) and how elasticity of those demands impacts BoP for a
depreciating currency, (5) the structure of how our current account deficit is financed,
and (6) the sustainability of our external debt and current account deficit situation..
(40 points)
This is a fairly open question. They need to make correct technical
arguments, be
persuasive, and explain why depreciation of the dollar would not actually
help the
BoP situation. They need to elucidate and answer each part of the questions
completely. If they leave out (1), -5 points. If they leave out (2), (3), (4), (5),
or (6), -7 points.
Some notes:
The demand for dollars derives from foreign demand for US exports.
Thus, the elasticity of demand for dollars is determined by the
elasticity of foreign demand for US exports. Determinants of
elasticity of demand for US exports are:
- Type of good – elasticity for manufacturing and luxury goods
tends to be high; demand for agricultural and primary goods
tends to be less elastic.
-
Share of country’s exports in world trade - If a country’s exports
are relatively small relative to the rest of the world, elasticity is
higher because there are many substitutes available.
-
Trade controls – tariffs, quotas, cartels, and other trade
restrictions reduce free trade, and thus reduce elasticity because
role of price in buying decision is reduced.
They may also mention time as a factor – people may adjust more
to changes in prices in the long run, so as time horizon gets longer,
elasticity rises. However, its’ not necessary for them to talk about
time here.
-
The supply of dollars derives from domestic demand for foreign
imports. Thus, the elasticity of supply of dollars is determined by the
elasticity of domestic demand for foreign imports into the US.
Determinants of elasticity of demand for foreign imports are:
- Type of good – elasticity for consumer and luxury goods, as well as
expensive capital goods, tends to be high; demand for agricultural,
intermediate goods, and raw materials tends to be less elastic.
-
Domestic substitutes - If a there are lots of domestic substitutes
available for the import good, elasticity tends to be high..
-
They may mention again trade controls – tariffs, quotas, cartels,
and other trade restrictions reduce free trade, and thus reduce
elasticity because role of price in buying decision is reduced. It is
NOT necessary to cite this one, but if they do, give an extra point!
-
They may also mention time as a factor – people may adjust more
to changes in prices in the long run, so as time horizon gets longer,
elasticity rises. However, its’ not necessary for them to talk about
this, and again, give an extra point.
On the interaction of these two things, need to convey:
-
When foreign demand for US exports is elastic, depreciation of
dollar will stimulate an expansion of exports. The more important
thing is that because a 1% fall in price of US exports overseas (say
depreciate 1%) causes a larger than 1% increase in demand, total
receipts of foreign exchange will rise. Thus, BOP deficit may fall.
-
If foreign demand for US exports is inelastic, you can expand
exports by devaluing dollar (because by law of demand,
depreciation = price of US exports falls = exports rise). BUT
because the response is small to a price change, the price reduction
is not offset by the rise in imports so total receipts of foreign
exchange fall. Thus, BOP deficit will likely actually worsen.
-
If US demand for foreign imports is elastic, a depreciation of t he
dollar will cause import demand to fall disproportionately (1%
rise in price of foreign goods due to 1% depreciation of dollar =
greater than 1% reduction in import demand). Thus, BOP deficit
will fall because imports are reduced.
-
If US demand for foreign imports is inelastic, the response in
imports to a rise in import prices will be fairly small. Thus, the
BOP deficit may worsen or not change at all.
Any way they hit those points is fine. The main thing they need to do
is hit and argue one of these cases in their advice to the president –
elastic and inelastic US export demand, elastic and inelastic US
import demand.
Structure of CA deficit – again, mostly owed to East Asian central
banks in a very mutually beneficial setup at the moment
Sustainability – need to talk about confidence/trust angle as well as
economic factors that could drive a financial crisis.
Happy Holidays – enjoy your break and hope to see you
in the new year!