Econ 457, Spring 2015
Exam III, April 9, 2015
Name:
UID:
Questions 1 – 18 are each worth 4 points.
1. There is a limit to a nation's ability to use international financial markets to supplement
domestic consumption or investment. Why?
A) Lenders like a diversified group of borrowers.
B) International lenders require collateral.
C) Communication is difficult because of language and differences in legal systems.
D) At some point, a nation will not be able to service the rising level of external
debt.
2. The United States has experienced a favorable situation in world financial markets.
What is it?
A) The United States has huge net external wealth and is able to control many foreign
corporations, banks, and governments as a result.
B) Even though the United States has huge net external debt, it has benefited
from a 1.5% gain in interest differential and an additional 2% capital gain on
its net debt/wealth.
C) Other nations deposit their funds in U.S. banks, making them available for U.S.
borrowers.
D) Politically the United States is very powerful, and most international financial
organizations want good relationships, making financial dealings more favorable to
the United States.
3. Low-income nations with poor credit ratings are often dependent on commodity sales as
a major portion of income. To insure against the effects of a fall in the prices of
commodities, the nation could:
A) borrow internationally.
B) save as a precaution and purchase sovereign wealth funds with that money.
C) ask for debt reduction and forgiveness.
D) enter into a cartel to boost the prices of commodities.
Page 1
4. Investment will occur in an open economy more often than in a closed economy
because:
A) investment decisions have fewer constraints because investors and borrowers
will compare the marginal product of capital in any nation with the world real
interest rate.
B) without information, investors often make poor investment decisions.
C) governments like to subsidize overseas investment for domestic firms.
D) international financial organizations prefer to lend for international investments
rather than domestic ones.
5. If the productivity of capital in low-income nations is substantially lower than
productivity in high-income nations, then:
A) output per worker will never catch up to the rich nations, even with access to
capital markets.
B) productivity of capital can be improved by better training of workers and more
foreign investment.
C) output per worker will grow more slowly, but at some point there will be
convergence.
D) the low-income nations will lose their ability to borrow in international markets.
6. Two nations each own 50% of the capital of the other nation (diversification). What is
the situation when labor comprises over 50% of available resources?
A) In order to achieve perfect diversification, labor must move from one nation to the
other.
B) No gain will occur from the diversification.
C) The risk from economic shock will be eliminated by the diversification of assets.
D) Some risk from economic shocks can be eliminated, but not all.
7. When the real exchange rate decreases in the United States, then there is a(n) ______ in
U.S. demand for U.S. goods and a(n) _________ in U.S. demand for Mexican goods.
A) decrease; increase
B) increase; decrease
C) increase; increase
D) decrease; decrease
8. The larger the percentage of U.S. imports already priced in dollars, the less likely
depreciation in the U.S. dollar will be to:
A) decrease prices of imports.
B) increase prices of imports.
C) limit trade imbalances.
D) increase trade with third-party nations.
Page 2
9. The J-curve effect means that import prices are higher, thus revenues paid out increase
while export prices are lower and incoming revenues decrease. Therefore, after a
currency depreciation:
A) the trade balance will improve, then decline, then improve, and then decline,
appearing to be a series of J shapes.
B) the trade balance will increase, then decrease, then jump higher, which economists
call the J-curve effect.
C) the nation will cut back on imports immediately causing the trade balance to
improve, which gives the curve an inverted J shape.
D) the trade balance decreases and then increases over time giving the curve a J
shape.
10. At some rate of interest, i, domestic demand is equal to output, and at some exchange
rate, the domestic return is equivalent to the foreign return. This must be one point on:
A) the IS curve.
B) the aggregate expenditure line.
C) the supply curve.
D) the LM curve.
11. If the United States cuts its government budget deficit, what impact would there be on
the IS curve?
A) It would shift right due to higher levels of total spending.
B) It would shift left due to lower levels of total spending.
C) It would shift left because of lower levels of total spending, and it would shift
right if U.S. interest rates decline due to lower borrowing.
D) It would shift left because of higher nominal and real interest rates due to increased
borrowing.
12. A set of combinations of nominal interest rates and GDP, for which the demand for
money is equal to the supply of money, is:
A) the IS curve.
B) the aggregate expenditure line.
C) the supply curve.
D) the LM curve.
13. When exchange rates are fixed, a temporary expansion in the money supply will:
A) Will have to be accompanied by an decrease in government spending to keep a
constant output
B) Have to be reversed by an equal monetary contraction.
C) lower output.
D) increase the exchange rate.
Page 3
14. In the wake of the world financial crisis in 2008, the Polish economy withstood the
economic impact by:
A) decreasing the money supply and increasing government spending.
B) increasing the taxes.
C) Increasing government spending as well as the money supply.
D) appreciating its currency.
15. If a nation experiences an exchange rate appreciation, what happens to the value of its
external wealth?
A) It decreases.
B) It depends on the currency composition of its assets and liabilities.
C) It increases.
D) It depends on the size of its assets compared to the size of its liabilities.
16.
A)
B)
C)
D)
If a nation's yearly trade balance exactly offsets the interest due on its net external wealth, what is
the effect on its net external wealth?
It remains the same.
It explodes.
It declines at first and then rises dramatically.
It rises gradually because of interest compounding.
17. The Economist article “Mighty dollar” argues that
A) Firms in emerging markets, particularly China, Brazil, Russia and Turkey have large
dollar denominated debt whereas their earnings are mostly in local currency
B) Dollar has further gained its dominant currency status after US began airstrikes
against ISIS
C) Dollar has further gained its dominant currency status after US began negotiations
with Iran for a long-term nuclear energy treaty
D ) Firms in emerging markets, particularly China, Brazil, Russia and Turkey have
large dollar denominated debt but their earnings are also in dollars, so there is no
liability mismatch.
18. The New York Times report “Bargain hunting with a strong dollar in Europe…”
argues that
A) All products in Europe have become cheaper with euro depreciations
B) All products in Europe have actually become more expensive in Europe because
with the large influx of American shoppers, European firms have increased their
prices
C) There is no effect on US-Europe real exchange rates due to dollar appreciation
D) It is only few products for which there are good bargains, whereas for others
products their effective dollar prices have hardly changed
Page 4
19. Suppose that the dollar real exchange rate falls by 10% against the euro, 20% against the
pound, and 25% against the yen. If the United States trades equally with each country,
what is the percentage decline in the real effective exchange rate? [4 points]
Ans: (0.1+0.2+0.25)/3 = 0.55/3 = 18.3%
20. Using the IS-LM framework, discuss the effects of an increase in government spending by a
country (a) under a flexible exchange rate system, and (b) under a fixed exchange rate system. (8
points)
In the flexible case, the IS shifts to the right raising output as well as equilibrium interest
rates. Under the fixed exchange rate, to keep the interest rate the same, a shift in LM to the
right would be required by increasing money supply, which will bring the interest rate
down to its previous level. However, the output will rise even further.
21. An open economy’s output is expected to be 100 units forever and it can borrow and lend
freely from the rest of the world at an interest rate 10%. Assume that the initial wealth is zero
and there are no unilateral transfers. An investment opportunity for this economy arises whereby
an investment of 45 units in the first period (i.e., t = 0) will increase its output by 10 units forever
thereafter (i.e., from t = 1 onwards). However, in t = 0 the output will remain at 100. Shall the
economy borrow and undertake this investment? If the economy always chooses a smooth
consumption, what will be the consumption level that it will choose? What will be the trade
balance in period 0? What will be the wealth level at the end of period 0? (12 points)
Answer: The present value of increase in output is 10/0.1 = 100 and the investment is only 45.
There is net positive worth of 55 in this investment. Undertake it. Consumption is calculated
using
(1 + 1/0.1) C = PV(Q) – I = 100 + 110/0.1 – 45 = 1155.
Thus 11 C = 1155, C = 105.
TB0 = 100 – 105 – 45 = - 50.
W0 = 0 – 50 = -50.
Page 5
22. Consider two symmetric (equal-sized) economies, Home and Foreign, in which households
earn income from their capital holdings (shares in the firms), that is capital share of income is
100%. There are two states of the world G and B. In state G, Home’s output is 110 whereas
Foreign’s output is 90. In state B, Home gets 90 while Foreign has 110. Both states, G and B, are
equally likely, i.e., their probabilities are 50% every period. How can the residents of both
countries make sure that their incomes are completely insured, i.e., it remains constant
irrespective of the state of the world? Show your work. (6 points)
Having 50% each of the two shares will ensure that in both good and bad states the income
of Home and Foreign households remains 110*0.5+90*0.5 = 100. There is no variation of
income.
23. Suppose every quarter US exports 10 million units of widgets at a unit price of $100, and
imports 10 million of another kind from Europe at a unit price of 100 euros.
a. If the exchange rate is 1.3$/euro, what is the US trade balance? (2)
b. Suppose dollar depreciates to 1.4$/euro but there is no change in export/import quantities
and the prices in both countries remain the same. What will be the trade balance for the
next quarter? (2)
c. Now suppose in one year exports increase to 12 million and imports decrease to 8
million. The exchange rate remains at 1.4$/euro, and the prices in both countries remain
the same. What will be the quarterly trade balance after one year? (2)
See the solution on the class website – this is the example discussed in class – March 31.
Page 6