Mark Scheme 2013 EC271: International Financial Economics
Question 1 a) i) Student s are expected to define the terms along the lines:
Trade creation: the increase in imports to the least efficient partner country.
Trade diversion: the change in origin of imports from a country outside the RTA to a country within.
Domino effect: a RTA results less trade with non-members increasing the likelihood of them joining the RTA. (2 marks for each definition) ii) Students should realise that a customs union has a common external tariff. Marks will be awarded for correct diagrammatic interpretation that illustrates trade creation/diversion and welfare effects. (up to 10 marks) b) Any reasonable discussion of the factors identified by Mundell in his original (1961) definition of a OCA and which are sensibly applied to the Euro area up to 17 marks. Student will also be credited for use of the LLGG framework.
Question 2
An outline of Krugman’s first generation model is expected. Diagrams and fundamental equations are expected and need to be explained fully for full marks.
Question 3 a) Students should define the IRP condition (i.e. along the lines that interest rates and exchange rates will be such that there is a zero-arbitrage equilibrium) and use the following expression to describe foreign exchange market equilibrium (I = I* + (E E -E/E)) where E e is expected ex rate and E the spot rate. Correctly drawn and labelled accompanying diagrams will be credited. b) i) depreciates , ii) appreciates iii)depreciates - marks also awarded for correct accompanying diagrams.

Mark Scheme 2013 EC271: International Financial Economics
Question 4 a) Students are expected to note that empirical tests amounts to a test of the EMH when applied to the foreign exchange market. This point should be emphasised in responses. Students should then note that basic empirical tests of the EMH assume agents are rational and risk neutral and are generally conducted using regression equations of the form: S t+1
= a +bF t
+ u t+1
, where S = future spot rate and F = forward rate. Students are only expected to note that empirical tests of the EMH involve testing: a = 0 and b =1, (no discussion of regression analysis or statistical inference is required) – up to 10 marks.
Students should also note that early empirical work suggested that the hypothesis of EMH holds for the foreign exchange market i.e. a = 0, and b =1. Later studies refuted this claim on technical and methodological grounds – students are expected to show some basic awareness of this issue, that is the methodology employed in the early studies introduced bias into the estimates of a and b (a technical discussion is not required) - up to 7 marks. b) Students are expected to note that several approaches to modelling exchange rate expectations have been adopted by researchers: static, adaptive, extrapolative, regressive, rational and perfect foresight. Students are not expected to provide a technical analysis of the methods but they should provide a description of the methods they quote. In particular they should note that the first three methods are often seen as rather arbitrary as they assume that future exchange rates are determined solely by current and past exchange rate, and ignores other ‘fundamentals’ (monetary/fiscal policy, inflation rates, interest rates etc). Students should also be aware that from a theoretical perspective the latter three are much better as they allow a wider information set to influence expectations, comments are expected along the lines that
Regressive: allows information on the long run relationship to enter the analysis
Rational: allows agents to make mistakes, but suggests they do not systematically get things wrong
Perfect: assumes that agents have the correct model of the exchange rate and therefore do not make errors regarding the future exchange rate. - up to 16 marks.

Mark Scheme 2013 EC271: International Financial Economics
Question 5
Students are expected to answer this question using partial equilibrium analysis and show the welfare effects using producer/consumer surplus/factor payments and the differences in tariff revenue in the case of large and small countries. Marks will be awarded for correct use of diagrammatic apparatus. In essence the statement can be shown to be false. The general points that should be raised in student responses are 1) consumer welfare/surplus falls in both small and large countries, and producer surplus increase. 2) there are efficiency distortions i.e. deadweight losses.
The major point that students are expected to highlight is that since a large country can affect world prices then it can increase tariff revenues and therefore potentially net welfare can be increased in contrast to the small country case. These points should be clearly stated and correctly analysed for full marks.
Question 6
a) Students are expected to be familiar with the effectiveness of monetary/fiscal policy under fixed /floating exchange rate regimes with perfect capital mobility. Responses should clearly allude to the following and be presented within a Mundell-Fleming ISLM framework or AA/DD framework
– both acceptable:
Fixed exchange rates: Fiscal Policy: effective in the short run and money supply expands
endogenously. Monetary Policy: ineffective and any monetary expansion must be reversed
Floating exchange rates: Fiscal Policy: ineffective. Monetary Policy: effective.
Students will be awarded up to 25 marks for a correct analysis of the above. Students should also realise that there is also the possibility of capital controls, and assuming a fixed exchange rate, macro policy will be directed at maintaining a current account balance. The central bank will use its foreign reserves for this purpose as the domestic interest rate need not equal the world rate. Note,
ISLMBP analysis is not expected – but if correctly incorporated into the answer then marks will be awarded accordingly. b) Students are expected to give at least 3 reasons with commentary 2 marks for each correct reason stated. Two extra marks for quality/accuracy of answers.