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Econ 371 Spring 2010 Midterm Exam (Form 1)
March 11, 2010
Instructor: Kanda Naknoi
Part One
Instruction: In the answer sheet, mark the test form as ”01.” Answer whether the following
statements are true or false. If you answer true, mark ”A” in the answer sheet. Mark
”B” otherwise. Note that you must use pencil no. 2. (1 point each)
1. Suppose the dollar short-term interest rate is 0.5% and the euro short-term interest
rate is 1%. The covered interest parity implies that there is forward premium for
the dollar.
2. According to the uncovered interest parity condition, a temporary purchase of government bond by the Fed causes the dollar to appreciate.
3. According to the uncovered interest parity condition, a temporary purchase of government bond by the Fed reduces the dollar short-term interest rate.
4. Tariffs and shipping costs cause deviations from the absolute purchasing power
parity.
5. Tariffs and shipping costs cause deviations from the relative purchasing power parity.
6. Real exchange rate appreciation implies that the purchasing of the U.S. dollar falls
at home but rises in the foreign country.
7. Assume free capital mobility between Argentina and the U.S, and Argentina has
higher inflation rate than the U.S. According to the Fisher effect, the real interest
rate in Argentina should be higher than the U.S. real interest rate.
8. According to the monetary approach of long-run exchange rate determination, permanent productivity growth in the euro area appreciates the U.S. dollar in the long
run, all else equal.
9. According to the monetary approach of long-run exchange rate determination, temporary growth in money supply in the euro area appreciates the U.S. dollar in the
long run, all else equal.
10. According to the monetary approach of long-run exchange rate determination, a
temporary increase in home productivity results in deflation.
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11. According to the monetary approach of long-run exchange rate determination, a
permanent increase in home productivity results in deflation.
12. In a country maintaining a fixed exchange rate system, capital inflows increase foreign exchange reserves as a result of a standard intervention in the foreign exchange
market.
13. According to the uncovered interest rate parity, the dollar depreciates when the
European Central Bank raises the short-term interest rate, all else equal.
14. According to the uncovered interest rate parity, the dollar dereciates when the European Central Bank is expected to raise the short-term interest rate, all else equal.
15. A permanent reduction in money supply in the Euro zone increases the expected
foreign return for the American residents in the short run, all else equal.
16. A permanent monetary reduction in the Euro area creates exchange rate overshooting when goods prices are flexible, all else equal.
17. Exchange rate overshooting arises from a permanent change in monetary policy
when it takes time to see adjustments in the price level.
18. The U.S. central bank is the only central bank in the world that does not face the
trilemma because the U.S. is the largest economy.
19. Current account surplus can cause a creditor country to become a debtor country.
20. Current account surplus can cause a borrower to become a lender.
21. When a country runs fiscal deficit and has zero saving rate, it runs current deficit.
22. Countries with current account surplus may be debtor countries.
23. The net factor income transfer from abroad of a creditor country is always positive.
24. When current account is balanced, financial account deficit implies capital account
deficit.
25. Present value of return of investment rises when the marginal product capital rises
and the real interest rate falls.
26. Given initially balanced current account and zero external wealth, in the absence
of investment a temporary improvement in productivity leads to current account
deficit.
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27. Given initially balanced current account and zero external wealth, in the absence
of investment a temporary improvement in productivity leads to current account
deficit.
28. Given initially balanced current account and zero external wealth, in the presence
of investment a permanent improvement in productivity leads to current account
deficit.
29. Financial globalization allows risk diversification when countries have different return structure.
30. Financial globalization helps us diversify risks on capital income and labor income.
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Part Two
Instruction: Answer the following questions and depict appropriate diagrams as required.
(60 points)
1. (10 points) Assume that the money demand function in the U.S. and the Euro area
are identical. Suppose the Fed and the European Central Bank announce that they
will coordinate monetary expansion in the same scale at the same time 1 month
from now, and the monetary expansion is permanent.
(a) Depict the time paths of money supply, interest rate and price level in the U.S.
and the Euro area.
(b) Will their policy create exchange rate overshooting? Explain using the FX
model. Depict the time path of the dollar-euro exchange rate.
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2. (10 points) Hong Kong is a special economic zone in China in a sense that it adopts
different policy related to capital markets from China. First, Hong Kong’s monetary
authority issues the Hong Kong dollar, which is fixed rigidly against the U.S. dollar.
At the same time, China’s central bank issues the Chinese Yuan, which fluctuates
against the U.S. dollar within a narrow band. The other difference is that China’s
central bank tightly controls movements of capital across border, but Hong Kong’s
monetary authority maintains free capital mobility.
(a) Characterize differences between monetary authorities in Hong Hong and China,
according to the so-called trilemma in international macroeconomics.
(b) Suppose there are no barriers in exports and imports of goods and services
between China and Hong Kong. Explain the effects of nominal appreciation of
Chinese Yuan against the U.S. dollar on the trade balance between China and
Hong Kong.
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3. (10 points) External wealth measures the accumulative sum of current account (CA).
By definition, CA is the sum of trade balance (TB), net factor income account
(NFIA) and net unilateral transfer (NUT). Assume for simplicity that NUT is balanced.
(a) Is it possible that a country is a creditor country and has CA deficit at the
same time? Explain why.
(b) Is it possible that a creditor country experiences net outflows in NFIA? Explain
why.
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4. (10 points) Assume the unit is real dollar in billions. Suppose Mexico finds domestic
investment projects, which cost 40 and yield the marginal product of capital 10
percent forever. The investment projects require investment in Year 0, and begin
to pay off in Year 1. Assume that the domestic production without investment is
100 in all years. Assume that the real interest rate in the world capital market is
5 percent. However, Mexico faces a borrowing constraint, which limits borrowing
from the world capital market to 30. Assume that the lenders do not demand
interest rate payments until the projects begin to pay off, and they do not demand
repayments of the principal. Assume that Mexico’s initial wealth prior to Year 0 is
zero, and fiscal budget is always balanced. Assume no unilateral transfers or labor
income flows.
(a) Should Mexico invest in these projects? Why? Does your answer depend on
whether Mexico is a closed-economy or an open economy?
(b) Suppose Mexico is open to the world capital market. Calculate the paths of
output, consumption and trade balance.