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International Macroeconomics
PSIA- Fall 2014
Nicolas Coeurdacier
Final exam
Documents not allowed. Simple calculator allowed.
For the Multiple Choice Questions, use the answer sheet at the end of the exam.
For the essay questions, please be precise but concise in your answers.
1. Multiple choice questions [50 points = 2 per question]
You have to select at LEAST one answer from the four proposed answers. You have to
select ALL the correct answers, AND ONLY the correct answers to get the maximum
number of points (no negative points).
Correct answers in bold.
1. Uncovered interest parity implies that
a. interest rates should converge across countries
b. high interest rate currencies should depreciate in the future
c. high interest rate countries should have higher inflation
d. the exchange rate between two countries is expected to stay constant if the two countries have
identical interest rates
2. Fill the blanks.
According to Uncovered Interest rate Parity, if an investor purchases a five-year U.S. bond that has an
annual interest rate of 4% rather than a comparable British bond that has an annual interest rate of
2%, then the investor must be expecting the _________ to ___________ at a rate of at least 2% per
year over the next 5 years.
a. British pound; appreciate
b. British pound; depreciate
c. U.S. dollar; appreciate
d. U.S. dollar; depreciate
3. If markets expect an increase in the interest rates by the ECB in the following year, the following
should occur:
a. The interest rate should increase immediately
b. The euro should depreciate immediately
c. The euro should appreciate immediately
d. The euro should appreciate in the following year
4. An unexpected expansion of aggregate demand and output in the eurozone should …
a. lead to an increase in the demand for money in the eurozone
b. lead to an increase in euro interest rates
c. have no impact on the euro as it is unexpected
d. lead to an appreciation of the euro
5. According to the quantity theory, in the long-run, a 10% increase in the supply of money should
lead to
a. a 10% increase in the level of prices
b. an 10% increase in the level of output
c. a 10% depreciation of the currency
d. a 10% increase in the nominal interest rate
6. In the long-run, a permanent fall in the rate of growth of the supply of money should lead to
a. a fall in the level of prices
b. a fall in the inflation rate
c. a fall in the nominal interest rate
d. a fall in the value of the domestic currency
7. In presence of price rigidities, an unexpected increase in the money supply should…
a. lead to a more valuable currency in the long-run
b. generate a depreciation of the currency in the short-run
c. generate a fall in ouput
d. lead to an increase in prices in the long-run
8. In the Mundell-Fleming model under flexible exchange rates (AA-DD model), an expansionary
monetary policy in Australia leads to
a. an increase in output and an increase in the Australian interest rate
b. an increase in output and a depreciation of the Australian dollar
c. an equivalent increase in exports and imports
d. a fall in net exports and output of the main trading partner of Australia, i.e New Zealand
9. As New Zealand experiences a recession, the country increases its fiscal spendings, which, leads to:
a. an appreciation of the Australian dollar
b. an appreciation of the New Zealand dollar
c. a further fall in output in New Zealand
d. an increase in output in Australia
10. As New Zealand is struggling to get out of the recession. Economists argue that the fiscal
expansion was not a very efficient policy because…
a. New Zealand is very open to trade in goods and assets
b. New Zealand is very far away from most countries
c. New Zealand is relying more on internal demand, which was already depressed
d. New Zealand and Australia have free floating currencies
11. The country King-Kong has a fixed exchange rate with the US dollar. Its currency is the King-Kong
dollar. Capital is freely mobile between the US and King-Kong.
a. Interest rates in King-Kong should be lower than in the US to compensate for the devaluation risk.
b. Net capital inflows into King-Kong dollars by foreign speculators should force the Central Bank to
sell US dollar reserves.
c. Net capital inflows into King-Kong dollars by foreign speculators should increase the supply of
King-Kong dollars in the economy
d. An unexpected increase of US interest rates should force the Central Bank to sell US dollar
reserves
12. Asymmetric demand shocks in a currency area can be cushioned…
a. if the monetary authority of the area raises interest rates
b. if fiscal transfers are easily implemented in the area
c. if workers mobility is restricted within the area
d. if prices and wages are very flexible in the area
13. According to absolute Purchasing Power Parity:
a. the rate of change in the nominal exchange rate equals the inflation differential between two
countries
b. countries with higher domestic inflation should see a depreciation of their currency
c. countries with lower domestic inflation should see a depreciation of their currency
d. a country’s prices are set in a foreign currency
14. Big Mac Prices and (spot) nominal exchange rates with respect to the US dollar and GDP per
capita in USD are presented in the table below for few countries (source: The Economist). We focus
on Purchasing Power Parity (PPP) based on Big Mac prices.
Country
USA
Switzerland
Russia
Taiwan
Thailand
Big Mac Price in local Spot nominal exchange
currency
rate (mid-quotes) with
respect to the USD
(Foreign
currency
units/USD)
3.2 USD
6.30 SWF
1.25
50 RBL
25
75 TWD
33
62 THB
34.7
a. According to PPP, the Swiss Franc is undervalued with respect to the US dollar
b. PPP would be verified if a Big Mac in Taiwan would cost approximately 106 Taiwan Dollars.
c. The exchange rate implied by PPP for Russia is close to 15 RBL/USD.
d. According to PPP, the Russian rouble is overvalued by roughly 40% with respect to the US dollar.
15. One year ago the spot rate of U.S. dollars for Canadian dollars was $1/C$ (read 1 USD per CAN$).
Since that time the rate of inflation in the U.S. has been 2% greater than in Canada. Based on the
theory of Relative PPP, the current spot exchange rate of U.S. dollars for Canadian dollars should be
approximately … .
a. C$0.98/$
b. $1.2/C$
c. $1.02/C$
d. $1/C$
16. China had a faster productivity growth in its export sector than the US over the last 10 years, you
expect this to generate:
a. a real appreciation of the Chinese currency
b. an increase in the price of services and non-traded goods in the country
c. an increase in the real wage of workers in the non-traded goods sector
d. a fall in the real wage of workers in the export sector
17. China is running large current account surpluses, this implies that:
a. aggregate savings in the country are higher than investment
b. the country is running fiscal surpluses
c. the country is importing capital from the rest of the world
d. the country is running a trade deficit
18. Banks in Singapore are mostly borrowing in foreign currency (US dollar). A depreciation of the
Singaporean dollar:
a. Makes banks in Singapore vulnerable to default as they are making capital losses.
b. Makes banks safer as they are making capital gains on their assets in the Singaporean economy.
c. Makes banks safer as it reduces their wage bill in Singaporean dollar.
d. Is irrelevant for the financial condition of banks if they have hedged their foreign currency debt
in FOREX markets.
19. Governments are more tempted to default
a. If a lot of debt is in the hand of domestic residents.
b. If debt is mostly in the hands of foreign banks
c. when the country is in a recession
d. when interest rate payments on the debt are high
20. If sovereign default is expected to be more costly in a country, one should expect the country to:
a. raise a higher level of public debt
b. raise a lower level of public debt
c. pay a lower rate of interest on its debt
b. default more often
21. If the interest rate is 2% per year in Germany and roughly 12% in Latvia, this can mean:
a. Latvia has a positive default probability of about 10% assuming a haircut close to 100%
b. Latvia has a positive default probability of about 10% assuming a haircut of 50%
c. The currency of Latvia is expected to depreciate by about 10% with respect to the Euro
d. The currency of Latvia is expected to appreciate by about 10% with respect to the Euro
22. A country with a fixed exchange rate to the US dollar is more sensitive to a speculative attack if…
a. the country has small amounts of international reserves
b. the country has been mostly borrowing in foreign currency
c. the country has a deficit of its financial account
d. the country is in recession and US interest rates are rising
23. The Bigstate faces the following fiscal situation….
Debt-to-GDP ratio = 100%; Real interest rate = 1%; Real growth rate = 3%
a. Bigstate needs a primary surplus of 2% of GDP or above for the debt to be sustainable
b. Bigstate needs a primary deficit of 2% of GDP or less for the debt to be sustainable
c. If Bigstate runs a primary deficit of 4% of GDP, the debt to GDP ratio will decrease (keeping real
interest rate and growth rate constant)
d. If Bigstate runs a primary deficit of 4% of GDP, the debt to GDP ratio will increase (keeping real
interest rate and growth rate constant)
24. The following statements are true
a. countries with high growth rates are likely to see their debt to GDP ratio fall if they face low
interest rates
b. a country for which the real interest rate r is equal to the growth rate of GDP g can reduce its
debt to GDP ratio by running a primary fiscal surplus of 1%
c. a country for which the real interest rate r is equal to the growth rate of GDP g can reduce its debt
to GDP ratio by running a primary fiscal deficit of 1%
d. a higher real interest rate makes it more likely for a country to default, which in turn might rise
even more the real interest rate
25. Which one of the following sentences is correct…
a. Under free capital mobility, countries have to decide between targeting the exchange rate and
keeping monetary policy autonomy.
b. Under capital controls, countries have to decide between targeting the exchange rate and keeping
monetary policy autonomy.
c. A country opening up its capital account is likely to see capital outflows if its return to capital is
below the world return to capital.
d. A country opening up its capital account is likely to see capital inflows if its return to capital is
below the world return to capital.
Short questions/essays [50 points=10+10+30]
1) Exchange rates forecasts
Smalland is a small country. Its currency is the Smiley and the exchange rate with the U.S. dollar is 1
Smiley per dollar in 1990. Purchasing Power Parity (PPP) holds in 1990 between Smalland and the US.
The price indexes in 1990 are equal to 100 in the United States and in Smalland. Today, the price
indexes are equal to 150 in the United States and 200 in Smalland. The current exchange rate is 0.5
Smiley per dollar.
(a) What should the current exchange rate be today if PPP prevailed? Is the Smiley over/undervalued
according to PPP?
S=1 per USD in 1990.
Today P(Smalland)/P(US)=4/3
So should expect a dollar to be worth 4/3 smiley (or 0.75 USD=1 smiley) (larger inflation in smalland
than in the US, imply a depreciation of the smiley according to PPP). It is worth 0.5, so large
appreciation of the smiley over the period while PPP predicted depreciation = smiley is overvalued.
(b) Five-year nominal interest rates in the US and in Smiley are both equal to 3% (in annual terms). If
you think that the spot exchange rate will revert back towards its PPP value (calculated in (a)) within
five years, what would you do as a currency trader? What is the (approximate) annual return
expected on this trading strategy? What are the risks associated with this strategy?
Should expect the smiley to depreciate by (1.33-0.5)/0.5=166% in the coming 5 years. Just borrow
smiley at 3% per year to invest in USD at same rate of interest. Should make 166% over 5 years so
(approximately) 33% per year [this is a very rough approximation: exact return is actually close to
22%=(1.33/0.5)^(1/5)]. Risky strategy as convergence towards PPP can be very slow and the
exchange rate might still move in the wrong direction.
2) Valuation effects of exchange rates
Define the valuation effects on the external position due to exchange rate fluctuations. Explain how
these valuation effects operate and facilitate the adjustment of current account imbalances in the US
case when the dollar depreciates with respect to other currencies?
[be concise: 500 words maximum]
Start by defining the valuation effects based on accounting identity:
Change in NFA = CA + Valuation effects (= capital gains on net external position)
See slides in class for definition of valuation effects on external position and see US example on how
exchange rates changes affect capital gains on net external position.
Mention that the US (contrary to many emerging countries for instance) is borrowing internationally
in its own currency (USD). The country has mostly foreign assets in foreign currency. A depreciation
of the dollar means that the US is making capital gains on its external asset and liability position. This
corresponds to a transfer of wealth from the rest of the world through the financial channel of
adjustment, which reduce the US net external debt. A depreciation will also boost net exports of the
US (trade channel). Both effects reinforce eachother and the financial channel due to valuation
effects indeed facilitates the external adjustment of the US.
3) Fiscal spillovers [source: Ivanova and Weber, IMF, 2011]
Percentage deviation of output following the government
spending shock in Germany, France and USA.
The following graph show the change in output (in %) in selected euro economies when a large
country (France, Germany or US) increase its fiscal spending by 1% of GDP.
Note: A spending shock is a 1% of GDP increase of government spending in a given large country.
Source: Ivanova and Weber, IMF, 2011
a. How does the output response to spending shocks differ across the three selected European
economies? Why is the response overall positive? How does the response depend on the country at
the origin of the shock? How could you explain the differential response across the three selected
countries?
Fiscal spillovers are expected to be positive from theory through two main channels:
(i) Aggregate demand channel: spending shock in large economies increase aggregate demand
elsewhere (shock leak into higher imports from the large economies boosting net exports of
the trading partners). With rigid prices, this increase in aggregate demand increases output.
(ii) Exchange rate channel: when the exchange rate is flexible (all countries with respect to US),
larger spillovers are expected. Appreciation of the high spending country currency (US),
increase net exports of the trading partners (competitiveness increased due to the
depreciation of their currency w.r.t the USD).
Spillovers expected to be more positive if:
(i) a country is more opened to trade with the large economies;
(ii) the country’s currency is allowed to freely float.
Positive spillover effects should thus be increasing in the level of trade openness of the country (for a
given country) and w.r.t to the level of trade with the country of origin.
Greece not very open to trade (Ireland very open and Portugal in the middle).
Larger effects of Ireland if shock comes from US as likely to trade more with US than other countries
[could develop here the reasons: US multinationals in Ireland, English-speaking country…] (Greece
much less so in particular).
Greece and Portugal trade more with France and Germany but still small effects due to fixed
exchange rates (larger in Portugal since it is a more important trading partner). All economies have
flexible exchange rate with US, so larger expected spillovers from theory from the US (everything else
equal).
b. In 2009-2010, Ireland, Greece and Portugal all started fiscal austerity measures. What are the
expected effects on their own GDP? What are the expected effects on output in France, Germany
and the US?
Fiscal austerity = negative shock to aggregate demand and thus contractionary if prices are rigid.
Fiscal multipliers typically between 0.2 and 1 [see class slides].
Theory predicts very large contractionary impact in Greece (fixed exchange rate and not very open):
larger fiscal multiplier in this country (also in Portugal but to a smaller extent). To the opposite,
Ireland will export more the contractionary effects and is expected to be less affected (lower
multiplier). Could partially explain a faster recovery in Ireland.
All three countries are still of moderate size so would not expect a large impact on the euro and
should not affect much aggregate demand in other countries. Negative spillovers on Germany and
France should also be limited as exchange rate is fixed. If small depreciation of the euro, they will
also be more competitive on markets outside Eurozone, which will offset part of the already small
negative spillovers. Rational for small coordination within the eurozone?
Ireland will have according to (1) the largest negative spillovers on others. If the euro depreciates due
to austerity measures in the Eurozone, Ireland is also one of the main beneficiary (more trade with
US).
Important to note that fiscal austerity is more contractionary in the zone if monetary policy at the
zero-lower bound as during the last financial crisis in Eurozone. No room for accommodative
monetary policy.