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THE GEORGE WASHINGTON UNIVERSITY
Department of Economics
Economics 180
Section 10
Prof. Steve Suranovic
Spring 2010
Midterm Exam - Answers
1.
JEOPARDY Answers (20 points) Please write out all acronyms.
A. name for the measure of national output that includes
production by US residents both domestically and
internationally.
Gross National Product (GNP)
B. the account recording all international transactions
between one country and another.
The Balance of Payments
C. term used to describe profit earned domestically by
foreign businesses
Income payments
D. term used to describe a country that has a negative
balance on its international investment position.
Debtor country
E. name of the fixed exchange rate system that prevailed
from 1945 – 1973.
F. name of a fixed exchange rate system in which
currency is fixed to a quantity of gold
G. term used to describe the difference between the
stock of US assets abroad and foreign assets in the US
H. of buying or selling foreign reserves, what a central
bank must do if there is pressure in the private market for
a fixed currency to depreciate.
I. term used to describe the action if China lowers its
fixed exchange rate from 6.7 yuan/$ to 4.5 yuan/$.
J. the balance on the balance of payments when a central
bank sells foreign reserves.
Bretton Woods or
Gold exchange standard
Gold Standard
International Investment
Position
Selling
Revaluation
Deficit
2. (12) Answer the following questions regarding the national income accounts.
2A. (3) What is the government’s budget balance if government spending is $300 billion,
private saving is $300 billion, government transfer payments are $200 billion, private investment
is $400 billion and tax revenues are $700 billion?
Budget balance = G + TR – T
= 300 + 200 – 700 = -200
 the budget is in surplus by 200 billion.
2B. (3) Domestic spending is a better measure of what a country consumes in the aggregate.
Calculate the level of domestic spending given the numbers above. Does this value suggest that
the country is better off or worse off than indicated by its GDP? Explain briefly
This question mistakenly left out the value for consumption, thus there is not enough info
to calculate domestic spending. However, from the twin-deficit identity we know that
(Sp – I) – CA = (G + TR – T). Thus, (300 – 400) –CA = - 200. This implies that CA = 100 and
is in surplus. With a CA surplus, GNP > DS therefore the country is consuming less and is
worse off than indicated by its GNP.
2C. (3) In addition to manufactured goods trade, what other categories are included in the
current account?
Services
Income payments and receipts
Unilateral transfers
2D. (3) What is the value of a country’s financial account balance if its GNP is $1.4 trillion,
consumption is $1000 billion, investment is $400 billion and government spending is $300
billion? Is it in deficit, surplus or balance?
GDP = C + I + G + (EX – IM)
1,400 = 1000 + 400 + 300 + x
x = - $300 billion
FA = -x = + $300 billion surplus.
3. (12) Suppose that each situation listed is the dominant effect on a country’s balance of
payments. Indicate by filling in the blank spaces, first, whether the current account and financial
account would be in surplus, deficit or balanced.
Current Account
Balance (2 pt)
Financial Account
Balance (1)
Surplus, Deficit or
Balanced
Surplus, Deficit or
Balanced
A. a country is
exporting more goods
and services than it is
importing
Surplus
Deficit
B. a foreign country
sells its government
treasury bills to the
domestic country
Surplus
Deficit
C. the domestic
country redeems the
treasury bills purchased
in the previous step
Deficit
Surplus
D. domestic residents
deposit money in a
domestic bank
Balance
Balance
4. (12) Table 1 below contains economic data for a fictitious country named Gamma.
Dollar amounts are in billions.
Table 1 Gamma Economic Data
GDP
$300
Trade Deficit (TD)
$7.5
Net International
investment position
(IIP)
Exchange Rate
change in previous
year
-10%
Projected GDP growth
Investment (I)
+$75
Govt. Budget
- $200 (debtor)
-1.0%
$13 (surplus)
A. Suppose you work for International Monetary Fund, and they have asked you to assess
this country’s trade deficit. Provide two reasons supporting the notion that Gamma’s
trade deficit is more worrisome and two reasons to support the notion it is less
worrisome.
More Worrisome
A.
a) Projected growth is also very low at 1.0%
b) Debtor position is very high at 67% of
GDP
c) Exchange rate depreciation may signal
lack of confidence in economy
Less Worrisome
A.
a) trade deficit is not too worrisome at
2.5% of GDP
b) Government surplus reduces borrowing
needs
c) Investment is very high at 25% of GDP
B.
B.
5. (10) The following Table shows the twin deficit identity values for a nameless country in
three successive years. Each value is given as a percentage of GDP.
Year
Private
Saving
Investment
CA Deficit
Govt. Budget
Deficit
2006
2007
2008
18.0%
20.0%
20.0%
20.0%
20.0%
16.0%
0%
2.0%
2.0%
-2.0%
2.0%
6.0%
9A. (2) Use the twin-deficit identity to fill in the blank values in the Table.
9B. (2) In which year is the country best described as financing its government budget deficit
with domestic saving?
2008
9B. (2) In which year is the country best described as financing its government budget deficit
with foreign saving?
2007
9D. (2) In which year is the country best described as financing extra domestic investment with
government saving?
2006
9E. (2) In which year, relative to the previous, is the country best described as government
crowding out private investment?
2008
6. For the following questions, suppose the investors believe that both CDs have identical risk
and liquidity characteristics.
6A. (4) Fred and Nikki are both considering investing in either a US CD or a Euro CD. Suppose
that US and Euro interest rates on a six-month CD are the same. Fred believes the US dollar will
appreciate during the next six months, but Nikki believes the US dollar will depreciate.
Fill in
the table below indicating which CD (US or Euro) Fred and Nikki will buy.
US or Euro CD
Fred
US CD
Nikki
Euro CD
Logic: No calculation is necessary. Since interest rates are the same the Euro return will
be higher if the euro is expected to appreciate and the US return will be higher if dollar is
expected to appreciate. Since Fred believes the $ will appreciate, he will buy the US CD.
Since Nikki believe the $ will depreciate, she believes the Euro will appreciate and thus will buy
the Euro CD.
6B. (4) Tina and Larry are both considering investing in either a US CD or a Euro CD. Suppose
that US and Euro interest rates on a six month CD are the same and that the US$/euro exchange
rate is currently 1.30. Suppose Tina believes the $/euro exchange rate will be 1.35 in 6 months
while Larry thinks it will be 1.45. Fill in the table below indicating which CD (US or Euro) Fred
and Nikki will buy.
US or Euro CD
Tina
Euro CD
Larry
Euro CD
Logic: No calculation is necessary. Since interest rates are the same the Euro return will be
higher if the euro is expected to appreciate and the US return will be higher if dollar is expected
to appreciate. Since Tina believes the $/euro exchange rate will rise, she believes the euro will
appreciate and thus will buy the Euro CD.
Since Larry also believes the $/euro exchange rate will rise, he believes the euro will appreciate
(by more than Tina) and thus will also buy the Euro CD.
6C. (4) Naveen and Ranvir are both considering investing in either a US CD or a Euro CD.
Suppose that US interest rate on a one year CD is 1% and the interest rate on a Euro CD is 2%.
Suppose Naveen believes the Euro will appreciate by 1% next year and Ranvir believes the Euro
will depreciate by 1%. Fill in the table below indicating which CD (US or Euro) Naveen and
Ranvir will buy.
US or Euro CD
Naveen
Euro CD
Ranvir
US CD
Logic: No calculation is necessary. Since Naveen believes the euro will appreciate and because
the euro CD also gives a higher interest rate, he will buy the Euro CD.
Since Ranvir believes the euro will depreciate by 1% and because the euro CD gives a 1% higher
interest rate, these two effects will cancel out according to the expanded RoR formula. However
because the third term, the interest rate term, is slightly negative the RoR of the Euro CD will be
a little bit less than i$, thus Ranvir will buy the US CD.
7. (10) Suppose you are comparing job offers in three different countries. Ignore other issues
related to working in a foreign country such as travel expenses, language issues, distance from
family, etc, and suppose your only concern is your wage and the standard of living it will give
you.
Wage
US
Mexico
China
$20 per hour
220 peso/hr
150 yuan/hour
Actual Exchange
Rate
14.4 peso/$
6.8 yuan/$
PPP Exchange Rate
9.3 peso/$
3.5 yuan/$
A. (2) Calculate the hourly wage rate in dollars in Mexico and Japan using the actual
exchange rates
wM = 220/14.4 = $15.28
wC = 150/6.8 = $22.06
B. (2) Calculate the hourly wage rate in dollars in Mexico and Japan using the PPP
exchange rates
wM = 220/9.3 = $23.60
wC = 150/3.5 = $42.86
C. (2) Based on the info above, in which country is the best job offer? … which secondbest? …. which third best?
China then Mexico then US
D. (2) In terms of PPP, is the US dollar overvalued or undervalued with respect to the peso?
…. with respect to the yen?
$ is overvalued to the peso
$ is overvalued to the yuan
E. (2) According to the PPP theory, given the conditions above, would the dollar be
expected to appreciate or depreciate with respect to the peso?
$ depreciate to the peso
8A. (4) Which FOUR of the following changes are likely to cause a dollar appreciation.
A.
B.
C.
D.
E.
F.
G.
H.
I.
J.
decrease in US interest rates
decrease in Euro interest rates
increase in US prices (rising US inflation)
increase in Euro prices (increase in Euro inflation)
decrease in US stock market values
increase in Euro stock market values
decrease in perceived risk of US assets
decrease in perceived risk of Euro assets
expectation of future dollar appreciation (euro depreciation)
expectation of future dollar depreciation (euro appreciation)
Write Answers here:
B
D
G
I
8B. (4) Which FOUR of the following are likely to be direct effects of a dollar depreciation
A.
B.
C.
D.
E.
F.
G.
H.
I.
price deflation.
Rising price inflation
Increase in imports of services.
Decrease in imports of goods.
Decrease in exports of goods
Increase in exports of services.
Decrease in the rate of return on foreign assets
Increase in the rate of return on foreign assets
Decrease in foreign interest rates.
Write Answers here:
B
D
F
G
8C. (4) Which FOUR of the following statements provide the best reasons to support fixed
exchange rates.
A.
B.
C.
D.
E.
F.
G.
H.
Fixed exchange rates can help reduce a nation’s inflation rate
Fixed exchange rates increases monetary independence
Fixed exchange rates can prevent the central bank from printing money
Fixed exchange rates can sometimes lead to balance of payments deficits
Fixed exchange rates are sometimes devalued unexpectedly
Fixed exchange rates can sometimes stimulate foreign investment
Fixed exchange rates can sometimes stimulate international trade
Fixed exchange rates requires central bank intervention
Write Answers here
A
C
F
G