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NAME: ________________________________________ 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