International Finance Exam

Chapter 5: 

1. Absolute vs. Relative PPP:

   • Absolute PPP suggests that identical baskets of goods should cost the same in different countries once exchange rates are accounted for. E=Pus/Peu (exchange rate equals price level ratio). Holds if goods are identical and tradable.

   • Relative PPP: %ΔE=πUS−πEU%ΔE=πUS​−πEU​. Explains exchange rate changes due to inflation differentials. Relative PPP states that changes in exchange rates between two countries reflect differences in their inflation rates, rather than identical price levels. 

2. Explain why exchange rate model based on PPP is a long run theory?

   • The exchange rate model based on PPP is considered a long-run theory because price adjustments due to monetary changes (inflation or deflation) occur slowly over time. Thus, PPP holds better over longer periods, allowing prices and exchange rates to align fully. Prices adjust slowly (sticky wages/menu costs). Short-run shocks (e.g., monetary policy) affect output first; prices adjust later.

3. Present and explain the Fundamental Equation of the Monetary Approach.

   • The fundamental equation of the monetary approach is E=PUS/PE=(MUS/L(R,YUS))/(ME/L(R∗,YE))E=PUS /PE =(MUS /L(R,YUS ))/(ME /L(R∗,YE )), indicating exchange rates depend on relative money supplies and demands in each country. It emphasizes that monetary factors, primarily money supply growth, determine exchange rates in the long run. 

   • E = Mus / Meu * L(R,Y)/ L(R,Y)

   • Money supply (M) and demand (L) determine price levels → drive exchange rates

4. Describe and explain the relationship between expected inflation rates in two countries and their interest rate differential according to the PPP theory.

   • According to PPP theory, the interest rate differential between two countries equals the expected inflation rate differential. If one country expects higher inflation, its currency depreciates, and investors require higher nominal interest rates to offset this depreciation risk. 

5. What is the Fisher Effect? Provide an example?

   • The Fisher Effect describes how nominal interest rates rise one-for-one with expected inflation.

   • For instance, if inflation expectations increase from 2% to 4%, nominal interest rates will rise similarly, from, say, 5% to 7%, to maintain a stable real return. 

   • RUS​−REU​=πUS​−πEU​ (Fisher Effect). Higher inflation → higher nominal rates to maintain real returns.

6. Explain the relationship between CA and real exchange rate disposable income (CA(EP /P, Yd)) i.e. how CA is affected the two factors: Y = C(Yd) + I + G + CA(EP /P, Yd)

   • The current account (CA) depends negatively on disposable income (higher disposable income leads to more imports, worsening CA) and positively on real exchange rates (depreciation boosts exports and reduces imports, improving CA). Thus, CA = CA(EP*/P, Yd), meaning CA improves if real depreciation occurs or disposable income decreases. 

   • ↑ Disposable Income (Yd): ↑ Imports → ↓ CA.

Chapter 6: 

1. Using a figure show that under full employment, a temporary fiscal expansion would increase output (over-employment) but cannot increase output in the long run

   • A temporary fiscal expansion under full employment initially boosts output, creating over-employment. However, over time prices adjust upward, reducing real balances and returning output to its original level, demonstrating no long-run effect. 

   • Y

     | /←DD₁

     | /

     |/______ Yₚ

2. Explain the following figure or this question is written as: Using the DD-AA framework, show the phenomenon of overshooting. Use a figure to explain when it is taking place.

   • Overshooting

     • Cause: Prices sticky → monetary expansion causes E to overshoot long-run value.

3. Using the DD-AA framework, show the phenomenon of overshooting. Use a figure to explain when it is taking place.

   • Overshooting occurs when, following an economic shock, the exchange rate initially moves beyond its new equilibrium level before gradually returning. This happens due to faster asset market responses relative to slower adjustments in goods markets. 

4. Demonstrate how a permanent fiscal expansion will not increase output in the long run.

   • Permanent fiscal expansions don't affect long-run output under flexible exchange rates because they lead to currency appreciation, reducing net exports. Thus, fiscal policy only redistributes spending, leaving overall long-term output unchanged. 

5. Draw the J-curve with proper labels on the axes. Provide the rational for beginning part of the curve and later part when current account improves.

   • The J-curve illustrates that a currency depreciation initially worsens the current account due to contracts and adjustment lags. Over time, exports rise and imports decrease due to new contracts and adjusted behavior, improving the current account. 

Chapter 7: 

a.a. What happens at point 2, above the DD-AA curves?
At point 2, above DD-AA, output and asset markets are imbalanced. To restore equilibrium (point 1), currency appreciation occurs, lowering exports, decreasing output, and moving the economy back toward balanced asset markets and full employment.

b. Why is fiscal policy more effective under fixed exchange rates?
Fiscal policy is more effective under fixed exchange rates because monetary authorities must intervene to maintain exchange stability, thus preventing currency appreciation that would otherwise offset fiscal stimulus.

c. Why does home output fall more under floating rates?
Home output falls more sharply under a floating rate because an adverse export shock causes currency depreciation and falling domestic spending, magnifying the shock’s effect. Under fixed rates, monetary intervention stabilizes the currency and limits output losses.

d. What is sterilization and why can it be ineffective under fixed rates?
Sterilization intervention involves central banks offsetting foreign-exchange interventions with domestic open-market operations to stabilize the money supply. Under fixed rates, this becomes ineffective as sustained intervention ultimately alters monetary conditions and undermines initial sterilization efforts.

e. How does fiscal policy affect output under fixed rates?
Fiscal policy under fixed exchange rates is effective as central banks intervene to maintain the currency peg. This prevents currency appreciation, thus sustaining increased output from government spending.

f. How does domestic money market instability affect output under floating vs. fixed rates?
Under floating rates, instability in the domestic money market directly affects exchange rates, causing wider swings in output. In fixed rates, central banks absorb these shocks, maintaining greater stability.

g. What is devaluation and how does it impact the economy?
Devaluation occurs when a country intentionally reduces the fixed value of its currency relative to others. It stimulates exports and reduces imports, initially improving the trade balance and output by making domestic goods relatively cheaper internationally.

k. Why are sterilized interventions ineffective under perfect asset substitutability?
Under perfect asset substitutability, sterilized interventions are ineffective because investors quickly adjust portfolios without changing exchange rates or interest rates, neutralizing the intervention.

l. How does the gold standard respond to money supply expansion?
Under the gold standard, if the Bank of England expands money supply by buying domestic assets, gold reserves fall due to increased spending and imports. This gold outflow shrinks money supply, reversing the initial increase.

m. What is a gold exchange standard?
A gold exchange standard is where countries hold reserves in currencies convertible into gold rather than gold itself, typically maintaining reserves in currencies like USD or GBP, which were themselves backed by gold.

n. How do sterilized purchases affect exchange rates under imperfect asset substitutability?
Under imperfect asset substitutability, sterilized purchases of foreign assets can affect exchange rates because investors demand compensation (risk premium) for holding more domestic assets. This shifts the exchange rate despite sterilization.

o. What is the implied $/€ exchange rate from gold prices?
If gold is pegged at $35 per ounce and €12 per ounce, the dollar/euro exchange rate must remain fixed at $35/€12 ≈ $2.92/€.

p. What is the euro price of gold at $2.40/€?
Given gold at $35 per ounce and exchange rate $2.40 per euro, the euro price of gold must be $35/$2.40 ≈ €14.58 per ounce.

Chapter 8

a. What do the XX and II curves represent?
XX and II curves represent external and internal balances, respectively. Point 2 indicates internal imbalance (over- or under-employment) and external imbalance (deficit or surplus), and policies adjusting fiscal or exchange rates would move the economy toward balanced points (3, 4, and ultimately 1).

b. How does foreign inflation affect domestic prices under fixed exchange rates?
Under fixed exchange rates, inflation in the foreign economy is imported as higher foreign prices translate directly into domestic prices, resulting from the currency peg requiring monetary policy adjustments to maintain parity.

c. What is the Impossible Trinity (Trilemma)?
The Impossible Trinity states that countries cannot simultaneously achieve fixed exchange rates, independent monetary policy, and free capital mobility. Governments must choose at most two out of these three objectives.

d. How does devaluation affect national saving and investment?
Devaluation improves current accounts by boosting net exports, thereby potentially raising national savings due to increased income, or decreasing domestic investment as imported capital goods become costly.

Chapter 10

a. What is the theory of optimum currency areas and how does it apply to Europe?
The theory of optimum currency areas defines regions that benefit economically from sharing a currency. Europe isn't perfectly optimal due to diverse economic structures and limited labor mobility but benefits from reduced transaction costs and stabilized trade relations.

b. What do the GG and LL schedules represent?
GG and LL schedules represent gains and losses from adopting a fixed exchange rate. GG slopes downward as economic integration reduces currency exchange benefits, whereas LL slopes upward as integration reduces the risk of asymmetric shocks.

c. How do demand shifts affect the GG-LL equilibrium?
Increased frequency and magnitude of demand shifts increase economic stability losses under fixed rates, moving the GG-LL equilibrium point and suggesting a higher critical level of economic integration required for fixed rates to be beneficial.

d. What are the Maastricht criteria and the Stability and Growth Pact?
Maastricht criteria establish guidelines for EU countries joining the euro, requiring stability in inflation, interest rates, fiscal deficits, debt levels, and stable exchange rates. The Stability and Growth Pact continues this discipline post-adoption.

e. What is the credibility theory of the EMS?
Credibility theory of EMS suggests pegging currencies to stable economies (e.g., Germany) reduces inflation expectations, fostering price stability and credibility in monetary policies among participant countries.

f. What were the "rules of the game" under the gold standard?
The "rules of the game" under the gold standard meant surplus countries should expand money supplies, and deficit countries contract theirs. Central banks rarely followed these rules, prioritizing domestic economic stability over external balance.

Chapter 11

a. What are the structural issues facing developing countries?
Developing countries often have structural issues including weak institutions, dependence on primary exports, limited financial development, income inequalities, and vulnerability to external shocks.

b. What is "original sin" in the context of borrowing?
"Original sin" refers to countries' inability to borrow abroad in their domestic currencies, forcing them to issue debt in foreign currencies. This situation acts negatively during downturns, as currency depreciations sharply raise debt burdens.

c. What are subprime mortgages and how did they lead to the 2008 crisis?
Subprime mortgages are loans provided to borrowers with poor credit, collateralized by securitization into tradable assets. This securitization, combined with high defaults, sparked the 2008 financial crisis.

d. What are seigniorage, currency boards, dollarization, and contagion?
Seigniorage is government revenue from issuing currency; a currency board fixes currency strictly to foreign reserves; dollarization adopts another country’s currency; contagion describes rapid financial crises spreading internationally.

e. What are austerity measures and how were they applied in Greece?
Austerity measures are spending cuts or tax increases to reduce deficits, commonly demanded during international bailouts. Greece had to implement such austerity, including wage reductions and tax increases, for financial aid.

f. What caused the East Asian crisis?
The East Asian crisis resulted from excessive borrowing, asset bubbles, currency mismatches, and speculative attacks. Thailand, Indonesia, and South Korea faced common issues of short-term foreign debts and unsustainable current account deficits, exacerbated by rapid capital flow reversals.